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.
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.