As is the case with most securities, CDOs and CDSs were designed to deter and withstand litigation. And as is the case with all securities, they do so only imperfectly, because those who sell investments to third parties, and do so with superior information, invite judicial scrutiny if they mislead. A critical variable affecting litigation prospects is the quality of the risk disclosures in the relevant subscription agreement, prospectus or other legal instrument. Broad, general risk disclosures are generally not effective. Specific disclosures that identify and fairly characterize the risks that actually emerged and caused the loss do tend to be effective. But even with such disclosures, evidence of other communications, including informal ones, might strengthen the claim, because courts understand that investors pay greater heed to real communications from the promoter of the investment than to “boilerplate” legal wording in a prospectus. Similarly, non-reliance clauses tend to be effective when they are not broad or boilerplate, but rather reflect actual negotiation between the parties as to the representations that are agreed as not having been relied upon in making the investment. “Special knowledge,” for example, risks disclosed to investors as merely possible when in fact they were known to be actual, might also lead to a finding of securities fraud.
These principles are useful, along with other variables, in predicting the outcome of claims in court, and therefore also their settlement value. In U.S. litigation, a critical threshold for a legal claim is the motion to dismiss — analogous to a strike-out application in the U.K. and similar legal systems. A defendant that does not succeed in having the claim dismissed faces the very considerable expense and distraction of U.S. discovery. Denial of the motion to dismiss also might change the handicapping for the other major pre-trial motion, the motion for summary judgment, which is usually filed at the close of discovery. It is therefore not unusual for a claim to settle after surviving a motion to dismiss. The parties at that point have tested the claim for legal sufficiency, it is headed for trial absent summary judgment, and significant expense and risk lie ahead for the defendant. Some other factors affecting settlement value include the solvency of the defendant(s), the availability and extent of insurance coverage and adverse enforcement actions and related publicity — for example, where the defendant was investigated by the Department of Justice, the Securities and Exchange Commission, or Congress — in some cases, with incriminating e-mails and documents laid bare.
A key legal issue that might result in permanent dismissal of claims is the expiration of the applicable limitations periods. Among the longest and most-often applicable limitations periods are the six-year periods that apply to fraud and misrepresentation claims under New York common law. The expiration of a limitations period can be a complete bar to bringing a claim, and hence it is extremely important to pay attention to this time-sensitive issue and to seek timely advice. A limitations analysis should not be undertaken by non-experts, as there are complicated rules for when a cause of action accrues; what factors may “toll” or stop the clock; which among different potentially applicable statutes actually apply; whether “borrowing” statutes or other special provisions may change the applicable period; and other issues that may determine whether a claim is untimely. An error can be costly: a time bar might nullify the claim and, even where there are arguable bases for extending the limitations period, the risk of dismissal is increased and the settlement value of a claim is accordingly diminished.
The experience to date with claims based on toxic securities is fairly typical of securities claims: according to one informal survey, nearly half survive a motion to dismiss. Available data suggest that settlement values are also fairly typical, albeit within a very broad range. Each case, of course, turns on its own facts, and a general overview is not a substitute for a thorough examination of the circumstances of the actual investment in light of applicable legal standards. We have learned that some securities were constructed precisely because of their poor quality, as an instrument to bet against; others were deliberately mispriced; and still others were intentionally misdescribed to potential investors.
What is important for a money manager holding CDOs, CDSs and/or shares in corporate vehicles that invested in these securities is to seek advice, without delay, to determine whether valuable claims may exist and what limitations periods apply. There is little risk in obtaining an evaluation of potential claims, a significant potential upside, and the possibility of a closed window if too much time is allowed to pass.
H. Bradford Glassman is a partner and Melissa M. Price is an associate with Lewis Baach PLLC, in Washington.