Why Take Stock Of Your Own House? How Subprime Mortgages Affect Us All

Tuesday, April 1, 2008 - 01:00

The following discussion is excerpted from remarks made by Mintz Levin Cohn Ferris Glovsky and Popeo PC attorneys, Richard H. Moche , Bridget M. Rohde and Jack Sylvia at a seminar held on March 4, 2008 in Washington, DC. Richard H. Moche is co-chair of the Firm's Subprime Practice Group and Manager of the Firm's Public Finance Section. His practice involves representing purchasers and end-users of structured finance products. Bridget Rohde is a Member of the Firm in its New York office. She practices in the area of white collar crime and investigations as well as the Subprime Practice Group. Prior to joining Mintz Levin she spent 16 yearswith the criminal division of the U.S. Attorney's Office for the Eastern District of New York where she rose to become head of the division. Jack Sylvia is co-chair of the Firm's Subprime Practice Group and a member of the Firm's Litigation Section in the Boston office. His practice encompasses all areas of commercial litigation with emphasis on securities-related representation of corporations, directors, officers, accountants and individuals. He is one of the few individuals who has tried 10(b)(5) cases through to defense verdict.

Background On The Crisis Involving Complex Instruments

There are many participants in these transactions involving complex instruments. In the financial services community most participants have claims to assert and transactions to defend involving the securitization of subprime mortgages including both the sale of mortgages to structured entities and the sale of securities on behalf of structured entities. There are buyers and sellers on both sides of the transactions and some on both sides.

There are huge losses. Write-downs as of February 2008 are reckoned at $120 billion with estimates on total losses ranging as high as $600 billion. If past experience of financial crises is any indicator, the actual losses to be incurred may be multiples of these estimates. Because of the broad public knowledge and concern, pressure is applied to prosecutors and other enforcement agencies to act, especially in view of the sympathy evinced for people losing their homes. This has led to a hot enforcement environment.

Who is to blame? If this is like other recent financial scandals, the consequences of this meltdown can be significant.

Overview of the history of the subprime debacle

A brief overview of the facts puts the current situation in context. Because of the collapsing value of subprime mortgages, their collateralization and the slump in the housing market, a perfect storm was created during 2005 and 2006. There had been a borrowing binge created by low interest rates and lax underwriting. In 2005 and 2006 there was a disconnect between the true cost of housing as measured by rent and replacement costs and the nominative cost of new construction. New loan products arrived on the scene such as "no verification", negative amortization loans and teaser rates producing a riskier loan pool while at the same time a refinancing boom created higher leverage. Appraisal levels for refinancing differed from those levels for new acquisitions. Securitization techniques were applied which separated the originator of the mortgage from the mortgage holder (unlike in former times when the original holder of the mortgage left it on its books and performed any workouts that might ensue).Finally, housing values began to deflate.

How a subprime loan became amortgage-backed security

The process first involves the home-owner getting original financing or refinancing from a direct lender or loan broker who builds up a stockpile of mortgages which are conveyed to a warehouse lender under a warehouse lending program. The warehouse lender uses structured investment vehicles (SIVs) to borrow from money market funds. A critical group of mortgages are then moved from the warehouse lenders to a trust with some servicing rights being retained by the originator of the mortgage. In order to enhance the value of the trust, credit default swaps and pool insurance are added. The underwriters and placement agencies then take the trust to the rating agencies prior to their sale to corporations, pensions funds, hedge funds, mutual funds, CDOs, etc. Some of these securities end up with individuals.

The question is for those financial service organizations: where is your organization positioned in this complex matrix of interests? Will you be asserting claims or defending against them? In many cases you may be doing both. This crisis has taken many unexpected turns. The default rates in this scenario involving highly rated instruments such as AAA bonds have been surprising. SIVs working with money market funds to finance the warehousing activities have caused consternation in the money fund markets and municipal bond insurersthat insured some of these instruments along with municipal bonds have caused the municipal bond market to be roiled.

What action plan to follow?

The action plan in this scenario for those involved is to be very proactive - to get ahead of the problem by analyzing it, assessing it, and preparing for any government action. The way to handle such an imbroglio is to set up an independent internal investigation. How does one conduct an investigation so that it protects the company, its officers and directors and its employees?

Who Is Under Investigation?

Investigations of all the players in the subprime arena have been occurring. In January 2008 the FBI working in collaboration with the SEC announced an investigation of 14 corporations across the subprime lending industry. The focus of the investigation includes developers, subprime lenders, securitizers of loans and investment banks. The SEC has formed a subprime mortgage taskforce which independently of other agencies has opened three dozen cases. In February the U.S. Attorney's Office for the Southern District of New York sought the SEC's information about one investment bank which is thought to have inflated its valuation of mortgage bonds on its books notwithstanding that the valuation on those bonds had been dropped.

What does this illustrate? It depicts a big financial fraud case wherein a major investigative agency like the FBI gets into the mix together with the SEC with its particular expertise. These investigations started about a year ago with the investigation by the New York State Attorney General's office looking at all kinds of permutations in this area, including inflated appraisals. Significant prosecutorial offices have now entered the arena. Additional investigations are being reported by the U.S. Attorney's offices in the Eastern District of New York, in the Central District of California, by the U.S. Trustee's Office, FINRA, HUD, numerous states attorneys general from New York to California, district attorney's offices and the New York Stock Exchange.

Investigations span the range of crimes from predatory lending to the packaging and sale of high-risk mortgage obligations. The inflated appraisals area suggests that appraisers are at risk for overstating the values of homes, which may have been prompted by inducements by overzealous mortgage brokers. Cases involving conflicts of interest are particularly applicable to the rating agencies.

What Can We Expect?

As in previous crises, we can expect intensive investigations, lengthy trials, stiff jail terms and hefty fines. Cautionary tales emerging from the accounting scandals of the early '90s such as the Enron collapse involving the prosecution of its Chairman, Ken Lay, and its CEO, Jeff Skilling, for federal securities fraud and other charges. While Lay died before sentencing, Skilling was sentenced to 24 years and four months in prison, fined $18 million and required to make $183 million in restitution. The Company is required to pay $12 million to creditors. Another example of an accounting fraud case is that of CEO and Co-founder of Adelphia Communications John Rigas and his son Timothy Rigas, CFO, prosecuted by the Manhattan U.S. Attorney's Office and charged with securities fraud and other charges. John Rigas is serving 15 years in prison and Tim Rigas 20 years. There was also a SEC settlement component and again the company had to pay a hefty fine. The Tyco International Ltd. case was brought against CEO Dennis Koslowski and CFO Mark Schwartz by the Manhattan District Attorney's Office with both men sentenced to 8 1/3 to 25 years in prison. Koslowski received a $70 million fine while Schwartz was fined $35 million. They are both subject to repaying $134 million in restitution. The company had to pay a $50 million fine to the SEC and a fee of $3.3 billion into a settlement fund. One of the most egregious examples of accounting fraud involved WorldCom in which CEO Bernie Ebbers was prosecuted by the U.S. Attorney's Office in Manhattan for securities fraud and other charges. He received 25 years in prison and WorldCom was also forced to pay a considerable sum. More recently, the stock backdating cases serve as cautionary tales, involving Brocade, Monster.com and Converse involving in some cases jail terms for executives and hefty financial expenses for their companies, not to mention lawyer's fees.

Conducting Effective Internal Investigations

When do you initiate an internal investigation? Our firm's general practice is to recommend to the client that they be proactive and act as soon as potential problems surface, even if the result of that investigation is a clean bill of health since they are better positioned to respond to government inquiries and/or government subpoenas, civil litigation and media inquiries. More importantly, however, a company's willingness to police itself is an important component of an effective compliance program. Being proactive permits the client to take corrective action before the regulator steps in and allows the client to make an assessment as to whether to self- report a violation and to correct any problem. There are also certain disadvantages to being proactive: internal investigations can cost a lot of money, they can be disruptive to the ongoing business operation of the client, and if nothing comes of the investigation, there will be a lot of second guessing as to why the company was put through this. These are all valid points, but in our view, the risk in being complacent, specifically being second-guessed by government regulators, outweighs the concern. Sometimes, of course, a client cannot be proactive because he simply does not know there is a problem. There may be a situation, for example, where there is an employee whistleblower who has been talking to the government for years without the client's knowledge, there may be an industry-wide investigation that has been going on for years, again without the client's knowledge. In these circumstances a premium is placed upon conducting an effective investigation and conducting it quickly, the government already has a head start, the client needs to get up to speed to be able to intelligently respond to subpoenas, stop any ongoing wrongdoing and take any other collective action.

Other vital considerations are:who is the client, who is going to conduct the internal investigation and be responsible for that investigation on behalf of the client? In many instances, management may be implicated in the alleged wrongdoing and,in fact, it may even rise to the board level. Typically, we aim to find a committee or a subset of the board that can be independent - whether they are board members who have joined the board after the alleged wrongdoing has occurred, or in some cases, the audit committee members become the client. Once the client is determined, the next issues are to determine: what is the committee's mandate, what is the committee commissioned to do, what will its authority be and who will the committee report to? In addition the question is: who is going to do the work generally?

The committee must be assisted by legal counsel because only they have the protections of the attorney/client privilege and the work product doctrine to shield the results of the investigation from governmental regulators, civil litigants and any other third party. Once counsel is involved, however, an important decision is: who do you use? In-house counsel is certainly an option but the problems with that is that courts have been less willing to recognize privileged communications invoked by in-house counsel who not only wears a legal hat but also a business hat. The second reason to go outside is that a troubling investigation can take on a bit of a prosecutorial air. Once you have internal counsel participating in grilling management witnesses, even if at the end of the day no wrong doing is discovered, that counsel will never be viewed again in the same way by management. In general, outside counsel is brought in and the only question there is: do you use the customary outside counsel of the client or do you seek independent counsel - and that decision is really based upon whether a determination is made that the wrongdoing could possibly implicate general counsel (who may have hired the regular outside counsel) or the allegation could be made that the customary outside counsel gave a wink and a nod to the possible wrongdoing.

Another important consideration - don't throw anything away. In the government's view there is no such thing as accidental document destruction. Accordingly, it is important to have an early and effective document hold, not limited only to paper documents; it must include electronic documents as well as email, Excel spreadsheets, text messages, etc. It is imperative for outside counsel to meet early on with the relevant IT individuals at the company so that there is an understanding as to what type of electronic information the company has, how it backs up data, where the backups are kept, what does the company do to recycle those backups. With this knowledge one can craft a document-hold that is tailored to the particular client. Importantly, it is not enough just to send out a memo to all employees advising them not to throw anything away; often times that memo may be the first thing that is discarded. One needs to follow up to make sure that the document-hold has actually been followed.

Still another matter involves witnesses. Who at the company is going to have relevant information that you need to extract in order to further the investigation? Any time you do conduct an interview you need to make sure that that employee understands that you as counsel are representing the investigative committee and that you do not represent the individual witness.

Finally, what do you do with the results? Do you have a disclosure obligation to the board or to management and the board or is this of such a nature that you wish to self-report to the Department of Justice or the SEC?

What Privileges Come Into Play?

The attorney/client privilege protects against disclosure of confidential attorney/client communication in connection with the rendering of legal advice. The decision to waive that privilege belongs only to the client. If this confidential information is shared with third parties, the privilege is lost and anyone is entitled to discover what you have discussed. The second privilege that goes hand-in-hand with the attorney/client privilege is the work product doctrine which protects work performed in anticipation of litigation by attorneys and their agents. This brings into the equation the way in which consultants are handled.One may need accountants or forensic accountants, IT consultants or other professionals. It is important when engaging consultants not to break the privilege and have the work be discoverable; therefore, consultants should be retained as agents of the attorneys so their work product is also subject to the same privileges.

The second major question is: whether to put the results of the investigation in writing or do an oral presentation? There are obviously pros and cons to each approach - oral presentation is by definition more difficult to discover in any ensuing litigation. In contrast, written reports are potentially easier to discover. The written report, once governmental regulators or civil litigants discover that it exists, is more likely to be subject to a challenge from some or all of the parties and would not be entitled to the work product or attorney/client privileges. Once the government has discovered that a written report exists, it will pressure a company to turn it over (though the government does not always get it.). The decision of how to disseminate the findings of the report and how broadly is an important one. If the investigation implicates members of management and/or members of the Board, who either through action or alleged inaction have permitted the wrongful conduct to occur, and the contents of the report are shared with these groups, many courts may decide that the sharing in and of itself constitutes a waiver of privilege. These considerations need to be weighed in advance because once the cat is out of the bag you cannot go back and reinstitute the privilege.

Finally the client may consider whether it wants to engage in a voluntary waiver of the privilege. As previously mentioned, the government always requests the results of an internal investigation and places a premium on cooperation during charging decisions. While there has been some backlash to this approach, both the DOJ and the SEC weigh the decision not to waive in determining whether a company is cooperating. Often requests for a waiver will be couched with an agreement to enter into what is called a "limited waiver agreement" where the government acknowledges the fact that the material is being shared with it, but agrees it does not constitute a waiver of the privilege. Some courts have upheld the legitimacy of these agreements and some do not. There is always a delicate balancing act with the government. If you make a determination early on that you are going to share that report with the government, you may wish to make a decision to do an oral presentation so there is no record for a civil litigant to pounce upon. An effective internal investigation is one which both determines whether and to what extent you have a problem.

It bears the hallmarks of independence such that a third party will accept and rely on the conclusions reached and any actions taken by the client as a result of the internal investigation.

What Is The Best White Collar Defense?

For the corporation : With respect to the corporation the first line of criminal defense is the internal investigation in order to have a total command of the facts, and be in a position to decide what your legal strategy should be. Based on those facts,you will make a decision on whether to move the corporation toward cooperating with the government or whether you think the government's case may be wrong or not entirely right, and hence defend the matter. Besides the internal investigation there are a whole variety of constantly moving interlocking factors to keep in mind. First, the corporation may well face a variety of plaintiffs - prosecutors, regulators and individuals, in some cases a combination of plaintiffs. Also, there may very well be shareholder suits. Another set of factors involves the variety of claims, civil and criminal, that the corporation may be confronted with.As regards the civil claims, the corporation could be facing Section 10(b)(5) claims or state law cognates or shareholder derivative claims. On the criminal side there is a whole range of charges including mail, wire and securities fraud under the U.S. Code and state Blue Sky laws. Additionally, it has become standard practice for perjury, obstruction of justice and false statements to the government claims to be part of the criminal prosecution. We have all seen how the cover-up can be worse than the crime. The most compelling evidence against the corporation is an employee ignoring advice or destroying documents or trying to coach a co-worker as to what he should say. Another complication occurs with a variety of co-defendants such as directors, officers and employees.There may be both civil as well as criminal claims combined - 10(b)(5) claims, shareholder suits or wire, mail and securities fraud charges all at once. There are many moving parts that call for a well organized, structured approach to a corporation's defense.

For Individuals : The corporation itself cannot commit a crime. The crime, if any, is going to be committed through individuals so the key questions are going to be: "Has any law been broken?" and if so, "Who is responsible?" That harkens back to the internal investigation, which should determine whether someone has actually done something wrong. If so, they should be getting separate counsel. Outside counsel conducting the separate investigation represent either the audit committee or the special committee. A more efficient coordination of the defense for the corporation is to have separate counsel for any exposed individuals who can deal with other outside counsel in a more lawyerly and less emotional fashion.

It has become standard practice for attorneys' fees to be advanced or reimbursed when individuals are involved. Directors, officers and employees not only have to worry about their response to the government as individuals but also about their status at the corporation. Sometimes this produces complicated and divergent interests, which is yet another reason for independent counsel for folks who might have some exposure.

Corporate And Individual Decisions In The Light Of Recent Events

The Department of Justice has had a series of memos guiding their prosecutors in making decisions about whether to indict corporations. The first memo was the Holder memo, followed by the Thompson memo, and most recently in December 2006 the Thompson memo was replaced by the McNulty memo. The SEC has a similar memo called the Seaboard memo. The point of the DOJ memos is that there are nine things that a prosecutor should be evaluating before charging a corporation. Those nine things are very common sense issues: how bad was the corporation's conduct and how pervasive? did it go up to the top of the corporation and was it endorsed by the people at the top? how indicative was it of the culture of the corporation?Another factor has taken on a life of its own: did the corporation cooperate with the regulators? It is on this key issue we find the corporation making its decisions separate from individuals making their decisions. Corporations have learned from Enron and other cases that an indictment can be a death knell so often they lean overboard towards cooperation since the government has interpreted cooperation broadly.The point is that the government's offer of leniency may provide some incentive for corporations to cooperate when individuals who might have some exposure may not feel it is in their best interests. This comes down to a conflict where the corporation feels it may be in its best interest to grant a waiver of the privilege while individuals may feel they are being sacrificed. The good news is that the environment has improved a bit. Judge Lewis Kaplan in the Southern District of New York made a decision in the KPMG case last summer which gives some solace to individuals; he found that putting a cap on and stoppingpayment of attorneys fees was a deprivation of due process rights as well as the deprivation of the right to counsel. Congress took an interest in this also in December of 2006 when Senator Arlen Specter introduced legislation to protect the attorney/client privilege following the reasoning of Judge Kaplan. This backlash against cooperation, which had caused individuals to suffer inordinately, now gives directors, officers and employees the ability to push back on the level of cooperation they will give the regulators. They must make distinct decisions at every juncture of the process. The bottom line for our white collar defense thesis is that a defense starts with the internal investigation and requires strategizing all along the way on what is best for the corporation as well as for the directors, officers and employees - and what is best for eachmay not always be the same thing. But certainly coordination among counsel is helpful and positive.

Please email the participants at rmoche@mintz.com, bmrohde@mintz.com or jsylvia@mintz.com with questions regarding this article.