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 September 24, 2010 order (here), Southern District of New York William Pauley denied the dismissal motions of Sallie Mae and its former CEO, Albert Lord, but granted the dismissal motion of CFO (and later CEO), Charles Andrews, in the credit crisis-related securities suit against Sallie Mae first filed in 2008. The decision is interesting in a number of respects, particularly concerning scienter issues.

Sallie Mae is one of the country’s largest providers of student loans. The complaint, which Judge Pauley described as "a behemoth" containing "labyrinthine allegations," alleges that in a series of statements in 2007, the defendants misled the market about Sallie Mae’s financial performance for the purpose of inflating its share price.

Among other things, the company was attempting during this same period to complete a planned merger with J.C. Flowers, an investment firm, in a transaction that ultimately was not consummated and that resulted in separate litigation (later settled) between the company and Flowers.

The complaint alleges that during the class period, the company lowered its borrowing criteria to increase its portfolio of lower quality but higher margin private loans; hid defaults by changing its forbearance policy; and inflated profits through inadequate loan loss reserves. The defendants moved to dismiss. My prior post about the lawsuit can be found here.

In his September 24 order, Judge Pauley denied the motion to dismiss as to Lord and the company, but he granted the motion to dismissal as to Andrews.

Judge Pauley first concluded that the plaintiffs had adequately alleged falsity. The defendants had argued that the plaintiffs had not alleged particularized facts sufficient to establish the falsity of the loan loss reserves. However, Judge Pauley observed, the plaintiffs primary challenge to the accuracy reserves, made in reliance on the testimony of confidential witnesses, was that Sallie Mae had not accurately reported its loan default rate (which in turn led to insufficient loan loss reserves). Judge Pauley held that "given the error in the default rate metric and its impact on Sallie Mae’s other financial reports, such allegations are sufficient to plead falsity."

In concluding that the plaintiffs had adequately alleged scienter with respect to Lord and Sallie Mae, Judge Pauley noted three reasons on which plaintiffs relied which, "considered together," are "sufficiently concrete to give rise to an inference" that Lord and Sallie Mae "possessed the intent to defraud shareholders." The three reasons were the Flowers transaction, Lord’s stock sales, and certain equity forward contracts.

Judge Pauley found that Lord had financial incentives to try to complete the Flowers transaction, because upon completion of the deal he would have received a $225 million cash payment and been free to exercise options at above market prices. In addition, Judge Pauley found that, in order to keep merger prospects alive, Lord also had an incentive to keep the company’s share price above the trigger in its equity forward contracts, because had the price gone below the trigger, the company would have been required to repurchase about $2.2 billion in shares, which "would have torpedoed the merger and Lord’s payout."

Judge Pauley also found that Lord made "unusual" stock sales in February, August and December 2007. The December sales, which took place two days after the Flowers transaction collapsed, and which represented a "liquidation of 97% of his Sallie Mae holdings," were "unusual for a corporate officer by any measure."

Lord had offered explanations for his stock sales – the August sales allegedly "were necessary to pay the exercise price of expiring options and associated taxes" and the December sale was "necessary to satisfy a margin call" – but with respect to Lord’s exculpatory explanations, Judge Pauley said "these facts remain in dispute."

By contrast, Judge Pauley found that the allegation of scienter as to Andrews were insufficient. Andrews not only had sold no shares but the defendants alleged he had acquired shares.

Lord’s incentives to complete the Flowers transaction clearly influence Pauley’s decision. The insider sales alone seem less determinative, as the timing of his sales seemed less than profit maximizing. For example, his December sale, the one he contends was triggered by a margin call, came two days after the Flowers deal collapse). This sale seems inconsistent with the theory that it represented the culmination of a fraudulent scheme.

In other words, it was the presence of the unusual and case specific circumstance of the Flowers deal that in large part explains this case’s survival of the dismissal motions.

I have in any event added the Sallie Mae case to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

Special thanks to a loyal reader for providing a copy of the Sallie Mae opinion.

Behemoth and Labyrinth: When Judge Pauley described the plaintiffs’ complaint as a "behemoth," he was invoking a literary reference with rather startling associations. According to Wikepedia, the word "behemoth" first appeared in the book of Job, which says the following about the beast:

15 Behold now the behemoth that I have made with you; he eats grass like cattle.
¹⁶ Behold now his strength is in his loins and his power is in the navel of his belly.
¹⁷ His tail hardens like a cedar; the sinews of his thighs are knit together.
¹⁸ His limbs are as strong as copper, his bones as a load of iron.
¹⁹ His is the first of God's ways; [only] his Maker can draw His sword [against him].
²⁰ For the mountains bear food for him, and all the beasts of the field play there.
²¹ Does he lie under the shadows, in the cover of the reeds and the swamp
²² Do the shadows cover him as his shadow? Do the willows of the brook surround him?
²³ Behold, he plunders the river, and [he] does not harden; he trusts that he will draw the Jordan into his mouth.
²⁴ With His eyes He will take him; with snares He will puncture his nostrils.

Judge Pauley also described the plaintiffs’ allegations as "labyrinthine," presuamably in reference to the Labyrinth from Greek mythology. According to Wikipedia (here), the Labyrinth’s elaborate structure was "designed and built by the legendary artificer Daedalus for King Minos of Crete at Knossos. Its function was to hold the Minotaur, a creature that was half man and half bull and was eventually killed by the Athenian hero Theseus. Daedalus had made the Labyrinth so cunningly that he himself could barely escape it after he built it. Theseus was aided by Ariadne, who provided him with a skein of thread, literally the "clew", or "clue", so he could find his way out again."

Geez, no wonder the complaint survived the dismissal motion.

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In the latest ruling to address the pleading adequacy of a securities suit based on a financial institution’s loan loss reserve disclosures, a federal judge has found that the plaintiffs’ allegations in the SunTrust Trust Preferred Securities lawsuit were not sufficient to state a claim under the securities laws. Northern District of Georgia Judge William Duffey, Jr.’s September 10, 2010 decision (here) , which granted the defendants’ dismissal motions without prejudice, may be particularly noteworthy because it found that the plaintiffs’ allegations were not sufficient even to meet the ’33 Act’s pleading standard.

As discussed at greater length here, the complaint relates to SunTrust’s February 2008 offering of Trust Preferred Securities. The defendants include SunTrust and certain of its directors and officers, as well as the offering underwriters and SunTrust’s outside auditor.

The complaint alleges that the offering documents underestimated SunTrust’s allowance for loan and lease loss reserves (ALLL). The plaintiffs allege that the bank failed to disclose its mortgage-related exposures, and accurately account for losses in those assets and their impact on the bank’s liquidity and capital adequacy. The complaint alleges that as the housing market collapsed, SunTrust failed to increase its ALLL to account for the rise of non-performing loans from the fourth quarter of 2007 to through the end of 2008. The defendants moved to dismiss.

In his September 10 order, Judge Duffey noted that the plaintiff’s allegations depend on their assertion that after the offering, and after the housing market deteriorated further, SunTrust raised its ALLL. The plaintiff, Judge Duffey observed, “thus seeks to assert its Securities Act claims using a backward-looking assessment that interprets, in the context of later events, the statements that Plaintiff has identified” as misleading.

Moreover, whether SunTrust had adequate loan loss reserves “is not a matter of objective fact, but rather a statement of SunTrust’s opinion regarding what portion of its loan portfolio would be uncollectable.” Judge Duffey commented that “Plaintiff only asserts that Sun Trust’s opinion with respect to its loan reserves was ill-founded and proved so by a later course of events.”

Judge Duffey noted that the plaintiff does not allege that the defendants did not hold the opinion it expressed in the financial statements when they were issued, and that “absent an allegation that the Defendants did not believe the statements,” the plaintiff has not stated a claim for misstatements relating to the inadequacy of the loan reserves.

Judge Duffey added that while he would allow the plaintiff to attempt to replead its loan loss reserve allegations, it will have to meet the heightened pleading standards required if the amended complaint alleges that the defendants knowingly or recklessly cause material misstatements to be published. He added that in the current complaint the plaintiff “appears to be attempting to have it both ways, that is, disavowing a claim for fraud to avoid the need to meet the heightened pleading standard, at the same time suggesting that SunTrust’s stated opinion was false because SunTrust knew or should have known that it was undercapitalized.”

Judge Duffey also found that the allegations in the complaint “fails to provide minimal factual content” to meet the requirements of Twombly and Iqbal, noting that the complaint “offers, at most, conclusory assertions, including that SunTrust’s ALLL and loan loss provisions were understated, as evidenced by the fact that SunTrust subsequently raised these figures after the economic downturn.” This “hindsight assessment” does not support an inference that “SunTrust’s financial assessments were false or misleading at the time they were made.” (emphasis in original).

Judge Duffey also granted the underwriter defendants’ and auditor’s motions to dismiss.

Discussion

Prior decisions granting dismissal motion rulings in loan loss reserve cases have depended on the insufficiency of the complaint’s allegations relating to ’34 Act claims, particularly with respect to scienter. Refer, for example, to my recent post (here) discussing the dismissal of the loan loss reserve disclosure case involving Raymond James Financial.

The SunTrust Trust Preferred Securities case may be noteworthy because the loan loss reserve allegations were found to be insufficient event to satisfy the requirements for a ’33 Act claim, which do not have a scienter requirement. From Judge Duffey’s opinion, and his statement that the plaintiff may have been “trying to have it both ways,” the plaintiffs may have walked too fine of a line in trying avoid having their claims sound in fraud.

Judge Duffey’s firm rejection of what he interpreted as the plaintiff’s hindsight allegations is also interesting. The plaintiffs in many loan loss reserve cases will be fighting similar judicial impressions, especially to the extent that they plaintiffs cannot marshal facts suggesting that the defendants knew the loan loss reserves were insufficient.

Judge Duffey’s rejection of hindsight allegations may also be significant simply because of where his court is located. Georgia has been the leading state for bank failures since January 1, 2008, and many investors have filed actions alleging they were misled regarding the defendant bank’s financial conditions. To the extent Judge Duffey’s rejection of hindsight analysis reflects a larger sense of skepticism about alleged misrepresentations in the context of the subprime meltdown and global financial crisis, many of these investor actions could face an uphill battle.

In that regard, it is worth noting that Judge Duffey’s opinion follows the highly skeptical August 19, 2010 opinion of Judge Tom Thrash in the separate SunTrust subprime securities lawsuit, filed on behalf of SunTrust’s common shareholders. As discussed in a prior post, the opinion was particularly noteworthy for the harshness of the tone Judge Thrash used in dismissing the case. Though Judge Duffey’s opinion lacks the harsh tone, it seems to evince a similar level of skepticism.

Finally, it worth noting that the SunTrust Trust Preferred Securities case is one of numerous lawsuits filed amidst the subprime and credit crisis litigation wave that related to financial institutions’ trust preferred securities offerings, as discussed here. As noted in my prior post, many banks conducted these kinds of offerings in the years leading up to the financial crisis, and investors in these offerings have been active in seeking judicial relief following the meltdown.

I have in any event added Judge Duffey’s opinion to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be found here.

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In a recent post, I discussed several recent decisions in which securities cases involving failed or troubled banking institutions survived dismissal motions. By contrast, however, in an August 16, 2010 ruling (here), Southern District of New York Judge Robert Patterson, Jr. granted the defendants’ motion to dismiss without prejudice in the securities class action lawsuit filed against Raymond James Financial and certain of its directors and officers alleging inadequate disclosures regarding the company’s banking subsidiary’s loan loss reserves.

As discussed in greater detail here, plaintiffs first filed their action against Raymond James Financial in June 2009. The plaintiffs’ allegations center on the loan portfolio and loan loss reserves at the company’s banking subsidiary, Raymond James Bank. Judge Patterson stated in his August 16 opinion that, despite the length of the complaint (which "extreme length," Judge Patterson noted, provides "an independent ground for dismissal"), the plaintiff’s allegations "boil down to one proposition: that the Defendants purposefully underfunded their loan loss reserves and then made material misrepresentations about het adequacy of those loan loss reserves during the class period."

With one small exception, Judge Patterson concluded that the misrepresentations and omissions on which plaintiff seeks to rely are not actionable. For example, he concluded that the alleged misrepresentations about the bank’s loan loss reserves "are, without exception, general statements of optimism" which "in and of itself renders these statements inactionable."

Similarly, Judge Patterson concluded that the statements about the quality of the bank’s loan portfolio "were, similarly, very general and not sufficiently detailed to have misled investors" and "for the most part" represent "classic puffery."

The one exception to his conclusion that the statements on which the plaintiff sought to rely are not actionable were two paragraphs in the Amended Complaint relating to the quality of the loan portfolio. These statements included representations that the bank "independently underwrote" all loans, including loans "sourced from agent or syndicate banks." The Amended Complaint reference the testimony of a confidential witness who avers that many loans that were later charged off were not independently underwritten.

However, Judge Patterson also concluded that the plaintiff had not sufficiently alleged scienter. He concluded with respect to the plaintiffs’ scienter allegations that:

None of the allegations of scienter are sufficiently specific that they allow the Court to determine whether the Defendants knew (or even likely knew) that their statements were false when made. For the most part, the scienter allegations are of the sort that could be made about nearly any company operating in the United States, namely that the executives were motivated to create profit, that the executives received a near-constant stream of information about economic trends, and that the executives made mistakes in some of their forward-looking projections.

These allegations, Judge Patterson concluded, were insufficient to give rise to a strong inference that the defendants acted with the requisite state of mind.

Accordingly, Judge Patterson granted the defendants’ motions to dismiss, but he did so without prejudice.

I have added Judge Patterson’s opinion to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

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