Banks including JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC) may pay more to resolve claims over their alleged roles in the collapse of a $2.3 trillion mortgage- backed securities market if sophisticated investors are allowed to sue as a group along with less savvy ones.
Class-action status allows investors to pool financial and legal resources, giving them greater leverage to win larger settlements or verdicts. The banks, however, have a court ruling on their side that may help fend off such blockbuster cases. It says class status is barred because some investors are too sophisticated -- in fact, because some of them are other banks, including JPMorgan.
“It is possible to be both an alleged perpetrator and victim at the same time,” said Jacob S. Frenkel, a former U.S. Securities and Exchange Commission lawyer now in private practice in Potomac, Maryland. “It’s unprecedented that you have the most sophisticated institutions as victims, to be in a position where their losses are so great that they have sued.”
The ruling by U.S. District Judge Harold Baer Jr. in Manhattan, favoring defendants Royal Bank of Scotland Group Plc (RBS) and Ally Financial Inc., held that investors may not sue as a class in part because some of them are being sued over the same claims. Last month, that ruling was countered by two judges in Baer’s courthouse, both of whom ruled that investors in home- loan backed securities may sue as a class.
Housing Bubble
Pools of home loans securitized into bonds were a central part of the housing bubble that, once burst, helped push the U.S. into the biggest recession since the 1930s. Investors have filed class-action, or group, lawsuits against at least 16 private issuers of securities backed by mortgages.
Mortgage-bond deals now involved in the class-action suits originally held $204.6 billion of loans, an amount that’s fallen to $89 billion amid defaults, borrower refinancing and home sales, according to data compiled by Bloomberg and a list of transactions provided by New York-based law firm Grais & Ellsworth LLP. Realized losses so far total $26.6 billion, with an additional $33.8 billion of remaining loans at least 30 days delinquent.
“Class certification raises the stakes tremendously,” said Alan White, a law professor at Valparaiso University in Indiana. “The damages are going be greater in a class action than a series of individual cases.”
The investors accuse the defendant financial companies of lying about the quality of the home loans underlying the securities they back, which have deteriorated in value. The defendant banks argued the housing collapse, rather than any misrepresentation on their part, caused investor losses.
Shrunk to $1.21 Trillion
From its $2.3 trillion peak in 2007, the market for mortgage-backed securities has shrunk to $1.21 trillion as of June 30, according to the Federal Reserve.
The class actions involve some of the same securities over which the Federal Housing Finance Agency sued Bank of America, New York-based Citigroup Inc. and 15 other financial institutions on Sept. 2. Those complaints were filed on behalf of Fannie Mae and Freddie Mac, the mortgage-finance companies under government conservatorship. The securities at issue in those cases total $196 billion.
Ruled for Investors
On Aug. 22, U.S. District Judge Jed Rakoff in Manhattan issued an opinion explaining why he had earlier ruled that investors, including Mississippi’s public pension system, may sue Charlotte, North Carolina-based Bank of America’s Merrill Lynch unit as a group in a unified lawsuit.
A week earlier, U.S. District Judge Paul A. Crotty in the same court similarly held that investors including the New Jersey Carpenters Health Fund may also collectively pursue their claims against Credit Suisse Group AG (CSGN)’s DLJ Mortgage Capital.
Rakoff and Crotty weren’t swayed by bank arguments that securities buyers couldn’t band together because they were sophisticated investors who knew about deteriorating home- lending practices before the meltdown. The plaintiffs knew that in part because some of them are also being sued over the same claims, the defendant banks argued.
The inability to sue as a group would mean many investors won’t pursue their claims, plaintiffs’ lawyers said.
“Getting a class certified in a case like this, in any case, is an important part of the litigation,” said Gerald Silk, a partner at Bernstein Litowitz Berger & Grossmann LLP in New York representing investors suing Merrill Lynch.
Three Funds
The three funds seeking to represent the class against Detroit-based Ally bought a total of $1.79 million of the $3.7 billion in securities issued, they wrote in court papers. The case has so far cost more than $3.5 million to litigate and may run to three times that if it goes to trial, showing the need for class-action treatment, they wrote.
The securities lost as much as 99 percent of their value soon after they were issued, the investors wrote.
Baer’s ruling in favor of defendant banks, if upheld, “could result in dozens of securities class actions erroneously being denied certification,” the investors wrote in their appeal in the Ally case. The litigation “would likely be terminated without class certification.”
Class certification has also been a point of contention in cases filed New York and Seattle over securities issued by IndyMac Bancorp Inc. (IDMCQ) and Washington Mutual Inc., now part of New York-based JPMorgan.
Pension System
Investors including Mississippi’s pension system who are suing Goldman Sachs Group Inc. are scheduled to file their motion for class certification in November.
“They’re the kinds of cases that have been brought for decades as class actions,” Silk said. “It’s our view that they’re ideally suited for class-action treatment.”
One bank, Wells Fargo & Co. (WFC), agreed to settle litigation against it for $125 million two weeks before a scheduled class- certification hearing in July. The case concerns $27.3 billion of certificates sold by the San Francisco-based bank.
“The proposed settlement agreement is a negotiated resolution as to all named defendants and is intended to avoid the distraction and expense of litigation,” Ancel Martinez, a spokesman for Wells Fargo, said at the time.
Baer, in his Jan . 18 decision, said investors couldn’t sue as a group because they had different knowledge levels of the alleged loosening of mortgage-underwriting standards that led to the home-loan defaults, and ultimately the decline in the value of the securities.
Different Times
The investors also bought the securities at different times, in some cases when more information was surfacing about underwriting standards being ignored, the judge wrote.
“Many putative class members are sophisticated investors with significant experience in asset-backed securities markets,” he wrote. New York-based BlackRock Inc. (BLK) and Fortress Investment Group LLC (FIG) and Old Greenwich, Connecticut-based Ellington Management Group LLC “each tout their expertise in mortgage-backed securities,” the judge wrote.
In its case, Merrill Lynch called Fannie Mae, the Washington mortgage-finance company, the biggest class member and a “quintessential housing-market insider,” according to Rakoff, citing redacted portions of Merrill Lynch’s court papers. Fannie Mae bought about $5 billion of the $16.5 billion of certificates in the case, according to Rakoff’s ruling. Fannie Mae may seek to opt out of the class now that FHFA sued Merrill Lynch individually on its behalf.
Amy Bonitatibus, a Fannie Mae spokeswoman, declined to comment on the litigation.
Financial Advisers
The investors said there’s no evidence they or their financial advisers knew about specific prospectus misstatements by the defendants, especially over the particular mortgage originators’ home-lending standards, before they bought the securities.
“The way we understand the law is that the investors had to know about the scheme or the misstatements in the prospectus, and not that they were just generally sophisticated about mortgage-backed securities,” said Joel P. Laitman, a New York- based lawyer at Cohen Milstein Sellers & Toll PLLC, which sued on behalf of investors in the RBS, Credit Suisse and Ally Financial cases.
Pholida Phengsomphone, a spokeswoman for Edinburgh-based RBS, and Lawrence Grayson, a spokesman for Bank of America, declined to comment.
Risk Awareness
“We are encouraged by Judge Baer’s analysis,” said James Olecki, a spokesman for Ally. “It recognizes the legal significance of the extent of knowledge that individual investors may have had as to the risks relating to the investment.”
In the case against Credit Suisse’s DLJ Mortgage unit, which involves $2.39 billion of securities, Crotty said the defendants produced no evidence that the more than 330 investors knew about specific misstatements in the offering documents.
Steven Vames, a spokesman for Zurich-based Credit Suisse, declined to comment on the case.
Some of the defendant banks noted that potential members of the class are other financial firms that are themselves being sued over mortgage-backed securities.
Having individual banks on both sides of these cases is “slightly unusual” and shows “the multi-headed hydras these investment banks have become,” said James D. Cox, a securities- law professor at Duke Law School in Durham, North Carolina. “But they do have these Chinese walls, to make sure the underwriting people are not talking to the investment advisers.”
New York-based JPMorgan, a potential plaintiff and class member in the lawsuit against RBS over $3.45 billion in securities, is being sued in federal court in Brooklyn, New York, over mortgage-backed securities it sold. JPMorgan “is alleged to have had knowledge regarding” disintegrating underwriting standards, Baer wrote.
Investment Funds
The bank’s role in underwriting some securities doesn’t mean its affiliated investment funds knew about misrepresentations in the prospectus for completely different securities, the plaintiff investors wrote in their appeal in the RBS case. RBS is Britain’s biggest government-owned lender.
“These were not the firms that underwrote the offering,” Laitman said. “They bought like everybody else.”
In the Merrill Lynch case, Rakoff agreed with the investors.
“Although defendants note that some members of the class, including Morgan Stanley (MS) Co., have been sued in connection with their own MBS offerings, this is irrelevant to the offerings at issue in this case,” he wrote.
Motions to Dismiss
The parties in the cases against JPMorgan and New York- based Morgan Stanley await decisions on the banks’ motions to dismiss. The federal appeals court in Manhattan hasn’t said yet whether it would accept Merrill Lynch’s appeal of Rakoff’s decision certifying the class of investors.
The cases are New Jersey Carpenters Health Fund v. Residential Capital LLC, 08-08781, New Jersey Carpenters Vacation Fund v. The Royal Bank of Scotland Group Plc., 08- 05093, Public Employees’ Retirement System of Mississippi v. Merrill Lynch & Co., 08-010841, New Jersey Carpenters Health Fund v. DLJ Mortgage Capital Inc., 08-05653, Public Employees’ Retirement System of Mississippi v. Goldman Sachs Group Inc. (GS), 09-01110, In re Morgan Stanley Pass-Through Certificates Litigation, 09-02137, and In re IndyMac Mortgage-Backed Securities Litigation, 09-04583, U.S. District Court, Southern District of New York (Manhattan); Plumbers’ & Pipefitters’ Local #562 Supplemental Plan & Trust v. J.P. Morgan Acceptance Corp., 08-01713, U.S. District Court, Eastern District of New York (Brooklyn); In re Wells Fargo Mortgage-Backed Certificates Litigation, 09-01376, U.S. District Court, Northern District of California (San Jose); and In re Washington Mutual Mortgage- Backed Securities Litigation, 09-cv-00037, U.S. District Court, Western District of Washington (Seattle).
To contact the reporter on this story: Thom Weidlich in federal court in Brooklyn, New York, at tweidlich@bloomberg.net.
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