The United States District Court for the Southern District of New York recently dismissed for a second time a federal securities class action against American Express Co. (“Amex”). The action, entitled In re: American Express Co. Securities Litigation, involves substantial losses by Amex from investments by one of its subsidiaries in high-risk, high-yield debt instruments. Although the suit was originally filed in July 2002, it bears some striking similarities to today’s credit crunch problems and provides insight into how courts should analyze cases involving more recent losses.
The Amex action involves losses resulting from investments that Amex’s subsidiary, American Express Financial Advisors (“AEFA”), made in high-yield, high-risk debt securities beginning in 1997. At that time, AEFA began under-pricing its insurance products to increase sales. In order to maintain profitability despite lower premium revenues, AEFA increased the percentage of its investment portfolio in high-risk, high-yield debt securities, including collateralized debt obligations. The market for those assets, however, began to dry up in 2001, forcing AEFA and Amex, as its parent, to write down the value of those assets. Shareholders then filed a class action in July 2002 accusing Amex of misrepresenting the risk to its balance sheet from owning these securities. The plaintiffs then filed a First Amended Complaint in December 2002, which more precisely accused Amex of: (1) misrepresenting its high-yield investments as conservative; (2) concealing the full extent it was exposed to such risk; (3) failing to disclose that Amex lacked sufficient risk management controls to measure that exposure; and (4) failing to disclose Amex’s violations of Generally Accepted Accounting Procedures (“GAAP”) in reporting the debt securities on its books.
In its original ruling in March 2004, the District Court dismissed the first two claims, ruling that the plaintiffs had failed to identify any misrepresentations that the high-yield investments were conservative and that the alleged misrepresentations about Amex’s risk exposure were protected forward looking statements. The court then dismissed the remaining two claims regarding Amex’s risk management controls and accounting, ruling that they were time barred. The Second Circuit disagreed as to the latter two claims, ruling that the risk management control and accounting claims were not time-barred because they related back to the first and second claims. The Second Circuit then granted the plaintiffs leave to file a Second Amended Complaint.
The Second Amended Complaint accused the defendants of: (1) making false and misleading statements about Amex’s risk management policies; (2) failing to properly account for AEFA’s losses in accordance with GAAP; and (3) mischaracterizing the deteriorating market and risks posed by the debt securities throughout 2001. The alleged violations of GAAP mainly involved the valuation of the debt securities based on Amex’s carrying costs, rather than writing them down based on significant decreases in the securities’ fair market values. As to scienter, the Second Amended Complaint alleged that the Individual Defendants were motivated to commit fraud by their desire to meet the aggressive revenue targets set by Amex and that certain Individual Defendants were motivated by their incentive compensation.
Relying in large part on Tellabs, Inc. v. Makor Issues & Rights, Ltd., __ U.S. ___, 127 S.Ct. 2499 (2007), the District Court again dismissed the action. According to the District Court, Tellabs requires that the plaintiffs must plead with particularity a strong inference of scienter and in doing so, must “take into account plausible opposing inferences.” Id., at 2510. This means that “a reasonable person [must] deem [it] cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” Id. The District Court ruled that the general allegations of scienter in the Second Amended Complaint did not meet this standard, were conclusory and should not be given any weight.
The District Court next considered specific allegations of scienter based upon the alleged statements of nine different confidential informants suggesting that the Individual Defendants were warned about the risks associated with the debt securities at issue. Citing Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753, 757 (7th Cir. 2007) , the court held that, for confidential informants to establish scienter, the complaint must provide adequate information about the confidential informants to support the assertion that they had access to the information. The District Court then noted that, in the Amex action, there are no allegations that any of the confidential informants had access to information about Amex’s risk control policies, Amex's alleged violation of GAAP or any materials contradicting any public statements at issue. To the contrary, the confidential statements relied upon in the Second Amended Complaint indicate only that certain Individual Defendants knew that the debt securities at issue posed some risks, not that Amex was not properly monitoring and evaluating those risks. The District Court, therefore, concluded that the only reasonable inference was that Amex had begun investigating the decline of these debt securities in an effort to get a handle on the problem as soon as it arose.
The current credit crisis, like the investments at issue in Amex, involves a liquidity crisis that has led to the write down of debt securities. In both instances, investors purchased these securities as a means of achieving better than average returns. As the demand for these debt securities disappeared, however, investors could no longer carry these securities on their books at cost. Instead, they were forced to write the securities down based on the absence of any demand, and thus market value, therefor. In both instances, these problems quickly escalated and investors have asserted that the potential risk of such a liquidity problem was not properly disclosed. Given these similarities, it seems likely that any court faced with securities claims arising out of the current debt crisis should look to the Amex ruling for guidance.