Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 1 .of 347

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 1 .of 347 UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK x IN RE THE BEAR STEARNS COMPANIES, INC. SECURITIES, DERIVATIVE, AND ERISA : LITIGATION This Document Relates To: . Securities Action, 08-Civ-2793 (RWS) x CLASS ACTION JURY TRIAL DEMANDED ECF CASE CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS EFTA00316714 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 2 of 347 TABLE OF CONTENTS Faee. GLOSSARY OF DEFINED TERMS viii I. NATURE AND SUMMARY OF THE ACTION 2 II. JURISDICTION AND VENUE 5 III. PARTIES 6 A. Lead Plaintiff 6 B. Bear Stearns Defendants 7 I. The Bear Stearns Companies Inc 7 2. Officer Defendants 7 C. Auditor Defendant 9 IV. FACTUAL BACKGROUND AND SUBSTANTIVE ALLEGATIONS 9 A. Bear Stearns' Storied Past 9 B. The Boom in Debt Securitization 11 C. Bear Stearns' Securitization Business 13 I. Bear Stearns' Mortgage Origination and Purchasing Business 14 2. Bear Stearns' RMBS Business 17 3. Bear Stearns' CDO Business 17 D. Bear Stearns' Business Practices Amplify its Risk Exposure 18 I. Bear Stearns' Concentration in Mortgage -Backed Debt 18 2. Bear Stearns' Leveraging Practices 19 3. Bear Stearns' Backing of the Hedge Funds 20 E. Bear Stearns' Misleading Models and Inadequate Risk Management 23 I. Bear Stearns' Misleading Valuation and Risk Models 23 a. The Importance of Valuation Models 24 EFTA00316715 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 3 of 347 b. Bear Steams' Valuation Models Were Misleading 25 c. The Importance of Value at Risk Models 27 d. Bear Steams' Value at Risk Models Were Misleading 30 2. Bear Stearns' Impoverished Risk Management Program 31 F. Bear Steams Hides its Mounting Exposure to Loss 33 1. Early Wamings 33 2. Bear Steams' Deception Begins 36 G. The Implosion of the Hedge Funds 45 H. Repercussions of the Hedge Funds' Implosion 52 I. Bear Stearns' Catastrophic Collapse 61 J. Post Class Period Events 69 K. Defendants' Fraudulent Statements Adversely Impacted Current and Former Company Employees 71 I. The RSU Plan 71 2. The CAP Plan 72 3. Defendants' Fraud Harmed Holders of RSU and CAP Plan Units 72 L. The SEC Comment Letters 73 M. Bear Stearns' Practices Violated Accounting Standards 76 I. GAAP Overview 76 2. Fraud Risk Factors Present at Bear Steams 79 a. Fraud Risk Factors Applicable to Depository and Lending Institutions 79 b. Risk Factors Applicable to Brokers and Dealers in Securities 81 3. Audit Risk Alerts 82 4. Bear Stearns Falsely Represented that its Internal Controls Over Financial Reporting Were Effective 84 ii EFTA00316716 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 4 of 347 a. Risk Management 88 b. Pricing Models and VaR Systems 89 5. GAAP Violations Relating to the Company's Financial Statements a. Bear Stearns Misstated Its Exposure to Loss from the 90 b. Failed Hedge Funds Bear Stearns' Financial Statements Misrepresented its 90 c. Exposure to Decline in the Value of RIs GAAP Violations Related to Failure to Appropriately 94 d. Determine the Fair Value of Financial Instruments Bear Stearns Failed to Provide Adequate Disclosure 99 e. About Risk and Uncertainties Bear Stearns Failed to Provide Reliable Disclosures to 104 Investors in Accordance with SEC Regulations 106 N. Bear Stearns' Practices Violated Banking Regulations 107 I. Overview of Capital Requirements 107 2. Bear Stearns Failed to Take Timely and Adequate Capital Charges 109 3. Inflation of Capital By Using Incorrect Marks 110 V. 4. Misrepresentations to Regulators Relating to VaR DEFENDANTS' SCIENTER 112 A. James E. Cayne 112 B. Alan D. Schwartz 115 C. Samuel L. Molinaro. Jr. 116 D. Warren J. Spector 120 E. Alan C. Greenberg 121 F. Michael J. Alix 123 G. Jeffrey M. Farber 124 H. Corporate Scienter 125 iii EFTA00316717 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 5 of 347 VI. ADDITIONAL ALLEGATIONS SUPPORTING THE OFFICER DEFENDANTS' SCIENTER 126 A. General Allegations of Scienter 126 B. Abnormal Profit Taking 129 VII. DELOITTE'S DEFICIENT AUDITS OF BEAR STEARNS' FINANCIAL STATEMENTS 133 A. Overview of Allegations Against Deloitte 133 B. Deloitte's Certifications 134 C. Overview of GAAS 135 D. GAAS Required Deloitte to Consider Risk Factors as Part of Audit Planning 136 1. Fraud Risk Alerts Relevant to Deloitte's Audit of Bear Stearns 136 2. Audit Risk Alerts Relevant to Deloitte's Audit of Bear Stearns 137 3. Deloitte's Experience Auditing the Hedge Funds 138 E. Red Flags Recklessly or Deliberately Disregarded by Deloitte 139 I. Bear Stearns' Misleading Fair Value Measurements 139 2. Bear Stearns' Failures to Disclose Risks Inherent In Its Financial Statements 142 3. Bear Stearns' Misleading Accounting Treatment of the Hedge Fund Bailout 143 4. Bear Stearns' Failure to Disclose Critical Information Relating to the Company's Valuation of Its Financial Instruments 144 5. Bear Stearns' Inadequate Internal Controls 146 6. Bear Stearns' Deficient Internal Audit Function 152 VIII. DEFENDANTS' MATERIALLY FALSE AND MISLEADING STATEMENTS 154 A. Statements Relating to Fiscal Year 2006 and Fourth Quarter 2006 154 I. December 14, 2006 Press Release 154 iv EFTA00316718 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 6 of 347 a. December 14. 2006 Press Release Statements Regarding the Company's Fourth Quarter 2006 Results b. Press Release Regarding Fiscal 2006 Results 155 156 2. Fourth Quarter 2006 Earnings Conference Call 156 3. Form 10-K for Fiscal Year 2006 158 a. The Company's Financial Results and Assets 159 b. The Company's Risk Management Practices 159 c. The Company's Exposure to Market Risk d. The Company's Compliance With Banking 162 Regulations 162 e. The Company's Internal Controls 163 f. Deloitte's Certification 164 B. Statements Relating to Fiscal Year 2007 Results 164 I. First Quarter 2007 Results 164 a. First Quarter 2007 Press Release 164 b. First Quarter 2007 Conference Call 166 c. First Quarter 2007 Form I0-Q 168 2. Second Quarter 2007 Results 172 a. Second Quarter 2007 Press Release 172 b. Second Quarter 2007 Conference Call 173 c. June 22. 2007 Press Release 174 d. Second Quarter 2007 Form 10-Q 175 3. August 3. 2007 Press Release and Conference Call 180 4. Third Quarter 2007 Results 182 a. Third Quarter 2007 Press Release 182 V EFTA00316719 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 7 of 347 b. Third Quarter 2007 Conference Call 184 c. Third Quarter 2007 Form 10-Q 185 5. November 14, 2007 Write Downs 189 6. Fourth Quarter and Fiscal Year 2007 190 a. Press Release 190 b. Fourth Quarter 2007 Conference Call 192 7. Fiscal Year 2007 Form 10-K 193 a. The Company's Financial Results 194 b. The Company's Risk Management Practices 195 c. The Company's Exposure to the Market Risk 197 d. Compliance With Banking Regulations 198 e. The Company's Internal Controls 199 f. Deloitte's Certification 200 C. Additional False and Misleading Statements in Calendar Year 2008 200 IX. LOSS CAUSATION 204 X. CLASS ACTION ALLEGATIONS 206 XI. PRESUMPTION OF RELIANCE 209 XII. INAPPLICABILITY OF STATUTORY SAFE HARBOR 211 CLAIMS FOR RELIEF 211 COUNT I For Violation of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunder (Against All Defendants) 211 COUNT II For Violation of Section 20(a) of the Exchange Act (Against the Officer Defendants) 214 COUNT III For Violations of Section 20A of the Exchange Act (Against Defendants Cayne, Schwartz, Spector, Molinaro, Greenberg, and Farber) 215 vi EFTA00316720 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 8 of 347 PRAYER FOR RELIEF 116 DEMAND FOR JURY TRIAL 218 vii EFTA00316721 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 9 of 347 GLOSSARY OF DEFINED TERMS 2008 OIG Report: A report entitled "SEC's Oversight of Bear Steams and Related Entities: The Consolidated Supervised Entity Program." AAG: AICPA Industry Audit and Accounting Guides. AAM: AICPA's annual Audit and Accounting Manual. ABS: Asset-backed securities. ABS CDOs: Asset-backed collateralized debt obligations -related investments. ABX: An index that tracked synthesized subprime mortgage performance, refinancing opportunities, and housing price data into efficient market valuation of subprime RMBS tranches. Advisers Act: U.S. Investment Advisers Act of 1940. AICPA: American Institute of Certified Public Accountants. Alix: Michael J. Alix, who served as the Company's Chief Risk Officer from February 3, 2006 until the Company's demise in 2008. Alt-A Mortgages: Mortgages made to borrowers who are considered less than prime because they are unable to document their income and assets, have high debt-to-income ratios, and/or have troubled credit histories. APB: Accounting Principles Board Opinions. ARM: Audit Risk Alerts. ARB: AICPA Accounting Research Bulletins. AS: Auditing Standard. AU Sections of the Statements of Auditing Standards, which are codified by the American Institute of Certified Public Accountants. Basel II: Recommendations on banking laws and regulations issued in June 2004 by the Basel Committee on Banking Supervision, an institution created by the central bank governors of the Group of Ten Nations. Basel II Guidelines: Basel II. Basel Committee: Basel Committee on Banking Supervision, an international banking group that advises national regulators, such as the SEC. viii EFTA00316722 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 10 of 347 B&D AAG: AAG that was applicable to Brokers and Dealers in Securities. Bear Stearns: The Bear Steams Companies Inc., Bear, Steams & Co. Inc., and Bear Steams Asset Management. Bear Stearns Defendants: The Bear Steams Companies Inc.; James E. Cayne; Alan D. Schwartz; Warren Spector; Samuel Molinaro; Alan C. Greenberg; Michael Alix and Jeffrey Farber. BEARRES: Bear Steams Residential Mortgage Corporation. Broker-Dealer Risk Assessment Program: A program requiring broker dealers that are part of a holding company structure with at least $20 million in capital to file with the SEC certain disaggregated information about their finances. BSAM: Bear Stearns Asset Management, a wholly-owned subsidiary of The Bear Steams Companies Inc. CAP: Capital Accumulation Program. Captive Originations: mortgages originated by BEARRES and ECC that were sent directly into the securitization process at Bear Steams. CAO: Center for Audit Quality. Cayne: James E. Cayne, a director, Chairman of the Board and Chief Executive Officer of Bear Stearns during the Class Period. Cioffi: Ralph Cioffi, the Bear Steams trader who started and managed the High Grade Fund, a Managing Director of BSAM and a Director of BSC. CDOs: Collateralized debt obligations. CDO Report: Report issued by an employee of BSAM, on April 19, 2007, showing that the CDOs in the Funds were worth substantially less than previously thought. CDO Squared: A CDO backed by other CDO notes. CES: Closed end second lien loans. CF Division: SEC Division of Corporation Finance, charged with ensuring that investors are provided with material information in order to make informed investment decisions. CFO: Chief Financial Officer. The Class: All persons and entities which, between December 14, 2006 and March 14, 2008, inclusive, purchased or otherwise acquired the publicly traded common stock or other equity securities, or call options of or guaranteed by Bear Stearns, or sold Bear Stearns put options, either in the open market or pursuant or traceable to a registration statement, and were damaged thereby (the "Class"). The Class shall also include all persons who received Bear Steams CAP ix EFTA00316723 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 11 of 347 Plan Units and Restricted Stock Plan Units that had fully vested, entitling them to an equivalent number of shares of Bear Steams Stock upon settlement at the end of a deferral period, as a part of their compensation as an employee with the Company and participation in its RSU Plan and the CAP Plan. Class Period: December 14, 2006 — March 14, 2008, inclusive. Company: The Bear Steams Companies Inc. COMs (or Offering Memoranda): Confidential Offering Memoranda. COO: Chief Operating Officer. COSO: Committee of Sponsoring Organizations of the Treadway Commission. CSE: Consolidated Supervised Entity. Deloitte: Deloitte & Touche LLP, the external auditor for Bear Steams during the Class Period. Dimon: JPMorgan CEO Jamie Dimon. D&L AAG: The AAG for Depository and Lending Institutions. Domestic Funds: The High Grade Domestic Fund and the High Grade Enhanced Domestic Fund. ECC: Encore Credit Corporation , which the Company purchased in early 2007. EMC: EMC Mortgage Corporation, a Bear Steams subsidiary. EPD: Early Payment Default, which is the failure of a borrower to make their first three payments on a mortgage. Equity Tranche: The most dangerous segment of a CDO which bears the first risk of loss. Exchange Act: Securities Exchange Act of 1934, codified as 15 U.S.C. §78(a). Farber: Defendant Jeffrey M. Farber, a Senior Vice President, and the Controller and Principal Accountant for the Company during the Class Period. FAS: Statements of Financial Accounting Standards. FASB: Financial Accounting Standards Board. FASCON: FASB Concept Statements. FIN: FASB Interpretations. FPD: First Payment Default, the failure of a borrower to make even their first payment on a mortgage. EFTA00316724 Case 1:08-cv-02793-RWS Document 102 Filed 02127/09 Page 12 of 347 FSP: FASB Staff Opinions. GAAP: U.S. Generally Accepted Accounting Principles. GAAS: Generally Accepted Auditing Standards. Goldman: Goldman Sachs & Co. Greenberg: Defendant Alan C. "Ace" Greenberg, Chairman of the Executive Committee of Bear Stearns during the Class Period. Hedge Funds: The High Grade Fund and the High Grade Enhanced Fund. HELOCs: Home-equity lines of credits. High Grade Fund: a hedge fund managed by BSAM under the supervision of defendant Spector. The High Grade Master Fund included two entities. Bear Stearns High Grade Structured Credit Strategies Fund, L.P. was a Delaware partnership responsible for raising money from U.S. investors to be placed in the High Grade Master Fund. Bear Stearns High Grade Structured Credit Strategies (Overseas) Ltd. was a Cayman Island corporation responsible for raising money from foreign investors to be placed in the High Grade Master Fund. High Grade Enhanced Fund: A hedge fund managed by BSAM under the supervision of defendant Spector. The High Grade Enhanced Fund was structured similarly to the High Grade Fund, but allowed for a much greater amount of leverage, thereby increasing potential returns. IPO: Initial public offering. JPMorgan: JPMorgan Chase & Co. Lead Plaintiff: The State Treasurer of the State of Michigan, Custodian of the Michigan Public School Employees Retirement System, State Employees' Retirement System, Michigan State Police Retirement System, and Michigan Judges Retirement System. Level I: Assets that are valued using the Mark-to-Market valuation technique. Level 2: Assets that are valued using the Mark-to-Model valuation technique. Level 3: Assets that are thinly traded or not traded at all and are given values based on valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. The techniques are developed by management. Leverage: The use of borrowed money secured by assets in order to invest in assets with a greater rate of return than the cost of borrowing. LTV: Loan to value ratios. Maiden Lane: Maiden Lane LLC, the entity set up to hold $30 billion of Bear Stearns' assets in conjunction with the takeover of Bear Stearns by JPMorgan. xi EFTA00316725 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 13 of 347 Margin Call: When a lender demands more collateral or a return of part or all of the money loaned in response to declining collateral values. Mark-to-Market: The valuation method for assets traded in an active market, classified as Level 1 assets. Mark-to-Model: The valuation method for assets whose values are based on quoted prices in inactive markets, or whose values are based on models using either directly or indirectly observable inputs over the full term, or most of the term, of the asset or liability, classified as Level 2 assets. MBS: Mortgage Backed Securities. MD&A: Management's Discussion & Analysis section of SEC filings. Mezzanine Tranche: Lower rated tranche of a CDO which bears the greater risk of loss than the tranches above it. Molinaro: Defendant Samuel J. Molinaro, Jr., Chief Financial Officer and Executive Vice President of Bear Stearns. On August 5, 2007, he was also appointed COO. NAR: National Association of Realtors. Net Capital Rule: Rule 15c3-1 of the Exchange Act. No-Doc Loans: Loans that required no documentation to corroborate the borrowers' and brokers' representations about the borrowers' income and assets. Nonprime Mortgages: Subprime and Alt-A mortgages. No-Ratio Loans: Loans that required less (or no) documentation to corroborate the borrowers' and brokers' representations about the borrowers' income and assets. OCIE: SEC Office of Compliance Inspections and Examinations. Officer Defendants: Individual Defendants Cayne, Schwartz, Spector, Molinaro, Greenberg, Alix and Farber. OIG: Office of the Inspector General of the Securities Exchange Commission. PCAOB: Public Company Accounting Oversight Board. PPP: Preliminary Performance Profiles. Punk Ziegel: Punk Ziegel & Co. Ratings Agencies: U.S. commercial credit rating agencies Standard & Poor's, Moody's and Fitch. xii EFTA00316726 Case 1:08-cv-02793-RWS Document 102 Filed 02127,109 Page 14 of 347 RMBS: Residential Mortgage Backed Securities. Repo: Repurchase agreement. A repo allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to immediately sell a security to a lender and also agrees to buy the same security from the lender at a fixed price at some later date. Retained Interests: Especially risky tranches of RMBS kept by Bear Stearns as a result of the securitization process. RSU: Restricted Stock Units. Sarbanes-Oxley Act: Sarbanes-Oxley Act of 2002. Schwartz: Defendant Alan D. Schwartz, Co-President and Co-Chief Operating Officer of Bear Stearns. He became sole President on August 5, 2007. Scratch and Dent Loans: Risky mortgages that were already in default that were purchased by Bear Stearns in the hopes of bringing the borrower back into compliance and securitizing the loan. SEC: The Securities and Exchange Commission. Securities Act: Securities Act of 1933, codified as 15 U.S.C. §§ 77k, 771 and 77o. SFAS 5: Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, issued in March 1975 by the FASB. SFAS 115: Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity, issued in December 1993 by the FASB. SFAS 140: Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. SFAS 157: Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued by the FASB in September 2006. SMRS: The State of Michigan Retirement Systems (consisting of the Michigan Public School Employees Retirement System, State Employees' Retirement System, Michigan State Police Retirement System, and Michigan Judges Retirement System). SOP: AICPA Statements of Position. SOP 94-6: AICPA's Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties. S&P: Standard & Poor's, including the Standard & Poor's Rating Service. EFTA00316727 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 15 of 347 Spector: Defendant Warren J. Spector, Co-President, Co-COO, and a director of Bear Steams. On August 5, 2007, Spector resigned those positions. Stated Income Loans: Loans that required less documentation to corroborate the borrowers' and brokers' representations about the borrowers' income and assets. Subprime Mortgages: Especially risky mortgages made to borrowers who have a heightened risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy or those with limited debt experience. Synthetic CDOs: A synthetic security that mimics or references a CDO. Synthetic Securities: A type of derivative, namely insurance contracts where the party buying the insurance paid a premium equivalent to the cash flow of an underlying RMBS which it was copying, and the counterparty insured against a decline or default in the underlying RMBS security. TABX: An index that tracked synthesized subprime mortgage performance, refinancing opportunities, and housing price data into efficient market valuation of Mezzanine CDO tranches. Tannin: Matthew M. Tannin, Chief Operating Officer of the Hedge Funds, a Managing Director of BSAM and a Director of BSC. TM: The SEC's Division of Trading and Markets. VaR: Value at Risk. xiv EFTA00316728 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 16 of 347 Court-appointed Lead Plaintiff, The State Treasurer of the State of Michigan, Custodian of the Michigan Public School Employees Retirement System, State Employees' Retirement System, Michigan State Police Retirement System, and Michigan Judges Retirement System (collectively, the "Lead Plaintiff" or "SMRS"), individually and on behalf of a class of similarly situated persons and entities, by its undersigned counsel, for its Consolidated Class Action Complaint for Violations of the Federal Securities Laws asserting claims against The Bear Stearns Companies Inc. ("Bear Stearns" or the "Company") and the other Defendants named herein, allege the following upon personal knowledge as to itself and its own acts, and upon information and belief as to all other matters.' Lead Plaintiff's information and belief as to allegations concerning matters other than itself and its own acts is based upon an investigation by its counsel which included, among other things: (i) review and analysis of documents filed publicly by Bear Stearns with the Securities and Exchange Commission (the "SEC"); (ii) review and analysis of press releases, news articles, and other public statements issued by or concerning Bear Stearns and other Defendants named herein; (iii) review and analysis of research reports issued by financial analysts concerning Bear Stearns' securities and business; (iv) the September 25, 2008 Report of the Office of Inspector General of the SEC entitled "SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program" and "SEC's Oversight of Bear Steams and Related Entities: Broker-Dealer Risk Assessment Program"; (v) interviews of numerous former Bear Stearns executives and employees; (vi) review and analysis of news articles, media reports and other publications concerning the mortgage banking and lending industries; and (vii) review and ' A glossary of certain defined terms in this Complaint and terms that are specific to Bear Stearns' business and the mortgage banking industry appears after the table of contents. EFTA00316729 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 17 of 347 analysis of certain pleadings filed in other pending litigation naming Bear Steams as a defendant or nominal defendant. Lead Plaintiff believes that substantial additional evidentiary support for the allegations herein exists and will continue to be revealed after plaintiffs have a reasonable opportunity for discovery. I. NATURE AND SUMMARY OF THE ACTION 1. As more fully set forth in paragraph 803 below, Lead Plaintiff brings this federal securities class action on behalf of itself and on behalf of a class consisting of all persons and entities that, between December 14, 2006 and March 14, 2008, inclusive (the "Class Period"), purchased or otherwise acquired the publicly traded common stock or other equity securities, or call options of or guaranteed by Bear Stearns, or sold Bear Steams put options and were damaged thereby (the "Class" or "Plaintiffs"). 2. Since its founding in 1923, Bear Steams was widely regarded as one of the preeminent investment banks of the world and as a shrewd manager of risk. 3. Beginning early in this decade, however, Bear Stearns embarked on a business plan that left it extraordinarily vulnerable to volatility in the housing market. It purchased and originated enormous numbers of unusually risky mortgages to securitizz and sell, and maintained billions of dollars of these assets on its own books. The Company used the assets on its books as collateral to purchase even larger quantities of debt, and to finance the ballooning costs of its daily operations. The future of the highly-leveraged Company had come to depend on the accuracy of its assessments of the value of these securities and the risk that their value might decline. 4. The investing public was unaware that even before the Class Period began, the Company had secretly abandoned any meaningful effort to manage the huge risks it faced. In 2 EFTA00316730 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 18 of 347 2005 and again in 2006 the SEC privately warned the Company of crucial deficiencies in models it used to value mortgage-backed securities and to assess risk, both critical tools for managing the Company's exposure to market declines. The SEC regulators told the Company that the mortgage valuation models it used failed to incorporate data about risk of default, and that its value at risk models did not account for key factors such as changes in housing prices. 5. Instead of revising its models to accurately reflect a rapidly accelerating downturn in the housing market, the Company bolstered the value of its stock by persisting in using its misleading mortgage valuation and value at risk models in an effort to conceal the extent of its exposure to loss. Indeed, throughout the Class Period, the Company reported value at risk figures to investors that were far lower and more stable than its peers. 6. At the same time, Bear Stearns falsely represented to the public that it regularly reviewed and updated its valuation and risk models to ensure their accuracy. Analysts, impressed by the strength of the Company's revenues and the apparent conservatism reflected in its risk management practices, recommended Bear Steams to investors as a sound investment. 7. The collapse of two massive hedge funds overseen by the Company in the Spring of 2007 dramatically increased Bear Stearns' exposure to the growing housing crisis. When Bear Stearns bailed out one of the funds, the Company effectively took onto its own books nearly two billion dollars of the hedge funds' subprime-backed assets that were worthless within weeks. Instead of revealing its losses on this collateral at the time of the bailout, the Company hid the extent of the declines, and continued to offer false and misleading asset valuations and value at risk numbers to the public, further inflating the price of its stock. The Company falsely stressed that any issues with the hedge fund collapse "were isolated incidents and [were] by no means an indication of broader issues at Bear Steams." 3 EFTA00316731 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 19 of 347 8. By the late fall of 2007, the Company's losses had become too big to conceal and it began to write down billions of dollars of its devalued assets. Surprised investors and analysts became concerned that they had not been given an accurate picture of the Company's exposure to losses. The Company's lenders, fearing that Bear Stearns might not be creditworthy, became unwilling to lend it the vast sums necessary for its daily operations. 9. In its public statements in December of 2007 and January of 2008, the Company continued to hide its steep slide, offering the public misleading accounts of its earnings and asset values. However, Bear Stearns' trading partners grew increasingly suspicious that the Company was in precarious straits. 10. On Wednesday, March 10, 2008, rumors began to circulate on Wall Street that Bear Stearns was facing a liquidity problem. The Company issued a press release denying the rumors and stated that its "balance sheet, liquidity and capital remain strong." On March 12, 2008, Bear Stearns' CEO Alan Schwartz appeared on CNBC to reassure investors that Bear Stearns had ample liquidity and that he was "comfortable" that Bear Steams would turn a profit in its fiscal first quarter and that there was no threat to the Company's liquidity. By the next evening, Thursday, March 13, 2008, Schwartz was making frantic phone calls to the Federal Reserve and to JPMorgan-Chase & Co. ("JPMorgan") hoping for a last minute rescue to avoid bankruptcy the next day. 11. On the morning of Friday, March 14, 2008, it was revealed that JPMorgan would provide short-term funding to Bear Stearns while the Company worked on alternative forms of financing. Bear Stearns' stock plummeted on the news, falling from $57 per share to $30 per share, a 47% one-day drop. 4 EFTA00316732 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 20 of 347 12. Over the weekend of March 15 and 16, JPMorgan bankers scoured Bear Steams' books and, with multi-billion dollar backing from the Federal Reserve, agreed to purchase Bear Steams for $2 per share. JPMorgan's CEO Jamie Dimon told investors on a conference call on Sunday evening, March 16, 2008, that, after examining Bear Steams' books, it had found that the Company faced $40 billion in credit exposure, including mortgage liabilities, and a $2 per share offer price was necessary to protect JPMorgan. JPMorgan's offer was particularly stunning in light of the fact that the Company's Manhattan headquarters alone was worth $8 per share. 13. Indeed, Dimon later stated that, without the Federal Reserve's provision of $30 billion in funding, the deal "would have been very hard to do. Without the Fed to help mitigate the risk, to protect us from an over concentration in some risky assets, I'm not sure it was doable at all." 14. On March 17, 2008, upon the revelation of the Company's full exposure to loss, Bear Steams' stock was in a free fall, closing at below $5 ($4.81) per share, an 84% drop from its previous close. While JPMorgan would eventually increase its bid to $10 per share, the Company's investors had already suffered historic losses. IL JURISDICTION AND VENUE 15. The claims asserted herein arise under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b), 78t(a) and 78t-1, and Rule 1013 5 promulgated thereunder by the SEC, 17 C.F.R. § 240.10b 5. 16. This Court has jurisdiction over the subject matter of this action pursuant to Section 27 of the Exchange Act, 15 U.S.C. § 78aa; and 28 U.S.C. §§ 1331 and 1337(a). 17. Venue is proper in this District pursuant to Section 22 of the Securities Act, Section 27 of the Exchange Act, and 28 U.S.C. § 1391(b) and (c). Many of the acts and 5 EFTA00316733 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 21 of 347 omissions charged herein, including the preparation and dissemination to the public of materially false and misleading information, occurred in substantial part in the Southern District of New York. Bear Stearns maintained its corporate headquarters and principal executive offices in this District throughout the Class Period. 18. In connection with the acts and conduct alleged herein, Defendants, directly or indirectly, used the means and instrumentalities of interstate commerce, including but not limited to the United States mails, interstate telephone communications, and the facilities of national securities exchanges and markets. III. PARTIES A. Lead Plaintiff 19. Lead Plaintiff SMRS serves the working and retired public servants of four SMRS systems: the Public School Employees Retirement System; the State Employees' Retirement System; the State Police Retirement System; and the Judges Retirement System. The beneficiaries of the SMRS include 563,576 people and include one out of every eighteen Michigan citizens. Within these systems, four defined benefit pension plans and two defined contribution pension plans are administered with combined assets of nearly $64 billion, making the SMRS the fourteenth largest public pension system in the U.S., the twentieth -largest pension system in the U.S., and the thirty-ninth largest pension system in the world. In 2006, the SMRS paid out $4.6 billion in pension and health benefits. 20. As set forth in the amended certification annexed hereto as Exhibit A, Lead Plaintiff SMRS purchased Bear Stearns common stock on the open market during the Class Period and suffered damages as a result of the misconduct alleged herein. 6 EFTA00316734 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 22 of 347 B. Bear Stearns Defendants 1. The Bear Stearns Companies Inc. 21. Defendant The Bear Steams Companies Inc. is and at all relevant times was organized and existing under the laws of the State of Delaware, with its principal place of business at 383 Madison Avenue, New York, New York. At all relevant times Bear Stearns, through its various subsidiaries, provided a broad range of financial services to clients and customers worldwide. Bear Stearns held itself out as a leading financial services firm with core business lines including institutional equities, fixed income, investment banking, global clearing services, asset management, and private client services. 22. On May 30, 2008, a wholly-owned subsidiary of JPMorgan Chase & Co. merged with, and into, Defendant Bear Stearns Companies, with Bear Stearns Companies continuing as the surviving corporation and as a wholly-owned subsidiary of JPMorgan & Chase Co. 2. Officer Defendants 23. Defendant James E. Cayne ("Cayne") was at all relevant times a director, Chairman of the Board, and Chief Executive Officer of Bear Stearns. Although Cayne resigned from his position as CEO on January 8, 2008, he continued to serve as Chairman of the Company's Board of Directors throughout the Class Period. During the Class Period, when the price of Bear Steams' shares was artificially inflated, Cayne sold 219,036 shares for a total realized value of $23,010,474. 24. Defendant Alan D. Schwartz ("Schwartz") was Co-President and Co-Chief Operating Officer ("COO") of Bear Stearns from June of 2001 to August of 2007. He became sole President on August 5, 2007, and remained in that position until January 5, 2008, when he was named CEO of the Company. Schwartz served on the Company's Board of Directors 7 EFTA00316735 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 23 of 347 throughout the Class Period. During the Class Period, when the price of Bear Stearns' shares was artificially inflated, Schwartz sold 91,233 shares for a total realized value of $9,867,001. 25. Defendant Warren J. Spector ("Spector") was Co-President, Co-COO of the Company from June of 2001 to August of 2007, and served as a director of Bear Stearns from 1990 until August of 2007. On August 5, 2007 Spector resigned those positions. However, he remained an employee of the Company with the tide Senior Managing Director until December 28, 2007. During his tenure as Co-President and Co-COO, all divisions of the Company save investment banking reported to Spector, including the two large hedge funds that were heavily invested in mortgage -backed securities. During the Class Period, when the price of Bear Stearns' shares was artificially inflated, Spector sold 116,255 shares for a total realized value of $19,066,373. 26. Defendant Alan C. Greenberg ("Greenberg") was Chairman of the Executive Committee of Bear Steams during the Class Period. During the Class Period, when the price of Bear Stearns' shares was artificially inflated, Greenberg sold 371,986 shares for a total realized value of $34,594,027. 27. Defendant Samuel L. Molinaro Jr. ("Molinaro") was, at all relevant times, Chief Financial Officer ("CFO") and Executive Vice President of Bear Steams. On August 5, 2007, he was also appointed COO. During the Class Period, when the price of Bear Steams' shares was artificially inflated, Molinaro sold 38,552 shares for a total realized value of $4,230,828. 28. Defendant Michael Alix ("Alix") was the Senior Managing Director and Global Head of Credit Risk Management for the Company during the Class Period. 29. Defendant Jeffrey M. Farber ("Farber") was a Senior Vice President, Controller and Principal Accountant for the Company during the Class Period. 8 EFTA00316736 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 24 of 347 30. Cayne, Schwartz, Spector, Greenberg, Molinaro, Alix and Farber are collectively referred to as the "Officer Defendants." The Bear Steams Companies Inc. and the Officer Defendants are collectively referred to as the "Bear Stearns Defendants." 31. The Officer Defendants, because of their positions with the Company, possessed the power and authority to control the contents of Bear Steams' quarterly reports, press releases, and presentations to securities analysts, money and portfolio managers, and institutional investors. They were provided with copies of the Company's reports and press releases alleged herein to be misleading prior to or shortly after their issuance. C. Auditor Defendant 32. Deloitte & Touche LLP ("Deloitte") was, at all relevant times, the independent outside auditor for Bear Steams. Deloitte provided audit, audit-related, tax and other services to Bear Stearns during the Class Period, which included the issuance of unqualified opinions on the Company's financial statements for fiscal years 2006 and 2007 and management's assessments of internal controls for the same years. Deloitte consented to the incorporation by reference of its unqualified opinions on the Company's financial statements and management's assessment of internal controls for fiscal years 2006 and 2007. IV. FACTUAL BACKGROUND AND SUBSTANTIVE ALLEGATIONS A. Bear Stearns' Storied Past 33. Bear Stearns was the fifth largest investment bank in the world before its stunning collapse in March 2008. For decades, Bear Stearns had been known as one of the most conservative of the Wall Street firms due to the perception that it took a cautious approach to risk. In fact, the Company survived the Great Depression without laying off any of its employees and, until December 2007, had never posted a loss. 9 EFTA00316737 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 25 of 347 34. As a registered broker-dealer, Bear Steams was subject to a regulatory scheme called the "Broker-Dealer Risk Assessment Program." The program was created in 1990, when Section 17(h) of the Exchange Act was amended to require broker dealers that are part of a holding company structure with at least $20 million in capital to file with the SEC certain disaggregated information about their finances. 35. The Broker Dealer Risk Assessment Program called for staff in the SEC's division of Trading and Markets (-TM") to monitor events that might threaten broker-dealers, customers, and the financial markets. Although TM officially tracked the filing status of 146 broker-dealers in the program, during the Class Period it only reviewed in detail the filings of the seven most prominent firms, including Bear Stearns, that elected to participate in the SEC's Consolidated Supervised Entity ("CSE") program. The CSE program allowed the SEC to supervise participating broker-dealer holding companies on a consolidated basis. 36. While Bear Steams was among the smallest of the CSE firms, it experienced rapid growth through the 1990s. By 1992, the Company's earnings had doubled to over $295 million, the best year in its history to date. During the same year, the Company managed more than $13 billion in initial public offerings ("IPOs") for a variety of U.S. and foreign corporations. Moreover, the Company had become a leader in clearing trades for other brokers and brokerages. 37. In 1993 Defendant Cayne succeeded Defendant Greenberg as CEO, but Greenberg stayed on as Chairman of the Board, and then as Chairman of the Company's Executive Committee starting in 2001. While Bear Steams under Cayne became a larger and more profitable firm, its business model was essentially unchanged. Its time-tested businesses — trading, mortgage underwriting, prime brokerage, and private client services— still received the bulk of the Company's capital and management attention. 10 EFTA00316738 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 26 of 347 38. At the beginning of the new century, with the economy weakening, Bear Stearns was in an increasingly precarious position. By mid-2000, Bear Steams' stock price was in a two- year slump. As one of Wall Street's last independent financial services firms, the Company struggled to keep up with competitors. B. The Boom in Debt Securitization 39. Soon after the turn of the new century, the Company's fortunes began to change. In the first years of this decade, persistently low interest rates and technical innovations lead to a boom in debt issuance— to back mortgages, credit card receivables, or leveraged buyouts. As a result, the Company experienced explosive growth in one area of business—debt securitization. 40. Debt securitization involves pooling and repackaging of cash flow-producing financial assets into securities that are sold to investors. The securities that are the outcome of this process are termed asset-backed securities ("ABS"). When mortgages are packaged together for securitization, they are referred to as Mortgage Backed Securities ("MBS"), and when the mortgages are residential, those securities are referred to as Residential Mortgage Backed Securities ("RMBS"). 41. RMBS are, in turn, divided into layers based on the credit ratings of the underlying assets. The typical structuring of an RMBS is set out in the chart below. II EFTA00316739 Case 1:08-cv-02793-RWS Document 102 Filed 02'27/09 Page 27 of 347 42. The credit quality of asset-backed securities such as RMBS can be more volatile than general corporate debt. If the value of the underlying assets declines, the affected securities can experience dramatic credit deterioration and loss. 43. The "B-Pieces" of an RMBS, that is, its riskier parts, can be pooled together to form a kind of asset-backed security called a collateralized debt obligation ("CDO"). CDOs are then once again divided by the CDO issuer into different tranches, or layers, based on gradations in credit quality. 44. While the top tranche of a CDO may be rated "AAA," CDOs are generally formed from RMBS that are rated BBB or lower. Accordingly, even the best tranches of a CDO are a very risky form of security. Lower-rated tranches of CDOs, such as the "mezzanine" tranches, bear even greater risk of loss. The most dangerous segment of a CDO is termed the "equity" tranche, and bears the first risk of loss. 45. Through the first part of this decade, mezzanine CDOs offered for sale proliferated, making up more than 75% of the total CDO market by April of 2007. The 12 EFTA00316740 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 28 of 347 mezzanine CDOs were stuffed with cash flows from especially risky types of residential mortgage loans, termed "subprime" or "Alt-A." 46. Subprime loans are made to borrowers who have a heightened risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. 47. Alt-A loans, although considered less risky than subprime loans, are still more risky than prime loans. Alt-A loans are typically made to borrowers with problems including lack of documentation of income and assets, high debt-to-income ratios, and troubled credit histories. Subprime and Alt-A mortgages are collectively referred to herein as "nonprime" mortgages. 48. Between 2003 and 2007, the total proportion of risky nonprime loans wrapped into the majority of all mezzanine CDOs increased dramatically marketwide, as set out in the chart below. Mezzanine CDOs: Average Collateral Composition CDO Vintage % Assets Subprime % Assets Alt-A % Assets CES % Assets Other CDOs Total Nonprime 2003 33.7% 7.6% 1.8% 7.0% 50.1% 2004 43.2% 10.1% 2.7% 5.9% 61.9% 2005 55.1% 9.3% 2.2% 5.9% 72.5% 2006 64.2% 6.9% 2.1% 5.5% 78.7% 2007 62.9% 5.8% 0.8% 6.9% 76.4% Source: Standard & Pools C. Bear Stearns' Securitization Business 49. Bear Stearns was in an ideal position to benefit from the market for CDOs backed by higher-risk nonprime mortgages, in that it was vertically integrated in that business-it 13 EFTA00316741 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 29 of 347 originated and purchased risky home loans, packaged them into RMBS, collected these RMBS to form CDOs, then sold CDOs to investors. As a result of this process, it also acquired a large exposure to declines in the housing and credit markets. 1. Bear Stearns' Mortgage Origination and Purchasing Business 50. Through its subsidiaries, Bear Stearns originated and purchased vast numbers of risky residential mortgage loans during the Class Period. 51. The Company originated loans through two wholly-owned subsidiaries, the Bear Stearns Residential Mortgage Corporation ("BEARRES") and later through Encore Credit Corporation ("ECC"), which the Company purchased in early 2007. ECC was strictly a "subprime" lender; it specialized in providing loans to borrowers with compromised credit. 52. BEARRES had several products available to subprime borrowers, but also made Alt-A loans to borrowers with somewhat better, but still compromised credit. ECC began operating under the BEARRES name in October of 2007, but still retained distinct product lines. 53. Many of the mortgages originated by BEARRES and ECC were "stated income," "no ratio," and "no-doc" loans that required less (or no) documentation to corroborate the borrowers' and brokers' representations about the borrowers' income and assets. 54. Moreover, the Company actively encouraged its loan originator subsidiaries to offer loans even to borrowers with poor credit scores and troubled credit histories. According to Confidential Witness Number 1 ("CW 1"), an Area Sales Manager who began work for ECC in January of 2006 and continued working at BEARRES until February of 2008, CW 1's office was under great pressure to "dig deeper" and originate riskier loans that "cut corners" with respect to credit scores or loan to value ("LTV") ratios. 14 EFTA00316742 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 30 of 347 55. As a result of these lax standards, the Company approved the great majority of all loan applications it received. While the national rejection rate was 29% in 2006, BEARRES rejected only 13% of applications in the same period. 56. In 2006 alone, using these questionable lending practices, BEARRES and ECC originated 19,715 mortgages worth $4.37 billion. Because these were "captive" originations, the mortgages originated by BEARRES and ECC were sent directly into the securitization process at Bear Stearns. 57. As a result of Bear Stearns' hunger for loans to securitize, it also purchased huge numbers of risky loans originated by other companies through its EMC Mortgage Corporation ("EMC") subsidiary. From 1990 until 2007, EMC purchased over $200 billion in mortgages. 58. The loans the Company purchased by this means were often as suspect as the loans it originated. Confidential Witness Number 2 ("CW 2"), a Quality Control and Reporting Analyst at EMC from April 2006 through August 2007, reviewed and examined loan origination and loan portfolio statistics on subprime loans purchased by EMC, and also created reports for upper management at EMC. CW 2 confirmed that EMC would buy almost everything, including extremely risky loans where the borrower's income and ability to pay could not be verified. 59. According to Confidential Witness Number 3 ("CW 3"), a former Collateral Analyst with the Company who worked for Bear Stearns in the first half of 2007, the Company understood that the loans it was purchasing through EMC were unusually risky. CW 3 reported that during the latter part of 2006 and the beginning of 2007 EMC was "buying everything" without regard for the riskiness of the loan. CW 3 explained that because of the potential for profits from securitizing these loans Bear Steams managers looked the other way and did not enforce basic underwriting standards. I5 EFTA00316743 Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 31 of 347 60. Confidential Witness Number 4 ("CW 4"), an Underwriting Supervisor and Compliance Analyst for EMC from September 2004 until February 2007, reported that the Bear Stearns traders responsible for buying the loans were fully aware of the weakness of the underlying loans. According to CW 4, the traders ignored CW 4's due diligence findings that borrowers would be unable to pay. 61. Bear Stearns also began funding and purchasing even riskier closed-end second- lien ("CES") loans and home-equity lines of credit ("HELOCs"). Most of these loans