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 were made to borrowers with poor credit. Moreover, they were secured by secondary liens on the home, meaning that, should the home go into foreclosure, Bear Steams would only be paid after the first mortgage was satisfied and was more likely not to be paid in full if the value of the home dropped. By the end of 2006, EMC had purchased $1.2 billion of HELOC and $6.7 billion of second-lien loans. Once these loans were purchased, they would go directly into the securitization process. 62. Finally, through EMC, Bear Stearns aggressively purchased exceptionally risky mortgages that were already in default in the hopes of bringing the borrower back into compliance and securitizing the loan along with other acquired and originated mortgages-so- called "scratch and dent" loans. A special desk at Bear Steams was designated to securitize the "scratch and dent" loans and sell them to investors. 63. Given the Company's poor underwriting standards and devil-may-care attitude towards purchasing mortgages originated by other companies, the loans that it purchased to package into RMBS and CDOs were especially vulnerable to declines in housing prices. 16 EFTA00316744

Case 1:08-cv-02793-RWS Document 102 Filed 02'27)09 Page 32 of 347 2. Bear Stearns' RMBS Business 64. After Bear Stearns acquired a sufficiently large pool of risky mortgages to securitize, it took the individual nonprime home loans and wrapped them into an RMBS. Some RMBS it sold to investors, and others it packaged into CDOs. 65. Especially risky tranches of RMBS were kept on the Company's books as "Retained Interests." Throughout the Class Period, the amount of these especially risky RMBS that the Company kept as retained interests steadily grew, from $5.6 billion as of November 30, 2006 to $9.6 billion by August 31, 2007. 3. Bear Stearns' CDO Business 66. In order for the Company to assemble RMBS into CDOs, a further step was required. Each CDO was set up as a new entity, typically an offshore limited liability entity, with its own assets and liabilities. Further, the CDOs produced by Bear Stearns incorporated cash flows from pools of risky subprime and "Alt-A" home mortgage loans. 67. Nearly all of the CDOs Bear Steams structured during the Class Period were backed, in addition to RMBS, by derivatives or "synthetic securities," which were, in effect, 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. In other words, a synthetic security is akin to a "side bet" on the performance of certain assets. Such CDOs are called "Synthetic CDOs." A CDO backed by other CDO notes is called a "CDO squared." 68. One of Bear Stearns' primary functions as a CDO underwriter was determining the marketable size of each CDO. This determination was based on three things: the supply of collateral that would make up the assets of the CDO, the market demand for the securities issued 17 EFTA00316745

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 33 of 347 by the CDO, and the risk-taking ability of the Company—that is, Bear Steams' ability to retain unsold CDO securities and to insure the CDO against losses. 69. In order to sell CDOs that were as large as possible, the Company retained increasing amounts of the CDOs it packaged on its books. By August of 2007, this figure had reached $2.072 billion. D. Bear Stearns' Business Practices .kniplify its Risk Exposure 70. During the Class Period, the Company's growing accumulation of subprime- backed RMBS and CDOs, combined with its leveraging practices, left it extraordinarily vulnerable to declines in the housing market. This vulnerability was only exacerbated by the Company's management and implicit backing of two enormous hedge funds holding subprime- backed securities. 1. Bear Stearns' Concentration in Mortgage-Backed Debt 71. According to documents privately submitted to the SEC, even before the Class Period began, on multiple occasions the amount of mortgage securities held by the Company exceeded its own internal limits on concentration. 72. Shortly after Bear Steams' March 2008 collapse, Senator Charles Grassley, Ranking Member of the United States Senate Committee on Finance, issued a request that the SEC's Office of the Inspector General ("OIG") analyze the SEC's oversight of the CSE firms, with a special emphasis on Bear Steams. 73. To assist in this audit, the OIG retained Professor Albert Kyle of the University of Maryland, an acclaimed expert on capital markets. Professor Kyle analyzed TM's oversight of Bear Steams, and from information submitted to the SEC, analyzed Bear Steams' capital, liquidity, and leverage ratios. Professor Kyle also examined the Company's access to secured and unsecured financing, and its compliance with industry and worldwide banking guidelines. 18 EFTA00316746

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 34 of 347 74. To prepare the report, the SEC relied on an extensive collection of internal memoranda and other documents relating to TM's oversight of Bear Stearns, including non- public correspondence between TM and the Company's top executives. 75. The OIG issued its conclusions in a September 25, 2008 Report, titled "SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program" (the "2008 OIG Report"). 76. In the report, the OIG stated that "[b]y November of 2005 the Company's ARM business was operating in excess of allocated limits, reaching new highs with respect to the net market value of its positions." Such a large concentration of business in this area left the Company very exposed to declines in the riskiest part of the housing market. 2. Bear Stearns' Leveraging Practices 77. The Company's exposure to declines in the value of the loans backing its assets was vastly magnified by its leveraging practices. In leveraging, a company takes out a loan secured by assets in order to invest in assets with a greater rate of return than the cost of interest for the loan. Leverage allows greater potential returns to the investor than otherwise would have been available, but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid. 78. Indeed, as a company's leverage ratio increases, its exposure to loss increases dramatically. As set out in the chart below, a leverage ratio of four to one increases losses by about 15%, while a leverage ratio of 35 to one magnifies losses by more than 100%. 19 EFTA00316747

Case 1:08-cv-02793-RWS Document 102 Filed 02:27/09 Page 35 of 347 Leverage Ratios at 1% Loss 0.00% 0 to 1 ito. A 111 2[1 31 1 -20.00% -40.00% -60.00% -80.00% -100.00% -120.00% 79. During the Class Period, the Company used the assets on its books as collateral for purchases costing many times the equity it possessed. In 2005, the Company was leveraged by a ratio of approximately 26.5 to 1. By November of 2007, the Company had leveraged its net equity position of $11.8 billion to purchase $395 billion in assets—a ratio of nearly 33 to 1. As a consequence, even a small decline in the value of its assets it held could have catastrophic effects on the Company's finances. For example, a 3% decline in asset values would wipe out 100% of equity. 80. Because of the interest charges the Company had to pay to support its soaring leverage ratio, the amount of cash the Company needed to finance its daily operations increased dramatically during the Class Period. By the close of the Class Period, Bear Stearns' daily borrowing needs exceeded $50 billion. 3. Bear Stearns' Backing of the Hedge Funds 81. Another key source of the Company's exposure to the subprime market came through its relationship with two large hedge funds that it managed and that bore its name. 20 EFTA00316748

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 36 of 347 82. In October of 2003, the Company staked a young trader named Ralph Cioffi ("Cioffi") to start the High Grade Structured Credit Strategies Fund, LP (the "High Grade Fund") which was housed in Bear Steams Asset Management. The High Grade Fund, which was under the supervision of defendant Spector, consisted of two separate entities. The Bear Stearns High Grade Structured Credit Strategies Fund, L.P., a Delaware partnership, was responsible for raising money from U.S. investors to be placed in the High Grade Master Fund. Bear Steams High Grade Structured Credit Strategies (Overseas) Ltd., a Cayman Island corporation, was responsible for raising money from foreign investors to be placed in the High Grade Master Fund. 83. In August of 2006 Cioffi created the High Grade Structured Credit Strategies Enhanced Leverage Fund, LP ("the High Grade Enhanced Fund") (the High Grade Master Fund and the High Grade Enhanced Fund are collectively referred to as the "Hedge Funds"). 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. 84. An important selling point for investors in the Hedge Funds was the funds' relationship with Bear Steams. Bear Steams was known as a leader in CDOs and other exotic securities. The Hedge Funds were marketed as safe investments because of Bear Steams' expertise and the use of the Company's proprietary systems to identify and manage risk. 85. Moreover, Bear Steams was involved in virtually every part of the Hedge Funds' business. Bear, Stearns Securities Corporation, a wholly-owned subsidiary of the Company, served as the prime broker for the Hedge Funds, and PFPC Inc., another Bear Steams subsidiary, was the Hedge Funds' administrator. BSAM was the investment manager for the Hedge Funds. Defendant Spector himself was ultimately responsible for the business of both of the funds. 21 EFTA00316749

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 37 of 347 86. The Hedge Funds invested according to a strategy developed by BSAM. The Hedge Funds' objective was to provide current income and capital appreciation in excess of LIBOR by investing primarily in High Grade structured financed securities, with an emphasis on long positions in triple-A and double-A rated asset backed securities, such as CDOs. The High Grade Fund increased its returns through the use of leverage: taking the CDOs it had purchased and borrowing against them, cheaply, through repurchase or "repo" agreements with counterparties. 87. In a repo, a borrower agrees to immediately sell a security to a lender and also agrees to buy the same security back from the lender at a fixed price at some later date. Because cash obtained through a repurchase agreement is secured by the collateral provided, it is a cheaper source of financing than unsecured loans with higher interest rates. 88. The loan proceeds from the repurchase agreements were used to buy additional CDOs, and the proceeds (in the form of interest payments) from those investments would finance additional borrowing. 89. Fortunately for the Hedge Funds, because of BSAM's role as an asset manager, they had in Bear Stearns a lender willing to extend large amounts of cash in exchange for collateral drawn from the Hedge Funds' risky CDO assets. In fact, Bear Stearns was one of the few repurchase lenders willing to take the Hedge Funds' CDOs as collateral for short term lending facilities. 90. The Hedge Funds, through BSAM, entered into many repurchase agreements on favorable terms with Bear Steams as the counterparty. When, in the summer of 2006, Bear Stearns entered into a temporary moratorium on repurchase agreements between the Hedge Funds and the Company, it briefly deprived the Hedge Funds of an important source of 22 EFTA00316750

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 38 of 347 financing. In an e-mail from Cioffi to Tannin in September, 2006, Cioffi underscored the importance of Bear Steams' role as a lender willing to take on the Hedge Funds' risky subprime- backed collateral: Do we have an official mandate to terminate our relationship with Bear? This hurts our investors as it eliminates a repurchase counterparty (reducing liquidity) and eliminates a source of trading secondary CDOs. Bear is among the best (reducing liquidity) and further eliminates a source for assets. 91. As a result of the Company's willingness to support the Hedge Funds by offering cash in exchange for subprime mortgage-backed CDOs of questionable value, Bear Steams' exposure to declines in the subprime market skyrocketed. E. Bear Stearns' Misleading Models and Inadenuate Risk !Umlaut:mon 92. The Company's assumption of vast amounts of risk and aggressive leveraging practices was especially reckless given that, even before the Class Period began, the Company knew there were grave deficiencies in the models it used in valuing mortgage-backed assets and assessing its exposure to loss. It had twice been informed by the SEC that these models failed to incorporate key indicators of a declining housing market. Moreover, the Company failed to take basic steps to ensure that its risk management department functioned independently and effectively. 1. Bear Stearns' Misleading Valuation and Risk Models 93. The 2008 DIG Report identified crucial deficiencies in models that the Company used for valuation and risk management purposes. 23 EFTA00316751

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 39 of 347 a. The Importance of Valuation Models 94. The valuation of assets is governed by Statement of Financial Accounting Standards No. 157, Fair Value Measurements ("SFAS 157"). Although SFAS 157 took effect on November 15, 2007, Bear Stearns opted to comply with the standard beginning January of 2007.2 95. SFAS 157 required that Bear Stearns classify its reported assets into one of three levels depending on the degree of certainty about the asset's underlying value. Assets that were easy to value because traded in an active market, such as shareholder's equity, were classified as Level 1 ("mark-to-market"). 96. Level 2 ("mark-to-model") assets consisted of financial assets whose values are based on quoted prices in inactive markets, or whose values are based on models — but the inputs to those models are observable either directly or indirectly for substantially the full term of the asset or liability. 97. Level 3 assets, because they are thinly traded or not traded at all, have values based on valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. 98. To value opaque Level 3 assets, companies rely on models developed by management. With respect to valuing mortgage-related securities, these models should incorporate assumptions critical to determining fair value such as the (i) interest rate environment (including term structure or "yield curve" and volatility), (ii) market liquidity levels, (iii) credit exposure and (iv) the economic environment including housing prices and default rates. 2 Prior to the Company's adoption of SFAS 157, it was subject to similar provisions under SFAS 115. 24 EFTA00316752

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 40 of 347 99. The information supplied by valuation models is incorporated into other models used to assess risk and hedge investments, such as the models measuring Value at Risk ("VaR"), described at paragraphs 115 to 117 below. b. Bear Stearns' Valuation Models Were Misleading 100. Even before the Class Period began, the Company knew that declining housing prices and rising default rates were not reflected in the mortgage valuation models that were critical to the valuation of its Level 3 assets. 101. In its 2008 Report, the OIG stated that, prior to the Company's approval as a CSE in November of 2005, "Bear Steams used outdated models that were more than ten years old to value mortgage derivatives and had limited documentation on how the models worked." 102. As a result, during the 2005 CSE application process, TM told Bear Stearns that "[w]e believe that it would be highly desirable for independent Model Review to carry out detailed reviews of models in the mortgage area." 103. According to the 2008 OIG Report, these concerns were again communicated to the Company in a December 2, 2005 memorandum from the SEC Office of Compliance Inspections and Examinations ("OCIE") to defendant Farber, then a Senior Managing Director and the Company's Controller and Principal Accounting Officer. Farber reported to defendant Molinaro, CFO and Executive Vice President. 104. TM documents cited in the 2008 OIG Report reflect that nearly a year after its admission to the CSE program, on September 20, 2006, Bear Steams' risk management personnel gave a presentation to the TM division regarding the models that Bear Steams used to price and hedge various financial instruments. The 2008 OIG Report stated that as a result of the presentation, TM concluded, among other things, that Bear Steams' "model review process lacked coverage of mortgage-backed and other asset-backed securities" and that "the sensitivities 25 EFTA00316753

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 41 of 347 to various risks implied by the models did not reflect risk sensitivities consistent with price fluctuations in the market." 105. The 2008 OIG Report also revealed that TM's discussions with risk managers in 2005 and 2006 indicated that Bear Steams' pricing models for mortgages "focused heavily on prepayment risks" but that TM documents did not reflect "how the Company dealt with default risks." 106. Defendant Cayne, the CEO of the Company, and defendant Molinaro, the CFO of the Company, were aware of the SEC's concerns about Bear Steams risk management program. According to a February 8, 2008 presentation by defendant Molinaro at a Credit Suisse Financial Services Forum, the Company's risk management structure "reports directly to the CFO." Moreover, it stated that the Company's "CEO is intimately engaged in the risk management process." 107. Despite its awareness of TM's concerns, the Company made no effort to revise its mortgage valuation models to reflect declines in the housing market. In fact, according to Confidential Witness 5 ("CW 5"), a former employee of the model validation department at Bear Steams during the latter half of the Class Period, Tom Marano, the head of the Company's mortgage trading desk, was "vehemently opposed" to the updating of the Company's mortgage valuation models. 108. This witness' statement is consistent with the findings in the 2008 OIG Report, which concluded that the Company did not begin to make any effort to incorporate measures reflecting declines in housing prices into its mortgage models until "towards the end of 2007"— long after the Company had acquired a huge hoard of highly illiquid mortgage-backed assets. 109. In fact, the OIG concluded, 26 EFTA00316754

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 42 of 347 the reviews of mortgage models that should have taken place before the subprime crisis erupted in February of 2007 appears to have never occurred, in the sense that it was still a work in progress when Bear Steams collapsed in March 2008. 110. As the housing market plummeted throughout 2007 and into 2008, Bear Steams continued to rely on its flawed valuation models which exacerbated the spread between the true value of their assets and the value Bear Stearns was publicly reporting. Level 3 assets, including retained interests in RMBS and the equity tranches of CDOs, made up 6-8% of the Company's total assets at fair market value in 2005, and increased to 20-29% of total assets between the fourth quarter of 2007 and the first quarter of 2008. 111. According to the Company's Form 10-K for the period ending November 30, 2007, the majority of the growth in the Company's Level 3 assets in 2007 came from "mortgages and mortgage-related securities"—the very assets that the Company was valuing using its misleading models. Indeed, as of August 31, 2007, the Company carried $5.8 billion in Level 3 assets backed by residential mortgages, a figure that grew close to $7.5 billion by November 30, 2007. c. The Importance of Value at Risk Models 112. The SEC's second criticism of the Company's models related to Bear Stearns' assessment of risk. 113. Broadly, risk is defined as the degree of uncertainty about future net returns, and is commonly classified into four types. Credit risk relates to the potential loss due to the inability of a counterpart to meet its obligations. Operational risk takes into account the errors that can be made in instructing payments or settling transactions, and includes the risk of fraud and regulatory risks. Liquidity risk is caused by an unexpected large and stressful negative cash flow over a short period. If a firm has highly illiquid assets and suddenly needs some liquidity, it 27 EFTA00316755

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 43 of 347 may be forced to sell some of its assets at a discount. Finally, market risk estimates the uncertainty of future values, due to the changing market conditions. 114. The most prominent of these risks for investment bankers is market risk, since it reflects the potential economic loss caused by the decrease in the market value of a portfolio. Because of the crucial role that market losses can play in the financial health of investment banks, they are required to set aside capital to cover market risk. 115. Value at Risk ("VaR") is one method of quantifying market risk. It is defined as the maximum potential loss in value of a portfolio of financial instruments with a given probability over a certain horizon. For example, a one-day 5% VaR of negative $1 million implies the portfolio has a 5% chance of losing $1 million or more over the next day. 116. Companies measure VaR using models that are intended to capture different variables that may lead to loss. One input to the VaR models is the data supplied by valuation models, such as models used to value mortgages and mortgage backed assets. 117. VaR models are used by investment banks to ensure that a company is maintaining sufficient capital to cover risks associated with potential market decline. If the company's VaR is high, it must increase the amount of capital it sets aside in order to mitigate potential losses or reduce its exposure to high risk positions. 118. When the Basel Committee on Banking Supervision, an international banking group that advises national regulators, decided that investors and regulators needed more accurate ways to gauge the amount of capital that firms needed to hold in order to cover risks, Bear Stearns, together with other Wall Street firms, successfully lobbied the Basel Group to allow them to use their internal VaR numbers for this purpose. 28 EFTA00316756

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 44 of 347 119. In an August 5, 2003 letter to the Board of Governors of the Federal Reserve System ("August 5, 2003 letter"), defendant Michael Alix, the Company's Head of Global Risk Management and the Chairman of the Risk Management Committee of the Securities Industry Association, described then-current capital requirements as "excessive." He advocated for the adoption of a new "flexible capital regime that relates regulatory requirements to observable risk," one that would turn on the use of VaR models. He explained: Investment banks typically value risk assets, including loans, on a mark-to-market basis, and estimate risk to that market using various tools, including robust VaR models. Risk models are continuously enhanced to incorporate new products and markets, and may be used by investment banks to measure the risk of activities that are considered under Basel II as part of the banking book. 120. Defendant Alix recommended in his August 5, 2003 letter that regulators rely on VaR "[t]ci the extent that an institution can produce reliable mark-to-market values and robust VaR base-based estimates." 121. This use of VaR was incorporated into the requirements for CSE program participants when the CSE program was launched in 2004. Companies participating in the program were required to regularly supply their VaR numbers to federal regulators and to the public. 122. During Alix's June 22, 2004 testimony before the House Financial Services Subcommittee, Alix touted the benefits of the CSE program's adoption of VaR as a measure of assessing the "true risks" faced by investment banks. He stated that: the framework will permit securities firms registered under it to determine the regulatory capital for their broker-dealers by means of approved Value at Risk ("VaR") models. This will better align capital requirements with the true risks of the securities business, with the added benefit of harmonizing the SEC's capital rules with global standards as represented by Basel II. 29 EFTA00316757

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 45 of 347 d. Bear Stearns' Value at Risk Models Were Misleading 123. According to the 2008 OIG Report, the Company knew before the Class Period began that its VaR models would not reflect declines in the housing market, the heart of Bear Steams' business and its principal source of risk. The 2008 OIG Report stated that in November of 2005, the OCIE "found that Bear Stearns did not periodically evaluate its VaR models, nor did it timely update inputs to its VaR models." 124. Bear Stearns was warned of these deficiencies in a December 2, 2005 memorandum from OCIE to defendant Farber, the Company's Controller and Principal Accountant. 125. The DIG also found that: Bear Stearns' VaR models did not capture risks associated with credit spread widening.... These fundamental factors include housing price appreciation, consumer credit scores, patterns of delinquency rates, and potentially other data. These fundamental factors do not seem to have been incorporated into Bear Steams' models at the time Bear Stearns became a CSE. 126. The 2008 OM Report stated that in September of 2006, TM concluded after a meeting with Company risk managers that the Company still had failed to improve the accuracy of the models it used to hedge against risk. In fact, according to the 2008 DIG Report, it was not until "towards the end of 2007" that Bear Steams "developed a housing led recession scenario which it could incorporate into risk management and use for hedging purposes." 127. Moreover, the DIG found that the mortgage-backed asset valuation inputs to the VaR models employed by the Company were never updated during the Class Period, and were still a "work in progress" at the time of the Company's March 2008 collapse. 30 EFTA00316758

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 46 of 347 128. As the housing crisis spread during the Class Period, the Company knew that fundamental indicators of housing market decline, including falling housing prices and rising delinquency rates, were not reflected in the VaR figures it disclosed to the public. 2. Bear Stearns' Impoverished Risk Management Program 129. In its 2008 Report, the OIG was also highly critical of the minimal role that risk management played in Bear Stearns' overall business. The 2008 OIG Report concluded that in 2006, as the Company's business was becoming increasingly concentrated in mortgage securities, the expertise of its risk managers was in "exotic derivatives" and in validating models for those derivatives. Accordingly, the managers were ill-equipped to offer reliable assessments of risk associated with the mortgage securities that had come to be the largest and riskiest part of the Company's business. 130. Moreover, the OIG saw ample evidence that during the Class Period Bear Stearns' trading desks had gained ascendancy over the Company's risk managers. TM found that model review at Bear was less formalized than at other CSE firms and had devolved into a support function. Indeed, the OIG concluded that "each of Bear Steams' trading desks evaluated profits and risk individually, as opposed to relying on one overall firm-wide approach." 131. As a result, the OIG investigators concluded that Bear Stearns reported different VaR numbers to OIG regulators than its traders used for their own internal hedging purposes. 132. The OIG's conclusion is confirmed by Confidential Witness 6 ("CW 6") who reported that during his work as a model valuator at Bear, traders were able to override risk manager marks and enter their own, more generous, marks for some assets directly into the models used for valuation and risk management. Traders did this by manipulating inputs into Bear Stearns' WITS system, which was the repository for raw loan data, including such crucial information as a borrowers' credit score, prepayments, delinquencies, interest rates and 31 EFTA00316759

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 47 of 347 foreclosure history. Traders did so to alter the value of pools of loans to enhance their profit and loss positions at the end of the day. 133. The OIG's expert also pointed out that the Company's risk managers sat at the same desks as the traders, an arrangement that reduces and potentially eliminates the independence of the risk management function. This finding is consistent with the statements of CW 6, who asserted that that when there was a dispute regarding the value of assets traded, Phil Lombardo, the head of Bear Steams' fixed income trading desk, would prevail over risk managers because of his close relationship with upper management. 134. The 2008 OIG Report reveals other ways in which risk management responsibilities at Bear Steams had been co-opted by the traders. TM memoranda reflected that the risk management department was persistently understaffed, and that the head of the Company's model review program "had difficulty communicating with senior managers in a productive manner." The OIG viewed this as an indicator that the Company's risk managers were telling its traders something they did not want to hear—that they were taking on too much risk. 135. The 2008 OIG Report asserts that the reins on the Company's trading desks were loosened even further in March of 2007 with the resignation of the beleaguered head of model review at the Company. According to the 2008 OIG Report, this vacuum in risk management gave trading desks more power over risk managers. The Inspector General found that by the time a new risk manager arrived in the summer of 2007, the department was in a shambles, and risk managers were operating in "crisis mode." 32 EFTA00316760

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 48 of 347 136. Indeed, according to CW 5, by October of 2007, just five months before the Company's collapse, "the entire model valuation team had evaporated, except for one remaining analyst." F. Bear Stearns Hides its Mounting Exposure to Loss 137. The Company's huge exposure to loss in the housing market, combined with its misleading valuation and risk models, were to have terrible consequences for investors. During the Class Period, as the housing market underlying the bulk of the Company's business began a titanic decline, the Company used its misleading models to inflate asset values and revenues and to offer the public artificially low calculations of its Value at Risk. 1. Early Warnings 138. The collapse in the housing market in late 2006 and 2007 did not come as a surprise to Bear Stearns. 139. Beginning in early 2006, record numbers of subprime loans began to go bad as borrowers failed to make even their first payment ("First Payment Default" or "FPD"), or failed to make their first three payments ("Early Payment Default" or "EPD"). These defaults were not caused by higher resetting rates, which were still one to three years off, but instead indicated borrower inability to pay even the initial, low teaser rates. 140. During 2005, only one in every 10,000 subprime loans experienced an FPD. During the first half of 2006, the FPD rate had risen by a multiple of 31; nationwide, about 31.5 out of every 10,000 subprime loans originated between January and June 2006 had a delinquency on its first monthly payment, according to Loan Performance, a subsidiary of First American Real Estate Solutions. 33 EFTA00316761

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 49 of 347 141. Bear Steams was well aware of the growth in EPDs. In April of 2006, Bear Steams' EMC Mortgage, reputed to be a primary EPD enforcer, sued subprime originator Mortgage IT over approximately $70 million in EPD buyback demands. 142. Just a month later, in May of 2006, the California Association of Realtors lowered expectations for California home sales from a 2% decline (2006 sales vs. 2005 sales) to a 16.8% decline. 143. In the same period, disasters in a U.K. subsidiary brought home to the Company the threat posed by lax underwriting standards to the values of its mortgages and mortgage- backed assets. Between April and June of 2006, the Company faced repeated crises in its United Kingdom subsidiary as a result of poor performance of U.K. loans due to weak underwriting standards. As a result, the Company was left holding some $1.5 billion in unsecuritized whole loans and commitments from this subsidiary. According to Confidential Witness 7 ("CW 7"), a former head of model valuation at Bear Steams at the time, top management at Bear Steams were deeply concerned about the U.K. developments and defendant Spector personally made calls to investigate the crisis. 144. Given the lax underwriting practices for the loans it packaged into CDOs and its careless standards for purchasing loans from other originators, there was every reason for Company management to believe that similar catastrophes awaited it in the United States. However, as the 2008 OIG Report points out, the Company did not "use this experience to add a meltdown of the subprime market to its risk scenarios." 145. In May of 2006, after recent data demonstrated dramatically slowing sales, the highest inventory of unsold homes in decades, and stagnant home prices, the chief economist for 34 EFTA00316762

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 50 of 347 the National Association of Realtors ("NAR") — a long-time advocate of the "soft landing" school — admitted that "hard landings" in certain markets were probable. 146. The monthly year-over-year data provided by the NAR showed that by August 2006, year-over-year home prices had in fact declined — for the first time in 11 years. In fact, sales of existing homes were down 12.6% in August from a year earlier, and the median price of homes sold dropped 1.7% over that period. Sales of new homes were down 17.4% in August of 2006. 147. As 2006 progressed, evidence of the deflation of the housing bubble was everywhere. Data aggregated in the NAR's monthly statistical reports on home sales activity, home sales prices, and home sales inventory revealed (1) accelerating declines in the numbers of homes sold during 2006, which continued and deepened throughout 2007; (2) steadily decreasing year-over-year price appreciation in early 2006, no year-over-year price appreciation by June 2006, and nationwide year-over-year price declines beginning in August 2006 and continuing thereafter; and (3) steadily rising amounts of unsold home "inventory," expressed in the form of the number of months it would take to sell off that inventory, rising 50% by August of 2006 and doubling by late 2007. 148. By the end of 2006, EPD rates for 2006 subprime mortgages had risen to ten times the mid-2006 FPD rate; 3% of all 2006 subprime mortgages were going bad immediately. The 2006 subprime mortgages from First Franklin Financial, Long Beach Savings, Option One Mortgage Corporation and Countrywide Financial had EPD rates of approximately 2%; those originated by Ameriquest, Lehman Brothers, Morgan Stanley, New Century and WMC Mortgage had EPD rates of 3-4%; and those originated by Fremont General had EPD rates 35 EFTA00316763

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 51 of 347 higher than 5%. See Moody's Investors Service, 2006 Review and 2007 Outlook: Home Equity ABS, January 22, 2007, p. 12 at Figure 14. 2. Bear Stearns' Deception Begins 149. Despite this inescapable evidence of a rapid decline in housing prices, by the time of its September 2006 presentation to TM personnel, Bear Stearns had still failed to revise the valuation and risk models that it knew to be outmoded and inaccurate. This was not an oversight. 150. On December 14, 2006, Bear Steams issued a press release regarding its fourth quarter and fiscal year end results for 2006, which closed on November 30, 2006.3 The release reported diluted earnings per share of $4.00 for the fourth quarter ended November 30, 2006, up 38% from $2.90 per share for the fourth quarter of 2005, ending November 30, 2005. It also stated that its net income for the fourth quarter of 2006 was $563 million, up 38% from $407 million for the fourth quarter of 2005. 151. The Company was only able to achieve these results by using valuation models that ignored declining housing prices and rising default rates. By using these inaccurate models the Company avoided taking losses on its Level 3 assets, increasing its revenues and earnings per share and falsely inflating the value of its stock. 152. During a press conference on December 14, 2006, defendant Molinaro fielded questions from analysts about the Company's exposure to the growing subprime crisis. Jeff Harte, an analyst at Sandler O'Neill, asked Molinaro whether the increased defaults threatened to make the securitization of those mortgages, which were increasingly being originated by Bear Stearns, a risky business. Molinaro responded "Well, I don't — no, it doesn't. Because 3 The Company's fiscal year ran from December 1 to November 30. 36 EFTA00316764

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 52 of 347 essentially we're originating and securitizing." Molinaro's statement was false, in that the Company faced dangerous exposure through both the retained CDO tranches it kept on its books and the agreements it maintained with counterparties and CDOs. 153. As a result of the Company's artificially inflated results and the false assurances by Molinaro, the Company's stock rose by $4.07, closing at $159.96. 154. As the mortgage crisis worsened, the scope of the problems with subprime mortgages was reflected in two indices that closely tracked the markets for nonprime mortgages. The ABX index, launched in January of 2006, and the TABX index, introduced in February of 2007, synthesized subprime mortgage performance, refinancing opportunities, and housing price data into efficient market valuation of CDOs' primary assets — subprime RMBS tranches, via the ABX — and of Mezzanine CDO tranches, via the TABX. These indices provided observable market indicators of CDO value. 155. In fact, The Bank of International Settlements has observed that "ABX price information also seems to have been widely used by banks and other investors as a tool for hedging and trading as well as for gauging valuation effects on subprime mortgage portfolios more generally." 156. In February of 2007, the ABX index, which tracks CDOs on certain risky subprime loans (those rated BBB), materially declined. According to Market Watch, in early February, the ABX Index was above 90. Then, the index had declined from 72.71 on February 22, 2007, to 69.39 on February 23, 2007. An ABS strategist at RBS Greenwich Capital commented in a Market Watch article dated February 23, 2007 stated that "ABX needs protection sellers badly. . . Real (not perceived) problems in select mortgage pools and in the 37 EFTA00316765

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 53 of 347 subprime mortgage lending industry do not make for an ideal fundamental opportunity at this time." 157. Further, immediately upon launch TABX tranches materially declined, indicating that the value of many CDOs had plunged. As depicted in the chart below, the Senior TABX Tranche dropped from a price of nearly 100 in mid-February 2007, to around 85 by the end of February 2007. Indeed, the TABX continued to fall significantly in the months after February 2007, also as shown in the chart below reflecting historical TABX data from Markit Group of London. 100 90 ea 70 E0 50 40 30 20 10 0 ,T44314 HEMS 07-1 C6-2 0.6 •- WU ME MEE 071 062510 TABX4-6.11166. 07.1 C6-210-15 TABXH6.11166 07-1 06-215-25 --.-TABCHE.111B9 071 06-2 2540 I -4- TAECCHE.888- 07-1 C6-2 40-11:0 .,--- 0 • 0 41- 1 1- 11111111111/1111II!Ill 1 !ill 158. Bear Stearns was aware of these declines because it was one of the 16 licensed market makers for the ABX and TABX. The changes indicated that the exceptionally risky tranches of CDOs that the Company kept on its books as retained interests were rapidly losing value. Because these assets were highly leveraged, their loss in value had serious repercussions for the Company. 38 EFTA00316766

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 54 of 347 159. Even as the indices tracking subprime performance began to crater, the Company embarked on an aggressive expansion of its subprime business. On February 12, 2007, the Company completed its acquisition of ECC, a major originator of subprime loans. 160. Bear Stearns knew that investors would flee if they found out that the Company was failing to undertake any meaningful assessment of its exposure to risk while it aggressively expanded its exposure to subprime losses. 161. Accordingly, in its Form 10-K for fiscal year 2006, filed February 13, 2007, the Company reported reassuringly low VaR numbers, including an aggregate risk of just $28.8 million — far lower than its peers. This statement was wildly misleading, in that the Company knew that its VaR modeling failed to reflect its exposure to declining housing prices and rising default rates. 162. Bear Stearns also asserted, "The Company regularly evaluates and enhances such VaR models in an effort to more accurately measure risk of loss." In fact, the Company had undertaken no such review, and had been repeatedly warned by government regulators that its VaR models were inaccurate and out of date. 163. The Company also asserted that it marked all positions to market on a daily basis and independently verified its inventory pricing. It assessed the value of its Level 3 assets as $12.1 billion. 164. These statements were materially misleading, in that the Company knew that the models it used to value its Level 3 mortgage-backed assets were badly out of date and did not reflect crucial data about housing prices and default rates. It also knew that its hamstrung risk managers had little power to provide any independent review of these figures. 39 EFTA00316767

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 55 of 347 165. Because the Company was failing to take appropriate losses on its Level 3 assets, the revenues and earnings per share it reported in its 2006 Form 10-K were false and misleading, artificially inflating the value of its stock. 166. Defendants Cayne and Molinaro executed a certification of these statements, annexed as an exhibit to the Form 10-K filing, stating that they had put in place disclosure controls and procedures to ensure the accuracy of the Company's filings, and that they had: Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared. 167. Accordingly, at the time the Company filed its Form 10-K for 2006, Defendants Cayne and Molinaro had taken care to inform themselves of the Company's improper risk management and valuation practices, and knew the harmful consequences this deception would have on investors. Moreover, the SEC had reported its findings regarding the Company's deficient models to Molinaro's immediate subordinate, Farber. 168. The Company's artificially low VaR numbers stood in sharp contrast to the risk exposures that many of its peers were reporting during the housing crisis. For the first half of 2007, as other investment banks with substantial subprime holdings saw their VaR figures increase dramatically in tandem with rising problems in the housing market, Bear Steams' reported VaR remained virtually unchanged and much lower than peers. 40 EFTA00316768

Case 1:08-cv-02793-RWS Document 102 Filed 02127/09 Page 56 of 347 Average Daily Value-at-Risk 400 350 300 250 a 200 O 150 100 • 50 0 OO-06 Jan-07 Apr-07 Aug-07 Nov-07 Feb-08 Cit Grot Coldnum Sack- Amon I koilicr, Bear Steams Sources: Company 10-K's and 10-9's. The reported quarterly avenge of daily value-at-risk amounts is used. 169. Bear Steams' deception about its risk exposure had the desired effect, as analysts covering the Company took note of its remarkably low VaR numbers. In a February 9, 2007 pre- filing comment, Credit Suisse analysts Susan Roth Katzke and Ross Seiden stated that Bear Steams' "[m]anagement will continue to invest to grow revenues via new products and new geographies, rather than increasing VaR (the latter has been the most stable amongst peers)." (Emphasis added.) 170. In a February 14, 2007 report, the same analysts were again struck by the Company's apparently rising revenues and low exposure to risk, observing: VaR and Revenue Growth; RoE and Book Value...Tying these elements together with valuation leads us to the conclusion that Bear ought to be a lower risk play in the brokerage group. From a business perspective, note that Bear's revenue growth has kept pace with peers, with far less VaR. 41 EFTA00316769

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 57 of 347 171. As a result of the Company's continuing misrepresentations about its 2006 results and its VaR exposure, its stock rose $5.71 on February 14, 2007, to close at $165.81. 172. Three weeks later the Credit Suisse analysts were still touting the Company's strong revenue growth and unusually low VaR numbers. In a March 5, 2007 report on the Company, they reported that: Not only has revenue growth been equal to or better than peers, the volatility of the revenue stream has been lower. This lower level of revenue (and earnings) volatility is consistent with Bear Stearns' less aggressive principal/proprietary trading posture- less VaR and lower loss rates. What's driven above-average equities revenue growth for Bear Stearns? Best we can tell, it's the combination of hedge fund client focus, personnel upgrades, and a somewhat increased capital commitment. How much capital? Judging by the relatively low level of VaR committed to the business, we think Bear's willingness to use capital is still quite limited. 173. Less than two weeks later, on March 15, 2007, the Company issued a press release touting its results for the first quarter of 2007. The press release provided, in relevant part, the following: The Bear Stearns Companies Inc. (NYSE:BSC) today reported earnings per share (diluted) of $3.82 for the first quarter ended February 28, 2007, up 8% from $3.54 per share for the first quarter of 2006. Net income for the first quarter of 2007 was $554 million, up 8% from $514 million for the first quarter of 2006. Net revenues were $2.5 billion for the 2007 first quarter, up 14% from $2.2 billion in the 2006 first quarter. 174. The Company knew these results were false and misleading because the encouraging revenue growth and earnings per share it reported were made possible by the fact that Bear Stearns relied on misleading valuation models. These models failed to reflect the declining value of its highly illiquid Level 3 assets, which at that point made up more than ten percent of its total assets. 42 EFTA00316770

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 58 of 347 175. The Company followed up the release with an even more deceptive conference call. On March 15, 2007, Bear Steams held its first quarter 2007 earnings conference call, conducted by the Company's CFO, defendant Molinaro. When Molinaro was asked by a caller whether he saw any trends in the Company's Value at Risk, Molinaro stated that there would be "No real change. Should be about the same." Molinaro, as CFO of the Company, knew at the time that the Company had been repeatedly warned by the SEC that its VaR numbers did not reflect omnipresent indicators of a rapidly declining housing market. 176. Molinaro had to parry more questions during the March 15, 2007 call from analysts regarding the Company's subprime exposure. An analyst asked, "[D]id you take any write downs during the quarter and do you expect to as conditions have worsened?" Molinaro responded that the subprime market was a small part of Bear Stearns' overall business, and the Company had reduced the number of subprime mortgages it was purchasing and securitizing. Molinaro failed to explain that the Company was avoiding writing down its illiquid subprime- backed assets only by using inaccurate models to value them. 177. Molinaro also stated in the March 15, 2007 call that the Company was well- hedged in the market for subprime-backed securities. Because Molinaro understood that the VaR numbers the Company relied upon to calculate hedging ratios did not take housing market deterioration into account, he knew that these assurances were misleading. 178. In fact, Molinaro actually boasted that the worsening outlook for housing would only increase the number of subprime-backed CDOs the Company would acquire. I think that the more likely scenario is there is going to be in dislocations like this, there's likely to be large bulk sales of assets, and certainly given the trouble that many companies have faced with their sub prime portfolios, there certainly would appear to be plenty of opportunity over the months and quarters ahead for that kind of activity. 43 EFTA00316771

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 59 of 347 179. As a result of these deceptions the Company's quarterly results sent its stock up by $2.10, to close at $148.50. 180. On April 9, 2007, Bear Steams filed its Form 10-Q for the quarterly period ended February 28, 2007. In it, Defendants made various representations concerning Bear Steams' risk management and mortgage-related operations. The Company asserted, inter alia, that it valued its Level 3 assets using "internally developed models or methodologies utilizing significant inputs that are generally less readily observable from objective sources." 181. However, the Company did not disclose that it knew that the models it was using for this valuation were outdated and inaccurate, and that it made no effort to review and update its valuation models. 182. The Company claimed that it engaged in an "ongoing internal review of its valuations" and that "senior management from the Risk Management and Controllers Departments" are responsible for "ensuring that the approaches used to independently validate the Company's valuations are robust, comprehensive and effective." In fact, the Company's risk management department was in chaos, and its chief of model review had quit the Company less than a month earlier. It also knew that no substantive review of its mortgage valuation or value at risk models had even been undertaken—indeed, its mortgage-backed asset valuation models were more than a decade out of date. 183. In the same filing, the Company continued to offer materially false and misleading Value at Risk numbers to investors, stating that, in the midst of the worst housing downturn in decades, its Value at Risk numbers had declined since the Company's last filing, to an aggregate level of $27.9 million, using a one-day interval and a 95% confidence level. 44 EFTA00316772

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 60 of 347 184. The Company hastened to allay any skepticism about this strange result, insisting that "[t]he Company regularly evaluates and enhances such VaR models in an effort to more accurately measure risk of loss." It also stated that "[t]he Company utilizes a wide variety of market risk management methods, including trading limits; marking all positions to market on a daily basis; daily profit and loss statements; position reports; daily risk highlight reports; aged inventory position reports; and independent verification of inventory pricing." 185. These statements were false and misleading, in that the Company had been repeatedly informed by the SEC that its VaR modeling did not reflect key market risks. Moreover, the Company knew that it had made no effort to review or update these defective models, and that its risk managers had no power to constrain the Company's trading desk. 186. The first quarter 2007 10-Q also stated that the Company's net revenues for Capital Markets increased 15.4% to $1.97 billion for the 2007 quarter and that its total assets at February 28, 2007 increased to $394.5 billion from $350.4 billion at November 30, 2006. These statements were false and misleading, because the Company only avoided taking losses on its Level 3 assets by using improper valuation models. This avoidance of loss permitted the Company to increase its revenues and asset values, inflating the value of its stock. 187. Defendants Cayne and Molinaro once again certified these statements, stating that they had made efforts to ensure the accuracy of the Company's reporting and the reliability of its internal controls. Unbeknownst to Bear Steams' investors, the scale of the Company's deception was about to get much larger. G. The Implosion of the Hedge Funds 188. The rapid decline in the subprime mortgage market in early 2007 had devastating consequences for the Hedge Funds, which were heavily laden with subprime-backed assets. The 45 EFTA00316773

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 61 of 347 implosion of the Hedge Funds contributed directly to the even larger crisis that would befall Bear Stearns just months later. 189. As subprime mortgage risks materialized and subprime mortgage performance deteriorated during late 2006 and early 2007, the prices fetched by subprime loans on the secondary market (i.e., the prices obtained by securitizers such as Bear Stearns) fell. The end result was that by March of 2007 subprime origination had almost entirely collapsed. 190. On February 8, 2007, HSBC, the largest originator of subprime loans during 2006, raised its subprime loan loss reserves to $10.6 billion to cover anticipated losses from its subprime lending. During a February 8, 2007 conference call, HSBC officials explained that ARM resets were set to explode, and that subprime borrowers likely would not be able to make their payments when their rates rise. Not surprisingly, HSBC also announced plans to cut back on further subprime lending and to eliminate all stated income lending. 191. HSBC' s February 2007 announcement proved to be a turning point in the industry. The announcement made the scale of subprime risks widely apparent, and precipitated further and severe contraction in subprime origination. Moreover, it caused indices tracking the securities backed by subprime mortgages to fall precipitously. 192. As the indices fell, capital rapidly receded from the subprime industry. With that withdrawal of capital, securitizers such as Bear Steams found themselves increasingly unable to sell the subprime mortgages they repackaged to investors. The decreased demand for RMBS and CDOs created a chain reaction. Because the demand for RMBS and CDOs was decreasing, securitizer demand for subprime mortgages (to turn into RMBS) and for subprime RMBS (to turn into CDOs) was decreasing. Because securitizer demand for subprime mortgages was decreasing, subprime mortgage origination itself decreased. 46 EFTA00316774

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 62 of 347 193. Rather than explain these difficult market conditions to investors, BSAM misrepresented the Hedge Funds' subprime exposure to hedge fund investors in "Preliminary Performance Profiles" ("PPP"). For example, in monthly PPPs, BSAM represented that only 6- 8% of the Hedge Funds' assets were invested in subprime RMBS. However, unknown to the Hedge Funds' investors and the market, BSAM was only disclosing the Hedge Funds' direct subprime RMBS holdings. In fact, the Hedge Funds held tremendous amounts of subprime RMBS indirectly through the CDOs it had purchased. 194. The Hedge Funds' large and undisclosed exposure to subprime assets placed enormous stress on the Hedge Funds as the subprime mortgage crisis accelerated. Returns in the subprime CDOs, and CDOs backed by slices of other CDOs, termed CDO-squares, diminished, thus creating diminishing yield spreads, leading to accelerating losses for the Hedge Funds. As a result, the High Grade Enhanced Fund experienced its first negative return in February 2007. 195. In an email dated March 1, 2007, Cioffi told BSAM managers not to "talk about [the February results] to anyone or I'll shoot you ...I can't believe anything has been this bad." 196. Declines in the High Grade Hedge Fund soon followed, resulting in its first negative return in March of 2007. 197. Because Bear Steams had effectively bankrolled the Hedge Funds by giving them huge sums of cash in exchange for their subprime-backed collateral, the Hedge Funds' crisis had serious implications for the Company. Notwithstanding the fact that Defendant Spector, Bear Stearns' Co-President, directly oversaw the Hedge Funds and understood the gravity of their situation, his CFO Molinaro denied the existence of any trouble. 198. On a March 15, 2007 conference call with analysts, Molinaro was asked "[c]an you give any insight about whether you've seen or had issues with margin calls or any kind of 47 EFTA00316775

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 63 of 347 difficulties in hedgefund-land given how volatile the Markets have been the last few weeks?" In response, Molinaro said that Bear Steams' hedge funds were having no issues with margin calls: "We haven't seen any difficulties. I would say it's been, obviously there's a lot of market volatility but we've had no difficulties there." 199. In making this statement, Molinaro not only misrepresented the crisis facing the Hedge Funds, but failed to disclose Bear Steams' exposure to the declining value of the subprime-backed Hedge Fund assets it held as collateral on its own books. 200. The Hedge Funds' situation continued to deteriorate throughout the Spring of 2007. On April 19, 2007, Matthew M. Tannin, Chief Operating Officer of the Hedge Funds, reviewed a credit model that showed increasing losses on subprime linked assets. Tannin agreed with the model's assessment and, in a April 22, 2007 e-mail stated: IF we believe the runs [the analyst] has been doing are ANYWHERE CLOSE to accurate I think we should close the Funds now. The reason for this is that if [the runs] are correct then the entire subprime market is toast ... If AAA bonds are systematically downgraded then there is simply no way for us to make money- ever." 201. Tannin concluded that "caution would lead us to conclude the [CDO report] is right and we're in bad shape." On May 13, 2007, Tannin reiterated to another BSAM manager that "1 think [the Enhanced Leverage Hedge Fund] has to be liquidated." 202. Bear Steams had much to fear in a liquidation of the Hedge Funds. A forced "fire sale" of the thinly traded CDOs held by the Hedge Funds could compel the Company to acknowledge the huge declines in value in the subprime-backed assets it already held as collateral and as retained interests, and would also reveal the fact that the Company had been grossly overvaluing its Level 3 assets. To avoid this, the Company became involved in an intense effort to prop up the Hedge Funds. 48 EFTA00316776

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 64 of 347 203. Defendant Spector, Bear Stearns' Co-President, personally made the decision to extend a line of credit to the High Grade Hedge Fund. He decided to let the High Grade Enhanced Fund fail, because its high leverage ratios left it virtually unsalvageable. The purpose of the facility was to allow the High Grade Hedge Fund to liquidate in an orderly way by gradually selling assets into the market without having other assets seized by repurchase agreements counterparties, who would mark the assets to their true value. 204. In the midst of this turmoil, on June 14, 2007, Bear Steams issued a press release regarding its second quarter 2007 results. In it, the Company continued to hide its mounting losses on Level 3 assets, permitting it to misrepresent its revenues and earnings per share. 205. On June 22, 2007, Bear Stearns announced that it was entering into a $3.2 billion securitized financing agreement with the High Grade Hedge Fund in the form of a collateralized repurchase agreement. In exchange for lending the funds, Bear Steams received as collateral CDOs backed by subprime mortgages allegedly worth between $1.7 to $2 billion. Pursuant to the agreement, Bear Steams gave up the right to collect all of the upside in the event that the collateral saw a miraculous increase in value. 206. During a Friday, June 22, 2007 conference call arranged to explain the bailout, Defendant Molinaro, the CFO of Bear Steams, took pains to explain that the Hedge Funds' problems with their subprime-backed assets did not extend to the securities that Bear Stearns itself held. Molinaro failed to disclose that even prior to the bailout, Bear Steams held large amounts of the Hedge Funds' toxic debt as collateral. Moreover, by virtue of the bailout, Bear Stearns had just taken on an enormous amount more of the same illiquid and devalued securities. 207. During the June 22, 2007 conference call, Molinaro was asked "To what extent has this event caused you to retook at some of your practices overall for Bear Steams since you 49 EFTA00316777

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 65 of 347 are such a big player in the mortgage market? I mean you have had the subprime problem for more than three months now. Are there other trigger events we should pay attention to over the next year?" Molinaro responded with the following: Well [] I don't know that it's causing us to have any different point of view on the activities in our mortgage business. Our mortgage business has basically been not affected by this and has not redly been a part of this situation. So our mortgage business continues to operate in a very effective way. Albeit in a more in a lower volume environment and a more difficult operating environment given the macro picture in the marketplace. As it relates to our Asset Management division, we feel that we have adequate controls in place. Obviously if you have a problem like this, you are going to reassess those controls and look to strengthen them. But I think the simple point in this Fund is that or these two Funds, they are invested in an asset class that went through a period of severe distress. 208. During the same June 22, 2007 conference call, an analyst asked Molinaro for his current sense of the broader impact of the losses being experienced by the BSAM funds. Molinaro stated: Well, I think clearly when you have a situation like this; it puts a lot of pressure on asset values and spreads in the marketplace. That's undoubtedly happening. I'm not expecting any material impact from that, at least as it relates to ourselves, can't speak to the broader market. We're not seeing any material difficulties in repo lines or in counterparties who are having difficulty away from this meeting margin requirements. So, I would say, at least from our perspective, at the moment it appears to be relatively contained. (Emphasis added.) 209. During the June 22, 2007 call, Mike Mayo, an analyst at Deutsche Bank, asked how Bear Steams valued the collateral that it had received from the Hedge Funds. Molinaro stated that "the collateral values that we have are a reflection of the market value levels that 50 EFTA00316778

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 66 of 347 we're seeing from our street counterparties." In fact, the market for such securities had become highly illiquid, providing no basis for Molinaro's statements. 210. On June 25, 2007, market reaction to the news of Bear Stearns' bailout of the High Grade Fund was sharply negative. Investors, fearing that the collapse of the Hedge Funds reflected on the Company's own exposure, sent Bear Steams' stock down by $4.65, to close at $139.10. 211. The next day, June 26, 2007, defendant Cayne assured investors that "we see no material change in our risk profile or counterparty exposure as a result of the reaction in the marketplace regarding the situation surrounding these hedge funds." The Company's share prices increased as a result. Cayne's statement was materially false and misleading, in that the Company had effectively taken onto its books billions of dollars of worthless subprime-backed collateral, causing its risk exposure to grow enormously. 212. According to Bear Stearns, by the end of June 2007, asset sales had reduced the loan balance to $1.345 billion, but the estimated value of the collateral securing the loan, the High Grade Hedge Fund's compromised CDOs, had deteriorated by nearly $350 million—that is, to approximately the value of the loan Bear Stearns had given the High Grade Hedge Fund. Because the High Grade Hedge Fund had no other assets, any further declines in the value of the assets that Bear Steams held as collateral would be borne directly by Bear Steams. 213. The 2008 OIG Report concluded that, given these circumstances, the Company should have taken this collateral onto its own books and taken an immediate charge against net capital. Instead of immediately reflecting its assumption of the declining collateral onto its books, the Company delayed for months. By doing so, the OIG stated, Bear Stearns was able "to delay taking a huge hit to capital." 51 EFTA00316779

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 67 of 347 214. On July 18, 2007, Bear Steams informed investors in the Hedge Funds that they would get little money back after "unprecedented declines" in the value of AAA rated securities used to bet on subprime mortgages. According to the Company, estimates showed there was "effectively no value left" in the High Grade Enhanced Fund and "very little value left" in the High Grade Fund, Bear Steams said in a two-page letter. 215. Accordingly, the more than $1.3 billion in collateral drawn from the Hedge Funds subprime-backed assets that the Company had effectively taken onto its books by assuming the assets as collateral just a month earlier was nearly worthless as well. Despite this fact, the Company did not reveal the enormous losses that it was absorbing. 216. According to internal credit memoranda reviewed by the GIG, Bear Steams ultimately did take much of the High Grade Fund's remaining collateral onto its books—but did not make the actual book entries until some time in the fall of 2007, months after the losses were actually incurred by the Company. As set out below, the Company ultimately only wrote off a fraction of the worthless collateral it held that it had valued at $1.3 billion. H. Repercussions of the Hedge Funds' Implosion 217. The implosion of the two Hedge Funds reverberated through both the financial markets and the Company's senior management. 218. In the wake of Bear Steams' assumption of billions of dollars of Hedge Fund collateral through the bailout, Bear Stearns' lenders increasingly questioned the true extent of the Company's exposure to loss. As a result, they became unwilling to supply the Company the vast amounts of cash it needed to finance its daily operations and interest payments. The 2008 OIG Report explained that the market no longer perceived the Company "to be sufficiently capitalized to justify extensive unsecured lending. In this sense, Bear Steams was not adequately capitalized." 52 EFTA00316780

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 68 of 347 219. As set out in the 2008 OIG Report, Bear Steams' declining ability to obtain unsecured financing meant that the Company had a strong incentive to lower capital costs by raising new equity capital, making the Company a safer bet for lenders offering unsecured financing. However, instead of raising new capital, the Company steadily shifted its funding model from unsecured to secured financing, using its mortgage-backed assets as collateral. In May of 2007, Bear Steams' short term borrowing was 60% secured. Just four months later, in September of 2007, it was 74% secured. By March of 2008 it was 83% secured. 220. Bear Steams' principal source of secured financing was the market for repurchase or "repo" agreements. By the end of the Class Period, Bear Steams was funding its $50 billion daily needs by using 71% of its risky mortgage-backed assets as collateral for repo agreements. 221. Given that the Company's mortgage-backed assets were serving to prop up the cash needs of the entire Company, Bear Steams literally could not afford to reveal that they were rapidly losing value. 222. Even financing through repo agreements was becoming difficult for the Company to secure. Bear Steams' repo agreement counterparties were increasingly suspicious that they were being duped about the value of the CDOs that the Company was using as collateral. As a result, the 2008 OIG Report states that mark disputes between Bear Steams and its counterparties became more common beginning in the summer of 2007. 223. A mark dispute can occur when two parties to a repo agreement disagree about the value of the collateral. If a lender believes that the collateral posted in a repo agreement has lost value, it can make a "margin call" on the borrower, demanding more collateral or a return of part or all of the money loaned. 53 EFTA00316781

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 69 of 347 224. The 2008 OIG Report revealed that, during July of 2007, shortly after the Hedge Fund bailout, Bear Steams told the SEC that there were two large dealers with whom it had mark disputes that were in excess of $100 million each. 225. Because Bear Steams knew that its assets were overvalued, it was frequently obliged to settle these disputes by paying money to its repo counterparties. However, the Company could not afford to reveal that its mortgage-backed collateral was rapidly declining in value. Accordingly, Bear Steams continued to carry the assets on its books at full value even while conceding to its counterparties that the value of the collateral had declined. 226. The 2008 DIG Report states that "[t]here are indications in the TM memoranda that Bear Steams tended to use the traders' more generous marks for profit and loss purposes, even when Bear Steams conceded to the counterparty for collateral valuation purposes." By failing to record the assets at the lower compromise price, the Company was able to perpetuate its scheme to hide from investors the extent of its losses on the value of its mortgage-backed assets. 227. Doubts about the Company's true exposure were slowly making their way to the market. On July 31, 2007, Standard & Poor's analysts downgraded the Company's stock because, among other things, "widening credit spreads and increasing risk aversion may cause a slowdown in its investment banking operation." The Company's stock fell $6.03 as a result, closing at $121.22. 228. On August 3, 2007, Standard & Poor's Ratings Services said it had revised its outlook on Bear Steams from stable to negative. Notwithstanding the Company's denials, the ratings firm explained that "Bear Steams has material exposure to holdings of mortgages and mortgage-backed securities (MBS), the valuations of which remain under severe pressure. It 54 EFTA00316782

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 70 of 347 also has exposure to debt it has taken up as a result of unsuccessful leveraged finance underwritings, and it has significant further underwriting commitments." 229. That same day, Bear Stearns issued a press release responding to the S&P downgrade: The Bear Stearns Companies Inc. (NYSE: BSC) said today that it is disappointed with S&P's decision to change its outlook on Bear Stearns. Most of the themes highlighted in its report are common to the industry and are not likely to have a disproportional impact on Bear Stearns. S&P's specific concerns over issues relating to certain hedge funds managed by BSAM are unwarranted as these were isolated incidences and are by no means an indication of broader issues at Bear Stearns. 230. On the same day, Cayne and his top lieutenants arranged a conference call with investors and analysts to try to calm concerns. They did this by touting the Company's illusory risk management program. 231. After prefatory remarks by defendants Cayne and Molinaro, defendant Michael Alix, the Company's Chief Risk Officer, stated that "our fixed income franchises, particularly our mortgage and securitization businesses, have long focused on the origination, transformation and redistribution of risk. We've always managed the risk in this process by adjusting the intake, the origination of risk, to the demand for the end products." He added that "we run risk analytics to demonstrate that the Firm is well protected against further deterioration in both the subprime and Alt-A sectors across both whole loans and all securitization tranches." 232. In fact, at the time of the August 3, 2007 conference call, Alix and the Company had already been informed that Bear Stearns' "risk analytics" did not take into account crucial information on risk of default and volatility in housing prices. Moreover, as a result of the Hedge Fund bailout, Bear Stearns had just assumed as collateral more than a billion dollars worth of subprime-backed CDOs that were virtually worthless. As the Company only held 55 EFTA00316783

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 71 of 347 approximately $11 billion in highly-leveraged net equity at the time, this was a very significant new exposure. 233. On August 5, 2007, in an effort to restore investor confidence in the Company's management and to distance itself from the collapse of the hedge funds, Bear Steams announced a management shake-up that included the ouster of Defendant Spector. He was replaced by Defendant Schwartz as the Company's sole president. Defendant Molinaro became the Company's Chief Operating Officer in addition to his continuing role as CFO. 234. On September 20, 2007, Bear Stearns posted its results for the third quarter, ending August 31, 2007 (closing stock price $108.66). It reported net income for the quarter of $171.3 million, or $1.16 a share, down from $438 million, or $3.02 a share, in the period a year earlier. Net revenue for the Company, or total revenue minus interest costs, fell 37% to $1.33 billion, while net revenue at the fixed-income division dropped 88%, to $118 million from $945 million in the third quarter of 2006. Return on equity stood at 5.3%, compared with 16% a year earlier. 235. During a conference call with analysts and investors, Molinaro said that, despite adverse impacts from "losses incurred from the failure of the [in-house funds], ... our counterparty exposures have been dramatically reduced and we've hedged remaining assets." When asked about "collateral damage that you might have suffered on the [BSAM) business [following the in-house hedge funds' collapse)", Molinaro responded that the damage "was relatively limited and we saw very few situations where clients moved their entire business ... I think the crisis passed in mid-August things have returned to kind of a normal state ... the wont is behind us there and business is normalizing and returning." 56 EFTA00316784

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 72 of 347 236. Bear Stearns' third quarter results and Molinaro's statements were false and misleading, in that they were achieved only by avoiding losses through the use of valuation methods that artificially boosted the values of the Company's growing hoard of Level 3 assets. 237. The Company explained that its declining profits were the result of diminished fixed-income revenue coupled with a $200 million loss from its June Hedge Fund failures. Of this figure, the Company stated that only $100 million represented decline in value of the collateral that the Company held as a result of the Hedge Fund bailout. 238. This $100 million figure was a far cry from the Company's true losses due to the Hedge Fund collapse, which had left more than a billion dollars of worthless subprime CDOs on the Company's balance sheet. The Company did not disclose the full amount of its losses on the collateral for fear that its lenders and counterparties would realize that it had been consistently overvaluing its assets. 239. The small size of the write down falsely reassured the markets about the Company's exposure. In a September 20, 2007 conference call with investors, an analyst asked "And — and then on the — on the $200 million writedown of the High Grade funds. That effectively a writedown what was last reported a $1.3 billion balance?" Company management responded: It basically — Roger, two big pieces to that. About $100 million — it is almost split evenly. About $100 million of that is the write-off of our investment in the fund and the write-off of receivables that we had from the funds related to predominantly related to management and performance fees that related to 2006. And the balance of that was the mark on the inventory when we closed out the position. 240. In fact, even by the Company's own estimations regarding the writedowns associated with the Hedge Fund, this statement was false and misleading. The 2008 OIG Report states that the Company's internal documents reflect that it ultimately took a $500 million write 57 EFTA00316785

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 73 of 347 down in connection with the bailout some time in the fall of 2007. The Company never disclosed this additional write down to investors, for fear that it would telegraph to the market the decline in the value of the other subprime-backed assets it carried on its books. 241. On October 10, 2007, Bear Stearns filed its Form 10-Q for the quarterly period ended August 31, 2007, which included the same misleading financial results it reported on September 20, 2007. 242. In addition, Defendants made various representations concerning Bear Steams' risk management. The Company stated that "I[n] recognition of the importance the Company places on the accuracy of its valuation of financial instruments as described in the three categories above, the Company engages in an ongoing internal review of its valuations." 243. In fact, at the time this statement was made, the Company had been repeatedly warned that its mortgage valuation models were outdated and inaccurate, but had refused to revise them. 244. The Company also stated that it "regularly evaluates and enhances [its] VaR models in an effort to more accurately measure risk of loss," and that its aggregate VaR was still only $35 million, well below its competitors. 245. This statements were false and misleading, in that the Company understood that its VaR models did not reflect key data showing declines in the housing market, and had made no effort to revise them. 246. On November 14, 2007, defendant Molinaro announced that Bear Steams would write down $1.2 billion of its assets in the fourth quarter. However, Molinaro attempted to reassure nervous investors by claiming that, in spite of the fact that Bear Steams still bore more than a billion dollars of subprime exposure in the form of the collateral it had received from the 58 EFTA00316786

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 74 of 347 failed High Grade Fund, Bear Stearns had reduced its CDO holdings to $884 million as of November 9, down from $2.07 billion at the end of August. Molinaro claimed that during the period between August 31, 2007 and November 9, 2007, the Company significantly increased its short subprime exposures—that is, its insurance against declines in the subprime market— reducing its reported August 31, 2007 net exposure of approximately $1 billion to a negative $52 million net exposure as of November 9, 2007. 247. During an analyst conference call held on November 14, 2007, Molinaro was asked what Bear Stearns was doing to "fight back" against "the impact of the unprecedented times in the mortgage market compounded by fallout from the firm's mortgage hedge funds this summer." Molinaro responded that: the liquidity crisis [with the hedge funds] that did ensure during July and August did have some effect on the business .... we did see some balance migration, but importantly we're seeing balance is coming back .... where we look at balances, currently they have been basically steady from where we closed the third quarter at, and the business, I would say, is continuing to show improvement from where we the quarter at, and we think getting back on track for what should be a very strong 2008. (Emphasis added.) 248. Peter Goldman of Chicago Asset Management was relieved, stating that lvde didn't have a clear picture of their exposures. Now we do, and it's much smaller than that of its peers." Bear Stearns shares rose $2.58, or 2.6 percent, to $103.45 in New York Stock Exchange composite trading. 249. Investors and analysts did not realize that the extent of Bear Stearns' exposure was in fact far from clear. The Company still had more than a billion dollars in subprime backed collateral from its Hedge Fund bailout to write down, and the Company's hedging efforts were 59 EFTA00316787

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 75 of 347 doomed by its failure to use accurate models to assess risk. These secrets were becoming increasingly difficult for the Company to hide. 250. On December 20, 2007, Bear Stearns announced that it would take the first quarterly loss in the Company's 84-year history (quarter closing on November 30, 2007 at $99.70 per share). It reported that its fiscal fourth-quarter loss after paying preferred dividends was $859 million, or $6.90 per share, compared to a profit of $558 million, or $4 per share, a year earlier. The Company had negative net revenue of $379 million, compared to revenue of $2.41 billion a year earlier. 251. These figures were false and misleading, because reported losses would have been far greater but for the Company's use of misleading valuation models to inflate asset values and revenues. 252. Notwithstanding Molinaro's assurance just weeks before that the Company's hedging efforts had resulted in a net negative exposure to subprime assets, the Company also announced on December 20, 2007 that it would write down $1.9 billion of its holdings in mortgages and mortgage-based securities — more than $700 million more than it had announced on November 14, 2007. 253. The lack of any schedule giving details regarding the nature of the write downs left investors with little information about the nature of the Company's true exposure. Write downs by other companies in the same period provided far more information, including the source of exposure (retained interest, derivatives, commitment to provide liquidity and/or credit support, or warehoused loans and mortgage-backed securities), the type of CDOs to which they were exposed (high grade, mezzanine, CDO-squared, etc.) and vintage of the subprime mortgages that underlie their CDO exposures. 60 EFTA00316788

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 76 of 347 254. In their write downs, Bear Steams' peers also provided other information with a bearing on the creditworthiness of the exposure and the extent of write-downs taken against par value, including the amount that was hedged and how it was hedged, how the exposures were valued, and the main drivers of value. The fact that Bear Steams was withholding such key information from investors began to fuel a consensus that the Company's risk was far greater than had been assumed and fanned investor anxieties about the Company. 255. Major shareholders begin questioning Cayne's leadership. On January 8, 2008, the Company announced that Cayne would step down as chief executive. However, he would continue reporting for work at Bear Stearns' headquarters, attempting to get the Company badly needed funding. Cayne was replaced as CEO by defendant Schwartz. 256. Analysts such as Punk Ziegel & Co. ("Punk Ziegel") saw Cayne's departure as an indictment of the Company's failed risk management policies. 257. Cayne's departure only raised investors' anxiety about the Company's exposure, and its stock dropped nearly 7%, to close at $71.17. I. Bear Stearns' Catastrophic Collapse 258. In the weeks following Cayne's departure, Bear Steams continued to try to reassure its shareholders. On February 8, 2008, the Company asserted that it had increased its short subprime position from $600 million in November 2007 to $1 billion in an effort to hedge its trading positions in subprime mortgages. Explaining the increase, Molinaro was quoted in a Bloomberg article as stating that one of the Company's biggest mistakes had been "not being conservative enough and bearish enough on the subprime market." The firm has reversed "long" subprime trades that stood at $1 billion at the end of August, Molinaro said. 259. The market was struck by the dissonance between Molinaro's statements and the Company's previous assurances that it dealt in less risky "agency" mortgages and was not 61 EFTA00316789

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 77 of 347 exposed to the subprime market. Punk Ziegel's Richard X. Bove ("Bove") was openly skeptical. In a report dated February 8, 2008 he stated that: the firm is marking down the value of its more questionable securities. Bear has actually gone to a net short position in its CDO/subprime portfolio. This latter condition is somewhat of a surprise since the company has argued, for almost ever, that it does not play the markets; it claims to be an agency-only company. (So much for that concept.) 260. Bove's chagrin was shared by the Company's lenders. On March 6, 2008, Rabobank Group, one of Bear Stearns' European lenders, told the brokerage that it wouldn't renew a $500 million loan coming due later that week. That meant Rabobank Group was unlikely to renew an additional $2 billion credit agreement set to expire the following week. 261. Moreover, analyst reports released the same day predicted that the Company's quarterly results would be dogged with problems stemming from its fixed income business, sending the Company's stock tumbling by more than $5, to close at $69.90. 262. As a result, on Friday, March 7, 2008, the cost of credit default swaps on Bear Stearns' debt surged. 263. Bear Stearns again tried to stanch the market's loss of confidence with announcements by senior management. In a March 10, 2008 press release the Company said that "Where is absolutely no truth to the rumors of liquidity problems that circulated today in the market" and suggested that the Company had some $17 billion in cash. The same day, Defendant Greenberg claimed during an interview with CNBC that the Company had no liquidity problems, calling such an assertion "ridiculous, totally ridiculous." 264. This assertion did little to quell fear, because investors knew that Bear Steams had $11.1 billion in tangible equity capital supporting $395 billion in assets, a leverage ratio of more than 35 to I. Almost daily, Bear Steams had to renew a large percentage of its $102 billion 62 EFTA00316790

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 78 of 347 worth of open repurchase agreements - or short term loans from Wall Street dealers - or make up the difference out of its cash position. 265. Interpreting Greenberg's announcement as a tacit admission that the Company faced liquidity problems, on March 10, 2008 investors sent the Company's stock down another $7, to close at $62.30. 266. The morning of March 11, 2008 saw still another blow, when Goldman Sachs' ("Goldman") credit derivatives group sent its hedge fund clients an e-mail announcement about Bear Stearns. In previous weeks, banks such as Goldman had done a brisk business agreeing to stand in for nervous institutions that feared Bear Stearns could not meet its obligations on an interest rate swap. But in the March 11, 2008 email, Goldman told clients that, at least temporarily, it would not step in for them on Bear Stearns derivatives deals. 267. Kyle Bass ("Bass") of Hayman Capital reported that he had a colleague call Goldman to see if it was a mistake. "It wasn't," said Bass, himself a former Bear Stearns salesman. "Goldman told Wall Street that they were done with Bear, that there was [effectively] too much risk. That was the end for them." 268. Hedge funds flooded Credit Suisse Group's brokerage unit with requests to take over trades opposite Bear Stearns. In a mass email sent out that afternoon, Credit Suisse stock and bond traders were told that all such "novation" requests involving Bear Stearns and any other "exceptions" to normal business required the approval of credit-risk managers. 269. Bear Stearns' counterparties began to back away from the Company. Early in the morning on Tuesday, March 11, 2008, ING Groep NV informed Bear Steams that it was pulling about $500 million in financing. Staffers at the Dutch bank told Bear Stearns that ING's management "wanted to keep their distance until the dust settled." 63 EFTA00316791

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 79 of 347 270. The same day, analysts at Punk Ziegel suggested that Bear Steams' future profits were likely to be squeezed by its exposure to "esoteric securities." The Company's stock dropped $3.75 as a result, closing at $62.97. 271. The crisis of confidence accelerated rapidly. Bear Steams' cost of insuring $10 million of debt via credit default swaps, which had hovered near $350,000 in the month before, shot past $1 million. By the end of March 11, 2008, the rate was irrelevant. Banks simply refused to issue any further credit protection on the Company's debt. 272. These developments had a devastating effect on the Company's liquidity. Liquidity is simply the measure of an organization's ability to meet its current financial obligations. In banking, adequate liquidity means being able to meet the needs of depositors wanting to withdraw funds and borrowers wanting to be assured that their credit or cash needs will be met. 273. According to a March 20, 2008 letter from SEC Chairman Cox to the Chairman of the Basel Committee on Banking Regulation, on March 11, 2008, the Company's liquidity pool stood at $15.8 billion, "adjusted for the customer protection rule." By March 13, 2008, according to the letter, the pool stood at $2 billion—a loss of more than $13 billion over the course of March 12, 2008. 274. On March 12, 2008 Defendant Schwartz, Bear Steams' CEO appeared on CNBC and said that the Company's liquidity position and balance sheet had not weakened at all. "We finished the year, and we reported that we had $17 billion of cash sitting at the bank's parent company as a liquidity cushion," he said. "As the year has gone on, that liquidity cushion has been virtually unchanged." Schwartz added that "We don't see any pressure on our liquidity, let alone a liquidity crisis." 64 EFTA00316792

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 80 of 347 275. Schwartz's statement was false, in that the day before his assertion that the Company's liquidity position was unchanged Bear Steams' liquidity pool already had fallen to an adjusted level of $15.8 billion. Moreover, as Schwartz spoke on March 12, 2008, some $13 billion of the Company's cash was evaporating. 276. Moreover, Schwartz specifically denied that the Company's risk had scared away any counterparties: CNBC: Let me start off with this broad idea that's been in the market now for a few days and pressuring your stock. Namely, that counterparty risk is something — new counterparty risk is something that a number of firms on Wall Street no longer want to take in terms of dealing with Bear Steams. Is that true? SCHWARTZ: No, it's not true. We are — there's a been a lot of volatility in the market, a lot of disruption in the market, and that's causing some pressure administratively on getting some trades settled up, but we're workin' hard gettin' that done. We're in a constant dialogue with all of the major dealers and the counterparties in the Street, and we're not being made aware of anybody who is not taking our credit as a counterparty. CNBC: All right, so when I'm told by a hedge fund that I know well, that last night they tried to close out a mortgage — a credit protection mortgage position with Goldman Sachs that they had bought a year ago, Bear was the low bid, and I'm told that Goldman would not accept the counterparty risk of Bear Steams. You're saying you're not aware that that would be the case. SCHWARTZ: I'm not aware that, you know, on a specific trade from one counterparty to another and where you're a third-party, we have direct dealings with all of these institutions, and we have active markets going with each one, and our counterparty risk has not been a problem. 277. At the time he made this statement, Schwartz, as the Company's CEO, was only too well aware that ING had pulled nearly half a billion in financing and that Goldman Sachs, 65 EFTA00316793

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 81 of 347 once a principal source of cash for the Company, had at least temporarily halted covering any more Bear Stearns risk. 278. Moreover, according to the 2008 OIG report, the Company informed TM on March 12, 2008, the same day as Schwartz's statement, that "Bear Stearns paid out $1.1 billion in disputes to numerous counterparties in order to squelch rumors that Bear Stearns could not meet its margin calls." 279. Investors were cheered by Schwartz' false optimism and the decline in the Company's stock value slowed, dropping only $1.39 for the day, closing at $61.58. 280. In fact, the Company's liquidity was plummeting, falling to just $2 billion on March 13, 2008. 281. On March 13, Renaissance Technologies Corp., a major hedge fund and trading client of the Company, said it was shifting more than $5 billion to Bear Stearns' competitors. 282. On the evening of March 13, 2008 a desperate Schwartz telephoned JPMorgan CEO Jamie Dimon ("Dimon") in an effort to negotiate a rescue package. 283. Dimon thought it was too risky for Morgan Stanley to lend the Company the $30 billion it needed to get through the following day, Friday. Schwartz and Dimon determined that Bear Stearns had to be given access to the Federal Reserve's "window," a credit facility available to the nation's commercial banks, but not to investment banks. The only way for the Federal Reserve to give the Company access to the window was to lend JPMorgan the money, allowing the bank to act as a bridge across which the Federal Reserve cash could stream into Bear Stearns. 284. JPMorgan and Bear Stearns contemplated that the Company could get the facility though JPMorgan as part of a deal in which JPMorgan bought Bear Steams. 66 EFTA00316794

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 82 of 347 285. On March 14, 2008 at 9 A.M., Bear Stearns announced $30 billion in funding provided by JPMorgan and backstopped by the federal government. 286. As a result, Bear Steams' stock dropped nearly 40% in the first half-hour of trading, closing at $78.47. 287. JPMorgan dispatched 16 teams of accountants, ultimately numbering more than 300 people, to Bear Stearns to meet with top management and assess the Company's books. On Saturday night, March 15, after the reports from these due diligence teams began to make their way back to JPMorgan management, JPMorgan's Steve Black and Doug Braunstein called defendant Schwartz. They told him that, given the state of the Company's exposure, JPMorgan's bid for the Company's stock would be low. 288. During the call, Black stated that "[t]tle fact you're at 32 doesn't mean much at this point." Black suggested that a JPMorgan bid might be in the range of $8 to $12 a share. 289. By the next morning, many JPMorgan executives were getting cold feet. The more they studied the securities Bear Stearns owned, the worse the Company looked. For instance, Bear Steams had initially estimated it had $120 billion in so-called risk-weighted assets, those that might go bad. By Sunday morning, JPMorgan executives felt the actual number was closer to $220 billion. 290. By Sunday, March 16, JPMorgan had concluded that the deal was too risky, and had informed Schwartz that they were unwilling to undertake the purchase. 291. JPMorgan relented only upon obtaining a promise from federal officials that taxpayers would foot the bill in the event that Bear Stearns defaulted on its securities. Late in the 67 EFTA00316795

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 83 of 347 afternoon on Sunday, it told Bear Steams that it would purchase the Company's shares for $2 per share.° 292. The same afternoon, JPMorgan held a conference call addressing questions about the offer. Analyst Guy Moszlowski of Merrill Lynch asked, "is there some reconciliation that you could give us in broad terms from the book value per share, which of course is a reported number of around $84 at last reporting, and the $2, other than the transaction related costs of $6 billion"? 293. Mike Cavanaugh, the CFO of JPMorgan, responded: Yes, Guy, I think that the — all I can tell you is we did extensive work over a short period of time to get comfortable with putting together a transaction that made sense all around. But obviously looking at our duties to JPMorgan shareholders and so the deal we've lined out — laid out, didn't result in the ability to pay more than the modest amount that was paid over to the Bear Stearns shareholders. 294. The next day, Monday, March 17, Bear Steams share prices tumbled to $4.81 as the market learned the true state of the Company's finances, a drop of 84%. 295. On March 24, 2008, one week after announcing its takeover deal with Bear Stearns, JPMorgan raised its takeover offer for Bear Stearns to $10 per share, or about $2.1 billion, and agreed to take on the first $1 billion of Bear Stearns' losses while the Federal Reserve guaranteed $29 billion in losses. The updated agreement also included a provision allowing JPMorgan to purchase 95 million newly issued shares of Bear Stearns common stock, or 39.5% of the Company, ahead of a shareholder vote on the acquisition deal. J.C. Rowers & Co., a leverage-buyout company, had also reviewed Bear Steams books the same weekend, and made an unsuccessful proposal to buy 90% of the Company at a price between $2.00 and $2.60 per share. 68 EFTA00316796

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 84 of 347 296. The higher offer price reflected JPMorgan's efforts to quell shareholder opposition to the deal and discourage competitors. Moreover, JPMorgan had been forced to renegotiate the price after it discovered that a mistake in the language of its guaranty agreement with Bear Steams obligated JPMorgan to guarantee Bear Stearns' trades even if the Company's shareholders voted down the acquisition deal. Post Class Period Events 297. On April 3, 2008, the United States Senate Banking Committee, chaired by Senator Christopher Dodd of Connecticut, held hearings to discuss Bear Stearns' collapse. Senator Dodd disclosed that weeks before Bear Steams' collapse he discussed with Schwartz whether Bear Steams should have access to the Federal Reserve's "discount window" which allows commercial banks (but not investment banks like Bear Steams) access to low interest loans to maintain liquidity. Senator Dodd's disclosure indicated that Bear Steams insiders, including Schwartz, were aware, weeks before investors, that Bear Steams' liquidity was threatened by its deteriorating asset values. 298. Shareholders approved the sale to JPMorgan on May 29, 2008. Just prior to the vote approving the merger, Cayne apologized to shareholders for Bear Steams' collapse. Under the terms of the merger, shareholders received about $10 worth of JPMorgan shares for every Bear Stearns share they held as of the date of the merger. 299. After the approval of the merger, JPMorgan moved aggressively to reorganize Bear Steams, dismantling some of the subsidiaries most implicated in the Company's collapse. JPMorgan first closed down BSAM, the subsidiary responsible for the mismanagement of the Hedge Funds and for hiding true value of the Hedge Funds' assets from investors while, in the process, soliciting additional investments. JPMorgan also did not acquire Bear Steams' merchant banking unit, which was spun off into an independent entity. 69 EFTA00316797

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 85 of 347 300. In June of 2008 the Department of Justice, through the U.S. Attorney for the Eastern District of New York, indicted Cioffi and Tannin, both Senior Managing Directors of BSAM and members of BSC's Board of Directors. The indictment charged that Cioffi and Tannin misled investors regarding the value of MBS and CDOs containing MBS owned by the Hedge Funds. 301. The indictment further charged that Cioffi's and Tannin's fraud caused $1.8 billion in losses to investors. Cioffi and Tannin were formally arrested on June 19, 2008. On the same day, the SEC filed a civil complaint against Cioffi and Tannin. The allegations in the SEC's civil suit were similar, but also focused on Cioffi's and Tannin's attempts to solicit additional contributions to the Hedge Funds when they knew the funds were failing. Both the indictment and the SEC complaint allege that key documents, including Cioffi's calendar and personal notes that could contain incriminating evidence, were destroyed by Cioffi and Tannin before the investigation began. 302. As of July 3, 2008 the assets of Maiden Lane, the entity holding the $30 billion in Bear Stearns assets, had already decreased in value to $28.9 billion—almost $1.1 billion less than the value given to them by Bear Stearns just several weeks earlier. By October 22, 2008, the value of the assets had dropped another $2.1 billion, to $26.8 billion. All told, the assets held by Maiden Lane were actually worth 10.6% less than the value provided by Bear Steams, another indication that Bear Stearns' valuation methods were deeply flawed. 303. On September 27, 2008, the SEC Inspector General's Office released a report detailing Bear Stearns' misleading VaR and mortgage valuation models, as well as Bear Stearns' manipulation of asset values. As alleged above, the practices discovered by the SEC's Inspector General had the effect of misleading investors about the value of the assets held on Bear Stearns' 70 EFTA00316798

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 86 of 347 books, the Bear Steams' daily VaR and the risk involved with Bear Steams' securitization business model, all of which fraudulently inflated Bear Steams' share price. K. Defendants' Fraudulent Statements Adversely Impacted Current and Former Company Employees 304. Defendants' materially false and misleading statements during the Class Period, as described at paragraphs 589 to 794 below, defrauded certain Class Members who are or were current and former employees of Bear Steams, and whose compensation, in part, was in the form of restricted stock units ("Restricted Stock Units") and/or Capital Accumulation Plan units ("CAP Units") issued pursuant to the Company's Restricted Stock Unit Plan (the "RSU Plan") and Capital Accumulation Plan (the "CAP Plan"). The Class includes only those holders of Restricted Stock Units and CAP Units whose rights to either Restricted Stock Units and/or CAP Units were vested, providing them a present entitlement to be paid and/or credited an equivalent number of shares of Bear Steams common stock upon settlement at the end of a deferral period. 1. The RSU Plan 305. Since at least 2000, the Company offered certain employees shares of its common stock through a Restricted Stock Unit Plan. In April of 2007 the Company explained that the purpose of its Restricted Stock Unit Plan was to provide stock ownership to certain employees as an incentive for superior performance. 306. The Company stated in April of 2007 that Restricted Stock Units could be granted to or for the benefit of any employee who held the position of a managing director or below. Employees who held the position of senior managing director or above were not eligible to be granted awards of restricted stock under the Plan. 307. Each Restricted Stock Unit represented a right for one share of Common Stock to be delivered upon settlement at the end of a defined Deferral Period. The Company established 71 EFTA00316799

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 87 of 347 and maintained an account for the participant to record Restricted Stock Units and transactions and events affecting such units. 2. The CAP Plan 308. Since at least 2000, the Company offered certain employees compensation through its CAP Plan that was tied to the value of the Company's common stock. In April of 2007 the Company described the purpose of the CAP Plan as follows: to promote the interests of the Company and its stockholders by providing long-term incentives for the benefit of certain key executives of the Company, Bear Steams and any of the Company's subsidiaries who contribute significantly to the long- term performance and growth of the Company. 309. Employees eligible for participation in the CAP Plan included any individual employed by Bear Steams or any of its subsidiaries and affiliates as a Senior Managing Director or an equivalent title. Under the Plan, Bear Stearns credited to each Plan participant, as of the last day of such Plan Year, a certain number of CAP Units. Each CAP unit corresponded to a single share of the Company's stock. The Company determined the number of units to award by dividing (i) an amount determined by the Board Committee with respect to such Participant, by (ii) the Fair Market Value of Bear Stearns' common stock on the date of the grant action by the Board Committee granting the Award. 310. The Company purchased shares of Common Stock in the open market or in private transactions during the term of the Plan for issuance to Participants in accordance with the terms of the Plan. 3. Defendants' Fraud Harmed Holders of RSU and CAP Plan Units 311. Class Members with compensation packages including eligibility for Restricted Stock and or CAP Units took these packages on the understanding that any stock received under the Plans accurately reflected the true value of the Company's shares. Such Class Members were 72 EFTA00316800

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 88 of 347 unaware when they took Units under these Plans that the value of the Company's stock had been artificially inflated by the Company's materially false and misleading statements and omissions. When the disclosure of the Company's fraud described at paragraphs 589 to 794 below caused Bear Stearns' share values to plummet, the RSU and CAP Plan Unit holders suffered enormous losses. L. The SEC Comment Letters 312. An exchange of letters between Bear Stearns and the SEC's Division of Corporate Finance ("CF Division") offers ample evidence that the Company's public filings for fiscal years 2006 and 2007 failed to disclose material information about the Company's risk management practices and exposure to risk in the subprime market. 313. The SEC's CF Division selectively reviews filings made under the Securities Act of 1933 ("Securities Act") and the Exchange Act to monitor compliance with those statutes' disclosure and accounting requirements. In general, the SEC only selects for review a filing that "at least on its face, seems to conflict significantly with generally accepted accounting principles or Commission rules, or to be materially deficient in explanation or clarity.s5 314. In September of 2007, amidst what appeared to be a substantial increase in mortgage defaults and the deteriorating value of assets linked to mortgages (such as RMBS and CDOs containing RMBS), the SEC reviewed Bear Stearns' Form 10-K for 2006. As a result of its review, in September 2007, SEC Accounting Branch Chief John Cash sent a comment letter to Defendant Molinaro requesting that Bear Steams provide the SEC with certain "material s March 20, 2002 Testimony by Harvey L. Pitt, Chairman of the U.S. Securities Exchange Commission, before the House Committee on Financial Services, at hap://www.sec.govinews/testimony/032002tshIp.htm#P124_30878. 73 EFTA00316801

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 89 of 347 information" not disclosed in the 2006 Form 10-K filing, including "a comprehensive analysis of your exposure to subprime loans" ("2006 Form 10-K comment letter"). 315. Specifically, the SEC asked Bear Steams to: -Quantify your portfolio of subprime residential mortgages. If practicable, please breakout the portfolio to show the underlying reason for subprime definition, in other words, subject to payment increase, high LTV ratio, interest only, negative amortizing, and so on. -Quantify the following regarding subprime residential mortgages. Explain how you define each category; -Non-performing loans; -Non-accrual loans; -The allowance for loan losses, and; -The most recent provision for loan losses. 316. In the 2006 Form 10-K comment letter, the SEC also requested information regarding Bear Steams' investments in subprime-backed securities that the Company had not made available in its public filings. The SEC requested that Bear Steams: -Quantify the principal amount and nature of any retained securitized interests in subprime residential mortgages. -Quantify your investments in any securities backed by subprime mortgages. -Quantify the current delinquencies in retained securitized subprime residential mortgages. -Quantify any write-offs/impairments related to retained interests in subprime residential mortgages. 317. In the same letter, the SEC asked that Bear Steams supply it with previously undisclosed information regarding its exposure to the special purpose entities that it created to purchase subprime loans and issue securities, as well as its exposure related to warehouse lines and reverse repurchase agreements involving subprime loans. 74 EFTA00316802

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 90 of 347 318. Finally, the SEC asked that Bear Steams "[p]rovide us with your risk management philosophy as it specifically relates to subprime loans." The SEC requested information regarding, inter alia: -Your origination policies; -The purchase, securitization and retained interests in loans; -Investments in subprime mortgage-backed securities; and -Loans, commitments, and investments to/in subprime lenders. 319. Pursuant to CF Rules, Bear Steams was obliged to reply to these requests within ten days of its receipt of the letter. Thus, Bear Steams' reply was due on October 12, 2007. As set out in the 2008 OIG Report, Bear Steams obtained an extension to early November to file its response. However, Bear Steams, without explanation, did not file its promised response until January 31, 2008-after it filed its 10-K for fiscal year 2007. Despite the fact that Bear Steams had been put on notice by the SEC that disclosures regarding its subprime exposure and risk management policies were material to investors, the Company failed to incorporate any of the additional information sought by the SEC into its 2007 Form 10-K. 320. Despite the fact that the Company was delaying any response to the SEC's pending questions, the Company falsely asserted in its Form 10-K filed January 29, 2008 that there were no "unresolved staff comments" in connection with its financial disclosures. 321. The reasons for the Company's long delay in responding were apparent in the Company's response on January 31, 2008, less than three months before its collapse. In reply to the 2006 10-K comment letter, Bear Stearns for the first time quantified its non-performing loans, non-accrual loans, allowances for loan losses and its most recent provision for loan losses. Bear Steams also, for the first time, disclosed to the SEC its retained interests in subprime 75 EFTA00316803

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 91 of 347 mortgages and losses due to payment delinquencies and defaults in mortgages contained in its retained interest in the securitizations. 322. Unfortunately for investors, the version of the Company's January 31, 2008 response that was released to the public redacted all relevant figures. Moreover, by the time the SEC completed its review of the Company's response on April 2, 2008, Bear Stearns had imploded. 323. In the 2008 OIG Report, the Inspector General concluded that the information regarding subprime exposure and risk management philosophy that the Company had omitted from its 2006 and 2007 Forms 10-K was "material information" that investors could have used "to make well-informed investment decisions." M. Bear Stearns' Practices Violated Accounting Standards 324. During the housing market declines of the Class Period, the Company's enormous exposure to losses on mortgage-backed securities made it especially critical that Bear Stearns ensure the accuracy of its reported results. The Company failed to do so. In fact, despite its public statements to the contrary, throughout the Class Period the Company suffered from a pervasive weakness in its internal controls, and repeatedly and systematically violated Generally Accepted Accounting Principles ("GAAP"). 1. GAAP Overview 325. SEC Regulation S-X, 17 C.F.R. § 210.4 01(a)(1), provides that financial statements filed with the SEC that are not presented in conformity with GAAP will be presumed to be misleading, despite footnotes or other disclosures. 326. GAAP constitutes those standards recognized by the accounting profession as the conventions, rules and procedures necessary to define accepted accounting practices at a particular time. The SEC has the statutory authority for the promulgation of GAAP for public 76 EFTA00316804

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 92 of 347 companies and has delegated that authority to the Financial Accounting Standards Board (the "FASB") and the American Institute of Certified Public Accountants ("AICPA"). 327. GAAP consists of a hierarchy of authoritative literature. The highest authority is the FASB Statements of Financial Accounting Standards (FAS), followed by FASB Interpretations (FIN), FASB Staff Positions (FSP), Accounting Principles Board Opinions (APB), AICPA Accounting Research Bulletins (ARB), AICPA Statements of Position (SOP), and AICPA Industry Audit and Accounting Guides (AAG). GAAP provides other authoritative pronouncements including, among others, the FASB Concept Statements (FASCON). 328. The AICPA issues industry specific Audit & Accounting Guides ("AAG") to provide guidance in preparing financial statements in accordance with GAAP. The AAG for Depository and Lending Institutions ("D&L AAG") was applicable to Bear Steams with respect to its mortgage banking activities, including mortgage originations, securitizations, and holdings of investments in debt securities (e.g., Ch.4, Industry Overview — Mortgage Companies). The D&L AAG interpreted GAAP pronouncements on the proper methods to assess fair value for financial instruments and Rh. 329. In addition, there was an AAG that was applicable to Brokers and Dealers in Securities ("B&D AAG"). Among other applications, the B&D AAG provided guidance on GAAP related to Bear Steams' trading of financial instruments. 330. Bear Stearns was also expected to adhere to fundamental accounting principles that state a Company's financial statements should be presented in a manner which, among other things, should: 77 EFTA00316805

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 93 of 347 (a) Provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions. (FASCON I 134); (b) Provide information about an enterprise's economic resources, obligations, and owners' equity. That information helps investors, creditors, and others identify the enterprise's financial strengths and weaknesses and assess its liquidity and solvency. (FASCON 1 140); (c) Provide information about an enterprise's financial performance during a period. "Investors and creditors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors' and creditors' expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance." (FASCON 1 142); (d) Include explanations and interpretations to help users understand financial information because management knows more about the enterprise and its affairs than investors, creditors, or other "outsiders" and can often increase the usefulness of financial information by identifying certain transactions, other events, and circumstances that affect the enterprise and explaining their financial impact on it. (FASCON 1 ¶ 54); (e) Be reliable in that it represents what it purports to represent. That information should be reliable as well as relevant is a notion that is central to accounting. (FASCON 2 U58-59); 78 EFTA00316806

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 94 of 347 (f) Be complete, which means that nothing material is left out of the information that may be necessary to ensure that it validly represents underlying events and conditions. (FASCON 2 179); (g) Be verifiable in that it provides a significant degree of assurance that accounting measures represent what they purport to represent. (FASCON 2 181); and (h) Reflect that conservatism be used as a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered. (FASCON 2 1195, 97). 2. Fraud Risk Factors Present at Bear Stearns a. Fraud Risk Factors Applicable to Depository and Lending Institutions 331. Because of Bear Steams' role in the mortgage origination market, it was subject to risks associated with depository and lending institutions. One such risk factor identified by the AICPA in the applicable AAG in the section was "significant declines in customer demand and increasing business failures in either the industry or overall economy," including "deteriorating economic conditions...within industries or geographic regions in which the institution has significant credit concentrations." (Ch. 5, Audit Considerations and Certain Financial Reporting Matters, Ex. 5-1, Fraud Risk Factors). Given the widespread evidence of housing declines set out in paragraphs 138 to 148 above, this risk factor assumed particular gravity as the Class Period wore on. 332. Another AICPA risk factor set forth in the AAG specific to depository and lending institutions is "Unrealistically aggressive loan goals and lucrative incentive programs for 79 EFTA00316807

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 95 of 347 loan originations", as shown by, among other things, "relaxation of credit standards", and "excessive concentration of lending." 333. Given the lax underwriting and loan origination standards described in paragraphs 53 to 63 above, Bear Steams' financial disclosures were deeply susceptible to this form of risk. For example, Bear Steams' 2006 Form 10-K disclosed that "Mortgage-backed securities revenues increased during fiscal 2006 when compared with fiscal 2005 on higher origination volumes from asset-backed securities, adjustable rate mortgage ("ARM") securities..." 334. Bear Steams did not disclose this critical information until January of 2008 pursuant to the SEC's efforts to seek expanded disclosure from the Company. As described below at paragraphs 346 to 347 and 579, these "2/28 ARMs" carried a particularly high degree of risk of misstatement, and constituted the types of risk highlighted by the D&L AAG. In fact, Bear Steams delayed efforts to adopt stricter underwriting standards related to non-agency loan originations until the quarter ended August 31, 2007. 335. The AICPA identifies another source of industry-specific risk as occurring when an institution has "assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate (Significant estimates generally include...fair value determinations)" and when "material amounts of complex financial instruments and derivatives held by the institution that are difficult to value." Because such a large proportion of the Company's assets were Level 3 instruments valued using Bear Steams' proprietary valuation models that required significant judgments by management, the Company faced significant risk of exposure to misstatement. 336. The AAG identifies another risk factor for lenders as occurring when "[v]acant staff positions remain unfulfilled for extended periods, thereby preventing the proper segregation 80 EFTA00316808

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 96 of 347 of duties", and when there exists an "[u]nderstaffed accounting or information technology department, inexperienced or ineffective accounting or information technology personnel, or high turnover." As set out above at paragraphs 129 to 136, during the Class Period the Company's risk management desk virtually evaporated, leaving a single analyst in October of 2007, as the housing crisis reached a crescendo. b. Risk Factors Applicable to Brokers and Dealers in Securities 337. Due to Bear Stearns' role in trading financial instruments, the Company was subject to special risk factors applicable to brokers and dealers in securities, including those described in Ch.5, Appendix A, 1 5.195, Part 1 Fraudulent Financial Reporting. 338. Among the risk factors the AICPA identifies for brokers and dealers are "concentration in a particular type of financial instrument" and "a failure by management and those charged with governance to set parameters (for example, trading limits, credit limits, and aggregate market risk limits) and to continuously monitor trading activities against those parameters." As set out in the 2008 OIG Report, Bear Stearns repeatedly exceeded its own internal limits on concentration in mortgage-backed securities, invoking this risk. 339. The AICPA identifies a further risk factor for broker dealers as being "A failure by management to have an adequate understanding of the entity's trading and investment strategies as conducted by the entity's traders, including the types, characteristics, and risks associated with the financial products purchased and sold by the entity." As set out at paragraphs 137 to 187 above, throughout the Class Period the Company persisted in using valuation and VaR models it knew to be faulty in an effort to avoid disclosing its losses to the public. Accordingly, Bear Stearns' management was deliberately "flying blind" with respect to the enormous risks the Company faced. 81 EFTA00316809

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 97 of 347 340. Several specific conclusions of the 2008 OIG Report are also implicated by the AAG. As set out above at paragraphs 134 to 135, the GIG concluded that during much of the Class Period the Company's risk management department was virtually deserted, preventing the department from functioning effectively. 341. Moreover, the Company's efforts to delay taking a huge charge against capital, as described at paragraphs 212 to 213 above, invoked the B&D AAG's assessment of risk associated with "Intercompany transactions designed to improperly manage earnings." 342. Finally, in that the B&D AAG warned accountants regarding the "[u]se of different valuations of same product in two related companies", the Company's accountants should have been especially wary of its practice of booking assets at full value even after making price concessions to counterparties in mark disputes and its knowledge that similar holdings of its hedge funds were worthless, as set out at paragraphs 222 to 226 above. This risk was observed by the 2008 OIG Report to be present at Bear Stearns (e.g., "...each of Bear Stearns' trading desks evaluated profits and risks individually, as opposed to relying on one overall firm- wide approach."). 3. Audit Risk Alerts 343. The AICPA issues Audit Risk Alerts ("ARAs") that are particularized by industry, including for the financial industry in which Bear Stearns participated. The ARAs are used by industry participants, such as Bear Stearns and its auditor, Deloitte, to address areas of concern and identify the significant business risks that may result in the material misstatement of the financial statements. The factors highlighted in the ARAs are most often summaries of existing industry-specific considerations such as those provided by, for example, the Office of the Comptroller of the Currency, the Federal Reserve, or the National Association of Realtors. 82 EFTA00316810

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 98 of 347 344. It was also typical practice for the audit quality departments of major accounting firms such as Deloitte to integrate the ARAs into firm memoranda for purposes of disseminating that information to applicable clients and firm professionals. The ARAs are included in the AICPA's annual Audit and Accounting Manual ("AAM"). 345. In particular, Farber, Bear Steams' Senior Vice President-Finance and Controller, had previously been a partner with Deloitte. Accordingly, Farber should have had familiarity with the existence and application of the ARAs. 346. The 2006 ARA observed the following risk factors that were relevant to Bear Steams' financial statements: (a) "Customers holding adjustable rate mortgages may not be able to make payments if interest rates rise significantly." The ARA continued to say "Upon foreclosure, these financial institutions may not be able to liquidate underlying assets without absorbing significant losses..." (2006 ARA 8050.37). (b) Any increase in originations of risky loan products, such as ARMs and Pay Option ARMs posed particular risks for entities that had not "developed appropriate risk management policies...." (2006 AAM 8050.35) (c) Of significant relevance to Bear Stearns, the 2006 ARA heightened awareness that the value of these non-conforming products was often predicated on an assumption that home prices would continue to rise, which it observed was an assumption unlikely to be sustainable: "[S]ome of these [ARM] products assume a continued rise in home prices that may not continue." (2006 AAM 8050.35) 347. The 2007 ARA reiterated the factors observed in the 2006 ARA and expanded on the following risk factors: 83 EFTA00316811

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 99 of 347 (a) It observed "This quarter's foreclosure starts rate is the highest in the history of the survey, with the previous high being last quarter's rate." (2007 AAM 8050.27) (b) That the "American Banker recently reported that home resales hit a 4- year low due to continued price decline. Many in the housing industry believe the decline in resales signifies a protracted housing slump. Another issue contributing to sluggish home sales is the rising number of foreclosures of properties financed with subprime debt." (2007 AAM 8050.30) (c) That "On June 29, 2007, the federal financial regulatory agencies (Board of Governors of the Federal Reserve System, FDIC, NCUA, 0CC, and OTS) issued the Statement on Subprime Mortgage Lending to address issues related, to ARMs. ...The agencies primary concern is the possibility of `rate or payment shock' to the borrower that may result from the expiration of a fixed introductory rate to an adjustable variable rate for the duration of the loan." (2007 AAM 8050.48) 348. These risk factors were relevant for Bear Stearns to consider in the establishment of its internal controls and ultimately the preparation of its financial statements. Moreover, these risk factors were generally observable to industry participants. And so, Bear Stearns, with its access to material inside information regarding its specific high-risk environment, had an obligation to ensure that its certifications regarding the effectiveness of its internal control over financial reporting as well as the assertions it made in its financial statements, reflected appropriate consideration of these issues. 4. Bear Stearns Falsely Represented that its Internal Controls Over Financial Reporting Were Effective 349. Throughout the Class Period, Bear Stearns falsely asserted in its public filings that it maintained effective internal controls over financial reporting in clear violation of SEC rules. 84 EFTA00316812

Case 1:08-cv-02793-RWS Document 102 Filed 02/27/09 Page 100 of 347 The lack of effective internal controls at Bear Steams facilitated its efforts to mislead investors because without those controls it was able to represent that: (a) It was exposed to significantly less risk than was truly inherent in the assets it possessed; (b) Its risk management personnel and procedures were effective and reliable, when Bear Stearns knew they were not; (c) It had properly recorded reserves for, and made adequate and complete disclosures about its failed hedge funds; (d) It was able to make reasonable estimates of the fair value of its financial instruments, when it knew at least its mortgage-related models were deficient; (e) The write-downs of the fair value of the Company's financial instruments and other securitization-related assets were adequate; and (f) Its reported revenue, earnings, and earnings-per-share were artificially inflated. 350. Bear Steams' 2007 Form 10-K filing asserted management's responsibility over internal controls: Management...is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. ... In making its assessment of internal control over financial reporting, management [claimed to] use[ ] the criteria established in `Internal Control-Integrated Framework' issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 351. COSO defines "internal controls" in Chapter 1 of its Framework as follows: Internal control is a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: (i) Effectiveness and efficiency of 85 EFTA00316813