September 22, 2010
Litigating the Financial Crisis: The World v. Countrywide (aka SEC v. Mozilo, et al.)
Posted by Christine Hurt

The 2008 Financial Crisis is an interesting reference point in examining the role of civil litigation in disciplining would-be wrongdoers and compensating losing investors.  What does a shareholder do when the firm loses a lot of money during a time when many firms inside and outside the industry lost money, particularly when losses are exacerbated by a common business strategy.  So, we have shareholder suits (derivative and securities fraud) against financial firms such as Goldman and Citigroup asserting such claims as (1) the board shirked its oversight responsibilities by not putting the brakes on risky business strategy and (2) the firm made false statements or omissions by not disclosing its risky business strategy.  These are tough claims to make, or one would think so.  State law oversight cases are not winners generally, and it's hard to point to a particular false statement or omission relating to broad business strategy.

So then what is going on in California with these Countrywide Financial cases?  As we all recall, Countrywide was the largest mortgage lender in the U.S. prior to the 2008 Financial Crisis.  Countrywide sold some mortgages to government sponsered entities (Fannie Mae, etc.), securitized many of them, and held some of them.  Countrywide was eventually acquired by Bank of America in 2008 after sustaining heavy losses in 2007 and 2008 and is currently a subsidiary of BoA.  The probable cause of those losses was Countrywide's increasing origination of high-risk mortgages, which then went into default in record numbers.  Then came the lawsuits:  derivative suits against Countrywide; private securities lawsuits against Countrywide; derivative suits relating to the BoA acquisition, criminal investigation of individual officers, and SEC enforcement action against individual officers.  But surely shareholders aren't winning?  Um, actually, yes.  So, in In re Countrywide Fin. Corp. Sec. Litig., 588 F. Supp.2d 1132 (C.D. Cal. 2008), the court rejected a MTD, even against individual officers.  For those of you used to reading loss causation opinions from other circuits, turn your attention to the cursory attention given to loss causation here.  How do you prove loss causation with so much else going on in the market in 2007?  The court is confident that this can be done.  So, that case settled for $600 million.  I believe the derivative suits are ongoing.

And recently, the Central District of California denied individual Countrywide Defendants' MSJ in the civil proceeding brought by the SEC for securities fraud (Law.com story here; order here; SEC complaint here.).  Having been tipped to this case by a student, I had already read the motions and was surprised by the outcome.  Even as the court admits that "[T]he mere fact that countrywide allegedly engaged in a risky or flawed business strategy does not violate the securities laws," there seems to be an undercurrent of general blame against the firm for making risky loans.  But, this is a securities fraud case, so where are the misstatements?  Here:

We don't see any change in our protocol relative to the quality of loans that we're originating "not aware of any change of substance in [Countrywide's] underwriting policies" "countrywide had not taken any steps to reduce the quality of its underwriting regimen" "backed away from the subprime area because of our concern over credit quality" "it would be a 'mistake' to compare monoline subprime lenders to Countrywide"

Man, those are stretches to me. The third one seems to be the only factual claim easily subject to verification. The other hook that the SEC hangs its hat on is the fact that instead of classifying its loans as "prime" and "nonprime," Countrywide had three classes: "conventional conforming," "conventional nonconforming," "Prime Home Equity" and "nonprime."  The SEC asserts that "prime" has a well-accepted meaning, so Countrywide was misleading.  However, Countrywide defined those categories and also included a table that listed all orginiated loans by a number of factors, which should have scared off anyone.  So, looking at the chart, someone would see that 85% of the loans at a loan-to-value ratio of over 95% and a weighted loan-to-value ratio of 99%. 

So, the defendants make arguments that you would expect:  truth on the market, puffery.  But these arguments didn't win in the private lawsuit, and they don't win here.  Here, the Court remarks that "truth on the market" is inapplicable to suits brought by the SEC because the SEC doesn't have to resort to "fraud on the market" because no reliance element.  The court notes that thought "[i]n the vast majority of cases such statements would be nonactionable puffery, "'that in this case "a company's essential operations were so at odds with the company's public statements that [the statements] are rendered cognizable to the securities laws.'"  Trial in October.

There are a lot more issues concerning the liability of the particular individuals, but that's all for now.

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