Subprime Mortgages and Theories of Liability--Deja Vu? (Part Two)

Background

Part One of this series focused on certain features of the subprime mortgages now defaulting in huge numbers and explained how these features also were uncovered in many improper transactions related to the Savings and Loan Crisis of the early 1990s as well as in the more recent scandals associated with enormous investor losses typified by Enron and WorldCom (which problems, coupled with similar corporate scandals, in turn, led to a crisis of confidence by the investing public that was followed by the enactment of various corporate governance reform measures set out in the Sarbanes-Oxley Act).

Part Two of this series now examines some cases, issues, and theories of liability that plaintiffs and regulators are relying upon to establish the civil and criminal liability of the defendants in various suits for damages sustained in connection with the implosion of the subprime mortgage market.

What is a Subprime Mortgage? (A High-Risk Loan by any Other Name)

If the term “subprime loan” had not become a widely used euphemism for describing high-risk loans, then perhaps investors would not have been so willing to buy the securities created by bundling and securitizing high-risk mortgages. Significantly, most buyers of these securities were “institutional” or “accredited” investors who should have known about the securities' inherent risk. Companies holding these securities have now lost many billions of dollars in shareholder equity and that is just a start. See, e.g., Steven L. Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, Research Paper No. 203 at 2, n.5 (March 2008) (citing, among other examples, Jenny Anderson, "Wall St. Banks Confront a String of Write-Downs," N.Y. TIMES, Feb. 19, 2008, at C1 (“major banks . . . have already written off more than $120 billion of losses stemming from bad mortgage-related investments”) and "Wall Street Banks Slashing Workforces," CHI. TRI., Mar. 25, 2008, at C2 (“[t]he collapse of the subprime mortgage market last year and the ensuing credit contraction have saddled the world’s largest financial institutions with at least $200 billion of write-downs and losses”)) (forthcoming Utah Law Review (2008), as part of the University of Utah S.J. Quinney College of Law and Utah Law Review symposium: “Subprime Meltdown: The Law and Finance of the American Home Mortgage Foreclosure Crisis”), available at http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1114810_code485747.pdf?abstractid=1113034&mirid=1

While they are risky, subprime mortgages are also thought to provide salutary effects by opening up the benefits of home-ownership to the poorer members of society (who are disproportionately minorities). This, of course, assumes the absence of predatory lending activities that have led too many subprime mortgage holders into financial ruin. See Roberto G. Quercia, et al., The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment Penalties and Balloon Payments, 18 Housing Policy Debate, No. 2, 311, 311 (2007) (“Even after we control for other factors, refinance loans with prepayment penalties are 20 percent more likely and those with balloon payments are 50 percent more likely to experience a foreclosure than other loans. These findings suggest that predatory loans have the potential not only to erode household wealth, but also to heighten negative effects on individuals, households, and communities”) and Kathleen Engel and Patricia A. McCoy, Turning A Blind Eye: Wall Street Finance of Predatory Lending, 75 Fordham L. Rev. (March 2007) (arguing, inter alia, that “Wall Street firms securitize subprime home loans without determining if loan pools contain predatory loans” and that some secondary market actors “have actively facilitated abusive lending”), available at: http://ssrn.com/abstract=910378

While there are Many Subprime Lawsuits, Can the Plaintiffs Meet their Burden?

Increasingly, shareholders of the companies and others are seeking relief from the courts: Over 100 class actions have been filed seeking damages allegedly tied to misconduct related to the purchase of such securities. See, e.g., Kevin M. LaxCroix, “Subprime-Related Securities Class Actions,” The D & O Diary (as of July 25, 2008), available at http://www.dandodiary.com/tags/subprime-related-class-action. See also Sherry Karabin, Wipeout!, Corporate Counsel (June 1, 2008) (citing a Navigant Consulting report that 448 subprime-related cases were filed in federal court from January 2007 to March 2008), available at http://www.law.com/jsp/ihc/PubArticleIHC.jsp?id=1202421863173. The defendants named in these actions are well known and include several of the nation's financial leaders: Merrill Lynch, Morgan Stanley, UBS AG, Wachovia Corporation, and Washington Mutual, among others. 

Sophisticated Investors and Disclosed Risks Spell Trouble for Plaintiffs

It is worth noting that the plaintiffs in these securities fraud class actions face major hurdles. For one thing, because institutional or accredited investors are considered to be capable of evaluating the merits and risks of prospective investments, they do not need to be given the breadth of warnings that the SEC otherwise ordinarily requires. See Securities Act Rule 501(a)(1), (2) and (3), codified at 7 C.F.R. §230.501(a)(1), (2) and (3). See also, SEC Staff Report of the Task Force on Mortgage-Backed Securities Disclosure, “Enhancing Disclosure in the Mortgage Backed Securities Markets” (Jan. 2003), available at www.sec.gov/news/studies/mortgagebacked.htm.

Consequently, these plaintiffs cannot realistically expect to establish securities fraud liability by relying, as they commonly do, on evidence of material omissions. Rather, they must allege and prove causation and damages tied to materially fraudulent or misleading acts of commission. As I have noted elsewhere,

because the securities laws are not designed to operate as insurance for foolish decisions, courts also examine the mix of information . . . already in the marketplace to determine whether the failure . . . to provide the information was actionable. "In analyzing Rule 10b-5 causation issues, courts often state that investors may not simply close their eyes to obvious risks, but must exercise due diligence in protecting themselves."

Michael E. Clark, “Securities Law Issues and Disclosure,” Ch. 12 IV. C., at 779, Pharmaceutical Law: Regulation of Research, Development and Marketing (BNA 2007) (citing C. Edward Fletcher, Sophisticated Investors under the Federal Securities Laws, 1988 Duke L.J. 1081, 1090 (1988) (internal notes omitted)).

Moreover, as Professor Steven L. Schwarcz explains, “[m]ost . . . of the risks giving rise to the collapse of the market for securities backed by subprime mortgages were disclosed, yet the disclosure was insufficient, in part because complexity made the risks very difficult to understand.” Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, Research Paper No. 203 at 2.

More to Come

©Michael E. Clark, Hamel Bowers & Clark LLP. Information provided in this blog does not, nor is it intended to, create an attorney-client relationship. Rather, it is offered solely for informational purposes and is not intended to constitute advertising. More information about me, my practice, background, and interests, is available from the firm website, www.lawyers.com/hamelbowers&clark, and the following sites (including links to some of my published papers and articles: www.avvo.com/attorneys/77007-tx-michael-clark-121553.html and www.superlawyers.com/texas/lawyer/Michael-E-Clark/a051f497-181f-4399-862b-cd4a7ad5c1cf.html

The treatise on pharmaceutical law for which I am Editor-in-Chief was published in December 2007 by the ABA Section of Health Law/BNA and is now in supplementation for 2009. See http://books.google.com/books?id=uWrhQSZ14AMC&printsec=frontcover&dq=%22pharmaceutical%22+%26+marketing+regulation&sig=ACfU3U1w36Sipb34e7yDRLiYdPylbg9-oQ.