The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a noteworthy subprime-related litigation development, on August 5, 2009, the parties to the Countrywide ERISA action filed a stipulation of settlement (here), together with a request for preliminary court approval. Under the stipulation, the case is to be settled by a payment of $55 million, to be funded entirely by Countrywide’s fiduciary liability insurers.

The plaintiffs first filed their complaint in September 2007. As reflected in the plaintiffs’ Corrected Second Amended Complaint (here), the case was brought on behalf of participants in the Countrywide benefits plan who made contributions to the plan between January 31, 2006 and July 1, 2008, and whose individual plan accounts were invested in Countrywide stock.

The plaintiffs’ complaint alleges that the plan fiduciaries "allowed the imprudent investment of the Plan’s assets in Countrywide’s equity," even though they knew or should have known that such investment was unduly risky," because of the company’s "serious mismanagement, highly improper and potentially unlawful business practices," particularly with respect to subprime loans. The plaintiffs alleged that the defendants breached their fiduciary duties to plan participants.

The Countrywide ERISA action joins the Merrill Lynch ERISA case as high profile subprime-related ERISA lawsuits that have resulted in significant settlements – as noted here, the Merrill Lynch ERISA action settled for $75 million. The Countrywide settlement may be particularly noteworthy given that the entire $55 million settlement amount is to be funded by the company’s fiduciary liability insurers. While the Countywide case may be particularly notorious, the ERISA action settlement size may represent an ominous sign for fiduciary liability insurers whose policyholders are involved in subprime-related ERISA litigation.

There have been a variety of estimates of the insurance industry’s overall prospective loss exposure due to the subprime meltdown and the credit crisis. Though the magnitude of many estimates is impressive, most of these estimates have largely been based on a series of conjectures about likely D&O and E&O losses. Potential fiduciary liability losses were not a prominent part of the calculation. But if the Countrywide ERISA action settlement is any indication, fiduciary liability insurance losses could prove to be a significant factor in the overall insurance industry exposure from the subprime and credit crisis events.

In any event, I have added the Countrywide ERISA action settlement to my roster of subprime and credit crisis-related lawsuit resolutions, which can be accessed here. The ERISA cases can be found in Section III of the roster.

State Street’s Subprime Litigation Contingency Reserve Too Small?: In a development that underscore both the massive scale of the subprime litigation exposure and the extent to which that exposure may largely be uninsured, on August 10, 2009 State Street Corporation filed its Form 10-Q (here), in which among other things the company reported that the approximately $625 million reserve it established in January 2008 (for the fourth quarter of 2007 reporting period) may not be sufficient in the event that regulators currently investigating the events were to bring an enforcement action. Details about the initial reserve can be found in a prior post, here.

State Street reports that as of June 30, 2009, $193 million of this initial reserve remains. But the filing goes on to note that on June 25, 2009, the SEC has served the company with a "Wells notice" and the SEC staff has recommended the initiation of enforcement proceedings. If the SEC or other regulators were to pursue enforcement actions, the report states, then, "depending upon the resolution of these governmental proceedings, the remainder of the reserve established in 2007 may not be sufficient to address ongoing litigation, as well as any such penalties or remedies."

The astonishing erosion of this massive reserve certainly highlights the expense involved in this type of litigation, and the company’s warning that the remaining reserve may not be sufficient, stresses the seeming boundlessness of the exposure. The fact that it is the company’s own reserve that is being eroded suggests that this exposure is largely or entirely uninsured, which shows that no matter how great the insurance industry’s exposure may be from the subprime and credit crisis-related litigation wave, the overall exposure, including uninsured liabilities and amounts, may be many multiples greater.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In its most significant enforcement action yet related to the subprime meltdown, on June 4, 2009, the SEC filed a civil securities fraud complaint (here) in the Central District of California against Angelo Mozilo, the former CEO of Countrywide Financial Corp., as well as the company’s former COO and CFO. The complaint alleges that the defendants mislead investors by misrepresenting the company’s loan origination standards and practices and by hiding the company’s deteriorating financial condition. The complaint also contains allegations of improper inside trading against Mozilo for initiating Rule 10b5-1 trading plans to sell shares while he was aware of material nonpublic information about the company’s deteriorating loan practices.

As discussed in its June 4, 2009 press release (here), the SEC’s complaint charges that from 2004 through 2007, Countrywide engaged in "an unprecedented expansion of its underwriting guidelines and was writing riskier and riskier loans, which these senior executives were warned might curtail the company’s ability to sell them" to investment bankers and other mortgage buyers.

The complaint alleges that while the company was issuing reassuring statements to investors, Mozilo "internally issued a series of increasingly dire assessments of the various Countrywide loan products and the risks to Countrywide in continuing to offer or hold these loans."

One of the more interesting aspects of the SEC’s press release about the suit is the accompanying document (here) in which the SEC summarizes email messages from Mozilo in which he delivered some of his "increasingly dire assessments." Among other things, an email attributed to Mozilo is quoted as saying that "we are flying blind on how these loans will perform in a stressed environment." Another email is also quoted as saying, with respect to the company’s subprime 80/20 loans, that "in all my years in the business I have never seen a more toxic prduct [sic]."

In other emails, Mozilo refers to the company’s 100% subprime second mortgages as "poison" and says that the 100% loan-to-value subprime mortgage is "the most dangerous product in existence and there can be nothing more toxic."

All of these statements attributed to Mozilo allegedly were made before Mozilo established several Rule 10b5-1 trading plans during the period October through December 2006. In December 2006 and February 2007, as the company’s share price was rising to record highs, he adjusted several previously established plans to allow him to sell even more shares. Pursuant to these plans and during the period November 2006 through August 2007, Mozilo exercised over 51 million stock options and sold the underlying shares for total proceeds of over $139 million.

Among other things, the complaint alleges that Mozilo approved his October 2006 trading plan one day after sending the email quoted above about "flying blind" on how the loans would perform. The complaint also alleges that five days before executing his December 2006 trading plan he circulated a memorandum to all managing directors and to the company’s board of directors noting a number of substantial concerns about the company’s subprime loan origination processes and noting that Countrywide expected its 2006 subprime loans to be the worst performing on record.

While many of these same kinds of allegations also appear in the pending Countrywide securities class action litigation (about which refer here), the SEC’s allegations nonetheless represent a significant development. SEC officials have been saying for over two years (as noted here, for example) that the agency would be cracking down on alleged Rule 10b5-1 trading plan abuses. Indeed, as discussed here, in an October 8, 2007 letter (here) to then-SEC Chairman Christopher Cox, North Carolina Treasurer Richard Moore had specifically asked the SEC to examine Mozilo’s stock trading pursuant to his Rule 10b5-1 plans.

With the SEC’s public commitment to cracking down on Rule 10b5-1 abuses and with the bull’s-eye drawn so specifically on Mozilo’s trading, it may have simply been a matter of time before some version of this complaint was filed. (Indeed, Alison Frankel’s June 4, 2009 American Lawyer article about the SEC’s complaint, which can be found here, is entitled "SEC (Finally) Charges Former Countrywide CEO Angelo Mozilo.") The SEC’s action nevertheless is a significant development, if for no other reason than the prominence of the company and of Angelo Mozilo and because of the nature and specifics of the allegations.

The more interesting question is the extent to which the SEC will be targeting other officials, whether for Rule 10b5-1 plan abuses or for disclosures relating to subprime loans and other lending practices. Given the continuing current public need to assign blame for the current crisis, the prospect for further enforcement activity in these areas seems likely.

Indeed, according to a June 4, 2009 Washington Post article (here), new SEC Chairman Mary Schapiro has specifically said that as part of her plan to try to rebuild the SEC’s tarnished reputation, she intends to step up enforcement efforts and to push cases related to the financial crisis. As a result, the Countrywide complaint may be only the first in a series of SEC enforcement actions designed to assign blame for the meltdown while also demonstrating that the SEC is "tough" again.

The World Was So Much Nicer Before Aggrieved Homeowners Had Access to Counseling Services:  Mozilo’s email practices got him in hot water even while he was still CEO of the company. In May 2008, Mozilo drew media attention (refer for example here) when he accidentally hit the "Reply" button rather than "Forward" after calling a homeowner’s plea for help "disgusting."

The borrower’s email had come from Daniel Bailey, a homeowner who was trying to stay in his home of 16 years. Bailey signed an adjustable rate mortgage and was told at the time that he could refinance after one year, before the payments became unaffordable. In drafting his note, Bailey had relied on suggested language from an Internet website that provided coaching services for troubled borrowers.

The email response Mozilo inadvertently sent Bailey said "Most of these letters now have the same wording. Obviously they are being counseled by some other person or by the Internet. Disgusting."

Mozilo seems to have had a deep commitment to ensuring that he would later look like a cartoon villain. I mean, here’s a guy who had just made a cool $140 million, yet when one of the suckers stuck with one of the loans that Mozilo himself described as "toxic" has the audacity to ask for relief, all Mozilo can think about is how "disgusting" it is that all of the losers stuck with these loans have the same grievances.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

We interrupt our regularly scheduled stream of dispatches from the credit crisis front to provide a quick update on the now seemingly remote options backdating scandal. Even though the whole world has moved on and though options backdating pales by comparison to what followed, many options backdating cases continue to grind on. At least a couple of these cases recently settled, and there appear to be many more yet to come.

First, on December 11, 2008, Amkor Technologies announced (here) that it had reached an agreement to settle the option backdating-related securities class action lawsuit that had been filed against the company and certain of its current and former directors and officers in connection with the company’s historical stock option practices. Background regarding the lawsuit can be found here.

According to the company’s press release, the plaintiffs have agreed to dismiss the case in exchange for a payment of $11.25 million. The company said that its directors and officers liability insurance carrier has agreed to pay $9 million of the settlement amount and the company will pay the balance.

Second, and also on December 11, 2008, the parties to the options backdating-related shareholders’ derivative suit filed against Foundry Networks, as nominal defendant, and certain of its directors and officers, filed a notice of a proposed settlement (here). According to the parties’ filing, the company will receive cash payments of $2.117 million, of which $1.637 represents payments from the individual defendants and $400,000 represents payments from the company’s insurer. Certain shares granted to certain individuals have been repriced and the company also agreed to certain governance changes. The company also agreed to pay plaintiffs’ attorney’s fees and expenses of $1.2 million.

I have added these two settlements to my running table of options backdating-related lawsuit settlements, dismissals and motion denials, which can be accessed here. The Amkor settlement is, by my count, the sixteenth options backdating-related securities lawsuit settlement, and approximately six of the cases were also dismissed. Given that there were according to my count (refer here) 39 options backdating-related securities lawsuits filed in total, there still may be as many as 17 of these cases yet to be resolved.

The individuals’ cash contribution toward the Foundry Networks settlement, if not indemnified, would represent an unexpected element, as it remains an unusual settlement element for directors and officers to make cash settlement contributions out of their own assets.

OK, enough about that. We now resume our regularly scheduled programming, which is already in progress.

California Countrywide Subprime-Related Derivative Case Dismissed: In a December 11, 2008 order (here), Judge Mariana Pfaelzer dismissed the Countrywide subprime-related derivative case pending in the Central District of California.

Judge Pfaelzer previously had denied the defendants’ motion to dismiss the derivative case, in a strongly worded May 2008 opinion (about which refer here). However, in July 2008, Bank of America acquired Countrywide in a stock for stock merger. As a result, and as discussed here, in October 2008, the Delaware federal court dismissed the parallel Countrywide subprime-related derivative case pending in that court, because of the plaintiffs’ lack of standing to pursue the claim owing to the plaintiffs’ inability to show "continuous ownership" due to the BoA transaction.

The plaintiffs in the California Countrywide subprime-related derivative case argued that, notwithstanding the merger, they could still satisfy the "continuous ownership" rule and therefore still had standing based on a merger-related exception to the rule recognized in the Ninth Circuit. After detailed consideration of Erie Doctrine issues, Judge Pfalzer declined to exercise equitable powers associated with the merger-related exception, and granted the defendants’ motions to dismiss the derivative claims due to the plaintiffs’ lack of standing.

Judge Pfaelzer’s ruling on the derivative claims was without effect on the plaintiffs’ merger related class claims, which she previously had stayed in favor of parallel proceedings pending in Delaware Chancery Court. In addition, the Countrywide subprime-related securities class action lawsuit remains pending before Judge Pfaelzer, as a result of her recent dismiss motion denial in that case, discussed here.

In any event, I have added the dismissal of the California Countrywide Derivative lawsuit to my list of subprime lawsuit settlements, dismissals and motions denials, which can be accessed here.

Special thanks to Michael Delhegan of the Tressler Soderstrom firm for providing a copy of Judge Pfalzer’s December 11, 2008 opinion.

Standalone Insurance for Independent Directors: In prior posts (most recently here), I have noted the considerations that may militate in favor of standalone insurance protection for independent directors. In a December 12, 2008 memorandum entitled "Independent Directors Require Additional Protection in Financial Crisis Litigation" (here), the Baker & McKenzie firm suggests that "there is an increasing interest by independent directors in coverage that protects only a company’s independent or outside directors, not its officers."

The memo reviews the origins of IDL insurance and examines why "it may be a useful tool for both attracting high quality independent directors, and as a means of protecting and retaining the best talent." Among other reasons suggesting the need for IDL protection is the increasing susceptibility of traditional D&O insurance limits to erosion or depletion through defense expense or indemnity protection for other persons insured under the D&O policy, a phenomenon on which I previously commented here.

More About the NY Insurance Commissioner’s Recent Opinion: In a recent post (here), I commented on the recent opinion of the New York Insurance Commissioner’s office requiring D&O insurance policies to incorporate a duty to defend. The opinion and its implications are reviewed at greater length in a December 2008 Client Advisory from the Edwards, Angell, Palmer & Dodge law firm entitled "The New York Insurance Department Will No Longer Approve D&O Policies Lacking ‘Duty-to-Defend’Coverage Feature" (here).

This memo contains a detailed analysis of the opinion and raises a number of important considerations about what the opinion does and does not mean. The memo also notes difficulties that carriers may face as the attempt to adapt to the opinion, and also suggests alternative responses available to the carriers, including seeking legislative relief.

Special thanks to John McCarrick of the Edwards Angell firm for sending along a copy of the memo.

And Finally: By far the best thing I have seen written on the Madoff scandal is the column that Wayne State Law Prof. Peter Henning wrote as a guest column on the DealBook blog, here.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On December 1, 2008, in a massive, detailed 112-page opinion (in three parts, here, here and here), Central District of California District Judge Mariana R. Pfaelzer substantially denied the defendants’ motions to dismiss the Countrywide subprime-related securities class action lawsuit.

Background regarding the case can be found here. The consolidated amended complaint can be found here.

Judge Pfaelzer’s ruling did dismiss with prejudice the plaintiffs’ claims against Grant Thornton, and also dismissed with prejudice allegations concerning certain alleged 2003 accounting misstatements as well as other specific alleged misstatements. Judge Pfaelzer also dismissed with leave to amend certain allegations as to certain defendants, but otherwise, and in substantial part, the motions were denied.

In certain respects, Judge Pfaelzer’s opinion may come as little surprise, as she wrote the lengthy May 2008 opinion denying the motion to dismiss in the separate California-based Countrywide subprime-related derivative lawsuit (about which refer here). Indeed, in her December 1 opinion in the securities lawsuit, Judge Pfaelzer even quotes her prior opinion in the derivative lawsuit.

If Judge Pfaelzer did not tip her hand about her views of the securities case in her prior opinion in the derivative case, she certainly did in the opening overview section of the December 1 opinion, in which she stated that the amended complaint’s allegations.

present the 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.

As an illustration, she notes that "descriptions such as ‘high quality’ are generally not actionable"; however, in this case, the amended complaint "adequately alleges that Countrywide’s practices so departed from its public statements that even ‘high quality’ became materially false and misleading" and "to apply the puffery rule to such allegations would deny that ‘high quality’ has any meaning."

Judge Pfaelzer’s view of the case may also be seen from her response to defendants’ arguments that allegations of falsity after the third quarter of 2007 should be barred because by that time the company was "forced to admit the poor quality of the mortgage loans." Judge Pfaelzer states that this argument "borders on the frivolous" because the 3Q07 disclosures "failed to correct all misrepresentations" but instead "the truth only gradually leaked."

That is not to say that Judge Pfaelzer is complimentary of the plaintiff’s pleading; to the contrary, she states that she "would have appreciated a complaint that is more concise, less redundant and better organized." She also noted that she "has little patience for excess – and 416 pages is excessive."

Having set the stage, Judge Pfaelzer then proceeded to undertake a painstaking review of each of the defendants’ dismissal grounds, substantially rejecting most of them.

Among her other noteworthy observations, and one that may reverberate in other subprime cases, is one she makes in connection with the defendants’ arguments based on market forces. Defendants in this case, as in many of the subprime cases, sought to argue that the company’s woes were largely due to marketwide forces. As Judge Pfaelzer put it, "for the past year, almost all defendants have recited…that an ‘unprecedented’ external ‘liquidity crisis’ caused all (or most) of Countrywide’s decline."

Judge Pfaelzer noted that Countrywide’s shares declined only as the company’s deteriorating underwriting standards came to light, though "Countrywide held itself out for a long while as situated differently than from other subprime lenders" and "concurrently with corrective disclosures" made "continued misrepresentations and omissions" into early 2008.

It is true, Judge Pfaelzer notes, that "the domestic market shifts will raise complicated questions on damages." But, she also notes by the same token, the amended complaint raises the "inference" that the company’s deteriorating lending standards "were causally linked to at least some of the macroeconomic shifts of the past year." In any event, she concludes that at this stage the issue is whether the alleged violations caused a loss, not how much of the loss the violations proximately caused.

With respect to the amended complaints Rule 10b-5 allegations, Judge Pfaelzer’s opinion concludes that the 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."

In concluding that the amended complaint adequately alleges scienter, Judge Pfaelzer relies in large part on the allegations of insider trading as well as allegations concerning the individual defendants’ respective positions of responsibility combined with their access to detailed underwriting information. Her analysis of the scienter issues relies heavily on her prior analysis of scienter in her May 2008 opinion in the Countrywide subprime-related derivative suit, and indeed, she repeatedly cites and even quotes her prior opinion.

In connection with the insider trading allegations, Judge Pfaelzer placed particular emphasis on the coincidence of the insiders’ sales with the company’s initiation of a share repurchase program financed with outside capital. The inference is that the company was raising funds to buy shares to keep the share price up so that the insiders could sell profitably.

She also specifically noted (as she did in her prior opinion in the derivative case) that former CEO Angelo Mozillo was increasing his sales, and even modifying his Rule 10b5-1 trading plan to facilitate further sales, as the company increased its share repurchases. She repeated her conclusion from the derivative suit that these actions defeat the very purpose of Rule 10b5-1 plans.

Based on the stock sales and the individuals’ positions within the company she concluded that there were no plausible innocent inferences (except to the extent that some of the chronologically earlier allegations involve periods prior to which certain individuals could have learned particularized information).

Finally, with respect to the loss causation issue, Judge Pfaelzer concluded that the amended complaint did not fail to establish loss causation merely because the corrective disclosures and the resulting stock declines were piecemeal. Citing the Ninth Circuit’s decision from earlier this year in the Gilead case (about which refer here), Judge Pfaelzer concluded that "loss causation is not precluded by a series of disclosures; serial disclosures just make it more difficult for plaintiffs as a practical matter."

In its overall effect, Judge Pfaelzer’s December 1 opinion is a substantial rebuttal to the suggestion I raised in an earlier post (here) that plaintiffs may not be faring well in the subprime cases. At a minimum, the opinion establishes that certain cases will survive preliminary motions and that the overall economic decline is, in and of itself, not a barrier to the assertion of securities violations, at least in certain cases.

The December 1 opinion may also be of in connection with attempts to hold companies’ auditors responsible for subprime problems. Though Judge Pfaelzer did allow the plaintiffs leave to amend their allegations against KPMG, her analysis in this opinion suggests that plaintiffs could well have difficulty presenting allegations that withstand scrutiny. Her analysis of the allegations against KPMG could have significance in connection with attempts in other subprime cases to hold auditors responsible. (Her dismissal of Grant Thornton is less relevant, as the dismissal largely relates to the firm’s early and limited involvement in the events described in the complaint.)

In any event, I have added Judge Pfaelzer’s opinion to my table of subprime case dispositions, which can be found here.

One final note, as I discussed here, in October 2008, the Delaware federal court dismissed the Delaware-based Countrywide subprime-related derivative lawsuit, due to the plaintiff’s lack of standing to pursue the case following Bank of America’s acquisition of Countrywide. It appears that the Delaware court’s decision had no impact of any kind on Judge Pfaelzer’s consideration of the motions to dismiss in the Countrywide securities suit.

Special thanks to a loyal reader for alerting me to the December 1 opinion.

• Email This
• Print
• Comments
• Trackbacks (2)
• Share Link

On October 7, 2008, in a decision that could affect other litigation relation to Countrywide Financial, Judge Sue Robinson dismissed the consolidated shareholders’ derivative lawsuit pending in Delaware federal court against the company, as nominal defendants, and ten of its former directors and officers. A copy of the October 7 opinion can be found here.

The plaintiffs in the Delaware federal court derivative lawsuit had alleged that the individual defendants had violated the federal securities laws’ disclosure requirements, and also had committed state law violations of breach of contract and breach of fiduciary duty. As Judge Robinson noted in her October 7 opinion, the plaintiffs’ "most serious allegation" was that the defendants caused Countrywide to repurchase $2.37 billion worth of the company’s common stock "concomitant to the sale of $373 million worth of shares personally owned by members of the Board who were in possession of non-public, materially adverse information."

The defendants had moved to dismiss the amended complaint based, among other things, on the plaintiffs’ failure to make demand on the Board prior to the filing of the lawsuit.

However, on January 11, 2008, Countrywide and Bank of America announced that Bank of America was acquiring Countrywide in a stock for stock transaction. Bank of American’s press release announcing the merger can be found here. On July 1, 2008, the merger closed and all outstanding shares of Countrywide were exchanged for Bank of America shares. Banks of America’s July 1, 2008 press release can be found here. Countrywide became a wholly owned subsidiary of Bank of America.

Defendants thereafter filed a further motion to dismiss, arguing that as a result of the merger, the plaintiffs were no longer Countrywide shareholders and therefore lacked standing to pursue the derivative lawsuit.

Judge Robinson granted the defendants’ motion, stating that "the Delaware Supreme Court has unequivocally declared that plaintiffs in derivative suits lose standing post-merger."

Notwithstanding several creative arguments plaintiffs raised trying to avert this outcome, Judge Robinson’s decision is unremarkable given Delaware law on the issue. The more interesting question is the impact Judge Robinson’s ruling may have on the other pending Countrywide litigation.

The most immediate impact may be on the Countrywide derivative lawsuit pending before Judge Mariana Pfaelzer in the Central District of California. Readers may recall that on May 14, 2008, Judge Pfaelzer issued a blistering opinion in that case largely denying the defendants’ motion to dismiss and granting plaintiffs leave to file an amended complaint regarding the few portions of the case that were dismissed. My prior post discussing Judge Pfaelzer’s opinion can be found here.

Among other thing, Judge Pfaelzer said in her May 14 opinion that plaintiffs’ allegations in that case 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 process."

The defendants in the California derivative litigation have now moved for judgment on the pleadings based on the same lack of standing argument that the defendants in the Delaware lawsuit had raised. Indeed, the parties in the California derivative litigation have already filed competing pleadings (here) with respect to the dismissal of the Delaware action. In view of the nature and tone of Judge Pfaelzer’s May 14 opinion in the case, it will be interesting to see whether she follows Judge Robinson’s ruling on post-merger lack of standing.

An even more interesting question is what effect, if any, these developments will have on the consolidated Countrywide subprime securities litigation, which is also pending before Judge Pfaelzer (and about which refer here). The Bank of America acquisition of Countrywide should have no impact on the standing of the securities class action plaintiffs. However, outcome of the dismissal motions in the California derivative litigation potentially could affect the context within which Judge Pfaelzer considers the motions to dismiss in the securities litigation, especially given the strong views Judge Pfaelzer previously expressed in her prior derivative lawsuit dismissal denial.

Oral argument on the pending securities litigation dismissal motions is upcoming.

Very special thanks to a loyal reader for providing copies of Judge Robinson’s October 7 opinion and related pleadings.

You Could Put ‘em on a List: I have added the Countrywide Delaware Derivative lawsuit dismissal to my table of subprime and credit crisis-related securities and derivative lawsuit case dispositions, which can be accessed here.

A Sign of the Times: In connection with a school assignment, my son conducted a census of Obama and McCain lawn signs in our community. He found that the sign that appeared on the highest number of front lawns said "For Sale." 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

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.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link