Suing Your Fund Manager

Last week, I wrote a piece about financial negligence. In it, I explained that it seemed theoretically very unlikely that someone could successfully sue an investment bank for negligence. This morning, however, the New York Times had a story about a lawsuit that could prove me wrong.

They report that a Russian investor who owns Access Industries is suing JP Morgan Chase. The investor's claim is that JP Morgan said it would put his firm's money in a safe investment. That safe investment? Yep, you guessed it: subprime mortgages-backed securities.

It seems that the facts of the case are in dispute, as the investor claims the investment mix he agreed to should not have included as high a percentage of mortgage-backed exposure. But here's a striking part of the article, assuming JP Morgan doesn't dispute it:

Officials at Access became concerned about the account in July 2007 after it lost $2.7 million in one month. They expressed concern to Mr. Ufferfilge and asked whether he could liquidate the money-losing holdings, but were told to hold onto the securities because the investments were "money good," meaning the principal on the package of mortgage bonds would eventually be repaid in full, according to the lawsuit, which is expected to be filed in New York State Supreme Court.

Since I'm no expert in securities litigation, I consulted someone who is. I spoke to John Donovan, a partner at law firm Ropes & Gray who focuses on business litigation, including corporate and securities matters. He told me:

The typical investment management contact includes a gross liability negligence standard. It's very difficult to overcome.

So the plaintiff needs to essentially prove that JP Morgan intentionally lied about the investments being "money good." That's pretty hard to do. Especially since virtualy the entire world mistakenly thought such investments were money good.

One claim that Access might, and almost certainly will, make is that JP Morgan was selling its own positions in subprime mortgage-backed securities, so how could the bank justify recommending Access keep its position? The Times' article also explains the following:

The bank also says the securities in the Access investment were not the same ones that JPMorgan was selling on its own behalf, adding that the two sets of securities had different risk characteristics.

JP Morgan will likely explain that there was a wall between the part of their firm selling those securities on its own behalf and the part managing money for clients like Access. So Access' manager might not have had the same outlook as its employees managing its own portfolio.

Access might get something out of it, however. According to Donovan, plaintiffs might still manage to squeeze some settlement value out of such lawsuits. If a bank worries that its legal or reputational costs might be significant from engaging in a lawsuit with an investor, then it may settle.

I also asked Donovan if the rating agencies might be susceptible to law suits from investors. For example, what if a rating agency had provided the bonds purchased by JP Morgan for Access a safe AAA rating (and I don't know whether they did, as this detail was not included in the article)? Could Access just sue the rating agency instead? He told me that he was not familiar with a case where an investor has successfully sued a rating agency. Current law does not really provide investors with standing to sue rating agencies.

The caveat, however, is that in the past eighteen months or so, there have been many lawsuits brought by investors trying to blame someone for their losses. So if you get an angry enough activist judge, I guess anything can happen. So stay tuned.