The financial crisis of 2007 and 2008 led to catastrophic losses for investors in residential mortgage-backed securities (“RMBS”). In the wake of the crisis, numerous suits were filed by investors and insurers against Wall Street banks. Plaintiffs allege that the banks issued loans to homeowners, packaged loans into securities, and sold them to investors—or induced plaintiffs to insure the securities—pursuant to offering materials that misrepresented the loans’ characteristics. The volume of these cases, all filed over the past few years, involving a similar set of background facts and a relatively new and complex type of security, created a series of decisions that have moved and clarified the law of statute of limitations. The holdings are not just relevant to the flood of RMBS cases currently facing the courts, but for all parties interested in bringing, or defending, securities and fraud-related claims.
Is “Inquiry Notice” Even the Standard Anymore?
A recent line of cases has suggested that the traditional “inquiry notice” standard for claims brought under the Securities Act of 1933 no longer applies. Rather, courts have adopted the more plaintiff-friendly standard of whether an investor could have actually amassed sufficient facts to survive a motion to dismiss.
The shift began with the Supreme Court’s decision in Merck & Co. v. Reynolds, 130 S. Ct. 1784 (2010). In Merck, the Supreme Court established a new test for measuring the statute of limitations for claims under the Securities Exchange Act of 1934. The 1934 Act’s two-year limitations period was traditionally measured by the “inquiry notice” standard, but Merck rejected it, holding that the limitations period does not begin to run until “a reasonably diligent plaintiff would have discovered ‘the facts constituting the violation,’ including scienter—irrespective of whether the actual plaintiff undertook a reasonably diligent investigation.” Id. at 1798. “Inquiry notice” does not trigger the statute of limitations, the Court held, because even a diligent investigation may not feasibly lead to “facts constituting the violation.” Id. at 1788. The Supreme Court thus confirmed that the proper focus is not on when the investigation should have begun, but rather must be on when a reasonable investigation would have borne sufficient fruit.
In City of Pontiac General Employees’ Retirement System v. MBIA Inc., 637 F.3d 169, 175 (2d Cir. 2011), the Second Circuit addressed the question of what is ‘sufficient’ fruit. The Second Circuit concluded that, under Merck, the 1934 Act’s statute of limitations does not begin to run until a plaintiff could plead sufficient facts to survive a motion to dismiss: A “fact is not deemed ‘discovered’ until a reasonably diligent plaintiff would have sufficient information about that fact to adequately plead it in a complaint.” As the Second Circuit explained: “Since the purpose is to prevent stale claims, it would make no sense for a statute of limitations to begin to run before the plaintiff even has a claim…. [I]n the limitations context, it makes sense to link the standard for ‘discovering’ the facts of a violation to the plaintiff’s ability to make out or plead that violation.” Lower courts have since applied the Merck and City of Pontiac standard to 1934 Act cases. See, e.g., S.E.C. v. Wyly, 788 F. Supp. 2d 92 (S.D.N.Y. 2011); Space Coast Credit Union v. Barclays Capital, Inc., No. 11-cv-2802 (S.D.N.Y. Mar. 20, 2012).
The question nonetheless remained: Was the abrogation of the “inquiry notice” standard driven by some peculiarity of the 1934 Act’s text? The numerous RMBS cases that were brought in the wake of the financial crisis provided the opportunity for many courts to address that question. RMBS defendants have argued that investors were on “inquiry notice” of their claims in 2007 and 2008, due to general news reporting about a shifting economy, loosened underwriting guidelines in the industry, and similar materials. One way plaintiffs have pushed back is to argue that defendants’ motions are focused on the entirely wrong standard—and many courts have agreed. For instance, the court in In re Bear Stearns Mortgage Pass-Through Certificates Litigation sided with “the majority of judges in this district” in holding that there was “no principled basis for cabining Merck’s holding” to 1934 Act’s claims. No. 08-cv-8093, 2012 WL 1076216, at *12 (S.D.N.Y. Mar. 30, 2012). As such, “Defendants’ focus on inquiry notice is misplaced. The operative question is no longer when a reasonable plaintiff would have known that she had a likely cause of action and inquired further. Rather, the question is whether a plaintiff could have pled ’33 Act claims with sufficient particularity to survive a 12(b)(6) motion . . . .” Id. at 13. Most recently, the Southern District sided with the Federal Housing Finance Agency in applying Merck to FHFA’s 1933 Act claims. Federal Housing Fin. Agency v. UBS Am., Inc., 11-cv-5201 (S.D.N.Y. May 4, 2012), Order at 22-24. See also In re Wachovia Equity Sec. Litig., 753 F. Supp. 2d 326, 371 n. 39 (S.D.N.Y. 2011) (applying Merck to 1933 Act claims); In re Direxion Shares ETF Trust, No. 09-cv-8011, 2012 WL 717967, at *2 fn. 3 (S.D.N.Y. Mar. 6, 2012) (same); Plumbers’ & Pipefitters’ Local No. 562 Supp’l Plan & Trust v. J.P. Morgan Acceptance Corp. I, No. 08-cv-1713, 2012 WL 601448, at *10 (E.D.N.Y. Feb. 23, 2012) (same).
While the concept of “inquiry notice” now appears all but dead in federal securities claims, courts have reached mixed results in extending Merck to state law claims. A federal court in Ohio recently applied Merck to Ohio’s blue sky law, drawing a comparison between the statutory language of the 1934 Act and the Ohio law, which requires knowledge of “facts” related to defendants’ wrongdoing. In re Nat’l Century Fin. Enter., Inc., 755 F.Supp.2d 857, 869-72 (S.D. Ohio 2010). But a Texas appellate court declined to apply Merck to the Texas Securities Act, “[i]n light of the differences in the language of the statutes’ limitations provisions,” particularly because intent is not at issue in the Texas statute. Allen v. Devon Energy Holdings, L.L.C. No. 01–09–00643–CV, 2012 WL 880623, *26 fn. 62 (Tex. App. Mar. 9, 2012). An Indiana appellate court likewise declined to apply Merck to the Indiana Uniform Securities Act, finding that Merck is not controlling and distinguishable on its facts, because plaintiffs were on notice of defendant’s wrongdoing “all along.” Paddock v. Maikranz, No. 82A05–1010–CT–6362011 WL 3849439, *4 fn. 6 (Ind. App. Aug. 31, 2011).
How Specific Must Information Be to Start the Clock?
Other courts dealing with RMBS cases have not felt the need to reach the Merck question. In so doing, they have established another clear statute-of-limitations trend: that, at the pleading stage at least, general information about the industry in question is insufficient to show the statute of limitations began with respect to the plaintiff’s particular securities.
Defendants in RMBS cases typically cite newspaper articles, filed complaints, and other public sources in arguing that plaintiffs were on notice of their claims outside of the limitations period. Plaintiffs push back, arguing that none of that information relates to their specific securities, and much of it does not even have to do with the specific defendants at issue. Courts have almost uniformly sided with plaintiffs, rejecting the sufficiency of materials untethered to the specific securities at issue. See, e.g., Mass. Mut. Life Ins. Co. v. Residential Funding Co., LLC, No. 11-cv-30035, 2012 WL 479106, *10-*11 (D. Mass. Feb. 14, 2012) (public information “did not directly relate to the misrepresentations and omissions alleged”); N.J. Carpenters Vacation Fund v. Royal Bank of Scotland Grp., 720 F. Supp. 2d 254, 267 (S.D.N.Y. 2010) (“Although defendants point to a number of publicly-available documents generally related to the weakening and outright disregard for underwriting guidelines by subprime originators, this information alone does not ‘relate directly’ to the [offerings] specifically at issue.”); In re Wells Fargo Mortgage-Backed Cert. Litig., 712 F. Supp. 2d 958, 967 (N.D. Cal. 2010) (whether press coverage was sufficient to put a reasonable investor on notice of its claims was a factual question not appropriate for resolution on a motion to dismiss).
For example, in Plumbers’ & Pipefitters v. J.P. Morgan, the court concluded:
[N]one of the newspaper articles proffered by defendants “refer to the offerings, the Certificates, or tie the originators to securities offered by the defendants. Of the stories that do refer to an originator, most describe the high rate of default experienced by subprime mortgages . . . . This information would put a potential plaintiff on notice merely that their mortgage-backed securities were likely to decline in value. But, default on subprime loans could be caused by any number of broad economic factors . . . . Even if this were enough to cause a reasonable investor to investigate, it would not establish that their offering documents contained material misstatements and omissions.
2012 WL 601448, at *11.
Courts that have dismissed RMBS claims as being untimely have done so where there were security-specific—or, at least, highly defendant-specific—facts publicly available. For instance, in In re Morgan Stanley Mortgage Pass-Through Certification Litigation, the securities had been downgraded twenty times prior to the relevant cutoff of May 2008. 2010 WL 3239430, at *8 (S.D.N.Y. 2010). And in Boilermakers National Annuity Trust Fund v. WaMu Mortgage Pass-Through Certificates, Series AR1, the trigger for finding that the period there had begun by August 2008 was a class-action complaint, filed against common defendants, that focused “almost exclusively” on the exact same offering materials being sued on in the later action. 748 F. Supp. 2d 1246, 1258 (W.D. Wash. 2010).
Similarly, the court’s analysis in Stichting Pensioenfonds ABP v. Countrywide Financial Corporation turned heavily on facts made public by multiple, defendant-specific, overlapping cases that had been filed before the 2008 limitations cutoff. 802 F. Supp. 2d 1125, 1136-37 (C.D. Cal. 2011). Indeed, while the court in Stichting found claims were time-barred as of February 2008, the same court denied a motion to dismiss other claims where the cutoff period was December 2007, noting that “the period between December 27, 2007 and February 14, 2008 was an important time in the Countrywide saga.” Allstate Ins. Co. v. Countrywide Financial Corp., No. 11-cv-05236, 2011 WL 5067128 (C.D. Cal. Nov. 21, 2011), at *14.
The RMBS cases dismissing claims as being untimely are thus the exceptions that prove the rule, that securities claims are only untimely if investors knew of the facts as to their specific investments.
How to Apply American Pipe
Another way that RMBS cases have shined a light on important statute of limitations questions—even if, here, it has not yet brought clarity to the issue—is in their repeated assessment of how to apply American Pipe.
In recent years, institutional investors have argued that the one-year statute of limitations and three-year statute of repose under the Securities Act of 1933 can be tolled by prior class actions that name overlapping securities. Tolling has the potential to extend the limitations periods for such claims by several years. Plaintiffs rely on the tolling rule announced in American Pipe & Construction Co. v. Utah, 414 U.S. 538, 554 (1974), that “the commencement of a class action suspends the applicable statute of limitations as to all asserted members of the class who would have been parties had the suit been permitted to continue as a class action.” If potential class members’ claims were not tolled, the Supreme Court held, they would be induced to file placeholder complaints and motions, which would undermine the “efficiency and economy” of class actions. Id. at 553.
One question that courts have grappled with is whether American Pipe can toll statutes of repose. In Footbridge Limited Trust v. Countrywide Financial Corp., 770 F. Supp. 2d 618, 624-27 (S.D.N.Y. 2011), Judge Castel of the Southern District of New York concluded that the three-year statute of repose is “absolute” and not subject to tolling, although he noted extensive case law to the contrary and conceded that “many of the policy considerations present in American Pipe would support tolling of a statute of repose.” Judge Kaplan of the Southern District followed the Footbridge decision in In re Lehman Bros. Sec. & ERISA Litig., 800 F.Supp.2d 477, 481-83 (S.D.N.Y. 2011), but likewise acknowledged that “most courts that have addressed this issue have concluded that American Pipe does apply to toll statutes of repose” and that his holding “is in tension with the policies animating the American Pipe decision.” Id. at 482-83. Other courts have since rejected the reasoning of Footbridge and In re Lehman, finding that the statute of repose can be tolled under American Pipe. See, e.g., Maine State Ret. Sys. v. Countrywide Fin. Corp., 722 F.Supp.2d 1157, 1166 (C.D. Cal. 2010); In re Bear Stearns, 2012 WL 1076216, at *16; Plumbers’ & Pipefitters’ Local No. 562 Supplemental Plan & Trust v. J.P. Morgan Acceptance Corp. I, No. 08-cv-1713, 2011 WL 6182090, at *4-*5 (E.D.N.Y. Dec. 13, 2011); Int’l Fund Mgmt. S.A. v. Citigroup Inc., No. 09-cv-8755, 2011 WL 4529640, at *5-*8 (S.D.N.Y. Sept. 30, 2011).
Another question that has repeatedly come up is whether class members can rely on American Pipe even if the named plaintiffs are later found to have lacked standing to bring the claims. The Third and Eleventh Circuits addressed the issue in the non-RMBS context, both finding that the principles of American Pipe—that the initial suit put defendants on notice of their claims, and creating ambiguity will result in an unnecessary flood of protective suits—require the doctrine’s application even if the named plaintiff is later found to lack standing. See Haas v. Pittsburgh National Bank, 526 F.2d 1083, 1086 (3d Cir. 1975); Griffin v. Singletary, 17 F.3d 356, 356 (11th Cir. 1994). Many RMBS courts have followed such rulings, applying American Pipe even if the relied-on class action was later narrowed due to a lack of standing. See, e.g., In re Morgan Stanley Mortg. Pass-Through Certificates Litig., 810 F. Supp. 2d 650, 669-70 (S.D.N.Y. Sept. 15, 2011) (“In cases where the law on standing was anything less than crystal clear, potential class members would be taking a tremendous risk by delaying intervention.”); Genesee County Emp.’ Ret. Sys. v. Thornburg Mortg. Secs. Trust 2006-3, 2011 WL 5840482, *61-*64 (D. N.M. Nov. 12, 2011) (“putative class members should not have to predict how the Court would decide the standing issues” but instead should be able to rely on filed class actions). Other courts have reached the opposite conclusion, fearing that recognizing such a rule would invite abuse by the class-action bar. See Stichting Pensioenfonds ABP v. Countrywide Fin. Corp., 802 F. Supp. 2d 1125, 1131 (C.D. Cal. 2011), appeal docketed, No. 11-56642 (9th Cir. Sept. 22, 2011).
The Statute of Limitations in Repurchase Claims
Most RMBS lawsuits allege fraud arising from misrepresentations in offering materials, but a subset allege breach of contract arising from the failure to repurchase non-compliant loans—so-called “putback” litigation. The contracts that govern RMBS trusts allow the trustee or other parties to the contracts to demand that the seller, sponsor, or other responsible party cure or repurchase defective loans in the RMBS trust. Investors arguably cannot make such a demand directly, but if they meet specific contractual requirements, they can direct the trustee to obtain the loan files, then analyze the files to identify breaches of representations and warranties, and then direct the trustee to demand the repurchase of defective loans.
The issue in these cases is whether the statute of limitations begins to run when the defendant refuses a repurchase request or when the alleged underlying misrepresentations were made. In Securitized Mortgage Trust 1997-2 v. Daiwa Fin. Corp., No. 02 Civ. 3232, 2003 WL 548868, *2 (S.D.N.Y. Feb. 25, 2003), an early mortgage-backed securities case, the court found that the defendant’s “false warranties and representations breached the contract at its inception,” as alleged in the complaint, and therefore the statute began to run when the contract was made (i.e. the closing date). The court rejected the argument that the statute of limitations only began to run later, when a demand was made, because the plaintiff could have made its demand earlier. Id. More recently, a Washington court applying New York law found that the failure to repurchase cannot constitute an independent breach for limitations purposes and, where two related breaches are alleged, the limitations period begins to run from the first breach. Lehman Bros. Holdings, Inc. v. Evergreen Moneysource Mortg. Co., 793 F.Supp.2d 1189, 1193-94 (W.D. Wash. 2011).
These holdings notwithstanding, plaintiffs can and will argue, with much force, that the failure to repurchase is a separate breach of contract, independent of the underlying breaches of representations and warranties. If the breaches are separate, the statute of limitations for the failure to repurchase should begin to run only when a repurchase demand is made and refused. Some RMBS offerings also include accrual provisions which provide that claims do not accrue until a repurchase demand is made and refused, but such provisions are still untested in the courts. RMBS lawsuits arising from repurchase claims are a small but growing area of RMBS litigation, and the courts’ rulings on the applicable statute of limitations will continue to develop.
Summary of the Implications of Recent RMBS Case Law
The Supreme Court’s decision in Merck, and the decisions that have followed it, have far-reaching implications for securities claims. Most of the decisions raise defendants’ burden for dismissal on a motion to dismiss—either by applying Merck even to 1933 Act claims, stressing the importance of security-specific information, or both. Given the principles of fairness to plaintiffs, who arguably should not have their clocks begin before they could even successfully bring a claim, is a universal concern, we may soon see courts re-assessing the application of “inquiry notice” standards even to common-law claims (though the courts have thus far split on whether Merck should govern state blue sky limitations periods).
The RMBS cases have also raised important questions regarding the application of American Pipe. Unless and until such questions as its applicability to the statute of repose and whether investors are protected are finally settled, one can expect prudent investors to file protective “opt-out” suits unless the named plaintiffs’ standing is beyond dispute. Though such would undermine the efficiency purposes of class-action litigation, that is the unfortunate side effect of those minority rulings that have read American Pipe narrowly.