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).