In a gigantic 398-page opinion dated January 19, 2011, Southern District of New York Judge Robert Sweet has denied the defendants’ motion to dismiss in the securities class action lawsuit filed in connection with the collapse of Bear Stearns. He did however grant defendants’ motions to dismiss the related shareholders’ derivative lawsuit and ERISA class action lawsuits. A copy of Judge Sweet’s January 19 opinion can be found here.
As detailed here and here, investors first filed a securities class action lawsuit against Bear Stearns and certain of its directors and officers in March 2008 in the wake of the company’s collapse and sale to JP Morgan. As amended the plaintiffs’ complaint also names the company’s outside auditor, Deloitte & Touche, LLP, as a defendant.
In their massive consolidated amended complaint (here) , the securities class action plaintiffs allege that in a series of statements during the class period, the defendants made material misrepresentations or omissions with regard to the company’s exposure to subprime mortgages; with respect to the performance of and valuations in connectionwith one of its hedge funds; with respect to the company’s liquidity; with respect to the company’s risk management and valuation practices. The company is alleged to have inflated its reported financial results and financial condition, among other things due to use of inappropriate models to value the company’s subprime-mortgage related assets. Deloitte is alleged to have knowingly and recklessly offered materially misleading opinions about the company’s accuracy.
A separate shareholders’ derivative action was also filed, as was an ERISA class action lawsuit, which were consolidated with the securities class action lawsuit. The defendants in the various actions moved to dismiss.
The January 19 Opinion
In a detailed analysis dozens of pages in length, Judge Sweet rejected the defendants’ contention that the plaintiffs’ allegations of materially misleading statements were insufficient.
Judge Sweet also held that the plaintiffs adequately pled scienter. While he concluded that the individual defendants’ trading in their shares of company stock were not sufficient to establish motive and opportunity to violate the securities laws, he nevertheless found that plaintiffs allegations were sufficient to establish a strong inference of conscious misbehavior and recklessness.
In concluding that the plaintiffs had adequately alleged scienter, Judge Sweet noted, among other things, that
the Securities Complaint has alleged that the Bear Stearns Defendants willfully or recklessly disregarded warnings from the SEC regarding Bear Stearns’ risk and valuation models which allegedly were designed to give falsely optimistic accounts of the Company’s risk and finances during the Class Period. The Securities Complaint also alleges that the Bear Stearns Defendants improperly delaying taking the hedge fund collateral, thus intentionally or recklessly avoiding the revelation of losses and the consequent negative effect. These allegations are sufficient to create a strong inference of scienter.
Judge Sweet expressly rejected the defendants’ allegation that the plaintiffs’ allegations represented mere fraud-by-hindsight, noting that “the adverse consequences of Bear Stearns’ disclosures relating to its exposure to declines in the housing market, and the adverse impact of those circumstances on the Company’s business going forward, are alleged to have been entirely foreseeable to Defendants at all relevant times.”
In rejecting the fraud-by-hindsight contention, Judge Sweet also cited with approval from the February 2010 dismissal motion ruling in the Ambac subprime securities lawsuit, in which Judge Naomi Reice Buchwald had noted that the conduct alleged, if true “make the defendants an active participant in the collapse of their own business, and of the financial markets in general, rather than a mere passive victim.” Judge Sweet added that “the same logic applies here, where Defendants’ alleged misconduct was integral to the decline of Bear Stearns, and the financial markets with it.”
Judge Sweet also held that the plaintiffs had adequately alleged loss causation, stating that:
The Company’s failure to maintain effective internal controls, its substantially lax risk management standards, and its failure to report is 2006-2007 financial statements in accordance with GAAP not only were material. but also triggered foreseeable and grave consequences for the Company. The financial reporting that was presented in violation of GAAP conveyed the impression that the Company was more profitable, better capitalized, and would have better access to liquidity than was actually the case. The price of Bear Stearns’ securities during the Class Period was affected by those omissions and allegedly false statements and was inflated artificially as a result thereof. Thus, the precipitous declines in value of the securities purchased by the Class were a direct, foreseeable, and proximate result of the corrective disclosures of the truth with respect to Defendants’ allegedly false and misleading statements.
Judge Sweet also rejected Deloitte’s motion to dismiss, holding that the securities complaint adequately alleged the firm’s recklessness, “if not actual knowledge, based on its awareness of red flags and its duty to investigate.” Judge Sweet held that the plaintiffs had adequately alleged scienter as to Deloitte, observing that “the facts underlying the alleged accounting violations with respect to the valuation models and fair value measurements, the hedge funds and the inference from the events of the collapse establish the failure to consider the red flags and constitute adequate allegation of reckless disregard sufficient to establish scienter.”
While Judge Sweet entirely denied the securities class action defendants’ motion to dismiss, he granted the defendants’ motions to dismiss the consolidated shareholders’ derivative suit. The derivative suit was essentially a “double derivative” suit brought on behalf of shareholders of JP Morgan, alleging misconduct on the part of various Bear Stearns defendants. Judge Sweet agreed with the defendants’ contention that the plaintiff lacked standing to assert the double derivative allegations because the plaintiff no longer holds Bear Stearns shares and does not sufficiently allege harm to JP Morgan. Judge Sweet also found that the plaintiff had not adequately alleged demand futility. He also concluded that certain of the plaintiff’s claims were barred by the doctrines of res judicata and collateral estoppel.
Finally, Judge Sweet granted the motion to dismiss the ERISA class action complaint, holding that the plaintiffs’ allegations were not sufficient to overcome the applicable presumption of prudence and failed to establish improper conflicts of interest.
In a recent post I noted that whatever may be the overall track record for plaintiffs in the securities lawsuits arising out of the subprime meltdown and credit crisis, the plaintiffs are showing a consistent record of success in this highest profile cases. The Bear Stearns case my be one of the highest profile cases of all, because, as Judge Sweet noted at the outset of his opinion, the Bear Stearns collapse “was an early and major event in the turmoil that has affected the financial markets and the national and world economies.”
Not only is the outcome of the dismissal motions in the Bear Stearns case entirely consistent with the prior outcomes in other high profile cases, but Judge Sweet’s rulings were made in reliance on the opinions in many of those other cases, including in particular AIG (refer here) and Fannie Mae (refer here).
One prior ruling on which Judge Sweet particularly relied is Judge Naomi Reice Buchwald’s dismissal motion denial in the Ambac Financial case, about which I previously commented here. I noted the significance at the time of Judge Buchwald’s holding that the general financial collapse is no defense to securities fraud if the defendants allegedly caused their own and the financial system’s collapse. I continue to believe this analysis may be influential in other pending cases, as it was here in the Bear Stearns case.
In any event, the Bear Stearns case joins the growing list of high-profile subprime meltdown and credit crisis cases in which the dismissal motions have been denied, including Citigroup (refer here), AIG (here), Countrywide (here), Fannie Mae (here), Washington Mutual (here), New Century Financial (here), Sallie Mae (here) and Bank of America (here).
It is entirely possible that JP Morgan anticipated the possibiltiy of this development at the time it acquired Bear Stearns; according to press reports at the time, in connection with the acquisition, JP Morgan set aside $6 billion to cover anticipated litigation costs (among other things).
I have in any event added the Bear Stearns decision to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here. (Note that I have separately tallied Judge Sweet’s rulings on the securities class action, derivative and ERISA lawsuits.)
David Bario’s January 24, 2011 Am Law Litigation Daily article about the Bear Stearns opinion can be found here.