Has the Credit Crisis Litigation Wave Reached an Inflection Point?

D&O Insurance Marketplace Entering a Transitional Phase

The growing wave of subprime-related litigation is among the many side effects of the subprime mortgage meltdown. The litigation wave has changed, too, as the subprime crisis evolved during the past two years and as new and different litigants became involved. But as a result of the dramatic, recent headline events in the financial marketplace, the economic crisis entered a dark new phase that has already produced its own distinctive round of lawsuits. Like the underlying circumstances, the new litigation phase also seems darker and more threatening. And the events indicate that the directors and officers (D&O) insurance marketplace is entering a new phase.

The first subprime-related securities class action securities lawsuit was filed in February 2007, just as the subprime meltdown began to surface. Since then, as the subprime-related problems developed into a more generalized credit crisis, the associated litigation also has grown to a huge wave of lawsuits. As of Oct. 10, 2008, 124 subprime and credit crisis related securities class action lawsuits were filed, in addition to 25 derivative lawsuits and 18 ERISA lawsuits.

The events producing that litigation took a dramatic turn in September 2008. Within the span of a few weeks, the government assumed control of Fannie Mae and Freddie Mac; Lehman Brothers filed for bankruptcy in the largest bankruptcy ever; Bank of America agreed to acquire Merrill Lynch; the government engineered a massive bailout of American International Group (AIG); government regulators took control of Washington Mutual in the largest bank failure ever; and Citigroup sought to acquire Wachovia in an FDIC-brokered deal, only to have its bid topped by Wells Fargo. On top of those events came the massive $700 billion governmental bailout.

Any one of the events alone would have been significant and disruptive. Taken collectively, the developments represent a massive reordering of the entire financial market. The sequence of events unfolded very rapidly, but it will be months or even years before all of the consequences become apparent.

As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of the companies caught up in those events. For example, Fannie Mae and Freddie Mac shareholders have filed securities class action lawsuits against the companies and their current and former directors and officers, alleging that they were misled about the companies’ financial condition.

In addition, Merrill Lynch shareholders have filed a shareholders’ derivative lawsuit alleging that the company’s planned merger with Bank of America is the result of a “flawed process and unconscionable agreement.” AIG shareholders also have initiated a shareholders’ derivative lawsuit against certain of the company’s current and former directors and officers, alleging that the defendants should be held accountable for the company’s “exposure to and grossly imprudent risk taking in the subprime lending market and derivative instruments.”

The lawsuits are perhaps the inevitable product of the headline events. But there also have been other related litigation, and it is this further litigation that suggests the credit crisis litigation wave may now have entered a new, more complex and perhaps more dangerous, phase.

As widely reported, the Primary Fund of the Reserve Family of Funds “broke the buck” when its net asset value fell below $1 per share. On Sept. 18, 2008, plaintiffs’ counsel commenced a securities class action lawsuit against the money market Fund’s underwriters, investment advisor, and officers and directors.

The complaint alleges that the Fund’s offering documents failed to disclose, among other things, “the lack of diversification of the Fund’s assets and exposure to, at a minimum, now largely worthless debt securities valued at $785 million of the now defunct Lehman Brothers Holdings Inc.”

In addition, on Sept. 22, 2008, plaintiffs’ lawyers filed a securities class action lawsuit against Constellation Energy Group and certain of its directors and officers. (Constellation Energy Group is an electric utility holding company.) The complaint alleges that on Sept. 15, 2008, after it was already reeling from accounting-related issues and the possibility of a rating downgrade, the company announced its exposure to Lehman Brothers’ bankruptcy. The complaint alleges that the company’s “exposure to credit problems of trading partners was much greater than represented” and that “in fact, one of Constellation’s key trading partners, Lehman, was having severe financial problems.”

The allegations relating to Lehman’s collapse represent only a part of the issues involved in the Constellation Energy lawsuit. Nevertheless, the lawsuit demonstrates that the reverberations from recent events are spreading far beyond the high-profile financial services companies whose names have featured so prominently and are now affecting those companies’ “trading partners,” adding to their partners’ difficulties. In the case of Constellation, it also is leading to litigation.

Reverberations from this latest phase of the credit crisis are rippling through the entire economy, encompassing a broad array of participants — many of whom themselves have little or no direct exposure to subprime related assets or investments. However those companies have exposures to other companies that had exposures to mortgage-related assets and investments.

Many companies are likely to be affected, and some will be sued. The subprime and credit crisis-related litigation wave, which is well into its second year, not only has much further to run, but it may have entered a new phase involving a broad spectrum of potential litigants.

These events also mark a new phase in the D&O insurance marketplace. D&O insurance for financial institutions, which already was under pressure, has become even more challenging. In addition, it is clear that the broader D&O insurance marketplace has entered a transitional phase. The larger trends continue to develop. However, insurers generally are proceeding more cautiously. Whether these events will result in a general market hardening remains to be seen. But these events have introduced the possibility that the competitive conditions that prevailed in the marketplace in recent years could be shifting.

Topics Lawsuits