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

On May 18, 2011, the California Intermediate Court of Appeals held in the Luther v. Countrywide Financial Corporation case that state courts have concurrent jurisdiction with federal courts to hear liability lawsuits under the Securities Act of 1933, and that more recent legislative enactments did not eliminate the concurrent state court jurisdiction for the plaintiffs’ ’33 Act claims.

 I suspect that those of you who, like The D&O Diary, have been following the Luther case are going to say – wait a minute, didn’t the Ninth Circuit decide that very issue in that same case several years ago? Alas, it is not so simple, nor so straightforward.

For those of you who have not been following the Luther case, here’s the background. The claims are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The securities were registered but not listed on any national exchange. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.  The plaintiffs do not assert any state law claims. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The defendants, in reliance on the Class Action Fairness Act of 2005, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court. As discussed here, on February 28, 2008, Central District of California Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that the removal bar in Section 22(a) of the ’33 Act trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that Class Action Fairness Act, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”  

And with that it seemed, and I so concluded at the time, that what would happen next is that the Luther case would go forward in state court.

But that is not exactly what happened. As reflected in the May 18, 2011 opinion of the California Court of Appeal in the Luther case  when the case returned to state court, the defendants filed a demurrer on the ground that the California state court lacked jurisdiction under the ’33 Act as amended by the Securities Litigation Uniform Standards Act (SLUSA). The trial court agreed with the defendants and sustained their demurrer. The plaintiffs appealed.

Before getting to the Court of Appeals ruling, it is worth pausing to review the grounds on which the defendants had demurred. The defendants’ argument was based on the language of Section 22 of the ’33 Act, as amended by SLUSA, which provides in pertinent part:

The district courts of the United States and the United States courts of any Territory shall have jurisdiction of offenses and violations under this title and under the rules and regulations promulgated by the Commission in respect thereto, and, concurrent with State and Territorial courts, except as provided in section 16 with respect to covered class actions, of all suits in equity and actions at law brought to enforce any liability or duty created by this title.

The defendants’ argument is based on the phrase “except as provided in Section 16 with respect to covered class actions” which was added under SLUSA. The parties do not dispute that this case is a “covered class action” within the meaning of SLUSA (as it involves a suit in which damages are sought on behalf of more than 50 people). The question is whether the “except as provided” creates an exception to concurrent jurisdiction for all covered class action or only “as provided” in Section 16.

In the May 18 opinion, a three-judge panel of the Court of Appeals reversed the trial court’s ruling, concluding that SLUSA did not eliminate the concurrent state court jurisdiction in Section 22 of the ’33 Act. Specifically, Court of Appeals concluded that the “except as provided” language did not create an exception to concurrent provisions for all covered class action, but only according to the terms of Section 16. Based on its review of Section 16, the Court of Appeals concluded that “nothing” in Section 16 ”puts this case into the exception to the rule of concurrent jurisdiction,” adding that “the fact that the case is not precluded and can be maintained, but cannot be removed to federal court if filed in state court, tells us that the state court has jurisdiction to hear this action.” The Court of Appeal concluded that the concurrent state court jurisdiction survived the SLUSA amendments.

So, now we can all agree, there is concurrent state court jurisdiction for securities class action lawsuits under the ’33 Act, right? Well, maybe. Or maybe not.

For starters, other Circuit courts have not agreed with the Ninth Circuit’s conclusions regarding the impact of CAFA on the ’33 Act’s concurrent jurisdiction provision. As noted here, in a 2009 opinion in Katz v. Gerardi , the Seventh Circuit held here the provisions of the more recently enacted statutes, particularly CAFA, trump Section 22. The Seventh Circuit expressly rejected Luther v. Countrywide’s conclusion that the more specific securities statute prevailed. However, the Seventh Circuit’s  opinion, depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions. The Seventh Circuit held that the underlying mortgage securities-related class action lawsuit was properly removable to federal court.

Similarly, an October 2008 decision in the Second Circuit in the New Jersey Carpenters’ Fund v. Harborview Mortgage case had refused to remand to state court a ’33 Act case, as is more fully discussed on the 10b-5 Daily blog (here). The Harborview decision was primarily based on the fact that the underlying securities lawsuit did not involve "covered securities" for which SLUSA created an explicit removal exception; because the exception did not apply, the case could appropriately be removed to federal court notwithstanding the nonremoval provision in Section 22.

The Seventh Circuit’s  opinion, like the Second Circuit opinion in Harborview, depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions. Of course that was also the case with the securities in Luther – so where does that leave us?

I suppose where that leave us is that if you are a plaintiff hoping to pursue a ’33 Act claim in state court, your best bet is to file the lawsuit in California stat court. That is, in fact, exactly what the plaintiffs involved in a mortgage securities class action lawsuit filed against Morgan Stanley did. As discussed here, even though the plaintiff is a Mississippi pension fund and the defendant is a New York investment bank, the plaintiff filed lawsuit in Orange County, California, superior court. Clearly, at least one plaintiff concluded that, if there is a tactical advantage to being in state court, then California state court is the place to be.

To be sure, it is not as if pursuing a state court claim has proven to be all that rewarding for the Luther plaintiffs, at least not so far. The Luther plaintiffs filed their lawsuit years ago, they have been through not one but two appeals already, and they have only just now finally established their right to proceed in state court. Or, perhaps not. Who knows, maybe the next stop for this case is in California Supreme Court, And perhaps from there to the U.S. Supreme Court. The parties could be fighting for years before the jurisdictional question is finally decided.

There does seem to be something wrong with a system where what “concurrent jurisdiction” between state and federal courts winds up meaning concurrent jurisdiction in some states but not others. With everything that Congress has to worry about these days, this issue may not make it to the top of the list, but this really does seem like something that Congress ought to clean up. Regardless of where you come down on this issue, there seems to be a lot for both sides to argue about when it comes to concurrent jurisdiction, which is hardly a desirable state of affairs.

Nate Raymond's May 19, 2011 Am Law Litigation Daily artilcle about the California appellate decision in the Luther case can be found here.

Special thanks to the several readers who sent me copies of the California appellate opinion.

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Among the many cases filed as part of the subprime litigation wave are the numerous cases filed on behalf of holders of mortgage-backed securities against the firms that issued the securities. In many of these cases, the plaintiffs have not alleged that they have failed to receive payments due under the securities, but rather they have alleged that their investments have declined in value or are now riskier than when purchased.

As these cases accumulated in 2008 and 2009, observers questioned whether these investors’ claimed harms represented injuries cognizable under the federal securities laws, as I discussed in an earlier post.

In an October 14, 2010 decision (here), Southern District of New York Judge Miriam Goldman Cedarbaum held in a case filed on behalf of holders of certain asset-backed certificates issued by Goldman Sachs-related entities that, where the holders had not alleged that they had failed to receive payments due under the certificates, they had failed to allege injuries cognizable under the federal securities laws.

The investors had purchased the asset-backed certificates in 2007 offerings. The certificates entitled the holders to monthly distributions of interest, principal or both. The offering documents for the certificates warned investors that the offering underwriters "cannot assure you that a secondary market" for the securities will exist, and "consequently, you may not be able to sell your certificates readily or at prices that will enable you to realize your desired yield."

In its amended complaint, the plaintiff did not allege that it had failed to receive the monthly distributions. The harm the plaintiff claimed is that a hypothetical sale in the secondary market at the time of the suit "would have netted, at most, between 35 and 45 cents on the dollar." The plaintiff also claimed that it is exposed to "much more risk than the Offering Documents represented with respect to both the timing and absolute cash flow to be received."

In her October 14 ruling, Judge Cedarbaum noted that at a prior hearing she had previously denied the defendants’ motion to dismiss the plaintiffs’ claims based on Section 12 (a) (2) of the ’33 Act. However, she granted the defendants’ motion to dismiss plaintiffs’ Section 11 claims, holding that the plaintiffs alleged injuries were insufficient to state a claim.

In rejecting the sufficiency of plaintiff’s argument that that their certificates would have a diminished value in a hypothetical sale, Judge Cedarbaum noted that "the Certificates were issued with the express warning that they might be resalable." She concluded that because the plaintiff "made an investment that it knew might not be liquid, it may not allege injury based upon the hypothetical price of the Certificates on a secondary market at the time of the suit." She noted further that the complaint failed to allege that a secondary market for the certificates "actually exists" and also failed to allege "any facts regarding the actual market price" for the certificates at the time of the suit.

Judge Cedarbaum also rejected the sufficiency of the plaintiff’s allegations about the increased risk of diminished cash flow in the future, not that "Section 11 does not permit recovery for increased risk." She said that "to allege an injury cognizable under Section 11," the plaintiff must "allege the actual failure to receive payments due under the Certificates," adding that though the plaintiff has "had three opportunities to amend its complaint, it has never made the allegation."

Discussion

As far as I am aware, Judge Cederbaum’s ruling is the first in which mortgage-backed investors’ Section 11 claims have been dismissed for lack of cognizable injury based on a failure to allege that payments due under the securities had been terminated or interrupted. There were quite a few of these mortgage-backed securities lawsuits filed during 2008 and 2009, and Judge Cedarbaum’s decision potentially could be quite significant in these other cases, at least where the investors have not alleged that payments due under the instruments have failed.

One aspect of this decision is the presence in these instruments’ offering documents of precautionary language warning about the potential unavailability of a secondary market for the instruments. Investors in instruments with offering documents that lacked this precautionary language may still be able to try to argue establish a cognizable injury based on the diminished resale value of the securities. However, those other claimants would also have to be able to allege that there actually is a secondary market for their securities and will have to allege what the resale price would be in order to allege injury sufficiently.

In any event, Judge Cedarbaum’s ruling potentially could be sufficient in many of the other securities suits that mortgage-backed asset investors filed in 2008 and 2009.

Special thanks to Doug Henkin of the Milbank Tweed law firm for providing a copy of Judge Cedarbaum’s opinion. Doug is the co-author of a paper I cited in my earlier post raising the question of whether mortgage-backed asset investors would be able to satisfy the requirements under Section 11 to allege a cognizable injury. An updated version of the paper can be found here.

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

A Securities Litigator’s Guide to D&O Insurance: Readers of this blog may be interested to know about two articles written by Jack Cinquegrana and John R. Barankiak Jr. of the Choate Hall law firm. The articles, which can be found here, are entitled "A Securities Litigator’s Guide to D&O Insurance," provide a brief overview of D&O insurance basics and also discusses issues that frequently arise concerning payment of defense costs and settlements. The articles are relatively short but contain some interesting observations and comments.

Sorry: My blog hosting service experienced a variety of service outages and problems on Monday. Readers may have experienced delays in receiving email notifications and difficulty in accessing the most recently added content. I am assured the problems have been addressed. I apologize for the inconveniences yesterday.

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On July 12, 2010, in one of the more high-profile investor actions filed as part of the subprime securities litigation wave, Southern District of New York Judge Sidney Stein substantially denied in part the defendants’ motions to dismiss in the Citigroup Bond Litigation. A copy of the opinion can be found here.

As detailed in greater detail here, Citigroup bondholders first filed their suits in September 2008 in connection with 48 different Citigroup bond offerings in which Citigroup raised over $71 billion between May 2006 and August 2008. (The first of these cases was filed in New York state court but later removed to federal court.) The defendants include the company itself and related corporate entities, as well 28 current or former Citigroup directors and officers and nearly eighty investment banks that served as offering underwriters in the bond offerings.

The plaintiffs, who purchased bonds in some of the offerings, alleged that the defendants had violated sections 11, 12 and 15 of the Securities Act of 1933 by failed to truthfully and fully disclose in the bond offering documents information concerning the company’s exposure to "toxic mortgage-linked documents."

Specifically, the plaintiffs alleged that Citigroup had failed to disclose Citigroup’s exposure to $66 billion worth of CDOs backed by subprime mortgage assets; Citigroup’s exposure to $100 billion in structured investment vehicles backed by subprime mortgage assets; that Citigroup "materially understated reserves" held for residential loan losses; Citigroup’s exposure to $11 billion of auction rate securities; that as result of these exposures, Citigroup was not, contrary to its representations, "well capitalized" and in fact required a massive government bailout.

In his July 12 order, Judge Stein first held that the plaintiffs had standing to assert claims in connection with all of the 48 offerings, even though plaintiffs had not purchased bonds in all offerings. Because the offerings were based common shelf registration document containing at least some common information, he found that the plaintiffs have standing to assert claims common to all purchasers.

But while he found that the plaintiffs has standing to assert Section 11 claims, he granted the defendants’ motions to dismiss the plaintiffs’ Section 12 for lack of standing, based on the insufficiency of plaintiffs’ allegations about whom the plaintiffs bought their investments from.

The centerpiece of the defendants’ dismissal motions was their argument that the plaintiffs had failed to allege any actionable misstatement or omission. Judge Stein found that that the plaintiffs’ had adequately alleged misrepresentation or omission as to Citigroup’s CDO exposure; with respect to plaintiffs’ allegations about Citigroup’s SIV exposure, at least with respect to statements made after those exposures were consolidated on Citigroup’s balance sheet; plaintiffs’ allegations about the adequacy of Citigroup’s residential mortgage loan loss reserves; with respect to Citigroup’s statements about the adequacy of its capitalization; and with respect to Citigroup’s statements that its financials were GAAP compliant.

However, Judge Stein also found that the plaintiffs had not sufficiently alleged misrepresentation or omission in connection with their allegations concerning Citigroup’s SIV exposure, at least those made prior to the consolidation of the SIV assets onto Citigroup’s financial statements; and about Citigroup’s exposure to auction rate securities.

Thus while a portion of plaintiffs’ claims did not survive defendants’ dismissal motions, a substantial portion of plaintiffs’ case will be going forward.

Both because of Citigroup’s prominence and because of the sheer magnitude of dollars involved in this case, this is a high profile decision. Though there is definitely a school of thought that defendants are faring better on the subprime securities cases in general, the plaintiffs are still managing to get some cases past the initial pleading hurdles, particularly in many of the highest profile cases (e.g., Countrywide, New Century, Washington Mutual, etc.).

In addition, Judge Stein’s decision in the Citigroup Bondholders case is the latest of several recent rulings in subprime related securities cases in the Southern District of New York that have favored the plaintiffs, including the recent decisions in the Ambac Financial subprime related case (about which refer here) and in the CIT Group subprime related securities case (about which refer here).

I have in any event added the July 12 decision in the Citigroup Bondholders’ suit to my running tally of subprime related securities class action lawsuit dismissal motion ruling, which can be accessed here.

Andrew Longstreth’s July 12, 2010 Am Law Litigation Daily article about the decision can be found here. A July 12, 2010 Bloomberg article about the decision can be found here.

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

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Rating agencies are not susceptible to ’33 Act liability as "underwriters," even if they helped structure the mortgage backed securities at issue, according to February 1, 2010 ruling (here) by Southern District of New York Judge Lewis Kaplan in which he dismissed Moody’s and McGraw-Hill (S&P’s parent) from the Lehman Brothers Mortgage-Backed Securities Litigation.

Plaintiffs had purchased the mortgage back securities that Lehman Brothers had issued in two offerings in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the rating agencies determined the composition of the loans in the mortgage pool that the instruments securitized. The plaintiffs also allege that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The plaintiffs premised their securities liability claims against the rating agencies based on their argument that the rating agencies were "underwriters" within the meaning of Section 11 of the ’33 Act. The plaintiffs based their theory that the rating agencies were "underwriters" within the meaning of Section 11 on the argument that the "underwriter" liability extends to those "who engaged in steps necessary for the distribution."
 

Judge Kaplan found this argument "unpersuasive," noting that

The Rating Agencies’ alleged activities may well have had a good deal to do with the composition and characteristics of the pools of mortgage loans and the credit enhancements of the Certificates that ultimately were sold. But there is nothing in the complaint to suggest that they participated in the relevant "undertaking" – that of purchasing the securities here at issue, the Certificates – "from the issuer with a view to their resale." The Section 11 claim is insufficient in law.

Judge Kaplan also rejected plaintiffs’ arguments that the rating agencies had "seller" liability under Section 12(a)(2) or control person liability under Section 15.

The rating agencies dismissal from this subprime-related securities class action lawsuit is not as significant as it would have been if it had based on the rating agencies’ claims that their ratings opinions are proteced by the First Amendment. Though Judge Scheindlin rejected that argument on narrow grounds in the Cheyne Financial case (refer here), the First Amendment defense undoubtedly will play a crucial role in many of the subprime-related securities cases that have been filed against the rating agencies, and the litigants in the many cases that have been filed against the rating agencies will have to await a later date to get a clearer sense of how those arguments will fare in these cases.

But though Judge Kaplan did not reach the first amendment issue, his ruling nevertheless is significant. As the subprime litigation wave unfolded, there were a number of complaints filed against the rating agencies asserting ’33 Act claims against them in which the plaintiffs in those cases had argued that the rating agencies were susceptible to "underwriter" liability under Section 11. Judge Kaplan’s rejection of that theory undoubtedly will be influential in those other cases where the plaintiffs have attempted to assert Section 11 "underwriter" liability against the rating agencies.

I have in any event added Judge Kaplan’s ruling to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

SEC Issues Climate Change Interpretive Guidance: The SEC decided recently to issue interpretive guidance on climate change disclosure. The SEC has now issued the interpretive guidance, which can be found here. I think this is a significant development, and not just because the SEC has now formally put climate change disclosure on the list of things to do for reporting companies.

It is clearly a topic worthy of much longer treatment than I am able to give it while I am in New York attending the PLUS D&O Symposium, but the danger is that the disclosure requirement establishes the predicate for a plaintiff to later claim that a public company failed to meet its climate change-related disclosure obligations. In my view, the SEC’s issuance of the interpretive guidance brings us that much closer to the day when we may start to see D&O claims arising out of misrepresentations or omissions concerning climate change related disclosures.

The End of the World: In response to my recent statement that I was tired and could use a nap, one of my much younger colleagues replied "O.K, first we take zee nap, ZEN WE DEESTROY ZEE WORLD!" She undoubtedly saw from the puzzled look on my face that I didn’t have a clue what she was talking about, so she immediately sat down and showed me this YouTube video, which she described as "the original viral Internet video." Readers should be forewarned that  the video uses vulgar language and contains humor that some may find crude or offensive. It is also seriously funny. Viewer discretion is, however, strongly advised.

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In a January 14, 2010 order (here), Southern District of New York Judge Robert W. Sweet granted the motion to dismiss in the ACA Capital Holdings subprime-related securities class action lawsuit. The decision is noteworthy in and of itself, but also because the plaintiffs’ securities claims were asserted under the ’33 Act. Subprime securities lawsuits asserting only ’33 Act claims have generally survived dismissal motions, but in the ACA Capital case the dismissal was granted -- with prejudice.

ACA Capital, which went public on November 10, 2006, was in the business of offering financial guaranty insurance products to participants in the global derivatives markets, and in its asset management business, it structured and managed collateralized debt obligation (CDO) transactions. During 2007, ACA began to experience deterioration in the credit obligations underlying the CDO transactions. ACA experienced losses in its portfolio, which caused its share price to decline. In November 2007, credit rating agencies downgraded ACA. In August 2008 ACA entered a global settlement with its structured credit counterparties, as a result of which the company effectively ceased operations.

Plaintiffs initially filed their securities class action lawsuit against ACA and its CEO in November 2007. Background regarding the lawsuit can be found here. In their consolidated amended complaint, Plaintiffs alleged that the defendants ACA’s prospectus had failed to disclose that "at the time of the IPO, the Company had materially increased its exposure to highly risky sub-prime CDOs and was planning to complete several more sub-prime CDO deals in early 2007 that would greatly increase the Company's exposure."

The plaintiffs further alleged that the Prospectus failed to disclose that due to "the rising default rates on sub-prime mortgages, it was highly likely that the Company would experience losses on the policies it had written to insure numerous CDOs and it would experience losses on its [collateralized debt securities] positions."

The defendants moved to dismiss, and in his January 14 order, Judge Sweet granted the defendants’ motion with prejudice.

Judge Sweet first held that, with respect to each of the sets of facts the plaintiffs alleged the defendants had failed to disclose that the allegedly omitted facts were disclosed in the Prospectus. He held that "the Prospectus’s disclosure of information alleged in the Complaint to have been withheld from prospective investors renders the Complaint insufficient as a matter of law."

The plaintiffs had also argued that the Prospectus had failed to comply with Item 303 of Regulation S-K by failing to describe "known trends and uncertainties" that the company faced. The plaintiffs argued that the Prospectus failed to disclose the existence of a "rising trend" of subprime foreclosures and delinquencies at the time of the IPO.

Judge Sweet held that the defendants could not be held liable for failing to disclose a trend of which they were unaware, and found that "the Complaint does not allege that the Defendants were actually aware of any purported ‘trend of delinquencies and foreclosures.’" Rather, many of the source on which the plaintiffs relied to try to establish the existence of a trend were not published until after the IPO. Only three of the sources on which plaintiffs relied were created prior to the IPO, one of which makes no references to delinquencies and foreclosures, another of which contains data reflecting less than a single calendar quarter (insufficient to show a "trend"), and material that was not publicly available at the time of the IPO.

Finally, Judge Sweet also granted the defendants’ motion to dismiss on the grounds of "negative causation" – that is, because, he found, that the complaint and the public filings on which the plaintiffs rely "establish that the decline in ACA’s stock was not caused by the allegedly false and misleading statements in the Prospectus." Instead, he found, "Plaintiffs cannot establish a causal relationship between Defendants’ alleged misrepresentations and subsequent declines in ACA’s stock price."

While there have been other dismissal motions granted with prejudice in subprime-related securities class actions, this dismissal stands out because the ACA plaintiffs’ claims were asserted under the ’33 Act. As I discussed in a recent post (here), research by Jon Eisenberg of the Skadden law firm regarding subprime dismissal motion rulings showed that all of the cases he studied that only asserted ’33 Act claims had survived motions to dismiss, in part, he speculated because of the absence of scienter pleading requirements for ’33 Act claims. Even claims that alleged ’33 Act claims in addition to claims under the ’34 Act tended to have a better survival rate than claims that asserting ’34 Act claims alone.

In light of the other dismissal motion rulings, Judge Sweet’s dismissal of the ACA Capital complaint with prejudice makes the case a noteworthy victory for the defendants. A significant number of the subprime and credit crisis-related cases asserted only ’33 Act claims, so the defendants in those other cases undoubtedly will be closely reviewing the ACA decision to see if they can use the decision in their cases.

I have in any event added the ACA Capital decision to my list of subprime and credit crisis-related securities class action lawsuit dismissal motion rulings, which can be accessed here.

Special thanks to the several readers who sent me a copy of the ACA Capital decision.

Small World: Wikipedia reports (here) that Eliot Spitzer served as one of Judge Sweet’s law clerks. And in light of my reference above to the research of Skadden attorney Jon Eisenberg, it seems relevant to note that prior to going onto the federal bench in 1978, Judge Sweet was in private practice at the Skadden law firm.

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Seventh Circuit Weighs In on State Court ’33 Act Jurisdiction and Removal: A January 5, 2009 Seventh Circuit decision in the Katz v. Gerardi case (here) may make it more difficult for plaintiffs to pursue ’33 Act litigation in state court, at least in the Seventh Circuit -- and possibly elsewhere, too.

As I detailed in a recent post (here), plaintiffs’ lawyers have proven keenly interested in pursing subprime and credit crisis-related litigation in state court, apparently for forum shopping type reasons. Defendants generally have sought to remove these cases to federal court, relying, among other things on the Class Action Fairness Act of 2005 (CAFA) and the Securities Litigation Uniform Standards Act of 1998 (SLUSA).

However, this past summer, the Ninth Circuit held in the Luther v. Countrywide case that the nonremoval provision in Section 22 of the ’33 Act (which provides concurrent state and federal court jurisdiction for ’33 Act cases) effectively trumps the more recently enacted SLUSA and CAFA because it more specifically relates to securities lawsuits. My discussion of the Luther v. Countrywide case can be found here.

An October decision in the Second Circuit in the New Jersey Carpenters’ Fund v. Harborview Mortgage case had refused to remand to state court a ’33 Act case, as is more fully discussed on the 10b-5 Daily blog (here). The Harborview decision was primarily based on the fact that the underlying securities lawsuit did not involve "covered securities" for which SLUSA created an explicit removal exception; because the exception did not apply, the case could appropriately be removed to federal court notwithstanding the nonremoval provision in Section 22.

In the recent Seventh Circuit opinion, Judge Frank Easterbrook wrote that the provisions of the more recently enacted statutes, particularly CAFA, trump Section 22. Judge Easterbrook expressly rejected Luther v. Countrywide’s conclusion that the more specific securities statute prevailed. However, Judge Easterbrook’s opinion, like the Second Circuit opinion in Harborview, also depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions.

In addition, Judge Easterbrook’s opinion does seem to have been influenced significantly by the fact that the plaintiff in the case was really a seller of the investments involved, rather than a buyer, and therefore lacked a legal basis to assert a ’33 Act claim. Although the opinion nevertheless examined the removal/jurisdictional issues as if the plaintiff had a legal right to assert the claim, the opinion’s starting point arguably influenced the outcome of its analysis.

In any event, the Seventh Circuit’s recent opinion, together with the Second Circuit’s Harborview opinion, clearly could create substantial jurisdictional hurdles (at least outside the Ninth Circuit) for the numerous plaintiffs now seeking to pursue ’33 Act claims in state court. Many (if not all) of the various subprime and credit crisis-related cases filed in state court related to investment instruments that are not traded on national exchanges and therefore are not "covered securities." Accordingly, contrary to the title of one of my prior posts, Section 11 cases may not be "coming soon to a state court near you" after all.

A January 12, 2009 Law.com article discussing the Seventh Circuit opinion can be found here.

Collins & Aikman Defendants Criminal Charges Dropped: On January 9, 2009, prosecutors dropped securities fraud and other criminal charges against former Collins & Aikman CEO David Stockman and three others. As reported in the January 10, 2009 Wall Street Journal (here), the U.S. Attorney’s office said further prosecution "wouldn’t be in the ‘interests of justice’ following a renewed assessment of the case."

While the individuals involved undoubtedly are relieved to have the prosecutorial threat removed, the government’s action comes only after the now-defunct company’s directors and officers insurance was entirely exhausted by defense fees, as I discussed at length in a prior post (here). Unfortunately for these individuals, they continue to face SEC enforcement proceedings as well as civil litigation (about which refer here), now without any further insurance available to fund their defense in these proceedings, not to mention any settlements or judgments that may follow.

A criminal prosecution has such an enormous potential to cause harm. On the one hand, it is commendable that the government was willing to reassess the case and to drop it before any further harm was done. On the other hand, even though the prosecution is over, it has done material damage to the individuals who were unfortunate to be subject to a prosecution that lacked an adequate basis. It is extremely regrettable when the government uses its enormous power when it is unwarranted. In this instance the government can drop the case and walk away without so much as an apology, but the unfortunate consequences of an unjustified prosecution continue for the individuals involved.

University of Denver law professor Jay Brown has extensively covered the Collins & Aikman criminal prosecution on the Race to the Bottom blog (here), including in particular his discussion (here) of how the criminal prosecution exhausted the company’s D&O insurance. The SEC Actions blog has a good summary description (here) of the criminal case and raises the question whether the SEC will proceed with the civil enforcement proceeding in light of the discontinuance of the criminal case. All of the key pleadings in the criminal case can be found on the University of Denver Law School’s corporate governance website, here.

2008 Delaware Case Law in Review: Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog has released the2008 installment of his annual review of key Delaware opinions. Pileggi’s report, which is must reading for anyone who wants an overview of important legal developments in Delaware’s court’s during 2008, is entitled "Selected Key Corporate and Commercial Delaware Decisions in 2008" and can be accessed here.

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As I have previously noted (here), one of the significant procedural developments in the subprime securities litigation wave has been the plaintiffs’ apparent interest in pursuing ’33 Act subprime-related lawsuits in state court. Section 22(a) of the ’33 Act expressly provides that the federal court’s jurisdiction for ’33 Act lawsuits is "concurrent with State and Territorial courts," which presents an immediate forum selection issue for any prospective ’33 Act plaintiff.

A recent ’33 Act lawsuit filing suggests that the forum selection issue involves not only electing between federal and state courts, but also deciding in which state to file, if a state court forum is to be preferred. The case also suggests that the forum selection may also entail forum shopping.

The Lawsuit

On December 2, 2008, the Public Employees’ Retirement System of Mississippi filed a ’33 Act class action complaint in Orange County (California) Superior Court against Morgan Stanley and several Morgan Stanley affiliates, several individuals associated with the Morgan Stanley affiliates and fourteen issuing trusts that sold certain mortgage pass-through certificates. The complaint also names as defendants McGraw Hill Companies, the corporate parent of S&P, and Moody’s. A copy of the complaint can be found here.

The complaint alleges that the offering documents associated with the securities "misstated and omitted material information regarding the quality of the loans underlying the Certificates," and failed to disclose" that the loan originators had "systematically ignored their stated and pre-established underwriting and appraisal standards." The complaint also alleges that Morgan Stanley entities "overpaid for underlying mortgages without regard to the quality of the loans for the sole purpose of increasing its position in the mortgage lending and securitization industry."

The complaint further alleges that the rating agency defendants "directly participated in structuring the securitization transaction" and that the rating agencies’ ratings "did not represent the true risk of the Certificates."

The complaint asserts claims under Sections 11, 12 and 15 of the ’33 Act and seeks relief on behalf of the class of investors who purchased securities pursuant to or traceable to the March 16, 2006 Registration Statement and accompanying prospectus.

Jurisdiction and Venue

The plaintiff is a Mississippi public employee pension fund. Morgan Stanley has its headquarters in midtown Manhattan. The complaint does not allege that any of the other defendants are domiciled in California. Apparently none of the parties are from California. So what exactly is this case doing in California?

As to why it is in state court rather than federal court, the state court has concurrent jurisdiction as I noted at the outset. But the mere availability of a state court forum does not explain why a state court was chosen in preference to a federal court. In my earlier posts (here), I have speculated that the plaintiffs are hoping to make an end run around the PSLRA’s procedural requirements, although no one has ever confirmed that.

But even if the preference of state court over federal court can be explained, why a state court in California?

The complaint itself purports to allege a variety of California connections: a "substantial portion of the wrongs complained of" are alleged to have occurred in Orange County. The defendants are alleged to have "availed themselves of the benefits of conducting business" in Orange County. Moreover, the complaint alleges that "a great percentage of the underlying mortgages pooled in the Certificates…were securitized by properties located in California."

All of these supposed connections to California are superficially plausible. But the fact is that all the parties are from outside California. The transaction that is at the heart of the lawsuit took place outside California. The supposedly misleading documents were created outside California.

I have my own theory why the case has been filed in California. That is, the plaintiffs really want the case to be in state rather than federal court. They anticipate that the defendants will seek to remove the case to federal court. The case law on which the plaintiffs would seek to rely in trying to have the case remanded back to state court is more favorable in California and less favorable in New York.

Specifically, as discussed here, in New York, in the HarborView mortgage case (about which refer here), the plaintiffs’ motion to remand the subprime-related securities case to state court was denied. However, in the Luther v Countrywide case, a subprime-related Section 11 lawsuit originally filed in California state court but removed by the defendants to federal court, the motion to remand the case to state court was granted, and the remand was specifically affirmed by the Ninth Circuit. For a detailed discussion of the Luther case including the Ninth Circuit’s opinion, refer here.

So did the plaintiffs choose a California state court because of the Ninth Circuit’s opinion in the Luther v. Countrywide case -- that is, because the chances of being able to proceed in state court in California was perceived to be greater than the chances of being able to proceed in state court in New York? If I am right, the plaintiffs selected the forum in order to increase the likelihood of a state court venue. Call it forum shopping to the second power.

Anyone who questions my theory should know that the complaint in the Morgan Stanley case explicitly references the Luther case, complete with case citation to the Ninth Circuit opinion. .

Of course, it may also be fairly observed that Orange County is ground zero for the mortgage meltdown, and as result the plaintiffs may expect a more sympathetic court and jury in that forum . This possible explanation is not inconsistent with my theory. Call it fourm shopping to the third power.

In any event, as I have previously noted, it appears likely that in connection with the subprime litigation wave, a significant amount of high stakes class action securities litigation will be going forward in state court. The plaintiffs’ lawyers ’33 Act forum selection preference is now well-established. Now we must wait and see what it all portends.

Rating Agency Defendants

The Morgan Stanley case is not the first subprime securities lawsuit naming the rating agencies as co-defendants. Indeed, the HarborView case referenced above also named rating agencies as defendants. However, in the HarborView case, the complaint alleged that the rating agency defendants were liable under Section 11 as "appraisers" as defined in Section 11(a)(4) of the ’33 Act. (Refer here for a detailed discussion of the allegations in the HarborView complaint.)

The Morgan Stanley complaint takes a different approach. Because it alleges that the rating agencies were directly involved in the creation of the securitized assets, the Morgan Stanley complaint alleges that the rating agencies are liable under Section 11(a)(5) as "underwriters" of the mortgage pass-through certificates. (The text of Section 11 can be found here.)

It will be interesting to see in any event whether these various liability lawsuits against the rating agencies succeed under any theory. As I have previously noted here, the rating agencies may have constitutional defenses protecting their rating activities. It remains to be seen whether the rating agencies involvement in the securitization process transformed them into "underwriters" sufficiently to subject them to Section 11 underwriter liability.

Run the Numbers

In any event, I have added the Morgan Stanley Pass-Through Certificates lawsuit to my running tally of subprime related securities litigation, which can be accessed here. With the addition of the new Morgan Stanley case, the current tally of subprime and credit crisis-related securities lawsuits now stands at 133, of which 93 have been filed in 2008.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for a copy of Morgan Stanley mortgage pass-through certificates lawsuit complaint.

Subprime Loans, Predatory Lending?: One of the recurring allegations on behalf of subprime borrowers is that the subprime loans in which the borrowers became ensnared represented "predatory lending." A November 20, 2008 article by three NERA Economic Consulting economists – Denise Neumann Martin, Faten Sabry and Stephanie Plancich – reviews "the definition of predatory lending and describe the recent litigation history. The authors then examine alleged discriminatory lending in detail, reviewing key economic theory and evidence, as well as relevant statistical techniques."

The paper also reviews predatory lending allegations and takes a look at recent predatory lending lawsuit filings. The article categorizes the lawsuits according to the specific allegations, and also examines predatory lending lawsuit settlements.

The report contends that proper statistical analysis is required to establish whether or not discriminatory or other improper lending activity has taken place. The report states that:

A proper assessment of alleged predatory lending, then, must control for characteristics including but not limited to the credit history, employment status, income level, and education of the borrower, as well as the borrower’s preference for risk (or discount rate). The competitiveness of the market in which the loan was arranged and other relevant macroeconomic factors may also need to be considered. Such analysis is essential to distinguish behavior that is predatory from that which is explainable by these other factors and would not be evidence of discrimination.

The paper, entitled "The Use of Economic Analysis in Predatory Lending Cases: Application to Subprime Loans," can be found here.

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Has the "due diligence" standard articulated in the WorldCom securities litigation produced an increase in the Section 11 litigation? That is the question addressed in David J. Michaels’s November 29, 2008 paper entitled "An Empirical Study of Securities Litigation After World Com" (here).

In this post, I review the analysis based upon which Michaels contends that, due to the WorldCom due diligence decision, Section 11 filings have increased as a percentage of all securities lawsuits, followed by my own discussion of the data on which Michaels relies.

The Author’s Analysis

Outside directors historically have had little Section 11 liability exposure, owing to their ability to rely on Section 11’s due diligence defense. Michaels notes that courts generally have found outside directors’ due diligence obligations to be minimal. However, Michaels contends, the Southern District of New York’s Section 11 due diligence decision in In re WorldCom Securities Litigation, 2005 WL 638268 (S.D.N.Y. 2005) (refer here) "significantly changed the landscape for outside directors" by holding them to a "stringent standard of liability."

A more detailed review of the impact of the WorldCom litigation on the due diligence defense can be found here.

Michaels hypothesized that because the WorldCom decision represents a change in the due diligence standard, making it easier for plaintiffs to pursue Section 11 claims (particularly against outside directors), securities cases under Section 11 would increase. In order to test this hypothesis, Michaels examined the ratio of securities filings asserting Section 11 claims to Section 10b-5 filings during the period 2002 through 2007, using data from the Stanford Law School Class Action Clearinghouse website. Because the court issued the WorldCom opinion in March 2005, the period selected included both years preceding and following the decision.

Michaels reported the following ratios of Section 11 filings to Section 10b-5 filings for the years 2002 through 2007:

2002 13%

2003 11%

2004 6%

2005 10%

2006 13%

2007 23%

Michaels concludes that these data suggest an "abnormal rise in Section 11 filings." Michaels concedes that "it is difficult [to] prove a causal relationship between WorldCom and the rise in Section 11 filings," he nevertheless asserts that it "is reasonable to attribute causation of the rise in Section 11 filings to WorldCom." In support of this conclusion, Michaels states:

Consider the following series of events. Prior to WorldCom, Section 11 filings were relatively constant; WorldCom comes along and greatly alters 35 years of precedent by making it easier for plaintiffs to survive a motion for summary judgment; Section 11 filings increase.

Michaels ends his paper by arguing that the upward trend in Section 11 cases will continue, but also that WorldCom’s holding applying a stringent standard to outside directors’ "due diligence" defenses is contrary to the ’33 Act’s purposes. He proposes a safe harbor for outside directors that "would exclude from liability outside directors who follow certain procedures designed to inform them of all material information surrounding a given offering."

Discussion

Michaels may be correct that the WorldCom decision will result in an increase in Section 11 filings. Reasonable minds may differ on whether the data support his conclusion that there already has been a demonstrable increase in Section 11 filings. Those same reasonable minds might hesitate before jumping to any conclusions about the causes of any increase that arguably may have taken place. A more conservative view is that it is at best premature to reach any conclusions in that regard.

First, the data on which Michaels relies represents only a brief time period. Since the WorldCom opinion was issued in 2005, that data from calendar year 2005 represent only a partial year. Michaels’s analysis places an enormous weight on data from just two years, 2006 and 2007. Michaels does not explain why he believes a data set that small is sufficient to support his conclusions.

Second, Michaels does not consider whether or not there were external factors that may have affected securities filings during the period after the WorldCom decision. In fact, it has been well documented (refer, for example, here) that there was a filing "lull" during the period from mid-2005 through mid-2007, in which there were an historically low number of securities filings overall. Michaels does not even mention this fact, nor does he consider whether the filing levels during that period may suggest that other factors may have been at work during this period.

Third, although Michaels is convinced that there was an "abnormal rise" in the Section 11 filings after WorldCom, the only thing I can conclude from looking at the data is that something was going on during 2007, as the 2005 and 2006 data are consistent with the prior years’ data. Michaels is essentially arguing the filing activity in a single year supports his hypothesis. Again, Michaels does not consider whether or not there may have been some anomalous factor behind the 2007 data.

My own prior review of the 2007 filing data (refer here) concluded that a significant number of the overall 2007 filings involved companies that conducted IPOs during the 12 months prior to getting sued. Many of these IPO cases involved foreign domiciled companies. Perhaps it may be concluded that the 2007 uptick in Section 11 litigation was due to a wave of IPOs involving foreign companies that were not ready to go public. At a minimum, there are certainly other plausible explanations for the 2007 uptick in Section 11 litigation other than the WorldCom decision alone.

Not only does Michaels fail to consider other possible explanations for the anomalies in the data, but the basis on which he nevertheless argues that WorldCom decision alone explains the supposed increase is also suspect.

In effect, he urges us to conclude that because the supposed increase in Section 11 filings came after the WorldCom decision, the decision must have been the cause of the supposed increase. This analysis arguably represents an example of the logical fallacy post hoc ergo propter hoc (after this, therefore because of this). Essentially, Michaels is trying to substitute chronological sequence for causation. However, the mere order of events does not rule out other factors that might explain the data, as the preceding paragraph shows.

From my perspective, given the anomalousness of the 2007 data, it is premature to reach any conclusions without the opportunity to consider subsequent years’ data, to see, for example, whether the 2007 uptick represented a trend or (as I strongly suspect) is merely a statistical outlier. I can say from my own informal review of the 2008 year to date filing data, a much smaller percentage of 2008 cases involve IPOs (14 out of 195 year to date in 2008, compared to 29 out of 172 in 2007), which suggests that the number of Section 11 filings will prove to have been down substantially in 2008 compared to 2007.

The decline in 2008 IPO-related lawsuits is hardly surprising given the downturn in the number of IPOs in recent months. Given the low level of IPO activity during 2008, and indeed the low level of securities offerings of any kind, it seems probable that Section 11 litigation could well taper off in the months ahead. All of which suggests to me the inadvisability of trying to make a few months of filing data support sweeping conclusions.

It may well be, as Michaels argues, that WorldCom’s articulation of the Section 11 due diligence standard arguably is inconsistent with the ’33 Act’s goals, particularly to the extent it may result in the imposition of greater Section 11 liability on outside directors. I simply disagree with Michaels’s conclusion that WorldCom decision has demonstrably caused an increase in Section 11 filings. Michaels’s hypothesis may or may not eventually prove to be correct, but it will be a significantly longer period of time than he has allowed before we can reach any conclusions.

Special thanks to Werner Kranenburg of the With Vigour and Zeal blog for the link to Michaels’s article.

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Over the last several years, Congress has made several different efforts to concentrate class action litigation in federal court.

For example, in the Securities Litigation Uniform Standards Act of 1998 (SLUSA), Congress amended portions of the Securities Act of 1933 and the Securities Exchange Act of 1934 to preempt class actions alleging fraud under state law in connection with the purchase or sale of securities. The Act specifically made state law securities class action lawsuits removable to federal court.

In addition, in the Class Action Fairness Act of 2005 (CAFA), Congress expanded federal court jurisdiction over class actions and mass actions. CAFA gives federal courts jurisdiction over certain class actions in which the amount in controversy exceeds $5 million and in which any of the class members is a citizen of a state different from any defendant.

But while Congress enacted these various legislative changes designed to concentrate class action litigation in federal court, Section 22(a) of the ’33 Act preserved state court jurisdiction by specifying that federal courts’ jurisdiction for ’33 Act lawsuits is “concurrent with State and Territorial courts.” Moreover, Section 22(a) specifically provides that no case “brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

These jurisdictional provisions have been a part of the federal securities laws since the basic statutes’ enactment. But the legislative developments in the interim raise the question whether the subsequent enactments override the concurrent state court jurisdictional provisions in Section 22(a).

As I have previously noted (here), plaintiffs’ lawyers have chosen to file a number of subprime-related securities class action lawsuits alleging ’33 Act violations in state court. In particular, plaintiffs’ lawyers have elected to file in state court several class action lawsuits alleging misrepresentations in connection with the creation and issuance of subprime mortgage-backed securities. These lawsuits, of which by my count there have been at least four, exclusively allege violations of the ’33 Act.

One of the first of these lawsuits to be filed is the case styled as Luther v. Countrywide, the background regarding which can be found here. The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

The claims in the Luther lawsuit are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.

The defendants, in reliance on CAFA, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court.

As discussed here, on February 28, 2008, Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that Section 22(a)’s removal bar trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that CAFA, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”

The defendants had argued that CAFA superseded Section 22(a)’s removal bar. But the Ninth Circuit, applying principles of statutory construction, held that while CAFA applies to a “generalized spectrum” of class actions, the ’33 Act is “the more specific statute” and that the removal bar “more precisely applies only to claims” under the ’33 Act. The Ninth Circuit concluded that the plaintiff’s initial state court class action “was not removable” and that “the motion to remand was properly granted.”

In other words, the Luther lawsuit will now go forward in state court. In light of the Ninth Circuit’s opinion, it seems likely that the various other subprime-related class action lawsuits filed against the mortgage securitizers will also eventually proceed in state court as well.

The “where” question has been resolved, but the “why” question still remains – that is, why do plaintiffs’ counsel want to proceed in state court rather than federal court?

One possibility is that plaintiffs’ counsel believes that state courts will be more sympathetic to the interests of local claimants, especially in connection with their claims against out-of-state moneyed interests. The search for a more favorable court has always driven forum shopping, and there may be some of that here. But I do wonder why plaintiffs’ securities attorneys, whose practices historically (especially in recent years) have concentrated in federal court, want to litigate in a state court with which they may be less familiar, and that will be unfamiliar with federal securities laws and securities litigation generally.

Another possible reason plaintiffs lawyers want to proceed in state court is that they want to try to circumvent the procedural requirements of the PSLRA. I have speculated elsewhere (most recently here) that plaintiffs’ counsel may try to argue that the PSLRA’s procedural requirements do not apply to a ’33 Act case in state court. The plaintiffs’ argument would be that the PSLRA, codified in Section 27(a) of the ’33 Act, provides that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiffs’ counsel may argue that because their suit was not brought pursuant to the Federal Rules of Civil Procedure, the PSLRA’s procedural requirements (such as the notice provisions, the discovery stay, and the lead plaintiff provision) do not apply. There could be a great deal of litigation turbulence if plaintiffs’ lawyers pursue these arguments (which seems likely).

Plaintiffs’ counsel apparently have the right to pursue ’33 Act claims in state court, which for whatever reason they seem inclined to do. There were of course a few securities lawsuits filed in state court after the enactment of the PSLRA, but my recollection is that that experiment did not go particularly well. Due to the state courts’ crowded dockets and unfamiliarity with federal securities laws, the cases bogged down. The enactment of SLUSA seemingly ended this prior flawed experiment.

Nevertheless, plaintiffs’ securities attorneys, for reasons they deem good and sufficient, are back again in state court, a place where they now seem eager to be. Some recalibration may be required to accommodate the prospect of further state court securities litigation. The plaintiffs’ lawyers’ interest in pursuing state court ’33 Act class action litigation is an unexpected development with uncertain implications. The road could be rough for all concerned.

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