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The report of an expert in economic analysis of securities will be admitted in a securities fraud case in which investors lost more than $230 million as a result of fund bankruptcy, a federal judge ruled Feb. 5 ( Primavera Familienstifung v. Askin, ABF Capital Management v. Askin Capital Management, Granite Partners v. Donaldson, Lufkin & Jenrette Securities Corp, Montpellier Resources Ltd.v. Askin Capital Management, Johnston v. Askin Capital Management, Bambou Inc. v. Askin, and AIG Managed Market Neutral Fund v. Askin Capital Management, Nos. 95 Civ. 8905 [RWS], 96 Civ. 2978 [RWS], 96 Civ. 7874 [RWS], 97 Civ. 1856 [RWS], 97 Civ. 4335 [RWS], 98 Civ. 6178 and 98 Civ. 7494 [RWS], S.D.N.Y.). In a 100-plus-page opinion involving seven cases combined for discovery purposes, U.S. Judge Robert W. Sweet of the Southern District of New York denied the brokers’ motion to exclude the testimony of John Y. Campbell. The judge also ruled on a host of motions and cross-motions for summary judgment. Granite Partners, Granite Corp. and Quartz were hedge funds that made leveraged investments in mortgage-backed securities, including collateralized mortgage obligations (CMOs). In 1993, David J. Askin became investment advisor to the Granite Funds and in 1994 to Quartz. The individual and institutional investors were shareholders and/or limited partners in the funds Askin and his Askin Capital Management purchased CMOs for the funds from various brokers, including Merrill Lynch, Donaldson, Lufkin & Jenrette (DLJ), Kidder Peabody and Bear Stearns. The brokers created the CMOs. COLLATERALIZED LOANS The Granite Funds were intended to take advantage of the mortgage-backed securities’ potential for high returns while being market-neutral by constructing portfolios comprised of a balanced mix of “bullish” and “bearish” securities. The funds purchased many of the most complex and esoteric CMOs in existence, making them among the riskiest. Through a process called repos, or collateralized loans, the brokers loaned the funds most of the purchase price for each CMO and took possession of the CMOs as collateral for the funds’ performing their obligations to repurchase the CMOs with interest on the buy-back date. In February and March 1994, the Federal Reserve Board raised interest rates for the first time in five years. As interest rates rose, prepayments on the underlying mortgage obligations for mortgage-backed securities fell. Askin magnified the effect of these market conditions by purchasing inappropriately bullish securities that were particularly sensitive to these adverse market conditions. In addition, the funds were highly leveraged. The value of the funds’ portfolios plummeted. Between March 28 and March 31, 1994, the various brokers with which the funds had entered into repo transactions issued repeated margin calls totaling $131 million. The funds transferred approximately $49 million in cash or unencumbered collateral to the brokers, leaving a shortfall of almost $82 million. As the funds were unable to meet the margin calls, the brokers liquidated the funds’ portfolios and the funds collapsed and filed for bankruptcy. The investors allegedly lost approximately $230 million. The investors sued Askin, the brokers and the funds. The funds sued the brokers alleging, among other things, breach of contract for improper margin calls and improper liquidation. ‘DAUBERT’ STANDARDS The funds submitted reports in support of their opposition to Merrill’s motion for summary judgment, and of their cross-motion against Merrill. Merrill moved to strike the reports as failing to meet the Daubert standards. Campbell is the Otto Eckstein Professor of Applied Economics at Harvard University and has a host of other academic credentials. He has published more than 50 articles on financial economics and the statistical analysis of financial data. He has conducted extensive research and has held editorial positions with scholarly journals. Campbell concluded in his report that (1) DLJ and Merrill credited to the funds lower-than-fair-market prices for the liquidated securities — on average, 14 percent lower in the case of DLJ and 13 percent lower in the case of Merrill; (2) had DLJ used fair market prices, the funds would have received $27.5 million more than was actually credited by DLJ; (3) had Merrill used fair market prices, the funds would have received $9.5 million more than was actually credited by Merrill; and (4) based on the fair market prices of the securities, the repo account of Granite Corp. did not have a margin deficit on the margin call dates, and the value of the securities held in each of the funds’ accounts at Merrill exceeded 102 percent of the outstanding repo obligation. In its motion to strike Campbell’s report, Merrill argued that his proposed testimony is neither reliable under Kumho Tire Co. and Daubert nor relevant, and that Campbell is not qualified to render the opinions offered. RELEVANCE The judge found Campbell’s proposed testimony was relevant to the calculation of damages under the highest intermediate price rule, to whether the brokers acted in bad faith in liquidating the funds’ accounts, and to whether the liquidation sale was commercially reasonable. The judge also concluded that Campbell’s extensive background and qualifications in the economic analysis of securities prices and interest rates qualified him to testify. He also teaches a course at Harvard that has included a segment on CMOs and their valuation, and has performed consulting work and advised on a Ph.D. thesis that involved CMO valuation, the judge noted. “Merrill’s claim that Campbell is not qualified suggests that only someone who specializes in CMOs could qualify as an expert on the subjects about which Campbell proposes to testify,” the judge said. “The law does not insist on such narrow qualifications.” Regarding reliability, Merrill contended that Campbell’s proposed testimony failed to meet any of the criteria set forth in Daubert as well as any other criteria that might reasonably apply. Merrill’s main contention is that Campbell erred by failing to take account of “actual trading prices” of the same CMOs for which he calculated “fair market prices” with his computer model. Merrill argued Campbell should have compared his results against those trading prices and used those trading prices as data inputs for his model. The argument is directed primarily at the first Daubert factor, whether the theory has been or can be tested. QUESTIONABLE PRICING Merrill pointed to actual prices it obtained in resales on March 31, 1994, of four CMOs obtained by Merrill through its auction, as well as evidence of its inability to sell other CMOs. Merrill argued that the reliability of Campbell’s model must be tested against these prices, and the fact that Campbell’s prices are higher than the actual prices obtained in these transactions requires the conclusion that his methodology is unreliable. However, the judge noted the legitimacy of the sales is one of the issues being litigated. It cannot be said that the prices necessarily represented fair market values and, thus, that Campbell’s report is unreliable because his numbers are different, the judge said. “Comparison of Campbell’s computer-generated prices for certain CMOs and these actual trading prices of the same CMOs may indeed be one worthwhile way of testing Campbell’s model,” the judge said. “However, under the circumstances of this case it is not the only appropriate test of that model, nor does the fact that Campbell’s methodology resulted in higher prices necessarily mean that his methodology is unreliable. Indeed, to require Campbell to use the resale prices as fair market value benchmarks is tantamount to assuming the conclusion of one of the issues in the case.” TESTING Merrill also contended that Campbell’s methodology failed the first Daubert factor because he himself has not tested his methodology or offered a way of doing so. Campbell described two ways he attempted to demonstrate that his model-computed prices are meaningful and accurate. The first was that he determined that the average changes in the portfolio values for the funds’ securities, calculated using the model-computed prices, are generally consistent with the average daily change in the Lehman Index. Although not precisely a “test,” this was “a rough cross-check of reasonableness,” the judge said. The second was that Campbell examined the weighted average OASs of the funds’ portfolios during the margin call and liquidation period, using the model-computed prices, and discerned that, like the OAS data from the Market Monitor, the OASs as he calculated them did not show a drastic change during the last week of March 1994. “In sum,” said the judge, “Campbell did employ techniques to evaluate the reliability of his model and the results he generated, though these techniques were not without their limitations.” PEER REVIEW The funds contended that the second Daubert factor — peer review and publication — is inapposite because Campbell’s methodology is so specifically focused on a particular fact situation that it is likely to be of little interest within academic circles. “Although Campbell’s model is indeed tailored to the specific factual situation in this case, there are elements of the model which would appear to have broader application,” the judge said. “Moreover, given the importance of CMOs within a particular sector of the financial market, and the difficulties of pricing them, it would seem that the development of a reliable pricing methodology would be of interest beyond the context of this litigation.” “Nonetheless, while peer review and publication can be a very important consideration, like any other factor it is not a prerequisite to admissibility. Finally, Merrill has not pointed to any similar studies of CMOs which have received peer review.” Testimony from two of the brokers supports the view that comparable securities-based pricing is accepted within the industry, the judge said. ‘SUFFICIENTLY RELIABLE’ “Although this does not mean that Campbell’s precise methodology for identifying comparable CMOs is the same as the method (or methods) employed in the industry for making such an identification, this testimony further supports the conclusion that Campbell’s methodology is sufficiently reliable to be admitted,” the judge said. However, the judge noted special attention must be given to the general acceptance factor as it pertains to Campbell’s other method of using repo marks to compute a given security’s option adjusted spread (OAS). There is no widespread acceptance within the industry of using a dealer’s mark, rather than a transaction price, as a starting point in determining the fair market value of a CMO, the judge said. However, there is evidence that repo marks are relied upon in situations involving valuation of CMOs, including for the purpose in a liquidation of crediting the funds with the value of their securities, and to report on a dealer’s net capital position. “Thus, the issue really comes down to whether Campbell’s methodology is unreliable because he has combined analytical tools in a particular way which has not gained general acceptance,” the judge said. “The Supreme Court has made clear that where an expert has applied an accepted technique in a particular way it is not enough to simply invoke the acceptance of other uses of that technique.” ‘KUMHO’ SATISFIED The judge concluded Campbell’s proposed testimony does not run afoul of Kumho Tire. The fact that essential principles of his technique do have general acceptance, buttressed by the exercises he has employed for assessing the meaning and accuracy of his results, provides a sufficient level of reliability to warrant admission of his testimony, the judge said. Merrill also urged that the unreliability of Campbell’s testimony is further demonstrated by application of an additional factor — whether an expert’s opinion grows naturally and directly out of research he has conducted independent of the litigation, or whether he has developed the opinions expressly for purposes of testifying. The funds suggested that this factor is inapposite given the highly particularized nature of the inquiry “This argument is no more convincing that the Funds’ similar contentions regarding the peer review and publication factor,” the judge said. “That is, the Funds characterize Campbell’s report too narrowly. Nonetheless, although satisfaction of this additional factor would provide further support for Campbell’s testimony, there are sufficient other indicia of reliability to warrant its admission.” The judge refused to permit the testimony of Burton G. Malkiel, a derivative instruments expert, on the grounds that his report consists of inadmissible legal conclusions. COUNSEL Counsel to Granite Partners are Eric Seiler, Robert J. Lack, Katherine L. Pringle and Lee D. Sossen of Firedman Kaplan & Seiler in New York and Steven E. Greenbaum, Scott M. Berman, Anne M. Cunningham and Melissa A. Sarubbi of Berlack, Israels & Liberman in New York. Counsel to Montpellier are Peter D. Morgenstern, Paul D. Wexler, Lawrence P. Eagle and Lisa K. Eastwood of Bragar Wexler Eagle & Morgenstern in New York. Catherine A. Ludden of Morgan, Lewis & Bockius in New York represents DLJ. Thomas Moloney, Mitchell A. Lowenthal, Carmine D. Boccuzzi, Allyson W. Haynes and Kesari Ruza of Cleary, Gottlieb, Steen & Hamilton in New York represent Kidder. Robert Pietrzak, Andrew W. Stern, Madeleine J. Dowling, Jonathan J. Brennan and Kimberly A. Johns of Brown & Wood in New York represent Merrill. Counsel to Primavera Familienstifung, Bambou Inc., Loukoum Inc., Samta Investment Inc. and Hubert Looser are Solomon B. Cera of Gold Bennett Cera & Sidener in San Francisco and Jeffrey A. Klafter of Bernstein Litowitz Berger & Grossmann in New York. David S. Hoffner of Swidler Berlin Shereff Friedman in New York represents Askin. � Copyright 2001 Mealey Publications, Inc.

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