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From Securities Regulation Daily, March 1, 2013

Court Could Draw "Reasonable Inference" That Offering Documents Misstated Underwriter's Practices

By Rodney F. Tonkovic, J.D.

A 2nd Circuit panel has found that a complaint stated a plausible claim that the offering documents for a mortgage-backed security misstated the applicable underwriting standards. The court accordingly reversed and vacated in part and remanded the district court's judgment dismissing the complaint. (New Jersey Carpenters Health Fund v. The Royal Bank of Scotland Group PLC, et al., March 1, 2013, Katzmann, R.).

An institutional investor, the New Jersey Carpenters Health Fund (the Fund) alleged that the registration statement and prospectus for a mortgage-backed security filed by the defendant-appellee, NovaStar Mortgage Funding Corporation (NovaStar) contained material misstatements and omissions. The offering documents, the Fund claimed, reported standards for underwriting mortgages that the relevant underwriter had supposedly abandoned. The Fund based its claims on the allegations that a disproportionately high number of the mortgages included in the security defaulted, that rating agencies had severely downgraded the security's ratings after becoming aware of the lax underwriting, and that the underwriter's former employees attested to "systematic loosening" of the underwriting standards. The district court concluded that these allegations failed to state a claim.

"Reasonable inference." The question before the court was whether the factual allegations allowed it to draw the "reasonable inference" that the underwriter abandoned its underwriting guidelines, rendering the statements in the offering documents misleading and incomplete. "Courts may draw a reasonable inference of liability when the facts alleged are suggestive of, rather than merely consistent with, a finding of misconduct," the court explained. Continuing, the court stated that district courts in the 2nd Circuit will allow claims under Sections 11 and 12(a)(2) to proceed if there is a "'fairly specific' account of how the relevant underwriters had systematically disregarded the guidelines disclosed in a security's registration statement."

In this case, the complaint included statements from former employees suggesting that the underwriter disregarded its own guidelines in an effort to generate a large volume of mortgages that it could then sell to third parties. These allegations, the court found, were suggestive of a finding of liability. The Fund also specifically tied the high rates of early payment default and the lowered ratings to the lax underwriting. Taking the allegations together, the court could reasonably draw the inference that the offering documents' description of the underwriting standards misstated the underwriter's actual practices.

Materiality. The court then found that the alleged misstatements and omissions were material as a matter of law. According to the court, there was a "substantial likelihood" that a reasonable investor would want to know that the underwriter had adhered to its standards for evaluating the capacity of borrowers to repay their loans and the adequacy of the collateral. NovaStar argued that the prospectus at issue contained risk disclosures. The court, however, stated that disclosures that a security might perform poorly cannot overcome an allegation that the description of the security was materially inaccurate. Additionally, contemporary news articles about the underwriter's loosening standards were too vague to render the alleged abandonment of the underwriting guidelines public knowledge.

Standing. Finally, the court vacated and remanded the district court's judgment that the Fund lacked standing to pursue claims based on securities in which it had not invested. Subsequent to the district court's decision, the 2nd Circuit issued NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., which held that a representative for a proposed class could bring Securities Act claims based on securities in which it had not invested if all of the relevant claims implicated "the same set of concerns." The court accordingly remanded for reconsideration under the standard set forth in NECA-IBEW.

This is Docket No. 12-1707-cv.

Attorney Names: Joel Paul Laitman, Michael Eisenkraft and Christopher Lometti (Cohen Milstein Sellers & Toll, PLLC) for New Jersey Carpenters Health Fund. Thomas C. Rice and Alan C. Turner (Simpson Thacher & Bartlett, LLP) for The Royal Bank of Scotland Group, PLC, Greenwich Capital Holdings, Inc., Wachovia Capital Markets, LLC and Deutsche Bank Securities, Inc. Steven J. Fink (Orrick, Herrington & Sutcliffe, LLP) for NovaStar Mortgage Funding Trust.

Companies: The Royal Bank of Scotland Group, PLC; Greenwich Capital Holdings, Inc.; Wachovia Capital Markets, LLC; Deutsche Bank Securities, Inc.

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