Subprime Mortgages and Theories of Liability - Deja Vu? - Part Three

Michael Clark
August 18, 2008 — 1,156 views  

Part One of this series focused on certain features of the subprime mortgages now defaulting in huge numbers and noted how these features also were common in many improper transactions that led to the Savings and Loan Crisis of the early 1990s, as well as in the more recent corporate governance scandals associated with enormous investor losses typified by Enron and WorldCom.

Part Two examined some statistics and problems with liability theories that plaintiffs are relying upon to establish the liability of defendants in various securities class actions for damages claimed to have been sustained in some way from with the implosion of the subprime mortgage market.

Part Three addresses the heightened pleading requirements for falsity and scienter imposed by the Private Securities Litigation Reform Act of 1995 (PLSRA) and the impact of caselaw interpreting these provisions that make it very hard for class action plaintiffs to successfully establish secondary liability of defendants.

Difficulties for Private Plaintiffs Seeking to Prove Securities Fraud Liability and Damages Related to the Subprime Mortgage Market's Collapse
The PSLRA imposes two key heightened pleading standards upon plaintiffs pursing securities fraud class actions. First, the complaint must set forth ‘‘each statement alleged to have been misleading, the . . . reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, thecomplaint shall state with particularity all facts on which that belief is formed. '' 15 U.S.C. §78u4(b)(1). Second, plaintiffs must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind . . . with respect to each act or omission alleged to be a violation of the securities laws. 15 U.S.C. §78u4

A district judge recently explained in Atlas v. Accredited Home Lenders Holding Co., 2008 WL 80949 (S.D. Cal. Jan. 4, 2008)(unpublished) why she granted and denied in part defendants' motions to dismiss the shareholders' securities fraud complaint against the seller of sub prime mortgages, its subsidiary, and various officers claiming that the defendants concealed the seller's true financial condition and made materially false and misleading statements about its operations and income to artificially inflated the price of the seller 's stock during the class period:

The PSLRA dictates that a securities complaint must "specify each statement alleged to have been misleading, [and] the . . . reasons why the statement is misleading." 15 U.S.C.§ 78u4(b)(1). The Ninth Circuit traditionally analyzes the overlapping requirements of falsity and scienter at the same time. Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001) (pleading requirements of PSLRA may be collapsed into single inquiry because analysis of both factors involves same facts); see No. 84 EmployerTeamster Joint Council Pension Trust Fund v. America West Holding Corp ., 320 F.3d 920, 932 (9th Cir.2003). A securities fraud claim must "state with particularity facts giving rise to a strong inference" that each defendant acted with the intent to defraud or with deliberate recklessness. 15 U.S.C. § 78u4(b)(2). Atlas, 2008 WL 80949 at *7.

If a complaint doesn't meet these requirements, dismissal is required (upon motion by defendant). 15 U.S.C. §78u4(b)(3)(A). See also, Edison Fund v. Cogent Inv. Strategies Fund, Ltd., 551 F. Supp. 2d 210, 216 (S.D.N.Y. 2008), in which a district judge similarly ruled on the securities fraud allegations of the plaintiffs, limited liability investment companies organized and operating in the Grand Cayman Islands, who asserted they could not redeem their substantial portfolio investments ($77,750,000) after the market for portfolios of subprime auto finance loans deteriorated. The judge observed that sufficient warnings were provided under the bespeaks caution doctrine about the associated investment risks noting that:

The NonLeveraged offering materials made no blanket guarantees about the liquidity of the investments or the ease of redemption. In fact, the NonLeveraged COM warned investors that the Funds were appropriate only for sophisticated investors and carried risks in particular, risks of the illiquidity of the investments. For example, the offering materials for the NonLeveraged Fund state that "[g]iven the relatively illiquid nature of the Loans, distributions will be made subject to sales of Loans and available cash in the Fund." . . . They continue by warning: [T]here is no public market for such loans and sales of loan portfolios are private transactions arranged on a case bycase basis. Accordingly, redemption of Interests by Members will be subject to the Fund 's available cash flow from principal and interest payments and the ability, with the assistance of Centrix Financial, to sell the Loans to third parties.

Edison Fund v. Cogent Inv. Strategies Fund, Ltd., 551 F. Supp. 2d at 223224.

In another recent subprime mortgage case, a district judge felt it was appropriate to take judicial notice about the widespread collapse of the subprime mortgage industry as part of his analysis of why he was granting the defendant's motion to dismiss. See In re 2007 NovaStar Financial, Inc. Securities Litig., 2008 WL 2354367 at *1 (W.D. Mo. June 4, 2008). The judge also noted that while the complaint was very lengthy (over 100 pages and 200 paragraphs), it still failed to meet the PSLRA's heightened pleading requirements for fraud and scienter, since the allegations about the use of nonGAAP accounting and the company's failure to set aside appropriate reserves did not demonstrate fraud, but only management's negligence:

The Complaint also alleges various [GAAP] violations . . . by overstating gains, understating loan loss provisions and reserves, and failing "to properly disclose the effect of known trends and uncertainties in its financial statements. " . . . However, it is noteworthy that nobody-the SEC, Novastar's auditors, or anyone else-has suggested Novastar should or must restate its financial reports. More importantly, although the allegations are couched in terms of GAAP principles, the allegations actually assert management 's failure to plan sufficiently for future events. For instance, according 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. 2008 WL 2354367 at *2 * 3.

More to Come...

Michael Clark


Michael E. Clark, a former federal prosecutor, has extensive trial experience in business and professional matters. He serves as an Adjunct Professor of Law, as a faculty instructor for NITA, is widely published, and speaks regularly on issues of importance to businesses and professionals. Within the ABA, he serves on the Standing Committee on Publishing Oversight; is the outgoing chair of the Business Law Section's White Collar Crimes Committee (and an Editorial Board member of The Business Lawyer); serves on the Governing Council for the Health Law Section and is the outgoing chair of its Publications Committee; and serves on the Planning Committee for the National Institute on Securities Fraud. Mr. Clark is a Fellow of the American Bar Foundation and he developed and serves as the Editor-in-Chief of a treatise published in 2007 by BNA and the ABA Health Law Section about pharmaceutical law. Mr. Clark has been Board Certified in Criminal Law by the Texas Board of Legal Specialization and the National Board of Trial Advocacy since the late 1980's.