Latest Gatekeeper Litigation: City of San Buenaventura Sues Deloitte Over WAMU Subprime Collapse

Following on the heels of the lawsuits against KPMG by New Century's debtors for contributing to the collapse of the mortgage giant, accounting firm Deloitte & Touche (D&T) and the officers and directors of Washington Mutual Bank (WAMU) have been sued by the City of San Buenaventura, California for failing to disclose the bad financial condition and poor risk management practices at WAMU (USDC, Northern District of California, Case No. 3:09-cv-01980 JSW). The complaint, filed by law firm Cotchett, Pitre & McCarthy, alleges that the plaintiff bought a note issued by WAMU, but that the bank's true financial condition was hidden by WAMU's officers, directors and its auditor. WAMU promptly defaulted on the note, allegedly due to losses from its portfolio of subprime loans.

Similar complaints have been filed by Cotchett in recent months, including a suit by the Monterey County Investment Pool (available here), which names D&T and WAMU's officers and directors as defendants and alleges fraud, negligent misrepresentation, and breach of fiduciary duty for losses resulting from WAMU's debt offerings, and a suit by the San Mateo County Investment Pool against Lehman Brothers and Ernst & Young along the same lines.

The suit by the City of San Buenaventura is the latest of what I have termed "gatekeeper litigation," meaning lawsuits against ratings agencies, accounting firms, due diligence firms and other "gatekeepers" who were supposed to be minding the store and ensuring that financial services companies were accurately representing their own risks and those of their debt offerings. All too often during the housing boom of the last decade, and especially in 2006-2008, investors placed a high degree of reliance on the approbation of these gatekeepers as to the health of companies or the investment-grade status of their securities. As we now know, these gatekeepers were often paid by the companies they were hired to vet, and as a result were incentivized to overlook financial red flags or outright infirmities.

Of the various gatekeepers, ratings agencies have faced the greatest maelstrom resulting from their role in the subprime crisis. It will be interesting to see how successful this gatekeeper litigation will be at tying investment losses to the negligence or fraud of the overseers (see this well-rounded article on lawsuits against the ratings agencies and my prior discussions regarding loss causation in general) and whether such litigation will result in changes to the legal treatment of these entities (see this early article by Kevin LaCroix of the D&O Diary and the debate over the First Amendment rights of ratings agencies in the WSJ) or in the manner in which they are compensated.