Opinion

Alison Frankel

Lawyers for MF debt, equity holders are sharpening their knives

By Alison Frankel
November 4, 2011

On Thursday, a firm called Brower Piven filed a Manhattan federal court securities-fraud class action against Jon Corzine and three other officials of the bankrupt brokerage MF Global. The complaint, as Jon Stempel reported for Reuters, claims that beginning in May, the MF execs deliberately misled shareholders about the brokerage’s leverage and risk-management controls. It’s really a placeholder: the plaintiff is one individual investor, and the suit asserts a single count of securities fraud based only on public MF Global regulatory filings, press releases, “and other information readily obtainable on the Internet.”

But meanwhile, behind the scenes, the big players in securities litigation are busily analyzing potential claims for MF shareholders and, perhaps more importantly, MF bondholders. They’re drafting memos and talking to the clients who usually lead major securities class actions — institutional investors such as public and union pension or health-care funds. There hasn’t been a lot of juicy securities fraud litigation of late, one plaintiffs’ lawyer told me, so firms are trying to figure out how to position themselves to lead this case. “It’s going to be a bloodbath,” another lawyer said. “Everyone is looking at this.” (Almost everyone I talked to declined to be named because they haven’t firmed up their plans for the MF litigation.)

So let’s take a look at how the shareholder and bondholder cases may shape up, and what pitfalls MF investors may face.

The biggest problem for investors, of course, is MF’s bankruptcy. It’s pointless to sue the company because of the automatic stay on litigation under Chapter 11. That’s why the shareholder suit filed Thursday names only officers of the company, not the company itself. Suing MF execs and directors is the only route for shareholders, no matter how egregious MF’s alleged behavior turns out to be: shareholder class actions, remember, are brought on behalf of investors who bought stock in a particular time frame, not investors who held the stock. And since MF didn’t issue stock in the period of time when its supposed deception took place, there are no deep-pocketed underwriters for shareholders to go after. (Interestingly, that fact distinguishes MF from Refco, the onetime rival of MF’s former parent Man Financial; Refco shareholders, who acquired their stock in an initial public offering not long before the company collapsed, were able to sue the underwriters.)

Deep-pocketed underwriters are the main reason that an MF bondholder class action may turn out to be a more lucrative undertaking than any shareholder litigation. The brokerage issued a series of bonds in the months leading up to its implosion. Those bond prospectuses made representations about the firm’s risk exposure that, in retrospect, look misleading. And under provisions of the Securities Act of 1933, underwriters are on the hook for disclosure failures. Unlike shareholders with securities-fraud claims under the Exchange Act of 1934, bondholders alleging violations of the Securities Act don’t have to show that the MF executives and underwriters who approved the offerings’ disclosure materials intended to deceive investors, but only that the documents were deficient. It’s an easier standard than shareholders face.

But that doesn’t mean shareholders won’t make a go of it. Even though MF is in bankruptcy, the company surely has directors and officers liability insurance, and Jon Corzine is a wealthy man. (For inspiration, shareholders can look to the $90 million settlement Lehman officers reached with investors in August.) Showing that shareholders’ investment losses were caused by MF’s failure to adequately disclose its exposure to sovereign debt shouldn’t be too tough, given that the firm collapsed. That leaves two key considerations in a shareholder securities-fraud suit against MF officers and board members: the class period and intent to defraud.

Usually, the highest hurdle for shareholders is proving scienter, or fraudulent intent. Under the toughened pleading standards the U.S. Supreme Court imposed in Bell Atlantic v. Twombly and Ashcroft v. Iqbal, class action complaints have to allege specific facts to support their assertion that shareholders were intentionally deceived. Three plaintiffs’ lawyers told me, however, that based on the allegations that have emerged so far about MF, they’re not worried about establishing scienter. MF, they said, appears to have engaged in what’s known as “window dressing” to make its quarterly financial reports appear as though the firm was much less leveraged than its account records at the New York Federal Reserve would suggest. There’s also the alleged borrowing from customer accounts, allegations that Corzine overrode risk controls in making investment decisions, and assertions that Corzine pushed back against regulators who wanted to rein in MF’s risky investments.

“In light of the facts and circumstances, it’s fair to assume that MF Global had serious problems with risk management,” said Steven Singer of Bernstein Litowitz Berger & Grossmann, one of the lead lawyers in the Lehman case. “That can show scienter.”

Like the Lehman investors, MF shareholders are also likely to benefit from investigations of what led to the firm’s collapse; Nick Brown of Reuters reported Friday that the bankruptcy judge has authorized the MF trustee to issue subpoenas, and there have been reports that both the Securities and Exchange Commission and the Federal Bureau of Investigation are looking into more than $600 million in allegedly missing customer funds.

Even if shareholder lawyers can establish scienter, however, the case won’t be worth much unless there’s a long enough class period for investors to establish big losses. “[It's] a very strong case, but a question of whether there are enough shareholders to make it worthwhile,” Adam Pritchard, a professor at the University of Michigan Law School, told Tom Hals of Reuters. If lawyers can show MF’s deception dates back just a couple of weeks, then only investors who bought in at the end would have claims. But plaintiffs’ lawyers are hoping to extend the class period back at least as far as May, when the company put out its first regulatory filings under Corzine’s leadership.

There’s one additional wrinkle that will complicate MF shareholder litigation: in August, MF and several underwriters agreed to a $90 million settlement of class-action allegations that MF and its underwriters misrepresented the brokerage’s risk-management controls in disclosures related to its 2007 IPO. That settlement, of which MF put up $2.5 million, was due for a November 18 final approval hearing before U.S. District Judge Victor Marrero of Manhattan federal court. MF’s bankruptcy has thrown that litigation into uncertainty. There’s a possibility that the judge could decide that, in light of the brokerage’s collapse — and related issues of risk management — the settlement should be put aside and talks should be reopened. That would raise fascinating issues in the competition to lead the class action based on MF’s more recent activities. Would Marrero appoint the plaintiffs firms from the 2008 case – Barrack, Rodos & Bacine and Cohen Milstein Sellers & Toll are co-lead counsel, with additional counsel from Labaton Sucharow – to lead additional investigations?

There’s a lot for MF investors and their lawyers to sort out over the few weeks. It’s fun to see the securities class action bar digging into corporate scandal and gearing up for an old-fashioned lead counsel fight — gives me plenty of material for future stories!

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Comments
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With all respect, how can it be accurately stated that there is not a lot of “juicy securities fraud litigation” in process? Is it because the lawyers for the BigLaw firms want to pursue just the most obvious cases with the lowest burden of proof? Throughout the nation, people are losing their home on forged promissory notes and false assignments of mortgages. Is BigLaw waiting for homeowners’ lawyers and the attorneys general like Eric Schneiderman (NY), Beau Biden(DE) and Catherine Cortez Mastro (NV) to make the cases for these law firms before they will pick up on the massive fraud being committed on shareholders of the robo-signing banks. Homes are being stolen with illegal documents creating huge risk to the shareholders of the banks engaging in those practices. Is that disclosed in annual reports or factored in as to risk of holding stock in those institutions? As a lawyer with 36 years of experience, I find it startling that so little has been done by the BigLaw firms in this area. Are they waiting for the collapse of Fannie, Freddie, MERS and the big five mortgage-lending institutions so that they can just go in and pick up the pieces after the fall as it appears they are doing in this case? STOP THE FRAUD NOW!

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