While investors pray for a bottom to a plunging stock market in the days or weeks ahead, experts say an end to litigation arising from issues fueling market turmoil could be years or even decades away. In the meantime, as the financial crisis widens and deepens, more potential defendants and plaintiffs are being identified for directors and officers as well as errors and omissions claims.

“There are a handful of S&L cases that my firm is still working on,” said Jeff Nielsen, managing director of the Washington office of Navigant Consulting, referring to cases arising out of the savings-and-loan crisis of the early 1990s, and giving some sense of the possible duration of litigation arising from the latest financial crisis involving subprime mortgages.

Mr. Nielsen, who heads up Navigant's Financial Services Disputes and Investigations group, which assists clients with regulatory inquiries and provides expert testimony in connection with litigation, is also tracking the number of subprime-related cases.

“What's been so striking is just the magnitude of it all,” he said, noting that over the 18-month period ended June 30, 2008, 607 subprime-related cases were filed in the federal court system alone.

Using the S&L crisis as a natural reference point, he said there were 559 cases handled by the Resolution Trust Corp. during the government-owned asset management company's six-year existence. “Right out of the gate, the volume of subprime-related cases exceeds the S&L crisis total accumulated over six years.”

In addition, he said the pace of filings has accelerated this year, with 310 cases filed in six months of 2008 eclipsing the 297 subprime-related cases filed in all of 2007.

“These cases are going to be fixtures for some time to come,” he said, noting that in the second quarter of 2008, three new cases were filed for every one disposed. While that's lower than the 5-to-1 ratio for the first quarter, “the real downhill portion of this journey will not begin in earnest until…the number of cases being disposed reach[es] the number of new filings,” he said.

Kevin LaCroix, an attorney and partner for Oakbridge Insurance Services, a Beachwood, Ohio, insurance brokerage, has also been tracking subprime cases since the first was filed last year against subprime lender New Century Financial Corp. He, too, expects filings to continue for years.

“There are many, many future litigants who don't even know yet that they've suffered losses,” he said, noting that losses are now emerging not just directly from subprime loan originations or securities tied to subprime mortgages, but from the ripple effects of the credit crunch and a resulting crisis in the world financial markets.

Giving a personal example, Mr. LaCroix said he sits on the board of a private school that has a large endowment, which still hadn't seen its third-quarter statement. “Even worse, a lot happened in October. So even if we get that statement, it's going to be awhile before board members know how bad this is for our endowment.”

“Think of that throughout the entire economy,” he added, noting that as people start to see their losses documented in black and white, they'll look for targets to sue.

The litigation target in that particular case might be an investment management firm, which could in turn be covered by a professional liability insurance policy. But experts agree that directors and officers liability insurers will also be on the hook for billions of dollars associated with securities fraud suits linking investment declines to incomplete or untimely disclosures.

While such nondisclosure allegations are typical in securities cases, Mr. LaCroix, who is the author of the “D&O Diary” blog, sees new waves of subprime-related securities cases that are distinguished from prior ones by new classes of plaintiffs and defendants.

Prior to events of September 2008 that produced “a headline crisis every single day,” defendants were either companies involved in residential real estate or subprime lending, or firms that had direct financial exposure to real estate or subprime lending. Now cases are being filed against those that “had exposure to other companies that were exposed to those things,” he said.

As an example, he cited a suit against the Primary money market mutual fund of the Reserve family of funds, which suffered significant losses from exposure to Lehman Brothers. It held significant debt instruments issued by Lehman, and when Lehman declared bankruptcy, those investments became largely worthless, he explained.

“The bottom line is that Reserve Fund itself didn't have any exposure to subprime real estate. It didn't even hold subprime investments. What it held was investments in Lehman Brothers,” he said.

Reverberations are even spreading beyond the financial sector, Mr. LaCroix said, noting that Constellation Energy, a holding company that operates an energy utility in the Mid-Atlantic states, was one recent recipient of a subprime-related suit.

He explained that Constellation, like other energy utilities, trades in commodities to sustain operations. “Its significant trading partner was Lehman Brothers,” he said, noting that the Lehman bankruptcy fueled a significant stock-price drop for Constellation because it no longer had a financially viable counterparty on its commodity activities.

Turning to new classes of plaintiffs, he said the litigants in past securities cases were usually common stockholders. “As a result of the very significant wave of failures, bailouts and bankruptcies in September, there have been huge losses to holders of preferred securities, subordinated debentures and other types of sophisticated investment instruments” for Lehman, Fannie Mae, Freddie Mac and American International Group, resulting in lawsuits.

Mr. LaCroix and Mr. Nielsen also took note of more than 20 class actions arising from another class of securities–auction-rate securities (long-term securities with floating rate features set through an auction process)–that began emerging in March.

More unique one-off cases highlighted by Mr. LaCroix on his blog defy categorization–including one filed by bond insurer MBIA against Countrywide Financial, alleging that the default insurance it provided on $14 billion of securities was provided on the basis of Countrywide's fraudulent misrepresentations about its loan underwriting standards.

“This really is becoming a war of all against all,” Mr. LaCroix said. “The losses are so large that it's a process to try to figure out where those losses are going to land and then trying to push them back upstream.”

Using a baseball analogy to describe the status of subprime-related litigation, he said, “If this is a nine-inning game, then we're only in the top of the second inning. It's going to be the fourth or fifth inning before we start getting to the outside professionals in a significant way,” envisioning claims not just against investment managers, but other professionals, like lawyers who helped put together securities documents.

Charting litigation progress another way, Mr. Nielsen said that for the 297 total actions filed in 2007 (all types, including borrower and securities cases), motions to dismiss were filed on 124 of those cases through June 2008. As of that date, rulings were made on 58 of the motions, and 38 of those “passed that first and often most onerous hurdle” of litigation, he said–meaning that motions to dismiss were either denied or denied in part on these 38 cases.

“We do see these cases on some level proceeding, and there's obviously a long road ahead on many of them,” Mr. Nielsen said.

Explaining one seemingly favorable trend highlighted in Navigant's second-quarter report on subprime litigation released in early September–a 30 percent drop in borrower actions from the prior quarter–he said, “our view of that is these are cases largely dealing with historical issues at this point….The entities that were active in making subprime loans are now either out of that business, or out of business altogether. The practices at issue are in the rearview mirror to a large degree.”

On the other hand, securities cases are rising. These cases by investors, which had trailed borrower actions in all prior quarters except fourth-quarter 2007, represented 41 percent of all second-quarter subprime cases, according to Navigant's September report, bringing total securities cases to 170 over the past 18 months. (See accompanying infographic, “Counting Claims.”)

“As we continue to see tremendous market volatility and real challenges around valuation questions of illiquid assets that firms have on their balance sheets, we're continuing to see a large volume of securities cases,” Mr. Nielsen said.

David Bradford, chief knowledge officer for New York-based Advisen, noted that his firm saw securities class-action suits actually trail off in the past quarter, but he expects another surge as a result of the current deterioration of financial markets.

For D&O insurers, such a surge won't necessarily mean there are more policy limits at risk, he said, explaining that it may be that many of the companies sued in this next round have already been sued before.

Advisen–which has not only been counting subprime-related suits but has also been working to estimate the potential magnitude of D&O insurance losses tied to securities cases–developed an initial figure of $3.6 billion in February. Mr. Bradford, who noted his firm will release a new estimate this month, also said he didn't expect that figure to jump tremendously.

“The situation obviously has not gotten better since we did the first report, but we built fairly conservative assumptions into the $3.6 billion estimate,” he said.

Advisen will be releasing an analysis of E&O losses as well, he said, reporting that total losses are “remarkably balanced between E&O and D&O. Similar sorts of numbers are falling out.” He noted that while cases implicating E&O coverage are greater in number, “they don't have the potential to explode into the massive sort of settlements that the D&O suits do.”

Turning to the question of why securities class actions started dropping off in the second quarter in his firm's count, Mr. Bradford speculated that law firm expenses had something to do with it. “A lot of law firms subsidize the upfront costs for securities class actions with income from their corporate practices, and that has fallen off dramatically. Firms are laying people off, so they're probably being more selective about cases they're going after,” he said.

Going forward, he said there will be more barriers for plaintiffs and their lawyers. “For companies that were just caught in the domino effect of a global financial crisis, they have to prove there was intent on the part of the directors and officers to commit fraud or deceive–and that may be something relatively difficult to prove in a lot of all these cases,” he said.

Fred Kohm, senior managing director in the forensic accounting and litigation support group of Smart Business Advisory & Consulting in Philadelphia, also weighed in on potential defenses as securities cases play out–like those pertaining to processes and controls for asset valuations that turned out to be incorrect.

It's not necessarily “the number that was placed” as the value that will be at issue, “but what was done to lead up to that valuation–whether proper procedures were in play to come up with those numbers. If those things were done appropriately, then they'll have better defenses,” Mr. Kohm said.

Even without lawsuit hurdles and potential defenses to mitigate payouts, experts said they aren't expecting D&O insurance losses to balloon to the level of an often-cited $9 billion estimate developed by an analyst at Bear Stearns earlier this year.

For one thing, Mr. LaCroix noted that a lot of the largest, high-profile headline-grabbing suits are against global financial services companies that probably structure their D&O insurance with very large self-insured retentions. “When I say very large, it could be nine figures,” he said.

In addition, they often structure D&O programs as Side-A-only coverage–providing protection only if corporate indemnification is unavailable due to insolvency or state law prohibitions (which exist for derivative suits in many states). While Lehman, Freddie and Fannie have potentially triggered Side-A coverage (if they purchased it), “for companies still in business, Side-A towers probably haven't been touched.”

“There is some irony in the fact that the higher estimate was put out by analysts at Bear Stearns,” and it won't be updated because Bear Stearns doesn't even exist anymore, Mr. LaCroix noted. “That shows how unpredictable this all is. That was not something they anticipated.”

“In any economic downturn, the potential for litigation will move beyond the source of the problem,” according to Mr. Kohm, going on to speculate on one somewhat less predictable outcome–the potential for suits arising from mergers and acquisitions.

M&A activity, he said, may be fueled by declines in the capital and stock prices of some companies. “Sellers and buyers try to position themselves well, and if one side doesn't feel like they got the best end of the bargain, there's a potential for lawsuits.”

William Boeck, senior vice president and claims counsel for Lockton Financial Services in Kansas City, noted that even asset purchases by the federal government, provided for in the Emergency Economic Stabilization Act, could give rise to shareholder derivative suits. Shareholders may complain that by participating in the Troubled Asset Relief Program created under the law, they're “selling off assets at fire-sale prices” when they're worth more.

Michael Turk, senior consultant for Towers Perrin in Stamford, Conn., noted the possibility that the government–as it did during the S&L crisis–might go after directors and officers of failed banking institutions and their D&O insurers.

“Back then, there were regulatory exclusions on the policies” presenting a bit of an obstacle for the government to tap insurance proceeds, he said. “To my knowledge, those [exclusions] all went by the wayside in the soft market.”

Teaser, reverse type on black bar:

With Litigation Snowballing, Is A Hard D&O Market Looming? See NU, Nov. 17

Special Reports /

No End In Sight To Investor Lawsuits Amidst Fallout From Subprime Crisis

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