By Amanda Ernst,

Tuesday, Jan 01, 2008 --- Lawsuits against financial institutions traditionally peak when the market suffers a downturn. In 2007, the subprime mortgage collapse resulted in a new breed of class action lawsuit against banks, a trend that is likely to continue into the new year.

Although securities suits relating to the mortgage mess are likely to be the most closely watched litigation among financial services professionals in 2008, there are a handful of other suits that may have an impact on the industry in the months ahead.

Here’s a quick look at five of those cases:

1. Mortgage-Related Class Action Litigation

Background

The mortgage downturn of 2007 will have an enormous impact on the type of class action suits that will be filed by the plaintiffs bar in 2008, according to attorneys who work in the financial services sector.

The first proposed class action shareholder suits of this kind have already been filed against companies like Merrill Lynch & Co. Inc. and Luminent Mortgage Capital Inc., claiming they failed to disclose to investors the true extent of their subprime involvement and related debts. Many companies claimed they were unaffected by the mortgage market’s decline, but then revealed real damage in their quarterly reports.

In addition to shareholder suits, financial services companies are at risk for potential ERISA suits brought by employees whose 401(k) funds were invested in company stock that took a turn for the worse during the mortgage crisis.

Merrill Lynch, Citigroup Inc. and Washington Mutual Inc. have already been hit with such suits, which claim the firms failed to inform employees that company stock was no longer a sound investment.

What’s at stake?

Although the first suits were filed by shareholders of companies that invested in subprime mortgages, cases could potentially be filed by investors in mortgage-backed securities and even borrowers, according to Meyers.

In January, companies who are at risk for these suits will be releasing their quarterly and year-end financial reports, which will reveal the real damage done by the mortgage downturn over the last few months. Some banks, such as UBS, have already disclosed huge write-downs due to the deteriorating subprime market, and more bad news is sure to come, according to Michael Bleier, a partner in Reed Smith LLP’s financial industry group.

“Once banks report their earnings for the year and file their fourth quarter reports we’ll start to get a better sense of what is going to happen with this litigation,” Bleier said. “Then we’ll see how deep and broad the subprime problem is. A lot of banks will be hit with suits around that time.”

Andrew Kaizer, head of McDermott Will & Emery’s SEC defense group in New York, agreed.

“There's going to be considerably greater information available about the seizing up of credit markets in the coming weeks,” he said. “And as more information becomes available, there will be more unhappy individuals turning to the courts for relief.”

Who should be watching this case?

“The subprime mortgage scandal connects Main Street to Wall Street,” Meyers said, pointing out the broad spectrum of companies that are at risk for litigation in the new year.

Every player in the industry will be watching to see who is suing, who they are suing and why. All eyes are also on regulators, who are just in the beginning stages of the investigatory process.

“The industry is in a circle the wagon mode, bracing for impact,” Meyers said. “Regulators are still involved and they are subpoenaing major investment banks.”

As the regulatory investigation progresses, a whistle blower may come forward, fines may be issued and other charges may emerge. However, the civil class actions probably will not progress significantly over the next year, Meyers said.

2. Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc. et al.

Background

This landmark suit, which was argued before the U.S. Supreme Court in October, raises the question of whether private parties can bring securities actions against an outside company for playing a role in deceptive activities as part of another company’s accounting fraud.

The case stems from a securities lawsuit filed against Charter Communications Inc. alleging that Charter paid cable box vendors Scientific-Atlanta and Motorola Inc. additional money for cable control boxes in exchange for an agreement to buy advertising from the cable company. T

he alleged scheme contributed $17 million in inflated revenue to Charter.

The suit was brought on behalf of Charter's investors against Scientific-Atlanta and Motorola for contributing to the fraud. Charter was not named as a defendant. A U.S. trial court originally tossed the lawsuit in a decision that stated Supreme Court precedent restricted such suits to the primary violators of securities regulations. The U.S. Court of Appeals for the Eighth Circuit backed the trial court’s ruling.

What’s at stake?

“Stoneridge is like the Brown v. Board of Education of securities law,” said Gary M. Brown, chair of the business department at Baker, Donelson, Bearman, Caldwell & Berkowitz PC.

At the heart of the Stoneridge case is the theory of “scheme liability,” which holds that private parties may bring suits alleging violations of section 10(b) of the Securities Exchange Act against third parties whose alleged deceptive conduct contributed to a larger plan, or “scheme,” of fraud that was primarily carried out by a different party.

This theory is also being asserted in another prominent case brought by a group of shareholders who have sued Enron Corp.'s underwriters – a who's-who of prominent investment banks – for contributing to the massive fraud that notoriously culminated in Enron's 2001 bankruptcy.

In March, the U.S. Court of Appeals for the Fifth Circuit rejected the plaintiffs' application of scheme liability in that case, Regents of the University of California v. Merrill Lynch, Pierce, Fenner & Smith Inc. et al. The plaintiffs then appealed to the Supreme Court for certiorari.

The Supreme Court decided neither to grant nor to deny certiorari, preferring to wait until it has ruled on Stoneridge. Ultimately, the fate of Enron’s underwriters depends on the High Court’s ruling in this case.

Attorneys also claim that the fate of the financial services industry lies in the hands of the Supreme Court as it mulls Stoneridge. If the Supreme Court legitimizes scheme liability, then it will have “a very significant impact” on the industry, according to Bleier.

“We would see a lot more class action suits filed against investment banks, and lenders would be under pressure to increase their due diligence in order to avoid getting dragged into litigation should any fraud arise,” Bleier said. “Financial institutions will have to look very carefully at their borrowers. They will have to know their background and how they plan to use the money. This extended due diligence may lead to loans being priced higher, because of the legal risk and the risk to the lender's reputation.”

But Brown disagrees. He supports the idea of third party fraud presented in Stoneridge, believing that investment banks should be held accountable for any fraudulent “schemes” they perpetrate.

Unlike other attorneys, Brown believes that a ruling in favor of Stoneridge will not exponentially increase legitimate securities class action suits against financial institutions or make the companies more vulnerable.

Who should be watching this case?

The Stoneridge case has been debated among the inner circles of securities attorneys for years. The long-awaited decision in either direction will send shock waves through the securities and financial services industry, especially if the ruling is in favor of scheme liability.

The plaintiffs bar and the defense bar are keeping close tabs on this case, along with financial institutions, investment banks and every party involved in the pending Enron suit.

The case is Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc. et al., case number 06-43, in the U.S. Supreme Court.

3. U.S. Commodity Futures Trading Commission v. Amaranth Advisors LLC et al. and Hunter v. Federal Energy Regulatory Commission

Background

Greenwich, Conn.-based hedge fund Amaranth Advisors LLC, once valued at $9.3 billion, collapsed in September 2006 after squandering more than $6 billion in poorly made bets in the natural gas sector. The fund traded huge amounts of natural gas futures on the New York Mercantile Exchange, and then transferred its holdings to IntercontinentalExchange Inc., an unregulated futures market.

In the wake of Amaranth’s collapse last fall, there have been calls for more regulation of hedge funds and increased oversight of the futures market. What’s more, two regulators, the U.S. Commodity Futures Trading Commission and the U.S. Federal Energy Regulatory Commission, launched competing investigations into Amaranth’s conduct.

The CFTC asserted its jurisdiction over the futures market when it filed a civil action against Amaranth and the former co-head of the fund’s trading desk for commodity derivatives, Brian Hunter, on July 25 in the U.S. District Court for the Southern District of New York. The futures regulator claimed that Amaranth not only manipulated prices on the ICE and NYMEX in violation of the Commodities Exchange Act, but also lied about its actions to the exchange.

A day later, FERC slammed Amaranth and two of its former heads, including Hunter, with $291 million in fines and a show cause order, giving the advisor 30 days to show why it should not be assessed those civil penalties and required to disgorge its profits.

But before FERC officially filed papers against Amaranth, Hunter filed a suit in the U.S. District Court for the District of Columbia on July 23 questioning FERC’s jurisdiction over the issue.

Hunter sought an injunction that would bar FERC from leveling $30 million in fines against him, but his request was denied on Dec. 10. He is planning to appeal.

Meanwhile, Amaranth asked the Southern New York District Court to stay the FERC fine until the CFTC case was resolved, but in November the court refused to stay FERC’s administrative action.

The fund also appealed to FERC, asking it to rehear its case. After FERC rebuffed the defunct hedge fund’s request, Amaranth appealed to the U.S. Court of Appeals for the District of Columbia, hoping to put off paying FERC’s fines until after the CFTC suit was wrapped up.

On Dec. 13, the appellate court refused to stay FERC’s fine.

What’s at stake?

Amaranth’s spectacular collapse is notable because of the issues it raised about hedge fund oversight, especially on ICE and NYMEX.

“There have been calls for more regulation, but the testimony by members of the CFTC before Congress showed that the regulator already performs a good amount of surveillance,” said Joe Messina, a partner in the securities ligation group at Mintz Levin Cohn Ferris Glovsky & Popeo PC. “The CFTC also requests a lot of information from ICE in order to detect and prevent misconduct. While there is this big push for regulation, the manipulation that Amaranth was charged with was discovered pretty regularly by NYMEX. Therefore, the regulation that is already in place worked well in this instance.”

However, Messina admits that fears of another Amaranth-like scheme have led to increased scrutiny of the futures markets.

“Following Amaranth, I think we’ll start to see a lot more letters being sent to funds and more requests by the CFTC to ICE,” Messina said. “And along with that, more people who may not be trying to manipulate the market are going get swept into these increasing investigations. We will also probably see an uptick in private litigation against companies that get caught trying to manipulate the market.”

Another interesting facet to the Amaranth debacle is Hunter’s dispute with FERC and the jurisdictional face off between the CFTC and the energy regulator.

“Legally, Hunter has a good point about FERC’s jurisdiction,” Messina said, agreeing that the CFTC, not FERC, commands oversight of the futures markets.

Who should be watching these cases?

Companies and traders involved in the energy futures market will be watching as the Amaranth cases continue to unfold, to see which regulator ultimately prevails. Hedge funds are also keeping a watchful eye over any new regulatory or legislative proposals that would impose stricter compliance or disclosure standards upon them.

But hedge funds can’t be too concerned, since Amaranth’s collapse did not prevent Hunter and others from moving on and starting new funds. In fact, the hedge fund industry seems undaunted by the calls for more regulation, according to Messina.

“Former officers of Amaranth have gone on to set up new hedge funds, so the CFTC and FERC’s complaints against them have not had a chilling effect,” Messina said. “People like Hunter can go forward and set up new funds and trade, and perhaps make money or lose money. But there is no shortage of money and people looking for inventive people to invest it for them.”

The cases are U.S. Commodity Futures Trading Commission v. Amaranth Advisors LLC et al., case number 1:07-cv-6682 in the U.S. District Court for the Southern District of New York and Hunter v. Federal Energy Regulatory Commission, case number 1:07-cv-1307 in the U.S. District Court for the District of Columbia. 

4. Department of Revenue of Kentucky et al. v. George W. Davis et al.

Background

This case, which was argued before the Supreme Court in November, deals with the question of whether states can exempt income earned from municipal bonds from taxation while taxing income earned on out-of-state bonds. Currently, 43 states exempt the income earned on any bonds issued within their borders while taxing the income earned on bonds issued in other states.

The case now before the High Court began in 2003, when George and Catherine Davis of Louisville, Ky., filed a class action lawsuit against the state’s Department of Revenue.

In their complaint, the Davises asked for declaratory judgment that Kentucky's practice of taxing the income earned on out-of-state bonds while exempting the income earned on in-state bonds violated both the Commerce Clause of the U.S. Constitution and the Equal Protection Clause of the 14th Amendment.

A trial judge granted summary judgment in favor of the state, but a Kentucky Court of Appeals soon overruled that decision, saying the state had, in fact, violated the Constitution.

In 2006, the Kentucky Supreme Court agreed with the Court of Appeals. Then, in November of that year, the Department of Revenue filed a writ of certiorari, which Supreme Court granted in May 2007.

What’s at stake?

“This is how bonds are treated nationwide,” Brown of Baker Donelson said. “If the Supreme Court rules to change this scheme in any way, it will cause a hiccup in the marketplace. There is a lot of history there.”

Brown added that since this is a rare example of the Supreme Court granting certiorari to a state court case, “it wouldn’t surprise me to see the Kentucky court’s ruling overturned and the tax scheme declared constitutional.”

Arthur Rosen, chair of McDermott Will's state and local tax practice group, isn't so sure of the High Court's ruling. Additionally, if the Supreme Court finds the scheme unconstitutional, it might also decide to apply the law retroactively.

"It might be seen as a real undue burden on the states if it were to apply retroactively," Rosen said. "If that were to happen, Congress would probably take action immediately to address it in some way. Either way, Congress would have the ability to address the municipal bond taxation issue. But Congress can decide not to get involved at all, thus allowing the Supreme Court's ruling to stand."

Who should be watching this case?

The state offices that issue these bonds are waiting for the ruling, as are holders of both in-state and out-of-state muni bonds.

Also, tax attorneys like Rosen are certainly interested in how the Supreme Court will ultimately rule.

“For decades, I’ve been thinking about this issue, along with my colleagues,” Rosen said. “This is something that many of us have thought about for many, many years and we’ve always wondered why it hadn’t been resolved before.”

The case is Department of Revenue of Kentucky et al. v. George W. Davis et al., case number 06-666 in the U.S. Supreme Court.

5. Klein & Co. Futures v. Board of Trade of New York

Background

The suit, argued before the Supreme Court in October, raises the question of which parties are granted permission, under the Commodity Exchange Act, to file a private right of action against a board of trade.

Klein & Co. Futures petitioned for Supreme Court review after the U.S Court of Appeals for the Second Circuit ruled that Klein lacked standing to bring claims against one-time New York Futures Exchange Chairman Norman Eisler, the New York Board of Trade, the New York Clearing Corp. and others.

Eisler, who served as NYFE chairman until 2000, was also a member of the NYFE’s Settlement Committee for the Pacific Stock Exchange Technology Index Futures Contract & Options (P-Tech).

The committee’s primary responsibility was to calculate the price of P-Tech contracts in order to calculate margin requirements in customers’ accounts.

Eisler allegedly used his pull as a member of the P-Tech committee to secretly manipulate settlement prices of contracts, which aided Eisler’s P-Tech positions at the same time and caused Klein to miscalculate margin requirements for an account on which Eisler was the principle.

Around March 2000, NYBOT began receiving complaints about P-Tech settlement prices, but didn’t make proper inquiries. In May of that year, Klein contacted NYBOT and expressed concerns regarding P-Tech contracts and Eisler. The merchant requested that the NYFE halt trading in P-Tech contracts, but it never did.

Then in July 2001, the CFTC filed a complaint against Eisler for manipulation and making false reports. The regulator required Eisler to pay a civil penalty of almost $5 million. Eisler’s NYBOT membership privileges were also suspended and he was dropped from the settlement committee.

Under recalculated settlement prices, the margin deficit of an account Eisler traded in, First West, ballooned to $4.5 million. Since Klein could not take on the $4.5 million deficit, its assets were forced below the minimum required for membership in the New York Clearing Corp. Its membership privileges were then suspended and its business collapsed.

Klein sued in the U.S. District Court for the Southern District of New York on various claims, including a claim that the NYFE had failed to enforce its rules and that NYBOT had violated anti-fraud provisions. The district court tossed the suit, ruling that Klein did not have the standing to bring the case, and the Second Circuit then agreed with that decision.

What’s at stake?

The Commodity Exchange Act is very explicit about which parties can and cannot bring private causes of action against specific parties, Brown explained.

To this end, the U.S. government filed an amicus brief with the Supreme Court in support of Klein, asserting that the requirements of the statute are clear.

Although the case deals with large market-related concepts, experts like Kaizer from McDermott Will say a ruling by the Supreme Court will not have a sweeping effect on the financial services industry.

"The appellee said it would have an enormous economic impact,” Kaizer said. “But the facts of this particular case involve a narrow statutory interpretation. Therefore, in deciding this case, the Supreme Court will probably want to take a narrow approach to correctly interpret section 25(b).”

And for Klein, a victory in the High Court is only a small step towards an ultimate ruling in its case. Essentially, if the Supreme Court rules in favor of Klein, the firm will be able to go back to the district court and proceed with its case. It will pick up where it left off: at discovery.

Who should be watching this case?

Although Kaizer and others claim this case is very narrow, a ruling in favor of either party will ultimately affect other brokers and commodity exchanges by further defining who can sue under the Commodity Exchange Act.

The case is Klein & Co. Futures v. Board of Trade of City of New York, case number 06-1265, in the U.S. Supreme Court.