Finacial Downturn, Not Fraud, Caused Plaintiffs’ Losses: In a ruling that is interesting for what it says about the relevance of the overall economic downturn to the wave of subprime lawsuits, on August 20, 2009, Eastern District of Pennsylvania Judge R. Barclay Surrick, Jr. granted the motion to dismiss the securities fraud lawsuit that Luminent Mortgage Corporate had filed against Merrill Lynch and related entities. A copy of the August 20 opinion in the case, which was filed solely on behalf of the named plaintiffs and not as a class action, can be found here.


In August 2005, Luminent had acquired $26 million worth of the most junior tiers of Mortgage Loan Asset-Backed Certificates that were backed by nearly $1 billion of underlying mortgage loans. Merrill and the related defendant entities underwrote, issued and sold the securities. Luminent acquired the securities as part of a complex transaction whereby Merrill had financed Luminent’s purchase and then held the securities as collateral, while Luminent retained the rights to the income stream from the certificates. As the court later noted, Luminent’ purchase of securities from the most junior layers represented a riskier investment, a consideration that clearly affected the court’s analysis.


In April 2007, Luminent reviewed a sampling of some of the underlying mortgages and found that several of the mortgages deviated from information about the mortgages Luminent had been given prior to the purchase transaction. Luminent contended that a result of these deviations, which allegedly showed the mortgages to be less secure than had been represented prior to the purchase transaction, the underlying mortgages were experiencing an unexpectedly harsh rate of default and delinquencies.


The investment performance on the certificates was so poor that in September 2007, Luminent demanded rescission of its purchase. After the defendants refused to rescind, Luminent filed suit under a variety of legal theories, among other things alleging that the defendants, in violation of the federal securities laws, had misrepresented the composition of the pool of mortgages and had misrepresented their due diligence in scrutinizing and selecting the mortgages. The defendants moved to dismiss.


Judge Surrick granted the defendants’ motion on several grounds. First, he held that the complaint did not adequately plead scienter, finding that the plaintiffs had not alleged facts sufficient to show that the discrepancies in the loan sample Luminent reviewed were the result of anything more than negligence. He also found that the plaintiffs’ theory of fraud was inconsistent with the fact that Merrill retained Luminent’s securities as collateral for the purchase loan, as a result of which any purported fraud would have harmed Merrill as well as Luminent.


Judge Surrick also granted the defendants’ motion to dismiss on the grounds that the plaintiffs had not adequately pled economic loss or loss causation. With respect to the economic loss issue, Judge Surrick found that Luminent did not hold the securities themselves and did not and could not have sold them at a loss, and he found further that the plaintiffs had failed to allege how their diminished income stream "can be distinguished from the market-wide losses in mortgage-backed securities generally."


This latter point, about the indistinguishability of the plaintiffs’ losses from market-wide losses is the most interesting aspect of Judge Surrick’s opinion. In similarly holding that the plaintiffs had not adequately alleged loss causation, Judge Surrick cited Second Circuit case law to the effect that "when the plaintiff’s loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that plaintiffs’ loss was caused by fraud decreases."


Though the Second Circuit case from this cited language is drawn is a RICO case, Judge Surrick’s opinion is the second recent decision in which a district court granted a motion to dismiss in a subprime-related securities class action lawsuit on loss causation ground in reliance on this language. As noted here, on August 5, 2009, District of Massachusetts Judge Joseph L. Tauro also granted a motion to dismiss in the subprime-related securities class action lawsuit pending against First Marblehead, citing the identical language from the Second Circuit.


In convincing courts to grant their securities lawsuit dismissal motions on loss causation ground in reliance on the language drawn from a RICO case, defendants seem to have hit on a formula that appears to be drawing a sympathetic judicial response – that is, the argument is that if the plaintiffs were harmed at all, it was due only to the global financial crisis, not to the defendants’ alleged misconduct. Given the magnitude of the economic downturn, which was nearly universally unanticipated, this argument could well be extended to many if not most of the subprime and credit crisis-related lawsuits. The extent to which the defendants are able to exploit this argument in other cases remains to be seen, but for now defendants seem to have established a significant formula for dismissal motion success in these cases.


Luminent’s directors and officers were themselves a target of a subprime-related securities class action lawsuit. (Luminent itself filed for bankruptcy in September 2008.) As noted in detail here, the Luminent securities lawsuit settled in December 2008 based on defendants’ agreement to pay $8 million.


An August 28, 2009 article in the Legal Intelligencer about Judge Surrick’s opinion can be found here.


Citigroup Shareholders’ Derivate Lawsuit Dismissed: In an August 25, 2009 order (here) that largely tracks the earlier dismissal of the related Citigroup derivate lawsuit that had been pending on Delaware, Southern District of New York Judge Sidney Stein, applying Delaware law, granted the defendants’ motion to dismiss the consolidated Citigroup derivative lawsuit, holding that "the complaint fails to allege with specificity facts showing that plaintiffs are excused from pre-suit demand."


The plaintiffs had filed their complaints, later consolidated, against certain directors and officers of Citigroup, in connection with the billions of dollars Citigroup had lost from its investments in mortgages and mortgage-related securities. The consolidated complaint alleged that the defendants should be liable for allowing Citigroup to invest in subprime mortgages; failing to disclose the extent of Citigroup’s exposure to subprime mortgages; approving a stock repurchase plan despite Citigroup’s subprime exposure; committing securities fraud for failed to adequately disclose the company’s subprime exposure; and engaging in or allowing others to engage in insider trading.


The allegations were similar to but not identical to the allegations in the separate Delaware derivate lawsuit. The Delaware action, for example and by contrast to the New York action, also contained a claim for waste based on the severance package awarded former CEO Charles Prince. The New York action, by contrast, contained claims not alleged in the Delaware suit based on securities fraud and insider trading allegations.


In concluding that the plaintiffs in the New York action had failed to establish that the pre-suit demand was excused, Judge Stein, applying Delaware law, largely followed (and expressly quoted from) Chancellor Chandler’s prior dismissal ruling in the Delaware case


The interesting part about Judge Stein’s opinion is with respect to the claims that were raised in the New York action but not in the Delaware lawsuit, and therefore with respect to which Chancellor Chandler did not rule in his earlier opinion.


Specifically, in concluding that the plaintiffs had failed to establish that demand was excused with respect to their derivative claim for securities fraud, among other things, Judge Stein concluded that the plaintiffs had not established that the defendants "face a substantial likelihood of liability of securities fraud." (If the faced such liability, then the plaintiffs’ pre-suit demand would be excused as futile.)


Judge Stein found that the plaintiffs’ complaint "fails to allege with specificity which statements plaintiffs contend are fraudulent," and that it does not "allege with specificity why any alleged misstatement is fraudulent." In addition, Judge Stein held, citing Tellabs, that the complaint "does not state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind."


While Judge Stein found that the plaintiffs had failed to show a substantial likelihood of liability for securities fraud, he was careful to note that his ruling related only to the allegations in the consolidated derivative complaint in this case, and not to the securities fraud allegations that may have been raised in other lawsuits involving Citigroup and the same or related circumstances.


Judge Stein expressed skepticism that the plaintiffs could cure their pleading defects, and therefore rather than simply allowing the plaintiffs leave to file an amended complaint, he required them to file a motion seeking leave. The plaintiffs’ motions are due September 14, 2009.


I have in any event added Judge Stein’s ruling to my register of subprime-related lawsuit dismissal motion grants and denials, which can be accessed here.


My prior post discussed the corporate waste allegations in connection with Charles Prince’s severance package in the Citigroup derivative lawsuit in Delaware, which allegations survived the initial motion to dismiss in that case, can be found here.

Plaintiffs Target Stanford Financial’s Outside Counsel: On August 27, 2008, former Stanford Financial investors claiming damages of over $7 billion filed a purported class action lawsuit in the Northern District of Texas against former Stanford Financial outside counsel Thomas Sjoblum and his law firm, Proskauer Rose. A copy of the plaintiffs’ complaint can be found here.


In an apparent attempt to circumvent the limitations of the Stoneridge case, the plaintiffs filed their aiding and abetting claims against Sjoblum and his firm under the Texas securities laws rather than under the federal securities laws. The plaintiffs also assert alternative legal theories under Texas law, including civil conspiracy, aiding and abetting civil conspiracy and respondeat superior.


Given the revelations of former Stanford CFO James Davis at his August 27, 2009 guilty plea, it may not be surprising that Sjoblum has now gotten drawn into the case. (In an August 27, 2009 post, here, the Law Blog details Davis’s revelations.) Among other things, Davis, in the factual recitations in his plea agreement, suggested that Sjoblum, in concert with Stanford officials, made representations to the SEC that were contrary to information he had been given about the company and its operations, including problematic characterizations of the company’s portfolio.


The extent to which the plaintiffs will succeed in imposing gatekeeper responsibility on Sjoblum remains to be seen. The interesting thing to me about the lawsuit is how unusual it is for the lawyers to have gotten dragged into the litigation. There have been very few instances (if any) where lawyers have become targets in the litigation arising out of the various other Ponzi scheme scandals or any of the collapses associated with the subprime meltdown and credit crisis. To my knowledge neither the Madoff scandal nor the subprime litigation wave drawn in gatekeeper claims against the lawyers involved in the underlying transactions, even though gatekeeper claims have been an important part of both related categories of litigation (primarily with respect to auditors, offering underwriters and rating agencies).


I have in any event added the lawsuit against Sjoblum to my running register of the Stanford-related lawsuits, which can be accessed here.


An August 31, 2009 National Law Journal article about the Sjoblum lawsuit can be found here.


Upcoming Directors and Officers Liability Conference: On November 30, 2009 and December 1, 2009, I will be co-Chairing the American Conference Institute’s Fifteenth Annual Advanced Forum on D&O Liability, in New York City. The program features an all-star cast of experts in the field on a wide variety of critical topics in the area. A copy of the agenda and registration information can be found here.