In a recent decision over liability for losses incurred as a result of the subprime lending crisis, Judge Richard J. Sullivan of the United States District Court for the Southern District of New York threw out numerous claims by stock and bond holders against Wachovia, in addition to several of its officers, directors, and auditors, which alleged that the defendants had overstated the stability and value of Wachovia’s holdings. Stichting Pensioenfonds ABP v. Wachovia Corp. (In re Wachovia Equity Sec. Litig.), 1:08-CV-6171, 2011 U.S. Dist. LEXIS 108279 (S.D.N.Y. 2011). Judge Sullivan’s holding highlights that, no matter how compelling the overarching narrative, claims of securities fraud must still be plausible and pleaded with particularity to survive a motion to dismiss.

Wachovia’s Demise

The allegations in the several complaints stemmed from Wachovia’s acquisition of Golden West in 2006, a company specializing in “Pick-A-Pay” adjustable-rate mortgages. Pick-A-Pay mortgages allowed borrowers to choose their payment rate each month, and even allowed for payments that did not cover the amount of interest that accrued monthly. Wachovia characterized these loans as “Alt-A,” or better than subprime. As the subprime lending crisis progressed, however, it became clear that the mortgages were drastically overvalued. The complaints alleged that this valuation was due, at least in part, to Wachovia’s failure to conform to its own purported appraisal standards. Wachovia lost billions of dollars from its books, causing the failure of the entire company, which was ultimately acquired by Wells Fargo for less than Wachovia had paid to acquire Golden West.  

The plaintiffs’ complaints painted an overarching narrative of Wachovia’s poor management and public statements that did not conform with reality, which allegedly led to tremendous losses. According to the complaints, the defendants overstated the quality of Golden West’s investments before the acquisition, and misrepresented the stability of the mortgages as the subprime lending crisis began. The plaintiffs also alleged that Wachovia did not follow its stated quality control procedures. In dismissing the majority of these claims, however, Judge Sullivan found that the complaints’ primary flaw was their failure to allege that the defendants either had information contradicting their allegedly fraudulent statements, or had an actual intent to defraud.

The Exchange Act Claims

The bulk of the securities fraud claims arose under Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), which imposes liability for material misstatements or omissions only if a defendant acted with scienter or, stated differently, with recklessness or motive and intent to defraud. Federal Rule of Civil Procedure 9(b) together with the Private Securities Litigation Reform Act (“PSLRA”), 15 U.S.C. § 78u-4(b), require that a plaintiff plead such claims with particularity, and that the allegations give rise to a strong inference of scienter. A “strong inference” of scienter exists when the inference is at least as compelling as any inference of lawful behavior.  

The court first dismissed the plaintiffs’ attempt to establish motive and intent to defraud by defendants’ profiting from the inflated value of Wachovia’s holdings and share value which resulted from the alleged misstatements. To show motive and intent to defraud, a plaintiff must allege that the defendants “benefitted in some concrete and personal way from the purported fraud.” The court noted that, although the defendants had sold “tens of thousands” of Wachovia shares during the relevant time period, their net holdings of vested Wachovia stock actually increased. This signaled “only confidence in the future of the company,” instead of suggesting that the defendants were trying to benefit by dumping their holdings while prices were inflated. Furthermore, while acknowledging that the artificial inflation of stock prices to use as “currency” for an acquisition could support a showing of scienter, the court found that the allegations of the complaints regarding Wachovia’s acquisition of Golden West merely demonstrated “a generalized desire to achieve a lucrative acquisition proposal.” Finally, the court noted that the complaints’ attempt to demonstrate motive and intent to defraud on the part of Wachovia’s directors and executives through the mere fact of executive compensation tied to stock value must fail, because otherwise “every company . . . that experiences a downturn in stock price could be forced to defend securities fraud actions.” The court thus held that the complaints had failed to adequately plead motive and intent to defraud.

The court also rejected the plaintiffs’ allegations that the defendants made reckless statements because information existed which contradicted the defendants’ public statements regarding Wachovia’s lending practices and the strength of Wachovia’s portfolio. In the securities fraud context, a finding of recklessness based upon possession of contradictory information requires a plaintiff to “specifically identify the reports or statements containing this information.” The complaints presented allegations of confidential witnesses who stated that — contrary to the defendants’ public statements — Wachovia did not follow its stated lending practices in certain cases and held subprime loans. The court pointed out, however, that the complaints failed to allege facts showing that the defendants actually possessed any of this information, and therefore the allegations of recklessness failed.

The plaintiffs attempted to bridge this gap by invoking the “core operations theory.” Under the core operations theory, “scienter may be imputed to key officers who should have known facts relating to the ‘core operations’ of their company.” Therefore, the plaintiffs alleged, because the defendants should have been aware of the company’s practice of hiring outside auditors and of the risky nature of the Pick-A-Pay mortgages, they should be charged with that knowledge when making the contradictory statements. Judge Sullivan acknowledged that the courts were split regarding the viability of the core operations theory in the securities fraud context. Judge Sullivan noted, however, that the core operations theory was in tension with the PSLRA’s requirement of particularity in pleading which “would seem to limit the force of general allegations about core company operations.” The court ultimately held that, because the PSLRA requires a plaintiff to allege that a defendant had actual knowledge contradicting his statements, the general core operations allegations were not sufficient to support a showing of recklessness.  

Finally, the court rejected the plaintiffs’ assertions that the defendants’ numerous laudatory statements regarding Wachovia’s practices and optimism regarding the quality of its various holdings constituted fraudulent statements. The court held that the defendants’ statements that Wachovia had a “‘highly disciplined’ risk management process” and a “reputation for ‘integrity’” were mere “puffery,” as statements too general to cause a reasonable investor to rely upon them and support a securities violation. The court also held that the defendants’ statements that the Pick-A-Pay loans were not “subprime” did not support an inference of scienter. The plaintiffs’ definition of subprime loans essentially applied the subprime label to any loan that defaulted during the subprime lending crisis; the court noted that such a post hoc definition could not support a finding that the defendants knowingly made misleading statements at the time of those statements.

Taking into account the allegations as a whole under the exacting pleading standard of the PSLRA, the court found that the complaints had not established that an inference of scienter was at least as compelling as an inference of lawful behavior. The court found that the most compelling inference based upon the facts alleged in the complaints was that the defendants “simply did not anticipate the full extent of the mortgage crisis and the resulting implications for the Pick-A-Pay loan portfolio.” Because negligence is insufficient to state a claim under Section 10(b), the court dismissed the 10(b) claims.  

The Securities Act Claims

The plaintiffs also alleged violations of Sections 11 and 12(a)(2) of the Securities Act, 15 U.S.C. §§ 77k(a), 77l(a)(2), which “create liability only for material misrepresentations or omissions in connection with a registered securities offering.” The court dismissed a number of these claims for lack of standing. The named plaintiffs argued that they had standing to sue as class representatives on behalf of all those who purchased securities traceable to the same shelf registration statements. A shelf registration statement permits an issuer to register multiple securities within a single SEC filing. The court disagreed with the plaintiffs, noting that Section 11 limits its causes of action to “any person acquiring . . . [a] security” under a given registration statement. Because the plaintiffs did not suffer injury from sales of securities they did not purchase, they could not assert standing to sue for injury suffered by purchasers of other securities registered within the same shelf registration statement, even if those other purchasers may have been among the class purportedly represented by the named plaintiffs. Therefore, the court dismissed claims based upon over half of the securities at issue, because the named plaintiffs had not purchased those securities.

The court, however, did allow certain Securities Act claims to proceed. Because Section 11 and 12(a)(2) claims may be premised upon negligence, and not fraud, the heightened pleading requirement of Federal Rule of Civil Procedure 9(b) does not necessarily apply. Therefore, although alleged misrepresentations regarding the value of mortgages in Wachovia’s portfolio were insufficient to support an inference of scienter necessary for liability under the Exchange Act, they did suffice to support a cause of action under the Securities Act.

Additionally, Section 11 imposes liability on all parties that play a role in a misleading registered offering, allowing for liability against a company’s auditors. Although auditors may technically avoid Section 11 liability by showing that they had reasonable grounds to believe that the statements at issue were true, such a “due diligence” defense is an affirmative defense, and therefore will not defeat a Section 11 claim at the motion to dismiss stage. The court thus also allowed certain Securities Act claims against Wachovia’s auditor, KPMG, to continue.

A Narrative Is Not Enough

Judge Sullivan’s decision in In re Wachovia Equity Securities Litigation highlights that a compelling narrative of mismanagement and misstatements is insufficient to support a claim of securities fraud unless a complaint points to specific facts demonstrating actual fraudulent intent or knowledge of contradictory information. Although the plaintiffs may have justifiably felt wronged and injured by Wachovia’s allegedly false statements and disastrous collapse, they were unable to allege facts that showed any specific fraudulent intent or possession of contradictory information by the defendants, and the bulk of their claims were thus doomed to fail.