These days underwriting a bond deal can be dangerous to an investment bank's health. On Tuesday, three big California pension funds filed suit against the investment banks that underwrote a $12 billion corporate bond issue for WorldCom ( WCOME), the ailing telecom giant that's accused of cooking its books. The pension funds allege that the investment banks failed to perform adequate due diligence before underwriting the bonds and if they had, the firms would have detected some of the $4 billion accounting fraud that's alleged to have gone on at the long-distance carrier. The pension funds, led by Calpers, are seeking $318 million in damages to cover their losses on bonds that are now all but worthless. The main defendants in the lawsuit are Citigroup ( C) and J.P Morgan Chase ( JPM), the lead underwriters on the bond issue. Also named are Bank of America ( BAC) and Deutsche Bank, which participated in the bond issue. "Our interest is in getting some of our losses back, but to also send a message to the underwriters of the world that they need to look under every rock before they sign their name to a bond deal,'' says Pat Macht, a spokeswoman for Calpers. "If we can't depend on the due diligence of the underwriters, how can we ever buy bonds. It's about rebuilding investor confidence.'' The lawsuit, Macht says, is consistent with Calpers' long history of advocating market reform and serving as an aggressive proponent of shareholder rights.
Officials from J.P. Morgan Chase and Citigroup were quick to dismiss the complaint filed in a California state court in Los Angeles. Kristin Lemkau, a spokeswoman for J.P. Morgan Chase, says the alleged fraud at WorldCom was not the kind that an underwriter would be expected to detect. Similarly, Dan Noonan, a Citigroup spokesman, says the "suit has no merit." "The underwriters conducted thorough due diligence in connection with WorldCom's bond offering, including reliance on the company's audited financial statements,'' says Noonan. The lengthy complaint also names WorldCom and its auditor, Arthur Andersen, as defendants. But with WorldCom headed for bankruptcy and Andersen headed for extinction, the chances of collecting from those two defendants are close to nil. So suing the investment bank is consistent with an age-old legal strategy of trying to find a deep pocket -- someone with the money to pay big damages, especially if the main culprit is sitting in the poorhouse. Indeed, this is not the first time in recent months that shareholders have turned their sights on the investment bankers. A number of investment banks are being sued by shareholders and bondholders of Enron. In fact, Milberg Weiss Bershad Hynes & Learch, the law firm representing the pension funds in the WorldCom case, in April filed a class-action suit on behalf of Enron shareholders, claiming Wall Street investment banks were intimately aware of Enron's plan to hide billions of dollars of debt in off balance sheet partnerships. It looks like Milberg Weiss, one the nation's best-known shareholder law firms, may be finding a new niche for itself.