As collateralized debt obligations continue to get hit by devaluations and defaults, the inevitable wave of lawsuits has begun. One of the prime issues being played out in courtrooms is the division of assets as CDOs liquidate and default. As widely reported in recent business press articles, a number of mortgage related CDO’s have entered liquidation, among them Carina CDOO, Adams Square Funding I, and Vertical ABS CDO 2007 I. Numerous others have had default events triggered.
Deutsche Bank, a trustee for one CDO that has had a default event, the Sagittarius CDO I Ltd, a $985 million mortgage backed CDO, has filed an action in New York State Court seeking judicial guidance on how to distribute ongoing payments. In that case, after a November 2007 event of default, the insurer, an MBIA affiliate, claimed it had senior status to other fund note holders, and was entitled to all remaining payments on the CDO. Note holders disagreed. The case is likely to provide some guidance on how these distributions are handled in the future.
A recent J.P. Morgan report predicted that there would be $40-50 billion in CDO liquidations over the next year. Thus, more such disputes are likely to arise. Not only CDO organizers, but trustees, and investors – junior and senior – need to be planning how to respond to liquidations and defaults.
Litigation also is targeting money managers that invested in CDOs. These investor lawsuits are reminiscent of the mid-1990s when bond funds suffered heavy losses from derivative instruments. The current actions allege that managers misrepresented or failed to disclose the risks associated with CDO investments, and the inherent valuation issues related to CDOs.
On December 6, 2007, lawyers for investors in two Morgan Keegan bond funds filed suit in federal court against Morgan Keegan, their auditors, and others alleging that the defendants’ breach of fiduciary duty was the reason for the funds losing more than half their value over the past year.
Institutional money manager, State Street Bank and Trust, also is the target of several lawsuits related to investments in CDOs on behalf of clients who claim they were told they were investing in conservative debt instruments. At the same time, State Street is named in a putative class action brought by the Unisystems, Inc. employee profit sharing plan. That complaint focuses on the potential problems facing investment managers in general, and ERISA fiduciaries in particular.
Similarly, this week Barclays Bank PLC sued Bear Stearns & Cos., in New York federal court alleging the investment bank misrepresented the health of one of its enhanced credit hedge funds that failed earlier this year when it did not disclose, in the months leading up to the failure, that the assets of the fund were worth less than their stated value.
The potential litigation risk from CDOs reaches a wide range of potential plaintiffs and defendants. In addition, there is a substantial likelihood of parallel SEC and/or FINRA investigations into the same areas raised in these lawsuits. We recommend that any entity with exposure to collateralized debt obligations begin undertaking a risk assessment of potential claims -- both affirmative and defensive.