For directors to be targeted in any situation there needs to be not only a perception of negligence or misconduct but also an economic reason to sue. In recent history in the UK such instances have been rare, with the effect that claims against directors have been confined to occasional obvious and unconnected events. The position in the US has been different given the huge losses suffered by investors in a series of high profile corporate collapses.
Sub-prime itself started as a US problem arising from banks lending money to people who were higher risk and therefore more likely to default on their mortgages. Defaulting borrowers and falling property prices have led to those banks suffering losses. D&O claims by shareholders against such banks in the US have already been filed.
But many of those banks sold the loans on in securitised form to off shore investment vehicles which raised their finance from institutional investors such as banks, insurance companies, pension funds and hedge funds (among others). This stage of the process is not just a US problem - many of the investors are based outside the US and, indeed, many are likely to be European-based. Such investors may suffer losses although they may not yet be aware of their extent. Such losses could give rise to shareholder claims against corporate investors. However, in our view the losses suffered would have to have had a profound effect on such investors’ businesses. Clearly, institutions whose primary business is investment in the property market, such as RIS Real Estate Investment Trusts, will have suffered losses. Claims against three such vehicles have already been filed in the US. As mentioned elsewhere in this update, in the UK, the new derivative action right becomes effective on 1 October 2007 and could have some early tests by minority shareholders. Regulatory investigations would also seem likely (where the investors are regulated). We would speculate that where institutional investors suffer poor performance the possibility of fraud to conceal such poor performance, so as not to attract the concern of their own investors may increase, and questionable governance could lead to D&O issues. A further consequence is that the US banks, whose business model relied heavily on selling the securitised loans, may find it harder to make those loans and raise finance to make further loans, thus threatening their business models. To the extent they have not been sued for the ‘direct’ losses mentioned above, this would seem a potentially fertile source of US shareholder claims.
What could be the wider consequences? The crisis has led to a collapse of the wholesale lending market so that financial institutions everywhere are finding it harder to borrow money from their counterparts to finance their lending operations. Banks that rely more heavily on inward borrowing are more vulnerable. However, whether this leads to losses of a nature that could provide the economic incentive for investors to sue is questionable. Central banks have already demonstrated they are not prepared to allow pure liquidity issues to threaten the viability of banks so as to weaken the entire banking system. In the UK, the new derivative action right could lead to greater D&O activity where some banks in difficulty survive but are considerably weakened.
Could all of this spark a fall in the financial and property markets so as to bring on a recession? If we knew the answer to that question we would not be in the legal business.