Opinion ID: 1033271
Heading Depth: 3
Heading Rank: 2

Heading: Misstatement in September Offering

Text: Turning to the September offering, the Plaintiffs also allege those offering documents contained a materially misleading statement. The alleged misstatement was contained in the offering prospectus: In early August 2007, the secondary market for financing prime quality mortgage assets and rated mortgage-backed securities (“MBSs”) came under severe pressure for a number of reasons. During 2007, lower credit quality loans and securities backed by subprime mortgage loans and, to a lesser extent, Alt-A mortgage loans were downgraded by ratings agencies as the credit performance of the underlying loans deteriorated and, as a result, the prices of securities backed by those loans declined. Supp. App. 1243. The statement came in the context of Thornburg’s explanation for its liquidity troubles. Prior to the decline in the MBS market, Thornburg had relied primarily on its prime mortgage assets to obtain liquidity; it pledged MBSs backed by prime mortgages as collateral for cash. The decline in the Alt-A and subprime markets infected the prime market, and the “market prices of privatelabel MBSs backed by prime mortgage loans suddenly and unexpectedly began to decline,” thereby restricting Thornburg’s access to new cash. Id. -19- The statement was misleading, the Plaintiffs contend, because it mentions the existence of a market trend relating to MBSs backed by Alt-A loans without also mentioning the company’s own exposure to that trend. The Plaintiffs insist that once a company chooses to address a topic, it must “disclose all material facts about that subject.” Aplts. Br. at 31 (citing Schaffer v. Evolving Sys., Inc., 29 F. Supp. 2d 1213, 1221 (D. Colo. 1998)); see also Schaffer, 29 F. Supp. 2d at 1221 (“[W]hen [defendants] chose to release selected, positive information from the first quarter statements, they should have revealed the potentially negative information as well.”); cf. Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002) (statement, in order to be misleading, “must affirmatively create an impression of a state of affairs that differs in a material way from the one that actually exists”). We recognize that the statement raises the possible implication that Thornburg had no direct exposure to the Alt-A market but only an indirect exposure through the effect of the Alt-A market on the prime mortgage market. Yet even assuming that a reasonable investor would have wanted to know Thornburg’s direct exposure to the Alt-A market, we cannot conclude that Thornburg failed to disclose the true state of affairs in its September offering documents. The September prospectus expressly incorporated Thornburg’s First and Second Quarter 10-Qs, or quarterly financial statements, which contain sufficient -20- information to render the disclosure not misleading. Those 10-Qs inform investors that Thornburg held several billion dollars of MBSs backed by Alt-A loans. The Second Quarter 10-Q discloses that, as of June 30, 2007, Thornburg held $24.5 billion of assets in its loan portfolio. Supp. App. 707. These loans were divided into two groups, those that Thornburg’s subsidiary originated (about $17.1 billion) and those that Thornburg purchased (about $7.4 billion). Both groups of loans consisted of “ARM loans held for securitization, ARM loans held as collateral for Collateralized Mortgage Debt and ARM loans securitized for our own portfolio for which we retained credit loss exposure.” Id. Thornburg disclosed that its pool of originated loans contained 11.1 percent in “stated income/no ratio” loans, and that its pool of purchased loans contained 42.2 percent of such loans. A reasonable investor would have viewed this information and could only have concluded that Thornburg had direct exposure to the Alt-A mortgage market. As a result, the disclosure of this information made Thornburg’s comments about the Alt-A mortgage market not misleading. The Plaintiffs object to this line of analysis because the $2.9 billion in MBSs backed by Alt-A loans was actually contained not in the “ARM Loans” category—about which Thornburg made disclosures relating to the proportion of stated income/no ratio loans—but in the “Purchased ARM Assets” category. 7 7 As already noted, in its financial statements, Thornburg categorized its over $50 billion in ARM assets into one of two groups, “ARM loans,” or (continued...) -21- Thus, they argue, Thornburg did not disclose in 2007 the precise assets that were ultimately disclosed in 2008. But the test for whether a statement is misleading is not whether in retrospect an investor might have wanted to know the omitted information, but whether additional material information was necessary at the time to make a statement reflect the true state of affairs. See McDonald, 287 F.3d at 998 (“[A] duty to disclose arises only where both the statement made is material, and the omitted fact is material to the statement in that it alters the meaning of the statement.”). Here, the only information that was needed to make Thornburg’s comment about the Alt-A mortgage market not misleading was that Thornburg actually had direct exposure to that market; more detailed information was not necessary or required. Though the Plaintiffs stress the distinction between the assets contained in Thornburg’s two accounting categories—loans that were both underwritten and securitized by third-parties compared to loans underwritten or securitized (or both) by Thornburg itself—the securities laws do not make that type of fine-grain disclosure necessary to make Thornburg’s statement not misleading. The statement did not mention third-party mortgages compared to 7 (...continued) “purchased ARM assets.” As of June 30, 2007, around $31.8 billion in assets were categorized as ARM loans and around $24.7 billion in assets were categorized as purchased ARM assets. Supp. App. 705. The $2.9 billion in purchased MBS backed by Alt-A loans was contained within the purchased ARM assets category. -22- Thornburg mortgages, and thus parsing such differences in its disclosures was unnecessary. Accordingly, we conclude Thornburg made no misleading statement in its September offering documents. Given our conclusion that the statement was not misleading, there is no need to consider whether omission of the $2.9 billion in Alt-A MBSs from the September offering documents was material. The Plaintiffs have failed to state a claim. 3. Duty to Disclose in the September Offering - Regulation S-K As an alternative basis for § 11 liability, the Plaintiffs argue that Item 303 of Regulation S-K required Thornburg (and its underwriter, FBR) to disclose in the September prospectus its portfolio of purchased Alt-A MBSs. The Plaintiffs contend Thornburg was under such a duty because the decline in the Alt-A and subprime mortgage markets was likely to have an adverse effect on Thornburg’s liquidity and income. See 17 C.F.R. § 229.303(a)(1), (a)(3)(ii) (requiring disclosure of known market trends affecting liquidity and income). By contrast, FBR, the sole underwriter of Thornburg’s September offering, relies on an accompanying instruction to the regulation to escape liability, arguing that omission of the $2.9 billion in MBSs did not make the reported financials any less “indicative of future operating results or of future financial condition.” 17 C.F.R. § 229.303(a), Instruction 3. -23- The district court agreed with FBR and so do we. The Plaintiffs have not alleged sufficient facts to demonstrate that Thornburg was under an obligation to disclose the existence of the $2.9 billion in MBSs. The September prospectus already warned investors that (1) Thornburg had been forced to sell $20.5 billion of its AAA-rated MBSs at a loss, Supp. App. 1245; (2) Thornburg had been cut off from two of its three sources of funding, id. at 1244; and (3) liquidity conditions could worsen, id. at 1247. Given these disclosures, more specific information concerning the $2.9 billion in purchased Alt-A MBSs (out of over $30 billion in “Purchased ARM Assets”) would not have better illumined Thornburg’s financial future “in any material way.” 17 C.F.R. § 229.303(a)(1). Prospective investors knew that the prices of Thornburg’s ARM assets had dropped due to turmoil in the housing market and that continued turmoil would hurt both its liquidity and revenue. The Plaintiffs have not offered a convincing argument why the $2.9 billion in purchased MBSs backed by Alt-A loans were materially different from Thornburg’s other Alt-A holdings—which were explicitly disclosed under the “ARM loans” category in Thornburg’s financial statements. The Plaintiffs contend that, because the Alt-A loans underlying the $2.9 billion in question were both securitized and underwritten by third parties, these loans were materially different from ones that were underwritten or securitized (or both) by Thornburg. As the basis for the difference between the two categories, the Plaintiffs claim -24- Thornburg and its subsidiaries represented that they maintained strict underwriting and securitization guidelines whereas the third parties did not. Yet Thornburg’s SEC filings undermine this claim. Thornburg clearly represented in its SEC filings that it also had “case-by-case” underwriting exceptions, just like the third-party originators supposedly had. Supp. App. 235. Thornburg allowed such exceptions based on “low loan-to-value ratios, low debtto-income ratios, excellent credit history, stable employment, financial reserves, and time in residence at the applicant’s current address.” Id. The result of these exceptions was that, at the end of second quarter 2007, 11.1 percent of the $17.1 billion of loans that Thornburg’s subsidiary originated and that Thornburg held on its books were Alt-A (i.e., “stated income/no ratio”). Id. at 707. As a result, the Plaintiffs have not established that prospective investors would have viewed Alt- A assets originated by Thornburg any differently from those Thornburg purchased from third parties. Decisions from other circuits support our conclusion that Thornburg did not violate Item 303 by failing to disclose the $2.9 billion in purchased Alt-A MBSs. For example, in Oxford Asset Management, Ltd. v. Jaharis, 297 F.3d 1182 (11th Cir. 2002), the Eleventh Circuit held that a pharmaceutical company did not violate Item 303 by omitting data about declining prescription volume because the prospectus already warned investors that the company had lost $80 million and -25- might never be profitable. Id. at 1192. The prospectus contained all the material information concerning the company’s financial future. By contrast, in Litwin v. Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011), the Second Circuit held that the plaintiffs had alleged a violation of Item 303 based on a company’s failure to disclose how the declining trend in the real estate market would affect its earnings, given that 22.6 percent of its assets were in real estate. Id. at 722. While the defendant was a portfolio company, with many different investments across various industries, it needed to disclose trends related to its major investments, including the real estate markets. This case reflects the same conditions as in Oxford rather than those in Litwin. Thornburg informed investors in its prospectus that its sources of financing were restricted, that it had been forced to sell off billions of dollars in assets, and that the situation could worsen. Like the defendant in Oxford, Thornburg painted an unvarnished picture of its finances. And unlike the defendant in Litwin, which neglected to discuss its exposure to an entire market, Thornburg painted a materially complete picture of how it was exposed to the decline in the MBS market. Item 303 imposed no additional disclosure obligations. 4. Duty to Disclose in September Offering - Regulation S-X As a final basis for Thornburg’s § 11 liability for omitting the $2.9 billion in Alt-A MBSs, the Plaintiffs contend Thornburg violated Regulation S-X in its -26- September offering. Regulation S-X requires all offering documents to be in compliance with GAAP; and the pertinent standard here, FAS 107, obligates companies to disclose significant concentrations of credit risk. The sole underwriter of the September offering, FBR, does not dispute this requirement but contends that to “state a claim that an entity’s failure to disclose a concentration of credit risk violated FAS 107, a plaintiff must plead facts that would permit findings that the entity in fact had ‘significant concentrations of credit risk’ and that the entity believed that to be so.” FBR Br. at 57 (emphasis added) (quoting In re Lehman Bros. Sec. & ERISA Litig., 799 F. Supp. 2d 258, 291 (S.D.N.Y. 2011)). This knowledge requirement stems from the recognition that whether a particular asset constitutes a significant concentration of risk is a matter of judgment. See FASB Staff Position SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk, at ¶ 7 (2005) (“Judgment is required to determine whether loan products have terms that give rise to a concentration of credit risk.”). A company, or its auditor, has not exercised “judgment” in deciding whether to disclose a significant credit risk if it never realized (or never consciously ignored signs) that it was exposed to the risk in the first place. The Plaintiffs do not contest the rule advanced by FBR—that they must allege facts sufficient to raise an inference that Thornburg believed it had a significant concentration of risk in its $2.9 billion of purchased MBSs backed by -27- Alt-A loans. Rather, they insist they have alleged the requisite facts. For two reasons, we disagree. First, the September prospectus demonstrates that Thornburg was concerned about the overall MBS market. The decline in its MBS assets had triggered margin calls and forced Thornburg to sell over $20 billion of its highestrated assets. Thornburg was concerned this trend would continue and warned investors about this possibility. The Plaintiffs have put forward no allegations that Thornburg saw its MBSs backed by Alt-A loans as significantly more risky than its other MBSs, such that it needed to make additional disclosures. Second, given the relatively small role the purchased MBSs backed by Alt-A loans figured in the overall portfolio, no inference is raised from the assets’ mere existence that Thornburg saw them as (or consciously ignored the possibility they were) a significant concentration of credit risk. Accordingly, the Plaintiffs have not pleaded facts demonstrating Thornburg violated its disclosure obligations under Regulation S-X. Given our conclusion that Thornburg had no duty to disclose the $2.9 billion in MBSs, under either Regulation S-K or S-X, we need not consider whether the omission was material. C. Disclosure of Cross-Default Provisions The Plaintiffs’ second non-disclosure argument contends Thornburg violated § 11 by failing to disclose in the September offering the cross-default -28- provisions in Thornburg’s repurchase agreements. The Plaintiffs advance multiple theories of liability. 1. Misleading Statement in the September Offering As an initial matter, the Plaintiffs contend that Thornburg made a material omission by failing to include in its September offering documents a disclosure that its repurchase agreements contained cross-default provisions. The result of these provisions was that a default on any one of the agreements triggered a default on all of them. The Plaintiffs contend that this omission made misleading the following statement: Because we borrow money under Reverse Repurchase Agreements . . . based on the fair value of our ARM Assets, our borrowing ability under these agreements could be limited and lenders could initiate margin calls in the event of interest rate changes or if the value of our ARM Assets declines for other reasons. Supp. App. 703. Yet the Plaintiffs cannot show how the omission of the cross-default provisions made the statement misleading. The statement merely mentions Thornburg’s dependence on repurchase agreements to borrow money and that a decline in the value of their ARM assets could trigger a margin call. There is no mention about the possibility of failing to meet a margin call or its consequences. Default, let alone cascading default, is an entirely different subject that is not even broached in the statement. Because the statement gives no impression, one -29- way or the other, about the effect on the company of failing to meet a margin call, there is no basis for believing the statement was misleading. Given our conclusion that the statement was not misleading, we need not consider whether the omission was material. 2. Duty to Disclose in the September Offering - Regulation S-K The Plaintiffs also argue that Thornburg had an obligation to disclose the cross-default provisions under Item 303 of Regulation S-K, which requires, among other things, disclosure of known trends or uncertainties that are reasonably likely or are reasonably expected to affect a company’s liquidity or earnings. 17 C.F.R. § 229.303(a)(1), (a)(3)(ii). FBR contends that the Plaintiffs have failed to plead sufficient knowledge for a violation of Item 303. Subsection (a)(1) requires allegations that the cross-default provisions were “reasonably likely” to be triggered, thereby harming Thornburg’s liquidity, and subsection (a)(3)(ii) requires allegations that Thornburg “reasonably expect[ed]” the crossdefault provisions to have an adverse impact on its earnings. We agree with FBR that the Plaintiffs have failed to allege the necessary facts. The state of the mortgage market as of the September offering does not raise an inference that there was a reasonable likelihood the cross-default provisions in Thornburg’s repurchase agreements would be triggered due to an unprecedented slump. Cf. Fulton Cnty. Emps. Ret. Sys. v. MGIC Inv. Corp., 675 F.3d 1047, 1050 (7th Cir. 2012) (“The subprime market had been in decline -30- during the first half of 2007, but that did not necessarily imply a continuing slump, let alone a collapse. For every seller of subprime loans in 2007 who thought them overpriced, there was a buyer who expected to make a profit when the market went back up.” (citing academic articles on the subprime credit crisis)). The Plaintiffs provide no allegations raising the inference that Thornburg knew the cross-default provisions were reasonably likely to be triggered. The complaint itself refers to the fact that Thornburg had been able to meet its margin calls up to then. Only if the prime and subprime mortgage markets collapsed at the same time would the value of Thornburg’s collateral decline to such an extent that the size of the margin calls would raise the specter of default, thereby triggering the cross-default provisions. Notwithstanding cautionary language in the prospectus about the future of the mortgage market, nothing in the complaint suggests Thornburg should have seen this catastrophic collapse as a reasonable likelihood (rather than a mere possibility) at the time of the September offering. Accordingly, Thornburg had no obligation under Item 303 to disclose the existence of the cross-default provisions. Given our conclusion that Thornburg had no duty to disclose the crossdefault provisions under Regulation S-K, we need not consider whether the omission was material. -31- D. Restatement of Financials As the third and final basis for liability, the Plaintiffs argue that the May, June, and September offering documents were materially misleading because they incorporated Thornburg’s 2006 financial statement, which allegedly contained material misstatements. This claim stems from a letter by KPMG, Thornburg’s outside auditor, which, on March 4, 2008, stated that Thornburg’s 2006 and 2007 annual statements “contain material misstatements associated with available for sale securities.” App. 119. Such misstatements, if true, would be violations of GAAP; and, as already noted, companies whose offering documents are not in compliance with GAAP are in violation of Regulation S-X, 17 C.F.R. § 210.4- 01(a)(1), thus potentially leading to liability under § 11 of the Securities Act. The Plaintiffs do not point to any specific misstatements, but rely only on KPMG’s disclosure that the 2006 and 2007 statements contain material misstatements. The reality, though, is that KPMG approved Thornburg’s 2006 financials. Following the release of the March 4 letter, Thornburg restated its 2007 financials, but left untouched its 2006 financials. In response, KPMG wrote a letter, dated March 7, stating that it had reviewed Thornburg’s restatements and “we agree with such statements.” Supp. App. 884. The district court concluded, and the Underwriters argue here, that this letter was an implicit approval of both the original 2006 financials and the restated 2007 financials. The Plaintiffs -32- contend that this inference is an impermissible evaluation of the facts, and that there is an alternate, equally plausible interpretation of KPMG’s March 7, 2008 letter—that KPMG still thought the 2006 financials were misleading. Yet any ambiguity in the March 7 letter is cleared up in an auditing statement included with Thornburg’s refiling of its 2007 10-K statement on March 11, 2008. In that statement, KPMG says it has “audited the accompanying consolidated balance sheets . . . as of December 31, 2007 and 2006” and determined that they “present fairly, in all material respects, the financial position of Thornburg,” and that the statements were “in conformity with U.S. generally accepted accounting principles.” Supp. App. 538. The statement is dated February 27, 2008 “except as to Notes 1, 2, and 13, which are as of March 9, 2008.” Id. at 539. In Notes 1 and 2, KPMG explains that the basis of Thornburg’s 2007 restatement was the proper valuation of certain MBS assets that would have to be sold to meet margin calls. Id. at 545–46. There is no mention of the 2006 financials, nor any other indication that their contents were misleading. The 2006 financials were only included in the 2007 10-K statement, as is customary, to provide a point of comparison. Cf. Deephaven Private Placement Trading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168, 1170 (10th Cir. 2006) (referring to similar auditing language as “standard language of the profession”). Given this practice of automatically grouping the past two years together, it is highly unlikely that KPMG would have remained silent after -33- Thornburg’s correction if its accountants thought the 2006 financials were problematic. KPMG’s statements, along with Thornburg’s decision not to restate its 2006 financials, conclusively defeat any claim that relies solely on the March 4 KPMG letter. Because the Plaintiffs do not make any additional allegations concerning Thornburg’s 2006 financial statements, the Plaintiffs have not adequately alleged an actionable misrepresentation or omission to state a § 11 claim.