March 23, 2009
What began in late 2006 as a disruption in the market for subprime mortgage-backed securities, collateralized mortgage obligations ("CMOs"), and collateralized debt obligations ("CDOs") has metastasized into a global financial crisis that has plunged much of the world into recession and brought down some of the world’s largest financial institutions. These adverse developments have generated a wave of private securities litigation, as well as regulatory inquiries by federal and state authorities.
In September 2008, the government takeover of mortgage giants Fannie Mae and Freddie Mac was followed by the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and an $85 billion (and now $170 billion) government investment in American International Group. With the stock market in freefall, the Treasury Department proposed a $700 billion "Troubled Asset Relief Program" ("TARP") to buy toxic assets from the nation’s banks in order to shore up their balance sheets and restore confidence to the financial system. The proposal was initially rejected by the House of Representatives, but passed in early October in a modified form that initially released $350 billion, with Congress retaining the discretion to release or withhold the remainder. As of February 6, 2009, nearly 400 financial institutions had received assistance under this program.
Concluding that prior government responses to the financial crisis were "late and inadequate," the Obama administration in February 2009 announced a comprehensive "Financial Stability Plan." The plan provides for the establishment of a Financial Stability Trust, a Public-Private Investment Fund designed to "cleanse" financial institutions’ balance sheets of legacy assets, and initiatives to support loan securitization and community lending while preventing foreclosures. The Financial Stability Plan also promises to impose accountability and transparency on financial institutions that receive government aid by subjecting them to a "stress test" before they may participate in the Financial Stability Trust and requiring them to limit executive compensation and dividends, mitigate foreclosures and expand public reporting. The initial reaction of the markets to the Financial Stability Plan was underwhelming. On the day the plan was announced, the Dow Jones Industrial Average dropped 4.6%.
On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (the "Stimulus Act"), which provides $787 billion in government spending and tax cuts and also codifies (and in some cases expands) the Treasury Department’s restrictions on executive compensation. Under the Stimulus Act, recipients of TARP funds must eliminate incentives that encourage executives to "take unnecessary and excessive risks" or manipulate reported earnings; recover any bonus or other compensation awarded based on financial statements later found to have been materially inaccurate; eliminate "golden parachute" payments to top executives; limit most bonuses to top executives to one-third of an executive’s total annual compensation; and permit nonbinding shareholder votes on executive compensation. Originally, all recipients of TARP funds were to be subject to the Stimulus Act’s executive compensation restrictions. Following the signing of the Stimulus Act, the Treasury Department announced that the requirements would not apply to recipients of TARP funds through the Term Asset-Backed Securities Loan Facility ("TALF"), which is designed to increase lending to consumers and small businesses on more favorable terms by encouraging investment in highly-rated asset-backed securities. The decision to exempt TALF participants from the Stimulus Act’s executive compensation restrictions appears to have been made out of concern that the requirements could chill participation in TALF. Following the signing of the Stimulus Act, the Obama administration announced it also would spend $75 billion to encourage home mortgage lenders to modify loans for borrowers in foreclosure or at risk of foreclosure, and up to $200 billion to allow homeowners to refinance through Fannie Mae or Freddie Mac.
In the meantime, activist shareholders are on the warpath. In December 2008, after the Securities and Exchange Commission ("SEC") concurred in the exclusion of shareholder proposals seeking greater disclosure of risks related to mortgage investments at Washington Mutual, a coalition of over 60 investors called on then President-Elect Obama to limit the ability of companies to exclude shareholder proposals related to corporate risk evaluation. The corporate governance challenges for the companies being targeted by these activist shareholders no doubt will be intense for the foreseeable future.
The Subprime Working Group of Gibson, Dunn & Crutcher LLP continues to be actively involved in the representation of a number of different clients in what has come to be called – perhaps too simplistically – the "subprime meltdown." Our working group includes lawyers throughout the United States and in the United Kingdom who are working across different practice groups and different disciplines to deliver timely and practical solutions to our clients facing exposure to subprime-related claims. Please see the working group’s curriculum vitae.
In this White Paper, we provide an overview of current exposures facing companies involved in subprime-related businesses, as well as early trends in subprime-related securities litigation, from the vantage point of lawyers who are at the front lines of the current conflict.
II. Current Civil and Regulatory Proceedings
A. Federal Regulatory Probes
The SEC has more than 50 subprime-related investigations underway, including of lenders, investment banks, underwriters, retail and institutional sellers of subprime loans, and home builders and insurers. The SEC has formed a "Subprime Task Force" to focus on these investigations. The Task Force includes all divisions of the SEC, including the Enforcement Division and the Division of Trading and Markets, and investigates possible fraud and breaches of fiduciary duties. The principal areas of focus for the SEC investigations include (1) the methodologies for valuating mortgage-backed securities; (2) whether firms valued their own mortgage-backed securities differently than those held by customers; (3) whether there was proper disclosure of the valuations of mortgage-backed securities portfolios and subprime mortgage exposure; and (4) insider trading. The SEC also launched an investigation of credit rating agencies, and, on February 2, 2009, adopted amendments to the rules governing nationally recognized statistical rating organizations to address concerns about the integrity of the process by which rating agencies rate structured finance products.
The SEC has filed civil charges against a number of market participants. For example, in June 2008, the SEC filed civil charges against two former portfolio managers for allegedly misleading investors and certain institutional counterparties about the financial state of Bear Stearns’ two largest hedge funds and their exposure to subprime mortgage-backed securities. On the same day, the U.S. Attorney’s office in the Eastern District of New York announced the criminal indictment of the two former portfolio managers. In September 2008, the SEC filed civil charges against two brokers in connection with purchases for customers of more than $1 billion in auction rate securities. The SEC alleges that the brokers misled customers into believing that the auction rate securities were backed by federally guaranteed student loans when they were actually backed by subprime mortgages, CDOs, and other non-student loan collateral. In addition, beginning in August 2008, the SEC announced settlements in principle pursuant to which a number of banks agreed to repurchase auction rate securities with a principal amount of over $50 billion. The settlements followed charges by the SEC that the banks misled investors about the safety and liquidity of their investments in auction rate securities. The SEC’s investigatory and enforcement efforts are likely to remain active and aggressive, particularly in light of the recent criticism that the SEC failed to adequately investigate Bernard Madoff’s investment business.
The Department of Justice ("DOJ") also has opened several criminal investigations relating to sub-prime mortgage activities, primarily through the Sub-Prime Mortgage Industry Fraud Initiative launched by the Federal Bureau of Investigation ("FBI"), as well as its 36 regional mortgage fraud task forces. The DOJ investigations seem to be targeting fraud, insider trading, and misrepresentations to investors regarding the financial health of a company. On June 19, 2008, the DOJ announced a national mortgage fraud enforcement sweep dubbed Operation "Malicious Mortgage." The enforcement sweep resulted in charges against more than 400 defendants across the nation and 60 arrests. The FBI estimated that approximately $1 billion in losses were inflicted by the mortgage fraud schemes targeted by Operation "Malicious Mortgage."
The enforcement unit of the Financial Industry Regulatory Authority ("FINRA") also is engaged in a market "sweep" of more than a dozen firms involved in the marketing and sale of CMOs. On September 4, 2008, in its first enforcement action arising out of the sweep, FINRA barred two brokers from the now defunct brokerage firm, SAMCO Financial Services, Inc., and suspended a third broker for two years, for misconduct in connection with selling "inverse floater" CMOs to retail customers. According to FINRA, the brokers failed to fulfill their obligation to ensure that they recommend CMOs only to those customers for whom they are a suitable investment – i.e., sophisticated investors with a high tolerance for risk. The brokers allegedly recommended CMOs to retail customers with little or no investment experience. The brokers also allegedly compounded the problem by permitting the head trader to exercise discretionary authority in the customers’ accounts to purchase CMOs.
B. State Regulatory Probes
Attorneys general and secretaries of state from a number of states also have opened criminal and civil inquiries in connection with subprime-related activities. States pursuing such inquiries include New York, Connecticut, Massachusetts, Maine, Illinois, Ohio, California, and Florida. Like the federal regulators, the state regulators are investigating a broad range of actors, including subprime lenders, loan servicers, property appraisers, investment banks and credit rating agencies. And like the federal inquiries, the state inquiries raise the threat of prosecution as well as the risk of additional civil litigation arising out of the resulting public disclosure.
A number of the state inquiries are focused on the underwriting practices of subprime lenders, and their methods for valuing mortgage-backed securities. There also have been state inquiries into the practices of rating agencies. In June 2008, the New York Attorney General reached an agreement with certain rating agencies designed to increase the independence of the rating agencies, ensure that all necessary loan data is provided to such agencies before they rate loan pools, and increase transparency in the residential mortgage-backed security market.
There also are a number of state inquiries into home appraisal practices and alleged tactics used to obtain inflated appraisals. As part of an industry-wide investigation, the New York Attorney General has issued subpoenas to a number of appraisal companies and filed suit against one appraisal company alleging that it colluded with Washington Mutual to inflate appraisal values of homes in violation of appraiser independence laws. The Ohio Attorney General has filed suit against ten real estate companies alleging that the companies violated Ohio’s consumer protection laws by coercing appraisers to inflate their appraisals.
State attorneys general also have sought, and obtained, relief for home mortgage borrowers. In October 2008, Bank of America Corporation agreed to settle claims brought by state attorneys general regarding loans originated by Countrywide Financial Corporation prior to its acquisition by Bank of America in July 2008. The deal covers nearly 400,000 borrowers who took out subprime loans serviced by Countrywide. Under the terms of the agreement, Bank of America will modify, where possible, the terms of those loans on which borrowers are seriously delinquent or likely to become so after their interest rate or monthly payment resets. In November 2008, the Ohio Attorney General reached a settlement with bankrupt subprime mortgage lender New Century Financial Corporation. Under the settlement, New Century and its subsidiaries cannot initiate new foreclosures, pursue pending foreclosures, or enforce foreclosure sale notices and evictions. In February 2008, the Massachusetts Attorney General obtained a preliminary injunction enjoining Fremont General and Fremont Investment and Loan, California-based subprime lenders that originated thousands of loans in Massachusetts, from foreclosing on loans considered "presumptively unfair" and "doomed to foreclose." The preliminary injunction was upheld in May 2008 by a Massachusetts appeals court.
C. Private Civil Litigation
There has been a predictable surge in subprime-related private civil litigation. There were 576 subprime mortgage and related cases filed in 2008 alone, and the breadth of industries affected, including mortgage origination, construction, ratings, financial services, real estate investment trusts, auction rate securities, student loan origination, and payment services, is unprecedented.
Suits relating to subprime losses have mushroomed, as the subprime "contagion" has spread across industry sectors. During the first three quarters of 2007, lawsuits targeted participants in the primary mortgage and real estate markets. Companies sued include mortgage originators, such as Accredited Home Lenders, IndyMac Bancorp Inc., New Century Financial Corp., and Fremont General Corp., and residential home builders, such as Beazer Homes, Levitt Corp., and Toll Brothers. Starting in the third quarter of 2007, rating agencies also were sued.
Beginning in late 2007 and continuing throughout 2008, the secondary mortgage market, in which mortgages are purchased, securitized, and traded, was targeted. Secondary market participants named in these suits include many of the large financial services corporations, such as the former Bear Stearns, Citigroup, E*Trade Financial Corp., Merrill Lynch, Société Générale, and UBS AG; mortgage securitizers, such as Freddie Mac; and numerous REITs, including Impac Mortgage Holdings, Inc., Luminent Mortgage Capital, NovaStar Financial, Inc., Opteum, Inc. and RAIT Financial Trust. Actions against bond insurers, including ACA Capital Holdings and Radian Group, also were initiated during this period.
The suits filed in 2008 suggest that the subprime meltdown is now better characterized as a credit crisis. For example, the first suits were filed against companies that had experienced losses due to an increased number of defaults on loan products other than mortgages. These companies include Sallie Mae, a student loan originator, First Marblehead Corp., a student loan securitizer, and MoneyGram International, a payment services company. There also were a number of suits filed in 2008 relating to credit default swaps and other forms of hedging transactions. Credit default swaps are derivative contracts designed to hedge against the risk of default of a debt instrument or loan. In 2008, the credit default swap market ballooned to a notional amount of over $45 trillion dollars and despite its size has remained largely unregulated. On the one hand, credit protection issuers have tried to use "technical defaults" to repudiate contractual obligations in their swap agreements. On the other hand, credit protection buyers have brought suit to enforce contractual rights after credit protection issuers have been unwilling or unable to provide adequate collateral. For example, in UBS AG v. Paramax International, UBS entered into a credit default swap with Paramax International, a Connecticut-based hedge fund. Paramax agreed to provide credit protection for $1.31 billion of UBS notes and to provide more collateral if the value of the notes declined. When the value of the notes subsequently declined, UBS demanded that Paramax commit $33 million more in collateral. Paramax refused, and UBS filed suit to enforce the terms of the swap agreement. In its defense, Paramax argued that UBS wrongfully induced it to enter into the swap transaction by representing that there was a minimal risk of assets being marked to market during the term of the swap agreement under a "subjective valuation method" employed by UBS. The parties ultimately settled the case. However, Paramax’s defense has been parroted by other hedge funds in similar cases.
As of late February 2009, over 161 securities class action lawsuits related to the subprime and credit crisis had been filed. With 210 total filings, the highest level since 2004, new federal securities class actions in 2008 increased almost 20% over 2007. Almost half of the new filings in 2008 were against financial institutions and were related to the subprime and credit crisis. During the 18 months prior to January 1, 2009, there were a total of 317 new securities class action filings – a 71% increase over the 185 filings over the prior 18-month period – and 40% of those filings were related to the subprime and credit crisis. A leading securities litigation scholar, Professor Joseph Grundfest of Stanford Law School, stated that "[t]his level of litigation intensity against a single industry is unprecedented since the passage of the 1995 Reform Act." Nearly a third of all large financial institutions – representing over half of the financial sector’s total market capitalization – were sued in a securities class action filed in 2008. Combining 2007 and 2008, institutions representing two-thirds of the financial sector’s market capitalization were the subject of a federal securities class action filing.
Securities class action filings related to the subprime and credit crisis were concentrated in the Second Circuit, Ninth Circuit and Eleventh Circuit, with over 50% of the filings in the Second Circuit and nearly 20% of the filings in the Ninth Circuit and Eleventh Circuit. In addition to securities class action lawsuits filed in federal court, there has been a surge in securities class action lawsuits filed in state court in connection with the issuance of subprime mortgage-backed securities. The plaintiffs in these lawsuits have argued that their claims under the Securities Act of 1933 should stay in state court under Section 22(a) of the Securities Act, which provides that actions brought in state court under the Securities Act may not be removed to federal court. The circuit courts have split on the issue of whether such claims are removable under the removal provisions of the Class Action Fairness Act of 2005 ("CAFA"). The Ninth Circuit has held that claims brought exclusively under the Securities Act are not removable under CAFA because of Section 22(a). However, following the Ninth Circuit’s decision, both the Seventh Circuit and a district court in the Second Circuit have come to the opposite conclusion holding that the removal provisions of CAFA trump Section 22(a).
Most of the securities class action cases are in the early stages of litigation, with only a limited number of rulings on motions to dismiss. There also have been few rulings in derivative actions brought in tandem with the securities class actions. One subprime-related securities class action has settled, before a ruling on the defendants’ motion to dismiss. In a suit against Merrill Lynch, plaintiffs alleged that the defendants failed to disclose that Merrill Lynch was "increasingly leveraging risky subprime mortgages," "increasing its holdings of risky U.S. subprime ABD CDO exposures," and significantly lowering "underwriting guidelines for subprime loans that were originated [by] and purchased from other subprime originators." In January 2009, Merrill Lynch announced that it had agreed to a proposed settlement of the securities class action for $475 million and a proposed settlement of a related ERISA class action for $75 million.
Notwithstanding the early stage of most subprime-related securities actions, some trends can be identified.
1. Plaintiffs’ Fact Patterns
A number of general fact patterns have emerged in subprime-related cases. The first involves originators, such as New Century, that issued substantial numbers of subprime mortgages during the subprime boom. Mortgage originators sustained heavy losses in late 2006 and early 2007, as a significant uptick in borrower defaults, along with a substantial decrease in real estate values and sales, prompted secondary market purchasers to stop buying sub-prime loans. Plaintiffs typically allege that these companies intentionally engaged in lax lending practices, including encouraging brokers to market loans with a high risk of default (such as interest-only loans) and facilitating fraud through the easy availability of "low documentation" or "liar" loans, and that these companies knowingly misled investors about the nature of these practices. Defendants also are accused of ignoring evidence that large numbers of loans deviating from the company’s underwriting guidelines were being made, concealing the true extent of the company’s exposure to risky loans, and failing to maintain adequate loan loss reserves, which, among other things, resulted in material misstatements of income.
A second common fact pattern centers on residential home building corporations, such as Toll Brothers, Levitt Corp. and Beazer Homes. After experiencing rapid growth in 2005 and 2006, these companies faced a steep decline in new home sales in 2007. Defendants are accused of intentionally misrepresenting business and financial prospects to investors, particularly with regard to prospects for the sale of housing inventory. Some companies, such as Beazer Homes, allegedly were involved in arranging mortgage loans for buyers as well. Like the mortgage originators, these companies are accused of marketing loans with a high risk of default and of facilitating mortgage fraud.
Under a third fact pattern, characteristic of cases against rating agencies, the rating agencies are alleged to have intentionally delayed downgrading the mortgage-backed securities and CDOs of various financial services companies. Plaintiffs articulate several theories for this delay, including that the relationship between the rating agencies and the companies selling the products in question was too "cozy," and further allege that the rating agencies knowingly or recklessly disregarded flaws in their proprietary valuation models.
A fourth general fact pattern is frequently seen in cases against large financial services companies and REITs such as NovaStar Financial, Inc. These companies were involved in the subprime market at nearly every level: mortgage origination, the provision of capital for other originators through warehouses and other funding vehicles, the purchase of mortgages for investment and securitization, the sale and trading of mortgage-backed securities and CDOs, and the maintenance of certain CDO tranches on their balance sheets. Plaintiffs allege that the significant losses sustained by these companies when the value of mortgage-backed securities and CDOs plummeted resulted from defendants’ intentional concealment of the extent of the companies’ exposure to sub-prime-related products and knowing failure to appropriately value the CDO tranches retained on the companies’ books.
2. Plaintiffs’ Theories of Liability
Plaintiffs have employed several different theories of liability. The breadth of the theories is representative of the sweeping nature of the civil litigation claims being advanced.
False Statements About Quality Or Integrity Of Business. In many cases, plaintiffs have challenged statements about the quality or integrity of a company’s loan portfolio, underwriting practices, and internal controls. Courts have long regarded statements touting a company’s business as immaterial "puffery" on which no investor would rely. Courts also have long rejected attempts to dress up allegations of corporate mismanagement as a securities claim. Consistent with this case law, the courts in New York State Teachers’ Retirement Sys. v. Fremont General Corporation, In re 2007 NovaStar Financial, Inc. Securities Litigation, In re Impac Mortgage Holdings, Inc. Securities Litigation, and Tripp v. IndyMac Financial Inc. rejected attempts to hold companies liable for alleged misleading statements praising the quality or integrity of their businesses. However, in cases such as In re Countrywide Financial Corporation Securities Litigation, In re New Century, In re RAIT Financial Trust Securities Litigation, and Atlas v. Accredited Home Lenders Holding Co., the courts have allowed claims based on statements touting the quality or integrity of a company’s business practices to survive motions to dismiss.
In Countrywide, the court candidly acknowledged that in most cases such statements would not be actionable, but felt compelled to make an exception because Countrywide’s business practices so departed from any reasonable interpretation of "quality" or "standards":
The federal securities laws do not create liability for poor business judgment or failed operations. Nor do the laws require public companies to disclose every change in operation. But the CAC’s allegations present the extraordinary case where a company’s public statements were so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws.
For example, descriptions such as "high quality" are generally not actionable; they are vague and subjective puffery not capable of being material as a matter of law. On an individual level, this is because a reasonable person would not rely on such descriptions; on a macro scale, the statements will have little price effect because the market will discount them. However, the CAC adequately alleges that Countrywide’s practices so departed from its public statements that even "high quality" became materially false or misleading; and that to apply the puffery rule to such allegations would deny that "high quality" has any meaning.
Similarly, in New Century, the court held that "New Century’s statements that it observed standards of high-quality credit and underwriting" were actionable in light of "detailed allegations of practices that utterly failed to meet those standards." In RAIT, the court stated that "[w]e cannot say that a statement claiming that RAIT’s ‘credit underwriting process involves and extensive due diligence process’ is mere puffery when Plaintiffs allege that RAIT ‘did not conduct any meaningful ongoing credit analysis whatsoever.’" And in Accredited, the court held that statements regarding the company’s underwriting practices were actionable where there was alleged "widespread deviation from company policy."
As the rulings in Countrywide, New Century, RAIT, and Accredited show, courts may be willing to indulge theories they ordinarily would not when presented with allegations that are perceived as depicting egregious misconduct by a defendant in the subprime industry.
False Statements About Appraisal Practices. In addition to challenging statements about underwriting practices, plaintiffs have challenged statements about appraisal practices. For example, in a lawsuit against an appraisal company and its parent, plaintiffs allege that the defendants failed to disclose "the undue and improper pressure placed on [defendants] by Washington Mutual executives in an attempt to obtain higher appraisal values." Plaintiffs allege that the failure to disclose the improper appraisal practices rendered false and misleading defendants’ statements about the value and accuracy of the company’s appraisals and defendants’ statements about the company’s ethical and legal guidelines. Similar allegations of improper appraisal practices permeate the claims in other cases. For example, the plaintiffs in a securities class action against Washington Mutual allege that "[t]he Company, in . . . inflating the value of appraisals underlying its loan portfolio materially understated its [loan loss] Allowance, and materially inflated the Company’s reported earnings and net income." In Countrywide, the plaintiffs allege that "all of Countrywide’s origination divisions" allowed loan officers to "hire appraisers of their own choosing" and then "discard appraisals that did not support loan transactions, and substitute more favorable appraisals . . . to obtain a more favorable loan to value ratio so that the loan would ‘qualify’ for approval." In a securities class action concerning IndyMac mortgage pass-through trust certificates, plaintiffs allege that IndyMac had an "ongoing practice of systematically inflating appraisals for properties which failed to satisfy its threshold for adequate [loan-to-value] ratios for mortgages."
False Financial Statements. In one way or another, most plaintiffs have challenged the integrity of reported financial statements. At its core, the accounting issue is whether the issuer used appropriate methodologies to establish the "fair value" of the securities or instruments under the relevant provisions of GAAP, and whether it failed to take impairment charges or other write-downs on a timely basis. For example, in RAIT, the plaintiffs allege that "RAIT avoided taking necessary charges to earnings" when "RAIT knew about other-than-temporary impairments that would have been noted if RAIT was in compliance with GAAP." In many cases, plaintiffs claim that issuers underestimated their exposure to anticipated losses, inflated the value of certain assets or collateral, or failed to timely write down impaired assets. For example, in Countrywide, the plaintiffs allege that "Countrywide overstated [mortgage-servicing rights] values by not properly accounting for default rates in its model."
Plaintiffs also have accused issuers of intentionally understating their loan loss reserves, the funds set aside to cover a lender’s expected rate of default. These understatements allegedly weakened the issuer’s buffer against a growing rate of defaults and foreclosures and also allegedly resulted in exaggerations of net income. For example, in New Century, plaintiffs allege that New Century’s reserve to account for expenses and losses that may be incurred due to the potential repurchase of loans by third-parties in the event of payment defaults by borrowers was understated by "tens of millions of dollars" and "in effect . . . overstated New Century’s income."
Undisclosed Risk Of Subprime Market Collapse. In some of the cases involving the origination of subprime mortgages, plaintiffs allege that the issuer failed to warn investors of an impending collapse of the subprime market. In Countrywide, for example, plaintiffs allege that Countrywide "knew that the economy could not possibly support the historically high real estate prices," and should have taken steps to "protect itself should the real estate market collapse, even though there was sufficient commentary in the media about the [housing] bubble." Beazer Homes faces allegations that it failed to disclose, and that its 2007 projections failed to account for, increased volatility in the lending market, thereby artificially inflating Beazer stock prices.
Undisclosed Exposure To Subprime Risks. Some cases allege that an issuer intentionally failed to disclose the nature and extent of a company’s involvement in subprime-related activities. For example, in a class action suit filed against the Royal Bank of Scotland in January 2009, plaintiffs allege that the bank failed to disclose its exposure to the subprime mortgage market before reporting one of the biggest losses in British banking history. Similarly, in a class action suit filed in October 2008, plaintiffs alleged that Fannie Mae’s officers, directors, and underwriters failed to disclose that Fannie Mae was "grossly undercapitalized" due to its "overwhelming investments in subprime and Alt-A mortgages." In a class action suit filed against AIG, plaintiffs allege that AIG disclosed that it had "notional exposure to over $6.5 billion in liquidity puts that it had written on CDOs linked to U.S. residential sub-prime mortgages," after previously stating that it had "’little to no exposure’ to asset-backed commercial paper, structured investment vehicles or collateralized debt instruments tied to residential mortgage-backed securities." In September 2008, a bond insurance company filed suit alleging that Countrywide misled it about the quality of the loans that it originated and used to collateralize its mortgage-backed securities. The bond insurance company alleges that it relied on these statements when agreeing to guarantee over $14 billion of Countrywide’s mortgage-backed bonds, and that payment obligations on these bond insurance contracts have cost it more than $459 million.
Breach Of Directors’ Duty Of Oversight. In some of the derivative suits filed to date, directors have not been sued for any direct complicity in the alleged improper conduct relating to subprime loans, but rather for having breached their "duty of oversight" under state law. In concluding that plaintiffs’ allegations satisfied the relevant standards in the Countrywide derivative litigation, the court examined the duties of each of the corporation’s oversight committees and concluded that, in light of its oversight responsibilities, Audit & Ethics Committee members knew, or should have known, of various red flags:
Audit & Ethics Committee members are required to oversee the Company’s risk management practices, its risk assessment policies, and Countrywide’s exposures and liabilities with management. Loan origination is at the core of all Countrywide’s business operations, and risks related to loan performance are central to the Company’s overall risk position. Even more crucially, the Complaint identifies a number of Countrywide internal systems for analyzing risk for which the Audit & Ethics Committee has oversight responsibility. . . .
As they are responsible for managing these systems, members of this Committee were uniquely positioned to understand the contribution of underwriting standards to overall Company risk. Plaintiffs raise a cogent and compelling inference that Audit & Ethics committee members were aware of (or proceeded with deliberate recklessness with respect to) the significance of red flags relating to increasing delinquencies, negative amortization, and other signs of loss performance.
The court employed a similar analysis to sustain allegations against members of Countrywide’s Credit Committee, Finance Committee, and Operations & Public Policy Committee. By contrast, the court dismissed the claims against those directors who were members only of the Compensation Committee, concluding that it was "unclear" how the oversight duties of that committee would have led members to encounter or "examine the red flags identified by Plaintiffs."
3. Defense-Oriented "Global" Fact Pattern
There is a defense-oriented "global" fact pattern that directly responds to the theory advanced by many plaintiffs that the market was either unaware of the risks associated with sub-prime lending in general, or of the adverse impacts that the downturn in the housing market might have on sub-prime lenders and syndicators.
At the end of 2006, several major companies involved in the origination of sub-prime loans began to experience financial adversity in a fairly public way: Ownit shut down operations in December 2006; ResMAE filed for bankruptcy in February 2007; and New Century followed suit in April 2007. According to many commentators, the downturn in the U.S. housing market, which had otherwise been on a tear for most of the last twenty years, played a major role in this collapse. As housing prices rose, the appetite for subprime loans increased, and consumers remained confident that an exit strategy from sub-prime loans featuring "teaser" rates would be available. In particular, consumers assumed that, because the market was continuing to rise, refinancing would always be an option, and the reset features on their sub-prime loans never would be triggered. Instead, as housing prices began declining, consumers became locked into loans they could not afford and could not refinance, and proceeded to default in record numbers.
Certainly, many of the underwriting practices of which plaintiffs now complain were not unknown. "No documentation" or "low documentation" loans, along with other features of subprime lending practices, were reported broadly. In February 2007, Freddie Mac publicly announced that it was revising its own underwriting criteria for the purchase of subprime adjustable-rate mortgage loans, and would require that originators evaluate a potential borrower based not only on the ability to pay the "teaser" rate, but also on any reset rates. This disclosure reflected that the market for subprime loans was tightening.
In April 2007, New Century, one of the industry’s largest subprime mortgage lenders, filed for Chapter 11 bankruptcy protection. By June 2007, the ABX index that tracks trading prices for BBB-rated subprime mortgage backed securities had dropped to roughly 50% of its value as of the beginning of the year. Also in June, Bear Stearns announced flat profits, in part due to adverse conditions in the mortgage market, and it committed more than $3 billion to support two Bear Stearns-sponsored hedge funds. By July 2007, rating agencies were beginning to downgrade bonds backed by subprime mortgages. On July 24, 2007, Countrywide reported $417 million in impairment charges on credit-sensitive retained interests and a $293 million loan loss provision on its loans held for investment. These and other developments have led plaintiffs to allege that, by mid-2007, the market "knew" that sub-prime issues would impact mortgage-backed securities. For example, one complaint filed alleges: "In mid-July , it became apparent to the market that banks . . . would be adversely affected by the mortgage meltdown."
The biggest write-downs of subprime mortgage backed securities came in 2008 and 2009. Why not sooner? The answer may depend in part on the practices of the individual firms in reviewing their valuation models, and adjusting them to reflect current market conditions. Of course, the answer also depends in part on how each firm evaluated and applied the accounting literature for fair value accounting.
4. Key Defenses
No False Statement. Many plaintiffs essentially have pleaded "fraud by hindsight," alleging that underwriting practices, statements made, projections issued, or reserves set by companies before they sustained subprime-related losses must have been fraudulent in light of the profound losses that ultimately occurred. Often, plaintiffs pressing fraud-by-hindsight arguments do not specifically identify false or misleading statements, or even a corrective disclosure. For example, in Novastar, "nobody – the SEC, Novastar’s auditors, or anyone else – ha[d] suggested Novastar should or must restate its financial reports." Nonetheless, plaintiffs brought suit seeking recovery of their investment loss alleging that the company concealed, inter alia, that it "lacked internal controls, which rendered its projections defective," "deviat[ed] from underwriting standard creat[ing] undue risk of default," and "failed to properly account for its allowance for loan losses." The court flatly rejected plaintiffs’ hindsight allegations and dismissed the plaintiffs’ complaint with prejudice:
Plaintiff has not specified the allegedly misleading statements, nor has he specified why the statements he has referred to are misleading. . . . There is no obligation to divulge every "fact" known to everyone in a company, and the PSLRA’s effort to combat claims of "fraud by hindsight" demonstrates a reluctance to countenance claims that attach heightened importance to facts only when looking back at the aftermath of misfortune. . . .
[A]ccording to Plaintiff[,] GAAP required Novastar to make adequate provisions for delinquent loans. Novastar made provisions, but those provisions turned out to be inadequate. This does not mean the initial provisions were "false;" it just means management did not do a good job.
Similarly, in Fremont, the court rejected plaintiffs’ attempt to characterize Fremont’s Form 10-Q for the third quarter of 2005 as false based on a later "massive impairment of over $161 million" because an impairment charge taken in 2006 was "not sufficient to show that the statement about GAAP compliance in the [third quarter 2005] 10Q at issue was materially false at the time it was made."
No Issuer Scienter. In Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court held that trial courts must consider all competing inferences that might bear on scienter, and may only allow a case to proceed if plaintiffs "plead with particularity facts that give rise to a ‘strong’ – i.e., a powerful or cogent – inference." Courts are taking seriously the Tellabs requirement that they "assess all allegations" and consider "plausible nonculpable explanations" for defendants’ conduct. For example, in Indymac, the court refused to infer scienter from IndyMac’s January 2007 announcements of sudden increases to loan loss reserves, charge-offs, and secondary market reserves because it concluded that another, more innocuous, inference arising from the same set of alleged facts was more plausible:
Plaintiffs cite these financial statement numbers as, respectively, "[f]urther evidence of IndyMac’s internal control problems" and a clear indication Defendants knew a significant portion of the loans they had sold on the secondary market during the Class Period were troubled when made and would need to be repurchased. However, an even stronger inference is that Defendants were simply unable to shield themselves as effectively as they anticipated from the drastic change in the housing and mortgage markets and, once that inability became evident, IndyMac’s financials were changed accordingly.
In Novastar, the court likewise concluded that "Plaintiff’s allegations are more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community."
By contrast, where plaintiffs have provided detailed allegations of a defendant’s scienter corroborated by confidential witness statements and contemporaneous internal documents, courts have found the requisite strong inference of scienter. For example, in New Century, the court determined that plaintiffs’ allegations created a "compelling inference" of scienter where "confidential witness statements describe[d] a staggering race-to-the-bottom of loan quality and underwriting standards" and "internal reports by New Century’s Senior Management . . . acknowledged serious problems with loan quality and underwriting." In addition, courts have found admissions relating to the core operations of a company to provide strong circumstantial evidence of scienter. For example, in determining that "Plaintiffs have created a cogent and compelling inference of a company obsessed with loan production and market share with little regard for the attendant risks," the court in Countrywide observed that "Countrywide’s core mortgage-related operations accounted for the vast majority of Countrywide’s earnings during the class period," yet "[u]nderwriting standards changed so much during the class period that, in December 2007, Countrywide told reporters that billions of dollars of loans in 2005 and 2006 could not have been made under . . . Countrywide’s pre-class period guidelines." Courts also have found massive restatements or write-downs to be probative of scienter. For example, in RAIT, the court stated that "the sheer size of the impairment eventually taken by RAIT adds to the inference that the Officer Defendants . . . must have had some awareness that the problem was brewing." In a similar vein, courts have found a company’s disputes with its outside auditors to provide strong circumstantial evidence of scienter. For example, in sustaining plaintiffs’ scienter allegations, the court in Accredited noted that "Accredited’s auditor during the class period refused to approve the company’s 2006 financial statements before the deadline to file the company’s Form 10-K."
No Auditor Scienter. In search of deep pockets, plaintiffs have predictably named outside auditors as defendants in the subprime suits. But even in cases where claims have been sustained against the issuer, courts have viewed securities fraud claims against auditors with skepticism. For example, in dismissing plaintiffs’ securities fraud claim against KPMG in Countrywide, the court explained that it is more difficult to infer scienter on the part of an outside auditor because of its limited access to company information: "KPMG is an outside auditor, making a position-based inference rather difficult because outside auditors have more limited information than, for example, the committee members who oversee the audit. Further, an auditor’s job requires complex and subjective judgments that courts are not ideally positioned to second guess." Similarly, in Grand Lodge of Pennsylvania v. Peters, the court dismissed the claim against Coastal Holdings’ outside auditor because the plaintiffs failed to "offer specific factual allegations that are sufficient to support the strong inference that the audit was so deficient that it amounted to no audit at all."
Underwriter Due Diligence. Plaintiffs also have predictably named underwriters as defendants in the subprime suits. Though due diligence is typically an affirmative defense to a Section 11 claim under the Securities Act of 1933, courts have been receptive to certain due diligence arguments on motions to dismiss. For example, the court in Countrywide found that the "Underwriter Defendants have a due diligence defense on the face of the [complaint] as a matter of law . . . because underwriters may reasonably rely on auditors’ statements, absent red flags that the underwriters were in a position to see." In dismissing certain accounting-related allegations, the court explained that, although "it is appealing to say the same red flags could have put Underwriter Defendants on notice that the accounting-related statements were false or misleading[,] . . . the present [complaint] does not adequately allege that Underwriter Defendants’ reliance on KPMG and Countrywide management’s accounting-related statements during this period was unreasonable."
Rating Agency Defenses. Plaintiffs also have named rating agencies as defendants. However, rating agencies have a number of available defenses. SEC Rule 436(g) exempts rating agencies from liability as experts under Section 11 of the Securities Act of 1933. Section 12(a)(2) liability against a person who "offers or sells" a security is difficult for plaintiffs to establish because rating agencies typically do not directly solicit the purchase of securities. As one court has explained in dismissing a Section 12(a)(2) claim against a rating agency, liability under Section 12(a)(2) "cannot be imposed upon those who merely assist in another’s solicitation’s efforts." Rating agencies also may argue that any reliance on their ratings is unreasonable given disclaimers that their ratings are "not a recommendation to buy, sell, or hold any [securities] and may be subject to revision or withdrawal at any time." In addition, the ratings issued by rating agencies have been considered by a number of courts to be protected under the First Amendment, though some courts have held that ratings should not be accorded heightened First Amendment protection where a rating agency specifically issues a rating for offering materials, as opposed to issuing a rating for general publication.
No Reliance. Some defendants may have powerful defenses to allegations of reliance, based not only on the publicly-disclosed facts concerning the downturn in the subprime market, but also on the copious disclosures of risk factors that companies were making, and Wall Street analysts were writing about, between late 2006 and mid 2007. These defendants can credibly argue that many of the adverse facts upon which investors have based their claims were known or knowable, and, therefore, that the claims are subject to a "truth on the market" defense. Indeed, as noted in a paper by several university professors, "with respect to macroeconomic issues, such as the current or future state of the economy, interest rates or the national housing market, it is quite implausible to believe that the SPVs or the investment banks sponsoring or underwriting the MBS or sponsoring the CDOs had any special knowledge concerning these matters that was not already known by the market."
A number of plaintiffs’ complaints even support the "truth on the market" argument. Coughlin, Stoia, Geller, Rudman & Robins LLP, one of the most active plaintiffs’ firms, has pleaded in many cases that the market came to "know" of warning signs by the third quarter of 2007. Other complaints filed by Coughlin Stoia place knowledge of warning signs even earlier. Coughlin Stoia’s complaint against Standard and Poor’s, for example, alleges that (1) by 2005, numerous studies and news articles were reporting rampant fraud in the mortgage industry, and were tying this fraud to increased risk of default; (2) by 2006, "it had been clearly established that mortgage brokers and lenders were borrowers who, in the past, would never have qualified for loans"; (3) "[d]elinquencies related to sub-prime and Alt-A mortgage loans began to spike in August of 2006 and reached historical highs by the end of November 2006"; and (4) "[b]y March 2007, the market was clearly concerned with a meltdown of the sub-prime and Alt-A markets." Coughlin Stoia’s complaint against Toll Brothers even cites concerns on the part of investors and analysts as far back as 2004 that the "long-running housing boom had entered a ‘bubble’ phase and was about to lose steam due to exhaustion of demand, rising interest rates and other adverse economic factors."
In cases where the plaintiffs have helped plead the defense-oriented "global" fact pattern, the "truth on the market" argument may be successful at the motion to dismiss stage. In other cases, the "truth on the market" argument ultimately may be a more powerful defense at the summary judgment stage. In Countrywide, for example, the court opted to "reject a truth-on-the-market defense at the pleading stage" on the ground that it was "perfectly reasonable to infer" at the pleading stage that the complexity of Countrywide’s mortgage-backed securities, "coupled with Countrywide’s alleged public misrepresentations, would blunt the effect of any disclosures in [Countrywide’s] prospectuses."
No Loss Causation. By the time the market began to react significantly to concerns about subprime mortgages, many corporate holders and purveyors of mortgage-backed securities already had seen their share prices fall steadily for months and even years. This fact poses a significant challenge to plaintiffs who bear the burden of pleading and proving loss causation.
Indeed, in 60233 Trust v. Goldman, Sachs & Co., the court held that a decline in stock price prior to the issuance of "curative" information may be fatal to a securities fraud claim. In 60233 Trust, the court dismissed, on loss causation grounds, a suit by the shareholders of Exodus Corporation against Goldman Sachs and one of Goldman’s analysts. Exodus shares had traded at $24.75 at the beginning of the class period in January 2001, and had trended steadily downward thereafter. The class period ended six months later, in June 2001. During the final week of the class period, Exodus’ share price fell from $5.01 (pre-disclosure) to $1.59 (post-disclosure). Focusing on the movement of Exodus’ share price during the class period, the court concluded that the case should be dismissed on loss causation grounds:
The loss in value of the stock occurred gradually over the course of the entire class period, and the stock had lost most of its value before the June 14-21 events. This gradual loss of value occurred during the time when the alleged false and misleading statements were being issued. The complaint does not even refer to the phenomenon of the gradual loss of the stock’s value, much less attempt to explain it as related to loss causation.
The court’s ruling in 60233 Trust holding could apply to any number of subprime cases. As the Second Circuit has explained, where an alleged "loss coincides with a marketwide phenomenon causing comparable losses to other investors . . . a plaintiff’s claim fails when it has not adequately [pled] facts which if proven, would show that its loss was caused by the alleged misstatements as opposed to intervening events." Stated differently, plaintiffs must allege facts demonstrating that their losses are not the result of "the tangle of factors affecting price." In subprime cases, plaintiffs will have to explain how their losses prior to a "curative" disclosure were not caused by an industry-wide meltdown.
To withstand dismissal at the pleading stage, plaintiffs have come up with alternative loss causation theories. For example, in City of Hialeah Employees’ Retirement System & Laborers Pension Trust Funds for Northern California v. Toll Brothers, plaintiffs alleged that the defendants intentionally concealed a softening demand for Toll Brothers’ homes. In pleading loss causation, plaintiffs pointed to four public statements over a three-month period that allegedly "gradually revealed" the truth about the lack of traffic and demand. Defendants decried this approach as "inappropriately group[ing] . . . the alleged ‘revelations’ together in an attempt to establish loss causation." The court sided with the plaintiffs, deeming "each of the four revelations . . . and subsequent drop in stock price" actionable." The court in Countrywide accepted a similar theory: "[L]oss causation is not precluded by a series of disclosures; serial disclosures just make it more difficult for plaintiffs as a practical matter. The point . . . is that the price of Countrywide securities dropped as the disclosures accumulated." However, the court did acknowledge that "dramatic market shifts will raise complicated questions on damages" and that "[i]t will be the fact-finder’s job to determine which losses were proximately caused by Countrywide’s misrepresentations and which are due to extrinsic of insufficiently linked forces."
The extent to which courts in subprime cases apply the stricter loss causation standard of 60233 Trust, or, alternatively, the more relaxed standard employed in Toll Brothers and Countrywide, remains to be seen. Even if some plaintiffs are successful at averting dismissal at the pleading stage, proving loss causation in the face of an industry-wide collapse will present a significant hurdle to plaintiffs.
Business Judgment Rule And No Bad Faith. On February 24, 2009, the Delaware Chancery Court dismissed breach of fiduciary duty claims brought by derivative plaintiffs against Citigroup directors. The plaintiffs had alleged that "the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities." In dismissing the breach of fiduciary duty claims, the court reiterated that Delaware law does not permit "judicial second guessing" of business decisions:
When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company. Delaware Courts have faced these types of claims many times and have developed doctrines to deal with them – the fiduciary duty of care and the business judgment rule. These doctrines properly focus on the decision-making process rather than on a substantive evaluation of the merits of the decision. This follows from the inadequacy of the Court, due in part to concept known as hindsight bias, to properly evaluate whether corporate decision-makers made a "right" or "wrong" decision. . . .
Business decision-makers must operate in the real world, with imperfect information, limited resources, and an uncertain future. To impose liability on directors for making a "wrong" business decision would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second guessing is what the business judgment rule was designed to prevent. . . .
The warning signs alleged by plaintiffs are not evidence that the directors consciously disregarded their duties or otherwise acted in bad faith; at most they evidence that the directors made bad business decisions. . . .
It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundreds of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. . . .
The Delaware Chancery Court’s opinion is a strong reminder that the business judgment rule should continue to be the standard by which directors’ alleged actions or inactions are judged in derivative actions.
D. Foreign Issuers
Issuers in other jurisdictions, such as the United Kingdom, also are feeling the impact of the credit crisis both in the U.S. and in their home markets. The Financial Services Authority ("FSA"), the United Kingdom’s equivalent to the Securities and Exchange Commission, has conducted a thematic review of certain sectors of the subprime market and has brought disciplinary proceedings against a small number of mortgage firms found to have mis-sold subprime mortgages. It also is clear that a significant portion of the U.S. subprime debt and securities ended up within English borders.
Plaintiffs are attempting to pull foreign issuers into litigation in the United States. A significant issue in cases against foreign issuers is whether (and, if so, the extent to which) courts will permit foreign investors to participate in class actions against these companies. Current case law is inconsistent. In the high-profile Royal Dutch Shell case in late 2007, the District of New Jersey dismissed outright the claims of a foreign investor who brought a putative class action against a foreign issuer for shares purchased on a foreign exchange, finding that the court had no subject matter jurisdiction over the case. On the other hand, in January 2008, a court in the Southern District of New York permitted an action to go forward under similar circumstances, even appointing the foreign investor as lead plaintiff. Other cases occupy a middle ground, looking at whether the shares at issue were purchased on a U.S. or foreign exchange, and whether the foreign purchaser’s country of origin would recognize any U.S. judgment reached, in determining whether foreign investors may bring suit or serve as lead plaintiff in suits against foreign issuers.
In October 2008, the Second Circuit issued a decision in Morrison v. National Australia Bank regarding subject matter jurisdiction in "foreign-cubed" securities cases – i.e., cases brought by foreign plaintiffs, against a foreign company, arising out of a foreign securities transaction. Though the Second Circuit declined to exercise jurisdiction because of the particular facts of the case, the Court also declined to adopt a bright-line rule barring jurisdiction in all such cases. The Second Circuit held that "the usual rules still apply" in foreign-cubed cases and that any "potential conflict between our anti-fraud laws and those of foreign nations does not require the jettisoning of our conducts and effects test." The Second Circuit reasoned that (1) foreign jurisdictions would appreciate the anti-fraud efforts of U.S. courts; (2) the Exchange Act is intended to prevent all parties – domestic and foreign – from staging frauds from the United States; and (3) this purpose can best be furthered by allowing for jurisdiction even in foreign-cubed cases. The Second Circuit noted that a "much stronger case" for a finding of subject matter jurisdiction would exist "where the American subsidiary of a foreign corporation issues fraudulent statements or pronouncements from the United States impacting the value of securities trading on foreign exchanges." That statement, along with the factors to which the Second Circuit pointed in declining to find jurisdiction in the particular case – including the locus of the "heart" of the fraud, the attenuated chain of causation linking it to any activities in the U.S., and the absence of any U.S. effects – provide at least some guidance from one Court of Appeals on the types of cases that might cause foreign issuers some concern.
E. D&O Insurance
There is some concern as to whether the exposures outlined above will be covered by D&O insurance. As one report put it, "forecasts concerning the impact of the subprime crisis on the D&O market at this early date are necessarily murky due to the complexity of the issues involved." A few areas of potential "murkiness" are set forth below.
First, there is the basic pocket book issue of whether defense costs will be covered for certain aspects of subprime-related legal proceedings. When an issuer is forced to commence an internal investigation, unconnected to pending litigation, and without any formal enforcement proceeding having been brought against the company, some D&O policies may prohibit reimbursement of costs for such purely investigative matters. These costs alone could amount to multi-million dollar sums.
Second, the extent to which fraudulent underwriting practices took place (e.g., falsely inflated appraisals), and whether such conduct may fall within the so-called "conduct exclusions" in the relevant D&O policies, remains to be seen. Typically, of course, it will be hotly contested whether members of senior management were aware of non-compliant underwriting practices.
Third, if any of the many pending derivative suits proceed past the pleading stage due to "demand futility," will the resolutions of those cases (whether by settlement or judgment) be covered by insurance? A company cannot indemnify directors or officers if there is an adjudication that they breached fiduciary duties to the company – but in theory the "Side A" coverage in the typical D&O policy should afford coverage, at least for settlements.
Fourth, issues may arise with regard to whether coverage for certain claims will be denied due to the alleged "improper personal benefit" received by individual defendants (e.g., improper executive compensation or stock options granted based upon the company achieving certain financial results that were falsely inflated by subprime-related revenues). Many D&O policies contain such an exclusion although the exclusion often requires an adjudication before the exclusion can be successfully invoked.
These and other coverage issues may complicate the job of defense counsel in the defense and settlement of the cases being brought.
There is unlikely to be any slowdown in the near future of new filings of securities cases related to the credit crisis. Until the U.S. and other world economies are stabilized, delinquency and default rates likely will continue to escalate. The values of securities linked to subprime mortgages are likely to remain depressed, and further writedowns are expected.
The pending civil securities cases are characterized by massive investor losses and will therefore be heavily litigated. Most of plaintiffs’ theories of liability are repackaged variations of theories of liability asserted in prior securities cases. However, when presented with allegations of what they consider to be particularly egregious misconduct in the subprime industry, some courts have shown a willingness to indulge theories of liability they ordinarily would not. While plaintiffs will continue to contrive theories of liability based on colorful factual allegations, defendants will be best served by applying longstanding legal principles and employing the defense-oriented "global" fact pattern discussed above.
The Gibson Dunn Subprime Working Group will continue to monitor all the important developments in the subprime arena.
 United States Treasury Department Office of Financial Stability, Troubled Asset Relief Program Transactions Report for Period Ending February 6, 2009, available at http://www.treasury.gov/initiatives/eesa/docs/transaction_report_02-10-09.pdf; Matthew Ericson & Elaine He, et al., Tracking the $700 Billion Bailout, N.Y. Times at http://projects.nytimes.com/creditcrisis/recipients/table (online ed., last accessed Feb. 12, 2009).
 United States Treasury Department, Fact Sheet: Financial Stability Plan, available at http://www.financialstability.gov/docs/fact-sheet.pdf (last accessed Feb. 12, 2009).
 Eric Dash & Jack Healy, Stocks Slide as New Bailout Disappoints, N.Y. Times, at B1 (Feb. 11, 2009).
 Sheryl Gay Stolberg, Signing Stimulus, Obama Doesn’t Rule Out More, N.Y. Times (Feb. 17, 2009). See also Gibson, Dunn & Crutcher LLP, Financial Markets in Crisis: Stimulus Act Enhances Executive Compensation Standards; TALF Expanded (Feb. 17, 2009).
 American Recovery & Reinvestment Act of 2009, H.R. 1 (2009), tit VI, Executive Compensation. See also SEC Division of Corporate Finance Interpretations of American Recovery & Reinvestment Act of 2009 (Feb. 26, 2009), available at http://www.sec.gov/divisions/corpfin/guidance/arrainterp.htm.
 Gibson, Dunn & Crutcher LLP, Financial Markets in Crisis: TALF Launched; Executive Compensation Restrictions Will Not Apply (Mar. 4, 2009) .
 Laura Meckler, Housing Bailout at $275 Billion: Obama Plan Would Fund Loan Modifications, Cover More Losses at Mortgage Titans, Wall St. J., at A1 (Feb. 19, 2009).
 Ted Allen, Investors Decry Proposal Omissions, Risk & Governance Weekly (Dec. 19, 2008).
 SEC 2008 Performance and Accountability Report at 2 (Nov. 14, 2008); SEC Actions During Turmoil in the Credit Markets (Jan. 22, 2009).
 Amendments to Rules for Nationally Recognized Statistical Ratings Organizations, SEC Release No. 34-59342 (Feb. 2, 2009).
 SEC Charges Two Former Bear Stearns Hedge Fund Managers with Fraud, SEC Litigation Release No. 20625 (June 19, 2008).
 SEC Charges Two Wall Street Brokers in $1 Billion Subprime-Related Auction Rate Securities Fraud, SEC Litigation Release No. 20698 (Sept. 3, 2008).
 SEC 2008 Performance and Accountability Report at C12 (Nov. 14, 2008).
 Press Conference by FBI Director Robert S. Mueller, III, on June 19, 2008.
 FINRA Sanctions Three Brokers for Sales of CMOs to Retail Investors, FINRA News Release (Sept. 4, 2008).
 Attorney General Cuomo Announces Landmark Reform Agreements with the Nation’s Three Principal Credit Rating Agencies, Office of the Attorney General of New York (June 5, 2008).
 Crenson L. Sharon, Mitchell Maxwell Revises Appraisal Rules Amid Probe (July 17, 2007).
 NY Attorney General Sues First American and its Subsidiary for Conspiring with Washington Mutual to Inflate Real Estate Appraisals, Office of the Attorney General of New York (Nov. 1, 2007).
 Dann Targets Brokers and Lenders for Undue Influence, Office of Ohio Attorney General (June 7, 2007).
 Dina El Boghdady, Bank of America to Modify Mortgages from Countrywide, Washington Post, D03 (Oct. 7, 2008); Bank of America Announces Nationwide Homeownership Retention Program for Countrywide Customers, Bank of America Press Release (Oct. 6, 2008).
 Ruth Simon, Bank of America in Settlement Worth Over $8 Billion, Wall St. J. (Oct. 16, 2008).
 Appeals Court Judge Upholds Preliminary Injunction Against Fremont in Predatory Lending Case, Office of Massachusetts Attorney General, Office of Massachusetts Attorney General (May 5, 2008).
 Navigant Consulting, 2008: Seeking Relief, Subprime Mortgage and Related Litigation (Mar. 2009); Subprime Mortgage Litigation Filings Surpass S&L Benchmark, Navigant Consulting Study Finds, Business Wire (Sept. 11, 2008); NERA Economic Consulting, Subprime Securities Litigation: Key Players, Rising Stakes, and Emerging Trends (July 2008).
 See e.g., GSF AL Nawras (Cayman) Ltd. v. Lehman Brothers OTC Derivatives Inc., Case No. 08-CV-8487 (S.D.N.Y. filed Oct. 3, 2008); Fir Tree Value Master Fund, L.P. et all. v. Lehman Brothers Special Financing Inc., (N.Y. Sup. Ct. filed Oct. 3, 2008).
 Arcane Market Is Next to Face Big Credit Test, N.Y. Times (Feb. 17, 2008).
 See, e.g., Merrill Lynch Int’l. v. XL Capital Assurance Inc., 564 F. Supp. 2d 298 (S.D.N.Y. 2008).
 UBS AG v. Paramax Int’l, No. 07604233 (N.Y. Sup. Ct.).
 UBS AG v. Paramax Int’l, No. 07604233 (N.Y. Sup. Ct.).
 VCG Special Opportunities Fund Ltd. v. Citibank N.A., No. 08 CV 01563 (S.D.N.Y.); CDO Plus v. Wachovia, No. 08 CV 05655 (S.D.N.Y.).
 See The D&O Diary, Counting the Subprime Lender Lawsuits (Feb. 23, 2009), available at http://www.dandodiary.com/2007/04/articles/securities-litigation/counting-the-subprime-lender-lawsuits/index.html.
 Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research, Securities Class Action Filings 2008: A Year in Review at 1, 4 (Jan. 2009).
 Id. at 4.
 Press Release, Litigation Against Financial Services Firms Dominates Securities Class Action Filings According to Annual Report by Stanford Law School and Cornerstone Research (Jan. 6, 2009).
 Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research, Securities Class Action Filings 2008: A Year in Review at 2 (Jan. 2009).
 NERA Economic Consulting, 2008 Trends in Securities Class Actions (Dec. 2008).
 See Kevin LaCroix, Section 11 Lawsuits: Coming Soon to a State Court Near You?, The D&O Diary (July 21, 2008), available at http://www.dandodiary.com/2008/07/articles/securities-litigation/section-11-lawsuits-coming-soon-to-a-state-court-near-you/. For example, in November 2008 and January 2009, there were securities class actions filed in New York and California state courts on behalf of investors who purchased mortgage pass-through trust certificates issued by IndyMac special purpose entities. See IBEW Local 103 v. Indymac MBS, Inc., et al., No. BC405843 (filed in Cal. Super. Ct. on Jan. 20, 2009); Tsereteli v. Residential Asset Securitization Trust 2006-A8, et al., No. 08-603380 (filed in N.Y. Sup. Ct. on Nov. 19, 2008). Subsidiaries of IndyMac Bank, F.S.B., which was placed in FDIC receivership in the summer of 2008, allegedly pooled together loans originated by the bank and securitized them into mortgage-backed securities that were sold to the special purpose entities which, in turn, issued trust certificates for sale to investors. Id.
 15 U.S.C. § 77v(a).
 Luther v. Countrywide Home Loans Servicing LP, 533 F.3d 1031 (9th Cir. 2008).
 Katz v. Gerardi, 552 F.3d 558 (7th Cir. 2009); New Jersey Carpenters Vacation Fund v. HarborView Mortgage Loan Trust 2006-4, 581 F. Supp. 2d 581 (S.D.N.Y. 2008)
 See Pittleman v. Impac Mortgage Holdings, Inc., 2009 U.S. Dist. LEXIS 18213 (C.D. Cal. Mar. 9, 2009);In re Moody’s Corp. Sec. Litig., __ F. Supp. 2d __, 2009 WL 435323 (S.D.N.Y. Feb. 23, 2009); In re Charles Schwab Corp. Sec. Litig., 2009 WL 262456 (N.D. Cal. Feb. 4, 2009); In re Centerline Holdings Co. Sec. Litig., 2009 WL 86850 (S.D.N.Y. Jan. 12, 2009); In re RAIT Fin. Trust Sec. Litig., 2008 WL 5378164 (E.D. Pa. Dec. 22, 2008); Hubbard v. BankAtlantic Bancorp, Inc., 2008 WL 5250271 (S.D. Fla. Dec. 12, 2008); In re New Century, 588 F. Supp. 2d 1206 (C.D. Cal. 2008); In re Countrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132 (C.D. Cal. 2008); N.Y. State Teachers’ Retirement Sys. v. Fremont Gen. Corp., 2008 WL 4812021 (C.D. Cal. Oct. 28, 2008); Pittleman v. Impac Mortg. Holdings, Inc., 2008 WL 4809962 (C.D. Cal. Oct. 6, 2008); City of Hialeah Employees’ Ret. Sys. & Laborers Pension Trust Funds for Northern California v. Toll Brothers, 2008 WL 4058690 (E.D. Pa. Aug. 29, 2008); In re 2007 NovaStar Fin., Inc. Sec. Litig., 2008 WL 2354367 (W.D. Mo. June 4, 2008); In re Impac Mortg. Holdings, Inc. Sec. Litig., 554 F. Supp. 2d 1083 (C.D. Cal. 2008); Grand Lodge of Pa. v. Peters, 550 F. Supp. 2d 1363 (M.D. Fla. 2008); Gold v. Morrice, 2008 WL 467619 (C.D. Cal. Jan. 31, 2008); Atlas v. Accredited Home Lenders Holding Co., 556 F. Supp. 2d 1142 (S.D. Cal. 2008); Tripp v. IndyMac Fin. Inc., 2007 WL 4591930 (C.D. Cal. Nov. 29, 2007).
 See In re Citigroup Inc. Shareholder Derivative Litig., Civ. A. No. 3338-CC (Del. Ch. Feb. 24, 2009); In re Merrill Lynch & Co., Inc. Sec., Derivative and ERISA Litig., __ F. Supp. 2d __, 2009 WL 367524 (S.D.N.Y. Feb. 17, 2009); In re Countrywide Fin. Corp. Deriv. Litig., 554 F. Supp. 2d 1044, 1062 (C.D. Cal. 2008).
 Complaint, In Re Merrill Lynch & Co., Inc. Sec., Derivative & ERISA Litigation, No. 07 CV 9633 (S.D.N.Y.), § III(A).
 Merrill Lynch & Co., Inc., Current Report (Form 8-K), at 2 (Jan. 16, 2009).
 See, e.g., In re Ford Motor Co. Sec. Litig., 381 F.3d 563, 570-71 (6th Cir. 2004) ("All public companies praise their products and objectives. Courts everywhere have demonstrated a willingness to find immaterial as a matter of law a certain kind of rosy affirmation commonly heard from corporate managers and numbingly familiar to the marketplace."); Lasker v. New York State Elec. & Gas Corp., 85 F.3d 55, 59 (2d Cir. 1996) (statement that a company refused to "compromise its financial integrity" constituted "precisely the type of ‘puffery’ that this and other circuits have consistently held to be inactionable"); Ladmen Partners, Inc. v. Globalstar, Inc., 2008 WL 4449280, at *13 (S.D.N.Y. Sept. 30, 2008) (dismissing claim based on company’s statement regarding the "high quality" of its products); In re American Bus. Fin. Servs., Inc. Sec. Litig., 413 F. Supp. 2d 378, 400 (E.D. Pa. 2005) (dismissing claim based on statement regarding company’s "focus on credit quality"); Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, 1245-46 (N.D. Cal. 1998) (dismissing claim based on company’s statement regarding "high quality product offerings"); Allison v. Brooktree Corp., 1998 WL 34074832, at *5 (S.D. Cal. Nov. 27, 1998) (dismissing claim based on company’s statement regarding its "high quality computer products"); Weill v. Dominion Resources, Inc., 875 F. Supp. 331, 336 (E.D. Va. 1994) ("[T]he Court simply cannot conclude that any reasonable investor would consider either statement to be meaningful in making an investment decision. ‘Compliance with domestic laws,’ conducting one’s affairs with the ‘highest standards of personal and corporate conduct,’ and ‘full disclosure of public information’ are mere characterizations of any lawful corporation. There is nothing extraordinary about these characterizations. If a corporation such as Dominion did not publish such ‘touting’ statements, it is incomprehensible that a reasonable investor would alter his or her opinion of the corporation.").
 See, e.g., In re Acito v. IMCERA Group, Inc., 47 F.3d 47, 53 (2d Cir. 1995) ("Section 10(b) was not designed to regulate corporate mismanagement."); In re Citigroup, Inc. Sec. Litig., 330 F. Supp. 2d 367, 377 (S.D.N.Y. 2004) (dismissing securities complaint because "[t]he securities laws were not designed to provide an umbrella cause of action for the review of management practices"), aff’d sub nom., Albert Fadem Trust v. Citigroup Inc., 165 F. App’x 928 (2d Cir. 2006) Ciresi v. Citicorp., 782 F. Supp. 819, 821 (S.D.N.Y. 1991) (""[A]llegations of mismanagement are not actionable under section 10(b) of the federal securities laws."), aff’d, 956 F.2d 1161 (2d Cir. 1992)
 Fremont, 2008 WL 4812021, at *5; NovaStar, 2008 WL 2354367, at *2-3; Impac, 554 F. Supp. 2d at 1096; Indymac, 2007 WL 4591930, at *3-4.
 Countrywide, 588 F. Supp. 2d at 1153-54; New Century, 588 F. Supp. 2d at 1225-26; RAIT, 2008 WL 5378164, at *5-6; Accredited, 556 F. Supp. 2d at 1154-56.
 Countrywide, 588 F. Supp. 2d at 1144 (citations omitted).
 New Century, 588 F. Supp. 2d at 1226. The New Century decision may be distinguishable from other subprime cases that are litigated at the pleading stage because the court placed heavy reliance on the findings in an extensive Bankruptcy Examiner’s Report.
 RAIT, 2008 WL 5378164, at *6.
 Accredited, 556 F. Supp. 2d at 1154-56.
 Amended Complaint, Berks County Employees’ Retirement Fund v. First American Corp, et al., No. 08-CV-5654 (S.D.N.Y.), at ¶ 6.
 Id. ¶ 7.
 Consolidated Class Action Complaint, ¶ 917, In re Washington Mutual, Inc. Sec. Litig., No. 2:08-MD-1919 (W.D. Wash.).
 Countrywide, 588 F. Supp. 2d at 1148.
 Complaint, ¶ 124, IBEW Local 103 v. IndyMac MBS, Inc., et al., No. CV 09-1520 (C.D. Cal.).
 RAIT, 2008 WL 5378164, at *7.
 Countrywide, 588 F. Supp. 2d at 1176.
 New Century, 588 F. Supp. 2d at 1214-15.
 Complaint, In re Countrywide Fin. Corp. Sec. Litig., No. 07 CV 5295 (C.D. Cal. filed Apr. 14, 2008).
 Complaint, Kratz v. Beazer Homes USA, Inc., No. 07 CV 725 (N.D. Ga. filed Mar. 29, 2007).
 RBS Faces 2nd Round Of U.S. Investor Disclosure Suits, Law360 (Feb. 2, 2009).
 Emerson Poynter LLP Files Class Action Lawsuit Against Fannie Mae On Behalf of Series S Preferred Stockholders, Reuters (Oct. 10, 2008).
 Complaint, Jacksonville Police and Fire Pension Fund v. AIG, No. 08 CV 4772 (S.D.N.Y. filed May 21, 2008).
 Complaint, MBIA Ins. Corp. v. Countrywide Home Loans Inc. et al., No. 081 602825 (N.Y. Sup. Ct. filed Sept. 30, 2008).
 In re Countrywide Fin. Corp. Deriv. Litig., 554 F. Supp. 2d 1044, 1062 (C.D. Cal. 2008).
 Id at 1064.
 See Freddie Mac Form 10-K at 69 (Mar. 23, 2007) ("We will only buy ARMs, and mortgage-backed securities backed by those loans, for which borrowers have been qualified at the fully-indexed and fully-amortizing rate in order to protect the borrowers from the payment shock that could occur when the interest rates on their ARMs increase.").
 Damian Paletta, Fed Admits Missteps on Banks, Wall St. J., Mar. 5, 2008, at A11.
 NovaStar, 2008 WL 2354367, at *3.
 Id. at *2-4.
 2008 WL 4812021, at *6.
 127 S.Ct. 2499, 2510 (2007).
 Id. at 2510-11.
 2007 WL 4591930, at *4 (emphasis added).
 2008 WL 2354367, at *4.
 588 F. Supp. 2d at 1229.
 588 F. Supp. 2d at 1146, 1151, 1186. See also RAIT, 2008 WL 5378164, at *12 ("One allegation in support of scienter is that the Officer Defendants . . . made frequent misstatements that concerned core business and operations despite access to contradictory information.").
 2008 WL 5368164, at *13.
 556 F. Supp. 2d at 1156.
 588 F. Supp. 2d at 1197.
 550 F. Supp. 2d 1363, 1372 (M.D. Fla. 2008).
 588 F. Supp. 2d at 1175.
 Id. at 1181-82.
 17 C.F.R. § 230.436(g).
 Shain v. Duff & Phelps Credit Rating Co., Inc., 915 F. Supp. 575, 577 (S.D.N.Y. 1996).
 Quinn v. The McGraw-Hill Cos., Inc., 168 F.3d 331, 336 (7th Cir. 1999).
 See, e.g., Jefferson County School District v. Moody’s Investor’s Services, Inc., 175 F.3d 848, 855-56 (10th Cir. 1999); In re Enron Corp. Securities Derivative & "ERISA" Litig., 511 F. Supp. 2d 742, 824-25 (S.D. Tex. 2005)..
 See, e.g., In re Nat’l Century Financial Enterprises, Inc., Inv. Litig., 580 F. Supp. 2d 630, 640 (S.D. Oh. 2008); LaSalle Nat’l Bank v. Duff & Phelps Credit Rating Co., 951 F. Supp. 1071 (S.D.N.Y. 1996).
 Bethel, A. Ferrell, & G. Hu, Legal and Economic Issues in Sub-prime Litigation, Discussion Paper, John M. Olin Center for Law, Economics and Business (Feb. 2008).
 See, e.g., Complaint, Wesner v. UBS AG, No. 07 CV 11225, (S.D.N.Y. filed Dec. 13, 2007) ("In July 2007, the market became aware of the problems that banks (including UBS) had with sub-prime debt.").
 Complaint, Reese v. The McGraw Hill Cos., No. 07 CV 1530 (D.D.C. filed Aug. 28, 2007).
 Complaint, City of Hialeah Employees’ Ret. Sys. v. Toll Bros., Inc., No. 07 CV 1513 (E.D. Pa. filed Apr. 14, 2007).
 588 F. Supp. 2d at 1160.
 540 F. Supp. 2d 449 (S.D.N.Y. 2007).
 Id. at 461.
 Lentell v. Merrill Lynch & Co., 396 F.3d 161, 174 (2d Cir. 2005).
 Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 343 (2005).
 2008 WL 4058690, at *5.
 588 F. Supp. 2d at 1200.
 Id. at 1174.
 In re Citigroup Inc. Shareholder Derivative Litig., Civ. A. No. 3338-CC (Del. Ch. Feb. 24, 2009), at 25.
 Id. at 25-26, 31, 34-35, 58.
 In re Royal Dutch/Shell Transport Sec. Litig., 522 F. Supp. 2d 712, 724 (D.N.J. 2007).
 Corwin v. Seizinger, 2008 WL 123846, at *4 (S.D.N.Y. Jan. 8, 2008).
 See, e.g., In re Rhodia S.A. Sec. Litig., 2007 WL 2826651, at *12 (S.D.N.Y. Sept. 26, 2007).
 See, e.g., In re Vivendi Universal, S.A. Sec. Litig., 242 F.R.D. 76, 109 (S.D.N.Y. 2007); Borochoff v. Glaxosmithkline PLC, 246 F.R.D. 201, 205 (S.D.N.Y. 2007).
 547 F.3d 167 (2d Cir. 2008).
 Id. at 175.
 Advisen, The Subprime Meltdown and D&O Insurance (Sept. 24, 2007).
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