On February 7, 2007, New Century Financial Corp. became the first company to be named in subprime-related securities lawsuit. On January 31, 2008, just short of one year later, Judge Dean Pregerson of the United States District Court for the Central District of California, granted the defendants’ motions to dismiss, but without prejudice and with leave to amend. For background on the lawsuit, refer here. For a copy of the January 31 opinion, refer here.
The plaintiff shareholders had initiated the complaint following the company’s February 7, 2007 announcement (here) that it would be restating its financial statements for the quarters ended March 31, June 30 and September 30, 2006, because of the company’s need to readjust the company’s allowance for “the potential repurchase of loans resulting from early-payment defaults by the underlying borrowers.” The company said that the reserve did not allow for the discounted price the company sustained upon its disposition of repurchased loans. The company’s press release also said that
the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculations did not properly consider, in each of the three quarters of 2006, the growing volume of repurchase claims outstanding.
On September 14, 2007, the lead plaintiff in the subprime-related securities lawsuit pending against New Century, the New York State Teachers’ Retirement System, filed a consolidated class action complaint. The consolidated complaint names as defendants the company and certain of its directors and officers; the company’s auditor, KPMG, and investment banks that underwrote the company’s June 2005 and August 2006 preferred stock offerings. The consolidated complaint raises allegations against all defendants under Section 11 of the ’33 Act, and against the company and its directors and officers under Section 10 of the ’34 Act.
In assessing the plaintiffs’ allegations, Judge Pregerson said that the complaint “lacks clarity in articulating the grounds for its claims.” The complaint “does not clearly identify the allegedly false statements or which of the factual allegations support and inference that particular statements are false or misleading.” The court attributed these shortcomings to the “lack of organization and somewhat unclear presentation of the allegations.” As a result, Judge Pregerson said, he “has difficulty determining whether plaintiffs have stated a claim.”
Judge Pregerson granted the motions to dismiss but allowed the plaintiffs leave to amend their complaint, by which the plaintiffs may attempt to “resolve deficiencies in the complaint by simple reorganization, revision and clarification of the currently long and at times meandering set of allegations.” The court instructed the plaintiffs that for each of the supposedly false or misleading statements, “the Complaint should identify some facts suggesting that the statement is false or misleading.” The court also directed the plaintiffs to attach to their amended complaint a chart specifying each allegedly false or misleading statement, the supporting factual allegations and the plaintiffs’ conclusion.
Like the prior dismissal of the subprime-related securities lawsuits involving IndyMac (about which refer here), the dismissal in the New Century case is without prejudice. Judge Pregerson’s opinion in the New Century case does not reach the merits, but nevertheless shows great impatience with the plaintiffs’ scattershot pleading approach. (“The Court,” Judge Pregerson observed in a footnote, “should not have to comb through the complaint to identify reasonable inferences from factual allegations to the legal conclusions.”) The plaintiffs have until February 25, 2008 to file an amended complaint. The court has scheduled argument on the updated motions to dismiss on April 21, 2008.
And so the motion to dismiss on the first-filed subprime securities lawsuit might be ready to be decided some 15 months (or more) after the complaint was initially filed. Obviously, at this rate it will take many years before the many subprime related cases have finally ground their way through the system, and before the full impact of the still evolving subprime crisis can be fully assessed.
But it is interesting to reflect, upon review of the events leading up to the New Century lawsuit, and as the subprime meltdown continues to unfold, that as early as the first quarter of 2006, New Century was already experiencing unanticipated loan repurchase requirements resulting from early-payment defaults on subprime loans. The subprime meltdown may seem like a sudden crisis, but has actually already been years in the making and will be even longer in the unfolding. Clearly, the wheels of finance, like the wheels of the law, grind exceeding slow but exceeding fine.
Hat tip to the Class Action Defense Blog (here) for the link to the January 31, 2008 opinion in the New Century case.
Loaded for Bear: The February 15, 2008 Wall Street Journal had an interesting article entitled “Bear Probe May Center on Investor Call” (here) discussing how federal prosecutors’ investigating the collapse of two Bear Stearns hedge funds managed by Ralph Cioffi are examining Cioffi’s statements in an April 25, 2007 conference call with hedge fund investors. Readers interested in this investigation will want to refer back to the December 17, 2007 Business Week article entitled “The Bear Flu: How it Spread” (here) for further background on the circumstances under investigation.
According to the Business Week article, in the April 25 call, Cioffi made statements about a Bear Stearns branded CDO mechanism that Cioffi also managed called “Klio funding.” This mechanism sold commercial paper and other short term debt to money market funds to allow the CDO to buy other higher yielding, longer-term securities. The money market funds were willing to invest because Citigroup agreed to refund their initial stake plays interest (in a so-called “liquidity put”). Citigroup, in turn, drew fees and also was able to sell the Klios mortgage-backed securities of its own.
According to Business Week, the Klio structure spread rapidly as other hedge funds, CDO managers and bankers “followed Cioffi’s lead.” Between 2004 and 2007, Wall Street raised $100 billion through these types of CDOs, “essentially creating a whole new way for industry to finance risky subprime loans.” The article goes on to detail how the Klios offered the Bear Stearns hedge funds a “ready, in-house trading partner,” and that in many months “the Cioffi-managed Klios traded only with the Cioffi-managed Bear funds.” The daisy chain ended in disaster when the subprime loans underlying these investments began to deteriorate. Much of the subprime-related writedowns amongst the investment banks are related to the liquidity puts they provided.
The Journal article reports that in the April 25 call, one participant wondered whether the packaged mortgage securities in the Bear hedge funds were tied to subprime assets. Cioffi reportedly responded that he didn’t have time to teach “CDO 101” or answer basic questions about the securities. It is probably worth observing that the April 25 call came several weeks after New Century had (as noted above) filed for bankruptcy as a result of deteriorating subprime mortgages that were already a problem more than a year before that. The questioner’s inquiry in the April 25 call about subprime was not, as Cioffi’s belittling response suggests, the result of naïveté, but rather well-grounded concern.
Cioffi’s response, although lacking the vulgarity, calls to mind Jeffrey Skilling’s now infamous conference call statement in the fateful final months of Enron. In response to an analyst’s comment that Enron was the only company that releases its earnings statement without a balance sheet, Skilling said “Well, thank you very much, we appreciate that … asshole.” (Refer here for the details about Skilling and the infamous call.)
The comparison may or may not be fair. But every scandal needs a villain, and fair or not, it appears at least based on the news coverage concerning the collapse of the two Bear Stearns hedge funds, that the casting is now complete. It appears that during the current Act of the subprime drama that the role of villain is to be played by Ralph Cioffi, and as with those called to play the villains in prior dramas, his arrogance will be one of the things held against him.
The Backdating Disposition List, Updated: Regular readers know that I have been maintaining a list (accessed here) reflecting all backdating lawsuit dismissals, denials and settlements. I have recently updated the list to add three additional dismissals in options backdating-related derivative lawsuits, two of which are late additions of dismissals I missed last fall. The three dismissals are as follows:
Openwave: On February 12, 2008, the United States District Court for the Northern District of California granted (here) the defendants’ motion to dismiss the plaintiffs’ options backdating related derivative suit, with leave to amend. The court had previously dismissed the plaintiffs’ initial complaint, with leave to amend.The February 12 decision related to the plaintiffs’ amended complaint. The court will allow the plaintiffs another opportunity to amend.
Westwood One: According to the company’s November 1, 2007 filing in Form 10-Q (here), on August 3, 2007, the N.Y. Supreme Court granted the defendants’ motion to dismiss the plaintiffs’ options backdating-related shareholders’ derivative suit. On September 20, 2007, the plaintiffs’ appealed the court’s dismissal and moved for “renewal” under relevant statutes. The appeal remains pending.
Clorox: According to the company’s November 1, 2007 filing on Form 10-Q (here), on October 27, 2007, the plaintiffs voluntarily dismissed their options backdating-related derivative lawsuit in response to the recommendation of the company’s Board’s Audit Committee’s recommendation to the Board that the Board reject the plaintiffs’ suit demand, on the grounds that the suit was not in the best interests of the company.
Special thanks to Adam Savett of the Securities Litigation Watch blog for the information regarding the Westwood One and Clorox dismissals.
Headline of the Week: Still unexplained: why would anyone want TWO dead dogs?: From the February 16, 2007 Financial Times: “Ground-Dog Day as Woman Pays $50,000 to Clone Dead Pitbull” (here).