Adam and Tina Kreysar lost nearly $100,000 in less than a year on just one investment. Late in 2007, the Kreysars bought 3,800 shares of a new issue of Freddie Mac stock. At the time, newspapers were filled with reports of the subprime mortgage crisis and the trouble it was causing banks and funds. But popular consensus held that Freddie Mac was not involved. Freddie was a familiar name, and most investors accepted that it bought good, prime, mortgages, freeing bank capital so it could be lent to other Americans. The company’s close ties to the government and its 37 year history gave the Freddie name an air of trustworthy infallibility. Its new offer, which drew the Kreysars to invest, was preferred shares, a favored product among investors looking for reliability. Freddie’s preferreds guaranteed investors a dividend and bumped them higher up the payment line, above common stock holders, should Freddie hit tough times or go bankrupt. These shares were sold by Goldman Sachs, the issue’s lead underwriter and Wall Street’s most prestigious investment bank. The bank was responsible for vetting Freddie Mac’s financial health. By going ahead with the sale, Goldman placed its stamp of approval on the shares, and the company.

But barely a year later, Freddie Mac and its sister company, Fannie Mae, were judged insolvent and taken over by the U.S. government. Freddie’s shares, in a precipitous decline for weeks, dropped below the $1 mark the day of the takeover, September 8, 2008. The Kreysars sold their holding for 98 cents a pop, having paid $26.79 per share back in 2007. This brought their losses to around $98,078.

The story could have ended there, but the Kreysars discovered they were not alone. Another investor in the same Freddie Mac preferreds, Robert Mark, took the matter to court, and the Kreysars joined his lawsuit. They’re not suing Freddie Mac or its executives for mismanagement. They’re suing the trio of underwriters responsible for bringing the Freddie Mac preferred shares to the market. The complaint lists the three survivors of the credit market collapse, Goldman Sachs, JPMorgan Chase, and Citigroup, as defendants, alleging they misrepresented Freddie’s true exposure to mortgage-related losses. And it isn’t the only lawsuit filed by disgruntled shareholders against Wall Street’s salesmen. Underwriters.

If you buy a faulty coffee maker that sets your kitchen on fire, you could sue the manufacturer for making an unsafe product. But what if you could sue the salesman for not thoroughly inspecting the product? For Wall Street banks, this is becoming a vexing legal problem. When securities flounder and investors head to court, they are armed with a 1933 ‘Truth in Securities Act’ designed to protect the public from suffering financial losses due to misleading or incomplete information from management or the underwriters who helped sell the securities. And as the number of troubled securities escalates, so does the number of securities filings against the banks. There were 139 shareholder class action cases filed in federal court in the first six months of 2008, compared with a total 195 suits filed in 2007, according to NERA Economic Consulting, which tracks investor litigation trends.

The resurgence in securities lawsuits stems from the subprime crisis. With companies failing and shareholder value plummeting across the market, many investors are re-reading the fine print in the sales brochure and realizing there was no mention of mortgage-market exposure. “The subprime/credit crunch fallout drove this spike, with almost all the financial sector filings involving related allegations,” said Cornerstone Research, which like NERA tracks shareholder class action suits. Subprime-related cases accounted for 20 percent of the 195 shareholder class action cases filed in federal court in 2007, and sprouted to over 50 percent of cases filed during the first half of 2008, according to NERA. The dollar amounts involved are also bigger for these cases. NERA notes that shareholder losses, which play a key role in determining settlement sizes, are typically ten times larger in subprime suits than in other types of shareholder litigation.

After two years of decline, shareholder class action suits are back on the rise thanks to the subprime meltdown. Source: NERA Economic Consulting, 2008 Trends.

This trend could be disastrous for investment banks, which are struggling to remain afloat in the wake of the subprime tsunami that wiped billions from their balance sheets. The mammoth size of the global underwriter business — worth around $3.1 trillion in 2007 — means the remaining banks could buckle under the sheer volume of the suits. Even though the settlement payments typically cover less than a quarter of investor losses, when added to subprime related writedowns the banks suffered, the litigation bubble could easily be the straw that breaks the camel’s back. While not every security will fail, and far from every investor will sue, each additional lawsuit means chalking up more money to cover mounting legal expenses or buttress a litigation reserve. Money that the banks do not have.

And none of the investment banks will escape underwriter liability suits. While thousands of new securities from numerous companies and funds are brought to market each year, the number of qualified underwriters is remarkably small. Just ten international investment banks accounted for 56 percent of the $876.3 billion in global equity and equity related underwriting done in 2007, according to Thomson Financial. Of these ten, six banks are based in the U.S. and only three, Citigroup, Goldman Sachs, and JPMorgan, survived as independent entities at the end of November 2008. Since underwriting is done in syndicates, or groups, a typical suit names several banks at once. This is how a very short lineup of the usual suspects finds itself on the threshold of a litigation crisis.

The underwriter’s legal duties are twofold: thoroughly inspect the company and accurately describe it in a prospectus so that a reasonable investor has all the necessary information to make an informed decision. For performing this task, the underwriter collects a hefty fee by scooping up all the company’s shares at a discount and selling them to public at a profitable mark up. Until the credit markets froze, the business was a gravy train for investment banks, bringing in over 20 percent of the $110 billion in revenues collected by the big five in 2007.

The first part, inspecting the company, is called due diligence. The investment bankers must look inside and out, interview key personnel, look over the company’s books and ledgers, and understand the product or service the company offers. Monroe R. Sonnenborn, who served in Morgan Stanley’s legal department for 16 years, recalls one case in which the underwriter team as part of their due diligence ventured out to major retailers to confirm Activision’s video games were moving off the shelf as briskly as company executives said they did. “The basic concept is that the underwriter has sufficient expertise to put a prospectus together, it protects the public, and all the information an investor needs is there,” Sonnenborn says. Underwriters also consult their own bank’s analysts to gain a deeper understanding of the business and the outlook for both the company and the industry.

Only then, with a firm grasp of the company and its business, do the underwriters compile a prospectus — the legal document they’ll use to promote the sale of the securities. A typical prospectus is a thick brochure printed on expensive paper, physically impressive and very professional. Inside, the text is a mix of legalese and financial jargon interrupted here and there with charts and graphs. It gives details about the industry, the company, how it makes its money and who’s running it, and the risks involved — all the information investors need to make an informed choice. The underwriters decide what goes in and what is left out. If the investment bank is sued over an underwriting, a thorough prospectus containing all relevant disclosure will be its key defense.

“The game is for the plaintiffs [investors] to try to find why the prospectus was misleading or omitted something,” Sonnenborn says. Investors may argue that the document includes false statements — like inflating the company’s profitability or understating the average number of products that get returned — or that it missed important information that would have influenced a reasonable investor. The Kreysars’ suit, for example, claims Freddie’s underwriters did not adequately disclose the company’s mortgage-related losses. “You’re liable even with a clear conscience, absent fraud,” Sonnenborn says. Simply not realizing what was important or relevant and failing to include it in the prospectus is all it takes to be liable under the law. “The people suing are going to claim that there was some specific kind of information that should have been disclosed, or the underwriter should’ve known about, and therefore it should’ve been included in the prospectus,” he says. The underwriter’s defense team must prove that they made a reasonable inquiry, found all the relevant information, and included it in the prospectus. “You have to demonstrate that you put people on the case who were expert in the area,” Sonnenborn says. “It makes it very, very difficult for the underwriters. They’re held to a very high standard,” Sonnenborn says.

While in the business world high standards are the foundation of a strong reputation and key to attracting customers, in the courtroom this asset quickly becomes a liability. “Many lawyers that I’ve spoken to have said that [investment banks] literally cannot win an underwriters liability claim because you have to make an argument that your world famous investment bankers had the wool pulled over their eyes in their due diligence process by a company,” said Brad Hintz, senior bank analyst at Sanford C. Bernstein & Company, a wealth management and research firm. Since his firm refrains from investment banking and underwriting, Hintz is free to talk about underwriter liability suits and the dangers they pose. He speaks quickly, excitedly, pausing just long enough for you to agree with his last declaration. He peppers his arguments with jokes, and he smiles and raises his eyebrows when revealing a particularly juicy statistic. Hintz, whose previous careers included a stint as chief financial officer of Lehman Brothers and treasurer at Morgan Stanley, has seen underwriter liability suits from inside the belly of the beast. This is why, in his third act as senior analyst at Bernstein, he’s had his litigation antenna up, searching for transmissions.

“We’re already in another litigation bubble,” Hintz says, his voice rising. The litigation bubble Hintz refers to is the growing number of shareholder class action filings, which in the first six months of 2008 outpaced the total cases filed in 2007 — 195 to 139. This number will likely double, reaching 278 by the end of the year, according to NERA Economic Consulting. Many of the current cases concern the underwriting of large, failed firms like Lehman Brothers, Fannie Mae, and Freddie Mac, for which due diligence will be harder for the underwriter to prove. Everybody on Wall Street had relationships with the failed firms, and the market was awash with rumors of internal trouble. This leaves burned investors feeling that the banks should have known better, which is why the conversation in many banks will soon turn to estimating damages.

“The public persona of the [investment bank] will be ‘we will defend this and we think our positions are strong,’ but inside they’ll have a conversation about whether they’re going to win or lose this claim,” says Hintz, who was privy to such discussions in his previous posts. The calculations are crucial in how the firm will proceed, whether it decides to settle or go to trial. After all, nearly 40 percent of cases are dismissed before trial. And even if the case reaches the jury, under the law investors can recoup only what they lost — no punitive damages, no lawyer’s fees — which results in a payout to investors that is well below the amount they lost. The median payout for a securities class action suit falls between 14 percent and 25 percent of investor losses. In the WorldCom underwriter liability suit, for example, the settlement paid investors around 37.5 percent of the $13 billion they claim to have lost. Still, 59 percent of the 235 filed in 2000 were settled.

Both underwriters and investors face a costly compromise when considering settlement discussions. Underwriters choose between handing a large chunk of cash to lawyers or the disgruntled investors suing them. Unlike fraud cases, where the investors’ complaint must present factual evidence of managements’ or banks’ intent to do wrong, underwriter liability suits give the investors the right to discovery. This means most cases hang around for at least two years while the bankers hand over every document connected with the underwriting and try to prove they did a thorough job. So a quick settlement is better than a lengthy document exchange that drives up internal legal costs and mires the underwriting team in distracting depositions. Investors are building up legal fees too, which will shrink the final amount recovered. All this creates a powerful incentive for both sides to settle. Bankers avoid the distractions of depositions and investors choose the prospect of accepting a little money now or seeing nothing at all later on if the judge decides the complaint has no legal merit.

Hintz is trying to quantify the scope of this litigation threat to banks, but keeps running into a recurring problem. “Lawyers get really nervous when you try to quantify something, because they always make the argument that, well, this case is different,” he says. As a CFO at Lehman, he often heard the same refrain from internal lawyers when trying to gather historical data and make statistical estimates for damages in similar suits. “They wouldn’t tell you exactly what they thought they were going to settle for, so you had to come up with some reasonable estimates.” In a recent research report, Hintz used historical data from a class action clearinghouse to estimate that the probability of a settlement in a securities-related lawsuit in federal court is around 56 percent with most settlements falling in the range between 14 percent and 25 percent of investor losses. This means banks must brace themselves for another round of charges against their already fragile balance sheets, as the number of suits filed against them continues to grow. “You’re really talking four years out, when all this stuff begins to hit the bottom lines of these firms,” he says.

Preparing for this future affects bank’s balance sheets today, as the underwriters begin building their litigation reserves. “Although it is too early to know whether recently filed cases will result in big settlements, there is reason to expect that they will,” NERA noted in its 2008 half yearly report. The median value of investor losses, which plays a key role in determining settlement size, rose to $800 million for suits filed in the first half of 2008. By contrast, the median value of investor losses for cases settled in the period between 2005 and 2007 was $350 million — less than half of this year’s number. This does not bode well for underwriters, who barely survived credit crash triage. “They’ll start building reserves, they know its coming,” said Hintz.

As the courts gear up for the underwriter liability bubble, neither underwriters nor investors face a bright future. Investors like Adam and Tina Kreysar are likely to recover only a fraction of their losses through underwriter liability litigation. Without the suits the Kreysars’ wouldn’t even recoup that. In normal times, the settlement payments would hardly cast a shadow on the underwriters’ billion dollar balance sheets, but as investment losses and a panicky market batter their share values, the need for litigation reserves is pouring salt on an open sore. “This is going to be a drag on the performance of these companies as they come out of this downturn because they are going to have to be building reserves in anticipation of losing some these cases,” says Hintz. And making the settlement payouts will be read by investors as another reflection of poor performance, driving investment banks’ share prices lower and pressuring their balance sheets. “There will be an announcement that will say ‘five investment banks have agreed to a settlement for exteen zillion dollars’ That will be depressing,” Hintz says. Come quarterly report time, analysts like Hintz look to profit numbers as a guide to bank performance, both in terms of the firm’s ability to keep costs down and earnings up, as a sign of the sector recovering. With litigation reserves dragging the numbers down, the firms will see their shares continue to suffer as lower profits lead to lower company valuations.

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