A Decade on, Crisis-Era Litigation Still Bedevils Banks

American Banker
April 04, 2018

Banks and other financial institutions might reasonably have expected that, 10 years after the collapse of Bear Stearns and the demise of Lehman Brothers, they would finally be free and clear of lawsuits spawned by the financial crisis.

That has not come to pass. Nor does freedom from legal actions rooted in the events of that era appear imminent.

This circumstance should be seen not just as an annoyance for banks, or another indication of how slowly our judicial system and claims resolution processes often operate. Instead, it is an opportunity for proactive, potentially curative action. Banks can take steps now that would minimize, or at least expedite resolution of, certain types of legal claims that tend to proliferate in the aftermath of a crisis.

Given that problems in the mortgage market were at the heart of the last crisis, it’s no surprise that mortgage-related lawsuits remain a key area of focus. Whether living (Bank of America or JPMorgan Chase, for example) or dead (Lehman and various failed banks for which the Federal Deposit Insurance Corp. is acting as receiver), financial institutions continue to pursue, and/or be the targets of, residential mortgage-related lawsuits. Many of these cases involve the alleged creation and sale of shoddy mortgage-backed securities. In other instances, they involve claims against trustees for alleged failures to fulfill their obligations to stakeholders in residential mortgage-backed securities trusts.

Both of these types of cases are typically preludes to yet another type of lawsuit grounded in the financial crisis: so-called “indemnification” and breach of contract lawsuits brought by trustees, liquidating trusts or banks against the financial institutions (other banks or mortgage companies) that sold loans that ultimately were deposited into the RMBS trusts. The focus of these cases is the contention that loan originators breached representations and warranties when they sold the loans to a loan aggregator, and that they should therefore make the plaintiff "whole" for losses that the plaintiff later sustained as a supposed consequence of the alleged breaches.

Beyond those cases aimed at institutions, there are the many mortgage-fraud lawsuits and investigations, Financial Institutions Reform, Recovery, and Enforcement Act and False Claims Act lawsuits and enforcement actions against individual directors and officers for oversight failures at banks during the financial crisis. These cases are significant both because they seek to impose penalties or establish specific "frauds" for which a bank should be held accountable, and because they tend to focus harsh spotlights on the policies, practices and procedures of a financial institution during some (usually lengthy) time period.

Litigation and claims resolution processes related to long-running bankruptcy proceedings are another major category of ongoing legal actions relating to pre-2008 actions of financial institutions. Lehman is the largest and perhaps longest lasting example of a crisis-era failed enterprise whose business affairs are still spawning plenty of active litigation in bankruptcy court. Both debtor and creditor banks seeking to protect their interests routinely become ensnared in cumbersome bankruptcy court proceedings. Then there are the banks and other financial institutions being sued by the failed companies looking to bring money into the bankruptcy estate.

As one might imagine, the typical reaction of a bank executive to being informed in 2018 that his or her bank is being sued about loans it — or even a predecessor company — sold in, say, 2005, is not a pretty sight to behold. The incredulity is understandable. Even though a variety of potentially powerful legal and factual defenses are available to defendants in these different kinds of cases, the process can often be painful and slow-moving.

But lawsuits of these types were never inevitable. Even leaving aside the thorny question of whether a regulatory regime could be created to effectively rein in reckless and excessive risk-taking, there are strategies to prevent the seemingly endless post-crisis legal reckonings next time around.

Consider, for example, how much of the current crop of litigation relates to conflicting interpretations of very general and broadly worded contractual provisions — representations and warranties, indemnification provisions and the like. The banking industry needs to adopt more precise, less "boilerplate" contractual wording to reduce openings for litigation that arise from ambiguity and uncertainty. Such contracts would better specify what is expected of different parties in a variety of potential scenarios.

Banks may also want to take a closer look at the now-booming marketplace for representation and warranty insurance — currently used most often in mergers and acquisitions, but certainly adaptable to other types of transactions — as an enhancement or replacement for indemnity provisions in sales contracts, or to deal with potential successor liability issues that tend to spin off plenty of litigation.

Finally, though this potential fix may require a lobbying effort, there should be ample incentive for banks to seek to limit the ability of bankrupt, liquidated institutions to seek to collect purported debts from their counterparties. Liquidating trusts, which are used to wind down failed businesses, effectively become long-running "litigation machines" with little reason to do anything other than pursue every claim, no matter how small, that they deem even arguably recoverable. Yes, creditors and former employees want to be paid as much as possible out of the bankruptcy estate, but it is past time for a thoughtful discussion about the costs of overzealous quests for settlement payouts in response to threatened legal claims resulting from the crisis.

The passage of time — not to mention the substantial restrictions on consumers' ability to bring class action lawsuits against financial institutions — has not spared banks from a continuing onslaught of actual and threatened litigation and enforcement actions. Limiting the extent of the next post-crisis onslaught is achievable and worth considering. In the meantime, banks must continue to look over their shoulders.

This article was first published by American Banker on April 04, 2018.

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