In the aftermath of the credit crisis, an increasing number of financial institutions have found themselves in a strikingly unfamiliar role: plaintiffs in securities litigation. Many institutions that were sold spurious financial instruments in the securitization boom now see pursuing recoveries as a matter of business common sense. Securities litigation on behalf of corporate entities-rather than conventional investors-presents new challenges for clients and litigation counsel on both strategic and legal issues.
Since enactment of the Private Securities Litigation Reform Act of 1995 (the PSLRA), institutional investors, usually public and union pension funds, have driven most of the securities fraud class action litigation in the United States. Congress encouraged the participation of such funds through the PSLRA itself, because "[i]nstitutions with large stakes in class actions have much the same interests as the plaintiff class generally; thus, courts could be more confident settlements negotiated under the supervision of institutional plaintiffs were 'fair and reasonable.'" S. Rep. No. 104-98, at 11 (citations omitted).
While they will likely continue to lead the charge in class actions, institutional investors are now sharing the spotlight with a new and unfamiliar breed of securities fraud plaintiff that has emerged in the wake of the credit crisis.
Large, sophisticated financial institutions and corporations-banks and insurers, many of which have been defendants themselves in securities actions-are now crossing over to the plaintiffs bar in droves to pursue individual securities fraud actions, primarily stemming from the "toxic" residential mortgage backed securities (RMBS) sold to them in the years preceding the financial crisis. The general theory of their claims is familiar: They suffered losses after being duped into buying meretricious securities. However, the RMBS cases they bring can be complex and data-intensive.
These lawsuits have advanced a number of different legal theories. They include claims under §§11, 12 or 15 of the Securities Act of 1933, §§10(b) and 20(a) of the Exchange Act of 1934, various state "blue sky" laws, and under common law theories such as fraud and negligent misrepresentation, as well as various claims for equitable relief, including recission. Some actions have even included civil RICO claims. See, e.g., Ogle v. BAC Home Loans Servicing, 2:11-cv-00540-GCS-TPK, Dkt. No. 48 (S.D. Ohio Jan. 1, 2012) (alleging RICO violations in connection with improper foreclosure).
Other investor plaintiffs have opted to bring "put-back" claims, which seek to require the originators or underwriters to repurchase loans put into RMBS-backed trusts. These lawsuits have been brought under provisions of Pooling and Servicing Agreements that allow investors representing at least a 25 percent interest in the RMBS-backed trust to give notice to the trustee of a default event, and to ask the trustee to take action based on alleged breaches of representations and warranties. These suits are not easy to bring, since the claims can be made only through the securitization trustee, and investors are not able to take any meaningful action unless they control 25 percent of the voting rights in the trust. Lately, though, some plaintiffs have been coordinating their efforts to create investor coalitions to get past that 25 percent threshold.
The sound financial reason for financial institutions to seek compensation in these actions is easy to understand: After the crisis hit, many companies were left with billions of dollars in losses. Forecasts of imminent additional losses are incentive to pursue recovery now. For example, it has been estimated that, on RMBS performing at December 2011-approximately $1.42 trillion in the aggregate-the amount of additional losses likely to materialize is $300 billion. About 17,000 tranches could lose up to 83 percent of their remaining principal, and approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. See Anne Rutledge, "RMBS Losses in Limbo: As Bad as They Seem, the Reality May Be Much Worse," R&R Consulting, Jan. 25, 2012.
RMBS defendants have already set aside reserves to cover their potential liability. For example, last year, Bank of America alone had reserved approximately $18 billion to cover its RMBS exposure. This included $8.5 billion to settle with Bank of New York Mellon, $3 billion to settle with Fannie Mae and Freddie Mac, and an estimated $2 billion to settle with Assured Guaranty. Last year also saw other significant settlements: Merrill Lynch paid $315 million, Wells Fargo paid $125 million, and Citigroup and Deutsche Bank in parallel actions collectively paid $165.5 million.
Investors with RMBS losses must carefully assess which claims can be pursued given widely varying statutes of limitation. The easiest claims for RMBS investors to prevail on, based on those that have been posited so far, also have the shortest statute of limitations. These are claims under §§11 and 12 of the Securities Act, which only require plaintiffs to prove that the defendant made a material misrepresentation in a registration statement or prospectus, and for purpose of §12, that the defendant sold the RMBS. Claims under §§11 and 12 can be brought only within the earlier of one year after an investor discovered or should have discovered the fraud, or three years after the SEC filing in question. Accordingly, claims under §§11 and 12 related to misrepresentations made before 2009 are likely time-barred unless the statute of limitations period has been tolled.
A typical securities fraud claim under §10(b) of the Exchange Act can be brought within two years of discovery, or no more than five years after the misrepresentations were made. Fraud and negligent misrepresentation claims under state common law generally have a two to six year limitations period, running from the discovery of the misrepresentation. Under New York law, a claim for fraud must be brought by the later of six years from the event or two years from discovery.
Statute of Repose
Beyond invoking statutes of limitations, defendants have now also begun asserting defenses based on the statute of repose. Unlike the statute of limitations, which can be extended based on agreements between the parties or other certain external circumstances, the statute of repose sets an absolute deadline for certain causes of action. In other words, under the statute of repose, if one fails to file particular claims within a specified time period, those claims will be categorically dismissed.
For claims brought under §§11 and 12, the statute of repose is three years "after the security was bona fide offered to the public." 15 U.S.C. §77m (1998). This already has had unfortunate consequences for investors whose RMBS were issued before 2009. For example, in May 2011, Judge Mariana Pfaelzer, in Maine State Retirement System v. Countrywide Financial, No 10-cv-00302-MRP-MAN, Dkt. No. 257 (C.D. Cal.), held that the statute of repose on federal securities claims is unassailable. This rendered Countrywide MBS investors who had not filed claims on notes issued before 2008-about half the class-without a remedy under the Securities Act.
Judge Pfaelzer's ruling did not go unnoticed. In February 2012, in Federal Housing Finance Agency v. UBS Americas, 1:11-cv-05201-DLC, Dkt. No. 59 (S.D.N.Y.), UBS argued that the Federal Housing Finance Agency (FHFA), as the conservator overseeing Fannie Mae and Freddie Mac, failed to sue UBS for alleged MBS fraud in time to comply with the statute of repose. UBS asserts that when Congress enacted the law that created FHFA and sent Fannie Mae and Freddie Mac into conservatorship, it explicitly extended the statute of limitations on their state law tort and contract claims, but did not address the statute of repose at all.
With the countdown of the relevant statutes of limitations and repose looming, and in light of some of the successful recoveries seen in the last year, many sophisticated financial institutions are turning to plaintiff's securities lawyers, rather than the "white shoe" mega-firms they are accustomed to, for assistance in navigating this new litigation landscape and to recover their losses.
This makes sense, since there is a big difference between prosecuting and defending investment fraud claims. Plaintiffs have stringent burdens of proof they must meet, and require significant resources to do so. In that regard, good plaintiff's firms often have strong in-house investigative teams, typically consisting of former federal law enforcement officials, certified public accountants, and securities and financial analysts. These teams have substantial experience in forensic accounting and are able to analyze complex data, identify and pursue leads quickly and efficiently, judge witness credibility, and develop effective, result-oriented legal strategies.
Plaintiff's lawyers also have close working relationships with experts that specialize in the evaluation of damages, tax issues, and, for RMBS cases, real estate mortgage investment conduits. Moreover, plaintiff's firms have been litigating RMBS fraud cases since the late 1990s.
Having a financial institution as a plaintiff may present securities lawyers with unusual challenges. Sophisticated commercial parties in heavily papered transactions are generally expected to take a number of steps to protect their financial interests. Because MBS investors and insurers receive due diligence information, defendant banks will likely assert "justifiable reliance" defenses, particularly in transactions that include comprehensive merger and integration clauses and that involve the disclosure of extensive amounts of information and data.
For example, in United Guaranty Mortgage Indemnity v. Countrywide Financial, 660 F. Supp. 2d 1163, 1172 (C.D. Cal. 2009), United Guaranty alleged that Countrywide falsely represented that mortgage loans were originated "in strict compliance with [the originator's] underwriting standards and guidelines." The court dismissed the United Guaranty's fraudulent inducement claim, however, stating that:
any reasonable mortgage insurer that (1) was conducting multibillion-dollar bulk transactions and (2) had an express right to audit or sample the underlying loan files before the transaction closed, would engage in some degree of auditing or sampling of the underlying loan files to be insured.
Id.at 1189. However, such arguments are not insurmountable. For example, in
Federal Home Loan Bank of Pittsburgh v. J.P. Morgan Securities, No. GD09-016892 (Pa. Commw. Ct. Nov. 29, 2010), the court declined to dismiss the claims of plaintiff Home Loan Bank of Pittsburgh on defendants' argument that the plaintiff was very sophisticated, knew good mortgages from bad mortgages, and had been provided clear information in the offering documents regarding the risk underlying the certificates it was purchasing. It held that once a plaintiff alleges reliance, questions as to whether it in fact did rely and whether the reliance was reasonable cannot be resolved at such a preliminary stage of the proceedings. Id. at 26 n.16.
In fact, although justifiable reliance is asserted as a typical defense to federal securities claims, neither the Securities Act nor the Exchange Act distinguish between "sophisticated" and "unsophisticated" investors. As Justice William Douglas stated in Scherk v. Alberto-Culver, 417 U.S. 506 (1974), "[t]he rules when the giants play are the same as when the pygmies enter the market." Id. at 526. While that may not have been the most delicate way to phrase it, courts within the Second Circuit still stand by the proposition that "the securities laws do not distinguish between sophisticated and unsophisticated investors; both are entitled to the protections of its disclosure and anti-fraud provisions." In re Scientific Control Corp. Sec. Litig., 71 F.R.D. 491, 512 (S.D.N.Y. 1976). After all, "sophisticated investors, like all others, are entitled to the truth." Credit & Finance Corp. v. Warner & Swasey, 517 F.Supp. 134, 135 n.1 (S.D.N.Y. 1981) (quoting Stier v. Smith, 473 F.2d 1205, 1207 (5th Cir. 1973)).
The investor's sophistication should only become legally relevant in the context of the "adequacy of disclosure" at the time the financial instrument was purchased. See Quintel Corp. v. Citibank, 596 F.Supp. 797, 802 (S.D.N.Y. 1984) (finding plaintiff's sophistication admissible as evidence for the purposes of determining the adequacy of disclosure and the extent plaintiff relied on any alleged misrepresentations). Essentially, "adequacy of disclosure" is a gauge to determine what an investor knew or should have known based on the information available to it.
Accordingly, in the case of a sophisticated financial institution, an analysis of justifiable reliance would not be limited only to a comprehensive understanding of the information contained in the offering materials (which, in fact, may be imputed to the financial institution), but also its institutional knowledge of the security and any other relevant information to which it had access. See Scarfarotti v. Bache & Co., 438 F. Supp. 199, 203 (S.D.N.Y. 1977) ("[I]f material which accurately describes the security is available to plaintiff, he is under an obligation to use it; knowledge of the information is imputed to him."). In contrast, a less sophisticated investor might have a lower standard. See Berger v. Merrill Lynch, Pierce, Fenner & Smith, 505 F.Supp. 192, 194 (S.D.N.Y. 1981) ("Whatever the soundness of imputation of knowledge in that context, it is inappropriate here, where the broker may be shown to have had reason to believe that the investor was not financially sophisticated and would be unable to recognize the material facts themselves or deduce their implications from the information provided him").
Common law claims of fraud in New York track the federal law. In Hunt v. Enzo Biochem, 530 F.Supp.2d 580 (S.D.N.Y. 2008), Judge Shira Scheindlin analogized that "courts in this Circuit have held that even sophisticated investors are entitled to the protection available under the federal securities laws, and there is no reason to believe that the same does not hold true in the common law securities fraud context." Id. at 599.
Like federal claims, however, a sophisticated investor's reliance may be found unjustifiable where, for example, it "enjoy[ed] access to critical information but fail[ed] to take advantage of that access." Lazard Freres & Co. v. Protective Life Ins., 108 F.3d 1531, 1541 (2d Cir. 1997) (quoting Grumman Allied Indus. v. Rohr Indus., 748 F.2d 729, 737 (2d Cir. 1984)). Where an alleged misrepresentation "relates to matters that are not peculiarly within the other party's knowledge and both parties have available the means of ascertaining the truth, New York courts have held that the complaining party should have discovered the facts and that any reliance under such circumstances therefore would be unjustifiable." Royal Am. Managers v. IRC Holding, 885 F.2d 1011, 1016 (2d Cir. 1989).
Conversely, if a sophisticated investor plaintiff does not have access to relevant information, and the facts were "peculiarly within defendant's knowledge," that plaintiff should meet the reliance standard "without prosecuting an investigation," since it does not have "independent means of ascertaining the truth." Mallis v. Bankers Trust Co., 615 F.2d 68, 80 (2d Cir. 1980).
Fraud on a sophisticated financial institution impacts the equity of that company, which directly affects its shareholders. In that respect, the large financial institutions that are now assuming the role of plaintiffs are not much different from the pension fund plaintiffs in securities class actions. However, the new crop of cases they bring is blurring historical divisions between the plaintiffs and defense bars and the clients they serve in ways that may linger long after the current wave of litigation is over.