A new issue came to the forefront in 2007 – the collapse of the subprime debt market. Economic conditions in 2007 triggered fears of widespread defaults in subprime mortgages that had carried the day during the years of the housing boom.38 Losses, often in the billions of dollars, were announced as companies were forced to come to grips with subprime mortgage vulnerability. In the wake of these announcements, securities lawsuits and regulatory activity flourished. This trend is expected to continue into 2008.

Because the subprime mortgage and mortgage-backed securities businesses involve multiple players at various stages, many potential targets for litigation exist. Lenders, investment banks, fund managers, underwriters, credit rating agencies, and other professionals, such as independent auditors, have all faced litigation this past year on these issues. These claims focus on the decreasing value of subprime loan portfolios as a result of past and anticipated homeowner defaults.

Beginning in February 2007,39 numerous shareholder class action lawsuits were filed on subprime issues, alleging violations of the federal securities laws. According to a recent study, 38 securities class actions were filed this past year against various participants in the subprime debt industry.40 These filings contributed to an overall increase in the number of securities class actions filed in 2007 as compared to the prior year, but were not the only factor thought to be responsible for this trend.41

The first wave of lawsuits focused on publicly traded mortgage lenders, alleging misrepresentations regarding the quality of lending practices, related internal controls, and the extent of their involvement with subprime loans. Shareholder plaintiffs argued that the lenders had concealed an increase in defaults that they were experiencing or expected to experience, the need to repurchase a greater number of loans in light of these defaults, and greater difficulties in selling loans due to diminishing market value. Other common allegations challenged the timing of taking losses, the adequacy of loan loss reserves, and the accounting for loan losses under Generally Accepted Accounting Principles (“GAAP”). Such suits have, at times, been accompanied by shareholder derivative suits, asserting state law claims based on similar facts for breach of fiduciary duty, waste of corporate assets, and unjust enrichment.42

Other players in the industry were soon drawn into litigation. Securities class actions have been filed by investors against the issuers and underwriters of mortgage-backed securities as well as investment management companies operating portfolios heavily weighted in favor of such securities or collateralized debt obligations. Credit rating agencies have also been sued by investors regarding the ratings they previously assigned to mortgage-backed securities. Companies in the business of providing real estate appraisals now face claims that they conspired with subprime lenders to inflate property appraisals. There have even been Sarbanes-Oxley whistleblower suits in which former employees of subprime lenders allege they were fired in retaliation for raising concerns that certain lending practices violated the federal securities laws.43

On the regulatory front, the U.S. Securities and Exchange Commission’s enforcement division has created a working group to tackle subprime market issues. The market regulation division has also increased its monitoring of the cash positions and balance sheets of certain major Wall Street firms. Lending patterns, structured finance deals and instruments, disclosure practices, the packaging and reselling of loans, and insider trading will all be subject to increased SEC scrutiny. The SEC further announced that it will aggressively enforce SEC Regulation AB,44 which applies to all asset-backed securities, and will examine credit rating agencies and their procedures for rating residential mortgage-backed securities, with a special focus on potential conflicts of interest.

Although it is estimated that as many as 36 companies are currently under investigation by the SEC on subprime issues,45 the SEC to date has announced the resolution of only one subprime enforcement action. In August 2007, the SEC settled for a penalty of $8.5 million with a bank holding company that purportedly engaged in $4 billion worth of transactions in “non-conforming mortgages.”46

Like the SEC, state regulatory authorities also stepped into the fray, with New York Governor Eliot Spitzer forming the Halt Abusive Lending Transactions task force. This unit will focus on so-called abusive practices in the subprime debt market. Other states have also initiated similar investigations.

On the legislative side, Senator Chris Dodd, Democrat from Connecticut, has introduced legislation entitled the Home Ownership Preservation and Protection Act of 2007.47 The bill, which was referred to the Senate Committee on Banking, Housing and Urban Affairs on December 12, 2007, is designed to institute mortgage reforms and to target predatory lending practices. The proposed law would prohibit mortgage brokers from steering prospective borrowers to more expensive subprime loans, create a fiduciary duty for mortgage brokers towards borrowers, and inject a duty of good faith and fair dealing on the part of the lender to the borrower. The bill also requires analysis of a borrower’s ability to pay before a loan is issued and prohibits prepayment penalties.

The legislation would further ease a borrower plaintiff’s litigation burden by providing a direct remedy against the current mortgage holder, rather than requiring the borrower to identify the party actually responsible for the harm who may have held the mortgage at an earlier point in time. The subprime activity this past year is thought by many to be the tip of the iceberg. Expected payouts from subprime related litigation are estimated to be in the billions of dollars. In the coming year, companies heavily invested in the subprime market will continue to face increased scrutiny by their shareholders and various regulatory entities. Any negative announcements from these entities will likely result in the kind of stock price drop that regrettably triggers the filing of lawsuits.