In early 2007, a purported class of investors in NovaStar Financial Corporation, a residential mortgage lender that made a percentage of its loans to subprime borrowers, sued NovaStar and certain of its directors and officers in the United States District Court for the Western District of Missouri. In their complaint, the plaintiffs alleged that the NovaStar defendants failed to adequately disclose NovaStar’s exposure to the downturn in the housing market arising out of (1) its alleged practice of disregarding internal underwriting practices in lending to subprime borrowers and (2) the risk that banks would stop purchasing securitizations of subprime loans once the housing crisis began. On June 4, 2008, the District Court dismissed the purported securities class action. The plaintiffs have now appealed this dismissal to the Eighth Circuit Court of Appeals. A copy of the plaintiffs' brief can be found here.

In dismissing this purported class action, the court ruled that the plaintiffs had failed to meet the stringent requirements for pleading securities fraud under the Private Securities Litigation Reform Act (PSLRA). Specifically, the Court found that the plaintiffs had not alleged facts giving rise to an inference of scienter because the “Plaintiff's allegations are more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community.”

On appeal, the plaintiffs argue that, under the competing inferences standard set forth by the U.S. Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the inference that the NovaStar defendants acted knowingly or recklessly is as at least as compelling as the inference drawn by the District Court. In support of their argument, the plaintiffs point to the NovaStar defendants’ efforts to distinguish NovaStar’s financial situation from that of its competitors that were similarly exposed to the subprime mortgage crisis. In addition, the plaintiffs allege that there was a disconnect between the company’s internal communications and its public disclosures, which allegedly gives rise to the inference that senior management knowingly or recklessly misrepresented NovaStar’s financial condition.