Opinion ID: 2807988
Heading Depth: 4
Heading Rank: 1

Heading: Dubuque and Murff 10

Text: Dubuque was President, CEO, and a director of Guaranty until his resignation on November 19, 2008. He was also Guaranty’s Chairman from August 26, 2008 until his resignation. Murff was Senior Executive Vice President and Chief Financial Officer of Guaranty until his resignation on July 10, 2009. From October 27, 2008 until his resignation, Murff was also Guaranty’s Principal Accounting Officer. Plaintiffs seek to hold Dubuque and Murff liable for their conduct throughout the Class Period, including statements made in Guaranty’s 2007 10-K, 2008 10-Qs, and several other statements made between February 2008 and November 2008. As discussed, supra, the SAC alleges that Dubuque and Murff knew of Guaranty’s undercapitalization and had a motive to falsify the MBS valuation to raise additional capital. However, because knowledge and motive alone are insufficient to raise a “strong inference” of scienter, Goldstein, 340 F.3d at 246, 9 Before the district court, plaintiffs argued that the timing of each defendant’s resignation suggested scienter. The district court concluded that Guaranty’s overall decline, rather than securities fraud, was likely the impetus for the resignations. The district court also concluded that defendants’ signatures on Sarbanes-Oxley certifications did not lead to scienter absent the signer’s knowledge of the underlying falsity or severe recklessness in recognizing it. See Garfield v. NDC Health Corp., 466 F.3d 1255, 1266 (11th Cir. 2006). On appeal, plaintiffs do not brief or argue either of these issues, so we do not include these factors in our analysis. See United States v. Whitfield, 590 F.3d 325, 346 (5th Cir. 2009) (“[A] party waives any argument that it fails to brief on appeal.”) (citing Fed. R. App. P. 28(a)(9)(A)). 10 We discuss Dubuque and Murff together because the allegations involving each largely overlap. 17 Case: 13-10928 Document: 00513076785 Page: 18 Date Filed: 06/12/2015 No. 13-10928 we consider whether additional scienter allegations raise the required inference. In addition to the knowledge allegations, the SAC alleges that Dubuque and Murff were aware of internal warnings regarding the MBS valuation. These allegations revolve around a confidential witness, designated in the SAC as CW1, who was responsible for purchasing MBS as Guaranty’s Senior Vice President of Investments and Secretary of the Asset Liability Committee (“ALCO”). 11 The SAC alleges that, in January 2007, CW1 sent an email to Dubuque and Murff identifying several deficiencies in Guaranty’s internal MBS pricing model, including (1) Guaranty’s use of outdated parameters to value MBS and assess MBS losses; (2) its failure to independently verify the cash flows used in valuing MBS; (3) the elimination of liquidity factors from its valuation; (4) inadequate accounting of interest rate changes on adjustable rate mortgages; and (5) inadequate modeling of credit risk. 12 The SAC further alleges that CW1 repeated his or her concerns about the model’s deficiencies at ALCO meetings attended by Dubuque and Murff. The SAC also alleges that CW5, the Chief Lending Officer and Chief Administrative Officer of Guaranty, attended ALCO meetings along with Dubuque and Murff, in which potential MBS write-downs were discussed. 13 The SAC alleges that Dubuque and Murff knew or recklessly ignored that the models were flawed, and continued to use 11 In cases under the PSLRA, plaintiffs may rely on confidential witnesses “provided 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.” Tchuruk, 291 F.3d 336, 352 (5th Cir. 2002). Here, plaintiffs describe the confidential witnesses’ job positions with sufficient particularity. 12 The district court discounted CW1’s email because it occurred before the Class Period. Knowledge gained before the Class Period may be retained months later and there is no indication that Guaranty drastically changed its valuation model after CW1’s email. Thus, the email is relevant to scienter. 13 The SAC does not plead with particularity the dates of the ALCO meetings or the substance of the conversations, alleging only that they began in the fourth quarter of 2007 and continued into 2008. Therefore, we do not draw any inferences from this allegation. 18 Case: 13-10928 Document: 00513076785 Page: 19 Date Filed: 06/12/2015 No. 13-10928 the models and report the resulting GAAP-noncompliant figures throughout the Class Period. Dubuque’s and Murff’s continued reliance on Guaranty’s internal valuation model and unchanged OTTI determinations, after CW1’s warnings, does not lead to a strong inference of scienter. That the reported figures are alleged to have violated GAAP is not, by itself, actionable. See Shaw, 537 F.3d at 534 (“[A] failure to follow GAAP, without more, does not establish scienter.”); Blackwell, 440 F.3d at 290 (“[F]ailure to follow accounting standards, without more, does not establish scienter.”). Plaintiffs must also plead facts leading to a strong inference that each defendant knew the numbers violated GAAP or was severely reckless in disregarding the concerns. See Abrams, 292 F.3d at 432. 14 An inference of severe recklessness is more likely when a statement violates an objective rule than when GAAP permits a range of acceptable outcomes. See In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620, 638 (E.D. Va. 2000) (“[I]f the GAAP rules . . . Defendants are alleged to have violated are relatively simple, it is more likely that the Defendants were aware of the violations and consciously or intentionally implemented or supported them, or were reckless in this regard.”). Applying GAAP often involves subjective determinations. See Fine v. Am. Solar King Corp., 919 F.2d 290, 297 (5th Cir. 1990) (“GAAP tolerates a wide range of acceptable Defendants propose a more difficult standard for pleading scienter related to 14 accounting estimates. They suggest that plaintiffs must plead the opinions were both (1) false and (2) not honestly believed by the defendant when made, a standard adopted by the Second and Ninth Circuits. See Fait v. Regions Fin. Corp., 655 F.3d 105, 113 (2nd Cir. 2011); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1162 (9th Cir. 2009). Requiring a plaintiff to allege that a defendant did not honestly believe a statement when made is inconsistent with the standard in this circuit, which permits scienter to be shown either by knowledge a defendant is publishing materially false information or by severe recklessness in publishing such information. See Abrams, 292 F.3d at 432. 19 Case: 13-10928 Document: 00513076785 Page: 20 Date Filed: 06/12/2015 No. 13-10928 procedures . . . .”); Thor Power Tool Co. v. C. I. R., 439 U.S. 522, 544 (1979) (“Accountants long have recognized that generally accepted accounting principles are far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions. Generally accepted accounting principles, rather, tolerate a range of reasonable treatments, leaving the choice among alternatives to management.”) (internal quotation marks omitted). While recognizing that some GAAP concepts may allow for subjective judgments, plaintiffs argue that defendants’ MBS valuation and decision not to recognize an OTTI were governed by objective standards. Specifically, plaintiffs argue that defendants violated an objective GAAP directive requiring that OTTI be assessed “at the individual security level” by failing to “drill down” and assess OTTI at the individual loan level. Plaintiffs misapprehend this GAAP requirement. In determining whether to recognize an OTTI, GAAP does not require a company to assess the likelihood of repayment of each of thousands of loans in each security. 15 Because plaintiffs do not allege that defendants failed to value each security, they have not plausibly alleged a violation of an objective GAAP component. Even at this early stage of the proceedings—where it is improper to engage in detailed discussion of GAAP rules—it is undeniable that there is some subjectivity present in Guaranty’s decision to continue using its internal models and to delay recognizing impairments as other than temporary. See FASB Staff Position No. EITF 99-20-1, at 1 (permitting “the use of reasonable management judgment of the probability that the holder will be unable to collect all amounts due”); id. at 4 (listing multiple factors that influence an OTTI determination); id. at 6 (“[J]udgment is required in determining whether 15 It is doubtful that Guaranty, as an investor in MBS, was even provided ongoing updates on the performance of each loan within the securities such that it could have engaged in a loan-by-loan valuation. 20 Case: 13-10928 Document: 00513076785 Page: 21 Date Filed: 06/12/2015 No. 13-10928 factors exist that indicate that an impairment loss has been incurred at the end of the reporting period. These judgments are based on subjective as well as objective factors.”). 16 Therefore, plaintiffs must show that Dubuque’s and Murff’s decision to disregard CW1’s warnings and to continue to use the internal model and OTTI recognition procedures was unreasonable even in light of the subjective nature of the GAAP requirements. See Fine, 919 F.2d at 297. Although plaintiffs argue that Dubuque and Murff were “repeatedly” made aware of the deficiencies in Guaranty’s models, the email from CW1 is the only warning alleged to have been conveyed to Dubuque and Murff. CW1’s warnings did not mention GAAP and do not seem to suggest that any issues were so severe that they could lead to a large overvaluation of the MBS portfolio. Dubuque and Murff relied on outside ratings agencies, which rated all of Guaranty’s MBS AAA until June 2008. We find that reliance on AAA ratings, when CW1 did not caution that reliance on major outside ratings agencies was unwarranted, was not severely reckless. FASB guidance explicitly instructs companies to consider a security’s credit rating when deciding whether to recognize a loss as other than temporary. Moreover, defendants were not alone in relying on AAA ratings in the face of potential red flags. OTS, Guaranty’s regulator, similarly failed to recognize risks associated with Guaranty’s MBS portfolio “primarily because the nonagency MBSs that Guaranty bought were graded AAA by credit rating agencies.” OTS’s report on Guaranty’s demise found that: “From 2004 through 2007, both [Guaranty] and OTS relied on the AAA ratings and considered the risk of purchasing AAA-rated nonagency 16We may consider these documents in our review because the SAC refers to them and they are in the record. See Tellabs, 551 U.S. at 322. 21 Case: 13-10928 Document: 00513076785 Page: 22 Date Filed: 06/12/2015 No. 13-10928 MBSs to be minimal.” At the time of CW1’s warnings in 2007, both Guaranty and its federal regulator viewed the AAA ratings to be a crucial factor in the MBS portfolio’s valuation. We find persuasive the Second Circuit’s discussion of very similar allegations in City of Pontiac Policemen’s and Firemen’s Retirement System v. UBS AG, 752 F.3d 173, 187 (2d Cir. 2014). There, plaintiffs alleged that UBS’s investment bank “disregarded . . . observable market inputs and red flags demonstrating that [its] mortgage-related asset portfolio was materially impaired” when it declined to write down its assets. Id. The Second Circuit held that UBS was not reckless in relying on the assets’ AAA rating in the face of internal and external uncertainty and disagreement about the valuation of mortgage-related assets. See id. The court concluded: While the collapse in the entire subprime market revealed UBS’s failure to recognize the vulnerability of all its mortgage-related assets to have been poor judgment, poor business judgment—even if attributable to monetary incentives—does not establish an inference of recklessness that is cogent and compelling [and] thus strong in light of other explanations. We do not recognize allegations of fraud by hindsight. Id. at 187–88 (internal quotation marks and citations omitted). Here, plaintiffs’ allegations similarly combine poor business judgment with financial motive. See Abrams, 292 F.3d at 433 (noting that failure to follow GAAP “can easily arise from negligence, oversight or simple mismanagement, none of which rise to the standard necessary to support a securities fraud action”). 17 Considered holistically, plaintiffs’ allegations of knowledge of Guaranty’s undercapitalization, a large misstatement, red flags, and ignorance of internal warnings, do not raise a strong inference of severe recklessness that is equally We do not foreclose the possibility of finding a strong inference of scienter based on 17 a GAAP violation in future cases should the totality of the allegations warrant such a finding. 22 Case: 13-10928 Document: 00513076785 Page: 23 Date Filed: 06/12/2015 No. 13-10928 as likely as the competing inference that Dubuque and Murff negligently relied on the AAA ratings and believed that Guaranty’s internal models were accurate. Plaintiffs come closest to alleging scienter by noting that Dubuque and Murff continued to use the internal models even after the ratings agencies downgraded or placed some of Guaranty’s MBS on negative watch. But the SAC contains no particularized allegations of renewed warnings to Dubuque and Murff in the 18 months between CW1’s January 2007 email and the earliest downgrades in June 2008. It is also undisputed that Guaranty never purchased the most junior tranche of MBS, meaning that there was a buffer before losses would begin to affect its portfolio. See Blackwell, 440 F.3d at 289 (finding no scienter, in part because outside investors absorbed the first 5 to 10% of losses). 18 We find that plaintiffs have not sufficiently alleged scienter as to Dubuque or Murff.