On March 18, 2009, Judge John F. Walter of the Southern District of California granted the defendants’ motion to dismiss, with leave to amend, in the subprim-related securities lawsuit involving certain former directors and officers of Downey Financial Corp. A copy of the order can be found here.

Background

Securities class action lawsuits were first filed against Downey and certain of its directors and officers in May 2008, following the company’s announcement before the market opened on March 17, 2008 that the company had experienced a significant increase in its nonperforming assets and that it found itself forced to restructure its loans with many borrowers. As reflected in its subsequently filed First Amended Consolidated Complaint , the plaintiff alleged that

(a) defendants’ portfolio of Option ARMs contained millions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (b) prior to the Class Period, Downey had seen Countrywide’s growth and had started to get more aggressive in acquiring loans from brokers such that the loans were extremely risky; (c) defendants failed to properly account for highly leveraged loans such as mortgage securities; (d) Downey had very little real underwriting, which led to large numbers of bad loans that would cause huge numbers of defaults; and (e) Downey had not adequately reserved for Option ARM loans, the terms of which provided that during the initial term of the loan borrowers could pay only as much as they desired with any underpayment being added to the loan balance.

In the amended complaint, the plaintiff alleged certain specific misrepresentations as to each of the three defendants, as well as other misrepresentation not attributed to any one defendant.

On November 21, 2008, the FDIC took control of Downey and sold its assets to another institution (about which refer here).

 The March 18 Order

The defendants moved to dismiss the plaintiffs complaint. Judge Walker summarized the plaintiff’s amended complaint (and perhaps tipped his hand about how he felt about plaintiff’s allegations) when he observed that "in short, Plaintiff alleges that the decline in Downey’s shareholder value resulted from alleged misrepresentations made to the investing public by Downey’s current and former officers and/or directors, and not from the current economic climate."

Judge Walker granted the motion on each of the grounds urged by the defendants: he found as follows: first, that the plaintiff failed to plead that the individual defendants made a material misrepresentation or omission; second, that the plaintiff failed to plead scienter adequately; and third, that plaintiff had failed to plead loss causation adequately.

With respect to the individual defendants’ own alleged misrepresentations, Judge Walter found that "there is not a single actionable misrepresentation or omission in the 161 pages of the [amended complaint] attributed to the Individual Defendants."The specific statements on which plaintiffs sought to rely were "far too vague to be actionable."

He also found that "the general allegations against Downey cannot be attributed to the Individual Defendants under the group pleading doctrine, because as this Court previously held, the group pleading doctrine did not survive the PSLRA."

With respect to the issue of scienter, Judge Walter found that the plaintiff’s allegations "when considered collectively, do not give rise to a strong inference of scienter." In reaching this conclusion, Judge Walter specifically observed that the defendants’ corporate positions alone do not give rise to scienter.

He similarly found that the plaintiff had not adequately pled scienter in connection with Downey’s public filings; the resignation and termination of Downey officials; the plaintiffs’ allegations of GAAP violations; and allegations based on confidential witness statements. In each instance, Judge Walter said the allegation were too vague and general and lacked the requisite specificity.

Judge Walter also found the absence of insider stock sales also negated the inference of scienter. He observed that two of the individual defendants had not sold any of their massive holdings of Downey stock. He found that “their substantial losses suffered "¦due to the failure to sell any stock during the class period negates any inference of scienter that may have been raised by other allegations."

Finally, with respect to loss causation, Judge Walter found that "the public disclosures referred to in the [amended complaint] do not contain disclosure of wrongdoing, and, at best, demonstrate only that the market learned of and reacted to Downey’s ‘poor financial health’ rather than any alleged fraud."

Judge Walter gave the plaintiff leave to file an amended complaint by April 1, 2009.

Discussion

Judge Walter’s opinion has a number of interesting features. First, in rejecting plaintiff’s contention that the defendants had misrepresented Downey’s exposure to "subprime" loans, he rejected plaintiff’s contention that a subprime loan is any loan made to a borrower with a FICO score below 660. He accepted defendantss argument that the company had fully disclosed that the company itself defined a subprime loan as one made to a borrower with a FICO score below 620. Because the company had fully disclosed its own definition of "subprime" loans (which definition Judge Walter also found had some support in financial literature), the defendants could rely on the company’s own definition of "subprime" in arguing that there had been no misrepresentations about the company’s exposure to subprime loans. 

Second, Judge Walter’s blanket statement that the "group pleading doctrine" did not survive the PSLRA is interesting, but it is a view that is not necessarily universally shared. Indeed, as I have noted elsewhere, the group pleading doctrine has recently undergone something of a revival in recent months.

In any event, the Downey Financial case can now be added to the lengthening list of subprime-related securities lawsuits in which motions to dismiss have been granted. It is also yet another example of a case, along with NovaStar Financial

I have added the Downey Financial decision to my register of subprime-related securities lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

Special thanks to a loyal reader for providing a copy of the Downey Order.

More Bank Failures: On March 20, 2009, the FDIC took control of three more banks: TeamBank N.A. of Paolo Kansas (refer here); Colorado National Bank, Colorado Springs, Colorado (refer here); and First City Bank, of Stockbridge, Georgia (refer here). The addition of these three banks brings the 2009 year to day bank failure tally to 20 (compared to 25 during the entire year of 2008). The FirstCity Bank closure is the eighth in Georgia since October 2007. The FDIC’s complete list of failed banks can be found here.

The possibility of additional claims growing out of these continuing banks failures undoubtedly remains as a significant factor, but prospective claimants might do well to review Judge Walter’s opinion in the Downey Financial case before pulling the trigger on filing a new securities lawsuit against the failed bank’s former directors and officers.

Apologies: I apologize for any typing, layout, font, or other errors that may appear in the published version of this post. I had more technical difficulties getting this one online than just about anything I have ever attempted with this blog. Gremlins, I suppose.