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Investors Learn How to Hold Prime Subprime Villains Accountable

Investors and attorneys left a "subprime crisis" seminar in New York armed with ways to hold officers, directors and advisers of troubled financial services giants accountable for losing more than $700 billion on risky mortgage-backed securities.

Grant & Eisenhofer, the nation's leading class-action law firm, assembled a panel of financial and legal specialists April 3 to brief representatives of hedge funds and institutional investors on who caused the subprime meltdown and how to hold them responsible.

The Perfect Storm

The subprime problem is "a perfect storm that has spiraled into a full-blown national liquidity crisis," said pension fund adviser Steve Malinowski, the managing director of Global Transition Solutions.

"You can tell the size of the sickness by the size of the cure," he said, noting that the Federal Reserve Bank and the U.S. Treasury have already pumped in more than $750 billion to rescue Bear Stearns and other banks on the verge of collapse because of bad bets on exotic subprime-related investments.

When financial experts realized the enormity of the problem, Malinowski said, their reaction was the same as the fictional character Chief Brody when he first saw the monster shark in the movie "Jaws" - "You're gonna need a bigger boat."

One reason the problem is so big and far-reaching is that the financial services industry that accounted for less than 10 percent of the national economy in 1980 had mushroomed to more than 40 percent by 2007, Grant & Eisenhofer name partner Jay Eisenhofer explained.

There is much blame to go around, but proving liability will not be easy, he warned.

It could not have happened without the rating agencies, the panelists agreed.

The agencies that graded the packages of subprime-related securities that were up for sale to investors became too cozy with the sellers of those packages and often showed them how to manipulate their products to get them a top rating despite their high rate of risk, the panelists said.

We Didn't See It Coming

In addition, banks, brokers and dealers used tricky accounting practices to make subprime securities look more solid than they really were and kept bad loan packages off the books, the accounting experts said.

Kirsten Flanagan, a principal of accounting firm Shechtman Marks Dover PC, told the audience, "If you wonder why you didn't see it coming, look for three things: improper valuation of securities, untimely loss recognition and inadequate disclosure."

She said the banks used some of the same accounting gymnastics made famous in the implosion of Enron Corp., such as special purpose entities and special investment vehicles that conducted phantom transactions with each other.

Flanagan noted that many of the revealing disclosures about the mounting risks of subprime-backed securities were hidden in footnotes of company fiscal reports.

Eisenhofer said it comes down to "what did the various entities know [about how risky the investments were], when did they know it and how much were they responsible for knowing."

Winners and Losers

Banks' top officers made hundreds of millions of dollars in bonuses and other undeserved compensation by reaping the short-term gains of investing in lucrative "securitizations," which were securities based on subprime loans and bundled into packages in various price ranges, Eisenhofer said.

When the roof caved in, he said, the directors of the large banks not only failed to hold those CEOs accountable for taking the company out on a limb, but they lavished them with huge compensation packages/

According to figures Eisenhofer presented:

• Angelo Mozilo reaped more than $250 million from Countrywide Financial Corp. from 1998 to 2007 while the mortgage lender lost $25.5 billion and had to be rescued by Bank of America;
• Charles Prince left Citigroup with $28 million in compensation and a $10 million bonus even though he presided over a $178 billion loss at the investment bank; and
• Stanley O'Neil of Merrill Lynch & Co. got a $161 million retirement package even though the company lost $50 billion on his watch.

Investor Responses

Shareholders and consumers already have filed hundreds of suits against officers and directors of the lenders and their advisers.

Some charge that the officials breached their fiduciary duty to manage the company prudently and refrain from putting their own interests ahead of the investors'.

Other suits seek to recover the allegedly undeserved compensation the officers and directors reaped.

However, few of these kinds of suits survive early threshold tests for shareholder actions, Eisenhofer cautioned, because most of the companies are chartered in Delaware, where the business judgment rule gives officers and directors the benefit of the doubt.

Some shareholders allege that officers and directors violated federal securities laws when they misrepresented the value of the subprime-backed investments or the worth of the company stock that was inflated by phantom subprime profits.

However, many of those suits also die in their infancy because of the toughened pleading standards that Congress included in its reform of the securities laws in the 1990s, Eisenhofer said.

Taking advantage of the upcoming flurry of annual stockholder meetings, some shareholders are banding together in an effort to vote out the directors who allegedly were asleep at the switch.

William Patterson, the executive director of the Change to Win Investment Group, said he is marshalling an alliance of shareholders to register a vote of no confidence against several directors of Morgan Stanley April 8.

The first step to get corporate governance reform is to oust the directors responsible for getting the company into the mess - or at least to exert enough pressure on them to make them sit down and talk to unhappy investors, Patterson said.

The boards of some financial services companies already have gotten the message and are looking at ways to rein in the power - and the compensation levels - of top officers, but in other cases, push is going to come to shove in the upcoming proxy season, he predicted.

Grant & Eisenhofer name partner Stuart Grant said investors who want to hold banking officials accountable have options, but none of them are simple or easy.

The prevailing view in the financial community is that this is a "no consequences" fiscal accident, he said.

"It seems there's so much blame and so little liability."

To comment, ask questions or contribute articles, contact West.Andrews.Editor@Thomson.com.

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Corporate Officers & Directors Liability Litigation Reporter
Volume 23, Issue 21
04/10/2008

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