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.
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