Mortgage Meltdown

Credit Crisis Excuses Contract Performance As Commercially Impractical

"This case provides a case study of some of the worst aspects of modern finance."  This is the opening line in Indiana Federal Judge David Hamilton's decision in Hoosier Energy Rural Electrical Cooperative, Inc. v. John Hancock Life Insurance Company, No. 08-CV-1560, 2008 WL 5068649 (S.D. Ind. Nov. 25, 2008).  The case involves a transaction described the judge as a "sham" and and abusive tax shelter, backed up by credit default swaps all revolving around the assets at a rural Indiana power plant.

SILO's and CDS

Hoosier Energy, which is rural electrical cooperative, owns and operates a power plant in rural Indiana.  In 2002, it appears that Hoosier was approached by John Hancock to enter into a "sale in - lease out" transaction (SILO) with John Hancock.  The transaction was specifically designed to allow John Hancock to claim to be the “owner” of the power plant for tax purposes and thus enable it to claim tens of millions of dollars of tax deductions (most likely due to depreciation of the equipment and plant facilities).  That deduction was useless to Hoosier because it was a non-profit energy cooperative.  Not surprisingly, the IRS has looked askance at these type of SILO transactions, finding them to be abusive tax shelters, although it has not gotten involved in the Hoosier - John Hancock deal.

The SILO transaction is complex (the transaction documents are over 4,000 pages) but essentially works as follows.  Under the transaction, Hoosier leased certain assets at the power plant to John Hancock for 63 years (longer than the useful lives of the assets) and John Hancock agreed to lease back the same assets to Hoosier for 30 years.  Hancock paid $300 million up-front for the lease rights.  Then John Hancock immediately leased the same assets back to Hoosier.  Hoosier pocketed about $20 million and deposited the remaining money with various entities of Ambac insurance company, which would disburse the funds back to John Hancock over time.

As part of the transaction, Hoosier was required to obtain a credit default swap (CDS) from Ambac to provide John Hancock with additional assurance that it would actually receive the lease payments.  Thus, if Hoosier defaulted on its payments, John Hancock was entitled to call in the swap and demand payment from Ambac.  Ambac, in turn, entered into a parallel CDS with Hoosier which would allow it to seek recovery from Hoosier for its payment to John Hancock.  As a further protection for John Hancock, the parties agreed that if Ambac's credit rating fell below AA, Hoosier would have 60 days to find another qualified swap provider or else John Hancock could declare Hoosier in default and demand immediate payment from Ambac under the CDS. 

Then in 2008, the credit crisis hit and Ambac's credit ratings, along with virtually every other financial guarantee company, were down-graded significantly -- below the AA rating required in the SILO agreements.  Hoosier attempted to find a replacement, but was unable to because of the credit crisis.  In late October, John Hancock sought to collect on the CDS. 

Hoosier Energy sought an injunction, claiming that it would be irreparably harmed because it would be forced into bankruptcy when Ambac sought to collect the payments it made to John Hancock from Hoosier.  Hoosier argued that the court would likely find later that the SILO transaction was an illegal sham transaction, and therefore unenforceable.  Hoosier also argued in the alternative that it was commercially impractical during the credit crisis to find a replacement for Ambac, and that it should therefore not be considered in default.

Commercial Impracticability

The court agreed with Hoosier on all points.  Of particular importance is the finding that Hoosier was likely to prevail on its commercial impracticality claim.  To relieve contract performance because of commercial impracticability, “the party must show that the un-foreseen event upon which excuse is predicated is due to factors beyond the party's control.”  Although the court noted that the doctrine should be applied with "great caution," he found that this could be one of those "extreme circumstances."  In so holding, the court wrote:

"If the nature and scope of the credit crisis were more limited or a mere economic downturn, John Han-cock's argument that the crisis was foreseeable or that Hoosier Energy should have protected itself better might be more persuasive. However, the credit crisis facing the world's economies in recent months is un-precedented and was not foretold by the world's pre-eminent economic experts. The crisis certainly was not anticipated in 2002, when the deal between Hoo-sier Energy, Ambac, and John Hancock was being finalized. Retrospect will not assist John Hancock here, nor will an assertion that it was Hoosier En-ergy's responsibility to prepare for and guard against any imaginable commercial calamity....

Hoosier Energy has come forward with evidence indicating that the obstacles it faced were not specific to Ambac but were the product of the credit crisis that effectively but temporarily froze the market for comparable credit products at any price.  Those effects were not anticipated and could not have been guarded against."

This is the first case I have seen endorsing the view that the credit crisis could excuse contract performance because the extreme and unforeseeable nature of the crisis would make performance under the contract commercially impractical.  It will be interesting to see if parties put forth similar defenses in other cases, and whether other courts will be receptive to those arguments.

Securities Class Action Against New Century Executives Survives Dismissal

On the heals of the recent decision in the Countrywide securities litigation allowing the complaint in that case to substantially survive the defendants' motions to dismiss (refer to my earlier post here), another California district court reached a similar decision in the New Century Financial Corporation Securities Litigation, Case No. 07-CV-00931 (C.D. Cal. Dec. 3, 2008) (opinion here).  The court had dismissed the first consolidated complaint back in February, but had allowed plaintiffs to re-plead (refer to earlier post here).  Combined with the Countrywide decision, these cases may prove persuasive to courts in other sub-prime related securities lawsuits.

The Allegations

New Century was one of the largest subprime lenders in the boom times.  It grew from only $357 million in loan originations in 1996 to over $56 billion in 2005.  A majority of those loans in 2005 were considered to be "sub-prime."  On February 7, 2007 New Century announced that it would be re-stating its 2006 financials, indicating material weaknesses in internal controls caused the errors.  New Century's stock declined 36% the next day, and by March 14, 2007 had lost 97% of its value following additional negative disclosures about the business.

New Century filed for Chapter 11 bankruptcy protection in April 2007.  Accordingly, the securities class action against the company was stayed, and is only proceeding against the officer and director defendants, underwriters of New Century's preferred stock offering during the class period, and the company's auditor.  The complaint alleges violations of Section 11 of the Securities Act of 1933 against all defendants, and violations of Section 10(b) against all but the underwriter defendants.

Plaintiffs alleged threegeneral categories of misrepresentations made by the defendants about New Century during the class period: (1) its loan loss reserves and reserves for repurchase of loans were fraudulently understated; (2) the value of its residual interest in loan securitizations was overstated; and (3) the adequacy of its internal controls, loan origination standards and the quality of its loans.

Falsity and Scienter

The court found actionable statements about the credit quality of New Century's loans, that it employed "improved underwriting controls and appraisal review process," selected borrowers with higher FICO scores, and had "strict underwriting and risk management disciplines."  Like the court in Countrywide, the judge found these statements actionable even though similar statements are often found to be puffery or inactionable opinions.  The court wrote:

"The allegations suggest New Century's repeated assurances of strong credit quality and strict underwriting practices.  Even in the sub-prime world, there must be a basis for distinction between loans to at-risk borrowers that meet basic standards of good lending practice and loans that plainly do not.  Those standards may provide the measure for evaluating Defendants' statements.  Here, Plaintiffs offer New Century's statement that it observed standards of high-quality credit and underwriting, and set those statements against detailed allegations of practices that utterly failed to meet those standards."

Similarly, as to the setting of loan reserves, the court rejected the notion that setting loss reserves involved substantial judgment and future projections.  The decision states, that "[t]he Complaint details declining loan performance, an increase in defaults, and a concimitant rise in repurchase claims, that were baldly disregarded in setting the reserve and valuing residual interests.  This suggests misrepresentations that did not turn on the outcome of future events."

As to the issue of scienter, the court relied heavily on the February 29, 2008 report of the bankruptcy examiner appointed in New Century's bankruptcy proceedings.  The report, which was summarized by this blog here, which was a scathing indictment of both the executives and the company's auditor.  Plaintiffs in other securities fraud actions likely will not have such readily available ammunition to support its scienter allegations.

In finding the requisite strong inference of scienter as to the statements about loan quality and underwriting, the court noted that "[t]he Examiner's Report found knowledge within high-levels of the company of its declining loan quality and underwriting as early as 2004.  The Report mentions the internal reports by New Century's Senior Management and negative internal audits that acknowledged serious problems with loan quality and underwriting, as well as the poor performance of the company's high-risk products, and concludes that the New Century failed to respond to 'red flags.'"

As to the alleged violations of GAAP in setting loan loss reserves, the court wrote: "The allegations indicate an acute awareness within New Century of the backlog making it highly unlikely that officers were unaware that the reserve was inadequate to cover the growing repurchase claims."

Auditor Claims Survive

The court also concluded that the fraud claims should survive against the auditor.  In concluding that the claims against the auditor were also actionable, the court cited allegations that a junior personnel on the audit raised several issues that were ignored or glossed over in the audit process.  For example, the court cites the allegation that a junior auditor obtained information indicating that there were $188 million in outstanding requests to repurchase defaulted loans.  Yet, KPMG certified the reserve of only $70 million.  The court also relied again on the bankruptcy examiner's report, even though the report itself concluded that there were no evidence of intentional misrepresentation by the auditor. 

Credit Default Swap Clearinghouse Taking Shape

Last week, the New York State Banking Department announced (here) the formation of a company that would act as a clearinghouse for CDS transactions.  The establishment of a clearinghouse is thought to be a first step in regulating the CDS market and establishing transparency to the transactions so that counter-party risk can be more effectively evaluated.  The next step is approval by the Federal Reserve.

On December 8, executives for the proposed clearinghouse and other major exchanges testified before Congress about the need to require most CDS transactions to be processed through clearinghouse.

One major culprit of the current financial crisis, was the explosion of unregulated credit default swaps (CDS).  The market for these issues exploded after 2001.  Back then, the CDS market was virtually non-existent, and increased to over $60 trillion by 2007.  The lack of regulation in the market made it diffucult to assess counter-party risk.  Large investments in unregulated CDS was largely responsible for the downfall of AIG.

Calculating Losses For Mortgage Fraud Under The Federal Sentencing Guidelines

In 2006, Toby Wayne Goss, a mortgage broker, was convicted in federal court of 19 of mail fraud, wire fraud, and money-laundering charges for submitting false documents like verifications of rent, W-2 Forms, and Social Security benefit letters in order to obtain mortgages for clients.  Goss was sentenced in August 2007.  One of the main issues for sentencing in a federal fraud case under the now-advisory sentencing guidelines is the amount of financial loss to the victims -- in this case, the lenders who provided mortgages in reliance on the falsified documents.  Goss was sentenced to 57 months in prison after the district judge concluded that the amount of financial loss to the victims was the full amount of the loans at issue, which should not be reduced by the value of the collateral - the real estate - pledged for the loans.

The Fifth Circuit reversed the district court's calculation of the financial loss under the federal sentencing guidelines.  Although the guidelines are now only advisory in nature, district courts are still required to properly calculate the guideline sentencing range in deciding the sentence to impose.  For assessing financial losses, a court should use the greater of the "actual loss" or the "intended loss."

Actual loss means the "reasonably foreseeable pecuniary harm that resulted from the offense."  Intended loss means the pecuniary harm intended (even if it all of it is not realized by the victim), including damages that would have been impossible or unlikely to occur, such as in a government sting operation or an insurance fraud where the claim exceeded the insured value.

The court held that Goss did not intend for lenders to lose the full amount of the loan, because the loans were backed by the real estate that secured the loans.  Accordingly, actual loss should be used, and therefore the value of the real estate at the time of sentencing should have been off-set against the loans when considering the actual loss.  The court also required the district court to estimate a fair market value for each property to determine this off-set.

Quote of note: "[T]he relevant losses in the case at hand are actual losses; and, on remand, the district court shall conduct a loan-by-loan inquiry to explore the factors discussed [in the opinion], as well as others it deems relevant.  After making the necessary findings of fact with respect to the collateral's likelihood of recovery and its fair market value at the time of the initial sentencing, the district court, for its loss calculation, should: deduct the fair market value of collateral likely to be recovered from the total value of the loans, using the court-determined value of that collateral; and obviously, should not deduct the value of collateral not likely to be recovered." The opinion is available here. 

Countrywide Securities Class Action - An "Extraordinary Case"

Federal judges' reception of securities fraud class actions arising out of the mortgage meltdown have been luke warm, typically dismissing complaints but allowing the lead plaintiffs to replead.  On Monday (Dec. 1), plaintiffs obtained a major victory when the securities fraud complaint against Countrywide Financial Corporation, its officers and directors, underwriters of its securities offerings, and its auditor largely survived the defendants' motions to dismiss.

But was it?  As the judge noted in the introduction to her 112-page opinion, the case of Countrywide was an "extraordinary case where a company's essential operations were so at odds with the company's public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws."  Thus, it is questionable whether the judge's opinion will carry much persuasive value for other judges considering sub-prime related securities fraud cases.  In any event, below summarizes some of the court's discussion on the issues of falsity, scienter and loss causation.

Falsity

The opinion's summary of the allegations against Countrywide led the judge to conclude that Countrywide engaged in a "unified course of abandoning sound underwriting practices" and intentionally misrepresenting those practices to investors.  The plaintiffs possessed specific documents that showed that beginning in mid-2003, Countrywide began systematically lowering its underwriting standards in order to meet a 30% market share goal set by its CEO.  Multiple confidential witnesses corroborated this.  At the same time, Countrywide repeatedly told investors that it had not changed its underwriting standards, and at all times possessed quality underwriting standards. 

Aside from the typical examples of providing no documentation loans, teaser rate ARMs, loans with high loan to value ratios, and inflated appraisals, the complaint alleged that even loans that did not meet these lower, riskier underwriting standards were still approved at a high rate through the company's Exception Processing System.  Instead of using the system for risk management, it appears the EPS was used to identify loans to which risk charges and add-ons could be made to drive additional revenue and market share.  Countrywide's top executives actively monitored the system.

Thus the court concluded that the complaint "sufficiently alleges that Countrywide systematically departed from any reasonable interpretation of 'quality' and 'standards' that such [public] statements could be materially false or misleading.  It cannot be emphasized enough that in the vast majority of cases such statements would be nonactionable puffery.  Given the gravity of the [complaint's] allegations about Countrywide's operations -- as well as the market's realizations regarding Countrywide's businesses and mortgages -- the Court cannot dismiss such claims at the pleading stage."

The Court also identified as one of the most glaring examples of Countrywide's alleged misleading statements involving its own unique definition of "Sub-prime."  The standard in the mortgage industry for "sub-prime" was a borrower with a FICO score of 660 or less (the U.S. median score is 720, and only 27% of the population scores under 650).  Countrywide only classified borrowers with a score of 620 or below as "sub-prime" but never informed investors of this, which made Countrywide's reporting of high percentages of "prime" loans misleading.  In July 2007, Countrywide's Chief Risk Officer disclosed this unique definition and the fact that Countrywide could consider other factors to conclude that a loan to a borrower with a credit score of 500 or less qualified as a "prime" loan as well.  According to the complaint, analysts expressed "shock" on the call.

Scienter

In addressing the pleading of scienter under Section 10(b), the court wrote: 

"Taking the [complaint] as a whole, Plaintiffs have created a cogent and compelling inference of a company obsessed with loan production and market share with little regard for the attendant risks, despite the company's repeated assurances to the market.  With respect to loan origination practices, they raise strong inferences that (1) borrower requirements were progressively loosened over the Class Period; (2) in many instances, the actual loan quality was lower than the borrower's FICO score and LTV ratio suggested because Countrywide misrepresented how lax its verification practices became; and (3) Countrywide management routinely circumvented the normal underwriting process by approving highly risky loans for sale into the secondary market." 

The court expressly found that the complaint provides a strong inference that most of the defendants acted with actual knowledge that their class period statements were false or misleading.

KPMG, the company's auditor during most of the class period, received at least a temporary reprieve as to the fraud claim against it. There were not enough "red flags" that KPMG allegedly overlooked in conducting its audits of Countrywide to support a finding of scienter. As to KPMG, the court found that "[t]he [complaint] does not 'bridge the gap' between gross recklessness and 'some degree of intentional or conscious misconduct' to satisfy the deliberate recklessness standard."  The complaint did state a claim against KPMG for Section 11 liability related to the company's 2006 financial statements, however, because Section 11 does not require scienter. 

As an aside, KPMG apparently argued both that the 416-page complaint should be dismissed both for violating Rule 8(a) of the Federal Rules of Civil Procedure's requirement that the complaint include "a short and plain statement of the claim showing the pleader is entitled to relief" as well as failing for lack of particularity under Rule 9(b) and the PSLRA (which it ultimately succeeded as to the issue of scienter).  As to the 8(a) argument, the court was sympathetic but rejected the argument, writing that the court "would have appreciated a complaint that is more concise, less redundant, and better organized.  This Court has little patience for excess -- 416 pages is excessive.  But given the extraordinary complexity of this case's factual allegations, the lengthy class period, and the wide swath of defendants, focusing on the CAC's rhetorical and structural flaws would be a pointless exercise."

Loss Causation

The defendants claimed plaintiffs could not adequately plead loss causation because Countrywide's stock declined over a long period of time and did not react with a precipitous drop following any particular corrective disclosure.  The court rejected this argument, stating:

"The point is that showing loss causation is not precluded by a series of disclosures; serial disclosures just make it more difficult for plaintiffs as a practical matter....  Defendants here attack Plaintiffs' loss causation theories because Countrywide's corrective disclosures were made over an extended period of time and often in combination with alleged further misrepresentations that dampened the disclosures' price effects.  The point, however, is that the price of Countrywide securities dropped as the disclosures accumulated.  By the end, Countrywide stock, at least, had plummeted.  Most corrective disclosures correlate tightly with declines, as is expected in an efficient market.  Plaintiffs identify these disclosures with particularity."

Hat tip to the D&O Diary that first wrote about the opinion and has its typically insightful analysis and a link to the opinion (here).