Defying the Defying the Laws of Physics-Laws of Physics-

Risks & Exposures forRisks & Exposures forFinancial InstitutionsFinancial Institutions

Raymond DeCarlo- Raymond DeCarlo- ModeratorModeratorAIG - National UnionAIG - National Union

R. Damian BrewR. Damian BrewMarsh FINPROMarsh FINPRO

Dr. Frederick C. DunbarDr. Frederick C. DunbarNERA Economic ConsultingNERA Economic Consulting

David KistenbrokerDavid KistenbrokerKatten Muchin ZavisKatten Muchin Zavis

Thomas WilkinsonThomas WilkinsonCozen O'ConnorCozen O'Connor

Frederick C. Dunbar, Ph.D.

Senior Vice President

19th Annual PLUS International ConferenceHosted by the Professional Liability Underwriting Society (PLUS)Chicago, Illinois

November 10, 2006

Defying the Laws of Physics—Risks & Exposures for Financial Institutions

3

Federal Filings by Year of Securities Class Action Cases Involving Financial Institutions

94111

84

144

97

57

84

128

8972

364

120

83

5134

17

0

50

100

150

200

250

300

350

400

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

Notes and Sources:1 2006 filings are projected based upon actual data through July 15, 2006. Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data.

4

7247 63 46

30 32 17

310

3

54

2017

12 2

7

9

2000 2001 2002 2003 2004 2005 20061

Federal Filings by Year of Securities Class Action Cases Involving Financial Institutions

Other Laddering Analyst Market Timing Contingent Commission

2000 through 2006 (Projected)

Nu

mb

er

of

Fil

ing

s

0

50

100

150

200

250

300

350

400

Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data.

Year

5

16

Federal Filings by Year of Class Action Lawsuits Involving Financial Institutions

15 1737

20 24 13 19 11 11 11 117

2420 18

7 6 10 15 9

5

321 21

18 6 11 1229

49

50

2820

331

6727

1

5 65 6

3

4 13

10

83

6

25

3319 17

34 2216

6144

10 82014

29 56

44

83

42

5

7

1111

5 7

Other Insurance Mutual Fund Bank Investment Bank and UnderwriterNotes and Sources:

1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data.

0

50

100

150

200

250

300

350

400

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

6

Federal Filings by Year of Securities Class Action Cases Involving Banks

25

6

3

1211

8

6

18

10

5

3

1111

14

20

Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

0

5

10

15

20

25

30

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

7

Federal Filings by Year of Securities Class Action Cases Involving Insurance Companies

6

9

15

10

67

18

20

24

7

5

14

65

16

7

Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

0

5

10

15

20

25

30

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

8

Federal Filings by Year of Securities Class Action Cases Involving Mutual Funds

1

2121

16

433

56

5

8

10

4

Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

0

5

10

15

20

25

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

9

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20061

Federal Filings by Year of Securities Class Action Cases Involving Investment Banks and Underwriters

71

27

67

331

2028

504929

42

83

4456

29

Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

0

50

100

150

200

250

300

350

1991 through 2006

Year

Nu

mb

er

of

Fil

ing

s

10

Filings by Circuit of Securities Class Action Cases Involving Financial Institutions Excluding Laddering Cases

6 10

88

37

184

22 18 14

35

8207

91

3

1

2

45

3

15

1

7

CircuitOther Underwriter NamedNotes and Sources:

1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

DC 1 2 3 4 5 6 7 8 9 10 110

20

100

120

140

160

180

80

200

60

40

Total for 2000 through 2006

Nu

mb

er

of

Fil

ing

s

11

Filings by Circuit of Securities Class Action Cases Involving Financial Institutions

1

7

2

3

2

14

4

1

4

2

66

0

2

4

6

8

10

12

14

16

2005 20061Notes and Sources:1 Data is projected by multiplying the actual number of filings by the ratio of days in 2006 to days in 2006 included in the filings data. Data is estimated based upon filings through 7/15/2006.

DC 1 2 3 4 5 6 7 8 9 10 11

For 2005 and 2006

Nu

mb

er

of

Fil

ing

s

Circuit

12

Dismissal Rates by Circuit Within Two Years of Filing

June 15, 1999–June 15, 2006

.08%

1.3%

.06%.06%.09%

5%

.03%

.07%.08%

0%

1%

2%

3%

4%

5%

6%

DC 1 2 3 4 5 6 7 8 9 10 11

Circuit

Dis

mis

sa

l R

ate

13

$9.05 $9.88 $10.66 $8.84 $14.03 $12.53 $8.73

$42.38

$23.22 $18.58 $11.78

$43.79

$7.83 $13.44

$378.65

$248.66

$0

$50

$100

$150

$200

$250

$300

$350

$400

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Average Settlement ValueS

ett

lem

en

t V

alu

e (

$M

M)

Year

14

Median Settlement Value

$3.83 $4.15 $4.90 $4.53 $4.60 $4.78 $5.00$6.80

$4.63 $5.00 $5.81

$16.00

$4.00$6.04

$7.50

$39.90

$0

$5

$10

$15

$20

$25

$30

$35

$40

$45

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

Se

ttle

me

nt

Va

lue

($

MM

)

15

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

35.29 70.81 42.73 37.89 93.78 71.81 113.06 60.18 56.19142.78 170.79

469.89

99.06

328.36 260.98

4326.05

4.14%

4.73%

6.07%

9.22%

5.21%

7.63%

4.32%

7.85%

5.79%

4.27%3.86%

2.93%

5.69%

2.71%

3.94%

10.37%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 20060%

2%

4%

6%

8%

10%

12%

Me

dia

n I

nv

es

tor

Lo

ss

es

Me

dia

n R

ati

o o

f S

ett

lem

en

t to

In

ve

sto

r L

os

se

s (

%)

Investor Losses and Settlements

Contact Us

Frederick C. Dunbar, Ph.D.

Senior Vice PresidentNERA—New York+1 212 345 5378fred.dunbar@nera.com

© Copyright 2006National Economic Research Associates, Inc.

All rights reserved.

19th Annual Plus International Conference

Primary Liability for Secondary Actors

David H. KistenbrokerKatten Muchin Rosenman, LLP525 West Monroe StreetSuite 1900Chicago, Illinois 60661312.902.5200

18

Primary Liability for Secondary Actors Civil liability for banks, issuers, broker-

dealers and other “secondary” actors.

– Primary liability under the evolving theory of “scheme” liability.

Liability under SEC enforcement provisions

– Primary liability under securities laws

– Secondary liability under traditional theories of aiding and abetting and “causing” primary violations.

– Liability under the USA Patriot Act

19

Primary Liability for Secondary Actors Civil liability under § 10b for financial

institutions and other secondary actors

– Traditional Rule 10b-5 claim requires a material misstatement or omission

– “Speaker” faces primary liability for a primary violation

Historically, financial institutions faced only secondary liability – aiding and abetting the fraudulent

statements of others

20

Primary Liability for Secondary Actors Central Bank of Denver (1994)

– No private action for aiding and abetting– A financial institution may still face potential

liability as a “primary violator”

The Battle Line: Primary liability versus non-actionable secondary actions

– Courts have utilized three tests•“Bright Line” test – secondary actor must

directly or indirectly make fraudulent statement: Wright v. Ernst & Young, LLP (2d Cir. 1998)

•“Substantial Participation” test – significant role in preparing fraudulent statements: In re Software Toolworks, Inc. Sec. Litig. (9th Cir. 1994)

21

Primary Liability for Secondary Actors

“Creation of Misrepresentation” test

– First advocated by SEC in 1998 in amicus brief in Klein v. Boyd (3d Cir. 1998)

– Focus is on secondary actors’ conduct rather than actual misstatements

– Relies on 10(b)-5(a) and (c)

•“device, scheme or artifice to defraud”

– First adopted in In Re Enron Corp. (2002)

•Lawyers drafted/approved false SEC filings

•intimate involvement with transactions supported allegation they “created” the misstatements

22

Developments in Secondary Actor Liability “Scheme” liability and the courts

Appellate courts reject “scheme” liability:

– 8th Circuit – In re Charter Communications, Inc.

– 9th Circuit – In re Homestore.com, Inc.•Third party vendors/arm’s length transactions – no other role

•Primary defendants failed to properly account for transactions

•No misstatements, “deceptive” device or “manipulative” conduct

23

Developments in Secondary Actor Liability District courts mixed on “scheme” liability

– In re Dynegy (S.D. Texas 2004) - claim rejected•Bank set up, executed two loans disguised as

investment and cash flow

•No role in accounting/reporting transactions

•No allegations deceptive acts “coincided with sales of Dynegy securities.”

– Quaak v. Dexia, S.A. (D.Mass 2005) – claim survives•Bank financed “sham” entities used to record

fictitious revenue

•“Substantial participation” -- bank a ‘primary architect’ of the scheme.

•Plaintiff subsequently filed amended complaint alleging direct liability; First Circuit vacated leave to appeal

24

Developments in Secondary Actor Liability District courts mixed on “scheme” liability

– In re Parmalat (SDNY 2005) – mixed outcome•Sham versus legitimate transactions

– The securitization and factoring of duplicate invoices for same goods was “deceptive device”

– Loans disguised as investments; deception resulted from company’s description, therefore Citigroup/BoA’s conduct not actionable

– No showing of reliance required in actionable transaction – no direct reliance is needed

25

Developments in Secondary Actor Liability District courts mixed on “scheme”

liability

– In re Mutual Fund Investment Litig. (D. Md. 2005) – mixed outcome

•Broker-dealers facilitated market-timed transactions

•No liability for knowingly financing or clearing late trading

•Liability for providing after-hours trading system, disabling time-stamp function

26

Developments in Secondary Actor Liability Line between primary and secondary

liability remains undefined– Legitimacy of underlying transaction

•Transaction has true business purpose

•Fraud is in accounting/reporting

– Direct or substantial participation in deceptive acts

• “substantial participation” in Quaak

•“orchestrating” in Mutual Fund Litig.

– SEC Liability for “aiding and abetting” remains

27

Developments in Secondary Actor Liability 31 C.F.R. 103.122 Implements § 326 of the

USA PATRIOT Act

– Final rule took effect on June 9, 2003, although broker-dealers had until October 1, 2003, to implement

– The rules seek to protect the U.S. financial system from money laundering and terrorist financing.

– Parallel rules exist for banks under § 103.121 and futures commission merchants and introducing brokers under § 103.123.

28

Developments in Secondary Actor Liability

Requires Customer Identification Program (CIP) that, at a minimum, includes:

– Identity verification procedures

– Recordkeeping

– Comparison with government lists

– Customer notice

– Reliance on another financial institution

29

Developments in Secondary Actor Liability On May 22, 2006, the SEC announced its first-ever

enforcement action under the USA PATRIOT Act

– Action was brought against Crowell, Weedon, a broker-dealer.

• From 10/03 to 4/04, Crowell opened approximately 2,900 accounts.

• In verifying customer’s identities, Crowell relied on its registered reps’ attestations that they had personal knowledge of the customers opening the accounts

• The practice not documented in the firm’s written customer identification program (CIP).

• Rather, the CIP stated the firm would verify the identity of new customers using certain non-documentary and documentary procedures, such as public data base searches and reviewing government issued identification.

30

Developments in Secondary Actor Liability

Violation– By failing to accurately document its CIP, Crowell

violated the record-keeping and record retention requirements under the rule.

– Crowell consented to the issuance of an order that it cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Exchange Act and Rule 17a-8 thereunder.