In recent decisions in separate subprime-related securities class action lawsuits reflecting a common unwillingness to engage in "backward looking assessments," two different Southern District of New York judges granted defendants’ motions to dismiss. In each of the cases, the judge’s recognition of the extent of the financial crisis played into their rulings, and in the absence of specific allegations showing how internal information or knowledge differed from the defendant companies’ public statements, both judges were unwilling to allow the cases to go forward.

The State Street Case　

In a February 22, 2010 opinion (here), Southern District of New York Judge Richard Holwell granted with prejudice the motion of defendants to dismiss the subprime-related securities class action lawsuit that had been filed against State Street Corporation, its management arm, and two executives and eight trustees of the management arm and one of the funds it managed, the Yield Plus Fund.

According to the complaint, the Fund’s value declined 34% during the class period of July 1, 2005 and June 30, 2008. This decline was alleged to have reflected the write-downs of the value of the Fund’s mortgage-related holdings. The Fund was liquidated on May 30, 2008.

The plaintiffs claimed that the Fund’s offering documents reflected three categories of misrepresentations: (1) a misleading description of the Fund’s investment strategy; (2) misrepresentations of the extent of Fund’s exposure to mortgage-related securities; and (3) inflated valuations of the Fun’s mortgage-related holdings. Based on these alleged misrepresentations, the plaintiffs sought to recover damages under the liability provisions of the Securities Act of 1933.

With respect to the plaintiffs’ allegations that the defendants’ misrepresented the Fund’s investment strategy, by misrepresenting its goal to invest in "high-quality debt securities," Judge Holwell found the plaintiffs had insufficiently pled falsity. He noted that though the phrase "high quality" is "somewhat vague when read in isolation," it "surely cannot be understood as a guarantee that investors would not suffer losses."

Judge Holwell also observed that the plaintiffs cannot allege that it was false for defendants to describe the Fund’s investments as high quality "without averring facts showing that the investments’ actual quality …was in fact otherwise." Judge Holwell went on to observe that:

Of course, from our vantage point on the other side of the financial crisis, it is conventional wisdom that highly rated, investment grade securities were exposed to risks that the rating agencies did not perceive….And not surprisingly, the Fund sustained most it is calamitous losses on securities with high investment ratings. …In hindsight then, it could be alleged that investments were viewed by defendants – and the marketplace – to be "high quality"…in fact stood on shaky foundations. But the accuracy of the offering documents must be assessed in light of information available at the time they were published…A backward-looking assessment of the infirmities of mortgage-related securities, therefore cannot help plaintiffs’ case.

 

As to the plaintiffs’ allegation that the offering documents misrepresented the Fund’s exposure to mortgage-related securities, Judge Holwell concluded that the plaintiffs had not alleged sufficient to plead that the Fund’s investment categorizations were materially misleading.

Finally, Judge Holwell held that plaintiffs’ allegations that the Fund overstated the value of its mortgage-related holdings "fail" because the Complaint "does not aver a single concrete fact to suggest that defendants deviated from the prescribed valuation methods." Judge Holwell noted that other financial entities, including even other mutual funds, have been accused of carrying mortgage-related securities on their books at inflated values, but in light of these other accusations, "the Complaint’s failure to identify information about how State Street overvalued its holdings is telling."

The CIBC Case　

In a March 17, 2010 opinion (here), Southern District of New York Judge William H. Pauley III granted the motions to dismiss the subprime related securities class action lawsuit filed against defendants Canadian Imperial Bank of Commerce (CIBC) and four of its officers and directors.

CIBC is a Canadian bank whose shares are traded on the New York and Toronto stock exchanges. The plaintiffs allege that the defendants misled investors about CIBC’s exposures to mortgage-backed securities.

In granting the motions to dismiss, Judge Pauley noted that not only had none of the defendants benefited from the alleged fraud, but in fact both CIBC and three of the four individuals bought CIBC shares during the class period. Judge Pauley noted that "it is nonsensical to impute dishonest motives to the Individual Defendants when each of them suffered significant losses in their stock holdings and executive compensation."

Judge Pauley also noted that the complaint "makes no reference to internal CIBC documents or confidential sources discrediting Defendants’ assertion that they were only adapting to a ‘rapidly changing economic environment’ during a ‘once-in-a-century credit tsunami’." He added that the plaintiffs "should, but do not, provide specific instances in which Defendants received information that was contrary to their public declarations."

Judge Pauley also noted a "compelling" alternative explanation for CIBC’s statements:

The Complaint describes an unprecedented paralysis of the credit market and a global recession. Major financial institutions like Bear Stearns, Merrill Lynch, and Lehman Brothers imploded as a consequence of the financial dislocation. Looking back, a full turn of the wheel would have been appropriate. That CIBC chose an incremental measured response, while erroneous in hindsight, is as plausible an explanation for the losses as an inference of fraud. …CIBC, like so may other institutions, could not have been expected to anticipate the crisis with the accuracy Plaintiff enjoys in hindsight.

Judge Pauley also found that the complaint "is bereft of factual allegations from which a reader could infer Defendants intentionally or recklessly failed to take write-downs on U.S. mortgage backed securities."

Judge Pauley’s dismissal order is not expressly without prejudice; however, he does close his opinion with the observation that "any request for leave to file an amended consolidated class action complaint should conform to this Court’s Individual Practices."

CIBC was represented by Jay Kasner and Scott Musoff of Skadden Arps. Andrew Longstreth’s March 18, 2010 AmLaw Litigation Daily article about the CIBC decision can be found here. Special thanks to the several readers who sent me copies of the CIBC ruling.

Discussion

These two opinions, both out of the Southern District of New York, where so many of the subprime and credit crisis-related securities class action lawsuits were filed, share a number of similar and significant features.

First and foremost, in both instances, the judges were reluctant to subject the defendant company’s pre-credit crisis disclosures to hindsight judgment. The courts were simply unwilling judge as fraudulent the defendants’ failure to anticipate the crisis that arose later.

Nor were the courts receptive to the arguments in both cases that the defendants knew their companies were vulnerable or knew that things were already going wrong. That is, without more specific details about what the defendants supposedly knew and how that differed from public statements, the courts were unwilling to let the cases go forward.

These two judges’ unwillingness, in light of the magnitude of the financial calamity, to engage in "backward-looking assessments," is a judicial predisposition that plaintiffs in many of these cases will have to struggle to overcome. Absent internal documents or confidential witness testimony showing internal company knowledge or information different from public statements, many other subprime and credit crisis cases may face the same fate as did the complaints in these two cases.

These ruling underscore how critical confidential witness testimony is. Indeed, as I noted here, in cases in which renewed motions to dismiss were denied after initial motions to dismiss had been granted, the critical additional detail that convinced the courts to allow the amended complaints to go forward was the addition of allegations supported by confidential witness testimony. In the absence of that corroborative support, courts seemingly are much more likely to follow their predisposition to avoid backward looking assessments.

In any event, I have added these two rulings to my register of subprime and credit crisis related dismissal motion rulings, which can be found here. The interim scoreboard continues to show that motions to dismiss in these cases are continuing to be granted in disproportionate numbers, at least so far than is the case for the universe of all securities class action cases. My recent status update of the subprime and credit crisis related litigation can be found here.

And Finally: "Outside of a dog, a book is man’s best friend. Inside a dog it’s too dark to read." Groucho Marx