A federal jury Monday held Lehman Bros. Holdings Inc. accountable for fraud at an Irvine mortgage company it helped finance, saying the investment bank aided and abetted a First Alliance Corp. scheme to cheat borrowers.
The verdict marked the first time a financial backer of an abusive lender has been held liable, carving out a new area of vulnerability for Wall Street. The 10-person jury in Santa Ana said Lehman not only knew that First Alliance engaged in fraud but also "substantially assisted" the deception.
The jurors awarded $51 million in damages to about 4,500 borrowers, assessing 85% to First Alliance and its executives and 10%, or $5.1 million, to Lehman.
For Wall Street firms doing business with shady lenders, the verdict is a wake-up call, experts said. Critics of what they see as Wall Street greed and arrogance praised the jury's decision.
"I think Wall Street will take notice. This is kind of a warning shot across the bow," said Kurt Eggert, a Chapman University associate law professor who has represented victims of lending abuse and has published law-journal articles about sub-prime mortgage securities.
According to testimony, First Alliance used a lengthy and intricate sales pitch to conceal the fact that it was adding as much as 24% in fees to the balances of the mortgages it refinanced for hard-pressed borrowers.
First Alliance founder Brian Chisick and his company last year settled fraud charges filed by the Federal Trade Commission for about $75 million and won't have to pay the damages assessed Monday.
The jury apportioned 5% of the damages to MBIA Insurance, which had insured First Alliance's mortgage securities, but because it wasn't a defendant, it won't have to pay.
Lehman attorney Helen L. Duncan portrayed the size of the damage award as a win for Lehman but said it would appeal. The firm said in a statement that its employees were "never aware of any wrongdoing that may have been committed by individual loan officers at First Alliance."
Lead plaintiffs' attorney Richard Scruggs, who helped devise the legal strategy that led to $246 billion in judgments against tobacco companies, said the precedent was important, especially because the verdict was handed down by a jury in Orange County, regarded as a conservative, pro-business area.
"This is going to slow down somebody who's thinking about funding a predatory lending scheme," he said in an interview at the courthouse in Santa Ana. "There's now a jury verdict that Wall Street can be held liable for failing to supervise the use of their money."
Scruggs said he would pursue other firms that "decide to provide funding for rogue companies" if the conduct was as deceptive as he said Lehman witnessed at First Alliance. "It has got to be egregious for me to want to do it," Scruggs said.
In their suit, the plaintiffs contended that First Alliance -- which specialized in loans to so-called sub-prime borrowers, those with poor credit -- would have been out of business had Lehman not provided a $150-million credit line and bundled its mortgages into securities that were sold to investors.
Lehman funded First Alliance in 1999 and through March 2000, when First Alliance filed for bankruptcy protection.
So-called warehouse lenders such as Lehman, which provide credit lines to mortgage companies and sell their securities, have always considered the risk they would run if borrowers defaulted on their loans. But they haven't had to worry about liability related to whether loan originators were complying with laws protecting consumers, noted Ronald Bendalin, an attorney specializing in mortgage finance at Akin Gump Strauss Hauer & Feld in Dallas.
Monday's verdict, Bendalin said, could have a "major impact on the sub-prime securitization market," which packaged $160 billion in mortgages for sale last year.
The trial began in February and played out over 36 days of action in court and 19 days of jury deliberations. The plaintiffs had asked the jury to award $87 million, including $47 million in origination fees charged to borrowers during the 15-month period before First Alliance collapsed amid a welter of lawsuits filed by several state attorneys general, borrowers' groups and the AARP.
U.S. District Judge David O. Carter told the three-man, seven-woman jury that to find liability they must all agree that Lehman knew of "systematic" fraud and had "substantially assisted" it. After the verdict, Carter said the case was important because it was the first time a claim involving such secondary liability had gone to trial.
First Alliance, founded in the 1970s, got a big boost in the '90s as Wall Street began providing funds to sub-prime lenders and packaging their loans into securities that traded like corporate bonds.
By the end of the '90s, Lehman had become the No. 1 underwriter of these securities, according to Thomas A. Myers, a Golden, Colo.-based white-collar crime expert who testified for the plaintiffs. He said Lehman created $11.5 billion worth of sub-prime mortgage securities in 1999, including $344 million for First Alliance.
Had Lehman not stepped in, First Alliance's prospects for finding a financial backer would have been "abysmal," Myers testified.
The FTC had declined to sue Lehman. Berkeley attorney Sheila Canavan, who had taken on First Alliance repeatedly in court, recruited allies for a lawsuit: Scruggs and fellow Mississippi trial lawyers John W. "Don" Barrett and Joseph C. "Joey" Langston. They put up $2.5 million and descended on Orange County in their private jets to press the case against Lehman.
As in battling Big Tobacco, Scruggs focused on internal memos, especially a Lehman report that said First Alliance required employees "to leave your ethics at the door." Lehman, he said in closing arguments, was "intent on winning the race to the bottom."
Defense attorney Duncan maintained that Lehman put careful thought and investigation into its decision to become First Alliance's chief financial backer, and believed the company had cleaned up its practices by the time Lehman assumed that role.