As the most dramatic evens from the financial crisis recede into the past, there is an urge to consign the downturn to the pages of history, But the banking crisis in Cyprus earlier this week, along with persistent unemployment in this country and elsewhere, show that, as much as we would all like to turn the page, the credit crisis still is not yet in the past. And just like the economic effects, the litigation that accumulated as a result of the crisis continues to grind through the courts as well.

The most recent example of the continuation of the credit crisis litigation involves a case pending in the Southern District of New York against Deutsche Bank and four of its directors and officers. The case was filed on behalf of investors who purchased Deutsche Bank common stock between January 3, 2007 and January 16, 2009. (Based on Morrison, the district court dismissed from the case any shareholders who purchased their shares outside the United States.) 

In a March 27, 2013 order (here), Southern District of New York Judge Katherine Forrest largely denied the defendants’ motions to dismiss the plaintiffs’ complaint. There are a number of interesting things about Judge Forrest’s ruling, in particular the significance she attached to the massive (and profitable) short bet a Deutsche Bank trader made against residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) at the same time Deutsche Bank was profiting from packaging and selling these very kinds of securities to outside investors.

Background

As discussed here, the plaintiffs first filed their lawsuit in 2011, seeking damages under the federal securities laws based both on an alleged scheme to defraud and on alleged misrepresentations or omissions. The plaintiffs alleged that the bank had structured and sold RMBS that it knew to be poor quality; misrepresented its risk management practices; failed to write down impaired securities; and disregarded findings that the residential mortgage loans did not comply with underwriting standards.

The defendants moved to dismiss, arguing that the “scheme” theory was after the fact construct rather than a before the fact plan; that the alleged misstatements were merely subjective opinions that are not actionable and that in any event were not made with scienter, and that the specific defendants were not the makers of actionable misstatements.

In drafting their complaint, the plaintiffs were able to draw extensively on the April 2011 report about the financial crisis of the U.S. Senate Subcommittee on Investigations as well as complaints that the U.S. Department of Justice and the Federal Housing Finance Agency filed against Deutsche Bank. Among other things to which plaintiffs were able to cite and to which Judge Forrest referred in her opinion were internal emails referring to the RMBS that the bank was marketing as “crap” and referring to the CDOs that the bank was structuring as a “balance sheet dump” (As is now all too familiar with allegations of damaging internal emails, there are many similar statements in this same vein.)

In her opinion, Judge Forrest also cites at length allegations based on internal communications relating to a massive bet a Deutsche Bank trader, Greg Lippmann, had made against the very kind of RMBS that the bank was packaging and selling. His short position ultimately grew to be as large as $4 to $5 billion. The position was so large that it drew the attention of the top company management, who reviewed his position and allowed him to continue to pursue his strategy. Judge Forrest’s opinion quotes numerous internal emails in which Lippmann disparaged Deutsche Bank’s own RMBS deals. Lippmann’s short bet ultimately returned profits of $1.5 billion, allegedly “the largest profit Deutsche Bank ever obtained from a single short position.”

In denying Deutsche Bank’s motion to dismiss, Judge Forrest found the “defendants had specific knowledge of the poor quality of the mortgages” and that the defendants “demonstrated this knowledge by authorizing Lippmann to take and expand a multi-billion dollar short position. Despite their awareness of these problems, the defendants “nonetheless repeatedly assured investors that their credit and lending practices were conservative and being adhered to.”

Judge Forrest specifically rejected the defendants’ argument that the alleged misrepresentations and omissions on which the plaintiffs sought to rely were mere non-actionable statements of opinion. She noted that the plaintiffs allege that “at the very time the market was beginning to experience the early effects of the sub-prime implosion, Deutsche Bank made statements that it had acted conservatively with respect to risk and had adhered to conservative lending standards.” Noting that the plaintiffs also alleged that at the same time defendants made these statements, “the same individuals who had made the statements had been provided information indicating the opposite,” allegations that present facts “supportive of both objective and subjective falsity.”

In concluding that the scienter allegations were sufficient as to three of the four individuals defendants (the fourth was dismissed for lack of any allegations tying the individual to any specific statements), Judge Forrest noted that the defendants had made statements about the mortgage-backed securities operations “while at the same time knowing that these assets were far riskier than an investor might reasonably suppose.” She specifically reference allegations that Lippmann had made presentations to the Executive Committee, of which the three defendants were members, supporting his view that a multi-billion dollar bet against RMBSs and CDOs was appropriate. These allegations, she found, “support a strong inference of scienter.”

Discussion

A few days ago, when it was announced that Citigroup had settled the subprime-related bondholders’ action for $730 million, there was a sense that the subprime litigation stage might finally be winding up, with only a little bit of moping up left to go. At almost the same time, however, the U.S. Supreme Court denied a writ of certiorari in the Goldman Sachs bondholders’ action, ensuring that the Goldman case would go forward with a broad class definition as a result of the Second Circuit’s opinion in that case (about which refer here, fourth item).

And now Judge Forrest has denied the motion to dismiss in this case involving Deutsche Bank. The ongoing cases against Goldman Sachs and now this one against Deutsche Bank are reminders that the subprime-related litigation wave may still have a lot further to run yet.

The significance that Judge Forrest attached to Deutsche Bank’s internal emails is nothing new. By now we have now grown accustomed to the damaging use that can be made of incautions or ill-advised internal emails. What is perhaps more interesting is the significance that she attached to Lippmann’s short position and his internal communications about it (that is, his defense to company management of his investment position). It is true that Lippmann’s short position ultimately grew to several billion dollars. At the same time, though, Deutsche Bank’s mortgage group held a $102 long position, and another affiliate held a separate long position of almost $9 billion.

The defendants had tried to argue that the much larger long position showed the company’s true beliefs about the market for mortgage-backed securities. Judge Forrest said about the divergent bets that “it simply means that they are gamblers unwilling to place their entire bet on red, versus black.” The plaintiffs’ complaint, she found, “plausibly suggests that they assured investors that their bets were in one direction – and omitted that they had taken bets in both directions.” That is, everything they said was consistent with and supported their long position, without divulging the (admittedly much smaller) short position.  The key seems to be that the plaintiffs alleged both that the defendants were aware of Lippmann’s short position and his reasons for taking it; they were not only aware of the concerns on which the short bet was based but they allowed him to expose billions of dollars on the bet, while providing reassuring words to investors.

Seventh Circuit Affirms Boeing Securities Suit Dismissal: The outcome of the dismissal motions in the Deutsche Bank case shows how advantageous it can be for plaintiffs lawyers when they have extensive public resources (like a 646-page Senate report) on which to rely in crafting their allegations. The Seventh Circuit’s March 26, 2013 affirmance of the district court’s dismissal of the securities suit that had been filed against Boeing and based on production delays involving its Dreamliner aircraft shows the challenges plaintiffs’ lawyers can face when they don’t have those kinds of resources to rely upon. The Seventh Circuit’s opinion can be found here.

As detailed in the appellate court’s opinion, written by Judge Richard Posner for a three-judge panel, the plaintiffs alleged that the defendants had misled investors by failing to disclose that the company would not make its target date for the “First Flight” of the airliner, despite knowing of production issues that would require the flight to be delayed. The plaintiffs’ initial complaint was dismissed because it lacked sufficient allegations to support the allegation that the defendants knew that the production issues would require the first flight to be delayed.

In order to try to address these problems in their amended complaint, the plaintiffs sought to rely on a single confidential witness, an engineer later identified as Bishunjee Singh. The complaint relied on Singh’s statements to support amended allegations that company management knew that the airliner had failed certain tests and that the failure might result in a delay of the first flight.

There was only one problem – “No one had bothered to show the complaint to Singh” and “investigations by Boeing soon revealed that the complaint’s allegations concerning him could not be substantiated.” In his deposition, Singh “denied virtually everything that the investigator had reported.” The appellate court noted that the district court thought that the plaintiffs’ lawyers “failure to attempt to verify their allegations in the investigator’s notes amounted to a fraud on the court.”

The appellate court not only affirmed the dismissal of the plaintiffs’ complaint but remanded the case to the district court for further proceedings with respect to question of sanctions. As if that were not bad enough, the appellate court made a point of noting that the same plaintiffs’ firm had been criticized for making misleading allegations concerning confidential sources in order to stave off dismissal in other cases. The appellate court noted that “recidivism is relevant in assessing sanctions.’

Alison Frankel has a particularly interesting commentary on the Seventh Circuit’s opinion in the Boeing case in a March 26, 2013 post on her On the Case blog (here).

Readers will be interested to note that the lead plaintiffs’ firm in both the Deutsche Bank case discussed above and in the Boeing case is the same firm. Any number of conclusions might be drawn from the outcomes in the two cases, starting with the fact that one case was dismissed and may result in the award of sanctions, whereas the other case is going forward. Among the many differences between the cases, however, is that in the one case, the plaintiffs were able to rely on a detailed report for a U.S. Senate Committee in drafting their complaint. In the other case, well, the sources were not so good.

Readers mulling this over and reaching conclusions about ultimate considerations of justice may want to pause a moment and consider, from the perspective of Boeing investors, the ultimate history of the Dreamliner aircraft. As detailed in an article entitled “Requiem for a Dreamliner?” in the February 4, 2013 issue of the New Yorker (here), the latest problems with the Dreamliner’s batteries, which have grounded the entire fleet of Dreamliners, “is just the latest in a long series of Dreamliner problems, which delayed the plane’s debut for more than three years and cost Boeing billions of dollars in cost overruns. The Dreamliner was supposed to become famous for its revolutionary design. Instead, it’s become an object lesson in how not to build an aircraft.”

Given the airliner’s checkered development history, the plaintiffs’ lawyers may feel that the problem was not that they didn’t have a valid claim, but that they just couldn’t come up with the right sources. And if you were of a certain frame of mind and only focused on the portion of the Seventh Circuit’s opinion about the sanctions issue (which has certainly drawn all of the media attention), you might (or might not) take the plaintiffs’ point.

However, Judge Posner also had some very interesting things to say about scienter, that might suggest how difficult it would be for plaintiffs’ to state a securities claims based on developmental stage production delays. Judge Posner’s comments about scienter go on for several pages and are worth reading in full; it would be hard to do them full justice here. Among other things, Judge Posner noted how implausible it is that the company had any motivation to mislead either investors or prospective customers by postponing for a few days (until after the Paris Air Show) the announcement that the first flight would be delayed. Posner noted that:

A more plausible inference than that of fraud is that the defendants, unsure whether they could fix the problem by the end of June, were reluctant to tell the world “we have a problem and maybe it will cause us to delay the First Flight and maybe not, but we’re working on the problems and we hope we can fix it in time to prevent significant delay, but we can’t be sure, so stay tuned.”

Citing Kant on the difference between “a duty of truthfulness and a duty of candor,” Posner added that “there is no duty of total corporate transparency – no rule that every hitch or glitch, every pratfall, in a company’s operations must be disclosed in “real time,” forming a running commentary, a baring of corporate innards, day and night.” (Call it a hunch, but I suspect that Posner’s words are in for a long run in future dismissal motions).

At this point, the Dreamliner has accumulated a lifetime supply of hitches, glitches and pratfalls. However, Posner is saying that without more, even a snootful of glitches doesn’t amount to securities fraud. As for what might constitute “more,” well, it seems like the factual details from a voluminous report of a Senate subcommittee appears to be enough. An unreliable witness definitely is not enough — except perhaps for sanctions

Special thanks to a loyal reader for supplying me with a copy of the Boeing decision.