Wall Street banks are facing damages to the tune of $25bn but are reluctant to set aside reserves as they fear it may encourage new claims. Suzanne Miller reports on the legal battle that threatens to spread overseas.

If Wall Street banks thought they had put the worst behind them when they shut the door on 2002, think again. Yes, many were vilified and bled of earnings because of their role in some of history's worst corporate failures. But 2003 could be a year of legal reckoning - the lawyers' ballroom dance on the corporate carnage still strewn across the marketplace.

An army of lawyers representing scores of banks and thousands of plaintiffs are squaring off for a battle where tens of billions of dollars in claims are at stake. Banks are already reforming research practices thanks to regulators, but the next big challenge is surviving a five-front legal war that could leave Wall Street short of billions of dollars. At the very least, many will stagger away from the boxing ring with torn pinstripe lapels, bruised knuckles and hefty legal bills.

Banks are facing down an unprecedented conurbation of legal ills. Analysts stand accused of tailoring research to help their investment bank cohorts clinch business while bankers stand accused of failing to perform their due diligence duties when underwriting tens of billions of dollars in securities for companies whose accounts were later found to be wanting.

Although New York Attorney General Eliot Spitzer clinched a $1.4bn global settlement with 12 investment banks in December, there are hundreds if not thousands of private arbitration claims still pending. Bankers are also fending off allegations that they committed fraud by artificially inflating stock prices to make a killing on "hot" initial public offerings (IPOs). Moreover, they must worry that the Supreme Court, the Securities and Exchange Commission (SEC) and an army of state attorney generals may exact hefty fines for alleged misdeeds. They have also been targeted by The National Securities Dealers Association.

On January 9, the NASD censored Robertson Stephens, and ordered the investment banking firm to pay $28m for receiving inflated commissions from more than 100 client accounts in exchange for the allocation of "hot" IPOs in 1999 and 2000 at the height of the IPO boom. More such fines and censures are expected to follow.

Finally, there is bankruptcy court, where creditors of fallen titans will go for the jugular of any involved parties still able to write a decent cheque. Banks have become the favourite quarry of just about everyone – institutional investors, retail investors, politicians and regulators.

In Europe, things are hardly better with the mania for suing banks spreading across the Atlantic. The chairman of Deustche Bank's supervisory board, Rolf Breuer, is the subject of a court ruling that he breached confidentiality by commenting publicly on the health of the Kirch media group. Meanwhile the bank's management board head Josef Ackermann has been charged with awarding payments to Mannesmann executives (he was on the company's supervisory board at the time) during the takeover by Vodafone.

Running for the hills

"This is the largest groundswell of investor complaints on different fronts that Wall Street has ever faced," says Charles Geisst, a market historian and professor of finance at Manhattan College. On this point, at least, most concur. "You're talking about systemic issues concerning banking practices and I don't think history is a great guide in terms of what must be done here," says Dennis Orr, a partner at law firm Mayer, Brown, Rowe & Maw, which represents issuing companies that have been named in lawsuits.

Melvyn Weiss, co-founder of Milberg Weiss Bershad Hynes & Lerach, the country's leading law firm on class action suits, has a simple solution: sue the pants off Wall Street. His firm is working on a toxic mix of class action suits against scores of companies and investment banks.

In April last year, the firm filed a consolidated class action suit against Enron and a coterie of banks that was whittled from nine to six defendants after a December 20 ruling by Judge Melinda Harmon, who is presiding in the Houston court where the Enron case is unfolding. Those six are Citigroup's Salomon Smith Barney, JP Morgan Chase, Credit Suisse First Boston, CIBC, Barclays Bank and Merrill Lynch. The Enron suit is being spearheaded by partner William S. Lerach, while Mr Weiss is chairman and co-chairman on two different class action committees involving securities and IPO abuses that target a total of 58 investment banks and 303 IPOs.

"We haven't had discovery yet, but once we do defendants are going to run for the hills because they can't afford to have us get in their records. It's going to be a disaster for them," Mr Weiss says of some cases his firm is working on. Mr Weiss is convinced banks will want to settle rather than open their books or face a messy courtroom battle. But that does not mean he expects swift progress. "One thing I've learned, even though corporate executives know they have a very bad case against them, they don't want the money to be spent on their watch so they stall and stall to put off the judgment date. But sooner or later the companies are going to have to pay," Mr Weiss says.

Counting the cost

Most agree banks and their corporate clients will end up paying something, but there is no consensus on how much and for what offences. Initially, private investors and their lawyers thought they would take the banks to court for abuse of research after Merrill Lynch was forced to pay $400m in settlement for a suit filed against the firm and its former internet star, Henry Blodget. At the end of last year, though, another private suit against Mr Blodget was dismissed out of hand. Some of these suits will succeed, but most probably will not because it is extremely hard to prove analysts intentionally lied about their views on shares to snare business and commissions. It is even more difficult to prove that investors relied on these reports to make investment decisions that led to losses. Banks, moreover, did not admit or deny wrongdoing when they settled with Mr Spitzer.

Gerard Cassidy, managing director and bank analyst at RBC Capital Markets, suggests tort (breach of duty) lawyers will have a tough time proving cases against banks because the legal hurdles are high. "Class action lawyers have to prove fraud. They're going to get some, but for the majority of people they're going to have to wake up and admit it takes two to tango. People wanted to get wealthy and didn't recognise the risks."

That may be true, but try explaining the technicalities of the tango dance to a courtroom packed with surly jurors. Lawyers are banking big on public sympathies while finance executives are praying that judges reviewing the merits of these cases will dismiss them based on legal flaws. One of the more significant rulings – the legal merit of the IPO class actions – is currently hanging in the balance as the judge presiding in that case determines if banks can be prosecuted on anti-trust grounds.

All of these unknowns make it tough to count ultimate costs. On January 7, Michael Mayo, a senior banking analyst at Prudential Financial, hosted a conference call with investors and guest speaker Donald Langevoort, a lawyer from the Georgetown Law Center, and an expert on securities law, to talk about litigation risks. Mr Langevoort said he had revised his initial damage estimates, excluding possible regulatory and federal fines, from $100bn to $20-25bn – an all-in estimate of damages he expects Wall Street banks to ultimately pay. That is a huge come-down, but it is also still a huge potential payout.

The real danger lies in underwriting abuses, where US securities laws are the toughest and clearest. "The liability that an investment bank faces for underwriting securities is the most powerful, the strongest of anything we see in the securities laws," Mr Langevoort told investors in the conference call. "If the bank was negligent, had reason to suspect that there might be problems, but looked the other way and ignored red flags, the bank is liable." Most agree Enron was loaded with red flags and it will not help that Capitol Hill has been suggesting bankers may have had a hand in styling some of the financial structures of Enron, he said.

The other big hurdle is fending off accusations that they facilitated fraud under the SEC Act of 1934 by artificially inflating stock prices on numerous companies. Plaintiffs have claimed roughly $30bn in damages from the Enron case alone, though a settlement would be far less as payments tend to be 10% to 20% of claims.

"You're talking about a $3bn case that plaintiffs expect to recover just on Enron," says Roy Smith, finance professor at New York University's Stern School of Business and a former partner of Goldman Sachs. "They may get half to three-quarters of a billion from the directors and money set aside from insurance. If they're going to succeed they're going to get it from the banks." He sees the tally climbing.

"Let's say plaintiffs get a couple billion dollars from the Enron banks and then move over to WorldCom and Global Crossing," Mr Smith says. For these deals alone, a small group of four to five banks might be forced to cough up $4bn or $5bn, he says, adding: "The question is if they've set aside sufficient reserves." That's a particularly relevant question for Citigroup and JP Morgan, which Prudential estimates underwrote $5bn to $6bn in securities for Enron and WorldCom alone.

The provisions problem

Piers Brown, analyst at Commerzbank Securities, said in January he initially expected banks most affected by legal claims to set aside a total of $3bn in litigation reserves. That estimate was driven, he says, by provisions that Citigroup and Credit Suisse First Boston took in the fourth quarter – $1.3bn and $450m respectively – for anticipated litigation costs. Both banks said those provisions could increase depending on developments. JP Morgan also said it set aside part of a $1.3bn charge in the fourth quarter to cover future litigation related to Enron and other legal problems. Otherwise, few others have made similar provisions.

"The danger of making a provision is that you're effectively telling people 'Hey, we've put away this pot of money – come and get it," Mr Brown says. He also says there is a feeling among some banks that they did not do anything wrong. Reserving money might send the wrong message. "Deutsche Bank made a point of saying it didn't allocate [the Spitzer fine] to investment banking but took it as a corporate cost. It doesn't feel guilt and said this is the cost of being in the business," Mr Brown says.

Robert Swanton, head of banking practice at Standard & Poor's, says banks want a better handle on legal risks before they commit reserves. "It's not clear cut that one wants to build reserves early," he says. "One can say it's conservative from a credit perspective but from an accounting perspective it may be considered rather aggressive."

Tom Foley, S&P brokerage analyst, believes banks are squirreling away legal reserves as a precaution – reserves that do not have to be disclosed unless they are material. As a general rule of thumb, analysts say, the bigger banks can sock away up to $100m in legal reserves before they have to disclose. In the long run, Mr Foley believes banks will weather financial damages.

Banks will use everything in their arsenal to avoid forfeiting any portion of their earnings. For that, many will pay hefty legal expenses. The estimated tab for lawyer bills has been another moving target – one that keeps climbing. A year ago lawyers and analysts were estimating a worse-case scenario of $100m. Now lawyers are saying banks may have to fork out at least $200m. One lawyer said some of the banks could be faced with individual legal bills averaging $30m to $40m a year. Unless everyone rushes to settlement, the litigation quagmire could easily take two or more years to resolve, experts say. Mr Weiss warns: "Banks are going to have to spend a lot more than $200m. There are a lot of lawyers out there – and that doesn't include the in-house cost of time spent by executives and support people."

Tort attack

It is hard to predict how many banks will wind up in court or settlement, although the majority of securities lawsuits tend to get settled if the judge permits the case to go ahead. Still, some banks may be tempted to fight some of the cases against them, especially those that have already tasted courtroom victory. Morgan Stanley, for instance, was emboldened when a lawsuit filed against its star internet analyst Mary Meeker was dismissed out of hand in August 2001 by US District Judge of New York Milton Pollack. The judge, esteemed in legal circles, denounced the claim filed by law firm Wolf, Haldenstein, Adler, Freeman & Herz as "an abuse of the tenets of federal pleading and to say the least is in grossly bad taste". The lawyers representing that case have said they will not re-file for "strategic" reasons, though they are still pursuing other Wall Street quarry.

Milberg Weiss and its team of 220 litigation lawyers are leading this hungry pack of class action lawyers who have become the scourge of corporate and finance executives for their propensity of extracting enormous settlements from their foes: think Big Tobacco and breast implants. Sometimes, their zeal to sue can backfire. Like the time one disgusted judge likened lawyers from Milberg Weiss to "squeegee boys" – itinerants who flock with dripping rags around the windshields of unsuspecting drivers at New York City traffic intersections.

Wall Street and its own flock of ivy-league lawyers would like nothing more than to flick these tort lawyers off like wanton fleas. "You ask most of corporate America would they rather have an elimination of the tax on dividends or tort reform and they'd go for tort reform without breathing," says Rodgin Cohen, chairman of the Wall Street law firm Sullivan & Cromwell.

In fact, reform was instituted in 1995 - the Private Securities Litigation Reform Act, designed to discourage group lawsuits. Many believe the Act has slowed the onslaught of lawsuits and increased the number of dismissals. "Since the reform act of 1995 the percentage of cases that are dismissed has increased. Very roughly, some 20% to 30% of cases brought are now dismissed out of the box, and that is the key statistic," says Robert Wise, a partner at Davis, Polk & Wardwell, a law firm that is representing Wall Street banks in some of the current lawsuits.

The 1995 legislation may have slowed the onslaught of cases filed, but the numbers have nonetheless steadily risen since the institution of the Act, with the exception of 1996 when the number of class actions fell to 108 from 1995's 188, according to Stanford Securities Class Action Clearinghouse. In 2001, though, investors were fuming after the internet bubble burst. That is when 488 class actions were filed, with 312 being IPO allocation allegations. Many of these cases are outstanding.

Banks may bluster that they will not be cowed by legal threats, but in truth their tribulations look like the equivalent of Hercules' travails – which is why many will want to stall settlements as long as they can, hoping tempers will eventually cool. That may well be worth the cost of outlandish legal bills.

"Right now quite candidly the atmosphere in this country makes it hard to go to trial," one Wall Street lawyer says. "As a defendant you don't want to be picking a jury now because it's guilt by association. It seems there's no end in sight."


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