//arNi r ' UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK IN RE THE BEAR STEARNS COMPANIES, INC. SECURITIES, DERIVATIVE, AND ERISA : Master File 4,14 sv ip • LITIGATION : 08 M.D.L. No. 1963:-AAMS)* This Document Relates To: : CLASS ACTION Securities Action, 08-Civ-2793 (RWS) : JURY TRIAL DEMANDED : ECF CASE CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS TABLE OF CONTENTS Page 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 1. 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 1. 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 1. 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 1. Bear Stearns’ Misleading Valuation and Risk Models 23 a. The Importance of Valuation Models 24 i b. Bear Stearns’ Valuation Models Were Misleading 25 c. The Importance of Value at Risk Models 27 d. Bear Stearns’ Value at Risk Models Were Misleading 30 2. Bear Stearns’ Impoverished Risk Management Program 31 F. Bear Stearns Hides its Mounting Exposure to Loss 33 1. Early Warnings 33 2. Bear Stearns’ 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 1. 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 1. GAAP Overview 76 2. Fraud Risk Factors Present at Bear Stearns 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 a. Risk Management 88 b. Pricing Models and VaR Systems 89 5. GAAP Violations Relating to the Company’s Financial Statements 90 a. Bear Stearns Misstated Its Exposure to Loss from the Failed Hedge Funds 90 b. Bear Stearns’ Financial Statements Misrepresented its Exposure to Decline in the Value of RIs 94 c. GAAP Violations Related to Failure to Appropriately Determine the Fair Value of Financial Instruments 99 d. Bear Stearns Failed to Provide Adequate Disclosure About Risk and Uncertainties 104 e. Bear Stearns Failed to Provide Reliable Disclosures to Investors in Accordance with SEC Regulations 106 N. Bear Stearns’ Practices Violated Banking Regulations 107 1. 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 4. Misrepresentations to Regulators Relating to VaR 111 V. 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 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 1. 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 1. December 14, 2006 Press Release 154 iv a. December 14, 2006 Press Release Statements Regarding the Company’s Fourth Quarter 2006 Results 155 b. Press Release Regarding Fiscal 2006 Results 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 162 d. The Company’s Compliance With Banking Regulations 162 e. The Company’s Internal Controls 163 f. Deloitte’s Certification 164 B. Statements Relating to Fiscal Year 2007 Results 164 1. First Quarter 2007 Results 164 a. First Quarter 2007 Press Release 164 b. First Quarter 2007 Conference Call 166 c. First Quarter 2007 Form 10-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 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 1 0b-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 PRAYER FOR RELIEF 216 DEMAND FOR JURY TRIAL 218 vii GLOSSARY OF DEFINED TERMS 2008 OIG Report: A report entitled “SEC’s Oversight of Bear Stearns 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. ARAs: 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 B&D AAG: AAG that was applicable to Brokers and Dealers in Securities. Bear Stearns: The Bear Stearns Companies Inc., Bear, Stearns & Co. Inc., and Bear Stearns Asset Management. Bear Stearns Defendants: The Bear Stearns Companies Inc.; James E. Cayne; Alan D. Schwartz; Warren Spector; Samuel Molinaro; Alan C. Greenberg; Michael Alix and Jeffrey Farber. BEARRES: Bear Stearns 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 Stearns Companies Inc. CAP: Capital Accumulation Program. Captive Originations: mortgages originated by BEARRES and ECC that were sent directly into the securitization process at Bear Stearns. CAQ: 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 Stearns trader who started and managed the High Grade Fund, a Managing Director of B SAM and a Director of B SC.