In an interesting and potentially significant February 22, 2010 opinion (here), Southern District of New York Judge Naomi Reice Buchwald denied defendants’ motions to dismiss the plaintiffs’ ’34 Act claims in the Ambac Financial subprime-related securities suit. Judge Buchwald also denied the motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s February 2007 securities offering, but granted the defendants’ motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s March 2008 securities offering.


Judge Buchwald’s decision is particularly noteworthy for her rejection of defendants’ attempts to argue that the company’s woes were not the result of fraud but rather were the result of the global financial meltdown; among other things, she stated that "the conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim."



Ambac Financial Group is a monoline insurer providing protection against credit risk. Traditionally the company insured municipal bonds, but in more recent years prior to the financial crisis, the company increasing provided default protection for structured financial products such as residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).


In early January 2008, Ambac announced that it was taking a $5.4 mark-to-market loss on its CDO portfolio, that it was taking a $1.1 credit impairment charge, and that it expected a net loss for the quarter. The company also announced the resignation of the company’s CEO. The company’s share price declined, and two days later the company received the first of several rating downgrades from the rating agencies.


As noted here, the plaintiffs first filed their complaint in January 2008. In their ’34 Act claims, in which the defendants named are the company and certain of its directors and officers, the plaintiffs allege that the defendants mislead investors by continuing to portray Ambac’s underwriting procedures as cautious and conservative, while failing to disclose that the company had lowered its underwriting standards; by stating that Ambac was actively monitoring its RMBS and CDO portfolios and that the portfolios continued to outperform; and by failing to disclose in a timely manner any material impairment to the RMBS-related instruments that Ambac insured.


In their ’33 Act claims, which the plaintiffs asserted against the company and certain of its directors and officers, as well as against the offering underwriters and the company’s outside auditor (KPMG), the plaintiffs allege that the defendants made misleading statements in the offering documents about the company’s underwriting standards as well as regarding the company’s RMBS and CDO-related exposures.


The defendants moved to dismiss.


The February 22 Ruling

In rejecting the defendants’ motions to dismiss the ’34 Act claims, Judge Buchwald found that "the plaintiffs allegations of recklessness support a strong inference of scienter" for each of the ’34 Act claim defendants.


Judge Buchwald cited numerous allegations which she found sufficient to show that Ambac’s officers were aware that "Ambac lowered its underwriting standards in several ways." Among other things, she cited an internal October 2006 email to one of the defendants asking "Why are we willing to insure stuff in the secondary market [i.e., the CDO market] that we would not touch with a ten foot pole in the primary market [i.e., the RMBS market]?"


Judge Buchwald also found that the officers’ own public statements "detail the regular reports by which they would have learned of the allegedly drastic deterioration of their CDO portfolio." She went on to note that in various public statements the officers "themselves described in the means by which the raw material was collated and analyzed, as part of the surveillance process, and how this formed the basis for defendants’ statements."


In concluding that the plaintiffs had adequately pleaded recklessness, she rejected the alternative inference that the defendants urged her to draw from the allegations, namely that the officers could not have predicted the economic collapse and therefore the company’s modeling tools failed to identify the risk of loss in the CDO portfolio. In reaching this conclusion she noted:


Viewing the allegations collectively, there is a vast gap between the picture that Ambac presented to investors – of an insurance company that maintained its conservative approach over the years – and the alleged practices within the company, namely the undisclosed lowering of underwriting standards to drive short-term profits. Additionally, defendants’ arguments on this issue are premised on a convenient confusion of cause and effect. The conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim.


Judge Buchwald also found that the plaintiffs had adequately alleged misrepresentation and loss causation. Interestingly, in concluding that the plaintiffs had adequately alleged misrepresentation in connection with the CDO valuation issues, Judge Buchwald cited and apparently relied on the characterization of the company’s CDO portfolio in the plaintiff’s expert analysis, an interesting step at the motion to dismiss stage.


Finally Judge Buchwald held that the plaintiffs’ complaint adequately stated a ’33 Act claim with respect to the company’s February 2007 offering, but failed to state a claim with respect to the company’s March 2008 offering because the alleged misstatements in connection with that offering are not actionable under the "bespeaks caution" doctrine.


In allowing the claims relating to the February 2007 offering to go forward, she expressly rejected the defendants’ statute of limitations arguments, holding that the "storm warnings" on which the defendants sought to rely were not sufficient to put the plaintiffs on "inquiry notice," because Ambac’s officers had actively sought to reassure investors about those supposed storm warning.



Judge Buchwald’s ruling in this case is interesting and perhaps significant in a number of respects.


First, reliable sources in the plaintiffs’ bar advise me that Judge Buchwald is viewed as a tough draw for plaintiffs. These same sources advise that the fact that she is the one that wrote the opinion makes it even more noteworthy.


Second, I think her language in rejecting the "hey, the whole economy tanked" argument is important. There are a number of companies about whom it might be alleged, as was alleged here of Ambac, that they were "an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim." In other words, the general collapse of the financial markets alone might not be enough to refute the potential existence of fraud, if the plaintiffs sufficiently allege that the defendant companies nevertheless contributed to their own collapse.


This is significant because many companies that have been sued in the wake of the credit crisis have tried to refute the inference of fraud by arguing that that no one could have foreseen what subsequently happened. However, as Judge Buchwald noted, the collapse was not the result of the operation of some inevitable physical force. While there were many factors that contributed to the collapse, one of the causes may well have been various companies’ actions and statements prior to the collapse.


The fact that the subsequent collapse was generalized is not necessarily inconsistent with the possibility that prior to the collapse that fraudulent misconduct may have taken place at any one specific company – or, as Judge Buchwald noted, that the misconduct may have helped bring the collapse about.


I also think Judge Buchwald’s rulings are interesting because of her willingness to rely on plaintiffs’ expert’s analysis in finding misrepresentations on the CDO valuation issue and also because of her rejection of the statute of limitations argument based on the contention that "storm warnings" put the plaintiffs on "inquiry notice."


But the final reason that Judge Buchwald’s ruling may be significant is that it is a very strong opinion ruling in the plaintiffs’ favor in a high profile subprime-related case in the Southern District of New York. So many of the subprime related cases are pending in the Southern District, so the plaintiffs lawyer will of course seek to rely on Judge Buchwald’s holdings in other cases pending in that District.


It of course remains to be seen to what extent plaintiffs will be able to get mileage out of Judge Buchwald’s holdings in other cases. But it does in any event represent a significant victory for the plaintiffs.


I have added the Ambac decision to my table of subprime and credit crisis-related securities class action lawsuit dismissal motion rulings, which can be accessed here. It certainly does seem that recently the dismissal motion rulings have been coming down fast and furious.


Special thanks to a loyal reader for providing me with a copy of the Ambac decision.


Climate Change and D&O Coverage: In a recent post (here), I noted the possibility that the requirements of the SEC’s new interpretive guidance about climate change disclosure could create a context within which climate change disclosure claims might arise. If these kinds of claims do materialize, they potentially could create important coverage issues under applicable D&O insurance policies.


A February 19, 2010 memo by Collin Hite and Sung Yhim of the McGuire Woods law firm entitled "Global Warming Litigation and D&O Insurance Coverage Issues" takes a look at the kinds of coverage issues that might be involved if climate change-related disclosure cases do arise. The memo can be found here.