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Shareholder Suits Face Uncertainty, Higher Hurdles
The National Law Journal
September 29, 2008
The bailouts and bankruptcies of some of Wall Street's most prominent financial firms could hinder the claims of plaintiffs who have filed shareholder lawsuits against those companies.
Also, attorneys warn that shareholder actions face much greater difficulty than those filed against Enron Corp. and WorldCom Inc.
This month's bankruptcy of Lehman Brothers Holdings Inc., the $85 billion loan to American International Group Inc. (AIG) and the bailout of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) have, in some cases, put a temporary freeze on the dozens of shareholder lawsuits filed in recent months against those companies.
While most of the companies have not responded to the suits, which generally allege securities fraud and breach of fiduciary duties, many defense attorneys anticipate that plaintiffs could have a difficult time blaming specific companies and their individual directors and officers for what could be interpreted as uncontrollable economic forces that caused the unprecedented collapse of so many firms.
Further, the U.S. Supreme Court's decision this year in Stoneridge Inv. Partners LLC v. Scientific-Atlanta, 128 S. Ct. 761 could limit plaintiffs attorneys' ability to target third parties who had some involvement in approving questionable investments. Stoneridge limits the ability of shareholders to go after accountants, bankers and customers of the firms.
But plaintiffs attorneys said the suits pin the blame on executives and directors, who are not subject to Stoneridge, for having made false statements about the defendant's financial health in the midst of a known mortgage crisis.
And in contrast to the days of the Enron and WorldCom collapses, plaintiffs attorneys now represent sophisticated institutional investors with considerable losses. Nowhere is this more apparent than in the suits filed against the managers of the Reserve Primary Fund, the money market mutual fund that "broke the buck" -- its valuation declined to below $1 a share -- less than two weeks ago.
THE UNCLE SAM FACTOR
What remains less clear on both sides is the involvement of the U.S. government in financing individual companies and in rescuing the nation's economy. Last week, President Bush, Treasury Secretary Henry M. Paulson and Federal Reserve Chairman Ben S. Bernanke proposed a $700 billion plan to salvage the financial system; members of Congress questioned several elements of that proposal. "All these things are up in the air," said Matthew Gluck, a partner at New York-based Milberg.
What is certain, he said, is that "many more people will want to sue and want to hold somebody responsible. That's the easy part. Beyond that, I don't think anybody really knows."
Most recent shareholder litigation has been against companies that have divulged investments in high-risk securities, often tied to subprime mortgages, which has caused stock prices to plummet. Other suits have pinpointed auction-rate securities.
But this month, some of Wall Street's largest companies made startling announcements. On Sept. 7, the U.S. government said it would seize control of mortgage lenders Fannie Mae and Freddie Mac. On Sept. 15, Lehman filed for Chapter 11 bankruptcy protection. One day later, the U.S. government loaned $85 billion to insurance firm AIG.
Meanwhile, the FBI is conducting preliminary investigations of AIG, Lehman, Fannie Mae and Freddie Mac, according to news reports last week.
In addition to dozens of shareholder lawsuits -- both derivative actions and class actions -- all four companies face related suits filed on behalf of their employees who had retirement plans tied up in company stock. Those suits are filed under the Employee Retirement Income Security Act of 1974 (ERISA).
Calls to AIG's lawyer, Joseph Allerhand, a partner at New York's Weil, Gotshal & Manges, were returned by Mike Ford, the law firm's spokesman, who declined comment.
Calls were not returned by a lawyer for Lehman, Michael Chepiga, a partner at New York's Simpson Thacher & Bartlett, or by Michael Walsh, of counsel to the Washington office of O'Melveny & Myers, who represents Fannie Mae, which, along with Freddie Mac, has been put under conservatorship of the Federal Housing Finance Agency.
In general, the claims involving these companies state that the defendants "knew that your financials, which you were telling to people, were untrue because you were carrying this garbage," Gluck said.
HIGHER HURDLE
Lawyers on both sides admit that shareholder cases face a higher burden this time around than they did in the litigation against Enron and WorldCom.
Gluck said the fraud is not as "blatant" as was the case in Enron and WorldCom. "This is just not as clear-cut as an Enron or WorldCom, where you have plain old phony transactions," he said.
A lawyer who represents companies implicated in the recent spate of shareholder suits, who spoke on condition of anonymity, said the defendants are anticipated to argue that nobody could have predicted the implications of the mortgage meltdown. Further, the questionable investments were public and not contrived behind closed doors.
In ERISA claims, said Shannon Barrett, of counsel to the Washington office of O'Melveny & Myers, the question becomes: What did the fiduciaries of the employee retirement plan know before failing to pull investments out? Most of those suits will focus on the dramatic collapses of the defendants, whether into bankruptcies or government bailouts, he said.
"That becomes a very big issue and will be a key issue in these cases, which are not developed on insider information or some type of alleged fraud," Barrett said.
Without evidence revealing that the fiduciaries had insider information, which would put them in a better position to administer the plan, the facts "set a hurdle higher for plaintiffs," he said.
The role of the U.S. government intervening in some of the defendant companies could complicate matters, also.
Gluck said the U.S. government could persuade plaintiffs attorneys not to sue the companies in which it has taken some form of control, such as Fannie Mae or Freddie Mac. "The company's decisions about how to handle your lawsuit will be made by people appointed by the government," he said.
Then there's Stoneridge.
"There's no question that the Stoneridge decision presents obstacles for recovering against culpable third parties who actively participated in the fraud but did not make statements to the market, which is utterly unfortunate because it could lead to a significant diminution of recovery for investors," said Blair Nicholas, a partner in the San Diego office of New York's Bernstein Litowitz Berger & Grossmann, which has filed shareholder suits against AIG and Lehman.
But plaintiffs lawyers remain optimistic about their cases. They note that many of the shareholder suits are filed against individuals not subject to Stoneridge, such as the directors and officers of the defendants and the underwriters of public offerings made prior to the defendant company's collapse.
Additionally, ERISA claims aren't subject to Stoneridge, said Mark Rifkin, a partner at New York's Wolf Haldenstein Adler Freeman & Herz, who has filed an ERISA suit against directors and officers of Lehman.
While the effect of U.S. government intervention is unclear, the dramatic cash infusions prevented bankruptcies that could have complicated shareholder claims, said Robert Izard, a shareholder at Izard Nobel in Hartford, Conn., who filed an ERISA suit against AIG's retirement board.
"I don't know how it's all going to ultimately work out," Izard said, "but for the ability of the cases to go forward, that's a plus."
Most of the suits are based on press releases, financial disclosures and other statements that members of management made assuring shareholders that their investments were sound.
A finding that individuals committed wrongdoing would strengthen those claims, said Darren Robbins, a partner at San Diego-based Coughlin Stoia Geller Rudman & Robbins, which has shareholder suits against Lehman, Fannie Mae and AIG.
But Robbins insisted that there already are indications of fraud, particularly in the circumstances surrounding Fannie Mae and Freddie Mac.
"If you are willing to agree that the balance sheets of Fannie and Freddie were appropriately stated over the last nine months," he said, "I've got an impressive bridge to sell you."
He also said plaintiffs attorneys have another spear to throw at defendants: sophisticated institutional investors.
THE PRIMARY FUND
Some institutional investors have filed individual claims in the past few weeks involving the Reserve Primary Fund, the money market mutual fund that fell below $1 per share this month after divulging it had invested in securities issued by Lehman. That figure is considered a benchmark for money market funds, and it is only the second time in history that such a fund has fallen below that level.
In one case, Ameriprise Financial Services Inc., which had client assets valued at $1.2 billion in the Primary Fund, claimed that other institutional investors were tipped off to pull their money out so as to redeem their holdings at $1 per share. Ameriprise Financial Services Inc. v. The Reserve Fund, No. 08-cv-05219 (D. Minn.).
H. Adam Prussin, a partner at New York's Pomerantz Haudek Block Grossman & Gross, filed another Reserve Primary Fund suit in which investors that redeemed their funds after a critical deadline got a lower price. "Our suit focuses on this: that essentially they shouldn't have allowed that to happen," he said. "They knew right away they would be writing off this major asset."
Other suits claim violations of the Investment Company Act of 1940. Those suits allege that, by making riskier investments than what was stated in the Reserve Primary Fund's investment objective, its managers deviated from the stated investment objective to preserve capital. "That deviation resulted in the fund 'breaking the buck,'" said James Harrod, a partner at New York's Wolf Popper, who filed such a class action against the Reserve Primary Fund. Pomerantz v. The Primary Fund, No. 08-cv-08060 (S.D.N.Y.).
