Following closely on the heels of the denial of the motion to dismiss in the Countrywide case earlier this week (about which refer here), on December 3, 2008, Judge Dean Pregerson of the Central District of California issued an opinion (here) denying the defendants’ motions to dismiss in the New Century Financial Corporation securities class action lawsuit.
Background
New Century was at one time the largest subprime mortgage lender. However, on April 2, 2007, the company filed for Chapter 11 bankruptcy protection. In a development with significance for the securities lawsuit, in March 2008, the New Century bankruptcy examiner filed a report (refer here) finding, among other things, that the company had "engaged in a number of significant improper and imprudent practices related to its loan originations" that "created a ticking time bomb that detonated in 2007."
The lead plaintiff in the New Century securities lawsuit is the New York State Teachers’ Retirement System. The plaintiff filed a consolidated class action complaint on September 14, 2007, and the defendants moved to dismiss. On January 31, 2008, as discussed here, Judge Pregerson granted the motions dismiss without prejudice, but the dismissal focused entirely on the organization and complexity complaint and the court’s difficulty in evaluating the basis of the plaintiff’s claims. Thereafter, the plaintiff’s filed a second consolidated amended complaint (refer here, referred to below as the amended complaint) and the defendants again moved to dismiss.
The amended complaint names as defendants certain officers and directors of New Century; its former auditor, KPMG; and the investment banks that underwrote certain New Century securities offerings. The complaint alleges that the defendants
misrepresented New Century’s ability to repurchase defaulted loans; overvalued its residual interests in securitizations; falsely certified the adequacy of its internal controls, loan origination standards, and the quality of its loans; and failed to identify these problems in public statements, registration documents, audits, or elsewhere.
Further background regarding the case can be found here.
Judge Pregerson’s Opinion
In his December 3 opinion, Judge Pregerson first considered whether the amended complaint remedied the organization and clarity issues for which he had previously granted the defendants’ motions to dismiss. While noting that the amended complaint is "truly massive" and commenting that he "questions whether the Complaint provides a manageable road map for litigation," he nevertheless concluded that the amended complaint was "responsive to the concerns" and that he was "now able to evaluate whether the allegations sufficiently state a claim." He also recognized that the PSLRA’s "stringent pleading requirements appear to invite both parties to throw everything and the kitchen sink into their respective pleading."
In turning to the merits, Judge Pregerson examined whether the plaintiffs could rely on the "group pleading doctrine," under which "group published documents" (e.g, press releases) for which there is not identified author can be considered the collective work of those with direct involvement in the company’s day-to-day affairs.
After reviewing the relevant case law, and noting that the Ninth Circuit had not expressly rejected the doctrine, Judge Pregerson joined the "majority of other courts in the Circuit" and held that "group pleading" is not longer viable under the PSLRA. He dismissed the plaintiff’s allegations that were made in reliance on the group pleading doctrine. However, he also noted that because the amended complaint alleges attributed misrepresentations that do not rest on the doctrine as to each of the officer defendants, his holding regarding group pleading "does not preclude any of the Officer Defendants from liability."
Judge Pregerson then addressed the 10b-5 allegations in the amended complaint. He concluded that the amended complaint adequately alleged falsity as to loan quality and underwriting and as to financial reporting and internal controls. Interestingly, in concluded that the allegations concerning loan quality and underwriting standards adequately alleged that the statements were false and misleading when made, Judge Pregerson expressly noted that other district courts in the Ninth Circuit had "found similar statements regarding loan quality and underwriting to provide a basis for actionable securities law violations," citing the Countrywide and Accredited Home Lenders decisions. (Refer here regarding the Accredited Home Lenders decision.)
On the issue of scienter, Judge Pregerson found that the amended complaint
sufficiently alleged facts giving rise to a strong inference that the Officer Defendants were at least deliberately reckless in making misrepresentations as to loan quality, internal controls and various financial statements.
Judge Pregerson noted that "the confidential witness statements describe a staggering race-to-the-bottom of loan quality and underwriting standards," noting that "the witnesses catalog an explosive increase in risky loan product." The allegations
are sufficient to infer a deliberately reckless set of statements telling the public one thing when New Century was doing something quite different – the loans were poor, not great quality; the underwriting was all but absent, not strict; and the internal controls were slack rather than searching.
Judge Pregerson also found that the insider trading allegations supported his finding of the adequacy of the scienter allegations, as did the allegations regarding the defendants’ bonus and other compensation. In that regard, it is interesting to note that Judge Pregerson specifically observed with respect to the defendants’ trading plans that "the timing of the 10b5-1 plans, several years after they became available, at least raises the question precisely why there was a delay in creating these plans, and why they were formed during the Class Period."
Judge Pregerson also denied KPMG’s motion to dismiss. The firm had issued an audit opinion on the company’s 2005 financial statements. He found that the amended complaint adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion. He found that the allegations against KPMG adequately alleged scienter and loss causation.
Finally, Judge Pregerson concluded that the amended complaint adequately pled claims under Section 11 in connection with New Century’s securities offerings, including as to the Underwriter Defendants.
Discussion
Judge Pregerson’s opinion is another subprime-related securities lawsuit pleading-stage victory in favor of plaintiffs. The New Century opinion, together with the recent decision in the Countrywide case, undermine the suggestion (refer here) that plaintiffs may not be faring well in the subprime related litigation. These cases establish that in at least some instances, plaintiffs can satisfy the pleading requirements, notwithstanding the fact that the current financial crisis has affected virtually every company and every segment of the economy.
Moreover, both the New Century and the Countrywide opinions are sweeping and strongly worded. The potential for these cases to take on a collective power may be seen in Judge Pregerson’s own reference, in connection with the loan quality and underwriting standards allegations, to the conclusions in prior rulings in other cases. A developing body of judicial decisions potentially could take on a collective and persuasive weight that could affect other cases.
Judge Pregerson’s ruling with respect to KPMG is also noteworthy. His decision may have been influenced by the strongly worded findings in the New Century bankruptcy examiner’s report. But in any event, his willingness to permit the allegations as to KPMG to go forward may suggest the possibility that auditors could be targeted in at least some other subprime and credit crisis related cases.
One interesting note in the opinion is Judge Pregerson’s reference to the defendants’ trading pursuant to Rule 10b5-1 plans. As in the Countrywide case, Judge Pregerson found that the defendants’ use of the trading plans raised suspicions. Rule 10b5-1 was intended to provide a way for insiders to trade without liability concerns, yet, ironically perhaps, the defendants’ implementation of trading plans was in and of itself found in these cases to be grounds for suspicion. As I have noted elsewhere (here), Rule 10b5-1 plans can still be a good idea if properly implemented, but they clearly can be dangerous is not used properly.
A final observation about Judge Pregerson’s comments on the trading plans. There is an odd note in his consideration of the defendants’ plans. He referred, with suspicion, to the timing of the defendants’ adoption of plans "several years after they became available." This is a curious statement, as if he is suggesting that the very fact that the defendants decided to adopt a plan later is itself suspicious. These seems to me to be the very kind of circumstances in which there a host of alternative innocent inferences, including even the possibility that the defendant just didn’t get around to doing it for awhile. The suggestion that a belated adoption is suspicious would potentially bar anyone who has not already adopted a plan from doing so now, which obviously would undermine the Rule’s purposes of attempting to allow corporate officials to trade in company shares without liability concerns.
In any event, I have added the New Century decision to my table of subprime and credit crisis-related lawsuit dismissals and denials, which can be accessed here.
D&O Indemnification and Insurance: As the credit crisis litigation wave gains momentum, issues surrounding indemnification and insurance for directors and officers are becoming increasingly important. A December 3, 2008 memo by the Gibson, Dunn & Crutcher law firm entitled "Director and Officer Indemnification and Insurance in Turbulent Times" (here) takes a look at recent case law developments regarding indemnification and review the key issues concerning D&O insurance.
The memo provides a good summary overview of these issues. I note parenthetically that readers who may be interested in more detail regarding the specific items in the memo can refer back to this blog, where I have discussed at greater length each of the items discussed in the memo.
One particularly noteworthy observation in the memo is the statement with respect to D&O insurance that:
Due to the complexity of policy language and the issues involved, expert advice from qualified insurance and legal professionals can be important in obtaining a thorough understanding of the coverage available under a company’s D&O insurance program. A growing number of boards of directors are seeking comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, in connection with the purchase or renewal of D&O insurance coverage.
As suggested in the memo, I have also noted that more boards are now seeking outside reviews of their insurance, and that an increasing number of boards (and, in particular, independent directors) are interested in a review of their insurance independent from the company’s broker or regular outside counsel, whom boards apparently are concerned have their first loyalties to company management. I have in recent months taken on a number of assignments along these lines, and I am available to discuss these services for others who may be interested.