Emails become smoking gun in UBS vs. Pursuit Partners

Reminiscent of the analyst scandals of the bubble, emails have proved to be the smoking gun in the case filed against UBS (UBS) by Pursuit Partners LLC. In the exposed emails, employees called the investment-grade securities sold to Pursuit Partner "crap" and "vomit" as they desperately tried to get rid of the securities.

After listening to the evidence presented by Pursuit and its lawyers during a three-day hearing, Connecticut Court Judge John F. Blawie ruled that they had established probable cause to back up their claim that UBS employees "were in possession of material nonpublic information regarding imminent ratings downgrades on the Notes it sold" to Pursuit.

The judge went on to order UBS to set aside $35 million to cover a potential judgment: "The court takes UBS employees at their word when they referenced their Notes, these purported 'investment-grade' securities which they sold, as 'crap' and 'vomit,' for UBS alone possessed the knowledge of what their product, their inventory, was truly worth."

The deal started In the summer and fall of 2007, as the credit crunch deepened. Some U.S. employees at UBS realized that billions of dollars of debt securities inventoried on the bank's books needed to be unloaded. In one email presented as evidence between UBS employees, one employee asked, "OK still have this vomit?"

After seeing the evidence, Judge Blawie wrote in his ruling that he became convinced that UBS had an "awareness that . . . high-grade securities on its hands would soon turn into financial toxic waste," while at the same time it was persuading Pursuit to buy debt securities known as collateralized debt obligations, or CDOs.

In explaining its case to the judge, Pursuit, which is a hedge fund, told the judge it wants to recoup money invested in three CDOs that lost $35.5 million. Pursuit alleges in the lawsuit that it asked UBS for investments that offered steady cash flow, but also specified that these investments must be investment-grade securities or securities with a low risk of default. For Pursuit to win this case, it must prove UBS sold them investment-grade securities but knew that the securities were about to be downgraded.

After being told to set aside the money, UBS told The Wall Street Journal that the order was preliminary and that UBS would prevail in the case.

This case highlights how the bank shifted from a conservative Swiss bank focused on specialized private banking to one more dependent on selling and trading debt securities in 2006 and 2007. All hell broke loose at the bank when, according to the judge's ruling, UBS "had reason to believe that Moody's was changing its methodology and that would result in the downgrading of certain asset-backed securities."

On July 11, 2007, Moody's told UBS that it would review for possible downgrade a small percentage of the universe of CDOs, just after it cut ratings on subprime-mortgage bonds -- the building blocks for many CDOs. In the court hearing transcript, UBS bonds salesman Robert Morelli told the court that this day "was essentially the beginning of the end of the CDO business, meaning the bonds were getting downgraded, they were probably going to get downgraded further, and we were going to lose a lot of money."

With this knowledge, court records show that UBS instructed employees to reduce CDOs, but that they did not need to publicly relay the Moody's review. Pursuit alleged during the hearing that it purchased the securities after UBS had this insider information from Moody's. In fact, another email presented to the court during the hearing was from Morelli who said he had "sold more crap to Pursuit." Pursuit alleges it purchased CDOs from UBS between July 11, 2007 and October 1, 2007, while at the same time UBS knew Moody's could downgrade them. Moody's downgrades started on October 11, 2007.

If Pursuit successfully proves its case, this could open the door for suits from other clients who bought bonds from UBS during the same period.

Lita Epstein has written more than 25 books including Trading for Dummies.

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