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

In the latest ruling on a motion to dismiss in a subprime-related securities lawsuit, on December 22, 2008, Judge Legrome Davis of the Eastern District of Pennsylvania granted in part and denied in part defendants’ motion to dismiss the suit that plaintiffs’ filed in August 2007 against RAIT Financial Trust and certain of its officers and trustees. The opinion can be found here.

Judge Davis’s ruling largely denied defendants’ motions, other than with respect to the plaintiffs’ ’33 Act claims concerning the company’s July 2007 secondary offering, which were dismissed due to the plaintiffs’ lack of standing. Otherwise, Judge Davis ruled in plaintiffs favor. The plaintiffs’ remaining ’33 Act claims and all of the plaintiffs’ ’34 Act claims will now go forward.

Background

RAIT is a real estate investment trust providing debt financing to home builders, mortgage lenders and other real estate companies. As more fully set forth here, plaintiffs’ complaint relates to the July 30, 2007 failure of American Home Mortgage to make a payment due under certain trust preferred securities, resulting in a net equity exposure to RAIT of at least $95 million. Shortly thereafter, the company disclosed that it had $373 million of similar exposures. The plaintiffs allege that the defendants failed to disclose its exposure to these types of investments and failed to reserve adequately for the risk of nonpayment or default.

The plaintiffs’ complaint asserts claims under both the ’33 Act and the ’34 Act. The defendants in the ’33 Act claims include the offering underwriters that facilitated RAIT’s January 2007 common stock offering and July 2007 preferred stock offering, as well as the company’s auditor, Grant Thornton. The defendants’ moved to dismiss.

The December 22 Opinion

First, the court dismissed the ’33 Act claims relating to the July 2007 preferred stock offering due to lack of standing, because none of the named plaintiffs purchased securities traceable to the offering.

However, the court denied the defendants’ motion to dismiss the ’33 Act claims raised in connection with the January 2007 offering. Judge Davis found that the plaintiffs had adequately alleged falsity and materiality, and rejected defendants’ contentions that the plaintiffs’ arguments represented nothing more than "fraud by hindsight." Judge Davis also rejected the defendants’ contentions that the alleged misrepresentations "bespoke caution" or were "mere puffery."

Judge Davis also found that his rulings that the plaintiffs had adequately pled falsity and materiality applied to the plaintiffs’ ’34 Act claims as well.The defendants nevertheless sought to have the ’34 Act claims dismissed, arguing that the plaintiffs had not adequately pled scienter.

Judge Davis found that "despite the demanding standard of recklessness imposed in pleading a strong inference of scienter," the plaintiffs nevertheless had adequately pled scienter. His ruling depended on the "core business operations" theory, with respect to which he stated:

Because the alleged misstatements involved RAIT’s core business operations and because the Officer Defendants had ample reason to know of the falsity of the statements, there is a strong inference of scienter in this case.

Judge Davis also found that though the core business operations allegations alone were sufficient, other allegations also supported the inference of scienter, including "the sheer size of the impairment eventually taken by RAIT," which he found adds to "the imputation" that defendants "must have had some awareness that problems were brewing." Judge Davis also found that "familial and business relationships involved" in a RAIT acquisition were "relevant in our consideration of scienter."

Discussion

Other than the ’33 Act claims relating to the July 2007 offering (which was dismissed for lack of standing), the plaintiffs largely prevailed on the dismissal motions. Judge Davis’s ruling is significant not only because it seems to run counter to the early trend other courts arguably have established (albeit with some notable exceptions) of general skepticism toward subprime-related allegations. Judge Davis’s ruling is noteworthy in that regard for its rejection of the defendants’ "fraud by hindsight" arguments.

Judge Davis’s opinion is perhaps most noteworthy in its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter. Though earlier courts had rejected this theory as inconsistent with the PSLRA’s pleading requirements, more recently courts, for example, in the Ninth Circuit (refer here) and the Seventh Circuit (refer here), have taken it up. As noted in a recent commentary by the Katten Muchin law firm entitled "Reform Act Under Attack?" (here), the core operations theory "has made a comeback in 2008," which the authors contend is inconsistent with the PSLRA’s meaning and intent.

Were other courts similarly willing to take up the core operations doctrine, it could substantially impact the many pending dismissal motions in various subprime-related securities lawsuits.

In any event, I have added the RAIT opinion to my table of subprime and credit crisis-related securities lawsuit settlements, dismissals, and dismissal denials, which can be accessed here.

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

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

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

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

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

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

present the extraordinary case where a company’s essential operations were so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws.

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

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

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

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

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

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

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

With respect to the amended complaints Rule 10b-5 allegations, Judge Pfaelzer’s opinion concludes that the plaintiffs "have created a cogent and compelling inference of a company obsessed with loan production and market share with little regard for the attendant risks, despite the company’s repeated assurances to the market."

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

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

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

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

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

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

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

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

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

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

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In what is as far as I am aware the first class action settlement in the current wave of subprime-related securities lawsuits, on October 14, 2008, WSB Financial Group announced (here) that it had entered into a settlement agreement of the class action lawsuit pending against the company and certain of its directors and officers.

As detailed in greater length here, on October 30, 2007, plaintiffs’ lawyers’ had initiated a securities class action lawsuit in the Western District of Washington. A copy of the plaintiffs’ consolidated complaint can be found here.

WSB Financial Group is the parent company of Westsound Bank. The lawsuit alleged that the offering documents associated with the company’s December 21, 2006 IPO contained material misrepresentations or omissions. Among other things, the complaint alleges that the offering documents stated that the company “focused on originating and maintaining a high-quality loan portfolio and had rigid underwriting policiesdesigned to ensure the credit quality of the Company's portfolio. In reality, however, WSB Financial originated hundreds of high-risk loans in violation of the Company's stated policies for a total amount of at least $90 million.”

In its October 14 press release, the company stated that the parties had agreed to a settlement of $4.85 million. The press release also states that the company’s D&O insurance policy would contribute $4.45 million toward the settlement and had previously contributed approximately $350,000 toward the cost of the settlement. The proposed settlement is subject to court approval.

As a relatively small settlement of one of the smaller, lower profile cases in the current litigation wave, this settlement is likely to have relatively little direct influence on other pending cases. The significance of this settlement may simply be that it has happened at all. With so many of the subprime and credit crisis-related cases only in their earliest stages, the likelihood of settlements emerging seemed like a distant prospect. It may yet be a considerable time before the higher profile cases move toward the settlement stage, even assuming they survive preliminary motions. This settlement suggests that at least some cases will move more quickly toward resolution.

Nevertheless, anyone who thinks that the current litigation morass might quickly be cleaned up may need to curb their enthusiasm. An October 13, 2008 Law.com article entitled “New Wave of Class Actions Filed in Wake of Subprime Collapse” (here) quotes a plaintiffs’ securities class action attorney as saying that he anticipates that subprime litigation “will keep us busy for seven or eight years.”

In any event, I have added the WSB settlement to my table of subprime and credit-crisis related case dispositions, which can be accessed here.

A Different Approach: In our country, the most important issue in any crisis is figuring out who to blame. Refined distinctions are not a necessary part of this blame assignment process, and blame can be assigned indiscriminately. (If you doubt this assertion, please refer to the public statements of any U.S. politician during the current financial turmoil.) Our transatlantic cousins apparently take a different approach, which I must say has much to recommend it.

According to an October 14, 2008 Law.com article (here), the nationalized British lender Northern Rock has announced that it will not bring legal action against its former directors and officers, after having concluded that "there are insufficient grounds to proceed with a negligence action against the ex-directors." The article also reports that "the bank's auditors are off the hook."

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On February 27, 2007, plaintiffs’ lawyers’ initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Swiss Reinsurance Company, the world’s largest reinsurance company, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

The lawsuit relates to the company’s November 19, 2007 announcement (here) of a 1.2 billion Swiss Franc mark-to-market loss on the two related credit default swaps the company had issued to provide loss protection against certain asset backed securities.

According to the plaintiffs’ attorneys’ press release,

The complaint alleges that during the Class Period, defendants made false and misleading statements about the Company’s financial condition. Specifically, defendants failed to disclose that Swiss Re’s Credit Solutions unit had written two credit default swaps that exposed the Company to great financial risk. In a credit default swap, one party guarantees that a third party borrower will not default on a debt. In this case, Swiss Re guaranteed certain mortgage-backed securities which included some subprime and collateralized debt obligations. When the existence and nature of the credit default swaps was disclosed, Swiss Re’s stock price dropped from CHF97.55 to CHF87.55 (Swiss Francs) the next day.

The complaint particularly emphasizes that the November 19 announcement came just days after the company’s November 6, 2007 third quarter earnings release (here), which did not mention the credit default swap write-off but contained certain representations about the company’s exposure to subprime issues.

There are several interesting things about this lawsuit. While this is not the first lawsuit filed against companies that provided default guarantee protection to subprime securities, the prior companies to be sued in this regard have been the bond insurers whose primary business is providing default protection. As far as I know, the Swiss Re lawsuit is the first lawsuit against a company specifically linked to the issuance of credit default swaps guaranteeing against the default of subprime-related securities. There have been other companies that have announced accounting write-downs in connection with credit default swaps (see, for example, AIG’s recent announcement here), and there undoubtedly will be others – just as there undoubtedly will be other lawsuits in relating to credit default swaps issued on mortgage-backed assets.

The second interesting thing about this suit is who the plaintiff is – the plaintiff is the Plumbers’ Union Local No. 12 Pension Fund, on whose behalf the same law firm (Coughlin Stoia) previously filed a securities class action lawsuit against Nomura Asset Acceptance Corporation and related entities, as discussed in my recent post here. This union fund certainly does seem to have had some remarkably bad luck with its investments as a result of the subprime meltdown. It also seems to have a durable client-attorney relationship with the Coughlin Stoia firm.

The third interesting thing about this lawsuit is that it comes more than three months after Swiss Re’s November 19 announcement. Up to this point, the subprime related lawsuits have followed pretty closely in the wake of disclosure of subprime related accounting adjustments. The delay in filing this lawsuit suggests that the "moping up" exercise may have begun – that is, the process of going back and combing over the prospective claims that might have been missed the first time through. There certainly have been a host of companies who have made fairly significant announcements over the last few months who have not yet been sued. Their date may yet be coming.

It is interesting in another respect that this lawsuit has arisen now. The company got a boost even after write down when on January 23, 2008 it announced (here) that Berkshire Hathaway had taken a 3% interest in the company and would be taking 20% of the company’s property and casualty reinsurance business over the next five years. This seeming validation from the sage of Omaha may not have been enough to mollify at least some investors, apparently.

I have in any event added the Swiss Re case to my running tally of the subprime-related securities lawsuits, which can be found here. The addition of the Swiss Re case brings the total count of subprime securities lawsuits to 47, eight of which have been filed in 2008. As I noted above, the Swiss Re case is to the best of my knowledge the first subprime related lawsuit based on the loss in value of credit default swaps; it seems prudent to assume at this point that there will be more to come.

Everyone Remain Calm: The subprime crisis not only threatens financial losses, it apparently could also hazard a massive loss of life. According to a February 26, 2008 Financial Times article entitled "Banking Crises Shown to Trigger Heart Attack Deaths" (here), between 1,300 and 5,100 people could die if "a significant proportion of banks suffered crises similar to that at North Rock.

Cambridge University researchers studied 40 years of data from the World Bank and the World Health Organizations, and concluded that "system-wide" crises increase average deaths from heart disease an average of 6.4 percent in wealthy countries – and more in developing countries. Researchers warn that a global banking crisis "would kill tens of thousands of people by heart attacks brought on by stress and anxiety." One of the researchers noted that "containing hysteria and preventing widespread panic is important not only to stop these incidents leading to a systemic banking crisis but also to prevent thousands of heart disease deaths."

More About Subprime: Just a reminder that Mealey's is sponsoring a Subprime-Backed Securities Litigation Conference on March 6, 2008 at the Harvard Club in New York City. The conference is to be chaired by David Grais of the Grais & Ellsworth firm. I will be speaking on the topic of "CDOs, Asset Valuation and the Subprime Litigation So Far." A copy of the conference brochure can be found here.

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