Corporate Governance

From the Pages of The Pomerantz Monitor: The Next Wave of Subprime Litigation

By Carolyn Moskowitz

As Joshua Silverman reports in the October issue of The Pomerantz Monitor, it?s not surprising that the first wave of litigation arising out of the mortgage meltdown focused on the common stocks of companies with subprime-related businesses. These were primarily run-of-the-mill securities fraud cases brought against investment banks, mortgage REITs, homebuilders and other companies that had invested in mortgage-related securities. The suits allege that these companies misled investors about the extent of the risks posed by their exposure to subprime loans or mortgage-related securities, and were forced to take charges or incur losses as the true exposure was revealed.

 
The second wave of mortgage-related litigation will likely be much different. The new cases will address direct losses of investors in mortgage-related securities products such as residential mortgage-backed securities (?RMBS?), also known as pass-through certificates, asset-backed securities (?ABS?), and even more exotic products like collateralized-debt obligations (?CDOs?). Some will be class actions, but many will be individual claims by institutional investors. 

These new cases will be driven by the structure of the securities in question. In a typical RMBS deal, for example, a mortgage originator or REIT will package and sell a large pool of mortgages to a special-purpose trust, which in turn (with the assistance of an underwriter) registers with the Securities and Exchange Commission to offer interest-bearing notes in various tranches, representing rights to the cash flow generated by the underlying mortgage pool. The underwriter then markets the securities by way of a prospectus or summary term sheet to fixed-income investors as conservative investments offering a modest yield premium to LIBOR or Treasury securities. 

If an RMBS declines in value, the representations made in the registration statement and prospectus become critical, and may determine whether investors can recover losses. Investors able to demonstrate that the origination guidelines, appraisal practices or underwriting safeguards described in the registration statement and prospectus were not actually followed in selecting the mortgage collateral backing the RMBS may have strong claims under the investor-friendly provisions of the Securities Act of 1933, or common-law theories such as negligent misrepresentation. 

CDO cases are generally more difficult, because the deals are structured to protect the issuing entities from litigation. CDOs are usually offered by way of a private placement. They are not registered in the United States, and frequently use trusts domiciled in the Cayman Islands or other offshore havens. As a result, CDOs are typically outside the scope of the Securities Act of 1933, and establishing personal jurisdiction is often a challenge. However, depending upon the specific facts involved, some CDO cases are still viable and worth pursuing. 

Although we don?t like to toot our own horn, we can say that while many securities firms shy away from RMBS, ABS and CDO cases because they?re labor intensive, demand specialized understanding of complex instruments, and require the assistance of top experts, the Pomerantz Firm does not. Instead, we developed that expertise internally, forged relationships with nationally-recognized experts, and have since investigated several dozen RMBS, ABS and CDO deals for our institutional clients. We have found numerous instances where mortgage originators systematically ignored stated guidelines, encouraged borrowers to lie on mortgage applications, or pressured appraisers to inflate the appraised value of the underlying property, or where brokers misrepresented CDO terms to investors. We currently represent three large state funds in a lawsuit against Countrywide Financial Corporation and its affiliates, underwriters, and responsible officers, for Securities Act and state law violations with respect to fifteen Countrywide RMBS and ABS offerings. We also represent several corporations which purchased CDO Auction Rate Securities through indicted Credit Suisse brokers Julian Tzolov and Eric Butler. 

Full post as published by PomTalk on October 23, 2008 (boomark / email).