Wall Street is being judged

September 8, 2009

Capitol Hill has yet to get its act together on financial regulatory reform. But another arm of the federal government, the judiciary, is emerging as the new best friend of investors.

It started a few weeks ago when Judge Jed Rakoff refused to approve the Securities and Exchange Commission’s wimpy $33 settlement with Bank of America over the bank’s failure to come clean with shareholders about its acquisition of Merrill Lynch.

The judge ordered the SEC to explain why it didn’t hold anyone at Bank of America personally accountable for Merrill’s decision to pay nearly $6 billion in bonuses before the merger was completed.

Now Judge Shira Scheindlin, who works in the same federal courthouse in lower Manhattan as Rakoff, has picked up the torch of investor rights.

Just before the start of the Labor Day holiday weekend, Scheindlin issued two decisions that could hold Wall Street accountable for more of its actions. In separate rulings, the judge sided with investors bringing lawsuits against a prime broker and two major credit rating agencies.

The prime broker case stems from the $1 billion hedge fund fraud perpetrated by Michael Lauer, who once managed money for Britney Spears, the University of Montreal Pension Plan and Morgan Stanley, among others.

Scheindlin ruled that the hedge funds’ offshore investors can press ahead with an aiding-and-abetting claim against Bank of America, which had been the prime broker for Lauer’s long defunct Lancer funds.

BankĀ of America, it appears, just can’t catch a break in court. Scheindlin, in rejecting the bank’s summary judgment motion, said the hedge fund investors had marshaled enough preliminary evidence to raise “a genuine material issue of fact” about whether Bank of America “actually knew of, and substantially assisted in, Lancer’s fraud.”

Scott Berman, a lawyer for the investors, said the decision means that it is likely that Bank of America will have to defend its actions at trial. It also raises the possibility that Bank of America may now choose to try to settle the case, because the damages in this case could run into the hundreds of millions of dollars.

More significant, the ruling could ultimately spell trouble for Goldman Sachs, JPMorgan Chase and Morgan Stanley–the three biggest prime brokers in the United States. The ruling may cause those firms to reassess their dealings with hedge funds.

In the other pro-investor ruling, Scheindlin said the First Amendment’s free-speech protection shouldn’t serve as a blanket defense for Standard & Poor’s and Moody’s Investors Service in a lawsuit brought by a group of investors suing over now worthless debt notes.

The judge said that ratings on notes that are sold to a small group of investors should not be entitled to the same kind of free speech protection as notes that are widely sold to the public at large. Historically, rating agencies have said their reports are opinion and protected by the First Amendment.

Each of these court rulings by Scheindlin represents a significant break with prior court decisions that generally have shielded prime brokers and credit rating agencies from legal liability. And that’s potentially bad news for Wall Street firms as investor lawsuits stemming from the financial crisis mount.

These three rulings are the first indication that the federal courts, which have not been particularly friendly to investor lawsuits in recent years, may be emerging as the great equalizer in the often tense relationship between Wall Street and Main Street.

And that would be some welcome news, as the nation approaches the first anniversary of the collapse of Lehman Brothers.

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