Worse than Madoff?

By Thomas Brom

If the fall of Bernie Madoff and the rise of pension-fund litigation are early economic indicators of a new direction, we may be headed for better times. In mid-July the California Public Employees' Retirement System (CalPERS) sued the three largest credit-rating agencies for losses of "perhaps more than $1 billion" on debt issued by structured investment vehicles (SIVs) that had been given AAA ratings. The suit alleges that the ratings amounted to negligent misrepresentations of the underlying securities.

Other pension funds are targeting so-called collateral managers, many of whom invested in the same or similar SIVs cited in the CalPERS complaint. The value chain works something like this: Pension funds turn over their portfolios to a custodian, who bundles the securities and gives the right to borrow them to a prime broker, who may lend shares to a hedge fund manager, who shorts the stock for anticipated profit at repurchase. The hedge fund client pays the prime broker a lender's fee and puts up collateral, which a pool manager invests in short-term securities. Got that? Until recently, everybody made money.

At least a dozen recent lawsuits, however, allege pool managers made inappropriate investments, breaching their fiduciary duties under provisions of the Employee Retirement Income Security Act of 1974 (ERISA) and causing billions of dollars in losses to the plan sponsors.

"Until last fall, the conventional wisdom was that collateral pool investments were eminently safe," says Carol Connor Cohen, a partner in the Washington, D.C., office of Arent Fox who defends employers, fiduciaries, and employee-benefit plans in ERISA litigation. "It was assumed that these investments could not produce negative net asset value."

Clusters of cases have been filed in federal courts against Northern Trust Investments, J.P. Morgan Chase, State Street, Bank of New York Mellon, and Wells Fargo. Some suits have been brought by plan participants, others by plan sponsors. One ERISA suit was even filed by a law firm in Boston representing its ABA retirement pool (Fishman Haygood Phelps Walmsley Willis & Swanson v. State Street Corp., No. 09-10533 (D. Mass. filed Apr. 7, 2009)).

"It's a little unusual for employers to be bringing these suits," Cohen says. "But they have their own fiduciary duties to watch out for. They are concerned that they themselves could be sued by plan participants."

Defense counsel, however, regard the suits as typical stock-drop litigation. "In a down cycle, the fiduciaries feel they have to go after anyone who could have done the plan harm," says Jay B. Gould, partner in the San Francisco office of Pillsbury Winthrop Shaw Pittman. "Some of these suits will probably settle?the fiduciaries are looking for any recovery."

Gould says it's significant that the suits are being filed in the context of "a real horror movie?the regulators were not regulating, the legislators were not legislating, and the [president] had abdicated responsibility." He adds, "Perhaps there was some taking advantage."

The securities-lending claims are second cousins to earlier subprime mortgage suits, because many of the SIVs were holding packages of mortgage-backed securities. "Liquidity is also an issue," says James O. Fleckner, a partner in the Boston office of Goodwin Procter who focuses on ERISA and securities law. "Some of the plaintiffs allege they cannot withdraw assets without injunctive relief."

Plan sponsors now feel that they can't win, and they can't get out of the game. "We believe the evidence will show securities-lending programs were run imprudently, without adequate safeguards," says Garrett W. Wotkyns, of counsel at San Francisco's Schneider Wallace Cottrell Brayton Konecky who represents plaintiffs in cases against Northern Trust and State Street. "It's a fairly dark view of forces at play in our financial superstructure, but we're not alleging a conspiratorial process."

Other plaintiffs lawyers, however, are alleging conspiracies in the securities-lending value chain. In April 2006 attorneys for Entwistle & Cappucci in New York filed a class action against eleven of Wall Street's prime brokers, claiming that common practices in their securities-lending programs violated antitrust laws (Electronic Trading Group, LLC, v. Banc of America Securities LLC, No. 06-2859 (S.D.N.Y. filed Apr. 12, 2006)). The complaint alleged that the prime brokers permitted traders to engage in illegal "naked short selling," or shorting stock without actually borrowing shares to cover the position. According to the complaint, "Defendants' combination, conspiracy, and restraint of trade is permitted, promoted and facilitated by agreements?including oral or implied-in-fact agreement?for tacit coordination and parallel conduct which no defendants could or would evade."

In December 2007 the trial court dismissed the antitrust claim, opining that securities laws implicitly preclude application of antitrust laws (In re Short Sale Antitrust Litigation, 527 F. Supp. 2d 253 (2007)). Plaintiffs appealed to the Second U.S. Circuit Court of Appeals; oral arguments are scheduled for this month.

Similar allegations of conspiracy against prime brokers for naked shorting have been filed in state courts in California and Georgia. The Georgia suit, filed in May 2008 by investors in Taser International and later joined by the company, cites a pattern of ineffective SEC sanctions against the prime brokers for "failure to deliver" in short sales. The defendants filed a motion to dismiss state securities law claims on federal preemption grounds, and a ruling is pending.

Even if the short-sale suits defeat motions to dismiss, plaintiffs lawyers will have an uphill battle to prove intent to defraud. "Plaintiffs are going to have to show, transaction by transaction, a pattern of illegal acts," says Pillsbury's Gould. "It's going to be very difficult to show that the brokers colluded, because they compete for clients viciously on prices and services."

In July the SEC made permanent a requirement that securities in short sales be delivered within four days of the transaction date. "In the past, some market makers, including Madoff Securities, were able to damage prices using the market-maker exemption for securities-lending rules," says Josh Galper, managing principal at Finadium, a Boston-based financial consulting firm. "Now, naked shorting is pretty much gone."

But as investors in Bernie Madoff's funds found out, so is a lot of their money.

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