In a September 24, 2010 order (here), Southern District of New York William Pauley denied the dismissal motions of Sallie Mae and its former CEO, Albert Lord, but granted the dismissal motion of CFO (and later CEO), Charles Andrews, in the credit crisis-related securities suit against Sallie Mae first filed in 2008. The decision is interesting in a number of respects, particularly concerning scienter issues.


Sallie Mae is one of the country’s largest providers of student loans. The complaint, which Judge Pauley described as "a behemoth" containing "labyrinthine allegations," alleges that in a series of statements in 2007, the defendants misled the market about Sallie Mae’s financial performance for the purpose of inflating its share price.


Among other things, the company was attempting during this same period to complete a planned merger with J.C. Flowers, an investment firm, in a transaction that ultimately was not consummated and that resulted in separate litigation (later settled) between the company and Flowers.


The complaint alleges that during the class period, the company lowered its borrowing criteria to increase its portfolio of lower quality but higher margin private loans; hid defaults by changing its forbearance policy; and inflated profits through inadequate loan loss reserves. The defendants moved to dismiss. My prior post about the lawsuit can be found here.


In his September 24 order, Judge Pauley denied the motion to dismiss as to Lord and the company, but he granted the motion to dismissal as to Andrews.


Judge Pauley first concluded that the plaintiffs had adequately alleged falsity. The defendants had argued that the plaintiffs had not alleged particularized facts sufficient to establish the falsity of the loan loss reserves. However, Judge Pauley observed, the plaintiffs primary challenge to the accuracy reserves, made in reliance on the testimony of confidential witnesses, was that Sallie Mae had not accurately reported its loan default rate (which in turn led to insufficient loan loss reserves). Judge Pauley held that "given the error in the default rate metric and its impact on Sallie Mae’s other financial reports, such allegations are sufficient to plead falsity."


In concluding that the plaintiffs had adequately alleged scienter with respect to Lord and Sallie Mae, Judge Pauley noted three reasons on which plaintiffs relied which, "considered together," are "sufficiently concrete to give rise to an inference" that Lord and Sallie Mae "possessed the intent to defraud shareholders." The three reasons were the Flowers transaction, Lord’s stock sales, and certain equity forward contracts.


Judge Pauley found that Lord had financial incentives to try to complete the Flowers transaction, because upon completion of the deal he would have received a $225 million cash payment and been free to exercise options at above market prices. In addition, Judge Pauley found that, in order to keep merger prospects alive, Lord also had an incentive to keep the company’s share price above the trigger in its equity forward contracts, because had the price gone below the trigger, the company would have been required to repurchase about $2.2 billion in shares, which "would have torpedoed the merger and Lord’s payout."


Judge Pauley also found that Lord made "unusual" stock sales in February, August and December 2007. The December sales, which took place two days after the Flowers transaction collapsed, and which represented a "liquidation of 97% of his Sallie Mae holdings," were "unusual for a corporate officer by any measure."


Lord had offered explanations for his stock sales – the August sales allegedly "were necessary to pay the exercise price of expiring options and associated taxes" and the December sale was "necessary to satisfy a margin call" – but with respect to Lord’s exculpatory explanations, Judge Pauley said "these facts remain in dispute."


By contrast, Judge Pauley found that the allegation of scienter as to Andrews were insufficient. Andrews not only had sold no shares but the defendants alleged he had acquired shares.


Lord’s incentives to complete the Flowers transaction clearly influence Pauley’s decision. The insider sales alone seem less determinative, as the timing of his sales seemed less than profit maximizing. For example, his December sale, the one he contends was triggered by a margin call, came two days after the Flowers deal collapse). This sale seems inconsistent with the theory that it represented the culmination of a fraudulent scheme.


In other words, it was the presence of the unusual and case specific circumstance of the Flowers deal that in large part explains this case’s survival of the dismissal motions.


I have in any event added the Sallie Mae case to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.


Special thanks to a loyal reader for providing a copy of the Sallie Mae opinion.


Behemoth and Labyrinth: When Judge Pauley described the plaintiffs’ complaint as a "behemoth," he was invoking a literary reference with rather startling associations. According to Wikepedia, the word "behemoth" first appeared in the book of Job, which says the following about the beast:

15 Behold now the behemoth that I have made with you; he eats grass like cattle.
16 Behold now his strength is in his loins and his power is in the navel of his belly.
17 His tail hardens like a cedar; the sinews of his thighs are knit together.
18 His limbs are as strong as copper, his bones as a load of iron.
19 His is the first of God’s ways; [only] his Maker can draw His sword [against him].
20 For the mountains bear food for him, and all the beasts of the field play there.
21 Does he lie under the shadows, in the cover of the reeds and the swamp
22 Do the shadows cover him as his shadow? Do the willows of the brook surround him?
23 Behold, he plunders the river, and [he] does not harden; he trusts that he will draw the Jordan into his mouth.
24 With His eyes He will take him; with snares He will puncture his nostrils.


Judge Pauley also described the plaintiffs’ allegations as "labyrinthine," presuamably in reference to the Labyrinth from Greek mythology. According to Wikipedia (here), the Labyrinth’s elaborate structure was "designed and built by the legendary artificer Daedalus for King Minos of Crete at Knossos. Its function was to hold the Minotaur, a creature that was half man and half bull and was eventually killed by the Athenian hero Theseus. Daedalus had made the Labyrinth so cunningly that he himself could barely escape it after he built it. Theseus was aided by Ariadne, who provided him with a skein of thread, literally the "clew", or "clue", so he could find his way out again."


Geez, no wonder the complaint survived the dismissal motion.