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

Earlier this week when I posted my list of subprime lawsuits dismissal motion grants and denials (here), I was hoping the publication would encourage readers to let me know about case dispositions of which I was previously unaware. My strategy worked, because a loyal reader who prefers anonymity responded to my post by alerting me to the May 19, 2008 opinion (here) in the subprime-related securities class action lawsuit involving Standard Pacific. Because the court’s opinion is particularly thorough, it merits a detailed review.

Standard Pacific is a California-based residential construction company that concentrated in recent years on the formerly go-go growth areas of California, Florida, Texas and Nevada. As s result of the residential real estate slump, the company’s sales activity declined in 2006 and 2007. Plaintiff shareholders initiated a securities class action lawsuit against two Standard Pacific executives in August 2007.

The plaintiffs alleged that the defendants misrepresented Standard Pacific’s ability to open new, successful communities; misled the public about the demand for Standard Pacific homes; and lied about the company’s ability to continue its historically strong earning growth. Further background regarding the lawsuit can be found here.

In a May 19, 2008 opinion, Judge Margaret M. Morrow of the United States District Court for the Central District of California granted the defendants’ motion to dismiss, but allowed the plaintiffs’ 45 days’ leave to amend.

The defendants first argued that the plaintiffs’ complaint failed to satisfy the PSLRA’s pleading requirements because it is a “classic example of prohibited puzzle-pleading,” in that it contains extensive block quotations from the company’s class period statements “without specifying the particular statements that are false and misleading.”

The plaintiffs sought to address this issue in their reply papers, but the court found that “the organization the plaintiffs offer in their opposition brief does not cure the deficiencies in the complaint. To the contrary, it highlights plaintiffs’ failures to plead defendants’ purportedly false and misleading statements with specificity as required by the PSLRA,” and accordingly the court granted the motion to dismiss, with leave to amend.

The defendants also moved to dismiss on the grounds that the plaintiffs had not adequately pled scienter. The plaintiffs alleged, based on the confidential witness information, that defendants misled investors because they continued to cite sales information in reliance on internal reports they supposedly knew to be inaccurate. Defendants contended that, to the contrary, they informed investors that the company was experiencing sales declines, and that “the crux of plaintiffs’ fraud claim is not that the defendants flatly misrepresented the company’s performance but that they were deliberately reckless because the failed to lower their projections enough.”

The court found that

the fact that defendants reduced earnings and home delivery guidance cuts against plaintiffs’ claim that defendants acted with fraudulent intent. As no facts are pled supporting an inference that defendants selected the level of reductions they announced fraudulently or with deliberate recklessness, the complaint suggests a plausible nonculpable explanation for defendants’ conduct…. Taken as a whole…plaintiffs’ allegations do not give rise to a “strong inference” that at the time they made the statements, defendants knew or should have known that the state of affairs was much worse than they had acknowledged publicly….In effect, by arguing that defendants’ predictions and forecasts were not low enough, plaintiffs improperly attempt to allege “fraud by hindsight.”

The court similarly rejected the plaintiffs’ attempt to rely on the defendants’ certifications of the company’s SEC filings.

The dismissal, even though it is without prejudice, is still significant. First, the opinion is very detailed and thorough, which could carry some weight in other subprime securities cases, particularly the numerous other cases pending in the Central District of California.

Second, many of the other subprime complaints arguable share the “puzzle pleading” defect of the complaint in this case – all too often, the complaints in these subprime cases consist of block quotations from the defendants company’s disclosure documents, without direct connections specifying what about the disclosure the plaintiffs allege is false and misleading, and in what way the statements are false and misleading.

Third, many of the companies named in subprime securities lawsuits, like Standard Pacific, are accused not of failing to acknowledge problems but of failing to recognize the problems enough. To the extent other courts view these pleadings with the same level of skepticism as Judge Morrow, the complaints could face some formidable challenges at the motion to dismiss stage.

In any event, I have added the Standard Pacific opinion to the list of subprime lawsuit dismissal motion grants and denials. I hope other readers will let me know of any other subprime lawsuit dismissal motion rulings of which they are aware, so that the list can be as complete as possible.

Special thanks to the anonymous loyal reader for alerting me to the Standard Pacific opinion.

Another Option ARM Lawsuit: In a different post earlier this week (here), I noted the lawsuits that had been filed up to that point relating to Option ARM mortgages, and I suggested the likelihood that there would be further lawsuits relating to Option ARMs. In a quick confirmation of my prediction, on June 11, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the Central District of California against IndyMac Bancorp and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ June 11 press release can be found here. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

defendants issued materially false and misleading statements regarding the Company’s business and financial results. Specifically, defendants downplayed and concealed IndyMac’s growing exposure to non-performing assets, particularly loans in its pay-option adjustable-rate mortgage (“Option ARM”) and homebuilder construction portfolios, and made numerous positive representations regarding the Company’s capital position to alleviate investors’ fears concerning the Company’s capital erosion. As a result of defendants’ false statements, IndyMac stock traded at artificially inflated prices during the Class Period.

It is important to note that IndyMac had previously been sued in a subprime-related securities class action lawsuit, the background regarding which can be found here. In concluding that this latest lawsuit is sufficiently distinct from this prior lawsuit to represent a new lawsuit, I note the following: first, the class period of the prior lawsuit was May 4, 2006 to March 1, 2007, whereas the purported class period for the new lawsuit is from August 16, 2007 to May 12, 2008. In addition, the substantive allegations in the two lawsuits relate to different alleged misrepresentations. In particular, the prior lawsuit does not appear to relate to the companies representations regarding Options ARM mortgages or the company’s capital position.

Accordingly, I am recognizing this latest complaint as a new and separate filing. However, I encourage readers who may disagree to let me know of any circumstances that might militate in favor of a different conclusion.

I have added the new IndyMac lawsuit to my running tally of subprime and credit-crisis related securities lawsuits, which can be found here. With the addition of the new IndyMac lawsuit, the tally of subprime and credit crisis-related lawsuits now stands at 90, of which 50 have been filed in 2008.

Finally, it is worth noting that, as reflected in my list of subprime dismissal motions grants and denials referenced above that motion to dismiss have twice been granted with leave to amend in the prior IndyMac lawsuit.

More Subprime ERISA Lawsuits:  I have also added two subprime-related ERISA lawsuits to my running tally of subprime-related lawsuits.

First, in a June 11, 2008 press release (here), plaintiffs’ lawyers announced that they had initiated a lawsuit in the Southern District of New York under ERISA against Wachovia Corporation and various of its officers and administrators. According to the press release, the defendants allegedly violated their duties to participants in the Wachovia Savings Plan by “continuing to invest in and hold Wachovia stock despite the fact that they knew or should have known that Wachovia was not properly reporting its financial condition and was not disclosing significant problems which had the effect of inflating the value of Company stock.”

Second, on May 9. 2008, plaintiffs’’ counsel initiated a lawsuit in the Western District of Tennessee on behalf of past and present employees of First Horizon National Corporation who participated in the First Horizon Savings Plan. A copy of the complaint can be found here. The complaint alleges that the defendants breached their fiduciary duty by requiring plan participants to invest in First Horizon shares, which the plaintiffs contend was “imprudent… because First Horizon was not fairly and accurately disclosing the risks and likely consequences of a number of its banking practices such that the Plan was purchasing shares of First Horizon Stock at an inflated price.” Among the undisclosed risks alleged is the company’s exposure to subprime and Alt-A mortgages.

I have added the Wachovia and First Horizon ERISA lawsuits to my running tally of subprime-related ERISA lawsuits, which can be found here. With the addition of the new ERISA lawsuit, the tally of subprime-related ERISA lawsuits now stands at 17

Special thanks to a loyal reader for identifying the new ERISA lawsuits.

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We knew it was coming but it sure got here fast. On March 17, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Bear Stearns and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here, and the complaint can be found here.

According to the press release, the complaint alleges that during the class period between December 14, 2006 and March 14, 2008, defendants issued false and misleading statements, as a result of which “Bear Stearns stock traded at artificially inflated prices … reaching a high of $159.36 per share in April 2007.” The press release further states that:

In late June 2007, news about Bear Stearns’ risky hedge funds began to enter the market and its stock price began to fall. On March 10, 2008, information leaked into the market about Bear Stearns’ liquidity problems, causing the stock to drop to as low as $60.26 per share before closing at $62.30 per share. On March 13, 2008, news that Bear Stearns was forced to seek emergency financing from the Federal Reserve and J.P. Morgan Chase hit the market and Bear Stearns stock fell to $30 per share. Then, on Sunday, March 16, 2008, it was announced that J.P. Morgan Chase was purchasing Bear Stearns for $2 per share. By midday on Monday, March 17, 2008, Bear Stearns stock had collapsed another 85% to $4.30 per share on volume of 75 million shares.

The press release states that the defendants’ statements during the class period “due to defendants’ failure to inform the market of the problems in the Company’s hedge funds due to the deteriorating subprime mortgage market, which would cause Bear Stearns to have to rescue the funds, cause the Company and its officers possible criminal liability and hurt the Company’s reputation.”

The principals at JP Morgan clearly anticipated this development. According to a March 17, 2008 Law.com article (here), JP Morgan is “setting aside $6 billion to cover potential litigation” as well as other transaction and severance costs arising out of JP Morgan’s acquisition of Bear Stearns JP Morgan’s own March 16 press release (here) announcing the transaction does not mention any reserve or set aside for transaction expenses, but the March 18, 2008 Wall Street Journal (here) also says that “J.P. Morgan plans to set aside about $6 billion in reserves to cover the potential exposure and other costs.”

(Perhaps it is an idle thought but one does wonder why the $6 billion was not applied directly to the acquisition price. …)

Yet another possibility that may yet arise is that individual Bear Stearns investors might choose to pursue their own litigation separately. According to the March 17, 2008 Wall Street Journal (here), there are individual investors whose losses from the Bear Stearns collapse approach $1 billion. According to the March 18, 2008 Wall Street Journal (here), “billionaire investor Joseph Lewis, one of Bear Stearns's biggest shareholders, with a 9.4% stake, rejected [J.P. Morgan’s] offer, saying it doesn't represent the true value of Bear Stearns. Mr. Lewis, though a spokesman, said the offer ‘is derisory, and I do not believe that shareholders will approve it.’” Certainly individual losses of that magnitude, if nothing else, raise the possibility of their proceeding on their own rather than as part of a larger shareholder class.

Update: According to news reports (here), an action has also been filed against Bear Stearns and its executives on behalf of Bear Stearns employees alleging that they "breached their fiduciary duties to plan participants by allowing their retirement savings to be invested in the company's stock despite knowing such an investment was imprudent."  The complaint alleges that the investment bank failed to disclose material adverse facts regarding its financial well-being, the potential consequences of its "substantial entrenchment in the subprime mortgage market," that the firm's stock price was artificially inflated and heavy investment of retirement savings in company stock would inevitably result in significant losses to the plan and its participants.

Securities Suit Against Deutsche Bank for Auction Rate Securities: On March 17, 2008, a different plaintiffs’ firm launched a securities lawsuit in the United States District Court for the Southern District of New York against Deutsche Bank and its wholly owned broker–dealer subsidiary, on behalf of a class of persons who purchased auction rate securities from Deutsche Bank and the broker dealer between March 17, 2003 and February 13, 2008, inclusive (the “Class Period”), and who continued to hold such securities as of February 13, 2008. A copy of the plaintiffs’ counsels’ press release can be found here and a copy of the complaint can be found here. 

According to the press release, the plaintiffs allege that the defendants violated the securities laws “by deceiving investors about the investment characteristics of auction rate securities and the auction market in which these securities traded.” The press release states that the defendants failed to disclose that:

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because Deutsche Bank and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) Deutsche Bank and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) Deutsche Bank continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a “freeze” of the market for auction rate securities would result.

The auction rate securities purchasers’ lawsuit against Deutsche Bank is not the usual class action securities lawsuits brought against a publicly trade company by its own shareholders. The Deutsche Bank auction rate securities lawsuit is, however, subprime-related and it is a class action that alleges violations of the federal securities laws. For those reasons, I have added it to my running tally of subprime-related securities lawsuits, which can be found here. On a going forward basis, I will try to keep the parallel tallies too, taking into account the different kinds of litigation within the larger running tally.

With the addition of the Bear Stearns and Deutsche Bank securities lawsuits, the current tally of subprime-related securities lawsuits now stands at 51, twelve of which have been filed so far in 2008. Of these 51, two are securities lawsuits filed by mortgage–backed securities investors against the asset securitizers, and one (as noted above) was filed by purchasers of auction rate securities. The remaining 48 are more traditional securities class action lawsuits by public company shareholders.

Bear Ironies and Morgan Echoes: Bear Stearns shareholders can be forgiven if they fail to appreciate it, but there is a certain irony that Bear Stearns was the bailout recipient last Friday. This weekend’s whirlwind meetings involving the Fed and the lions of Wall Street present an uncanny echo of the closed door meetings at the New York Fed on September 23 1998, when government officials and Wall Street bankers were struggling to avert the collapse of Long Term Capital Management that all feared might trigger global financial panic. As colorfully told in the prologue of Roger Lowenstein’s excellent book about LTCM, When Genius Failed (here), the government’s rescue efforts nearly aborted because one Wall Street bank refused to cooperate in the government’s rescue plan - none other than Bear Stearns, whose then CEO and current Chairman James Cayne refused to play along.

This past weekend’s events also harken back to an even earlier episode, one in which JP Morgan Chase’s founder and primary namesake played the central role. As described in Robert Bruner and Sean Carr’s readable recent book, The Panic of 1907 (here), a capital crisis that originated from a liquidity drain following the 1906 San Francisco earthquake culminated in October 1907 in runs on a series of New York banks. J.P. Morgan himself, in effect functioning as the central banker in the absence of any more formal institution, caused his firm to intervene to provide liquidity to the Trust Company of America, declaring, to his colleagues “This is the place to stop the trouble, then.”

A century later, his firm is once again playing a central role in an effort to avert a financial crisis, and while some may argue that an important difference is that in 1907 Morgan didn’t acquire any of the rescued banks, it is a fact that one of the steps Morgan took in 1907 was a U. S. Steel-led buyout of Tennessee Coal, Iron & Railroad Company, a move claimed at the time was designed to avoid a collapse that could have undermined the stock market. The TCI & R rescue efforts, for which he and his firm were later criticized and subjected to a congressional investigation, ultimately proved to be good both for the Morgan firm as well as for the financial markets.

UPDATE: CFO.com has an excellent March 18, 2008 article entitled "J.P. Morgan Returns to Its Rescue Roots" (here) going into much greater detail about J.P. Morgan's storied past.

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