Mortgage-Backed Securities Litigation€¦ · © 2012 Ulmer & Berne Repurchase Cases In repurchase...

© 2012 Ulmer & Berne www.ulmer.com

Mortgage-BackedSecurities Litigation

Litigation and Regulatory Trends

Richik Sarkar


Key Participants

Securities Firms

CDO Managers

Rating Agencies

Investors

Guarantors

Trustees

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Civil Litigation

Who are the Primary Defendants inMBS Litigation?

The Investment Banks who Underwrotethe Offerings

Their related entities that served assponsors sellers and depositors of theMBS Offerings

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Who are the Plaintiffs in MBSLitigation?

Insurers (monolines)

Private investors

Public investors – GSEs, FHFA

Trustees

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What Do MBS Plaintiffs Typically Allege?

The risks of MBS investments were notaccurately disclosed

There was systematic disregard forunderwriting guidelines

Failed (or no) due diligence

Ratings failed for the riskier types ofmortgages being fed into the mortgagepools

Outdated ratings models assigned falselyinflated ratings

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Most Common Claims

Breach of Contract

Breach of Covenant of Good Faithand Fair Dealing

Fraudulent Inducement

Negligent Misrepresentation

Unjust Enrichment

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Generally subprime-related lawsuitsfiled since the credit crisis have falleninto discrete categories:

Shareholder class actions

These comprise the majority of subprime-related suits

Typically allege violations of sections10(b), 14(a), 20(a), and 20A of the SEAand/or §§ 11, 12(a)(2), and 15 of theSecurities Act

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Typically claim that defendant companymisled investors about their exposure tosubprime mortgages through falsestatements and omissions about theirinternal controls and underwriting practices.See, e.g., In re Manulife Fin. Corp. Sec.Litig., 2011 WL 1990883 (S.D.N.Y. May, 23,2011); Kuriakose v. Federal Home LoanMortgage Corp., 2011 WL 1158028(S.D.N.Y. 2011); Smit v. Charles Schwab &Co., Inc., 2011 WL 846697 (N.D. Cal. 2011).

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Shareholder class actions also have beenbrought against loan originators, allegingthat the defendant companies misledinvestors about their underwriting practicesand concealed information such as theLTV ratios of the mortgage portfolios andthe types of mortgages they originate.See, e.g., In re BankAtlantic Bancorp, Inc.,2011 WL 1585605 (S.D. Fla. 2011); In reWachovia Securities Litigation, 753 F.Supp. 2d 326 (S.D.N.Y. 2011); In reFranklin Bank Corp. Securities Litigation,2011 WL 1100272 (S.D. Tex. 2011).

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Suits Brought by Purchasers ofMortgage-Backed Securities

Most of these plaintiffs assert claimsunder sections 11 and 12(a)(2) of theSEA, alleging misstatements oromissions in prospectuses andregistration statements, as well as statelaw claims.

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These suits typically allege that theoffering documents contained falsestatements, leading purchasers to believethat the security was backed by assetswith smaller risks than was in fact thecase. See, e.g., Emps. Ret. Sys. v. J.P.Morgan Chase & Co., 2011 WL 1796426(S.D.N.Y. May 10, 2011); Me. State Ret.Sys. v. Countrywide Fin. Corp., 2011 WL1765509 (C.D. Cal. Apr. 20, 2011);Oughtred v. E*Trade Fin. Corp., 2011 WL1210198 (S.D.N.Y. Mar. 31, 2011).

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Rating agencies have also been namedas defendants, facing allegations thatthey effectively acted as underwritersand are therefore liable formisstatements in the offering documentsconcerning the ratings assigned tomortgage-backed securities as well asthe underwriting standards applicable tothe loans in the mortgage pools backingthe securities. See N.J. CarpentersHealth Fund v. NovaStar Mortg. Inc.,2011 WL 1338195 (S.D.N.Y. Mar. 31,2011).

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Monoline Suits

Monolines are entities that enter into acredit default swap with the Trust, bywhich they receive a stream ofpayments from the trust and inexchange promise to reimburse thetrust for any losses it incurs on theRMBS tranches – they are essentiallyinsurers of the Trust’s risk on itsinvestment in the RMBS.

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Purporting to stand in the shoes ofinvestors whose losses the monolineshave absorbed pursuant to theinsurance policies, monolines havesued mortgage originators and issuers,and underwriters of mortgage-backedsecurities, claiming misrepresentationsin the offering materials. See, e.g.,MBIA Ins. Corp. v. IndyMac ABS, Inc.,No. 2:09-cv-07737 (Cal. Super. Ct.2009).

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Trustee Suits

Allege that Defendants maderepresentations and warranties aboutthe quality and documentation of themortgage loans and that they promisedthat, if a breach of a representation orwarranty materially and adverselyaffected the value of a mortgage loan,then they would cure the breach orreplace or repurchase that loan.

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Representations and warranties havebeen breached and, as a result, themortgage-loan pool has not generatedsufficient funds for the Trust to make allscheduled principal and interestpayments on the certificates.

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Repurchase Cases

In repurchase cases, investors seek toenforce repurchase obligations underthe deal documents for mortgage-backed securities, which generallyrequire the seller of the loans to theissuer to repurchase or substitutesimilar loans for any nonconformingloans in the pool.

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Civil Actions Brought By the Government

S.E.C. v. Goldman Sachs & Co., et al.,Civ. Act. No. 10 Civ. 3229 (S.D.N.Y., filedApr. 16, 2010.

Alleged that the defendants knowingly,recklessly, or negligently misleadinvestors into believing that a particularhedge fund was investing in the equity ofthe RMBS, when in fact it was taking ashort position.

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Federal Housing Finance Agency (FHFA)Litigation

FHFA, as conservator for Fannie Mae andFreddie Mac, filed lawsuits against 17major financial institutions and others,alleging violations of the federal securitieslaws and common law in the sale ofprivate mortgage-backed securities toFannie Mae and Freddie Mac.

See Federal Housing Finance Agency v.Ally Financial Inc., et al., (Sup. Ct. N.Y.,filed Sept. 2, 2011).

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Common Defense Strategies

Lack of Standing

No Scienter

Showing No Reasonable Reliance

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Arguing that the overall economicdownturn, housing price declines, andreduced liquidity – not the allegeduntrue statements and omissions –were to blame for the decline in thecertificates’ value

Plaintiffs failed to perform adequatedue diligence before investing orotherwise becoming involved withRMBS

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Disclaimers in their MBS offering documents,arguing that the allegedly false statementsare non-actionable opinions

In Lehman Bros. Sec. & ERISA Litig., 684 F.Supp. 2d 485 (S.D.N.Y. 2010), plaintiffs'underwriting claims survived a motion to dismissdespite defendants' cautionary disclosures. Thecourt found that, while defendants had “disclosedthat the loan originators had discretion to issueloans pursuant to exceptions to the guidelines,”plaintiffs' claims “that the originators systematicallyfailed to follow the underwriting guidelines”exceeded the scope of defendants' warnings.

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Lack of Causation

“[W]hen a plaintiff’s loss coincides with amarket-wide phenomenon causing comparablelosses to other investors, the probability thatthe loss was caused by an alleged frauddecreases.” Hampshire Equity Partners, II,L.P. v. Teradyne, Inc., No. 04-cv-3318, 2005WL 736217, at *5 (S.D.N.Y. Mar. 30, 2005),aff’d, 159 F. Appx. 317 (2d Cir. 2005).

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For example, in State St. Bank & Trust Co. FixedIncome Funds Inv. Litig., 774 F. Supp. 2d 584, 585(S.D.N.Y. 2011), the court found that defendants'statements regarding the composition of the fundhad no bearing on the value of the securities in thefund and was therefore irrelevant to losscausation. While misrepresentations about thecomposition of the fund might have induced theplaintiffs to invest in the fund, that would onlyprove transaction causation. Although theplaintiffs offered alternative theories of losscausation, the court concluded that the statute“require[d] a connection between the allegedmaterial misstatement and a diminution in thesecurity's value” and granted defendants' motionto dismiss.

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No Actual Losses

Argument based upon the notion thatinvestors haven’t actually lost thatmuch on their RMBS investments asmany trusts that have been payingprincipal and interest more or less onschedule.

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Trends and Developments

While the number of new subprime-relatedfilings has decreased, settlements ofsubprime cases have increased.

After only eleven settlements in 2009 andeight in 2010, fifteen lawsuits already havesettled in 2011 through the end of July.Settlements have ranged in size from $4.0million to $624 million, averaging $103.1million, with a median value of $31.3 million.

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By comparison, the average settlement valuefor non-credit crisis-related securities classactions during the same period was $31.6million, with a median value of $10 million.

There are over 100 pending cases that havenot yet been dismissed or resolved.Accordingly, the number of settlements mayincrease in the coming years, as previouslyfiled cases mature.

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Government Enforcement Activities

Legislative Reform

U.S. Financial Crisis InquiryCommission, The Final Crisis InquiryReport (Jan. 2011)

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The Report contained severalobservations potentially relevant toestablishing certain claims or defensesin mortgage-backed securities litigation:

Banks took low investment-gradetranches – largely rated BBB or A –from many mortgage-backed securitiesand repackaged them into newsecurities

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Approximately 80% of these CDOtranches would be rated AAA despitethe fact that they generally comprisedthe lower-rated tranches of mortgage-backed securities.

Banks assert that they thought CDOswould be safe because they werediversified – but this stated assumptionproved untrue: the mortgage-backedsecurities turned out to be highlyhomogenous.

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The Report additionally drew a numberof conclusions about the mortgage-backed securities market.

Certain products in particular, includingCDOs Squared, Credit Default Swaps,Synthetic CDOs, and asset-backedcommercial paper programs fueleddemand for subprime mortgagesecuritization and contributed to thehousing bubble.

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“The high ratings erroneously given toCDOs by credit rating agenciesencouraged investors and financialinstitutions to purchase them andenabled the continuing securitization ofnonprime mortgages.”

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Regulatory Actions

In February 2012 the SEC issued WellsNotices to Goldman Sachs Group, Inc.,Wells Fargo & Co., and JPMorganChase & Co. for their involvement inthe sales of mortgage-backedsecurities

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SEC is looking for evidence that firmsfailed to disclose the underlying creditweaknesses in mortgage pools anddelinquencies

Institutions are being investigated todetermine whether it properlydescribed facts and risk in its offeringdocuments as well as whether it mayhave violated fair-lending laws andother regulations tied to making homeloans

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Financial Fraud Enforcement TaskForce (www.stopfraud.com)

This organization was recentlyassembled under the Obamaadministration and is Chaired byAttorney General Eric Holder

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It is divided into several subgroups, themost notable for MBS purposesinclude:

The Residential Mortgage-BackedSecurities Working Group

The Mortgage Fraud Working Group

The Securities & Commodities FraudWorking Group

Other than to flag its existence,however, there has not been much toreport regarding this organization

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