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From Securities Regulation Daily, September 28, 2017

FHFA remains victorious in remaining RMBS row

By John M. Jascob, J.D., LL.M.

Noting "the persistent power of the Securities Act’s full-disclosure requirement in the context of the Great Recession," the Second Circuit has affirmed a judgment against two private banks that sold residential mortgage-backed securities (RMBS) during the housing bubble. The court concluded that the defendants failed to discharge their duty under the Securities Act to disclose fully and fairly all the information necessary for investors to make an informed decision whether to purchase the certificates at issue, while failing to meet the standard to establish a reasonable care defense. The appeals court also rejected the defendants’ loss causation defense, while holding that the plaintiff, the Federal Housing Finance Agency (FHFA), properly exercised jurisdiction over analogous claims brought under the Virginia and District of Columbia blue sky laws (Federal Housing Finance Agency v. Nomura Holding America, Inc., September 28, 2017, Wesley, R.).

The litigation represented the sole remaining action in a series of 16 similar, coordinated actions brought in the Southern District of New York by FHFA as statutory conservator to recover losses experienced by Fannie Mae and Freddie Mac (the GSEs) from their purchases of RMBS. The FHFA alleged that the offering documents used by banks and related persons in those transactions overstated the reliability of the loans backing the securitizations. The case on appeal, which was the only one to go to trial, ended with the trial court awarding the FHFA more than $806 million in rescission-like relief from defendants Nomura Holding America, Inc. and RBS Securities, Inc.

Statutes of repose. Turning first to issues that the district court resolved before trial, the Second Circuit upheld the lower court’s ruling that an extender provision in the Housing and Economic Recovery Act of 2008 (HERA) replaced the statutes of repose contained in the Securities Act and the Virginia and D.C. blue sky laws. The extender provision permits the FHFA to bring any "tort claim" within three years and any "contract claim" within six years of its appointment as the GSEs’ conservator on September 6, 2008.

Although the defendants argued that the HERA displaces only otherwise applicable statutes of limitations, and not statutes of repose, the appellate panel relied on its decision in an interlocutory appeal in one of the FHFA’s parallel coordinated actions (FHFA v. UBS Ams., Inc., 2013). There, the Second Circuit held that reading the extender provision to preclude and preempt all types of time-limitation statutes was consistent with Congress’s intent because it allowed the FHFA more "time to investigate and develop potential claims on behalf of the GSEs."

This holding was not abrogated by the Supreme Court’s later decision in CTS Corp. v. Waldburger (2014) that the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) did not preempt state statutes of repose. The panel reasoned that CTS’s holding is firmly rooted in a close analysis of CERCLA's text, structure, and legislative history, and none of those statute-specific considerations undermined the Second Circuit's close analysis of the significantly different HERA extender provision.

Knowledge issues. Next, the court rejected the defendants' arguments concerning issues that turned on the extent to which the GSEs were or should have been aware that statements in the prospectus supplements concerning underwriting guidelines were false. The defendants argued that the federal claims were barred under Securities Act Section 13’s statute of limitations because the GSEs became aware of two categories of storm warnings before September 6, 2007, one year prior to the effective date of the HERA’s extender provision. The court was not persuaded by arguments that the generalized experience with originators in the mortgage loan market by one side of the GSEs’ operations, known as the "Single Family Businesses," triggered inquiry notice to investigate specific representations in the prospectus supplements.

Neither would the credit downgrades of junior tranches cause a reasonable investor in the GSEs’ shoes to investigate whether the prospectus supplements contained material misstatements or omissions, given that senior and junior certificate-holders did not have the same risk exposure, the court opined. A reasonable senior certificate-holder might understand the credit rating agencies’ decisions to downgrade junior tranches while maintaining the senior-tranche ratings to mean that any misrepresentation in the offering documents was mild enough that the subordination and over-collateralization still insulated them from loss.

Reasonable care defense. The defendants also argued on appeal that a reasonable jury could find that they met the standard for a reasonable care defense under Securities Act Section 12(a)(2) because their due diligence complied with industry practices for private-label securitizations at the time. The appellate panel disagreed, noting that Nomura, as the sponsor, depositor, and occasional underwriter, was uniquely positioned to know more than anyone else about the creditworthiness and underwriting quality of the loans. As a result, investors relied on Nomura’s review of the loans and representations about the loans’ likelihood to default. In making those representations, Nomura fell below the standard of conduct Section 12 requires.

RBS’s conduct was no better because RBS relied entirely on Nomura’s diligence and thus failed to adequately discharge its responsibility as an underwriter to verify independently the representations in the offering documents.

Loss causation defense. The appellate panel also found no basis for reversal regarding the defendants’ attempted loss causation defense. The court agreed that it is uncontested that the housing market and related macroeconomic forces were partial causes of the certificates’ losses. What doomed the defendants’ loss causation defense, however, is that those macroeconomic forces and the misstatements in the prospectus supplements were intimately intertwined. While the financial crisis may have been an important step in between the misstatements and the certificates’ losses, all three events were linked together in the same causal chain, the court stated.

The case is No. 15-1872-cv(L).

Attorneys: Kathleen M. Sullivan (Quinn Emanuel Urquhart & Sullivan, LLP) for Federal Housing Finance Agency. Adam R. Brebner (Sullivan & Cromwell LLP) for Nomura Holding America, Inc., Nomura Asset Acceptance Corp. and Nomura Home Equity Loan, Inc.

Companies: Federal Housing Finance Agency; Nomura Holding America, Inc.; Nomura Asset Acceptance Corp.; Nomura Home Equity Loan, Inc.

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