The plaintiffs’ complaint cited twenty-three confidential witnesses and relied on statements the appellate court itself described as “extravagant,” but the First Circuit nevertheless affirmed the lower court’s dismissal of the credit crisis-related securities class action lawsuit investors filed against Textron and certain of its directors and officers. A copy of the First Circuit’s June 7, 2012 opinion can be found here.


The plaintiffs’ complaint relates to events at Textron just before and at the beginning of the financial crisis. During 2007 and 2008, Textron made reassuring statements about the strength and depth of order backlog at its Cessna Aircraft subsidiary, which backlog Textron represented would help carry it through the difficult economic times. In early 2009, after several reassuring statements in 2008 about the strength of the backlog, Textron reported substantial cuts to Cessna’s production levels in the fourth quarter of 2008, citing few orders, as well numerous cancellations and delivery deferrals. The company’s share price slumped and securities class action lawsuits ensued.


As detailed here, the plaintiffs alleged that the Cessna airplane order backlog was artificially inflated. The plaintiff relied on 23 confidential witnesses in support of its allegations of known weak nesses in the backlog, in part by showing weaknesses in the underwriting for aviation financing offered in support of the airplane purchases. The defendants moved to dismiss.


In an August 24, 2011 order (here), District of Rhode Island Judge Paul Barbadoro found that the plaintiffs’ allegations were insufficient to show that material information was omitted. Judge Barbadoro found that the plaintiffs’ allegations of relaxed financing underwriting standards were too vague and failed to show that the alleged misrepresentations about the order backlog were false when made.


In its June 7, 2012 opinion written by Judge Michael Boudin for a three-judge panel that included retired Supreme Court Justice David Souter sitting by designation, the First Circuit affirmed the lower court’s dismissal of the case, saying that “we conclude that the complaint was deficient but regard the materiality issue as a close call and rest instead on the failure of the complaint to plead facts justifying a reasonable inference of scienter.” 


In addressing the question of materiality, the court did note that the confidential witnesses do “provide at least some indication that underwriting standards were loosened,” while at the same time “Textron comforted investors with assurances of its ‘traditional strong conservative underwriting process.’” After noting that discovery might “have clarified issues” in this regard, the Court observed that “we need not decide the materiality issue because the complaint fails adequately to allege scienter.”  


With respect to scienter, the Court said:


Nothing in the complaint suggests that any of the named officers believed, or was recklessly unaware, that the backlog’s significance had been undermined by weakened underwriting standards, sales to intermediaries, or any of the other flaws on which the plaintiffs rely…. Textron’s top managers may have been negligent if they were not aware; surely French [Textron’s CFO] was extravagant in saying of the backlog that Textron had “torn it apart.” But negligence or puffing are not enough for scienter…


The Court added that “while the relatively detailed factual proffers in the complaint go some distance toward making a case for materiality, they are considerably weaker in offering any direct evidence of guilty knowledge or fraudulent intent.” On the “crucial question” of when the airplane order cancellations began piling up, the various reassuring statements during 2008 and the confidential witnesses description of cancellations increasing “suddenly in ‘late summer 2008’” are, the Court said, “not in conflict.”


The Court concluded with the acknowledgement that the PSLRA’s heighted pleading requirements leave “a plaintiff’s counsel with a greater than usual burden of investigation before filings a securities fraud complaint.” District courts can, the Court said, refuse to dismiss cases that “fall into an intermediate gray area,” but “this complaint’s scienter allegations were weaker than its materiality allegations and did not even arguably fall into a gray area encouraging further proceedings.”



The underlying facts in this case clearly reflect the impact of the global financial crisis as it unfolded in the third and fourth quarters of 2008. The First Circuit does not expressly say it, but its analysis seems to reflect an awareness of how suddenly and dramatically things unraveled during that period. The Court’s analysis does seem to imply that merely because later circumstances turned out significantly different than anticipated, that alone does not mean that earlier statements were untrue or misleading when first made.


Nevertheless, the case does demonstrate, as the Court itself acknowledges, how difficult it is for plaintiffs to overcome the PSLRA’s heightened pleading standards. It is difficult to show materiality, and even if a plaintiff can establish materiality, the plaintiff must still establish scienter, and it is hard to establish scienter as well. The sheer difficulty of the task is highlighted by the fact that these hurdles cannot be overcome even with the benefit of the testimony of 23 confidential witnesses and even reliance on statements that the court itself described as “extravagant.”


In the end, however, and even though the subsequent events turned out differently than expected, the plaintiff’s case will not be going forward because the plaintiff wA unable to show that the statements were known to be untrue when made. Indeed, given how rapidly the crisis unfolded in late 2008, it seems at least equally plausible that the company truly believed that airplane order backlog would carry it through, and that the company, like so many others, was caught short by the extent of the drop off that followed the dramatic events in September 2008.


I have in any event added the First Circuit’s affirmance of the lower court’s dismissal to my running tally of the subprime and credit crisis-related lawsuit case resolutions. The tally can be accessed here.


Claire Zillman’s June 8, 2012 Am Law Litigation Daily article about the First Circuit’s opinion and entitled “23 Confidential Witnesses Still Can’t Save Textron Shareholder Suit” (here).


And Speaking of the Financial Crisis: With the passage of time, it is easy to forget just how crazy things were in late 2008. (If things continue as they are going in Europe now, we may get to re-experience many of the same emotions and sensations later this summer.) One of the many dramatic events during that period was the collapse of Washington Mutual, which failed on September 25, 2008. As I noted at that time (here), there were so many extraordinary things going on then that even the largest bank failure in U.S. history quickly faded from the front pages.


On June 8, 2012, the Wall Street Journal, in an article entitled “A Bank on the Run: How WaMu’s Demise Hit Home” (here) published an excerpt from a new book by Kirsten Grind entitled The Lost Bank, about the collapse of Washington Mutual. The excerpt recounts how the “seeds” of WaMu’s demise “were sown” in a “headlong push into subprime lending that sprouted with the 2004 purchase of Long Beach Mortgage, which was among the most aggressive sellers of home loans to people with sketchy credit histories.”


The bank’s subprime mortgage operations quickly produced problems, and the Long Beach Mortgage operations were the subject of critical internal audit reports, which cited the operations “unsafe” lending practices. American International Group, the company insuring WaMu’s mortgages, based on its own sampling of the mortgages, found evidence of mortgage fraud, but WaMu ignored the insurer’s warnings.


The excerpt also recounts how WaMu’s own marketing department, attempting to devise ways to make subprime mortgages more attractive to borrowers, compiled video footage of existing borrowers that gave “a sneak peak of the mortgage bust.” Rather than providing support for the attractiveness of the mortgages, the video footage unintentionally constituted a “raw and merciless documentary on high-risk lending.” When shown the footage, the “startled” head of WaMu’s Home Loans Group ordered the marketing team to begin working on “a friendlier approach.”


In the end the bank’s collapse has left a legacy of problems for homeowners, for investors and even for J.P. Morgan, which bought WaMu’s assets and which continues to increase its reserves because of deterioration in the WaMu mortgage portfolio.


WaMu’s collapse may have taken place nearly four years ago, but the events surrounding its collapse continue to reverberate. Just this past Friday night, the FDIC closed four more banks, after closing only two during the entire month of May. The four latest closures bring the 2012 YTD total number of failed banks to 28. The financial crisis may have peaked a while ago, but the consequences are still continuing to unfold.


Man in the Middle: It is never a good sign when  a U.S. Supreme Court justice appears on the cover of Time Magazine. It usually signifies that the Court is at the center of an important controversy, which certainly is the case these days. The justicve on the week’s cover is Justice Anthony Kennedy, who could well cast the deciding vote on several key cases either now before the Court or likely soon to be before the Court.


The article, entitled "What Will Justice Kennedy Do?" (here) takes a detailed look at Kennedy’s backgrodund, his judicial track record, and on his pragmatic, non-ideological approach to the cases before the Court. The article tries to tie his approach to Kennedy’s upbringing and professinal career in Sacramento.


The article rocounts how Kennedy has in recent years often served as the deciding vote in 5-4 decisions. The article asks rhetorically whether "sonething is wrong with democracy when one person holds so much sway over so many?" and the points out the "Kennedy is not the only person responsible for this state of affairs," adding:


He would not havd his majority-making power if his eight colleagues were not so rigid in their views. And the eight woudl not be so adamant if the political parties had not decided over the past generation that only carefully groomed, philosophically pure ideologues should be placed on the high court. Like the rest of the government, the Supreme Court has become polarized, increasingly unable to rise to the American tradition of splitting the difference, finding a compromise, muddling through.


Kennedy, the article says,  has "wrestled openly with the complications and nuances of a tough call."


The question is whether or not it is a good thing that Justice Kennedy may well prove to be the deciding vote on several of the ksy cases yet to be decided this term and to be decided next term.