On October 19, 2009, in a securities case from an earlier era involved allegedly misleading statements regarding asset-backed securities, Southern District of New York Judge Harold Baer substantially denied the defendants’ motions to dismiss the plaintiffs’ complaint as amended, following the long-running case’s trip through the Second Circuit on interlocutory appeal. A copy of the October 19 opinion can be found here.

Judge Baer’s decision in the Dynex Capital securities case is noteworthy not only because of the previous high profile appellate decision in the case, but also because Judge Baer found plaintiffs’ amended allegations sufficient to survive the renewed motion to dismiss, after prior pleadings had failed in whole or in part to withstand scrutiny.

Though the case is from a slightly earlier era (it was initially filed in 2005), it raises many allegations similar to those involved in the current round of subprime and credit crisis-related securities lawsuits, and therefore could be influential with respect to dismissal motions in the more recent cases.

Background

Dynex was in the business of packaging mortgage loans into securities. Between 1996 and 1999, Dynex originated or purchased 13,000 mobile home loans that served as collateral for bonds that a unit of the company issued. The underlying loans performed poorly and in 2003-04 the bonds were downgraded by the rating agencies. The bonds’ value dropped by as much as 85%.

The plaintiffs filed a securities class action lawsuit on behalf of investors who had purchased the bonds between February 7, 2000 and May 13, 2004. The plaintiffs allege that the defendants artificially inflated the bonds’ price by misrepresenting that the poor performance of the bond collateral was due to market conditions, concealing that the defendants’ "aggressive and reckless loan underwriting and origination practices generated a pool of collateral loans of poor credit quality and inherent defects."

In a February 2006 opinion (here), Judge Baer granted the defendants’ motion to dismiss the complaint as to the individual defendants for failure to adequately allege scienter, but he denied the motion as to the corporate defendants. In June 2006 he certified his opinion for interlocutory appeal on the question "whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite scienter."

In 2008, the Second Circuit held (here) that corporate scienter may be sustained even "in the absence of successfully pleading scienter as to an expressly named officer." However, the Second Circuit held that the plaintiffs had not met the standard for corporate scienter, vacated Judge Baer’s prior ruling and remanded the case to allow the plaintiffs an opportunity to replead.

The plaintiff filed a second amended complaint (hereafter, the amended complaint) and the defendants’ renewed their motion to dismiss.

The October 19 Opinion

In their newly amended complaint, the plaintiffs added the statements of nine confidential witnesses and also identified and described for the first time four categories of reports that the plaintiffs alleged put the defendants on notice that their public statements were materially misleading.

Based on the confidential witnesses’ statements, which bolstered the plaintiffs’ allegations about how the defendants accessed and used the identified categories of reports, Judge Baer found that the plaintiffs had sufficiently alleged that several categories of the statements on which plaintiffs sought to rely were misleading and false. These categories included defendants’ statements regarding the adherence to underwriting standards; the defendants’ statements about the reasons for the deterioration in the collateral performance; and the defendants’ statements about the adequacy of the company’s loan loss reserves and internal controls.

More significantly in light of the case’s prior procedural history, Judge Baer found that the plaintiffs had adequately pled scienter. Judge Baer found that the plaintiffs’ allegations about the information available to defendants in the newly referenced documents represented strong circumstantial evidence of scienter. Judge Baer found that the amended complaint, by contrast to the plaintiffs’ prior complaint, "contains factual allegations about several forms of reports that collectively provided to Dynex’s senior management, including the Individual Defendants, information that contradicted their misleading statements."

The information in the documents was "available to and reviewed by the senior management responsible for the public statements at issue that either put them on notice of the falsity of these statements or clearly should have done so." Judge Baer found that the inference of scienter from these allegations was as least as compelling as the contrary inference that the defendants sought to draw.

Judge Baer found that when the amended complaint is viewed "holistically," a "cogent story of securities fraud is revealed":

The Defendants originated or purchased a large number of mobile home loans of generally low credit quality, a substantial number of which were "inherently defective," and packaged them into the Bonds failing to disclose that the stated underwriting guidelines were "systematically disregarded"; then, when adverse market conditions coincided with rising defaults and many loans were uncollectible as a consequence of inherent defects, Defendants publicly stated that market conditions were to blame in an attempt to forestall deeper drops in the value of the Bonds, many of which they held for their own account.

Accordingly, Judge Baer held that the amended complaint "alleges facts giving rise to a strong inference" that the statements he "found to be false and misleading were made with scienter."

Discussion

The Dynex Capital case arose in February 2005, two years before the current round of subprime and credit crisis litigation began, but the plaintiffs’ allegations are remarkably similar to many of the allegations raised in the more recent lawsuits. The fact that the amended complaint largely survived the most recent motions to dismiss is all the more significant given the plaintiffs’ early difficulties in the district and appellate courts in trying to get over the initial pleading hurdles.

The fact that the plaintiffs in the Dynex Capital case were ultimately able to overcome the initial pleading hurdles will obviously be of particular interest to the plaintiffs in the more recent cases. The plaintiffs were able to survive the renewed dismissal motion in this case because of the large number of well-placed confidential witnesses who were able to provide detailed descriptions of the company’s processes and of the key documents and their availability to senior management, as well as how the information in the documents allegedly contrasted with the defendants’ public statements.

Obviously not all plaintiffs in other cases will be able to muster the same number or caliber of confidential witnesses or success in being able to utilize confidential witnesses to show with such particularity what information was available to senior management and how the available information contrasted with public statements.

But the fact that the plaintiffs in this case were able to put those elements together, and were able to do so in a way sufficient to overcome the court’s original skepticism shows that plaintiffs in general can put together allegations to surmount even the heightened scienter pleading standards of the Tellabs case. The fact that these plaintiffs were able to do so after the initial pleading challenges also suggests that in other cases in which plaintiffs initial complaints failed to survive, the pleading defects still may be overcome with sufficiently particularized amended pleading, even on the critical issue of scienter.

In any event, because of the similarity of the allegations on this case to the allegations in many of the current cases, Judge Baer’s recent decision in the Dynex Capital case is likely to be important in the current cases similarly involving asset-backed securities allegedly misleading disclosures about underwriting standards, collateral quality, internal controls and adequacy of loan loss reserves.

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing a copy of Judge Baer’s October 19 opinion.