In an October 28, 2009 opinion (here) in a case in which the Ninth Circuit found the plaintiffs’ allegations met the heightened pleading standards of Twombley and Tellabs, the appellate court reversed the district court’s dismissal of the plaintiffs’ complaint in the Matrixx Initiatives securities class action lawsuit. The decision is significant not only because the appellate court reversed the lower court’s prior dismissal of the case, but also because of what the Ninth Circuit’s opinion implies about the heightened pleading requirements.

 

The plaintiffs sued Matrixx and three of its officers in April 2004, alleging that the defendants were aware that numerous users of Matrixx’s intranasal cold remedy, Zicam, had developed anosmia (loss of the sense of smell), but that they had failed to disclose the risk and instead issued false and misleading statements regarding Zicam. The complaint alleges that the defendants were aware of these problems because of various calls to the company’s customer service line; because of certain academic research, the results of which were communicated to the company; and because of product liability lawsuits that had been filed against the company.

 

The district court granted the defendants’ motions to dismiss, finding that the complaint failed to adequately allege materiality, because the number of anosmia-related complaints of which Matrixx was aware was not "statistically significant." The district court also found that the complaint failed to allege scienter adequately because it "fails to allege any motive of state of mind with relation the alleged omissions."

 

The Ninth Circuit first held that the district court "erred in relying on the statistical significance standard" in concluding that the plaintiffs had not adequately alleged materiality, finding that a court "cannot determine as a matter of law whether such links [between Zicam and anosmia] were statistically insignificant because the statistical significance is a question of fact."

 

Instead the Ninth Circuit said that the appropriate "fact-based inquiry" is (citing Twombley and its progeny) whether the complaint states a claim that is "plausible on its face" – and, with respect to the issue of materiality, whether "the possible link between Zicam and anosmia was information that a reasonable investor would have found significant."

 

After reviewing the plaintiffs’ allegations, the Court found that the complaints allegations were sufficient to meet the PSLRA’s pleading requirements for materiality and, citing Twombley, to "nudge" the plaintiffs’ claims "across the line from conceivable to plausible."

 

The Ninth Circuit further held, with reference to Tellabs standard for pleading scienter, that the inference that the defendants "withheld information intentionally or with deliberate recklessness is at least as compelling as the inference that [the defendants] withheld the information innocently."

 

In reaching this conclusion, the Ninth Circuit noted that the company’s disclosures were "misleading because [they] spoke of the risk of product liability actions without revealing that lawsuits had already been filed." The Ninth Circuit observed that the inference that "high level executives such as [the individual defendants] would know that the company was being sued in a product liability action is sufficiently strong to survive a motion to dismiss."

 

The Ninth Circuit also referenced the various customer complaints and academic studies the results of which were communicated to the company’s director of research and development.

 

Based on its conclusions about materiality and scienter, the Ninth Circuit reversed the lower court’s dismissal and remanded the case for further proceedings.

 

The Ninth Circuit’s decision in the Matrixx case is interesting in a number of respects, not least of which is because the decision reversed the district court’s prior dismissal of the case, although it is certainly interesting in that respect as well.

 

Among other things, the decision is also interesting for its application of the Twombley "facial plausibility" standard to the question of the sufficiency of the plaintiffs’ allegations of materiality. In a prior post (here), I discussed the question whether the "facial plausibility" test of Twombley and its more recent companion case, Iqbal, would have much impact on securities cases, given the PSLRA’s heightened pleading standards. The Matrixx decision suggests that the Twombley standard could indeed impact securities cases, even with respect to elements of a securities claim for which heightened pleading standards are defined in the PSLRA, since the Ninth Circuit cited both the PSRLA’s materiality pleading requirements and Twobley in determining the sufficiency of the plaintiffs’ allegations.

 

The further significance of the Ninth Circuit’s citation to Twombley is the fact that the court also found that the Twombley standard had been satisfied here. Though many objections to Twombley and Iqbal have been raised, the fact is that the "facial plausibility" standard can be satisfied and cases will still be going forward, notwithstanding the pleading standard articulated Twombley and Iqbal.

 

Another interesting thing about the Ninth Circuit’s decision is the way in which the court found that the scienter pleading requirements to have been satisfied, particularly with respect to the individual defendants. The court seems to have put great weight on the individual defendants’ positions, and was less focused on the question whether or not there were allegations of knowledge or awareness as to each of the individual defendants.

 

Thus, for example, with respect to the existence of product liability litigation, the court was willing to draw an inference of scienter as to the individual defendants because "high-level executives… would know" the company had been sued. – without apparent consideration of the question whether the individual defendants did know about the litigation, or even what the company’s practices were for circulating information about new litigation to the company’s senior officials.

 

Similarly, the allegations of scienter based on the alleged awareness of the existence of customer complaints and academic studies was found sufficient as to all three individual defendants, though the allegations refer only to communications of these matters to the company’s director of research. The court’s decision does not refer to what the other two individual defendants are alleged to have known, or even what they would have known in light of the company’s processes for communicating this kind of information internally.

 

If nothing else, the Ninth Circuit’s finding that the scienter allegations were sufficient represents a suggestion that in at least some circumstances (and in at least some courts) allegations that individual defendants held a certain office or position may be sufficient to support a finding of scienter, even where no supporting allegations about what the defendants know or what information they were provided or had access to.

 

Readers may be interested to know that on June 16, 2009, the FDA warned consumers (here) to stop using three Zicam intranasal products because the products may cause a loss of smell. As reflected here, a second securities class action lawsuit was filed after the company’s share price plunged following this announcement.

 

Iqbal on the Hill: Meanwhile, the Iqbal debate arrived on Capitol Hill this week, as the House Committee on the Judiciary Subcommittee on the Constitution, Civil Rights and Civil Liberties held hearings on October 27, 2009. The hearing was entitled "Access to Justice Denied – Ashcroft v. Iqbal." The Committee’s page about the hearing, including links to the witnesses’ testimony can be found here. An October 29, 2009 AmLaw Daily article by Alison Frankel about the hearings can be found here.

 

In a detailed October 27, 2009 opinion (here), Western District of Washington Judge Marsha J. Pechman substantially denied the defendants’ motions to dismiss the plaintiffs’ amended complaint in the Washington Mutual subprime securities class action lawsuit. Judge Pechman’s ruling is noteworthy in and of itself, but perhaps even more because Judge Pechman had previously granted the defendants motions’ to dismiss all of the plaintiffs’ ’34 Act claims and all but one of defendants’ ’33 Act claims.

 

As discussed here, in granting the prior motions to dismiss, Judge Pechman had been sharply critical of the clarity and organization of the plaintiffs’ initial consolidated amended complaint, which she characterized as "verbose and disorganized." and as embodying "puzzle pleading."

 

By contrast, in her October 27 ruling, Judge Pechman stated that the second amended complaint (hereafter, the "complaint") presents "cogent and concise allegations against Defendants." She also stated that the Plaintiffs have "largely succeeded in remedying the deficiencies of their initial complaint."

 

As described in the October 27 opinion, the complaint alleges that the defendants "(1) deliberately and secretly decreased the efficacy of WaMu’s risk management policies; (2) corrupted WaMu’s appraisal process; (3) abandoned appropriate underwriting standards; and (4) misrepresented both WaMus’ financial results and internal controls."

 

The complaint’s ’34 Act claims assert claims for securities fraud against the seven officer defendants, although the complaint also alleges Section 20 control person liability against the outside director defendants as well as the officer defendants.

 

With respect to the plaintiffs’ ’33 Act claims, the complaint alleges different specific allegedly misleading statement as to each of the individual officer defendants. The defendants moved to dismiss these allegations on the grounds that the complaint does not sufficiently allege that the statements are false and misleading and failed to allege "particularized facts giving rise to a strong inference of scienter."

 

In reviewing the adequacy of the plaintiffs’ allegations, Judge Pechman reviewed each of the alleged misstatements with respect to each of the individual officer defendants, grouping the allegedly false statements in four categories "(1) risk management; (2) appraisals; (3) underwriting; and (4) internal controls."

 

Other than with respect to two statement of WaMu’s former CEO, Kerry Killinger, which Judge Pechman found to "lack sufficient clarity to state a claim," Judge Pechman found that the plaintiffs’ ’34 Act claims were sufficiently pleaded, and therefore (other than with respect to two of the CEO’s statements), the motion to dismiss the ’34 Act claims was denied. Judge Pechman also denied the motion to dismiss the Section 20 control person liability claims against the individual officer defendants and the outside director defendants.

 

In denying the motion to dismiss, Judge Pechman referred repeatedly to the allegations drawn from internal memoranda and on testimony from confidential witnesses. With respect to the plaintiffs’ scienter allegations, Judge Pechman found with respect to each of the statements (other than the two statements of the CEO that were dismissed) that the "defendants have not raised a competing inference of innocence that outweighs the strong inference of scienter."

 

In her prior ruling in the case, Judge Pechman had granted the defendants’ motions to dismiss the ’33 Act claims, finding that the plaintiffs at that time did not have standing to assert ’33 Act claims in connection with WaMu’s August 2006, September 2006 and December 2007 securities offerings. The most recent amended complaint purports to add several additional plaintiffs, in an effort to establish standing to assert ’33 Act claims as to the August 2006, September 2006 and December 2007 offerings.

 

Judge Pechman found none of the new plaintiffs had standing to assert claims as to the August 2006 offering of 5.50% Notes. Judge Pechman also found that the plaintiffs’ lacked standing to assert Section 12(a)(2) claims as to both 2006 offerings. She otherwise found that the plaintiffs had standing to assert ’33 Act claims as to the other offerings. She also found that the complaint’s allegations met the ’33 Act’s substantive pleading requirements.

 

In short, virtually all of the plaintiffs’ most recent amended complaint survived the renewed dismissal motions. This is a fairly dramatic turnaround from the outcome of the initial motions, in which the initial dismissal motions were substantially granted, other than with respect to the ’33 Act claims in connection with the August 2007 offering. The turnaround is all the more noteworthy given how critical Judge Pechman was of the plaintiffs’ initial complaint. It is a very long way from Judge Pechman’s assessment that the prior complaint was "verbose and disjointed" to her assessment that the most recent complaint is "cogent and concise."

 

But the difference in outcomes is not attributable solely to the improved organization of the amended complaint. It is also clear that the added allegations, particularly those drawing on confidential witness testimony, were instrumental in bringing about the different outcome.

 

This turn of events could be significant in connection with the many other pending subprime and credit crisis related securities class action lawsuits, particularly those in which initial motions to dismiss have been granted with leave to amend. If nothing else, Judge Pechman’s October 27 opinion shows that plaintiffs can successfully amend their complaints in order to remedy initial pleading deficiencies. This possibility underscores the fact that initial dismissals without prejudice are indeed provisional, and no one should assume that a case in which initial motions have been granted is done – the plaintiffs in those cases, like the plaintiffs in the WaMu case, may yet succeed in overcoming the initial pleading hurdles.

 

A couple of aspects of the way in which the WaMu plaintiffs overcame the initial pleading hurdles are instructive for other plaintiffs in subprime and credit crisis-related securities lawsuits. Clearly, Judge Pechman preferred the more organized presentation of the amended complaint to the "puzzle pleading" presented in the prior complaint. Clarity and brevity are indeed virtues, in pleading cases as in all other endeavors, which is a consideration other plaintiffs might well want to heed.

 

Another clear implication from Judge Pechman’s October 27 order is the value of allegations based on the testimony of well-placed confidential witnesses. This lesson was also apparent from the recent ruling on the renewed motion to dismiss in the Dynex Capital case (about which refer here). While not every plaintiff will be similarly able to present allegations based on the testimony of well-place confidential witnesses, that clearly is one way to overcome the steep pleading hurdles that plaintiffs face at the outset of these cases. And, as I noted in connection with the Dynex Capital ruling, even the rigorous requirements for pleading scienter under the Tellabs case can be overcome with the right kind and quantum of confidential witness testimony.

 

But perhaps the greatest significance of the ruling on the renewed motions to dismiss is that the motions were denied in a high profile case like the WaMu suit. As I have noted elsewhere on this blog, the defendants generally have seemed to be doing better on the motions to dismiss in the subprime and credit crisis cases. However, the WaMu ruling adds a significant counterweight to the plaintiffs’ side of the ledger, along with the dismissal denials in the Countrywide (refer here) and New Century Financial subprime suit (refer here). The WaMu ruling may be even more significant, given that the dismissal motion had previously been substantially granted.

 

One final note about the October 27 order in the WaMu case is that the motion was denied as to all defendants, including the offering underwriters and WaMu’s auditors, Deloitte. The fact that the gatekeepers have been kept in the case is significant if for no other reason that its suggestion that gatekeepers generally will continue to be a part of the subprime and credit crisis-related litigation, which could have important implications for how these cases are resolved, as well as what the aggregate costs of these cases might eventually be.

 

In any event, I have added the October 27 ruling in the WaMu case to my running tally of the dismissal motion rulings in the subprime cases, which can be accessed here.

 

Special thanks to a loyal reader for providing me with a copy of the October 27 opinion. I get my best material from readers and I am always grateful when readers take the time to send things along to me.

 

Andrew Longstreth’s October 28, 2009 article on AmLaw Daily about the WaMu decision can be found here.

 

Another Belated Securities Suit Filing: In several prior posts (most recently here), I have noted the recurring phenomenon during 2009 of new securities class action lawsuit filings in which the proposed class period cutoff is well in the past, in some cases nearly two years before the filing.

 

The securities class action lawsuit filed on October 28, 2009 against Pitney Bowes and certain of its offices pushes this belated filing phenomenon to its furthest edge of its theoretical possibilities. As reflected in the plaintiffs’ counsel’s October 28 press release (here) , the proposed class period in the case runs from July 30, 2007 to October 29, 2007. In other words, the plaintiffs filed their complaint on what appears to be the last day before the two-year statute of limitations would have expired. A copy of the complaint in the case can be found here.

 

The Pitney Bowes case is merely the latest (and arguably most extreme) example of this phenomenon. I have long speculated that this rash of seemingly belatedly filed lawsuits may be attributable to a backlog of case filings that built up over prior periods in which plaintiffs lawyers were concentrating on filing subprime and credit crisis related lawsuits as well as lawsuits related to the Madoff scandal. Now that the new filings in those other areas are dying down, the plaintiffs’ lawyers may be getting around to working off the backlog.

 

The Pitney Bowes case, as is the case with many of these other seemingly belated cases that have been filed during the latter half of 2009, was filed against a company outside the financial sector. This feature of the phenomenon seems to suggest that as the plaintiffs’ counsel work off what seems to be a backlog of cases, the mix of companies sued will shift back toward the more usual spread of kinds of companies, and away from the concentration in the financial sector that characterized filings during the period from mid-2007 through the first part of 2009.

 

The one thing about these belated filings is that it does create a challenge in trying to determine when a company is "out of the woods" with respect to any adverse developments the company might have had.

 

Lawsuits seeking to recover large amounts of money are commonplace. But how about a claim that seeks to recover more money than exists in the entire world?

 

According to a September 24, 2009 order (here) by Southern District of New York Judge Denny Chin, the complaint of plaintiff Dalton Chiscolm, Jr. against the Bank of America seeks to recover "1,784 billion trillion dollars," to be deposited in his ATM account "the next day." Oh, and in addition, another $200,164.

 

Judge Chin states that in Chiscolm’s complaint (which Chin describes as "incomprehensible"), the plaintiff "seems to be complaining" that his checks apparently have been rejected because of incomplete routing numbers and when he placed a series of calls to the bank he "received inconsistent information from ‘a Spanish wom[a]n.’"

 

Judge Chin’s September 24 Order directs Chiscolm to show cause in writing by October 23, 2009 the basis on which his claim, which purported to be filed in reliance on federal question jurisdiction, is brought in federal court, or the complaint will be dismissed. As of October 25, 2009, PACER did not show that any statement had been filed.

 

The astonishing quantum of damages sought is more than just a random large number. As it turns out, 1,784 billion trillion – equal to 1.784 multiplied by 10 to the twenty-fourth power, or 1,784 followed by 21 zeroes – corresponds to a value in the International System of Units known as a "Yotta." According to Wikipedia (here), Yotta currently is the largest unit in the system of measurement. In other words, the plaintiff is literally seeking to recover the largest describable number of dollars.

 

An October 23, 2009 BBC News article (here) about Chiscolm’s lawsuit quotes Kevin Houston, a University of Leeds mathematics professor, as saying that "the guy wants more money than there is in the entire world."

 

Well, yeah, but the customer service really was terrible.

 

Judge Chin, who recently was nominated to the Second Circuit, of course is the judge that sentenced Bernard Madoff to 150 years of imprisonment, and so Chin knows a thing or two about large amounts of damages, but the amount of damages that Chiscolm has claimed even managed to get Judge Chin’s attention.

 

The Supreme Court’s decision in the Iqbal case earlier this year has generated a great deal of controversy and comment and even a proposal to overturn the decision legislatively. Iqbal does seem to be having an impact on a number of cases. An interesting question, however, is whether the Iqbal case will have an impact on federal securities cases, given that the securities laws already have their own separate heightened pleading standards. But a recent Eighth Circuit decision, applying Iqbal to affirm a lower court dismissal, suggests that Iqbal could indeed have an impact in damages actions under the federal securities laws.

 

Background

First, some background. Fed. R .Civ. P. 8(a)(2) requires that a "claim for relief" must contain a "short plain statement of the claim showing that the pleader is entitled to relief." Historically, courts had come to use the shorthand phrase "notice pleading" to describe the requirements under this rule.

 

In the Supreme Court’s 2008 Twombley case (here), the Court said that in order to satisfy these pleading requirements, the complaint must contain sufficient factual matter, accepted as true, to "state a claim to relief that is plausible on its face."

 

In the 2009 Iqbal case, the claimant in a Bivens action had sought to argue that Twombley’s "facial plausibility" test should be limited to the pleadings made in the context of an antitrust dispute, as had been involved in Twombley. The Supreme Court held that the argument  that Twombley was limited to antitrust actions "is not supported by Twombley and is incompatible with the Federal Rules of Civil Procedure." Twombley, the Iqbal court said, "expounded the pleading standard for all civil actions."

 

The Iqbal decision that the "facial plausibility" pleading sufficiency test applies to all federal civil actions has been the subject of a great deal of heated discussion. It has been criticized in many quarters. For example, in a September 3, 2009 article entitled "Plausibility Pleading Revisited and Revised: A Comment on Ashcroft v. Iqbal" (here), Boston University Law School Professor Robert G. Bone argues that Iqbal "takes Twombley’s plausibility standard in a new and ultimately ill-advised direction." Seton Hall Law Professor Edward Hartnett, less critical of the decision, argues in his recent paper (here) that Twobley and Iqbal can and should be "tamed."

 

Twombley and Iqbal have thir supporters. Fellow bloggers Mark Herrmann and James Beck argue on their Drug and Device Law Blog (here) that:

  

There’s nothing radical about requiring a plaintiff to have sufficient facts to plead a prima facie case before the courts will entertain the lawsuit – and that goes for all forms of litigation. It’s simply a construction of the language of Rule 8 "short and plan statement" that emphasizes "statement" a little more and "short" a little less. It’s about time, we think, that courts adopt a construction of the Rules that favors reduced, rather than expanded, litigation.

 

Whether Twombley and Iqbal are generally viewed as good or bad developments largely seems to depend on where your starting point is. But regardless of whether they are good or bad, the cases are having an impact in the lower courts, as Beck and Herrmann underscored in their more recent Drug and Device Law Blog post (here) detailing developments, by way of illustration, in recent medical device cases applying Twombley and Iqbal.

 

These practical impacts have registered with the plaintiffs’ bar, and indeed a September 21, 2009 Law.com article (here) discussed how civil rights and consumer groups and trial lawyers have been meeting to discuss ways to undo Iqbal. According to the article, Iqbal has already had a very significant impact – it has "already produced 1,500 district court and 100 appellate court decisions."

 

These groups have already managed to get proposed legislation introduced in Congress seeking to have Iqbal overturned. On July 22, 2009, Senator Arlen Specter introduced Senate Bill 1504, "Notice Pleading Restoration Act of 2009," which basically provides that courts shall not dismiss a complaint except under the notice pleading standards applicable under Supreme Court precedent prior to Twombley.

 

Whether this legislative effort will go anywhere remains to be seen. Congress has rather a full plate these days, and a bid to adjust a narrow feature of civil pleading standards may not make the cut. On a related note, according to a Point of Law blog post (here), there will be a House hearing on October 27, 2009 on the topic of "Access to Justice Denied – Ashcroft v. Iqbal."

 

Impact on Securities Cases?

Whatever the impact of Iqbal may be in other contexts, it has seemed an uncertain question whether Iqbal will prove to have a substantial impact in damages actions under the federal securities laws, due to the fact that the securities laws already have their own particularized pleading standards. Indeed, under the PSLRA, there are very specific requirements regarding what must be pleaded with respect to misleading statements or omissions and with respect to the required state of mind. The Supreme Court’s 2008 decision in the Tellabs case even further underscored the degree of specificity required to satisfy the state of mind pleading requirements.

 

Given these very specific statutory requirements applicable to the federal securities laws, it could be argued that the more generalized pleading requirements expounded in Twombley and Iqbal might have relatively less impact in the context of a damages action under the federal securities laws. However, a recent decision from the Eighth Circuit suggests that Iqbal could have an impact in securities cases after all.

 

In an October 20, 2009 decision in McAdams v. McCord (here), the Eighth Circuit was reviewing an appeal of a district court’s dismissal of the securities class action lawsuit that have been filed against Moore Stephens Frost (MSF), the outside auditors of UCAP. The district court had held that the complaint "failed to plead with particularity the circumstances of MSF’s alleged fraud, as well as facts giving rise to a strong inference of scienter."

 

The Eighth Circuit held that it "need not decide whether the complaint adequately states with particularity facts giving rise to a strong inference that MSF acted with scienter," because, the court held applying Iqbal to the loss causation pleading requirement under the Dura Pharmaceuticals case, that "the complaint fails to sufficiently plead loss causation."

 

The court referenced what it called the complaint’s "threadbare, conclusory allegation" that as a "direct and proximate cause" of defendants’ fraud the plaintiffs had lost their investments. The court noted that this allegation failed to "specify" how MSF’s alleged statements "as compared to the complaint’s long list of alleged misrepresentations and omissions by the executives, proximately caused the investors’ losses." The court noted further that the complaint "does not state the value of UCAP’s stock when the investors made their investments, or its value right before, or right after, the need for restatement was announced."

 

The Court concluded that without these allegations "the complaint does not show that the investors’ losses were caused by MSF’s misstatements," which "defeats the plausibility of the investors’ claims that MSF’s audit opinions …caused their losses."

 

Discussion

The Eighth Circuit’s decision in the McAdams case, in which the Eighth Circuit held, applying Iqbal, that the claimants’ loss causation allegations lacked "plausibility," shows that Iqbal could indeed have an impact on securities cases.

 

It is particularly interesting that the Eighth Circuit affirmed the lower court’s dismissal on the grounds of insufficient loss causation plausibility, while observing that it did not even need to reach the question whether the plaintiffs had plead scienter with sufficient particularity under the PSLRA. The conclusion suggests that Iqbal’s generalized pleading requirements must be considered analytically prior to the PSLRA’s more particularized requirements. And whether or not the Iqbal standard is to be viewed as prior, its "facial plausibility test" apparently applies to the elements required to state a cause of action under the federal securities laws, even those elements for which the PSLRA does not itself specify particularized pleading requirements.

 

In any event, the basic holding of the McAdams case that the complaint’s loss causation allegations must meet the Iqbal "facial plausibility" standard in order survive an initial motion to dismiss could be a valuable tool for defendants’ to use at the initial pleading stage. (Of course, many plaintiffs will include allegations in the complaint of the kind that the plaintiffs in the McAdams case had omitted, so the extent to which the McAdams decision will affect other cases could be limited – with the inclusion of seemingly minimal additional information about their alleged investment loss, plaintiffs could likely defeat a motion raising similar arguments.)

 

One question that may be of more interest to civil procedure buffs is whether it matters that in McAdams the court was considering a complaint to which (as the McAdams court itself noted) Rule 9(b) applied, rather than (or perhaps, in addition to) Rule 8. Rule 9(b) requires that fraud must be plead with "particularity." To my mind, it does not and should not matter whether the applicable pleading standard is under Rule 9 rather than under Rule 8, either way it would seem (as the McAdams court noted) that the Iqbal "facial plausibility" test should apply, although I would be interested to know if readers disagree.

 

One final thought about Iqbal itself. I tend to agree with the school of thought in favor the decision. I recognize the argument that the "facial plausibility" test does not appear in the Fed. R. Civ. P., but then neither does the phrase "notice pleading." And I find myself puzzled by the critics of Iqbal – are they suggesting that complaints that are not facially plausible should be allowed to go forward? In any event, under Rule 15 (a)(2), courts are admonished to allow pleading amendments "freely when justice so requires," so plaintiffs will typically have at least a second crack at trying to present a "facially plausible" complaint.

 

In any event, based on the McAdams decision at least, Iqbal appears to represent yet another factor raising the hurdle that plaintiffs’ initial pleads must overcome in order to survive a motion to dismiss in a securities class action lawsuit. Clearly, the accumulating number of substantive and procedural developments increasingly favors the defendants in these cases.

 

Very special thanks to Tom Gorman of the SEC Actions Blog for his recent post (here) discussing the McAdams case.

 

More About Loss Causation: An October 21, 2009 memo entitled "Loss Causation Challenges in Securities Cases" (here) by Michael Smith and William Hutchinson of the King & Spaulding law firm surveys recent case law regarding loss causation issues under the federal securities laws.

 

 

It been a catastrophic week for Galleon Group and its founder, Raj Rajaratnam, with the firm reportedly about to wind itself up in the wake of the epic insider trading allegations raised against Rajaratnam. But the trading indictment is not the only recent stunning legal development involving Rajaratnam and his firm.

 

Among other things, on October 22, 2009, a group of survivors of alleged "terrorist" bombings sued Rajaratnam and his father claiming they knowingly provided financial support to the Tamil Tigers.

 

On a more positive note, Galleon was recently affirmed as lead plaintiff in a securities class action lawsuit pending in the Eastern District of Pennsylvania.

 

The terror victims filed their lawsuit on October 22, 2009 in the District of New Jersey. The seven-count complaint (copy here) was, according the plaintiffs’ lawyers press release (here), the result of "a year-long investigation." The complaint was filed under the Alien Tort Claims Act of 1789, which gives U.S. district court jurisdiction "of any civil action by an alien for tort only, committed in violation of the law of nations or a treaty of the United States."

 

The complaint alleges that Rajaratnam and the family foundation headed by his father provided millions of dollars in funds used for terrorist attacks by the group formerly known as the Liberation Tigers of Tamil Elam (LTTE). The complaint alleges that from 2004 to 2009 LTTE conducted hundreds of attacks and bombings, claiming over 4,000 victims. The complaint alleges that Rajaratnam and his family foundation provided millions in funding to a group that the Treasury Department has described as "a charitable organization that acts as a front to facilitate fundraising and procurement for the LTTE." The complaint alleges that Rajaratnam’s donations were given "with the intent of supporting specific LTTE attacks and operations."

 

The complaint alleges that the defendants aided and abetted terrorist acts "universally condemned as violations of the law of nations: aided and abetted, intentionally facilitated or recklessly disregarded "crimes against humanity in violation of international law," as well as, among other things, wrongful death, negligence and negligent or intentional infliction of emotion distress.

 

Things said about Rajaratnam and his firm in the September 30, 2009 ruling (here) by Eastern District of Pennsylvania Judge Juan R. Sanchez, in which Sanchez affirmed Galleon as lead plaintiff in the Herley Industries securities class action lawsuit, were decidedly more positive. The subsequent events (which the court obviously had no way of anticipating) do cast a very strange light on the opinion.

 

Even prior to events of the last week, Galleon’s selection as lead plaintiff in the case was notable. Investment advisors typically are regarded as lacking standing to pursue the claims of their clients’ funds, because they lack an "injury-in-fact" – that is, they suffered no direct injury. A long line of district court cases have declined to appoint investment advisers as lead plaintiffs for that very reason. In considering these issues, Judge Sanchez observed that Galleon, unlike the investment advisors in the other cases, was "closely connected" to the Galleon funds that held the company’s stock.

 

With respect to the connection between Galleon and the funds, Judge Sanchez noted that "the same people control both Galleon and the funds," adding that "Raj Rajaratnam serves as director of the two funds and as Galleon’s managing partner." There were, however, further standing issues involved because the funds had not assigned their claims to Galleon until after Galleon was initially appointed to serve as lead plaintiff.

 

Finding that Galleon now had standing in light of the assignment, and noting further that "Galleon has served as an adequate plaintiff for more than two years," and that it had a larger financial interest in the case than the competing pension fund, the court exercised its discretion to affirm Galleon as the lead plaintiff in the action.

 

In support of this conclusion, Judge Sanchez observed, among other things that "to appoint a new lead plaintiff at this late date would unduly disrupt the litigation process."

 

Certainly, no one wants the litigation process unduly disrupted, but I suspect that in light of events subsequent to Judge Sanchez’s September 30 order, the litigation process in the Herley Industries case is about to be duly disrupted.

 

Among other ironies is that in the court’s prior order initially appointing Galleon as lead plaintiff (here), the competing pension fund had argued that Galleon was an "unsuitable" lead plaintiff owing to the "unique defenses" to which Galleon was subject. Among other things, the competing pension fund had argued that Galleon was a hedge fund that had shorted Herley’s stock during the class period (and therefore allegedly profited from the fraud on the market), and further argued that the short sale activity violated the federal securities laws. Judge Sanchez found the securities law violation allegations to be speculative and selected Galleon as lead plaintiff in light of the PSLRA’s presumption in favor of the plaintiff that suffered the greatest financial.

 

The competitor pension fund presumably could be substituted in as lead plaintiff, but, as Judge Sanchez noted, the pension fund’s losses "pale by comparison" to Galleon’s.

 

As interesting as all of these things are, I suspect there will be more attention-grabbing legal developments about Galleon and Rajaratnam in the weeks and months ahead.

 

Special thanks to Adam Foulke of the Motley Rice firm for providing me with a copy of the plaintiffs’ complaint in the Tamil Tiger case. Special thanks to a loyal reader for providing copies of the opinions in the Herley Industries case.

 

In Case You Missed It: OakBridge Insurance Services announed yesterday that Mickey Estey and Lance Sunder, both previously of NASDAQ Carptenter Moore,  have joined OakBridge and will be opening offices for the company in the metro regions of San Francisco, CA and Minneapolis, MN, respectively.

 

On October 19, 2009, in a securities case from an earlier era involved allegedly misleading statements regarding asset-backed securities, Southern District of New York Judge Harold Baer substantially denied the defendants’ motions to dismiss the plaintiffs’ complaint as amended, following the long-running case’s trip through the Second Circuit on interlocutory appeal. A copy of the October 19 opinion can be found here.

 

Judge Baer’s decision in the Dynex Capital securities case is noteworthy not only because of the previous high profile appellate decision in the case, but also because Judge Baer found plaintiffs’ amended allegations sufficient to survive the renewed motion to dismiss, after prior pleadings had failed in whole or in part to withstand scrutiny.

 

Though the case is from a slightly earlier era (it was initially filed in 2005), it raises many allegations similar to those involved in the current round of subprime and credit crisis-related securities lawsuits, and therefore could be influential with respect to dismissal motions in the more recent cases.

 

Background

Dynex was in the business of packaging mortgage loans into securities. Between 1996 and 1999, Dynex originated or purchased 13,000 mobile home loans that served as collateral for bonds that a unit of the company issued. The underlying loans performed poorly and in 2003-04 the bonds were downgraded by the rating agencies. The bonds’ value dropped by as much as 85%.

 

The plaintiffs filed a securities class action lawsuit on behalf of investors who had purchased the bonds between February 7, 2000 and May 13, 2004. The plaintiffs allege that the defendants artificially inflated the bonds’ price by misrepresenting that the poor performance of the bond collateral was due to market conditions, concealing that the defendants’ "aggressive and reckless loan underwriting and origination practices generated a pool of collateral loans of poor credit quality and inherent defects."

 

In a February 2006 opinion (here), Judge Baer granted the defendants’ motion to dismiss the complaint as to the individual defendants for failure to adequately allege scienter, but he denied the motion as to the corporate defendants. In June 2006 he certified his opinion for interlocutory appeal on the question "whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite scienter."

 

In 2008, the Second Circuit held (here) that corporate scienter may be sustained even "in the absence of successfully pleading scienter as to an expressly named officer." However, the Second Circuit held that the plaintiffs had not met the standard for corporate scienter, vacated Judge Baer’s prior ruling and remanded the case to allow the plaintiffs an opportunity to replead.

 

The plaintiff filed a second amended complaint (hereafter, the amended complaint) and the defendants’ renewed their motion to dismiss.

 

The October 19 Opinion

In their newly amended complaint, the plaintiffs added the statements of nine confidential witnesses and also identified and described for the first time four categories of reports that the plaintiffs alleged put the defendants on notice that their public statements were materially misleading.

 

Based on the confidential witnesses’ statements, which bolstered the plaintiffs’ allegations about how the defendants accessed and used the identified categories of reports, Judge Baer found that the plaintiffs had sufficiently alleged that several categories of the statements on which plaintiffs sought to rely were misleading and false. These categories included defendants’ statements regarding the adherence to underwriting standards; the defendants’ statements about the reasons for the deterioration in the collateral performance; and the defendants’ statements about the adequacy of the company’s loan loss reserves and internal controls.

 

More significantly in light of the case’s prior procedural history, Judge Baer found that the plaintiffs had adequately pled scienter. Judge Baer found that the plaintiffs’ allegations about the information available to defendants in the newly referenced documents represented strong circumstantial evidence of scienter. Judge Baer found that the amended complaint, by contrast to the plaintiffs’ prior complaint, "contains factual allegations about several forms of reports that collectively provided to Dynex’s senior management, including the Individual Defendants, information that contradicted their misleading statements."

 

The information in the documents was "available to and reviewed by the senior management responsible for the public statements at issue that either put them on notice of the falsity of these statements or clearly should have done so." Judge Baer found that the inference of scienter from these allegations was as least as compelling as the contrary inference that the defendants sought to draw.

 

Judge Baer found that when the amended complaint is viewed "holistically," a "cogent story of securities fraud is revealed":

 

The Defendants originated or purchased a large number of mobile home loans of generally low credit quality, a substantial number of which were "inherently defective," and packaged them into the Bonds failing to disclose that the stated underwriting guidelines were "systematically disregarded"; then, when adverse market conditions coincided with rising defaults and many loans were uncollectible as a consequence of inherent defects, Defendants publicly stated that market conditions were to blame in an attempt to forestall deeper drops in the value of the Bonds, many of which they held for their own account.

 

Accordingly, Judge Baer held that the amended complaint "alleges facts giving rise to a strong inference" that the statements he "found to be false and misleading were made with scienter."

 

Discussion

The Dynex Capital case arose in February 2005, two years before the current round of subprime and credit crisis litigation began, but the plaintiffs’ allegations are remarkably similar to many of the allegations raised in the more recent lawsuits. The fact that the amended complaint largely survived the most recent motions to dismiss is all the more significant given the plaintiffs’ early difficulties in the district and appellate courts in trying to get over the initial pleading hurdles.

 

The fact that the plaintiffs in the Dynex Capital case were ultimately able to overcome the initial pleading hurdles will obviously be of particular interest to the plaintiffs in the more recent cases. The plaintiffs were able to survive the renewed dismissal motion in this case because of the large number of well-placed confidential witnesses who were able to provide detailed descriptions of the company’s processes and of the key documents and their availability to senior management, as well as how the information in the documents allegedly contrasted with the defendants’ public statements.

 

Obviously not all plaintiffs in other cases will be able to muster the same number or caliber of confidential witnesses or success in being able to utilize confidential witnesses to show with such particularity what information was available to senior management and how the available information contrasted with public statements.

 

But the fact that the plaintiffs in this case were able to put those elements together, and were able to do so in a way sufficient to overcome the court’s original skepticism shows that plaintiffs in general can put together allegations to surmount even the heightened scienter pleading standards of the Tellabs case. The fact that these plaintiffs were able to do so after the initial pleading challenges also suggests that in other cases in which plaintiffs initial complaints failed to survive, the pleading defects still may be overcome with sufficiently particularized amended pleading, even on the critical issue of scienter.

 

In any event, because of the similarity of the allegations on this case to the allegations in many of the current cases, Judge Baer’s recent decision in the Dynex Capital case is likely to be important in the current cases similarly involving asset-backed securities allegedly misleading disclosures about underwriting standards, collateral quality, internal controls and adequacy of loan loss reserves.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing a copy of Judge Baer’s October 19 opinion.

 

Because private equity firms often place representatives on the boards of their portfolio companies, questions can sometimes arise about the interplay between the private equity firms’ and the portfolio companies’ D&O insurance when claims are asserted against portfolio companies’ boards. All too often, these questions are considered only after claims have emerged. However, the better approach is for these issues to be considered at the outset, when the coverages are first put in place.

 

An October 19, 2009 article entitled "Getting Your Portfolio D&O Insurance Right (The First Time Around)" (here) by Paul Ferrillo of the Weil Gotschal law firm takes a look at the factors to be considered in connection with structuring both the portfolio companies’ and the private equity firm’s insurance in order to ensure that the policies are appropriately coordinated.

 

The first question the memo addresses is the issue of how much insurance the portfolio company should carry to ensure that the insurance is sufficient "to insulate the sponsor’s own D&O coverage and more importantly the fund from liability." There are, the memo notes, a host of factors to be considered, including how large the portfolio company is and whether or not the portfolio company under consideration is private or public, but the memo correctly points out that the most important consideration is that the portfolio company’s insurance "should be adequate to insure the portfolio company and its directors and officers against risks related to that company."

 

As the memo notes, the question of the sufficiency of the portfolio company’s policy limits "is not an area to get caught short" because otherwise the private equity firm’s insurance might be looked to in order to "make up the difference."

 

The memo notes that in addition to the adequacy of the portfolio company’s limits of liability, the adequacy of the terms and conditions in the portfolio company’s policy must also be considered, since neither all D&O policies nor all D&O carriers "are created equal."

 

The memo lists a number of particularly important policy features to consider, including: making sure the policy is non-cancelable and that the Side A coverage is non-rescindable; confirming that the Insured vs. Insured exclusion has a broad coverage carve back for claims brought by the bankruptcy trustee, receivers or other bankruptcy constituencies; that the policy has a priority of payments clause; and ensuring that the conduct exclusions are fully severable so that no one’s conduct is imputed to another insured person for purposes of precluding coverage. (I have more to say below about the memo’s comments concerning the conduct exclusions.)

 

The memo also discusses indemnification issues that can arise when private equity firm’s representatives sit on portfolio companies boards. In a prior post (here), I discussed the potentially conflicting indemnification issues that can arise when private equity firm representatives serve on portfolio company boards, and I reviewed recommendations on how these conflicts may be addressed. The law firm memo also notes that the potentially conflicting indemnification obligations could lead to confusion over the applicability of the private equity firm’s and the portfolio company’s insurance. In particular, the memo raises the concern that if these indemnification issues are not addressed in advance, the portfolio company’s carrier might try to claim that the private equity firm’s insurance should "share" in settlement and litigation expense incurred in connection with a claim against the portfolio company’s board.

 

In order to prevent an outcome that is not a "result that anyone intended," the memo suggests that the private equity firm’s D&O insurance policy should incorporate wording in its "other insurance clause" stating that with respect to a portfolio company claim against a private equity firm representative on the portfolio company’s board, the portfolio company’s D&O policy is primary and the portfolio company’s policy is excess. The portfolio company’s policy should contain "similar clarifying language."

 

The memo also suggests that the private equity firm and the portfolio company should enter "separate letter agreements" confirming that the portfolio company is the primary indemnitor for advancement, indemnification and D&O insurance purposes.

 

Overall, the memo provides a good overview of the issues and raises some important considerations. However, I respectfully disagree with the memo on two points.

 

The first has to do with what the memo describes as important with respect to the conduct exclusions in the portfolio company’s policy. The memo states that the "fraud and personal profit exclusions should contain ‘in fact’ and/or ‘final adjudication" language.

 

I disagree with the memo’s suggestion that "in fact" and "final adjudication" wordings may be viewed as somehow equally acceptable, as they most definitely are not.

 

The "after adjudication" wording requires a judicial determination that the precluded conduct has occurred. The superiority of an adjudication requirement is in fact well-established (see for example my discussion here), as an "in fact" wording potentially could permit a carrier to try to deny coverage even though there has been no determination that the precluded conduct actually took place. Contrary to the suggestion in the memo, the "in fact" wording should be avoided. Indeed, in the current competitive insurance marketplace, there will rarely be a circumstance where any insured should have to accept "in fact" wording in the conduct exclusions.

 

The second point with which I respectfully disagree is the memo’s repeated suggestion that insurance brokers cannot be relied upon to guide firms with respect to the issues raised in the memo. I agree with the memo’s statement that the task of coordinating private equity firm’s insurance with that of their portfolio companies "is not a task for many ‘generalist’ brokers." However, I disagree with the memo’s later suggestions that brokers may not be a reliable source on the issue of carrier’s claims reputations, or that getting the portfolio company’s insurance right is "not a job to leave" to the insurance broker.

 

Generalist brokers may not be adequately equipped to address these issues, but there are specialized brokers who have the requisite experience and expertise to deal with these concerns. Of course many companies will also find it reassuring to have their outside counsel involved in the insurance transaction, but experienced insurance professionals with the requisite specialized expertise are eminently qualified to put together insurance programs that coordinate appropriately between private equity firms and their portfolio companies.

 

UPDATE: After this post’s publication, I spoke with Paul Ferrillo, the author of the law firm memo referenced above. To be clear, Paul’s comments on insurance brokers were only directed to the "generalist" broker without specific cross-training in Private Equity/Portfolio company D&O issues. Paul notes that he has a great many friends on the brokerage side who add tremendous value to complex D&O insurance transactions involving Private Equity firms and their portfolio companies. His practice pointer here was only that this area is a complex one involving both insurance and legal questions, which all must be melded into a wholistic solution for the client.

 

One of the questions insurance professionals have been asking with interest and anxiety since the financial crisis began is whether the economic recession will lead to a "hard market" for insurance (characterized by rising prices and tightening terms and conditions).

 

Earlier this year, Advisen, the insurance information firm, created a stir by predicting that a hard market for insurance would "begin to set in" as early as mid-2009, and in any event no later than 2010. The earlier Advisen report did, however, note that the current recession could reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition. My post about the prior Advisen report can be found here.

 

In an updated October20, 2009 study entitled "Planning for 2010: The Recession Will Keep Insurance Premiums Under Pressure" (here), Advisen now reports that "while rates are firming in a few isolated segments of the market," overall, due to falling demand resulting from the recession, insurance buyers "will continue to enjoy favorable pricing in 2010," and "materially higher rate levels most likely will have to wait until 2011."

 

The insurance cycle is basically a result of the shifting relationship between the demand for and supply of insurance. Prices fall when supply increases faster than demand. In order to track these shifting relationships, the Advisen report uses Gross Domestic Product (GDP) "as a proxy for demand," on the assumption that demand for insurance moves in relation to overall economic activity.

　

The study notes that historically, when the ratio of the supply of insurance (the insurers’ policyholder surplus) to GDP crosses the 3.2 percent mark, either up or down, "the market changes directions within the next 12 months or so." Part of the reason Advisen had earlier this year made its prediction of an approaching hard market is that the ratio fell to about 3.2 percent at the end of 2008 and continued to fall in the first quarter of 2009. However, the ratio crept back up to 3.27 percent at the end of the first half of 2009. Now, "the market remains unsettled with conflicting forces pushing and pulling on both sides of the tipping point."

 

The reason for this uneasy equipoise is that the recession is affecting both the supply and the demand sides of the equation. On the supply side, declining investment portfolio values has significantly reduced the insurers’ policyholder surplus. On the other hand, reduced economic activity has resulted in lower demand due to reduced numbers of "exposure units" (such as payroll levels, sales, vehicle units, etc.)

 

Other factors that have complicated the insurance cycle transition are: lower levels of catastrophe losses during 2009 compared to prior years; heightened competition from wounded market participants; the entry of new insurance capacity; and the insurers’ release of redundant loss reserves from prior years. Some of these factors could disappear (for example, catastrophe claims could emerge with little advance warning), or are less likely to be a factor going forward – in particular, loss reserve redundancies "now have been almost fully harvested," which eliminates insurers’ "cushion against adverse developments" and "could contribute to upward pressure on rates in 2010 and beyond."

 

Even if the recession may have ended as a matter of technical economic analysis, its effects are still being widely felt and the impacts from recovery "will be uneven, leading to further complexity and uncertainty" with respect to capacity and pricing. While these factors will continue to complicate the insurance cycle transition and "delayed the hard market," the shifting elements of the supply and demand equation "favor a modest increase in insurance demand by the end of 2010" – though "materially higher rate levels most likely will have to wait until 2011."

 

In the meantime, other than in certain areas, commercial insurance rates "on average continue to drift downward, though at a much reduced rate compared to a year ago." With respect to D&O insurance, financial sector premiums have "increased sharply" and financially stressed or highly leveraged companies "are likely to see higher premiums and some may have trouble finding adequate coverage." However other companies can expect to see premiums continue to fall into 2010, though "at a much slower pace."

 

Even at the time of Advisen’s earlier report, I had commented that "if there is going to be a hard market, its arrival could be more delayed than the report suggests." The more recent report seems consistent with my prior view that a hard insurance market could prove to be a long time coming. At this point, I don’t think I have any better sense of when it might arrive. I do agree that the uneven and gradual nature of the economic recovery could further delay the cycle transition. Unanticipated events (such as significant natural catastrophes) could intervene to accelerate the change, but absent those kinds of developments, the prospects for a market change anytime soon seem remote.

 

In any event, at 11 am EDT on October 22, 2009, Advisen will be hosting a free one-hour webinar on the State of the Insurance Market and the 2010. Registration for the webinar can be found here.

 

The worst of the global financial crisis may be past, and we may even be well on the road to economic recovery, but there still may be considerable pain yet to come, particularly in connection with commercial mortgages. Increased vacancies, declining property values and shortages of refinancing capital could mean increasing numbers of commercial mortgage defaults ahead.

 

These problems could spell trouble for banks holding commercial mortgage loans, as well as for those who invested in securities backed by commercial mortgages (CMBS). These problems likely will lead to commercial mortgage-related litigation, in what may be the final surge in the credit crisis-related litigation wave.

 

Background

The business pages recently have been full of tales of commercial mortgage defaults. For example, an October 6, 2009, Bloomberg article (here) reported that hotel foreclosures in California tripled in the first half of this year. An October 13, 2009 Wall Street Journal article (here) reports that declining hotel room demand in Hawaii "means a number of Hawaii’s resorts no longer generate enough revenue to pay the mortgage" and overall Hawaii’s distressed debt tied to hotels totals nearly $1.6 billion.

 

Similarly an October 15, 2009 Wall Street Journal article (here) detailed the danger of default on the massive mortgage debt of the Peter Cooper Village and Stuyvesant Town properties, which the article noted could "signal[] the beginning of what is expected to be a wave of commercial property failures." The lead article on the front page of the October 16, 2009 Cleveland Plain Dealer asks the question "Will Bad Commercial Loans Leave Cleveland Area Banks Targets" (here).

 

An August 31, 2009 Wall Street Journal article entitled "Commercial Real Estate Lurks as Next Potential Mortgage Crisis" (here) explores the sources of the problems in the commercial mortgage sector. Many of the mortgage-related problems "are simply the result of bad underwriting." The Wall Street "CMBS machine" lent owners money "on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising," but now "a growing number of properties aren’t generating enough cash to make principal and interest payments."

 

Another source of difficulty is that property owners are unable to refinance as mortgages come due. The August 31 Journal article reports that by the end of 2012, $153 billion in loans that make up CMBS are coming due, and as much as $100 billion will face difficulty in refinancing.

 

Declining property values are contributing to the problem. According to Bloomberg (here), commercial property prices have fallen 39 percent since their 2007 peak. As the Journal article notes, the property values have "fallen so far that borrowers won’t be able to extend existing mortgages or replace them with new debt."

 

All of this spells serious trouble for already struggling banks. Banks hold $1.8 trillion in commercial mortgages and construction loans, and as the Journal notes, "delinquencies on this debt already have played a role in the increase in bank failures this year."

 

Indeed, banks’ exposure to commercial mortgage losses is a serious concern for banking regulators, particularly since banks have been "slow to take losses on their commercial real estate loans," according to an October 7, 2009 Wall Street Journal article (here). According to one analysis quoted in the article, banks with heavy exposure to real estate loans have set aside just 38 cents in reserves during the second quarter for every $1 of bad loans. As the Journal article notes, "the recession combined with inadequate loan loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real estate market."

 

A significant amount of commercial mortgage debt is also held by the pools backing the CMBS. According to an October 2009 memorandum from the Robbins, Kaplan, Miller & Ciresi law firm entitled "Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities" (here), there was nearly $650 billion in CMBS issuance during the period 2005 to 2007, at the same time as there was a "dramatic decrease in the underwriting standards for commercial mortgages." The recent problems in the commercial real estate sector have "resulted in more loan defaults and potentially significant losses for CMBS investors."

 

Potential Litigation

The commercial mortgage woes have already led to a certain amount of litigation. By far the most significant number of lawsuits growing out of commercial mortgage problems involves the handful of cases where companies and their directors and officers have been sued by the company’s own shareholders for alleged misrepresentations or omissions about the company’s ability to support its mortgage debt or commercial property acquisition debt obligations. Examples of the companies involved in these kinds of lawsuits include General Growth Properties (about which refer here); Station Casinos (refer here); Perini Corporation (refer here); and MGM Mirage (refer here).

 

There may well be more of this type of shareholder or investor driven "commercial mortgage disclosure" litigation ahead, as commercial mortgage defaults continue to emerge in the months ahead.

 

There also seems to be every prospect for litigation to emerge in the wake of bank failures caused by commercial mortgage defaults. There certainly has already been considerable litigation following in the wake of bank failures driven by residential mortgage losses. Example of this kind of residential mortgage-related failed bank litigation include the lawsuits filed by the shareholders of Corus Bank (refer here) and Pacific Capital Bancorp (refer here). At this point, it seems prudent to expect that as rising commercial mortgage defaults lead to further bank failures that there would be similar failed bank litigation pertaining to the banks’ commercial mortgage losses.

 

The more interesting question may be whether there will be investor litigation relating to the CMBS. The Robins Kaplan memo linked above notes that "while there hasn’t yet been much specific CMBS litigation yet," as the CMBS mature over the next few years, litigation could arise similar to the many lawsuits that have emerged involving residential mortgage backed securities (RMBS).

 

The law firm memo does go on to note that there could be some practical considerations that could forestall, or at least complicate, prospective CMBS-related litigation. For example, the memo notes, CMBS offering documents "generally have substantially more property specific information" than for example typically was found in RMBS offering documents, which "may eliminate" omission-based claims of the type that have been asserted in RMBS-related litigation.

 

In addition, as time passes, CMBS investors’ ability to bring ’33 Act claims based on alleged misrepresentations or omissions in the offering documents may face statute of limitations constraints. Indeed, given that the CMBS marketplace ground to a halt in after the financial crisis in September 2008, we may already be past the point where CMBS investors will even have the option to pursue ’33 Act claims alleging misrepresentations or omission in the offering documents, due to the operation of the applicable one-year statute of limitations.

 

Nevertheless, and despite these litigation impediments, as growing defaults mean mounting losses for CMBS investors, the aggrieved investors likely will seek alternative theories on which to pursue claims, including, for example, common law fraud or misrepresentation. A long-running CMBS lawsuit now being pursued against the Cadwalader law firm and related to a 1997 CMBS offering (about which refer here) dramatically underscores how far into the future the litigation threat may extend. Moreover, if the commercial mortgage-related losses prove to be anywhere near the current theoretical potential, investors will have substantial incentives to pursue claims, even if it means relying on a wider array of legal theories in order to assert their claims.

 

All of which suggests that there may yet be a further surge of credit crisis-related lawsuits before the credit crisis litigation wave has finally played itself out.

 

This past Friday night, San Joaquin Bank of Bakersfield, California became the 99th bank the FDIC closed this year (refer here) The growing wave of bank failures has been a troubling story all year, and one that unquestionably will get worse before it gets better. But now that the 100th bank failure of the year is approaching, the mainstream media have noticed and have taken up the story.

 

The approaching bank failure century mark certainly is noteworthy, but not all of the reporting is appropriately balanced. Some of the media reports have gotten a little overexcited about the whole thing.

 

Among the recent news reports observing the approaching 100th bank failure of the year are the October 11, 2009 New York Times article entitled "Failures of Small Banks Grow, Straining FDIC" (here) and Time Magazine’s article, in its October 26th issue, entitle "Spotlight: Bank Failures" (here). The Cleveland Plain Dealer’s lead article on Sunday October 18, 2009 was devoted to the topic, as well as to the threat that local banks face from souring commercial real estate loans.

 

The growing number of failed banks is unquestionably an important story and one that rightly deserves the media attention it is getting. But apparently not content with the presently available facts, some media sources have felt compelled to try and sensationalize the story.

 

Both the Time Magazine and New York Times article linked above repeat the alarmist (and as I detailed here, arguably suspect) forecast that as many as 1,000 banks – approximately one eighth of all the banks in the country – will fail by the end of next year. The Time Magazine article goes even further by reciting without question or comment an unsubstantiated projection that "soured commercial real estate loans may generate a fresh $600 billion of losses by 2013."

 

Not only is this projection out of proportion to other published commercial real estate loan loss projections – the highest number generally circulating is $100 billion – but it is self-evidently questionable. The total amount of commercial real estate and construction loans held by banks is $1.8 trillion (a figure recited, among other places, in the Times article linked above). How likely is it that one third of all of these loans will become total losses by the end of 2013? To put this question into context, the current commercial loan default rate that has everyone so alarmed is 3.8%.

 

In the current economy, we have more than enough real challenges to deal with without the media conjuring up projections to try to make things seem even scarier than they already are.