In New Jersey Carpenters Health Fund v. Royal Bank of Scotland Group, PLC, 2013 U.S. App. LEXIS 4317 (2d Cir. Mar. 1, 2013), the United States Court of Appeals for the Second Circuit reversed the dismissal of a claim for violations of Sections 11 and 12(a)(2) of the Securities Act of 1933 (“Securities Act”), 15 U.S.C. §§ 77k, 77l, holding that the plaintiff pleaded sufficient facts to support a reasonable inference that defendants misstated mortgage underwriting guidelines to investors. This decision is notable for its application of the Federal Rule of Civil Procedure 8(a) pleading standard, as clarified by the United States Supreme Court in BellAtlantic Corp. v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2009), to claims under the Securities Act.
Plaintiff’s allegations centered on its May 2007 investment in a mortgage fund trust (the “trust”) offered by defendants. The trust was offered under a registration statement and supplemental prospectus (the “prospectus”) that provided a detailed description of the underwriting guidelines used in originating the mortgage loans. The prospectus also contained statements warning investors of certain risks associated with the trust, including a likelihood of higher loss and foreclosure rates, characteristics which would increase the likelihood of default, and systemic risks such as market decline.
The value of plaintiff’s investment decreased substantially between May 2007 and March 2010. Plaintiff sued, alleging that the registration statement and amended prospectus misstated defendants’ underwriting guidelines and failed to disclose defendants’ abandonment of those guidelines, thus violating Sections 11 and 12(a)(2).
The United States District Court for the Southern District of New York dismissed plaintiff’s complaint for failure to state a plausible claim, holding that plaintiff had failed to make allegations “specific to” the loan origination practices. N.J. Carpenters Health Fund v. NovaStar Mortg., Inc., No. 08 Civ. 5310(DAB), 2012 WL 1076143 (S.D.N.Y. Mar. 29, 2012). The district court also held that plaintiff had failed to allege the materiality of any potential misstatements or omissions in light of the risk disclosures that were contained in the prospectus. Plaintiff appealed.
The Second Circuit reversed. The Court acknowledged that the Rule 8(a) notice pleading standards set forth in Twombly and Iqbal apply to claims under Section 11 and 12(a)(2). The Second Circuit explained that courts may “draw a reasonable inference of liability” where the pleaded facts are “suggestive of” a finding of misconduct. The Court held that the existence of competing inferences does not render a plaintiff’s claim unreasonable unless those inferences rise to the level of “obvious alternative explanation[s].” In establishing this standard, the Court cited with approval the decision of the United States Court of Appeals for the First Circuit in Plumbers’ Union Local No. 12 Pension Fund v. Namer Asset Acceptance Corp., 632 F. 3d 762 (1st Cir. 2011), which applied the same standard to a similar case, and noted that the majority of districts within the Second Circuit have allowed similar claims to proceed where plaintiffs pled “fairly specific” accounts of systematic disregard of underwriting guidelines. The Court also contrasted the “plausible inference” pleading standard under Twombly/Iqbal with the “strong inference” pleading standard under the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b)(2)(A), and Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) [blog article here].
The Court held that plaintiff’s allegations, viewed as a whole, allowed for the reasonable inference that defendants had misstated their underwriting guidelines. Plaintiff provided three factual allegations in support of its claims: (1) that credit rating agencies had downgraded the trust’s rating due to loosening of underwriting practices; (2) that the trust experienced unusually high default rates; and (3) that statements of at least eight former employees contradicted the prospectus’ description of the trust’s underwriting standards. The Court noted that the alleged employee statements constituted a “more substantial source” that were not merely consistent with, but suggestive of defendants’ liability. These alleged statements, read in conjunction with plaintiff’s other factual allegations, described plaintiff’s claims with sufficient specificity to state a claim under Sections 11 and 12(a)(2).
Defendants argued that this inference of liability was unreasonable on three grounds. First, defendants argued that the testimony of unnamed employees was both untrustworthy and unrepresentative of company policy. The Court disagreed, noting that plaintiffs may rely on unnamed sources described with “sufficient particularity” to demonstrate the probability of their knowledge. The Court also noted that, as the former employees had allegedly worked at offices spread across the country, their statements could support a reasonable inference that they described company-wide policies. Next, defendants argued the inference of liability was unreasonable because the prospectus had disclosed the risk of higher rates of default and market collapse, and because the reduction in the trust’s rating was due to a deterioration of its credit quality. The Court disagreed again, noting that these facts did not rise to the level of an “obvious alternative explanation” and were consistent with plaintiff’s allegations. Finally, defendants argued that the prospectus did not misstate the loan origination practices because it disclosed that defendants could make “exceptions” to the underwriting guidelines. The Court rejected this argument as well, noting that a disclosure that “exceptions” might be made does not support complete abandonment of the underwriting standards.
Despite the Court’s attempt to reconcile the “plausible inference” pleading standard under Twombly/Iqbal with the “strong inference” pleading standard under Tellabs, some tension remains. While it may appear obvious that a “plausible inference” standard is less onerous than a “strong inference” standard, in practice the two standards arguably are converging. Perhaps when a court applies Twombly/Iqbal to a securities claim also subject to Tellabs it can provide some additional clarification.