Opinion ID: 822874
Heading Depth: 2
Heading Rank: 1

Heading: Misstatements or Omissions

Text: Section 11 of the ’33 Act provides: In case any part of [a] registration statement . . . contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may . . . sue—(1) every person who signed the registration statement; (2) every person who was a director of . . . or partner in the issuer at the time of the filing[;] . . . [and] (5) every underwriter with respect to such security. 15 U.S.C. § 77k(a). Section 12(a)(2), in turn, permits a plaintiff to sue “[a]ny person” who “offers or sells a security . . . by means of a prospectus . . . which includes an untrue statement of 15 a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading.” 15 U.S.C. § 77l(a)(2). “Claims under sections 11 and 12(a)(2) are . . . Securities Act siblings with roughly parallel elements.” In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 359 (2d Cir. 2010). “So long as a plaintiff establishes one of the three bases for liability under these provisions—(1) a material misrepresentation; (2) a material omission in contravention of an affirmative legal disclosure obligation; or (3) a material omission of information that is necessary to prevent existing disclosures from being misleading—then, in a Section 11 case, the general rule is that an issuer’s liability . . . is absolute.” Litwin, 634 F.3d at 715-16 (citation and internal quotation marks omitted). “[U]nlike securities fraud claims pursuant to section 10(b) of the Securities Exchange Act of 1934, plaintiffs bringing claims under sections 11 and 12(a)(2) need not allege scienter, reliance, or loss causation.” Morgan Stanley Info. Fund, 592 F.3d at 359 (citation omitted).4 Because claims under §§ 11 & 12(a)(2) of the ’33 Act need not include allegations of fraud, “this is an ordinary notice pleading case, subject only to the ‘short and plain statement’ requirements of Federal Rule of Civil Procedure 8(a).” Litwin, 634 F.3d at 715. Thus, as described above, to prevail on appeal, the Fund must have alleged “factual content that allows the court to draw the reasonable inference that the [Defendants-Appellees are] liable for the misconduct alleged.” Iqbal, 556 U.S. at 678. Here, the Fund’s general claim that NMI abandoned 4 The Fund also asserted a claim based on § 15 of the ’33 Act. That sections imposes liability on anyone who “controls any person liable under” §§ 11 & 12(a)(2). See 15 U.S.C. § 77o(a). Because the district court held that the Fund had failed to state a claim under §§ 11 & 12(a)(2), it further dismissed the Fund’s claim under § 15. N.J. Carpenters, 2012 WL 1076143, at . As described below, we reverse the district court’s decision with respect to the claims under §§ 11 & 12(a)(2). Accordingly, we also vacate its decision to dismiss the claims under § 15. 16 its underwriting guidelines is the functional equivalent of an allegation that the 2007-2 Prospectus contained material misstatements and omissions. We need not accept such a “legal conclusion” merely because the Fund has “couched” it as a “factual allegation.” Id. (quoting Twombly, 550 U.S. at 555). In contrast, however, the Fund’s allegations concerning default rates, credit ratings, and NMI’s specific practices—as described by its former employees—all contain “factual content,” which we must accept as true. Id. The question, then, is whether this factual content permits us to draw the “reasonable inference” that NMI abandoned its underwriting guidelines, rendering the statements in the 2007-2 Prospectus misleading and incomplete. Id. The Supreme Court has offered considerable guidance on what qualifies as a “reasonable inference.” For example, in Twombly, the Supreme Court clarified that factual content that is “merely consistent with,” rather than suggestive of, a finding of liability will not support a reasonable inference. 550 U.S. at 556. Thus, where the antitrust laws required a plaintiff to plead that the defendants had agreed not to compete, the plaintiff could not simply rely on allegations that the defendants had acted as if they had agreed. Id. at 566-68. As the Supreme Court explained, the conditions of the relevant market provided an “obvious alternative explanation” for the conduct alleged, specifically, that the defendants had more to lose by competing with one another than they had to gain. Id. The factual content at issue, then, would not support a reasonable inference of liability because it was “just as much in line with a wide swath of rational and competitive business strategy.” Id. at 554. The Supreme Court has also implicitly contrasted the reasonable inference standard with the higher standard that applies under the Private Securities Litigation Reform Act (“PSLRA”), 15 U.S.C. § 78u-4. When construing the PSLRA’s requirement that plaintiffs in securities fraud cases allege facts that support a “strong inference” of scienter, id. § 78u-4(b)(2)(A), the Supreme 17 Court emphasized that a strong inference “must be more than merely ‘reasonable’ or ‘permissible’—it must be cogent and compelling, thus strong in light of other explanations.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007). The Supreme Court further held that an inference qualifies as strong “only if a reasonable person would deem [it] . . . at least as compelling as any opposing inference one could draw from the facts alleged.” Id. By implication, then, a reasonable inference need not be “as compelling as any opposing inference” one might draw from the same factual allegations. Thus, courts may draw a reasonable inference of liability when the facts alleged are suggestive of, rather than merely consistent with, a finding of misconduct. Moreover, the existence of other, competing inferences does not prevent the plaintiff’s desired inference from qualifying as reasonable unless at least one of those competing inference rises to the level of an “obvious alternative explanation.”5 The United States Court of Appeals for the First Circuit has applied this standard to a similar set of allegations. See Plumbers’ Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp., 632 F.3d 762 (1st Cir. 2011). In Nomura, as here, the plaintiff brought claims under §§ 11, 12(a)(2), & 15 of the ’33 Act, alleging that the offering documents of certain mortgage-backed securities misstated the relevant underwriter’s guidelines. Id. at 766, 772. Specifically, the plaintiff alleged that “First National Bank of Nevada (‘FNBN’), one of the ‘key’ 5 The Supreme Court has not defined the phrase “obvious alternative explanation.” See generally Iqbal, 556 U.S. at 682; Twombly, 550 U.S. at 567. Whatever the phrase means, the standard under Rule 8(a) undoubtedly remains less stringent than the “heightened” pleading standard imposed by the PSLRA. See Tellabs, 551 U.S. at 321. The resolution of this appeal, however, does not depend on a precise definition of “obvious alternative explanation” because no argument advanced by the DefendantsAppellants even comes close to identifying such an explanation. As described below, the DefendantsAppellants’ explanations for the SAC’s factual content do not impugn the inference of liability that the Fund asks us to draw. In other words, even crediting the Defendants-Appellants’ explanations, the Fund’s inference of liability remains reasonable. 18 loan originators” for the relevant securities, had “‘routinely violated’ its lending guidelines,” approving “as many loans as possible” and “even ‘scrub[bing]’ loan applications of potentially disqualifying material.” Id. at 772 (alteration in original). These practices allegedly contradicted the registration statement’s claim that borrowers had “demonstrate[d] an established ability to repay” and that FNBN had “verified” their employment history. Id. at 772-73. Finally, the complaint asserted that, in 2007, Moody’s had “downgraded the rating of all of the” securities. Id. at 766. Considering “whether enough ha[d] been said in the complaint . . . to link [FNBN’s] practices with . . . the mortgages that underpinned” the securities at issue, the First Circuit, with Judge Michael Boudin writing for the Court, held that, although a “judgment call, the sharp drop in the credit ratings after the sales and the specific allegations as to FNBN offer enough basis to warrant some initial discovery aimed at these precise allegations.” Id. at 773-74. In passing, the First Circuit commented that “[s]imilar complaints in other cases have cited to more substantial sources, including statements from confidential witnesses, former employees and internal emails.” Id. at 773. A majority of district courts in this Circuit have agreed with the First Circuit, permitting claims under §§ 11 & 12(a)(2) of the ’33 Act to proceed where the plaintiff has provided a “fairly specific” account of how the relevant underwriters had systematically disregarded the guidelines disclosed in a security’s registration statement. Id.; see In re Morgan Stanley Mortg. Pass-Through Certificates Litig., 810 F. Supp. 2d 650, 672 (S.D.N.Y. 2011); Emps.’ Ret. Sys. of the Gov't of the V.I. v. J.P. Morgan Chase & Co., 804 F. Supp. 2d 141, 152-53 (S.D.N.Y. 2011); In re IndyMac Mortg.-Backed Sec. Litig., 718 F. Supp. 2d 495, 509-10 (S.D.N.Y. 2010); Pub. Emps.’ Ret. Sys. of Miss. v. Merrill Lynch & Co., 714 F. Supp. 2d 475, 483 (S.D.N.Y. 2010); N.J. Carpenters Health Fund v. Residential Capital LLC, No. 08 Civ 8781(HB), 2010 WL 19 1257528, at  (S.D.N.Y. Mar. 31, 2010); N.J. Carpenters Health Fund v. DLJ Mortg. Capital, Inc., No. 08 Civ 5653(PAC), 2010 WL 1473288, at - (S.D.N.Y. Mar. 29, 2010).6 We also agree. Here, the SAC incorporates one of the “more substantial sources” identified by the First Circuit. Nomura, 632 F.3d at 773. The statements from prior NMFC and NMI employees suggest that NMI—throughout the relevant time period and at different locations across the country—disregarded its underwriting guidelines, approving loan applications despite deficiencies in an effort to generate a large volume of mortgages that it could sell to third parties. These allegations are suggestive of, rather than merely consistent with, a finding of liability. To connect its specific description of NMI’s conduct with the Series 2007-2 Trust, the Fund has alleged that the loans in the trust had exceedingly high rates of early payment default. Had NMI in fact disregarded its underwriting guidelines, which helped it to “evaluate” each borrower’s “capacity and willingness . . . to repay,” J. App’x at 370, it would have become more vulnerable to mortgage fraud. Thus, according to the FBI’s 2007 Mortgage Fraud Report, which the SAC referenced, one would reasonably expect higher rates of early payment default, like those allegedly experienced by the Series 2007-2 Trust, to be a consequence of loosened underwriting. Finally, the Fund has alleged that the credit rating agencies, after becoming 6 In support of its contrary holding, the district court cited two cases. First, it relied on a case in which a court concluded that allegations that a mortgage originator had “abandoned” its “guidelines and issued Mortgage Loans with little or no consideration for borrowers’ ability to repay” failed to state a securities fraud claim under the heightened standard set forth in the PSLRA. Footbridge Ltd. v. Countrywide Home Loans, Inc., No. 09 Civ. 4050(PKC), 2010 WL 3790810, at - (S.D.N.Y. Sept. 28, 2010). The district court also cited a case that held that, although the “strong nature of the cautionary language contained in . . . disclosure materials brings this case very close to the dismissal line,” plaintiffs were nonetheless entitled to replead in order to “put the court in a better position from which to evaluate the merits of the claims alleged.” City of Ann Arbor Emps.’ Ret. Sys. v. Citigroup Mortg. Loan Trust Inc., 703 F. Supp. 2d 253, 263-64 (E.D.N.Y. 2010). To support its claim that the complaint was “very close to the dismissal line,” the court in City of Ann Arbor cited Plumbers’ Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp., 658 F. Supp. 2d 299 (D. Mass. 2009), the district court decision that the First Circuit later reversed on this issue. 20 concerned about “loose” and “aggressive” underwriting, expressed greater and greater skepticism about the Series 2007-2 Trust. J. App’x at 1786-88. In sum, the Fund has alleged that NMI disregarded its underwriting guidelines in specific ways, that the signs of disregard materialized for the Series 2007-2 Trust, and that those charged with evaluating the security looked for disregard and apparently found it. These allegations, taken together, permit us to draw the reasonable inference that the 2007-2 Prospectus’s description of NMI’s underwriting standards misstated NMI’s actual practices, and the district court erred in concluding that something more was required.7 The Defendants-Appellees resist this conclusion, challenging the capacity of the Fund’s allegations to support any inference of liability. First, the Defendants-Appellees argue that we should distrust the unnamed prior employees’ purported statements and that, in any event, those few employees could have conceivably described NMI’s practices at only a tiny fraction of its 432 offices. Even under the higher standard imposed by the PSLRA, however, we have permitted plaintiffs to rely on unnamed sources so long as “they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.” Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir. 2000). Here, the SAC describes its sources as employees who would have participated in different aspects of NMI’s origination process during part or all of the relevant time period. These descriptions easily “support the probability” that the unnamed prior employees would 7 We do not attempt to identify any “minimum” that a plaintiff must plead in order to state a claim under §§ 11 & 12(a)(2) of the ’33 Act based on offering documents’ description of an underwriter’s guidelines. As the Supreme Court has observed, “[d]etermining whether a complaint states a plausible claim for relief will . . . be a context-specific task that requires the reviewing court to draw on its judicial experience and common sense.” Iqbal, 556 U.S. at 679. Nonetheless, we note that, both here and in Nomura, the plaintiff gave a “fairly specific” account of a “key” underwriter’s practices and alleged facts that tied the purported practices to the specific securities at issue. 632 F.3d at 772-74. 21 have the alleged knowledge of NMI’s underwriting practices. Id.; see also New Orleans Emps.’ Ret. Sys. v. Celestica, Inc., 455 F. App’x 10, 13-14 (2d Cir. 2011) (summary order). Moreover, although the unnamed employees apparently worked at only a few of NMI’s many offices, the SAC alleges that those offices were “regional operations offices” and that they were spread across the country. J. App’x at 1771-72. Finally, the statements relayed in the SAC provide no basis for believing that factors unique to the relevant offices, rather than company-wide practices, resulted in the “pressure to achieve loan production” that these employees allegedly experienced. Id. at 1775. Thus, we must draw the reasonable inference that these factual allegations support, namely, that the unnamed employees described widespread practices at NMI. Litwin, 634 F.3d at 715. Second, the Defendants-Appellees argue that the 2007-2 Prospectus disclosed that the loans in the Series 2007-2 Trust might default at rates “higher,” and perhaps even “substantially higher,” than those experienced by loans that conformed to different standards. J. App’x at 297. According to the Defendants-Appellees, the materialization of the very risks described in the 2007-2 Prospectus, including the risk that the housing market would collapse, explains the default rates alleged by the SAC, rendering the inferences the Fund attempts to draw unreasonable. But this argument does not provide an “obvious alternative explanation.” Twombly, 550 U.S. at 556. The fact that the risks described in the 2007-2 Prospectus may have caused many of the defaults that occurred does not impugn the Fund’s central allegation, namely, that unconstrained underwriting increased the number of defaults, causing the ultimate rate of default to “skyrocket[]” to 68.6%. J. App’x at 1790.8 Moreover, the SAC relies not only on the 8 If, after discovery, the Fund successfully proves that the 2007-2 Prospectus in fact misstated NMI’s underwriting practices, then evidence that other risks caused the defaults that occurred would 22 number of defaults that occurred, but also on the timing of those defaults. Given the findings set forth in the FBI’s 2007 Mortgage Fraud Report, the frequency of early defaults suggests that mortgage fraud contaminated a significant portion of the loans in the Series 2007-2 Trust.9 Because anyone evaluating a borrower’s “capacity and willingness” to repay a loan would want to detect fraud, J. App’x at 370, the apparent portion of the Series 2007-2 Trust that was affected by fraud provides additional support for the Fund’s conclusion that NMI employees did not conduct the evaluations that the company’s disclosed underwriting guidelines required. Third, the Defendants-Appellees argue that the rating agencies reduced the Series 2007-2 Trust’s ratings not because they had discovered NMI’s underwriting practices, but instead because the trust’s credit quality had deteriorated. Once again, however, the deterioration of the trust’s credit quality is wholly consistent with the Fund’s allegation that NMI had abandoned its underwriting guidelines. Indeed, the rating agencies’ decisions to amend their methodologies to account for instances of loosened or aggressive underwriting indicates that adherence to published underwriting guidelines constituted one component of the credit quality that the agencies sought to assess. Thus, the SAC’s claim that the rating agencies significantly reduced the Series 2007-2 Trust’s ratings after amending their methodologies to account for aggressive underwriting again provides further support for the inference that the Fund asks us to draw. pertain only to the calculation of damages. Under § 11(e), for example, the Defendants-Appellees may prove “that any portion or all of [the Fund’s] damages represents other than the depreciation in value of such security resulting from such part of the registration statement, with respect to which . . . liability is asserted, not being true or omitting to state a material fact.” 15 U.S.C. § 77k(e). 9 The SAC alleges that 18% of the loans defaulted within six months of the Series 2007-2 Trust’s offering. The 2007-2 Prospectus disclosed that 91.9% of the loans in the Series 2007-2 Trust had been originated within six months of the offering. While we cannot know exactly what percentage of the loans that defaulted no later than six months after the offering had been originated more than six months before the offering, at least 9.9% of the loans in the trust defaulted within a year of their origination. 23 Finally, the Defendants-Appellees argue that the 2007-2 Prospectus did not misstate NMI’s origination practices because it disclosed that NMI could make “exceptions to [its] underwriting guidelines” based on any “criteria” that “the loan underwriter” found persuasive. J. App’x at 371. As the First Circuit has explained, however, “saying that exceptions occur” does not reveal what the Fund alleges, “namely, a wholesale abandonment of underwriting standards.” Nomura, 632 F.3d at 773. Thus, because the factual content set forth in the SAC allows us to draw the reasonable inference that NMI disregarded the underwriting standards described in the 2007-2 Prospectus, the acknowledgment that those standards permitted exceptions does not cure the misstatements and omissions that the Fund alleges.10 Discovery may reveal that the actual facts support the inferences drawn by the Defendants-Appellees, rather than those drawn by the Fund. But that has no bearing on the question before us. As the Supreme Court explained in Twombly, “a well-pleaded complaint may proceed even if it strikes a savvy judge that actual proof of those facts is improbable, and that recovery is very remote and unlikely.” 550 U.S. at 556 (internal quotation marks omitted). Thus, we ask only whether the facts alleged in the SAC, taken as true, allow us to draw the “reasonable inference” that the Series 2007-2 Trust’s offering documents contained misstatements and omissions. Iqbal, 556 U.S. at 678. For the reasons set forth above, we find the SAC’s factual allegations support such an inference. 10 We do not consider the SAC’s allegations that the underwriters of the Series 2007-2 Trust failed to reasonably investigate the 2007-2 Prospectus’s description of NMI’s underwriting standards. Whether the underwriters conducted a reasonable investigation pertains only to an affirmative defense that the Defendants-Appellees may raise in future proceedings. See 15 U.S.C. § 77k(b)(3); cf. Pani v. Empire Blue Cross Blue Shield, 152 F.3d 67, 74 (2d Cir. 1998) (“An affirmative defense may be raised by a pre-answer motion to dismiss under Rule 12(b)(6), without resort to summary judgment procedure, if the defense appears on the face of the complaint.”). 24