Two governmental reports released this past year confirmed that the issuance and securitization of risky residential mortgage loans were critical factors in causing and fueling the financial crisis. See U.S. Senate Subcommittee on Investigations, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse (Apr. 13, 2011); Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, The Financial Crisis Inquiry Report (Jan. 2011). The risks associated with these toxic loans were passed on to investors worldwide when they purchased the resulting residential mortgage-backed securities (“RMBS”) in reliance on misleading offering materials and inflated credit ratings. Investors lost billions when the loans defaulted in massive quantities and the value of the securities plummeted.
To recover their losses, investors began filing lawsuits in 2008 against the banks that sold RMBS or originated, acquired, and securitized the underlying mortgage loans. As more evidence of underwriting violations emerged, lawsuits increased. This past year saw a surge in RMBS lawsuits by large, well-known investors, such as Allstate Insurance Co., American International Group, Massachusetts Mutual Life Insurance Company, the National Credit Union Administration Board, and the Federal Housing Finance Agency, as receiver for Fannie Mae and Freddie Mac. These lawsuits and others have resulted in the issuance of a number of opinions by courts that have defined the parameters for RMBS litigation. This article discusses the developments in RMBS litigation over the past year.
Typical Misrepresentation Claims That Have Been Asserted by RMBS Investors
RMBS investors have asserted a variety of claims under federal and state law based on alleged misrepresentations in connection with the sale of the securities. The claims have typically included:
• Claims under Sections 11 and 12(a)(2) of the Securities Act of 1933 (the “1933 Act”):
These claims may be brought only by investors that purchased securities as part of the
initial public offering (rather than on the secondary market or in a private transaction).
See 15 U.S.C. § 77k; Gustafson v. Alloyd Co., 513 U.S. 561, 583-84 (1995). The claims
do not require any proof that an investor relied on the misrepresentation or that a
defendant acted with scienter or even negligence. A Section 11 claim may be asserted
only against those persons identified in the statute (e.g., those who signed the
registration statement and underwriters), 15 U.S.C. § 77k, and a Section 12 claim may
be asserted only against the “sellers” of the securities. Pinter v. Dahl, 486 U.S. 622, 645-
47 (1988). The statute of limitations for Section 11 and 12(a)(2) claims is one year after
the misrepresentation was discovered or should have been discovered in the exercise of
reasonable diligence, and in no event more than three years after the sale. See 15
U.S.C. § 77m.
• Claims under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (the
“1934 Act”): These claims may be brought by any purchaser of securities that can show a
material misrepresentation in connection with a purchase of securities; reasonable
reliance on the misrepresentation; that a defendant acted with scienter; and that the
misrepresentation was the cause of the loss. See Dura Pharms., Inc. v. Broudo, 544 U.S.
336, 341-42 (2005). The statute of limitations is two years after the facts constituting the
violation were discovered or should have been discovered in the exercise of reasonable
diligence, and in no event more than five years after the violation. See 28 U.S.C. § 1658
• Claims under various state securities laws (or “blue sky laws”): A number of states,
including California, Massachusetts, Ohio, and Virginia, have blue sky laws that create
civil liability for misrepresentations in connection with the sale of securities in that state.
Because the civil liability provisions are typically modeled off Section 12(a)(2) of the
1933 Act, claims do not ordinarily require a showing of reliance or scienter, but they can
be asserted only against the sellers of securities. The statute of limitations for blue sky
claims varies from state to state. For example, California uses the same two-year/five-
year limitations period that appears in the 1934 Act, while Massachusetts provides that
the statute of limitations is four years after the facts constituting the violation were
discovered or should have been discovered in the exercise of reasonable diligence. An
investor may typically assert claims under the blue sky laws of any state in which the
offer originated or the sale occurred.
• Claims for common law fraud or negligent misrepresentation: Finally, RMBS investors
have asserted claims for common law fraud or negligent misrepresentation. The statute
of limitations for these claims depends on which state’s law governs the claims, which is
ordinarily determined by an interest analysis that considers where the injury occurred,
among other factors. The statute of limitations varies widely by state. The California
statute of limitations, for example is three years after the facts constituting the fraud
were discovered or should have been discovered, while the New York statute of
limitations is two years after discovery of the facts constituting the fraud or six years
after the claim accrued, whichever is greater.
The Importance of the Statute of Limitations
The statute of limitations has become an important impediment on the misrepresentation claims that can be maintained by RMBS investors. Two dates are relevant to a statute of limitations analysis – the date when the sale of securities occurred and the date when the facts constituting the claim were discovered or should have been discovered.
RMBS investors have typically asserted claims based on sales of securities that occurred between 2005 and 2007. Because claims under Sections 11 and 12(a)(2) of the 1933 Act are time-barred if brought more than three years after the sale, many courts are dismissing these claims at the pleading stage based on the statute of limitations. See, e.g., Stichting Pensioenfonds ABP v. Countrywide Fin. Corp., 802 F. Supp. 2d 1125, 1130-31 (C.D. Cal. 2011). Some investors have been able to save their claims from dismissal by showing that their claims “relate back” to earlier-filed complaints under the tolling doctrine set forth in American Pipe & Construction Co. v. Utah, 414 U.S. 538 (1974). Courts will toll the statute of limitations for claims based on RMBS transactions at issue in earlier-filed class actions in which the investor was a putative class member. To receive the benefit of tolling, some courts are requiring an investor to show that its claims are based on not only the same RMBS transactions at issue in a prior class action, but also on the same specific classes (or tranches) of securities at issue, under the theory that each tranche is a separate security. See, e.g., Me. State Ret. Sys. v. Countrywide Fin. Corp., No. 2:10-cv-0302, 2011 WL 4389689, at *4-*5 (C.D. Cal. May 5, 2011). Thus, an investor that purchased securities in Class 2 of the 2006-17 Countrywide transaction, for example, may not receive the benefit of tolling if a prior class action asserted claims only on behalf of purchasers of securities in Class 1. Investors are finding that American Pipe tolling does not cover a majority of their holdings, and they have had to rely on claims other than Section 11 and 12(a)(2) claims for recovery.
In addition to the date of sale, the date when an investor discovered or should have discovered the facts constituting its claims is important to the statute of limitations. A number of defendants have argued that RMBS investors should have discovered their claims in 2007 and 2008 based on news articles that reported increasing delinquencies and defaults in mortgage loans, borrower fraud, bankruptcies of large lenders, and similar information that defendants have asserted is relevant to underwriting misrepresentations. Courts have consistently rejected these arguments at the pleading stage, especially because almost all of the articles cited by defendants are general articles that do not mention the specific defendants or securitizations at issue in the particular action. See, e.g., Mass. Mutual Life Ins. Co. v. Residential Funding Co., LLC, -- F. Supp. 2d --, 2012 WL 479106, at *10-*11 (D. Mass. Feb. 14, 2012); Genesee Cnty. Emps.’ Ret. Sys. v. Thornburg Mortg. Sec. Trust 2006-3, -- F. Supp. 2d --, 2011 WL 5840482, at *65 (D.N.M. Nov. 12, 2011). The notable exceptions are the Countrywide cases pending in the multi-district litigation before Judge Mariana Pfaelzer in the Central District of California. She has held, at the pleading stage, that investors in Countrywide RMBS should have discovered their claims by late 2007 or early 2008, and has dismissed claims based on a February 14, 2008 discovery date. See Stichting, 802 F. Supp. 2d at 1137.
Based on these decisions, investors that filed suit in early 2010 have typically been able to maintain claims subject to a two-year discovery statute of limitations, including claims under Section 10(b) and Rule 10b-5. Investors that filed suit in late 2010 or 2011, on the other hand, have faced dismissal of those claims as untimely, especially if the claims relate to Countrywide RMBS. Nevertheless, these investors have been able to maintain claims with lengthier statutes of limitations, including certain blue sky claims and common law fraud claims.
Actionable Misrepresentations That Support a Claim
Investors have supported their misrepresentation claims by alleging different categories of misrepresentations. The categories have typically included misrepresentations about the underwriting standards that were used to originate the underlying mortgage loans, false loan-to-value (“LTV”) ratios for the loans, false owner-occupancy rates for the loans, and false credit ratings for the securities. Courts have typically concluded that investors have stated claims based on misrepresentations about the applicable underwriting standards. Investor have had mixed success with the other categories of misrepresentations.
• Underwriting Misrepresentations: To allege underwriting misrepresentations, investors
have identified specific statements in the offering materials about the applicable
underwriting standards and have alleged that the statements were false because the
banks systematically abandoned those standards. Courts have analyzed whether
investors have alleged a plausible abandonment of underwriting standards for the specific
loans at issue. When an investor has supported its allegations only with reports of
general underwriting violations in the industry, courts have dismissed the claims as
conclusory. See, e.g., N.J. Carpenters Health Fund v. Novastar Mortg., Inc., No. 08 Civ.
5310, 2011 WL 1338195, at *10-*11 (S.D.N.Y. Mar. 31, 2011). When, however, an
investor has supported its allegations with a sharp drop in the credit ratings for the
securities at issue and facts specific to the banks at issue, courts have typically allowed
the claims to proceed. See, e.g., Plumbers’ Union Local No. 12 Pension Fund v. Nomura
Asset Acceptance Corp., 632 F.3d 762, 773-74 (1st Cir. 2011) (“Nomura”); Mass. Mutual,
2012 WL 479106, at *5; Genesee, 2011 WL 5840482, at *68-*69.
Some courts have demanded still more specificity, requiring investors to link the allegations about the banks with the specific mortgage loans at issue. See N.J. Carpenters Health Fund v. Novastar Mortg., Inc., No. 08 Civ. 5310, slip op. at 11-12 (S.D.N.Y. Mar. 29, 2012). To increase the specificity in their complaints, some investors have retained forensic analysis firms with access to certain data for the underlying mortgage loans, and have supported their allegations of underwriting abandonment with an analysis of actual loan-level data. Courts have accepted this analysis at the pleading stage. See, e.g., Mass. Mutual, 2012 WL 479106, at *7; Allstate Ins. Co. v. Countrywide Fin. Corp., -- F. Supp. 2d --, 2011 WL 5067128, at *18 (C.D. Cal. Oct. 21, 2011).
• LTV Ratios: Investors also have alleged that the represented LTV for the underlying
loans were false because the property values used to calculate the LTV ratios were
materially inflated. These values were supposed to have been determined by objective
appraisals conducted in accordance with the standards disclosed in the offering materials,
but were instead determined by what value was needed to justify the loan. Courts have
almost universally held that property values and the resulting LTV ratios are opinions that
are actionable only if an investor can allege that the defendant did not honestly believe
the opinion or knew that it bore no reasonable relationship to the actual facts. See, e.g.,
Tsereteli v. Residential Asset Securitization Trust 2006-A8, 692 F. Supp. 2d 387, 393
(S.D.N.Y. 2010). Investors have been successful by alleging facts sufficient to show that
one of these two bases exists. See, e.g., Mass. Mutual, 2012 WL 479106, at *6-*7.
Investors also have been successful in separating the disclosed appraisal practices from
the resulting LTV ratios and alleging that defendants did not follow the disclosed appraisal
practices, a misrepresentation of fact. See, e.g., id. at *6; Emps.’ Ret. Sys. of the Gov’t
of the Virgin Is. v. J.P. Morgan Chase & Co., -- F. Supp. 2d --, 2011 WL 1796426, at *9
(S.D.N.Y. May 10, 2011).
• Owner-Occupancy: Investors have alleged that the owner-occupancy rates for the
mortgaged properties were false because substantially fewer homes were owner-
occupied than what was represented in the offering materials. Investors typically have
not been successful in maintaining claims based on this category of misrepresentation.
Many offering materials disclosed that the owner-occupancy rates were based on the
representations of borrowers regarding their intended use of the property. Courts have
held that when this disclosure appears in the offering materials, there was no
misrepresentation; the offering materials accurately reported the representations of
borrowers. See, e.g., Mass. Mutual, 2012 WL 479106, at *7-*8; Footbridge Ltd. v.
Countrywide Home Loans, Inc., Civ. A. No. 09-4050, 2010 WL 3790810, at *9 (S.D.N.Y.
Sept. 28, 2010).
• Credit Ratings: Finally, investors have alleged that the credit ratings for the securities
were false and misleading because, for example, the ratings were generated based on
outdated models or false information. Investors have attempted to state claims not only
against the banks involved in the securitizations, but also against the ratings agencies.
Credit ratings are considered opinions and are therefore actionable only if an investor
can allege that a defendant did not honestly believe the ratings or knew that they bore no
reasonable relationship to the underlying facts. See Nomura, 632 F.3d at 775. Courts
have typically dismissed claims against the ratings agencies, finding that the facts were
insufficient to show that the ratings agencies did not honestly believe the ratings at the
time they were given. See id.; Genesee, 2011 WL 5840482, at *98. Claims against the
banks involved in the securitizations have met with slightly more success because
investors have been able to allege that these defendants provided the false information
to the ratings agencies and knew the ratings bore no reasonable relationship to the
underlying facts. See, e.g., Allstate, 2011 WL 5067128, at *15-*16.
This past year has seen significant developments in RMBS litigation. Many investors have been able to survive pleading challenges on at least some of their claims. In response, some banks have entered into settlement with investors, including Deutsche Bank’s and Citigroup’s recent settlement with the National Credit Union Administration Board. As discovery in these cases proceeds, there will likely be substantially more settlements.