Mortgage meltdown: offers lessons for all.

As the U.S. economy struggles to recover from the collapse of the sub-prime mortgage market, falling real estate prices and rising energy costs, plaintiffs' lawyers are gearing up.
Make no mistake: their actions will not help American businesses recover. Lawsuits will likely hit some companies at the same time more stringent government regulation increases their cost of doing business. The plaintiffs' bar is doing its best to subvert the nation's businesses as they attempt to regain their economic footing.
One positive result of these suits, however, is that they provide lessons for businesses on how to protect themselves from aggressive plaintiffs' lawyers. And though it may be too late to avoid litigation this time around, executives who pay attention to recent events will be better positioned when the next round of lawsuits hits.
Starting late last year, plaintiffs' lawyers began filing what will likely be a plethora of suits seeking to profit from the mortgage meltdown, blaming various types of businesses for the fallout. Citing figures from Cornerstone Research (which compiled the figures in cooperation with Stanford Law School), The New York Times reported earlier this year that class-action filings spiked in the early 2000s, with 497 filed in 2001, up from 215 the previous year. As those cases were resolved, new filings fell to a low of 118 in 2006. But there were about 170 filed last year, over 30 of which were related to the mortgage crisis.
"American homeowners are suing mortgage lenders. Mortgage lenders are suing Wall Street Banks. Wall Street Banks are suing loan specialists. And investors are suing everyone," the Times noted. Analysts warn that there is no end to the list of potential legal targets because so many players share a piece of the blame for the mortgage meltdown.
Though subprime-related lawsuits are not all the same, some trends have emerged in the types of suits filed and defendants targeted. A recent study by Navigant Consulting Inc. found that while "virtually every participant in the subprime collapse is being sued ... mortgage bankers and loan correspondents represent the highest percentage of defendants (32 percent)." Other defendants named by the study include mortgage brokers, lenders, appraisers, title companies, homebuilders, underwriting firms, bond insurers, money managers, accounting firms and company directors/officers.
Kevin M. LaCroix, an attorney who maintains a running list of subprime lending lawsuits, said a large majority of the suits are securities fraud class actions. They fall into the following categories:
Securities fraud and shareholder-derivative actions. The most common subprime-related suits are class-action securities fraud or shareholder-derivative actions. These suits usually allege that defendants, such as American International Group Inc., Countrywide Financial Corp. and Citigroup Inc., made false and misleading statements in press releases and public disclosures about their financial conditions.
Borrowers vs. lenders. These suits generally claim that lenders have misrepresented aspects of their mortgage loans, or have otherwise engaged in deceptive or unfair trade practices. For example, a class action recently filed against NovaStar Financial Inc., on behalf of a proposed class of 1,600 borrowers, alleged that the broker or lending officer who placed the mortgage was financially rewarded for steering borrowers to higher interest rate loans. (The case settled for $5.1 million.)
In another recent settlement, Wells Fargo & Co. agreed to pay up to $6.8 million to settle a class action filed over its subprime lending practices.
Borrowers vs. financial firms. These actions are generally premised on the idea that financial institutions encouraged and profited from under-handed and unsavory tactics used by subprime lenders in which the financial institutions invested. In one such suit, borrowers sued a unit of Lehman Brothers for enabling a subprime lender's fraudulent tactics by investing in the lender.
Financial firms vs. lenders. A number of investor-instituted law-suits allege that subprime lenders failed in various duties. For example, a subsidiary of Deutsche Bank filed at least 15 suits against mortgage companies, alleging that they failed to buy back loans with early defaults. Subsidiaries of Credit Suisse Group and UBS AG also have reportedly filed similar suits.
Regulators vs. lenders. A story this big inevitably will attract grand-standing politicians. In June Ohio Attorney General Marc Dann sued 10 mortgage lenders, accusing them of pressuring real estate appraisers to inflate home values.
'Wacky' Suits
Many of the cases filed in the present panic lawsuit market can only be characterized as unprecedented. For example, the cities of Cleveland and Baltimore are pursuing claims against some Wall Street banks, alleging that local residents are suffering because the banking companies "fostered the proliferation of high-risk home loans." Cleveland claims the mortgage companies' lending policies created a public nuisance.
Similarly, in 2007 the National Association for the Advancement of Colored People filed a lawsuit against 14 of the largest U.S. mortgage lenders alleging that they had engaged in "institutionalized racism" by steering African-Americans into subprime home mortgage loans. (The NAACP previously criticized lenders for not making loans to minority borrowers.) Baltimore's suit also claims lending discrimination based upon race.
Other actions related to the subprime mortgage crises do not fit within traditional categories. For example, credit agencies that graded mortgage-backed securities as safe investments are being sued for fraud or misrepresentation. As noted by Columbia University Law Prof. John C. Coffee, "credit-rating agencies have never been held liable in any class action suit since the beginning of time ... they have had virtual legal immunity to any kind of statement."
As the first wave of the subprime suits wind through the judicial process, results so far have been mixed. Some have been thrown out of court. Several have passed the first level of judicial scrutiny. Some have already settled. It appears that the Private Securities Litigation Reform Act has demonstrated its value, as securities fraud class actions have been most vulnerable to dismissal.
Lawsuits are being held to higher standards so that bad business decisions and erroneous market predictions are not equated with securities fraud. On the other hand, where plaintiffs have been able to show actual wrongdoing, even securities fraud suits are proceeding.
Lessons to Learn
On the business side, if there is any lesson to be learned from the current economic crisis, it's that whatever can go wrong eventually will go wrong. American businesses have learned that at some point high-risk ventures result in losses. Future estimates of cost-benefit considerations will be calculated to assess more accurately the risk of catastrophic market conditions. On the legal side, C-suite executives must pay attention to the fundamentals. The factors that make companies targets for lawsuits do not change in a market downturn. In fact, they are magnified. Some points to remember:
* The best defense against shareholders' lawsuits is a strong and independent board. Though some CEOs consider their directors an unwelcome nuisance, they are actually the best protection executives have against shareholder-derivative suits. Under the laws of Delaware and most other states, if the majority of directors are not personally implicated in alleged wrongdoing, they retain the ultimate decision whether to approve or disapprove a shareholder's right to sue the company. Failure of the shareholder to submit a claim to the board for pre-suit review is usually fatal to the lawsuit.
* Protections built into U.S. securities law are working. More than any time in the last four decades, the securities laws are functioning as they should. More often than not, bogus fraud claims are dismissed at an early stage. As always, full disclosure of material events is always the best policy. Unlike some times in the past, however, companies that make forward-looking statements can now do so without facing extreme risks if business conditions don't turn out as the companies predicted.
* Arbitration clauses may avoid litigation altogether. Many companies that conduct business in dangerous jurisdictions have used mandatory contractual arbitration provisions to keep cases out of the legal system. In several cases, companies have also used arbitration clauses to block class-action suits. The law in this area is in flux, however, until the U.S. Supreme Court settles the matter. (In 2003 the justices were unable to reach a consensus in Green Tree Financial Corp. vs. Bazzle, leaving lower courts without clear guidance on the enforceability of arbitration clauses that preclude class action litigation.)
* Good business makes good legal protection. At the end of the day, companies that treat their customers well face fewer lawsuits.
Like business, litigation runs in cycles. Economic downturns, like the present slump, emphasize the benefits of following fundamentally good practices. Cutting corners to maximize short-term profits can generate litigation that over-shadows the benefits realized.
Well-managed companies will survive the present barrage of lawsuits. Managers should consider the claims that are being asserted, so that they can form layers of protection for their companies against similar future claims.
RELATED ARTICLE: TAKEAWAYS
* Almost no business is immune from class actions resulting from the subprime meltdown. Some 170 suits were filed last year, more than 30 of which related to the mortgage crisis.
* The majority of suits are securities-fraud class actions that fall into the following categories: securities fraud/shareholder-derivative actions; borrowers suing lenders; borrowers suing financial firms; financial firms suing lenders; or regulators suing lenders.
* Though high-risk business ventures can--and frequently do--result in losses, C-suite executives who pay attention to the current legal climate and focus on their firms' fundamentals can avoid costly future litigation.
* The key defense against shareholder suits is a strong and independent board of directors. That's because if the majority of directors are not personally implicated in alleged wrongdoing, they usually have the power to authorize a shareholder's right to sue.
LARRY B. CHILDS (larry.childs@wallerlaw.com) is a partner in the Birmingham, Ala., office of Waller Lansden Dortch & Davis LLP where his practice focuses on complex financial services litigation.
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