US could emerge as major player in suits stemming from financial crisis

In the wake of most economic crises, the silver lining for lawyers and law firms is a surge in litigation. The present mess on Wall Street will no doubt spill into the courtroom too, though the players may be somewhat different this time around.

When the economy took a dive at the beginning of the decade amid a rash of accounting scandals, securities class action lawyers were centre stage. William Lerach carrying boxes of documents into federal court in Houston to file a suit on behalf of Enron shareholders is one of the iconic images of that period.

But the massive scale of government intervention may limit the scope of private action in the current crisis. Instead, the US Government, especially if it proceeds with a proposal for a bailout agency similar to the Resolution Trust Corporation (RTC) created in response to the 1980s Savings & Loan crisis could emerge as the biggest litigant of all.

"We're really in uncharted territory here," Evan Chesler (pictured), presiding partner of Cravath Swaine & Moore, said of litigation that could emerge from government takeovers of financial institutions like insurance giant AIG.

Chesler said a certain amount of litigation would be likely to focus on actions taken by companies before the Government became involved. But the Government's actions in bailing out financial institutions, he said, raised the possibility of litigation on behalf of taxpayers.

"Whenever taxpayers' money is used in that manner, that's a possibility," Chesler said.

The cost to taxpayers is expected to be enormous. The Government agreed Tuesday to lend AIG $85bn (£47.2bn) and Treasury Secretary Henry Paulson acknowledged on Friday (19 September) that a plan to shore up the financial system by purchasing distressed mortgage securities could cost hundreds of billions of dollars.

Talk of modelling a new government office to dispose of those securities on the RTC is likely to have sent a shiver down many lawyers' spines last week. The RTC, along with the Office of Thrift Supervision (OTS) and Federal Deposit Insurance Corporation (FDIC), still inspire a special dread within the legal profession for the way they went after law firms in the early 1990s. Charged with recouping as much as possible of the $124bn (£69bn) taxpayers paid for the savings and loan bailout, the agencies aggressively sued those whose negligence allegedly contributed to the savings and loan failures, with law firms near the top of the list.

Law firms that had represented thrifts, including Jones Day, Kaye Scholer and Paul Weiss Rifkind Wharton & Garrison, paid millions to settle claims brought by thrift regulators. In the case of Kaye Scholer, the 1992 decision to pay $41m (£22.7m) came after the OTS controversially moved to freeze the law firm's assets, a potentially crippling blow.

"If the history of the RTC and OTS is any guide, the government can be very aggressive in going after professionals," said Philip Forlenza, a partner at Patterson Belknap Webb & Tyler who in 1999 successfully defended New Jersey law firm Pitney Hardin (now Day Pitney) against a government savings and loan suit. "There is the potential for that again."

Exactly what legal advice could be targeted in the current crisis remains unclear. During the savings and loan crisis, regulators took over failed savings and loans and filed claims standing in the thrifts' shoes, alleging that lawyers and other professionals co-operated in the fraud of the thrift managers. It is uncertain yet whether the proposed bailout announced by Paulson contemplates taking over more financial institutions or simply purchasing distressed mortgage-backed instruments.

If the government takes over institutions, its litigation stance could be similar to that of a bankruptcy trustee, said Forlenza. Such suits, where trustees stand in the shoes of failed companies, have become a growing worry for law firms in recent years as trustees have grown more aggressive in pursuing claims.

Though such suits against professionals are frequently barred on the grounds that company management is also to blame, Forlenza said many courts are following a trend of separating the interests of executives and companies.

A large government role may not be all bad news for law firms. During the savings and loan crisis, the FDIC hired Cravath and other law firms to handle certain litigation. Similarly, the current crisis has already seen the government turn to Davis Polk & Wardwell and Wachtell Lipton Rosen & Katz. Securities class action lawyers may face particular challenges in an environment where the interests of taxpayers trump those of shareholders.

AIG, for instance, was already facing a number of shareholder suits before the Government stepped in. The government's acquisition of an 80% interest in the insurer through its $85bn loan then squeezed shareholders further. How a Government-controlled AIG will deal with securities class actions remains uncertain.

Milberg partner Matthew Gluck said there was some hope on the part of plaintiff's lawyers that the Government would allow AIG to continue to function as a normal company, with non-bureaucratic managers making the decisions about whether to settle or defend shareholder litigation.

But Gluck said the politically-charged environment could certainly lead to a different outcome. Beyond the political difficulties raised by government intervention, Gluck said many shareholder lawyers still felt uncertain what to make of the current crisis in terms of where to cast blame.

"The Enrons of the world were flat-out frauds," he said. "Will we see things as bad this time? I don't know yet."

Posted on 19 September by Anthony Lin on the website of the New York Law Journal, Legal Week’s US sister title.