Many of the subprime and credit crisis related securities lawsuits, particularly those filed in early in the subprime meltdown, involve subprime mortgage originators and financial institutions that pooled the mortgages into investment securities. A separate category of litigation distinct from that relating to originators and securitizers involves the companies that purchased the investment securities and that are alleged to have misrepresented the value of these assets on their balance sheet.
One company whose balance sheet exposure to toxic subprime mortgage backed assets resulting in securities litigation is the international money transfer and payment company MoneyGram International. Background regarding the MoneyGram securities lawsuit can be found here.
On May 20, 2009, District of Minnesota Judge David Doty issued a detailed opinion (here) substantially denying defendants’ motion to dismiss the plaintiff’s consolidated complaint in the MoneyGram case. Because many of the other credit crisis-related securities lawsuits contain allegations similar to the balance sheet toxic asset exposure allegations in the MoneyGram case, and because the parties’ arguments in the MoneyGram case reflect the battle lines that are likely to be drawn in many of these cases, Judge Doty’s opinion represents an interesting and potentially significant examination of the issues that may well recur in other cases.
MoneyGram’s global payment and money transfer business requires the company to hold, transfer or to guarantee payments of large amounts of cash. To secure these payments and guarantees, MoneyGram maintains an investment portfolio. At the beginning of the class period in January 2007, the majority of MoneyGram’s $5.85 billion portfolio was held in asset-backed securities, mortgage-backed securities and collateralized debt obligations, backed in part by residential mortgages.
By the end of the class period in January 2008, the value of the portfolio had significantly deteriorated. In order to be able to maintain adequate capital, the company entered a substantial financing transaction that forced the company to recognize over $1 billion in losses in its investment portfolio. The company’s share price declined nearly 50%, and securities litigation ensued.
The consolidated complaint alleges that during the class period, the defendants made a series of misleading statements regarding the composition, valuation and quality of the company’s investment portfolio, and about its investment valuation processes, standards and controls.
The May 20 Opinion
Judge Doty’s May 20 opinion undertakes a detailed and painstaking review of all of the parties’ arguments. However, after having detailed the parties’ positions, he then in a few efficient paragraphs reduces the parties’ positions to two "competing narratives," as reflected on pages 67-68 of the opinion.
The "defendants’ narrative," Judge Doty writes, "maintains that at the beginning of the class period the eventual scope of the market failure was unforeseeable," but as 2007 progressed and the market decline became apparent, "defendants maintain that they proactively disclosed additional sufficient details" about the investment portfolio and its susceptibility to further declines.
The defendants further assert that their "increased recognition of unrealized losses and [other than temporarily impaired] securities accurately tracked the actual market decline." They also allege that they "made disclosures in good faith as reflected by the absence of insider trading allegations and financial restatements," and therefore they argue it is "improper to impose liability for failure to presage the nation’s worst economic meltdown in decades."
The "plaintiff’s narrative," on the other hand, argues that by the beginning of the class period "external ‘red flags’ reflecting the failure of the subprime and Alt-A markets were so apparent that defendants knew or should have know" that the investment assets were substantially impaired and could not be reliably priced. Moreover, the plaintiffs contend, the defendants "selectively and misleadingly released information about the investment portfolio," misleading investors into believing that the general market decline did not threaten MoneyGram.
In the meantime, the plaintiff alleges, the defendants were exploring bankruptcy and recapitalization options that were not revealed to the investing public, and rejected buyout overtures "to prevent revelation of [the company’s] financial problems." The plaintiffs allege that the defendants failed to disclose these problems "for fear of the market’s reaction."
Judge Doty found that "despite the shortcomings of some of lead plaintiff’s additional allegations of scienter," considering all of the circumstances "and with particular emphasis on the alleged misrepresentations and omissions, a reasonable person could find lead plaintiff’s fraud narrative to be cogent and at least as plausible as defendants’ opposing fraud narrative."
In finding that the plaintiff adequately alleged that the defendants had made material misrepresentations or omission, Judge Doty found that "the complaint connects the external ‘red flags’ with the defendants’ internal recognition of the effect of those flags," without which connection the allegations "would fail as prohibited hindsight claims." The complaint does not merely assert that "later disclosures should have been made earlier or that later-determined facts show that earlier statements were false," but rather allege why the statements may have been false when made or the omission should have been made earlier in light of the then-existing facts. Therefore, although "extensive, repetitive and occasionally abstruse," the complaint adequately alleges the existence of material misrepresentations.
Judge Doty concluded that the complaint’s allegations were sufficient to survive the motion to dismiss, except as to one individual defendant.
In many ways, Judge Doty’s succinct presentation of the two competing narratives recapitulates the arguments that likely will be raised in many of the toxic asset balance sheet valuation securities cases that have been filed. The defendants will contend, as did the defendants in the MoneyGram case, that the plaintiffs’ allegations are simply fraud by hindsight, depending on later asset valuation declines or losses as supposed evidence of prior disclosure shortcomings.
Judge Doty’s opinion shows that in at least some instances plaintiffs will be able to overcome the fraud by hindsight "narrative." Significantly, Judge Doty found the plaintiffs’ narrative to be at least as compelling as the defendants, even in the absence of insider trading or a restatement.
To be sure, many aspects of Judge Doty’s ruling depend on specific allegations particular to this case. In particular, Judge Doty’s ruling on the scienter issue depended, for example, on allegations relative to a specific communication company officials had with an institutional investor in which defendants refused to disclose details of the company’s portfolio for fear the disclosures would be "disruptive," and on allegations that, contrary to the company’s public statements, the company’s securities were not of a higher quality and different vintage than those being downgraded by rating agencies.
Nevertheless, while Judge Doty’s ruling undeniably depended on factors specific to the case, the opinion does demonstrate that "fraud by hindsight" defenses may be overcome, a suggestion that is likely to hearten the plaintiffs in other cases. What seemed to matter, and what will likely matter in other cases involving toxic asset valuation disclosures, is not whether or not the company’s losses were greater than those of other companies, but rather what the company said or failed to say about its losses as they accumulated, as well as about the company’s exposure to losses before they occurred.
I have added the MoneyGram decision to my table of subprime and credit crisis settlements, dismissal and dismissal motion denials, which can be accessed here.
Securities Litigation and the Foreseeability of the Housing Decline: One of the critical issues imbedded in the MoneyGram case, and in many of the other cases in which plaintiffs seek to recover investment losses related to the subprime meltdown, is "the extent to which the downturn in the housing market and the resulting financial institutions’ writedowns and losses on securities with substantial real estate exposure was foreseeable earlier in time."
This question is examined in a May 6, 2009 paper entitled "Securities Litigation and the Housing Market Downturn" (here) written by Harvard Law Professor Allen Farrell and Atanu Saha of Compass Lexecon. The authors examined the question of foreseeability of the housing downturn (and related investment decline) beginning in 2006, as that is when the vast majority of class periods in the current wave of securities lawsuits begin, even though the bulk of the subprime investment writedowns took place in the fourth quarter of 2007 and the first quarter of 2008.
The authors posit that in order for disclosures prior to the massive writedowns to be actionable the possibility of these writedowns occurring had to be foreseeable. A company’s failure to disclose its exposure to certain asset valuation risks, or to create reserves for future losses on those assets, would be relevant only to extent it was foreseeable at the time of the disclosure that the valuation of the assets would decline. By the same token, the scienter element can only be established of senior managers’ actions were reckless in light of the foreseeable risks that the asset valuations would decline.
Based on their detailed review of housing price and interest rate data, the authors conclude that "there is little indication that the market was anticipating during the course of 2007 the serious market downturn that in fact occurred in the fourth quarter of that year." The authors conclude that "the evidence is consistent with the proposition that the serious housing market downturn was not generally foreseeable and was not foreseen by sophisticated market participants prior to the fourth quarter of 2007."
The authors’ paper provides substantial grist for the mill for litigants seeking to contend that class action plaintiffs’ securities lawsuit allegations constitute fraud by hindsight. Defendants can hardly be held liability for failing to anticipate or failing to disclose the risks of circumstances that not only were not foreseen but that were not foreseeable.
Unfortunately for defendants in these cases, these arguments may be unavailing. Very few of these cases ever go to trial; for most cases, the most critical stage is the determination of the dismissal motion. At the motion to dismiss stage, the plaintiffs’ allegations must be taken as true and the extensive factual data of the kind on which the authors rely is not considered or even relevant.
The presumption at the motion to dismiss stage that the plaintiffs’ allegations are true permits them to posit circumstances that might later prove to be demonstrably untrue. The authors’ paper may well establish that plaintiffs could struggle to prevail were they ever put to their proof. However, the name of the game for the plaintiffs is usually just to get past the dismissal motions, with the assumption that the case will settle long before the allegations are tested. It may not matter what the plaintiffs ultimately might be able to prove about forseeability; they are concerned rather only with what they can allege.
Special thanks to Kelly Rehyer for forwarding a link to the article.
A Reliable List of Tweeters: Within the world of Twitter are a few worthwhile notes dispersed in a deluge of noise. Filtering the notes from the noise requires identifying the tweeters worth following, a process that can be hit or miss. Fortunately, for those who want to identify reliable Twitter sources on securities litigation issues, Bruce Carton of the Securities Docket has developed a comprehensive list of the "15 People All Securities and Corporate Litigators Should Follow on Twitter" (here).
I commend Bruce’s list – I already follow everyone on Bruce’s list, and so I know it to be trustworthy and complete. Very special thanks to Bruce for including me in the company of illustrious tweeters.