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Corporate & Securities Law

: Wall Street Law Blog

Self-interested gross negligence cannot be protected by the business judgement rule.

By Brett D. Sherman

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Guest blogger Phyllis Barrack

The Sherman Law Firm

Repeated decisions by Jimmy Cayne and Alan Schwartz not to seek an equity investment after the onset of the subprime crisis are not protected by the business judgement rule.

Bear Stearns' CEO Jimmy Cayne and his successor Alan Schwartz each made deliberate decisions not to raise equity after the collapse of Bear Stearns' subprime hedge funds in the summer of 2007. These decisions were irresponsible and driven in part by self-interest.

Credit markets began to constrict when the subprime crisis began in the summer of 2007. Lenders grew more cautious during the flurry of bank mark-downs on mortgage-backed securities and collateralized debt obligations.

From early September 2007 Bear Stearns executives frequently urged Bear Stearns CEO Jimmy Cayne andPresident Alan Schwartz to obtain a substantial cash infusion.

Cayne and Schwartz met with potential investors but ultimately found a reason why each deal could not work. Ultimately, Cayne concluded that he was not interested in an equity investment, and Schwartz concurred.

In January 2008, when Schwartz took over as CEO, Bear Stearns executives stressed the need to raise money. Schwartz expressly stated that Bear Stearns had no need for additional equity.

Bear Stearns had a huge portfolio of mortgage-backed securities and related products, which the firm estimated to be worth 45 billion in October 2007 and 46 billion in March 2008.

Regardless of Bear Stearns' appraisal of its portfolio, during the week of March 10, no lender was willing to accept the mortgage portfolio as collateral worth 46 billion (or anything remotely close).

Bear Stearns could not have been surprised at the further tightening of credit and the dimmer view that lenders were taking of mortgage securities in the early months of 2008.

In mid-February, UBS had written down more than 20 billion from its Alt-A mortgage holdings.

In early March a large mortgage-backed securities hedge fund owned in part by the white-shoe Carlyle Group could not meet margin calls and ran out of money.

On March 10, 2008, Moody's downgraded an Alt-A offering issued by Bear Stearns itself. The markets clearly were according virtually no value to mortgage-backed securities. Bear Stearns had a liquidity problem. The rumors were true.

Still, Executive Committee Chairman Ace Greenberg and CEO Alan Schwartz publicly claimed that the Company did not face a liquidity crisis until late in the week of March 10. They pointed to the $18 billion in cash Bear held in its accounts.

However, Bear Stearns' liquidity requirements were far greater than $18 billion.

In fact, Bear had a daily liquidity requirement of about $50 to $75 billion to fund its businesses. Most of Bear Stearns daily liquidity came in the form of overnight repo loans. Overnight repos must be renewed, or rolled, each business day. Repo loans are secured. They require collateral.

Much of the collateral Bear Stearns regularly used to secure repo loans came from the firm's huge portfolio of toxic mortgage-backed securities and related instruments.

In March 2008, Bear Stearns showed 45 billion in mortgage-related securities on its balance sheet. No lender was willing to accept Bear Stearns' valuation, and many lenders chose not to accept mortgage-backed securities as collateral at any price.

Board Chairman Jimmy Cayne and CEO Alan Schwartz each knew the MBS collateral the firm used to secure its short term lending was distressed if not totally illquid. Allowing the firm to reach that point without raising equity, selling the Company, or selling off mortgage securities was more than an error in judgment. It was plain ignornance and incompetence by men who have a duty to be knowledgeable and competent. Bear's executives cannot be protected by the business judgment rule.

Full post as published by Wall Street Law Blog on May 21, 2009 (boomark / email).