Selling subprime-related securities while shorting them is a common practice in the ABS market. However, some argue that the strategy might be grounds for lawsuits.
While legal action might be in the works, the argument seems not strong enough to warrant much litigation, market players said.
"I would be surprised if there were very many lawsuits based upon an alleged conflict of interest because the vast majority of financial institutions that underwrote subprime securities did not make money but lost substantial amounts of it, as you can see from their reported financial results," said Richard Spehr, a partner at Mayer Brown with a focus in securities litigation. He said that in principle, had these banks shorted the securities to a great extent, these institutions would not have lost the significant amount of money that they have.
Market players have blamed a lot of the buzz about potential lawsuits on media allegations, particularly to The New York Times columnist Ben Stein, who recently suggested that Goldman Sachs was selling CDOs into the market while also shorting them. In response to the article, U.S. Senator Chris Dodd (D-Conn.) noted his concern regarding the investment bank's lending strategies and has threatened a formal investigation if the matter is not addressed by Goldman.
The conflict of interest argument might not be as compelling as some investors have hoped. Banks trade securities that they underwrite all the time, Spehr said. He added that the reason it is permissible is because there are walls between the underwriting and the trading sides to avoid conflicts of interest.
Furthermore, for any plaintiff who is a securities holder, whether they are holding a security out of a CDO or are holding MBS directly, if a bank were shorting a security other than that being held by an investor, then where is the harm to the security held by that buyer? said Richard Hans, partner at Thacher Proffitt & Wood. "In all likelihood, the securities they are shorting are not those being held by these investors in the market place or ones that they underwrote." The other main caveat to the idea of a conflict of interest is the fact that shorting securities in an inefficient market like the current one is very hard to do efficiently, Hans said. "It is a big, big hill that the plaintiffs' bar is going to have to climb if they are going to make that claim."
The biggest source of claims against the investment banks has been that these institutions have failed to adequately disclose the extent of their subprime exposure to their investors, according to market participants. This argument is the primary claim in current lawsuits against a number of the largest investment banks.
An example of this type of litigation is found in a case filed against Citigroup on Nov. 5 known as Gray v. Citigroup. The lawsuit alleges that Citibank failed to provide complete and accurate information about its loan loss exposure and continued to invest its Citigroup 401(k) Plan and the Citibuilder 401(k) Plan for Puerto Rico despite the risk.
Merrill Lynch was also slapped with a suit from Life Enrichment Foundation, filed last Oct. 30. The suit also alleged the bank did not provide accurate information on its risky loan exposures. In response to the suit, representatives from the bank said, "The suit has no merit and we will defend ourselves vigorously."
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