High Standards

To read the experts' opinions on subprime securities fraud, click here.

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In the final days of September, as bank failures, buyouts and historic market turmoil dominated headlines, a judge for the Southern District of New York granted a motion to dismiss a class action lawsuit shareholders had filed against a major financial services company.

The suit, alleging violations of Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934, describes a profit-driven organization, headed by bonus-driven executives, that turned to high-yield investments in collateralized debt obligations (CDOs) but failed to disclose information or made untrue statements about their inherent risk. When the assets backing the CDOs began to default beyond the anticipated rate, stock values dropped sharply. The complaint alleges that "virtually no control was exercised over the pertinent investments except for an insistence that such investments be purchased."

In the wake of the subprime mortgage meltdown, this scenario seems immediately familiar, but the case in question, In re American Express Securities Litigation, predates the current financial turmoil. Filed in 2002, it deals with events dating back to 1997, years before "subprime" would become a dirty word. Still, the similarities are uncanny.

"Basically, if you just took out the words that describe the assets that backed the investments in [American Express] and substituted the term 'subprime mortgages,' you'd have a very similar complaint," says Kevin LaCroix, an attorney and partner in Oakbridge Insurance Services. LaCroix writes extensively about the subprime litigation fallout on his blog, The D&O Diary.

Sticky Standard

Given the recent influx of securities fraud suits stemming from the financial crisis, we will continue to see dismissals in the vein of American Express for years to come. To survive the motion to dismiss stage, plaintiffs will have to clear a pleading standard on which the U.S. Supreme Court raised the bar last year. They will have to establish more than just bad management and bad choices; they will have to establish intent--and the current state of the law doesn't make it easy to get there, to the relief of the defense bar. Legally speaking, it's straightforward, but in the coming litigation it will come into play over and over again.

"There's a tremendous amount of losses that everybody has suffered. It's become a political football to attack Wall Street, and if ever there were a time when it's important that we be very precise in requiring that lawsuits pass a preliminary muster before they're allowed to proceed, I think it's in this environment," says Robert Zimet, a partner at Skadden, Arps, Slate, Meagher & Flom. Zimet was lead defense counsel in American Express.

In American Express, the court found that the plaintiffs failed to meet the pleading standards set forth in the Private Securities Litigation Reform Act of 1995 (PSLRA) and refined in the 2007 Supreme Court ruling in Tellabs v. Makor. That decision stated, "A complaint will survive ... only if a reasonable person would deem the inference of scienter [intent to defraud] cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

Screening Out Scapegoating

The central aim of the pleading standard is to avoid claims of so-called "fraud by hindsight." In the context of the credit crisis, in which emotions are high and hindsight is the official language of the blame game, it's perhaps not surprising that some plaintiffs, impatient for retribution, have stumbled in meeting the pleading standards. Indeed, it may mean the provision, and judges that interpret it, are doing their jobs.

"The job of the courts is to stand in between the understandable, perhaps emotional or political, effort to find a scapegoat and make sure that, at least on a preliminary basis, the plaintiff has a real basis for believing the defendants acted to conceal bad news as opposed to being, like most of us, bystanders to the unexpected financial tsunami," Zimet says.

Some of the dismissed subprime suits reflect just that. A California judge dismissed a subprime-related securities fraud claim against Impac Mortgage Holdings Inc. in October, writing, "Plaintiff packs the complaint with 30 pages of supposed misstatements and culpable acts, but none of them shows fraudulent intent or deliberate or conscious recklessness."

Similarly, in a securities fraud suit filed in Missouri against Novastar Financial Inc., the judge noted in his June dismissal, "Plaintiff's complaint reads more like a cautionary tale from a treatise on business management than a charge of knowing misstatements and concealments. ... Companies (and their management) are not expected to be clairvoyant, and bad decisions do not constitute securities fraud."

Tellabs Backlash?

Frank Mayer, chair of the financial crisis team at Buchanan Ingersoll & Rooney and a former in-house lawyer at the FDIC, points to the heightened Tellabs standard as something that may change.

"I suspect that the PSLRA could be modified by the next Congress to give the [plaintiffs bar] an effective tool to go after those who have been complicit in the subprime market crisis," he says. "Obviously it was not catching some of the conduct that has precipitated the crisis that we're in right now."

It's interesting to note that Treasury Secretary Henry Paulson and other Bush administration officials have backed limits on shareholder suits, for instance supporting the Supreme Court's ruling in Stoneridge Investment Partners v. Scientific-Atlanta, which barred fraud claims against third parties that did not directly deceive investors. Mayer points out that the establishment of the PSLRA in 1995 and the Supreme Court ruling in Tellabs in 2007 bookend an era that championed the free market.

So in many ways, the Tellabs pleading standard for securities fraud could easily fit into the overall deregulation of financial markets that is being widely blamed for allowing the crisis to develop, making it a potential walking target for legislators in the new Congress or even sympathetic judges.

"The cases that have come down, both in the subprime area and in other areas in the recent cases, all give lip service if not actual service to those principles, but if you go back in time, when there has been [significant market deterioration]--whether it's the dot-com bust or other events--there is a risk that the courts will cite the same cases but come out the other way," Zimet says.

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