Among the many cases filed as part of the subprime litigation wave are the numerous cases filed on behalf of holders of mortgage-backed securities against the firms that issued the securities. In many of these cases, the plaintiffs have not alleged that they have failed to receive payments due under the securities, but rather they have alleged that their investments have declined in value or are now riskier than when purchased.
As these cases accumulated in 2008 and 2009, observers questioned whether these investors’ claimed harms represented injuries cognizable under the federal securities laws, as I discussed in an earlier post.
In an October 14, 2010 decision (here), Southern District of New York Judge Miriam Goldman Cedarbaum held in a case filed on behalf of holders of certain asset-backed certificates issued by Goldman Sachs-related entities that, where the holders had not alleged that they had failed to receive payments due under the certificates, they had failed to allege injuries cognizable under the federal securities laws.
The investors had purchased the asset-backed certificates in 2007 offerings. The certificates entitled the holders to monthly distributions of interest, principal or both. The offering documents for the certificates warned investors that the offering underwriters "cannot assure you that a secondary market" for the securities will exist, and "consequently, you may not be able to sell your certificates readily or at prices that will enable you to realize your desired yield."
In its amended complaint, the plaintiff did not allege that it had failed to receive the monthly distributions. The harm the plaintiff claimed is that a hypothetical sale in the secondary market at the time of the suit "would have netted, at most, between 35 and 45 cents on the dollar." The plaintiff also claimed that it is exposed to "much more risk than the Offering Documents represented with respect to both the timing and absolute cash flow to be received."
In her October 14 ruling, Judge Cedarbaum noted that at a prior hearing she had previously denied the defendants’ motion to dismiss the plaintiffs’ claims based on Section 12 (a) (2) of the ’33 Act. However, she granted the defendants’ motion to dismiss plaintiffs’ Section 11 claims, holding that the plaintiffs alleged injuries were insufficient to state a claim.
In rejecting the sufficiency of plaintiff’s argument that that their certificates would have a diminished value in a hypothetical sale, Judge Cedarbaum noted that "the Certificates were issued with the express warning that they might be resalable." She concluded that because the plaintiff "made an investment that it knew might not be liquid, it may not allege injury based upon the hypothetical price of the Certificates on a secondary market at the time of the suit." She noted further that the complaint failed to allege that a secondary market for the certificates "actually exists" and also failed to allege "any facts regarding the actual market price" for the certificates at the time of the suit.
Judge Cedarbaum also rejected the sufficiency of the plaintiff’s allegations about the increased risk of diminished cash flow in the future, not that "Section 11 does not permit recovery for increased risk." She said that "to allege an injury cognizable under Section 11," the plaintiff must "allege the actual failure to receive payments due under the Certificates," adding that though the plaintiff has "had three opportunities to amend its complaint, it has never made the allegation."
As far as I am aware, Judge Cederbaum’s ruling is the first in which mortgage-backed investors’ Section 11 claims have been dismissed for lack of cognizable injury based on a failure to allege that payments due under the securities had been terminated or interrupted. There were quite a few of these mortgage-backed securities lawsuits filed during 2008 and 2009, and Judge Cedarbaum’s decision potentially could be quite significant in these other cases, at least where the investors have not alleged that payments due under the instruments have failed.
One aspect of this decision is the presence in these instruments’ offering documents of precautionary language warning about the potential unavailability of a secondary market for the instruments. Investors in instruments with offering documents that lacked this precautionary language may still be able to try to argue establish a cognizable injury based on the diminished resale value of the securities. However, those other claimants would also have to be able to allege that there actually is a secondary market for their securities and will have to allege what the resale price would be in order to allege injury sufficiently.
In any event, Judge Cedarbaum’s ruling potentially could be sufficient in many of the other securities suits that mortgage-backed asset investors filed in 2008 and 2009.
Special thanks to Doug Henkin of the Milbank Tweed law firm for providing a copy of Judge Cedarbaum’s opinion. Doug is the co-author of a paper I cited in my earlier post raising the question of whether mortgage-backed asset investors would be able to satisfy the requirements under Section 11 to allege a cognizable injury. An updated version of the paper can be found here.
I have in any event added Judge Cedarbaum’s ruling to my running tally of subprime and credit crisis related dismissal motion rulings, which can be found here.
A Securities Litigator’s Guide to D&O Insurance: Readers of this blog may be interested to know about two articles written by Jack Cinquegrana and John R. Barankiak Jr. of the Choate Hall law firm. The articles, which can be found here, are entitled "A Securities Litigator’s Guide to D&O Insurance," provide a brief overview of D&O insurance basics and also discusses issues that frequently arise concerning payment of defense costs and settlements. The articles are relatively short but contain some interesting observations and comments.
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