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From lenders to investment banks to rating agencies, the subprime wave is dragging down all the key players in mortgage markets. But the vulnerable don’t stop there. This disaster is seeping toward major nonfinancial companies, such as Bristol-Myers Squibb Co. and Ciena Corp., that hold securities backed by subprime mortgages. Huge losses could swamp many more. The flotsam of this economic crisis is litigation and prosecution on a scale perhaps larger than any seen before. At current count (which is rising daily), about 40 subprime-related securities class actions have been filed. There are at least 10 lawsuits under the Employee Retirement Income Security Act, alleging fiduciary breaches that impaired the value of retirement accounts. The Securities and Exchange Commission is investigating more than 20 companies; the FBI is investigating at least 16. The Federal Trade Commission is said to be considering unfair- and deceptive-marketing suits. Attorneys general in several states have issued subpoenas. The waves are rushing in. Corporate counsel must launch the rescue boats now. Who will allege that your company caused them harm? What is the likely nature and scope of those allegations? With multiple plaintiffs claiming a variety of wrongs and hundreds of places to look for facts, how do you identify the data needed for defense? WHO WILL GET STUCK? Begin by thinking about potential plaintiffs. When asked to forecast the scope of subprime litigation, a panelist at a recent conference for investment bankers said simply, “Everyone’s going to sue everyone.” He may be right. Waves of litigation have struck before — over accounting fraud, tobacco, and the savings-and-loan crisis. But in the sheer number of potential participants, applicable laws and regulations, and complex data, none was more pervasive than subprime litigation is becoming. If lawyers remember nothing else from their commercial-paper class, they should recall the ultimate question to be answered in any commercial transaction gone bad: Who will be the “stuckee”? In other words, who will get stuck bearing the loss? Potential subprime stuckees are those who bought, held, sold, bundled, insured, rated, or otherwise dealt with loans that may have been bad from the outset or may have become tainted along the way. Defendants for today and tomorrow include the following parties. Lenders and mortgage brokers: With the biggest role at the very outset of the mortgage loan, lenders and mortgage brokers face a host of allegations related to subprime abuses: Did they misrepresent loan terms, lure borrowers with deceptive teaser rates, fail to adequately disclose the risks to borrowers, or engage in discriminatory lending practices? From the borrower’s first contact through loan origination, possible securitization, and sale to a Wall Street investor, a single loan can be touched by more than a dozen parties and generate hundreds of pieces of paper. Among the billions of data points created by origination and securitization — now hidden in document warehouses, in virtual warehouses, and in process and training manuals — are the facts needed to defend lenders and brokers. The litigation heat is coming from those both up and down the subprime supply chain, from Wall Street investors and interest groups representing borrowers. Even cities are going after lenders in court. Last month, Baltimore sued Wells Fargo Bank, alleging that it engaged in a pattern of predatory lending in Baltimore’s poorest neighborhoods, leading to foreclosure rates almost twice the city’s average. Baltimore claims that Wells Fargo engaged in so-called reverse redlining by targeting black neighborhoods for high-risk and unfairly priced loans. Mortgage service providers: Third-party providers such as mortgage servicers, appraisers, title and mortgage insurers, and closing attorneys are also litigation targets. Several examples illustrate the diversity and complexity of the potential allegations. In November 2007, the attorney general of New York filed suit against eAppraiseIT and its parent company, First American Corp., alleging their complicity in providing inflated property appraisals to the lender Washington Mutual, which may have resulted in corporate losses adversely affecting investors. The four biggest title insurance firms in New York also face suit — for alleged anti-competitive practices, including price fixing, collusion, and payment of kickbacks in exchange for business. Regulators in at least six states are examining whether title insurers engaged in steering, kickbacks, and referral fees that raised the cost of mortgagees’ policies. Investment banks: Investment banks made a major dive into the mortgage water in 2004 and 2005, issuing bonds representing pools of mortgage loans, otherwise known as mortgage-backed securities. As subprime loans became more popular, these bonds often included the riskier loans. The riskier the bond, the higher the potential payoff. And many investors bit. After all, it looked like a pretty safe bet: Even if mortgage borrowers couldn’t make their payments, the value of homes was appreciating rapidly across the country. If a borrower was unable to make payments, the property could surely be resold for a profit. Fast-forward to the present: Over the past six months, more than $175 billion in write-downs have resulted from the unexpected decline in the subprime market. Shareholder suits will be the obvious source of discomfort for investment banks. In December, for example, Reuters reported that an upset UBS AG shareholder was suing the Swiss banking giant for misstatements related to multibillion-dollar write-downs. Similar lawsuits are on the way, as are allegations surrounding more complex subprime-related financial instruments. A vigorous battle not to be the stuckee is playing out in court among trustees, investors, and insurers of “collateralized debt obligations,” a relatively new Wall Street instrument that coincided with the enormous upswing in the housing industry. Investors in hedge funds, pension funds, and mutual funds are suing fund managers who invested in the mortgage-backed CDOs. Among them, the Massachusetts state securities regulator has sued Merrill Lynch & Co. for selling unsuitable subprime-mortgage-backed CDOs to the city of Springfield. And the Justice Department is looking into questions of fraud in the packaging and sale of CDOs. Another relatively new Wall Street construct, variable-rate debt instruments called “auction rate securities” backed by subprime loans, is the subject of current and anticipated litigation. Auction rate securities are generally long-term bonds issued by municipalities (including the Port Authority of New York and New Jersey), student loan authorities, and cultural institutions (including Georgetown University). Businesses bought these on the assumption that they would be easy to sell at a future date, and now the businesses are stuck with assets they hadn’t intended to hold. MetroPCS Communications Inc.’s suit against Merrill Lynch is illustrative: MetroPCS alleges that Merrill invested the company’s cash in auction rate securities without disclosure or authorization and that Merrill later misrepresented the assets’ level of risk. Nonfinancial businesses: Companies in nonfinancial industries are not safe, either. All too many invested their corporate assets in a range of risky subprime-based assets. Soon they may wear two hats: plaintiff and defendant. They will be defending themselves against angry shareholders’ allegations that the company’s officers and directors acted imprudently and without due care in managing the company’s finances. Shareholders and the SEC may argue that officers and directors did not thoroughly disclose the degree of the company’s exposure to risky credit vehicles and that they misrepresented the value of the company’s offerings. Under the Securities Exchange Act of 1934, officers must relay accurate and truthful information about the company’s financial standing. From the WorldCom debacle earlier this decade, we know that officers and directors can be held personally liable for corporate losses. As plaintiffs, nonfinancial companies may turn the tables on their own investment firms, claiming fraud in the firms’ investment of the companies’ capital in risky holdings without appropriate disclosure. Corporate advisers: Those outsiders who advised companies on their financial practices should not rest easy. Recently, New York state and city pension funds expanded the class action against Countrywide Financial Corp. to name (in addition to individual officers and directors) 26 different financial-services companies that underwrote Countrywide stock and bond offerings, as well as two major accounting firms. The underwriters and accountants are charged with violating their obligation to ensure the accuracy of the company’s statements and securities filings. In short, in-house counsel across a wide spectrum of business need to do some digging to assess their corporate liability. WHAT SHOULD COUNSEL DO? Heed the lessons of the Sarbanes-Oxley Act: Lawyers employed by public companies must act on the basis of their duty to corporation and shareholders. They are the gatekeepers responsible for preventing corporate fraud. And you can be sure that prosecutors will review the integrity of any in-house investigation and, in effect, ask whether the investigators themselves obstructed the process. The “bullets” of the subprime litigation battle will be facts — not the facts as the company wishes them to be, but the facts as they are. Marshaling data early allows counsel to analyze the fact patterns on which litigation may be based for years to come. Counsel should make two key assumptions with any program of fact gathering: 1. Fact gathering is not complete when all the historical facts are gathered. Establishing past patterns is but the first phase. Documents and statements produced in the future may — indeed, will — be needed as evidence in future investigations or litigation. The processes that collect, maintain, and archive facts must therefore run for years. 2. Fact gathering must proceed with all the rigor inspired by pending litigation, whether or not it exists. Building a robust fact base early has a multitude of benefits: It shields corporate management from misstatements; allows concise, timely, and truthful cooperation with government regulators, potentially thwarting litigation; and minimizes inconsistent disclosure of facts throughout the litigation life cycle. Fortunately, while the number of potential subprime claimants and the volume of possible subprime allegations warrant assessing risk before the company is sued or decides to sue, covering the entire spectrum of mortgage-related data is not necessary. Because allegations will focus on a discrete and predictable set of processes and communications, the number of data sources to be scrutinized is somewhat limited. For example, an investment bank might have 3,000 data elements that drive the business, but the important elements could be boiled down to a top 150. Counsel should go after these data in parallel work streams. The information should then be consolidated in a secure, controlled environment that can be accessed throughout the litigation life cycle. Take the previously mentioned case of Bristol-Myers Squibb, which is taking a $275 million write-off on the value of its own investments. As a potential defendant, the company might be asked to produce (among other documentation) statements made to its investors, documents used to generate a Form 10-K for the SEC, and opinions from its accountants. It might also be asked to demonstrate what the company’s top officers knew about its holdings, when they learned about the subprime-mortgage-backed securities in its portfolio, and what actions they took to manage and disclose those holdings. As a plaintiff, Bristol-Myers Squibb might turn the tables on its investment firms, potentially claiming fraud in the firms’ investment of its capital in risky holdings without appropriate disclosure. Of course, proof of fraud requires evidence of intent, so the company will seek to gather the data and projections that the investment firms had at the time they permitted, encouraged, or maintained the company’s investment in those securities. Here are some other points to consider in planning a subprime fact query. Independence: Because perceived independence is critical to credibility, the data extraction, accumulation, and interpretation should be handled by an independent team. Those in charge of suspect processes should not be in charge of, or able to influence, fact finding. Moreover, this independent team needs a forensic mind-set. In-house definitions may not equate with definitions used by prosecutors. The usual data acquisition processes may not be sufficiently transparent for or consistent with the needs of litigation. Communications: In the midst of a crisis, managing requests for information is difficult but critical. Lack of organization and transparency can lead parties inside and outside the company to cry that they’re not getting answers. Officers and directors need a view into the fact-gathering program. For planning purposes, parallel fact-gathering efforts must be aware of each other’s status. Plus, the general counsel and the corporate communications team must know when “certified” facts are available for public release. And directors must be prepped to convey accurate information to concerned shareholders. Nobody benefits but the plaintiffs and their lawyers when statements made under pressure are later found to be untrue. Transparency: In a highly scrutinized situation like the subprime collapse, knowing how facts are mined is very important. Documentation on data sources, data transformation logic, derivations, and change controls should be well organized and readily available. There must be a clear chain of custody and security for data from sources through transformations to final “locked-down” forms. “Reach-through” mapping should show how final answers were reached. Counsel must anticipate requests and ensure that the proper data are provided to those less familiar with the myriad of mortgage documents. Systems: Preparing for subprime litigation demands a wide range of technological systems. The investigation will almost surely require a relational database and analysis platform (to store raw data and allow users to analyze that data again and again), a request management platform (to capture in writing, provide status checks on, and track information requests), and an image management platform (to capture, store, and analyze documents leading to or produced during the crisis). Other useful systems include data integration software, data-mining tools, rules engines, and fraud detection software. BRACING THE SEAWALL As mortgage interest rates continue to reset and properties lose value, the waves of the subprime disaster will keep rolling across the business world. It doesn’t make sense to wait and hope your company doesn’t get caught in the undertow. The best advice today is to establish a fact-gathering program that anticipates subprime litigation. Get smart. Try to stay dry.
Daniel Reiman is a Jacksonville, Fla.-based partner in Newbold Advisors, a management consulting firm that focuses on real estate finance markets. Susan Holik is a partner in Great Elm Solutions, a D.C.-area management consulting firm. Previously, at Fannie Mae, she led corporate investigations.

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