Bissinger's Securities and Finance for Trial Lawyers

Refco Complaint -- Allegations Against Grant Thornton, Mayer Brown, and Many More

For a comprehensive summary of what happened at Refco, see the attached complaint.Download refcocomplaint.pdf  The complaint states, "[t]he defendants include a 'who's who' of some of the biggest names in corporate finance, law, and accounting, whose reputations and substantial assistance were required for [Refco's officers] to strip out billions of dollars in Refco assets."

Credit Crisis Litigation Update

Today's New York Law Journal has a helpful report on the litigation arising out of the credit crisis.

Central Bank Intervention, the Credit Crisis, and Bond Data

Professor Becker and Judge Posner have posted an illuminating exchange of comments on their blog questioning the wisdom of the intervention of the U.S. Federal Reserve and other banks in increasing liquidity in the current credit crisis.

Judge Posner's citation to a 2005 Economist story regarding the housing boom probably reminds most of his readers of their awareness of the housing boom at that time. Savvy analysts began to question the financing of the housing boom back then, but one wonders if more information about the relatively opaque bond market (which includes the complex debt derivatives at the heart of the crisis) might have helped avert today's crisis.

Despite the power of the internet, the public has little access to information about mortgage-backed bonds and bond prices.  This stands in contrast to stock price data and public company disclosures, which are widely available at low cost.  Bond data resides in Bloomberg terminals and other proprietary databases that cost around $1500 per month per user. 

Cheaper access to information about collateralized debt obligations, collateralized mortgage obligations, and other derivatives might have led to more rigorous study of these instruments in Congress, academia, the press, and trials and arbitrations.  The costs of dissemination could be charged to industry participants who benefit from participating in these markets.  These costs would seem nominal compared to the costs of imploding hedge funds, collapsing lenders, and central bank intervention.  Saving the stock market from a steep decline and the economy from a recession would be icing on the cake.

In any event, most people agree that free flow of market information lies at the heart of free enterprise in general and the securities industry in particular.  Meanwhile, astute observers question the rating agencies that awarded investment-grade designations to many debt instruments.   

Yet even sophisticated investors have limited ability to scrutinize those ratings.  Perhaps wider availability of bond price data and other metrics would have helped raise questions sooner.

The Hedge-Fund Manager's New Clothes

For a spoof on hedge funds reminiscent of Jeff Skilling's "hypothetical future-value accounting" featured in  the film Enron:  The Smartest Guys in the Room, check out this piece by Mark Gilbert of Bloomberg.com.

Suits Against Bear Stearns Mulitiply

Bear Stearns faces litigation on several fronts.  Investor advocate Jake Zamansky has initiated at least one  arbitration claim before the former National Association of Securities Dealers, now known as the Financial Industry Regulatory Authority, or FINRA, as reported on CNBC.  At least one institutional investor has initiated legal action against Bear Stearns for losses arising out of its hedge funds.

British banking giant Barclays may bring suit, too, for losses arising out of its investment in Bear Stearns Asset Management's High-Grade Structured Credit Strategies Enhanced Leverage Fund. 

Defense law firms have formed various practice groups to address the subprime mortgage crisis.  According to the Wall Street Journal, Paul Hastings, Patterson Belknap, and Pillsbury Winthrop have all announced formation of teams for this purpose. 

CMOs on Margin, the Collapse of Brookstreet Securities, and the Potential Role of NFS/Fidelity

June 2007 witnessed the failure of a broker-dealer that specialized in trading collateralized-mortgage obligations ("CMOs") on margin.  See Bruce Kelly, "Brookstreet Clients, Counting Losses, Ponder Arbitrations," Investment News, July 9, 2007. 

Published reports indicate that Brookstreet sold clients volatile species of CMOs known as "interest only strips" and "inverse floaters."  These CMOs behave much like the margined investments.  In comparison to less volatile types of CMOs, these instruments deliver compounded returns -- and compounded losses.

A brokerage firm selling inverse floating CMOs on margin would compound that risk even more.  That's what many believe happened at Brookstreet.  Reports indicate that Brookstreet sold these investments, on margin, to elderly and/or unsophisticated investors.  When the CMOs declined in value, these elderly investors suffered not only major losses, but became indebted on their margin interest.  That's generally not the kind of thing firms should be selling to elderly or unsophisticated investors.   

Because many of Brookstreet's brokers operated out of their homes, it's doubtful that Brookstreet brokers did a lot of business with large institutional purchasers for whom these high-risk securities are best suited.

Games may also have been played with the valuation of Brookstreet's CMOs that hurt investors even more by overvaluing the CMOs at the time Brookstreet sold the investments, but undervaluing the CMOs in making margin calls.  This would be like a homebuilder loaning money based on an overvalued house and thereby creating a larger monthly note.  But when the borrower defaults, the homebuilder/lender grossly undervalues the house at foreclosure, leaving the borrower with jumbo liability but shrunken collateral. 

According to a major defense-oriented law firm, that's may have happened at Brookstreet.  In July, Holland & Hart posted an extraordinary blog post criticizing not only Brookstreet, but also its clearing firm, NFS -- owned by Fidelity -- for possible manipulation of the values of the CMOs that Brookstreet sold to retail investors.  See "Brookstreet Securities Collapse: Where Were the Regulators?"   

That sort of conduct could expand the scope investor recovery beyond the failing Brookstreet to the well-heeled NFS/Fidelity. 

Covenant-Lite, Covenant-Heavy, and Fraudulent Transfer Claims

The financial press has devoted much of its reporting on the credit markets to so-called "easy credit" or "covenant-lite" financings.  See, for example, http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_pauly&sid=a5ZErZ8qQogs.  The past few months have seen a sharp reduction on these "covenant-lite" financings and a reduction in merger activity.  As deals collapse, litigation will likely follow.

But of equal signficance to the business community -- and to commercial litigators -- are "covenant-heavy" financings.  These loans give creditors extraordinary remedies in the event of default, such as replacing a company's senior executives.  As a result, when a company defaults on its debt service under such an arrangement, creditors can find themselves with extraordinary remedies that rival and even exceed those of shareholders.  An excellent discussion of these financings appears in an article by Douglas G. Baird (University of Chicago Law School) and Robert K. Rasmussen (Vanderbilt University Law School), Private Debt and the Missing Lever of Corporate Governance, http://ssrn.com/abstract=692023 or downloaded here: Download baird_and_rasmussen_private_eq_and_corp_gov.pdf.

As Baird and Rasumussen observe, competing creditors and potential creditors often challenge these extraordinary provisions.  Id. at 20-21 (describing how Warnaco's lenders were able to "fundamentally alter" corporate governance and obtain "de facto control over every aspect of the business").  I handled such a challenge in a Harris County jury trial in 2006.  In Icoworks Holdings v. Cannon v. De Bie Midland, Inc., Cause No. 2003-41017 (125th Jud. Dist. Ct., Harris County), my client, a creditor, had financed an already-unstable small-cap company with "covenant-heavy" provisions.  The company defaulted and my client wound up owning the company.  A disgruntled former owner of the company claimed that my client's financing constituted a fraudulent transfer under Texas law, arguing that the many indicia of control in the financing agreement satisfied the Texas's version of the Uniform Fraudulent Transfer Act.  A Harris County jury rejected the former owner's claim, and Judge John Coselli entered judgment in favor of my client. 

In short, the dramatic events in the credit markets will draw attention to both "covenant-lite" and "covenant-heavy" restrictions.

Bissinger on Blackstone on CNBC's "The Closing Bell"

On the eve of the initial public offering of private-equity firm Blackstone, Rep. Henry Waxman, D-CA, called on the SEC to block it.  CNBC's Maria Bartiromo invited me to participate in a panel discussion of the issue.  I agreed with the panel that intervention made little sense, but that Congress should use the Blackstone IPO to investigate the largely nonpublic world of private equity.  The drop in Blackstone's share price following the IPO raises further questions about why a private equity firm like Blackstone, which long preached the benefits of avoiding the burden of public disclosures, quarterly earning reports, and so forth, would choose to go public.  What does the Blackstone IPO, particularly its drop in share value following the IPO, tell us about the future of private equity and the credit markets which have long supported private-equity firms?

Bissinger on E-Document Examinations

"E-documents" have changed the mode of witness examinations in securities and other financial cases.  My article, "The Smoking E-Mail," from the June 26, 2007 Texas Lawyer, addresses some of the issues that trial lawyers may want to consider in handling these examinations -- whether in depositions, hearings, arbitrations, or trials. 

For a download of this article, click on the following link:  Download texas_lawyer_bissinger_edocument_examinations.pdf

What Is a Hedge Fund?

Think of a hedge fund as a private club of investments in anything the hedge fund manager wants to invest.  Hedge funds have limitless investment options.   One feature unites hedge funds today:  performance fees in the range of 20 percent of the funds profits plus management fees of about 2 percent of principal.  That makes hedge funds far pricier than mutual funds, which charge no performance fees at all.  Index funds, like Vanguard's fund based on the S&P 500, charge as little as one tenth of one percent (0.10%).

 

Roger Lowenstein describes hedge funds in his excellent book about the largest hedge fund collapse to date, When Genius Failed:  The Rise and Fall of Long-Term Capital Management:

 

"As far as securities law is concerned, there is no such thing as a hedge fund.  In practice, the term refers to a limited partnership, at least a small number of which have operated since the 1920s. . . .  Unlike mutual funds, their more common cousins, these partnerships operate in Wall Street's shadows; they are private and largely unregulated investment pools for the rich. . . .  For the most part, they keep the contents of their portfolios hidden.  They can borrow as much as they choose (or as much as their bankers will lend them - which often amounts to the same thing). . . .  [H]edge funds are free to sample any or all of the more exotic species of investment flora, such as options, derivatives, short sales, extremely high leverage, and so forth."

 

Lowenstein, When Genius Failed, at 24 (2000) (emphasis in original).

 

The phrase “hedge fund” mischaracterizes most of the hedge funds in the news.  The term "hedge" ordinarily refers to hedging one's bets.  Trial lawyers do this when they enter high-low settlement agreements before a jury trial in which a defendant promises to pay the plaintiff no less than $500,000 but no more than $2,000,000, regardless of whether the jury awards $1.00 or $10 million.

 

Some hedge funds operate this way, but not the ones in the business pages.  To the contrary, as Lowenstein points out in When Genius Failed, many hedge funds have investments that not only lack any real hedges, but contain large amounts of leverage.  These leveraged funds present substantial risks of gain and loss to their investors. 

 

For that reason, Warren Buffett refuses to use that label when referring to the funds making all the news today. As Buffett wryly observes, the funds retain one important hedge: the hedge fund manager's compensation. His 2006 letter to shareholders describes the hedge-fund trend in classic Buffett style:

 

"[Imagine the] allegorical Gotrocks family – a clan that owned all of America’s businesses [that] counterproductively attempt[s] to increase its investment returns by paying ever-greater commissions and fees to ‘helpers.’ [That is, high-profile hedge-fund managers.]

. . . .

 

"[The hedge-fund managers,] Wall Street’s Pied Pipers of Performance[,] have encouraged the futile hopes of the family. The hapless Gotrocks will be assured that they all can achieve above-average investment performance – but only by paying ever-higher fees. A flood of money [has gone] from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he is accomplishing nothing – or for the matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. . . .

 

"The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have had it never heard of these ‘hyper-helpers.’ Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.”

See Warren Buffett, Berkshire Hathaway 2006 Annual Report, at 21-22 (emphasis in original).