Subprime Mortgages and Theories of Liability - Deja Vu? - Part TwoMichael Clark
August 13, 2008 — 1,158 views
Part One of this series focused on certain features of the subprime mortgages now defaulting in huge numbers and explained how these features also were uncovered in many improper transactions related to the Savings and Loan Crisis of the early 1990s as well as in the more recent scandals associated with enormous investor losses typified by Enron and WorldCom (which problems, coupled with similar corporate scandals, in turn, led to a crisis of confidence by the investing public that was followed by the enactment of various corporate governance reform measures set out in the SarbanesOxley Act).
Part Two of this series now examines some cases, issues, and theories of liability that plaintiffs and regulators are relying upon to establish the civil and criminal liability of the defendants in various suits for damages sustained in connection with the implosion of the subprime mortgage market.
What is a Subprime Mortgage? (A HighRisk Loan by any Other Name)
If the term "subprime loan " had not become a widely used euphemism for describing highrisk loans, then perhaps investors would not have been so willing to buy the securities created by bundling and securitizing highrisk mortgages. Significantly, most buyers of these securities were "institutional " or "accredited" investors who should have known about the securities' inherent risk. Companies holding these securities have now lost many billions of dollars in shareholder equity and that is just a start. See, e.g., Steven L. Schwarcz, Disclosure's Failure in the Subprime Mortgage Crisis, Research Paper No. 203 at 2, n.5 (March 2008) (citing, among other examples, Jenny Anderson, "Wall St. Banks Confront a String of Write Downs," N.Y. TIMES, Feb. 19, 2008, at C1 ("major banks ... have already written off more than $120 billion of losses stemming from bad mortgagerelated investments") and "Wall Street Banks Slashing Workforces," CHI. TRI., Mar. 25, 2008, at C2 ("[t]he collapse of the subprime mortgage market last year and the ensuing credit contraction have saddled the world's largest financial institutions with at least $200 billion of writedowns and losses ")) (forthcoming Utah Law Review (2008), as part of the University of Utah S.J. Quinney College of Law and Utah Law Review symposium: "Subprime Meltdown: The Law and Finance of the American Home Mortgage ForeclosureCrisis "), available at http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1114810_code485747.pdf?abstractid=1113034&mirid=1.
While they are risky, subprime mortgages are also thought to provide salutary effects by opening up the benefits of home ownership to the poorer members of society (who are disproportionately minorities). This, of course, assumes the absence of predatory lending activities that have led too many subprime mortgage holders into financial ruin. See Roberto G. Quercia, et al., The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment Penalties and Balloon Payments , 18 Housing Policy Debate, No. 2, 311, 311 (2007) ("Even after we control for other factors, refinance loans with prepayment penalties are 20 percent more likely and those with balloon payments are 50 percent more likely to experience a foreclosure than other loans. These findings suggest that predatory loans have the potential not only to erode household wealth, but also to heighten negative effects on individuals, households, and communities ") and Kathleen Engel and Patricia A. McCoy, Turning A Blind Eye: Wall Street Finance of Predatory Lending, 75 Fordham L. Rev. (March 2007) (arguing, inter alia, that "Wall Street firms securitize subprime home loans without determining if loan pools contain predatory loans" and that some secondary market actors "have actively facilitated abusive lending"), available at: http://ssrn.com/abstract=910378
While there are Many Subprime Lawsuits, Can the Plaintiffs Meet their Burden?
Increasingly, shareholders of the companies and others are seeking relief from the courts: Over 100 class actions have been filed seeking damages allegedly tied to misconduct related to the purchase of such securities. See, e.g., Kevin M. LaxCroix, "Subprime Related Securities Class Actions, " The D & O Diary (as of July 25, 2008), available at http://www.dandodiary.com/tags/subprimerelatedclass action. See also Sherry Karabin, Wipeout!, Corporate Counsel (June 1, 2008) (citing a Navigant Consulting report that 448 subprimerelated cases were filed in federal court from January 2007 to March 2008), available at http://www.law.com/jsp/ihc/PubArticleIHC.jsp? id=1202421863173 . The defendants named in these actions are well known and include several of the nation's financial leaders: Merrill Lynch, Morgan Stanley, UBS AG, Wachovia Corporation, and Washington Mutual, among others.
Sophisticated Investors and Disclosed Risks Spell Trouble for Plaintiffs
It is worth noting that the plaintiffs in these securities fraud class actions face major hurdles. For one thing, because institutional or accredited investors are considered to be capable of evaluating the merits and risks of prospective investments, they do not need to be given the breadth of warnings that the SEC otherwise ordinarily requires. See Securities Act Rule 501(a)(1), (2) and (3), codified at 7 C.F.R. §230.501(a)(1), (2) and (3). See also, SEC Staff Report of the Task Force on MortgageBacked Securities Disclosure, "Enhancing Disclosure in the Mortgage Backed Securities Markets" (Jan. 2003), available at www.sec.gov/news/studies/mortgagebacked.htm .
Consequently, these plaintiffs cannot realistically expect to establish securities fraud liability by relying, as they commonly do, on evidence of material omissions . Rather, they must allege and prove causation and damages tied to materially fraudulent or misleading acts of commission . As I have noted elsewhere, because the securities laws are not designed to operate as insurance for foolish decisions, courts also examine the mix of information . . . already in the marketplace to determine whether the failure . . . to provide the information was actionable. "In analyzing Rule 10b5 causation issues, courts often state that investors may not simply close their eyes to obvious risks, but must exercise due diligence in protecting themselves." Michael E. Clark, "Securities Law Issues and Disclosure, " Ch. 12 IV. C., at 779, Pharmaceutical Law: Regulation of Research, Development and Marketing (BNA 2007) (citing C. Edward Fletcher, Sophisticated Investors under the Federal Securities Laws, 1988 Duke L.J. 1081, 1090 (1988) (internal notes omitted)). Moreover, as Professor Steven L. Schwarcz explains, "[m]ost . . . of the risks giving rise to the collapse of the market for securities backed by subprime mortgages were disclosed, yet the disclosure was insufficient, in part because complexity made the risks very difficult to understand." Schwarcz, Disclosure's Failure in the Subprime Mortgage Crisis , Research Paper No. 203 at 2.
More to Come...
Michael E. Clark, a former federal prosecutor, has extensive trial experience in business and professional matters. He serves as an Adjunct Professor of Law, as a faculty instructor for NITA, is widely published, and speaks regularly on issues of importance to businesses and professionals. Within the ABA, he serves on the Standing Committee on Publishing Oversight; is the outgoing chair of the Business Law Section's White Collar Crimes Committee (and an Editorial Board member of The Business Lawyer); serves on the Governing Council for the Health Law Section and is the outgoing chair of its Publications Committee; and serves on the Planning Committee for the National Institute on Securities Fraud. Mr. Clark is a Fellow of the American Bar Foundation and he developed and serves as the Editor-in-Chief of a treatise published in 2007 by BNA and the ABA Health Law Section about pharmaceutical law. Mr. Clark has been Board Certified in Criminal Law by the Texas Board of Legal Specialization and the National Board of Trial Advocacy since the late 1980's.