The Credit Bubble Bulletin
by Zev Abraham
Zev Abraham is an equity analyst at a hedge fund in New York and former securities lawyer.
In September 2000, while Jack Grubman, Henry Blodget, Andrew Fastow and the like still enjoyed lofty rank and privilege, the SEC brought charges against Jonathan G. Lebed. Jonathan Lebed was a 16-year old New Jersey High School student who made $270,000 by repeatedly recommending illiquid stocks that he owned on internet message boards. In its order, the SEC accused Mr. Lebed of making "baseless price predictions" that caused an "increase in the volume and price of the stock." They complained that he said the stocks were "about to take off" and were "the most undervalued stock ever". Upon reading the charges, it was difficult to discern why what Mr. Lebed did was worse than what most brokerage house research departments do in the ordinary course of business. In fact, Mr. Lebed issued a disclaimer on each of his publications advising readers to do their own independent research. It could be argued that his recommendations were less ethically questionable than those of Wall Street analysts because he did not cloak his opinion in the supposed expertise of the research staff of a major brokerage house or a holder of a CFA designation or top school MBA. Unlike Mr. Grubman, Jonathan Lebed never pretended to have graduated from MIT.
While not changing its opinion of Mr. Lebed, belatedly, the SEC as well as several state attorneys general, some Congressional committees and various other regulatory bodies have come to realize the similarities between Mr. Lebed's conduct and the normal business practices of the securities industry. This has not been good news for the companies in this industry or their stock market values, but the full exposure of these firms to this issue may not yet be discounted.
Law enforcement, politicians and regulators have tremendous power over private industry. This has always been so. Every period of speculative excess has had ample amounts of fraud and malfeasance, which in turn has elicited legal, political and regulatory responses. This time, however, there is a crucial additional factor: the plaintiffs' bar. This politically powerful, well-capitalized and hugely successful group is going to dramatically impact the direction of events surrounding the speculative bubble of the late 90's.
The plaintiffs' bar has grown dramatically over the past 25 years. There are many reasons for this. A short explanation is that mass media and the prevailing social and political norms encouraged the evolution of a legal environment that is sympathetic to enabling those who have been harmed to recover damages from those who have money, notwithstanding that they may not have a preponderance (or, in some cases, any) culpability in causing the damage. In addition, the success of these organizations has made them incredibly wealthy. Coupled with political and legal savvy, their financial resources have enabled them to influence state and federal law and the media. This has served to make the legal climate even friendlier for them.
Another important factor in the continued success of plaintiffs' lawyers is their ability to finance new claims. Bringing tort actions on novel legal theories is very costly, especially since the defendants tend to have ample resources to fully exploit the legal system to cause maximum delay. Thus, bringing an action on a new theory of law is incredibly risky. The new theory may not win, and even if it could, it might take a decade or more before all the litigation is completed and a judgment is paid. Today, the plaintiffs' bar has enough money to finance these endeavors. In fact, knowing that they face adversaries with ample financial and legal resources discourages defendants from using the "drown them in paper and motions" strategy of delay.
At present, these organizations as well as traditional law firms, representing individuals, institutions, pension funds and other claimants, are suing to recover losses in all the recent large bankruptcies and accounting scandals. Due to their questionable conduct and "deep pockets", bankers and underwriters are the primary targets of these lawsuits.
SEC rules require companies to disclose all material legal proceedings in their public filings. In November of 2001, the same month that Enron filed for bankruptcy, Citigroup filed its third quarter 2001 10Q. Its legal issues section was entitled "Contingencies" and encompassed four short paragraphs. The first three dealt with the uncertainties of asbestos exposure of, presumably, Travelers, while the fourth dealt with all other legal issues. The fourth paragraph stated in its entirety:
"In the ordinary course of business, Citigroup and its subsidiaries are defendants in various litigation matters incidental to and typical of the businesses in which they are engaged. In the opinion of the Company's management, the ultimate resolution of these legal proceedings would not be likely to have a material adverse effect on the results of the Company and its subsidiaries' operations, financial condition, or liquidity."
The language with respect to these proceedings "not having an adverse effect on results" is standard for public filings. When a filing does not contain such language, it is worth noting.
In Citigroup's 10Q for the most recent quarter, the section is renamed "Legal Proceedings" and expanded to nine long paragraphs with subheadings. The subheadings are: "Enron Corp."; "Research"; "WorldCom, Inc."; and "Other". According to the document, with respect to Enron, Citigroup has already been named in several lawsuits. These include: (1) a class action brought in federal court in Texas on behalf of purchasers of Enron securities alleging violations of federal securities laws; (2) a class action brought in federal court in Texas on behalf of Enron employees alleging ERISA and RICO violations as well as negligence and civil conspiracy; (3) a RICO action brought in federal court in New York on behalf of purchasers of certain Enron Credit-Linked Notes and Enron related special purpose vehicle securities; (4) a state court action brought by state pension plans alleging violations of securities laws and common law fraud; (5) an action brought by banks that participated in two Enron revolving credit agreements administered by Citigroup alleging fraud; (6) an action brought by several funds that purchased Enron debt alleging violations of securities laws, fraud and misrepresentation; and (7) a series of class actions relating to securities of another Enron special purpose vehicle alleging violations of federal securities laws. In addition "Citigroup [has] received inquiries and requests for information from various regulatory and governmental agencies and Congressional committees regarding certain transactions and business relationships with Enron and its affiliates." The other subheadings had similar numbers of actions alleging similar as well as other types of violations.
There are several interesting things to note from examining the disclosures. First, despite the fixation of Wall Street analysts and the media on the governmental inquiries, Citigroup features the civil suits far more prominently. This makes sense because the exposure to civil liability is far greater than to regulatory action. However, the governmental inquiries are critical to the civil litigation because these inquiries are providing a valuable and efficient roadmap for the civil lawyers to follow in pleading the cases and moving for discovery. A second interesting thing to note is that the disclosure is for the period ended June, 2002 and therefore predates the late July Senate Committee on Governmental Affairs Hearings on the Roll of Financial Institutions in the Collapse of Enron. This inquiry uncovered some very damaging internal information from Citigroup as well as JPMorgan and Merrill and likely will result in many more suits being filed. The same is true with respect to some of the inquiries into WorldCom. Which brings us to the most noteworthy part of the disclosure . . . the fact that Citigroup did not opine at all on the materiality of these lawsuits. Gone is the language about these actions not having a material adverse effect on the results of the company. In its place there is silence. One can draw only one conclusion from this omission.
As for JPMorgan, it devotes almost three pages of its second quarter 10Q to "Legal Proceedings". Its headings include: "Enron litigation"; "Worldcom litigation", "Commercial Financial Services litigation"; "IPO allocation litigation"; and "Research Analysts' Conflicts". JPMorgan does opine on its legal exposure in these matters. The disclosure states:
Some of the legal actions, proceedings or investigations in which the firm is involved assert claims for amounts that could be material to the financial condition of the firm and could result in adverse judgments, penalties or fines. In view of the inherent difficulty of predicting the outcome of legal matters, particularly in cases where the claimants seek very large or indeterminate damages, JPMorgan Chase cannot state with confidence what the eventual outcome of its pending matters will be, or predict with confidence what the eventual loss . . . will be. JPMorgan Chase believes, based on its current knowledge and after consultation with counsel, that the outcome of the pending matters should not have a material adverse effect on the consolidated financial condition of JPMorgan Chase, but may be material to JPMorgan Chase's operating results for any particular period.
It is puzzling that JPMorgan has no "confidence" about the outcome of these matters but believes that they will not have a "material impact . . . on the consolidated financial condition". It should be noted that the first two sentences quoted above were added for the most recent 10Q. The last sentence appeared alone in the previous 10Q. The only explanation is that JPMorgan and its lawyers now feel that the probability of losses impacting the financial condition of the company is high enough to require that the last sentence be qualified.
All this may seem trivial but it is not. What the disclosures from both Citigroup and JPMorgan indicate is that the banks believe there is potential for material judgments against them. Despite what the managements appear to be saying on conference calls and despite Wall Street research departments almost uniform dismissal of these issues as regulatory matters, in formal public filings, both Citigroup and JPMorgan are warning investors of potential big exposure.
The question is what is the true probability of judgments being rendered against the banks in these civil cases and how big might these judgments be? However, to answer these questions, one cannot simply look to the past history of similar actions. Many lawyers and analysts have taken the position that finding lenders and underwriters liable for frauds committed by their clients has been very difficult as has finding brokers liable for faulty or conflict-ridden research. This has been true, but plaintiffs have been successful in both types of suits in the past and, regardless, the current environment is very different. The law is not absolute and static. It constantly changes and evolves with the prevailing social, political and economic climate. As noted earlier, the ability of plaintiffs to prevail in tort actions has changed dramatically over the past 30 years. For example, there was a time when it was uniformly believed that plaintiffs in smoking cases could not win at trial because prevailing theories of assumption of risk and contributory negligence made it impossible to win such cases. These theories held that the smoker should have known of the risk and thus assumed it and therefore another party, even if partly responsible, couldn't be held liable for the injury. However, a combination of judges, juries and politicians that were sympathetic to the plaintiffs' arguments, over time, turned the tide of some of these legal battles against the cigarette companies.
The allegations of securities law violations and fraud against Citigroup and JPMorgan are very substantial. Any lawyer who watched the Senate Committee on Governmental Affairs hearing or who understands the basis of the SEC's action against Jonathan Lebed can come to no other conclusion. As noted earlier, the governmental inquiries have already uncovered a lot of damaging information for civil lawyers to use in their complaints. However, the strength of the cases is only part of the story. Equally important is the prevailing economic, social and political climate that makes it incredibly dangerous for the banks to litigate these matters regardless of the facts or the current law. This is particularly true if the litigation were to proceed to the point that the issues were questions for a jury in Texas or Mississippi to decide. These are places where the economic pain from the demise of Enron and Worldcom is particularly acute and there is a natural antipathy towards New York banks.
The next question then is how much exposure might the banks have? Citigroup has $88 billion of book equity and JPMorgan has $43 billion. This seems like an adequate cushion against even large damage awards - and it probably is. But can one be completely sure? Let's start with the Enron and WorldCom bankruptcies. They are likely to result in $20 billion each of unsatisfied debt obligations. Worldcom had $185 billion of market equity value wiped out and Enron $65 billion. The average cost to holders who lost money is less than those amounts (because all shareholders did not pay the peak price for their shares), nevertheless, the total losses were probably as much or more than the equity capital of the two banks. Those found to have committed federal securities fraud in connection to these companies are likely to be held liable in proportion to their culpability in the harm. However, the proportion of a defendant's culpability is a determination to be made by the jury. In state court actions, depending on the jurisdiction, if there are no other culpable parties able to pay, the rules of joint and several liability might pin the entire loss on a single defendant even if it were only minutely responsible for the resulting harm. Recent large asbestos awards against companies only tangentially involved with the presence of asbestos in products is a scary example of this. In those cases, the main asbestos players were already bankrupt and thus did not have assets on which judgments could be levied. In addition, if state court actions are allowed to proceed, punitive damages may be awarded in fraud cases and in RICO cases treble damages are mandated by statute. Although the success of state court actions and RICO claims are a long shot, they are possible. In addition, suits arising from Worldcom and Enron have already started, but there are many other potential claims. It is reasonable to assume that the malfeasance of financial institutions will spawn litigation in connection to some of the other large bankruptcies and accounting frauds. At the Senate hearings, there was testimony that JPMorgan helped seven energy trading firms besides Enron use "prepay transactions." These transactions enabled the bank's clients to book financial debt as a trading liability. Citigroup did these transactions with three other firms. All the merchant energy firms have sustained tens of billions of dollars of market value losses, so the shareholders (and bondholders) of whomever these transactions were with are potential claimants against the banks. The list of possible plaintiffs is very long and holds very substantial economic losses.
None of the foregoing is arguing that Citigroup, JPMorgan or anyone else will be rendered insolvent by these issues, merely that there is potential for very material liability. As JPMorgan itself states in its 10Q, "[we] cannot state with confidence what the eventual outcome of [the] pending matters will be, or predict with confidence what the eventual loss . . . will be". One can reasonably conclude that the possibility of insolvency, although remote, is real. Most of the companies that filed for bankruptcy due to asbestos litigation insisted until near the date of filing that their exposure to the litigation was manageable and not material to their financial health. However these companies, after losing a few key cases, were inundated with claims and realized the only answer was to seek the protection of bankruptcy court. It is possible that a similar situation could unfold with respect to the banks. Particularly if there is a key court ruling that interprets the law in favor of the plaintiffs. Of course national banks cannot file for bankruptcy. If Citigroup or JPMorgan were faced with insolvency, it would be taken over by the FDIC, which would operate it in receivership.
This leads to a discussion of the "too big to fail" doctrine with respect to these potential legal issues. The prevailing opinion is that Citigroup and JPMorgan in particular are too crucial to the financial system for the "authorities" to let the worst-case scenario described above occur. This may be true, but the question is how and at what point can they do anything to prevent it? There are and will be a variety of legal proceedings occurring in bankruptcy court, different federal courts and different state courts. As mentioned earlier, the plaintiffs' law firms are powerful organizations that will have different goals and agendas depending on who their client is, whom they are suing, what the facts of the particular case are and where the litigation is taking place. The plaintiffs are diverse parties from individual shareholders and bondholders to public pension funds and bankruptcy court creditors committees. In many cases, the plaintiffs' are likely to believe they have a fiduciary duty to pursue the banks on behalf of their principals. The notion that all this could be shut down by a regulator outside of insolvency proceedings without an act of Congress is fanciful. While an act of Congress could do the trick, given the prevailing climate, a bill to save the banks and brokers from liability for the equity bubble is not likely to be politically feasible.
Where does this leave us? As noted by Doug Noland repeatedly on these pages, the United States economy is at great risk due to the past two decades of dramatic credit expansion. Due to the central role Citigroup, JPMorgan and others play in that system, the economy is at further risk from the other dramatic expansion that occurred over the past few decades - the expansion of the plaintiffs' bar and the vulnerability of defendants to it.