Mortgage Meltdown

AIG Derivative Lawsuit Dismissed

A derivative shareholder lawsuit against AIG was recently dismissed by a federal court judge in New York.  Should this give comfort to other directors and officers in litigation resulting from the financial crisis?  After all, if a court did not allow claims against management in the wake of the stunning collapse of AIG -- a collapse which almost brought down the entire financial system with it -- how could claims against management of other companies that run into to trouble succeed?  However, because the dismissal was based on the defendant shareholders failure to make a pre-suit demand on the board of directors to file a suit against the company's management, the case may not give much solace to other directors and officers.

In the AIG case, the plaintiff-shareholders alleged that the defendants had failed to properly oversee the company’s credit default contracts and had made misleading statements about the company’s financial health and risk management. The plaintiffs also allege defendants wasted corporate resources and breached their fiduciary duties when they caused AIG to increase its dividend and buy back its stock in the months leading up to the company's collapse and government rescue.

The case was brought by shareholders on behalf of the company in what is known as a derivative shareholder suit.  Because of the nature of these derivative actions, there are special procedures to allow the company to intervene and decide whether it is in the company's best interests to assert any claims against its own current or former officers and/or directors.  One procedural rule requires shareholders who wish to bring derivative actions to first issue a demand upon the corporation to bring the claims.  The demand requirement may be excused where the shareholder demonstrates that a demand would be futile.

In the AIG case, the defendants moved to dismiss the case because the plaintiff failed to make a presuit demand.  The plaintiff-shareholder contended that demand would have been futile because AIG's board was conflicted and inherently biased against asserting the claims.  The judge disagreed and granted the defendant's motion, reasoning that five of the nine directors at AIG in June 2009, when the lawsuit was filed, were disinterested and therefore demand was not excused.

The plaintiffs tried to argue that all of the directors were interested because they faced personal liability even though they were not directly involved in any of the problems in AIG's credit default swap/derivatives unit which took the company down.  Plaintiffs claimed that these directors breached their duty of oversight.  The court notably rejected this argument, and relied on the Delaware Chancery Court's decision dismissing a similar derivative lawsuit against Citigroup, and wrote that plaintiffs "may not support a claim based on the duty of oversight…merely by identifying signs of general difficulty in the market in which the company participates and asserting that the defendants should be held liable for exercising their business judgment in a manner that appears to have been inconsistent with those indications."

As to the allegations about the issuing dividends and the stock buy-back, the court also found that AIG directors did not face liability:

"AIG’s decision to increase its dividend by a modest ten percent redounded to the benefit of all
shareholders equally and presumably, in the short term, made AIG’s stock more attractive to
investors, thereby heightening demand for the stock, increasing the share price, and potentially
lowering the Company’s cost of capital. Although Plaintiff baldly alleges that “the dividend
declaration was directly tied to the desire to compensate certain Officer Defendants,” Plaintiff
pleads no particularized facts to render this inference plausible. The Court cannot conclude that
this decision was “so egregious or irrational that it could not have been based on a valid
assessment of the corporation’s best interests.”

The case is American International Group Inc 2007 Derivative Litigation, U.S. District Court, Southern District of New York (Manhattan), No. 07-10464.

In First Subprime Criminal Trial, Managers Of Bear Stearns Hedge Fund Acquitted

In the first criminal trial related to the subprime mortgage meltdown, prosecutors were unable to secure the convictions of Ralph Cioffi and Matthew Tannin when the jury acquitted each defendant on all counts today (coverage here and here).  Cioffi and Tannin were managers of two Bear Stearns hedge funds heavily invested in securities backed by subprime mortgages.  Those funds collapsed in mid-2007, and investors lost about $1.6 billion.  The two faced charges of wire fraud, securities fraud and conspiracy.  In addition, Cioffi was charged with insider trading.  He withdrew about $2 million of his own money from the hedge funds just prior to the collapse.

Based on coverage of the trial, it appears the prosecution had two major failings in the case.  First, the acquittal shows that a trial cannot be won on documents alone.  A trial is theater that requires real live witnesses to introduce the documents and tell the jury how the documents fit into the case.  Here, the government did not prepare this aspect of their case well enough.  For example, take the famous "toast" email.  On April 22, 2007, Mr. Tannin, in a message sent from his personal Gmail account to the personal account of Mr. Cioffi’s wife, wrote that “the whole subprime market is toast,” and if the CDO report "is ANYWHERE CLOSE to accurate I think we should close the funds now" and "There is simply no way for us to make money -- ever."   A few days later, on an investor conference call, Mr. Tannin assured investors:  "we're very comfortable exactly where we are" in the subprime market.

Pretty damning don't you think?  However, the prosecution failed to slam the door shut through the testimony of the author of the CDO report referenced in Tannin's email, and the defense, by all accounts (here, here, and here) was better able to use witness testimony to put the email into the context it wanted the jury to understand.  The defense brought out on cross-examination of the author that he was actually optimistic about the report, believing that the hedge funds could used increased volatility in the subprime market to make even more money.  By allowing this to come out on cross-examination rather than innoculating against it on direct, the prosecution allowed the author's state of mind (positive) to be reflected on to Tannin's state of mind (negative). 

Of course, it is Tannin's state of mind that was critical at the time he made the statements to investors.  If he believed that the hedge funds were in trouble at the time he made the positive statements to investors, he should have been convicted.  By failing to cement in the context on the "toast" email the prosecution allowed the defense to put its own context on the email and the case -- the future is uncertain, the defendants did not know where the subprime market was going, so they simply could not have had the intent to commit fraud.

The prosecution's case was also hurt by something that happened long before the case ever went to trial.  During the middle of the trial, the district judge prevented the prosecution from introducing another smoking gun email because it found the government's subpoena to get email from Tannin's Google email account violated the 4th Amendment (article here).   In the November 2006 email (again using a non-work account), Tannin wrote  “I became very worried very quickly....  Credit is only deteriorating. I was worried that this would all end badly and that I would have to look for work.”  Tannin went further stating the funds, under a more extreme situation could "blow up."  Another lesson for criminal and civil litigators alike.  Mistakes or carelessness in carrying out tasks early in the case can be compounded and magnified at trial.

In the end, the government's loss is significant for future prosecutions and may chill new criminal cases from being brought.  Given the climate amongst the general public following the financial crisis and the so-called Wall Street bailouts, one would have thought that juries would just be waiting to convict somebody, anybody, for the fallout everybody has felt from the subprime bubble bursting.  In the end, the defendants got a fair shake, and the defendants' lawyers apparently did a better job of putting the emails and other documents in context through the testimony of live witnesses.

Connecticut Judge Says UBS Probably Defrauded Hedge Fund In Sale Of CDO's

After a one-week hearing on a hedge fund's claim that UBS violated state securities laws when it sold mortgage-backed CDO's to it in 2007 and early 2008, a Connecticut trial court judge required UBS to post a $35 million bond to secure a potential future judgment against the investment bank.  In requiring the posting of a bond, the court found that there was "probable cause" for a determination that UBS had violated securities laws.

During the hearing, the court took testimony of several witnesses from UBS.  As quoted in the Reuters coverage of the decision (here), the court made several damning findings against UBS.  The main thrust of the decision is that UBS had already been told by rating agencies Moody's and S&P that they would be issuing downgrades on the credit ratings of the CDO's that UBS was selling.  Despite this knowledg, UBS sold the CDO's without disclosing the impending downgrades.

The main issue in this case is whether UBS had a duty to disclose the knowledge of impending downgrades.  The judge found that it did.  This is most likely based on the fact that the securities offering materials for the CDO's contained discussion of the risks of buying the securities, which no doubt included the risk or people defaulting on the mortgages that backed the CDO's.  The offering materials also no doubt touted the investment-grade rating of the bonds.  Under these circumstances, the court found that UBS had a duty to speak, to disclose the new information in order to correct the information already disclosed to investors.

The court also focused on internal UBS emails that referred to the CDO's it sold to the hedge fund as "crap" and "vomit" to support the allegations of fraudulent nondisclosure, and concluded that "UBS alone possessed the knowledge of what their product, their inventory, was truly worth.  While UBS would argue that such descriptors lack a precise meaning, the true meaning of these words and the true value of UBS's wares became abundantly clear when the Plaintiffs' multi-million dollar investment was completely wiped out and liquidated by UBS shortly after the last of the Note purchases was consummated."  Thus, in addition to the securities issues, this case is another example of how the careless use of email and the conversational tone that people use in emails can boomerang back at a company during litigation.

Catching Up

Well, it's good to be back writing this blog again.  Sorry to my readers for the long, unexplained absence.  I just returned from an almost month-long trial in Baltimore, Maryland (I am based in Reinhart's Milwaukee office).  A lot has happened in the interim, so let's get to it.  What follows is quick summary of some of the legal developments/stories from the mortgage meltdown:

(1)  Countrywide boss Anthony Mozilo was served with a "Wells notice" by the SEC.  As first reported by the Wall Street Journal and the L.A. Times, Countrywide's former CEO and other executives have been provided notice from the SEC that it intends to file formal civil charges for securities fraud and insider trading.  A Wells Notice is the name for this formal notification, and it provides the lawyers for Mozilo and the other executives to submit argument and evidence to try and persuade the Commission not to file the charges. Reuters June 2 story on the subject is here.  Although SEC may bring civil charges, criminal charges are also a possibility.

(2)  Subprime securities class action dismissal motions decided.  Several motions to dismiss were denied, as in the Moneygram, Inc. case involving allegations that the company failed to disclose risks of its own investments in mortgage backed securities (opinion here).  Similarly, a Florida District Court permitted claims to proceed against BankAtlantic Bankcorp., a Florida-based bank.  The court held that the amended complaint had cured prior deficiencies in pleading a strong inference of scienter (here).  Conversely, the case against Washington Mutual was dismissed with leave to amend (see here), and a securities fraud complaint against mortgage insurer Radian Group was dismissed with prejudice (here).  For more detail on these dismissals, go over to the D&O Diary blog which has consistent, in-depth analysis of the opinions and a running tally of the subprime securities motion to dismiss decisions.

(3)  Legislation Passed.  On May 20, President Obama signed two bills, the Helping Families Save Their Homes Act and the Fraud Enforcement and Recovery Act of 2009.  The first expands the mortgage foreclosure mitigation efforts, increased FDIC deposit insurance to $250,000 through 2013, and increases the borrowing authority for both the FDIC and the credit union deposit insurance counter-part.  The bankruptcy cramdown provision, which would have allowed bankruptcy judges to modify mortgages, was defeated and did not make it into the law.  The Fraud Enforcement and Recovery Act is intended to provide more resources and penalties for financial fraud, by extending the prohibition against making false statements in a mortgage application to employees and agents of a mortgage lending business; expanding the concept of monetary proceeds under federal anti-money laundering statutes to include gross receipts, a response to the Supreme Court’s June 2008 Santos decision; and expanding False Claims Act liability by, in part, overruling the Supreme Court's interpretation of the mental state required to prove a claim under the Act in Allison Engine Co. v. U.S. ex rel. Sanders, 128 S. Ct. 2123 (2008). 

(4)  More bank failures.  Throughout the first half of this year banks have failed at an accelerated rate, with the largest failure this year (the 34th) being Florida's BankUnited FSB, with $12.8 billion in assets.  The BankUnited closure was also notable because several private-equity firms, rather than another bank, purchased the deposits from the Office of Thrift Supervision and will operate the new BankUnited.  All of these bank closures have also substantially depleted the FDIC deposit insurance fund, so the FDIC approved a special assessment on banks to replenish the fund (the details are found here.)

(5)  Cleveland's Nuisance Suit Dismissed.  City of Cleveland's nuisance lawsuit against various investment banks and mortgage lenders was dismissed.  The district judge considering the case concluded that the nuisance claim was (1) barred by the economic loss doctrine, which prevents recovery in tort for purely economic damages (i.e. no personal injury or property damage); (2) preempted by Ohio law governing municipal regulations; (3) barred because a nuisance claim cannot be founded on subprime lending, which was lawful activity and heavily regulated; and (4) barred because the alleged damages were to remote.  The opinion is here. 

(6)  General Motors filed for bankruptcy protection this week at about the same time that another auto industry stalwart, Chrysler, was emerging from bankruptcy.  The United States government will own about 60% of the new GM.

Financial Crisis Creates Wave Of FINRA Broker Litigation

The mortgage meltdown, and the ensuing financial crisis has resulted in a wave of new FINRA arbitrations by investors against their brokers and financial advisors.  Although it is easier to track new securities class action filings arising out of the financial crisis, FINRA arbitrations are much harder to follow.

However, a recent Associated Press article (here) sheds light upon the huge increase in new FINRA filings.  In 2008, new arbitration filings with FINRA increased by 54% over 2007 (which I suspect were also higher than 2006) to 4,982.  Much of these are no-doubt directly related to the subprime lending and the credit crisis; many are the result of the Madoff scandal, the Stanford fraud, and the significant general decline in the stock market.

FINRA recently reached a significant decision in a case directly related to the credit crisis.  In that case, the agency awarded over $400 million to an investor in Auction Rate Securities, who lost money when the ARS market froze up in February 2008.  The award included compensatory damages, interest and $3 million in attorneys' fees.  The investor, a European microchip maker, claimed that its investment advisor caused it to invest in ARS rather than safer federally guaranteed student loan securities it had asked to invest in.  An article with more detail about the decision is available here and the award is available through the investor's press release here.

I expect that the volume of FINRA arbitrations and the announcement of other significant decisions will increase again in 2009.

New Litigation Round-Up

New cases arising from the ashes of the mortgage meltdown continue a-plenty and take many forms.  A sampling of recent cases:

ERISA  According to an article here, on January 29 the ERISA retirement plan for a Minneapolis glass-ware manufacturer called Apogee sued State Street Bank alleging that State Street breached its fiduciary duties to the plan.  State Street is alleged to have been an investment adviser to the fund.  According to the suit, State Street touted the Daily Bond Market Fund as a conservative, stable, risk-controlled, well-diversified option for Apogee's 401(k) plan, but changed the fund's strategy during 2006 to take on significantly more risk. Apogee alleged that State Street applied leverage in making the investments in subprime mortgage-backed securities, which had the effect of adding greater risk to the fund.  The fund also alleged that State Street prevented it from exiting the bond fund, while it allowed others to get out.  The fund alleges it lost $5 million.

Title Insurer Sued Over 1031 Exchange Program.  When the large title insurance company LandAmerica Financial Group, Inc. filed for bankruptcy last November, people who sold real estate in the months prior to the bankruptcy intending to reinvest the proceeds of the sale into new real estate through an IRS 1031 exchange (the benefit is deferring capital gains) had their money tied up in the bankruptcy.  For some it appears the money was tied up too long, and they lost their ability to make the exchange.  Several lawsuits have been filed against LandAmerica related to these issues, including a $300 million class-action lawsuit claiming breach of contract, fraud and theft of property filed in LandAmerica's bankruptcy case in Virginia.  A separate class action, raising similar issues, was filed in federal court in California.  As reported here, the cases are similar, and allege that the 1031 Exchange customers were misled about the financial health of LandAmerica.

Hedge Fund Sues Over Mortgage Bond Investments.  As reported by Bloomberg (here), Ellington Management Group LLC, the hedge-fund firm focused on mortgage bonds, sued Ameriquest Mortgage Co. and other ACC Capital Holdings units over soured subprime home loans.  Ellington alleges that its $354 million investment in certain bonds backed by subprime loans was virtually lost in its entiretly.  Ellington claims it was misled about the risk and the loans' potential for default.

Another Securities Class Action Filed.  This time the company in the cross-hairs is mortgage insurer Triad Guaranty, Inc.  The plaintiff's lawyers press release (here and here) from earlier today states that they allege that Triad misled investors about its underwriting practices for insuring Alt-A and pay-option mortgage and failed to adequately disclose to investors its weakening financial position as the financial crisis deepened throughout 2008. 

One Step Forward; Two Steps Back For BofA-Merrill Lynch

One day after Bank of America received a second bailout from the federal government, which included stop-loss guarantees on assets BofA acquired through its January 1 acquisition of Merrill Lynch, the company announced that it was settling the subprime securities class action filed against Merrill Lynch last May for $475 million.  At the same time, it reached a separate $75 million settlement to resolve employee ERISA claims, for a whopping total of $550 million.  The complaint alleged that Merrill Lynch misled investors about its holdings of collateralized debt obligations and other securities backed by subprime mortgages.

The timing of the settlement suggests that  BofA had priced the cost of the settlement into the merger costs.  The settlement comes only about three weeks after the acquisition of Merrill closed on January 1, and comes before a motion to dismiss had even been filed in the case.  It seems that BofA wanted to put the securities litigation behind it and focus on getting Merrill integrated into its corporate structure.

Well throw that thinking out the window.  This week Bank of America has been hit with several new securities lawsuits related to the merger.  The class action filed today (here) against BofA, CEO Ken Lewis and Merrill Chief John Thain alleges that the proxy statement provided to BofA shareholders prior to the vote on the merger was false or misleading.  In addition, the complaint purports to represent a class of shareholders who bought BofA stock after the merger was completed on January 1.  Information about the other shareholder suits are available here and here.

The lawsuits follow BofA's January 16 announcement that Merrill suffered $15.3 billion in losses during the fourth quarter of 2008.  BofAs stock declined significantly following the announcement.  The discovery of these significant losses almost scuttled the acquisition.  BofA wanted to back out, but regulators pushed the company to conclude the deal.  The result was the second bail out discussed in yesterday's post.

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. 

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).

Appeals Court Denies Class Certification Involving Asset Backed Debt Securities

In a case that could have important implications for securities class action lawsuits arising out of securities backed by mortgage debt, the Second Circuit last week affirmed the denial of class certification for investors in debt certificates backed by mobile home loans.  The court concluded these securities were not traded in an efficient market, such that each investor would have to prove individual reliance on the defendants' alleged misstatements.  Accordingly, the court held that class certification under Rule 23 of the Federal Rules of Civil Procedure would be improper.  The case is Teamsters Local 455 Freight Div. Pension Fund v. Bombardier, Inc. et al.  (available here).

The plaintiffs' allegations in Bombardier, filed in 2005 before the credit crisis, are similar to the wave of lawsuits that followed the mortgage meltdown in 2007.  Plaintiffs alleged that Bombardier Capital Mortgage Securitization Corporation, a subsidiary of Bombardier Inc. (whose main business is selling aircraft, RV's and locomotives), issued debt certificates backed by mortgages on mobile homes, and that Bombardier Inc. and its subsidiaries made misrepresentations to investors.  Like securities that were backed by subprime mortgages, the debt certificates were given an investment-grade rating by bond rating agencies.  A couple years later, those securities were down-graded below investment grade and investors lost money.

The plaintiffs alleged that Bombardier's subsidiary "disregarded underwriting standards, regularly underwrote loans to borrowers who were not creditworthy, and purchase large quantities of facially defective and deficient mobile home loans."  These lax underwriting standards later caused soaring loan delinquincy rates and a collapse in the price of the securities.  Sound familiar?

Although the first battle in most private securities litigation is fought on the motion to dismiss, the Bombardier defendants were not able to get the case dismissed at that stage (it is unclear from the appellate court opinion whether they tried).  Instead, the defendants effectively gutted the claim by convincing the district court to deny class certification.  The district court found that the plaintiff failed to demonstrate that these debt securities were traded in an efficient market so that the fraud-on-the-market presumption of reliance did not apply.  Thus common questions of fact did not predominate over individual questions of each investors' reliance on the alleged misrepresentations, as required under Rule 23 of the Federal Rules of Civil Procedure in order to maintain a class action.

The Second Circuit affirmed denial of class certification.  The court relied on three factors in concluding that the debt securities were not traded in an efficient market:  (1) the lack of analyst coverage of the securities; (2) the lack of market makers in the securities; and (3) the lack of price reaction to news about the securities.

Lack of analyst coverage:  If a large number of analysts follow a particular security and make recomendations to investors, this supports a finding of market efficiency.  The greater number of analysts, the greater likelihood that information released by a company is being relied on by investors.  In Bombardier, there were a lot of analysts reporting on the parent company, but no analyst coverage of the debt securities themselves.  Accordingly, the court found that, although the parent company's stock might trade in an efficient market, the debt certificates themselves did not.

Lack of market makers:  A market maker is a term of art defined by the securities regulations.  A "market maker" is a dealer who, with respect to a particular security, regularly publishes bid and offer quotes on a recognized interdealer quotation system; furnishes bid and offer quotes on request; and is willing and able to effect transactions in reasonable quantities at its quoted prices.  17 C.F.R. 240.15c3-1[c]8 (2006).  Market makers promote efficiency by reacting swiftly to company news or finanical results by buying or selling and thereby "driving [the security] to a changed price level."  The plaintiff presented evidence that both the underwriters of the securities and other broker-dealers traded extensively in the securities, and should therefore be considered market makers.  The court rejected this, however, because there was no evidence that these companies published or furnished bid quotations or were able to effect transactions at quoted prices.  Accordingly, anecdotal evidence of trading activity did not demonstrate an efficient market.

Lack of causation:  As the court stated, "the essense of an efficient market and the foundation for the fraud on the market theory" is that "unexpected corporate events or financial releases cause an immediate response in the price of the security" at issue.  Plaintiffs presented an event study, which attempts to plot reactions in the debt securities' prices to unexpected news about them.  The district court and court of appeals rejected the event study because the study focused on unexpected disclosures about Bombardier rather than the mortgage division or the debt certificates themselves.  These disclosures were immaterial to investors in the certificates, the court found, and therefore proved nothing about market efficiency in the debt securities.  Moreover, the price of the securities "reacted weakly" to the downgrades by the rating agencies.  This would also indicate lack of market efficiency.

As a parting thought, the court noted that the plaintiff was correct in one contention -- the factors considered apply more aptly to stocks rather than bonds, which are traded more infrequently.  However, the court put off the "nettlesom question" of whether different factors should be considered in the sale of bond instruments for another day.

Impact on credit crisis securities lawsuits:  The Bombardier case has the most precedential value and potential impact on securities fraud cases involving allegations of fraud in the sale of Auction Rate Securities, preferred stock (such as the Freemont or Freddie Mac cases), or class actions involving alleged fraud in the sale of mortgage backed securities themselves, rather than the majority of cases that have been filed related to common stock in companies that trade on a national exchange.  The case provides another arrow in the quiver of a class action defendant if their motions to dismiss miss the target.