In the most in-depth review yet of a subprime-related lawsuit complaint, Judge Mariana Pfaelzer of the Federal District Court in Los Angeles, in an order dated May 14, 2008 (here), denied the defendants’ motions to dismiss the amended complaint in the consolidated derivative lawsuit filed against Countrywide Financial, as nominal defendant, and against eleven individual current and former officers and directors.
The derivative complaint (a copy of which can be found here) accuses the defendants of misconduct and of disregard of their fiduciary duties, and alleged lack of good faith and lack of oversight of Countrywide’s lending practices, financial reporting and internal controls. The amended complaint also contains insider trading allegations, based on the individual defendants’ sale of over $848 million of their holdings in Countrywide stock while in the possession of material inside information, between 2004 and 2008.
The defendants moved to dismiss the plaintiffs’ derivative claims on the ground that the plaintiffs had not make pre-suit demand or adequately pled that demand was excused.
Judge Pfaelzer began her analysis with some harsh words for the plaintiffs’ complaint, which she described as “prolix and sprawling.” Notwithstanding these concerns, she proceeded to the merits in a ruling that largely went the plaintiffs’ way.
She opened her analysis with the observation that standards to determine whether demand is excused “overlap considerably” with the standard for establishing a claim under Section 10(b) of the ’34 Act. She said that the two issues are “inextricably intertwined,” and proceed to determine that in several material respects the plaintiffs’ allegations satisfy the pleading requirements under the standards of the recent Tellabs case.
Judge Pfaelzer found that the plaintiffs’ allegations create a “cogent and compelling inference that the individual Defendants misled the public with regard to the rigor of Countrywide’s loan origination process, the quality of its loans, and the Company’s financial situation – even as they realized that Countrywide had virtually abandoned its own loan underwriting processes.”
In support of these allegations, the plaintiffs relied on confidential witnesses, whom the court said “paint a compelling picture of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States.” The court said that “plaintiffs’ numerous confidential witnesses support a strong inference of a Company-wide culture that at every level emphasized increased loan origination volume in derogation of underwriting standards.”
The court found further that the plaintiffs' allegations support the contention that many of the individual defendants were aware of the deterioration of standards. After reviewing the “red flags” that should have alerted the individual members of various board committees, the court found that the plaintiffs’ allegations raise “a cogent and compelling inference that the Audit & Ethics committee members were aware of (or proceeded with deliberate recklessness with respect to) the significance of red flags related to increasing delinquencies, negative amortizations, and other signs of loan nonperformance.”
Similarly, the court also found that the allegations “give rise to a compelling inference” that Credit Committee members were made aware of signs of deterioration. The court also found that members of the Finance Committee “either knew or proceeded with deliberate recklessness with respect to, the fact that loans to borrowers who could not pay back their mortgages would ultimately be counterproductive, lucrative as it was in the short run.”
The court also found that plaintiffs had asserted facts to support a strong inference that members of the Operations & Public Policy Committee had acted with scienter. However the court found that “without more, the court does not fund membership on the Compensation Committee probative of scienter.”
In concluding that the allegations taken as a whole support an inference of scienter, the court stated that
independent of any turmoil in the capital markets, the widespread violations of underwriting standards would significantly raise risk of loan defaults. When combined with what the Plaintiffs allege are misrepresentations concerning the quality of Countrwide’s loans, the underwriting issues would ultimately undermine confidence in the secondary market for Countrywide products.
In further support of the scienter findings, the court referred to the company’s aggressive stock repurchase program, undertaken and continued at a time when the company’s share price escalated and while insiders were dumping their own shares. While the defendants offered competing innocent explanations for the insider sales, the court found that the plaintiffs’ “repurchase-related insider trading allegations … are at least consistent with their theory of fraud” and “provide some support” against the motion to dismiss. The repurchase program could be viewed as “an attempt to keep the ball rolling” by steadying the company’s share price “before the weight of the loan origination practices began taking their toll on the company’s operations and the value of its stock.”
The plaintiffs also relied on Countrywide CEO Angelo Mozillo’s alleged manipulation of his Rule 10b5-1 trading plan, about which the court said that “Mozillo’s actions appear to defeat the very purpose of Rule 10b5-1 plans.” The court rejected the innocent explanations offered for the changes to Mozillo’s plan, saying that the factors “do not mitigate against the inference of scienter given the magnitude and timing of Mozillo’s trading,” which amounted to hundreds of millions of dollars in stock trading proceeds.
After this detailed review of the scienter requirements and allegations, the court quickly worked through the other pleading requirments and proceeded to the ultimate question whether the plaintiffs’ allegations satisfied the demand futility standards. In considering this issue, the court again reviewed the allegations that the various board committee members were aware of the deteriorating loan practices yet failed to take corrective actions.
Since the same individuals who would have had to have considered the litigation demand were involved in these alleged circumstances, the court found that “a majority of the directors are ‘interested’” and therefore demand is excused (except as pertains to a category of claims relating to Mozillo’s compensation). The court also dismissed out two individual defendants based on the specific allegations relating to their individual involvement. The court directed the plaintiffs to file an amended complaint consistent with the order within 20 days.
At one level, Judge Pfaelzer’s order is a reflection of the specific allegations in the Countrywide complaint, particularly as pertains to the allegations of deteriorating underwriting and loan origination practices, and as pertains to the Mozillo’s insider trading. The outcome was also influenced by the allegations based on the factual observations of numerous confidential witnesses. To that extent, Judge Pfaelzer’s order may simply be a reflection of the alleged circumstances of the specific case and have relatively little potential significance for other pending subprime-related cases.
However, there may yet be a sense in which this order is relevant for other cases, and that is the court’s clear discomfort for the allegedly deteriorating practices in contrast to the company’s statements and the insiders’ stock sales. Other pending cases contain allegations pertaining to the excesses of the subprime lending marketplace, and other cases also contain allegations of insiders profiting while underwriting and loan origination practices deteriorated.
While there is at least this potential relevance of the Countrywide case for other subprime-related litigation, the larger significance is simply its primacy. Because it is one of the first cases with a detailed review of the allegations, the courts’ apparent receptivity to the plaintiffs’ allegations may be significant. Other defendants in other cases may be able to establish the insufficiency of the plaintiffs’ allegations, but the Countrywide decision could be interpreted to suggest that the defendants will have to overcome courts’ receptivity to similar allegations.
Judge Pfaelzer’s analysis of the allegations concerning Mozillo’s Rule 10b5-1 plan are also interesting, because they underscore the extent to which courts will be wary of apparent attempts to use plans to shield improper trading. When the dust settles on this case, there likely will be a fruitful opportunity to consider the lessons from these circumstances for proper and improper uses and structures of Rule 10b5-1 plans.
The WSJ.com Law Blog has a interesting post here discussing the background and context of Judge Pfaelzer’s opinion.
Special thanks to a loyal reader who prefers anonymity for providing a copy of the order.