From the February 2008 issue of Investment Advisor • Subscribe!

Litigation A-Go-Go

Lawsuits, investigations, and probes, oh my!

Following months of giant bank and broker/dealer write-downs, losses, CEO expulsions, runs on banks, and the pummeling of shareholder value at many of the world's largest banks and brokerages, now come the lawsuits, and even word of criminal investigations. There seems to be something to directly or indirectly affect everyone: ERISA litigation attorneys Keller Rohrback filed a class action against Merrill Lynch November 29 on behalf of the firm's 401(k) Savings and Investment Plan and Employee Stock Ownership Plan, alleging that the firm "allowed heavy, imprudent investment of the Plans' assets in Merrill Lynch common stock throughout the class period even though they knew or should have known that such investment was clearly risky and imprudent," citing the firm's foray into the CDO markets, according to the complaint. Citigroup faces a similar case, filed December 13, and the law firm is investigating whether to proceed with an action against Morgan Stanley, it announced January 4. Two other shareholder suits were filed against Merrill Lynch, on October 30, and December 4, both alleging that the company made "materially false and misleading statements regarding the company's business and financial results," related to the CDO and mortgage backed situation.

Coughlin Stoia Geller Rudman & Robbins, LLP announced a shareholder class action against UBS December 13, alleging that UBS made statements about its business results that were "materially false and misleading because they failed to disclose the Company's failure to timely write-down impaired securities containing subprime debt."

Meanwhile, there is the potential for escalation of Bear Stearns's woes into a criminal investigation. The firm's CEO, James Cayne departed on January 8, replaced by Alan Schwartz, who has been president, though Cayne retains the chairman title. Bear Stearns Asset Management was sued for fraud by Barclays Bank PLC December 19, by investors Samuel T. Cohen, November 19, and FIC, LP on December 21. A December 17 Business Week article reported that the Brooklyn U.S. Attorney's Office and the SEC are investigating whether insiders may have redeemed shares in a hedge fund--which was managed by Bear Stearns Asset Management, and which later collapsed because of its leveraged investments in CDOs--while "the funds' managers were urging other investors to stay put."

Shareholders, borrowers and institutions are not the only disgruntled parties; there may have been some trickling down of CDOs or CMOs into individual investors' accounts. Recently, the Financial Industry Regulatory Authority (FINRA) started its own investigation, sending a sweeps letter to a number broker/dealers on December 14 asking for detailed information "regarding sales of principal only ("PO"), interest only ("IO"), and inverse floater ("IF), tranches of collateralized mortgage obligations," from "June 30, 2006 to July 31, 2007," according to a copy of the letter obtained by IA. The letter states that the information request does not necessarily mean that FINRA enforcement "has determined that any violations of the federal securities laws or NASD rules has occurred," though it says firms must respond fully or face potential sanctions. FINRA spokesman Herb Perone explains in an e-mail that though FINRA has "seen an increase in the number of complaints," about mortgage-related or other structured securities, "the sweep wasn't prompted by the complaints--we typically do informational sweeps whenever a product that's commonly the province of institutional investors works its way down to the retail market."

FINRA wants details on, among other things, sales practices, the "suitability review process," copies of holdings pages of the customers who bought the securities from the five "registered representatives who generated the largest amount of commissions," "presentation materials," and "customer communications," according to the sweep letter. They've also asked for "all daily CMO offering sheets or similar documents, used to indicate CMO's that your firm had available for sale that were created, used or distributed during the month of March 2007 and the month of June 2007."

What does all this have to do with independent B/Ds? Just this: while the majority of independents may have had no direct exposure in terms of issuance of CMOs and CDOs, what firm does not have clients invested in bank, brokerage, or insurance company securities? If there were sales of mortgage-related securities, perhaps with the exception of something like a GNMA, a review of firm or practice policies may be necessary. How widespread are holdings of CMOs among retail? "I personally believe that it was not widespread--it may have been done in isolated circumstances," says Brian Rubin, partner at Washington D.C.-based Sutherland Asbill & Brennan LLP, a firm that does "regulatory counseling" and represents financial services firms in "enforcement matters." But B/Ds of all stripes should take note: "Even if they are not the subject of the sweep there are often second rounds of the sweeps," Rubin explains, "it is in their best interest to review their policies, procedures and disclosures of these products."


E-mail Senior Editor Kathleen M. McBride at kmcbride@investmentadvisor.com.

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