As I have previously detailed (refer here), the subprime meltdown has led to a flood of new securities lawsuits. The extent to which many of these subprime-related lawsuits will withstand judicial scrutiny still remains to be seen. A recent opinion from the Central District of California — which is as far as I know the first decision on a dismissal motion in a subprime-related securities lawsuit — may provide some indication of the challenges many of these new lawsuits may face as they proceed.
In a November 29, 2007 order (here)in the Indymac Bancorp securities lawsuit , Judge George Wu of the federal court in Los Angeles granted the defendants’ motion to dismiss the securities class action lawsuit that had been filed against Indymac and three individual defendants. The dismissal is without prejudice, and the plaintiffs have until January 18, 2008 to file an amended complaint. Although the dismissal is without prejudice, the court’s analysis may be indicative of the obstacles that may confront many of the subprime-related lawsuits.
The plaintiffs’ allegations, as summarized by the court, are that “despite the downturn in the national housing and mortgage markets, Defendants maintained that they were well-positioned, contrary to the other players in the markets.” Plaintiffs contend that the defendants’ statements about the company’s position were misleading, because Indymac had “inappropriately loosened its underwriting guidelines such that it had extended far riskier loans that were going into default at an increasing rate”; had “inadequately hedged against its risks”; and had “inadequate internal controls.”
The defendants moved to dismiss the complaint in reliance on the U.S. Supreme Court’s recent Tellabs opinion (about which refer here). The defendants argued that the plaintiffs “failed to allege sufficient facts giving rise to a ‘strong inference’ of scienter.”
In response, the plaintiffs had “cited the beliefs and opinions of certain confidential witnesses with respect to the allegedly problematic areas.” But the court noted that the plaintiffs “failed to allege that the individual Defendants share these beliefs” or even “that they were aware of them.”
The plaintiffs also cited press statements where the defendants admitted certain mistakes, and also cited subsequent actions where the company increased loan loss reserves and took certain charge-offs. The court, weighing competing inferences as required under Tellabs, found that these allegations, rather than supporting an inference of scienter, supported “an even stronger inference…that Defendants were simply unable to shield themselves as effectively as they anticipated from the drastic changes in the housing and mortgage markets, and once that inability became evident, Indymac’s financials were changed accordingly.”
The Court went on to note that the plaintiffs might have been able to satisfy the scienter requirements with insider trading allegations or allegations of GAAP violations. But because two of the individual defendants sold no shares and the third individual’s sales were “relatively small given his overall holdings and less than half what he sold in the preceding year,” the insider trading allegations did not give rise to a strong inference of scienter. The Court also found that the plaintiff had “failed to plead facts regarding GAAP accounting which would strongly support” a finding of scienter.
The court did not reach the defendants’ further contention that their cautionary statements brought their alleged misrepresentations within the safe-harbor for forward looking statements. The court said it would address these arguments once the plaintiffs had filed their amended pleading. The court sounded its own precautionary note when it observed that “Plaintiffs would appear to have a hard time convincing the Court that the safe harbor warnings employed here…were ‘blanket’ or ‘boilerplate.'”
Even though the IndyMac dismissal is without prejudice, it is a good reminder that even though the plaintiffs’ lawyers are piling on the lawsuits in response to the subprime mess, many of these lawsuits face some formidable obstacles. At lease in cases that, like the Indymac case, lack significant insider sales during the class period, the plaintiffs may face hurdles in satisfying the Tellabs scienter requirements. In addition, the precautionary disclosures for many of the financial services companies that are the targets of the subprime lawsuits are also as profuse as Indymac’s appear to be. The statutory safe harbor protection or the “bespeaks caution” doctrine may afford these defendants a substantial defense.
Finally, and even though it was not a factor in the Indymac order, plaintiffs in many of these cases may have a difficult time satisfying the loss causation pleading requirements. Given the general decline in financial services companies’ stock prices as a result of macroeconomic circumstances behind the subprime meltdown, it may be difficult in many cases for the plaintiffs to pinpoint a specific price decline that resulted for the alleged corrective disclosure. The challenges that plaintiffs in these cases may face in this regard is clearly suggested by Judge Wu’s reference to the “defendants’ inability to shield themselves” from the “drastic changes in the housing and mortgage markets.”
There are of course some cases where plaintiffs will have little difficulty in overcoming these obstacles. And of course the Indymac plaintiffs might well succeed in filing an amended complaint that can withstand a motion to dismiss. But the recent decision in the Indymac case is a reminder that the mere fact that a lawsuit has been filed does not necessarily mean that plaintiffs will achieve a substantial recovery or that the company or its D & O insurer will sustain a substantial loss. This could be an important consideration to keep in mind when assessing various estimates of the likely exposure of the D & O insurance industry to litigation arising from the subprime meltdown.
Securities Regulation a Little Lax, Eh?: Would-be corporate reformers cite the burdensome U.S. securities regulation as one factor affecting U.S competitiveness in the global financial marketplace. But at least the U.S securities regulator is an effective regulator. It would be far worse for the U.S. to have an expensive, ineffective regulator, as is amply demonstrated in the December 1, 2007 Toronto Star article about the Ontario Securities Commission (OSC), entitled “Why the OSC Rarely Gets Its Man” (here).
According to the article, because of the OSC’s ineffectiveness, “many high-profile cases of stock market manipulation or corporate fraud in recent years have left investors fuming that authorities have either failed to hold people accountable or taken way too long to apply justice.”
The article quotes an Indiana University finance professor who completed a comparative study of the OSC and the SEC and who said that “we found that enforcement in Ontario was pathetic. Canada is a first-world country with second-world capital markets and third-world enforcement.” As if that is not enough, the article also quotes the former CEO of the Toronto Stock Exchange as saying that Canada’s securities enforcement is an “international embarrassment.”
The problem does not seem to be funding. According to a Harvard law professor the article cites, “Canadian budgets and staffing may actually be somewhat more intensive than those in the United States.” Yet, despite this expenditure, as one commentator noted, “if you did a cost-benefit economic model, Canada would be the place to go for white-collar crime. Your chance of detection is small and the consequences of getting caught are not high.”
It should probably be noted that the apparently lax Canadian enforcement is simply the result of ineffectiveness; it is not the intended result of a conscious effort to make Canadian financial markets more competitive. But on the whole, the article indirectly makes a pretty strong case that the best way to maintain market integrity and an international reputation is to maintain effective regulation.
Special thanks to alert reader Shelley Lloyd for providing a link to the Toronto Star article.