[authors: Jennifer Broda, Matthew Ferguson, Thomas Orofino, and Eric Scheiner]
This issue of the Credit Crunch Digest focuses on various actions brought by the FDIC, as the receiver for failed banks, against large financial institutions for losses arising out of mortgage-backed securities sold to the defunct institutions; a standing decision by the Second Circuit Court of Appeals in mortgage-backed securities class actions; a guilty plea by a former Peregrine CEO; a mortgage-backed security lawsuit against Goldman Sachs; developments in the Libor scandal; issues pertaining to the implementation of the Volcker Rule; and resistance to the Consumer Financial Protection Bureau.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Litigation and Regulatory Investigations
FDIC Seeks Extensive Damages From Big Banks for Losses of Failed Guaranty Bank
The Federal Deposit Insurance Corporation (FDIC) has sued Goldman Sachs & Co. and other big banks in a Texas state court, seeking $2.1 billion in damages for the banks’ alleged role in convincing the now-defunct Guaranty Bank to purchase mortgage-backed securities (MBS). Guaranty’s 2009 failure was attributed to massive losses in its securities portfolio, which invested more than $5.4 billion in MBS products. The FDIC, as receiver of Guaranty, has alleged that the MBS offering documents, offered by the big banks, contained omissions or made misleading statements regarding the conditions of the underlying loans, including the appraisal quality, occupancy rates of borrowers and underwriting standards employed by loan originators.
Other banks named in connection with the lawsuits surrounding Guaranty’s failure are Bank of America Corp., JP Morgan Chase & Co., Ally Financial Inc., Royal Bank of Scotland and Deutsche Bank AG. The FDIC has also recently brought similar lawsuits in Alabama, New York and California against other large financial institutions in connection with the failure of Colonial Bank and its MBS investment losses. (“FDIC Demands $2B From Goldman, BofA, Others Over MBS,” Law360, August 21, 2012).
Second Circuit Issues Pro-Plaintiff Standing Decision in MBS Cases
On September 6, 2012, the U.S. Court of Appeals for the Second Circuit held that a plaintiff had standing to assert claims not only against originators of offering certificates in which the plaintiff specifically invested, but could also proceed with claims on behalf of purchasers of certificates backed by mortgages originated by the same lenders. According to the court, such claims implicate “the same set of concerns” as the plaintiff’s individual claims. In doing so, the Second Circuit rejected the defendants’ argument that the plaintiff lacked standing to bring claims on behalf of investors in different certificates.
The District Court previously found that the plaintiff, who had purchased securities in two of the 17 MBS offerings by Goldman Sachs, could only assert claims on behalf of those investors in the offerings in which the plaintiff participated, but not on behalf of the investors in the other 15 offerings. The Second Circuit reversed, reasoning that since the plaintiff sought to represent investors in a securities case where the alleged misrepresentation involved the origination practices of the same mortgage lenders, the plaintiff’s claims and the other investors’ claims represented the “same set of concerns.” While the Second Circuit concluded that the plaintiff could represent investors in seven of the offerings since they involved mortgages originated by common lenders, it also held that the plaintiff could not represent investors investing in securities backed by mortgages originated by other originators, since those were “different in character and origin.” (“Second Circuit Hands Subprime Mortgage-Backed Securities Plaintiffs Substantial Standing Victory,” D&O Diary, September 7, 2012).
Fraud and Ponzi Schemes
Peregrine CEO Signs Plea Agreement to Fraud and Embezzlement Scheme
Federal prosecutors report that they have reached a plea agreement with Russell Wasendorf, Sr., the head of Peregrine Financial Group, Inc., in which he admitted to orchestrating a $200 million embezzlement scheme. Wasendorf will plead guilty to mail fraud, making false statements to authorities and embezzlement. He faces up to 50 years in prison. Wasendorf previously pleaded not guilty to 31 state and federal charges relating to the fraud and embezzlement.
Wasendorf was reportedly cooperating with investigators probing his actions in inflating the value of customer funds that were held by the shuttered brokerage. Peregrine’s receiver noted that Wasendorf has spent hours with prosecutors and regulators assisting in the identification and recovery of assets.
Peregrine filed for bankruptcy on July 10, 2012, after receiving notification that it was subject to an action by the U.S. Commodities Futures Trading Commission (CFTC) for misappropriating more than $200 million in customer funds. The filing also followed Wasendorf’s failed suicide attempt, in which he left a note addressing the fraud.
In other developments, the CFTC urged an Illinois court overseeing the bankruptcy to be cautious and not to return customer funds too quickly, asserting that the company’s records may be unreliable given the circumstances of the collapse. The CFTC stated that additional testing should first be performed to ensure that Peregrine’s books were not further manipulated by Wasendorf. (“Peregrine CEO Admits To $200M Fraud, Inks Plea Agreement,” Law360, September 11, 2012).
Lawsuit Filed Against Citigroup, Goldman Sachs and UBS Alleging Fraudulent Misrepresentations Related to Mortgage-Backed Securities
On September 5, 2012, three separate lawsuits were filed in New York state court against Citigroup, Inc., Goldman Sachs Group, Inc. and UBS AG alleging both fraud and negligent misrepresentation in connection with the banks’ sales of certain residential mortgage-backed securities. Specifically, IKB Deutsche Industriebank, AG alleges it lost more than $137 million in the securities it purchased from Citigroup, and lost in excess of an additional $73 million from the securities it purchased from Goldman Sachs. In a separate suit, Sealink Funding Ltd. sued UBS alleging that it lost more than $158 million in bonds that Sealink either held or sold at a loss. (“Citigroup, Goldman, UBS Sued Over Mortgage-Backed Bonds,” Bloomberg, September 5, 2012).
Congress Grants NY Fed Additional Time to Provide Libor Documents
The Federal Reserve Bank of New York has received some relief from Congress’ prior requests that it produce internal communications related to possible Libor manipulation, granting the New York Fed additional time to respond. In addition, the House Financial Oversight Committee has also scaled back the scope of documents it initially requested, narrowing its requests to emails among New York Fed employees, as well as emails between those employees and regulators. Previously, Congress sought all bank communications since August 2007 regarding reporting and submissions of Libor rates, communications between the New York Fed and U.S. and U.K regulators, as well as all communications between the New York Fed and the 16 other banks that are responsible for setting Libor. However, Congress has reserved its rights to request additional documents at a later date. Reports suggest that the New York Fed is required to provide the documents by the end of September 2012. It appears that it has already produced some documents responsive to the more limited request, and that such documents indicate that the bank was dealing with the Libor manipulation issue as early as 2008. Specifically, the documents include communications from U.S. Treasury Secretary Timothy Geithner, the former New York Fed president, urging U.K regulators to implement changes relating to transparency in setting Libor. (“New York Fed Gets More Time To Produce Libor Documents,” Law360.com, August 29, 2012).
Government and Regulatory Intervention
Regulators Aim to Finalize Volcker Rule by Year’s End
According to the FDIC, the Volcker rule, named for former Federal Reserve Chair Paul Volcker, is on track to be completed by year’s end. Mandated by the 2010 Dodd-Frank financial reform legislation, the Volcker rule is aimed at preventing financial institutions that receive government backstops from taking risky positions for their own benefit, instead of investing on behalf of customers. With intense lobbying from groups both inside and outside the financial industry, the Volcker rule has received considerable publicity regarding its potential effect on banks. Banking groups have argued that the rule could make it hard for banks to raise capital. Additionally, banks have made it known that any rule must contain an exemption for proprietary trading aimed to help the banks hedge their own risk. The breadth of any exemption for hedging is now under scrutiny after it was revealed in May that JPMorgan Chase & Co. lost at least $5.8 billion due to a failed hedging strategy that put the bank into risky bets. After the Volcker rule is finalized and in place, banks will have until July 21, 2014 to fully comply. (“UPDATE 2 - Volcker Rule on Track for Completion by Year-End-FDIC Chief,” Reuters, September 14, 2012).
Consumer Financial Protection Bureau Faces Stiff Opposition From Republican State AGs
As part of the 2010 Dodd-Frank financial reform legislation, the Consumer Financial Protection Bureau (CFPB) was created in order to consolidate federal financial consumer protection into one agency. Republicans were not in favor of the new agency and would not confirm any appointments to the head of the CFPB. As a result, on January 4, 2012, President Obama appointed Richard Cordray to the head of the CFPB in a recess appointment. After his appointment, Cordray asked all 50 states to sign a memorandum of understanding designed to ensure confidentiality of any sensitive information exchanged among the states and the agency. To date, only 12 states, all but one with Democratic attorneys general, have signed the document. Four Republican attorneys general, led by Oklahoma Attorney General Scott Pruitt, have announced their intention to join an existing lawsuit that is challenging the constitutionality of Dodd-Frank, and specifically the CFPB. “There are misgivings I have about the authority and scope and power of the CFPB and the power granted to the director,” said Pruitt. According to Pruitt, “until some of those issues are fleshed out, it is very premature for a state to enter into [the memorandum of understanding].” (“Republican State AGs Resisting Cooperation With CFPB,” Bloomberg, September 19, 2012.)