In a nearly 400-page opinion in January, a Manhattan federal judge (Robert Sweet) denied motions to dismiss a securities class action against Bear Stearns, Deloitte & Touche, and seven individual defendants. As one might imagine from its length, the Court thoroughly addresses the allegations, and rebutted the defendants’ reasons for dismissal.
Here is a background summary. Over the weekend of March 15 and 16, 2008, the Federal Reserve brokered a deal for JP Morgan to purchase Bear Stearns for approximately $2 per share – a small fraction of Bear Stearns’ preceding stock trading price. On March 24, 2008, the deal was restructured and improved for Bear Stearns shareholders, with the adjusted price equal to around $10 per share. Nevertheless, from its high in January of 2007, Bear Stearns lost around $18 billion in market capitalization.
SFAS 157 requires Bear Stearns to value its financial assets at an exit price. Their 10K discloses what is required by SFAS 157 regarding recording investments at “fair value”. Here is what Bear Stearns reported:
On December 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. …
Fair value is generally based on quoted market prices. If quoted market prices are not available, fair value is based on other relevant factors, including dealer price quotations, price activity for equivalent instruments and valuation pricing models. Valuation pricing models consider time value, yield curve and volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other measurements.”
If Bear Stearns applied fair value accounting in the manner that it disclosed, Bear Sterns would have valued its financial assets at an exit price that would allow it to raise additional funds without incurring the additional losses that became apparent when the crisis unfolded. Additionally, Bear Stearn’s CEO confirmation of expected profits on March 12, 2008 (just three days before the Fed-brokered deal) effectively also confirmed that no further write-downs were needed under SFAS 157. Stated otherwise, in describing Bear Stearns’ situation less than a week earlier, their CEO claimed that no additional write-down of illiquid assets was needed based on current market conditions.
The investors’ loss and the government-brokered merger transaction are historic because:
- The Federal Reserve became directly involved by loaning $30 billion of taxpayer funds necessary to allow the transaction to occur. The Fed also coordinated all other government approvals that would ordinarily have taken months to address. During every significant financial strain, including immediately following the September 11, 2011 attacks, the Federal Reserve reminds financial markets that it has the power to lend money to financial institutions, but the Bear Stearns transaction was the first time in decades that such authority was actually used.
- An enormous amount of investor losses occurred with heavy trading volume in just the few days prior to the confirmed failure. The unprecedented losses occurred because of Bear Stearns’ inaccurate information that propped up its stock price in the days just before its imminent collapse.
Litigation involving these circumstances was inevitable. In the Court’s denial of dismissal, the Court was generally careful to specify that it was repeating allegations. However, in light of the large public record of certain undisputed information regarding what occurred, the Court occasionally indicated its own evidence summary. When this occurred, a reader clearly got the impression that the Court thought there was real substance to the allegations.
Two examples of such summaries follow. In the first example, the Court addresses loss causation, which is typically a major defense, since these losses corresponded with a major recession. However, the Court concluded:
…the Company’s failure to maintain effective internal controls, its substantially lax risk management standards, and its failure to report its 2006-2007 financial statements in accordance with GAAP not only were material, but also triggered foreseeable and grave consequences for the Company. The financial reporting that was presented in violation of GAAP conveyed the impression that the Company was more profitable, better capitalized, and would have better access to liquidity than was actually the case. The price of Bear Stearns’ securities during the Class Period was affected by those omissions and allegedly false statements and was inflated artificially as a result thereof.
The following quote addresses whether plaintiffs simply seek to use hindsight to identify wrongdoing. The Court notes extremely recent disclosures that the Court believed were incorrect, as follows:
No such significant time lag between the disclosures and the losses occurred here. As discussed above, substantial indicia of the risk that materialized was not unambiguously apparent on the face of Bear Stearns’ public filings, and the Company’s boilerplate cautionary statements did nothing to alert the market to the truth about Bear Stearns’ inadequate VaR models, improper valuation of illiquid assets, risk management practices, exposure to market risk, compliance with banking capital requirements, and internal controls.
This ruling puts enormous pressure on JP Morgan, whose acquisition of Bear Stearns’ stock provides them with successor liability. Additionally, a potential $18 billion loss is too substantial for Deloitte to absorb, providing substantial motivation for them to settle.