A conflict has emerged in a trio of class certification rulings filed this year in the United States District Court for the Southern District of New York. Three cases with similar facts and theories split two-to-one in favor of granting class certification to mortgage-backed securities (“MBS”) investors. The courts differed on the quality of evidence defendants must put forward to raise the certification-defeating question of whether some portion of the proposed class knew about purported misrepresentations.
Before the last of these decisions, MBS litigants had cause to believe there was a general trend away from class certification in these cases. In 2006, the Second Circuit Court of Appeals had de-certified a securities class and tightened the standards for certification. In re Initial Pub. Offering Sec. Litig., 471 F.3d 24 (2d Cir. 2006) (“IPO”). In January 2011, the first Southern District decision in an MBS investor class action denied certification. Numerous individual MBS case filings followed, as well as the Supreme Court’s well publicized decision de-certifying a class in the Wal-Mart employment discrimination case. Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541 (2011) (“Wal-Mart”).
The two most recent Southern District cases, however, may have shifted the current back in plaintiffs’ favor. The conflict is now headed toward a possible resolution by the United States Court of Appeals for the Second Circuit.
Class Action Certification Standard
A federal court considering a class certification motion must first determine whether the claims meet four threshold requirements commonly referred to as numerosity, commonality, typicality and adequacy. If these threshold requirements are satisfied, as they were in each of the three Southern District cases, the court may then certify a class if questions of law common to the class predominate over individual issues, and if a class action would be superior to other available methods of adjudication.
All three Southern District cases involved claims brought under Section 11 of the Securities Act of 1933, for alleged misrepresentations in offering documents. Section 11 claims may be defeated with proof that purchasers were aware of the falsity of the representations or of the purported omissions at the time of the sale. Where plaintiffs within a proposed class differed in their knowledge, a court may find that individual knowledge determinations must be made and that such determinations will predominate over class issues. The Southern District split centered on this point.
The Second Circuit De-Certification Precedent
The significant precedent for these three cases was the Second Circuit decision in IPO. That case turned on the same issue faced by the three subsequent Southern District cases.
IPO concerned alleged schemes, undisclosed in registration statements and offering documents, by which underwriters increased their profits from initial public offerings. The underwriters allegedly required investors who wished to receive an allocation of shares in an offering to agree to buy additional shares in the secondary market. Plaintiff investors who had made such purchases brought claims under Section 11 for failure to disclose the scheme in registration statements. Plaintiffs pleaded that potential class members did not know about the scheme when they purchased. According to the Second Circuit, however, the pleadings themselves established the contrary as the plaintiffs had alleged an “industry-wide understanding” that the scheme existed. The scheme, as alleged, actually required the investors to know of it in advance because the investors had to agree to make aftermarket purchases before they would get an allocation to buy. Furthermore, discovery showed that cable news programs, Barron’s newspaper and even an SEC Staff Bulletin had discussed the aftermarket purchase requirements. The court concluded that “the broad extent of knowledge of the scheme throughout the community of market participants and watchers … would precipitate individual inquiries as to the knowledge of each member of the class,” defeating class certification. The Second Circuit did not elaborate, however, on how specific that knowledge must be.
Factual Background of the Three Southern District Cases
All three Southern District cases involved series of pass-through certificates that permit holders to collect principal and interest payments from a pool of residential home equity loans that are secured by mortgages. Two factors largely determine the certificates’ ultimate value, the ability of the underlying borrowers to make their payments, and the market price of the collateral. Defendants in these cases generally purchased the home equity loans from originators, deposited the loans into trusts, and securitized the cash flows through the certificates. Defendants then sold the certificates to investors in registered offerings. Within months after each of the offerings, the complaints alleged, delinquency and default rates on the underlying home equity loans began to rise, impeding cash flows and degrading the value of the certificates. Plaintiffs have attributed their losses to loan originators who failed to assess borrower credit or the fair value of the mortgaged properties, practices that plaintiffs claim “flagrantly violated underwriting guidelines” set forth in the relevant offering documents.
One Southern District Court Denies Class Certification
The first of the three Southern District class certification decisions was New Jersey Carpenters Health Fund, v. Residential Capital, LLC, 272 F.R.D. 160 (S.D.N.Y. Jan. 18, 2011) (“Residential Capital”). In the case, investors in mortgage-backed pass-through certificates brought a purported class action against underwriters alleging that the offering documents falsely represented the underwriting standards used in residential home loan originations. The court found that the threshold requirements supporting class certification were met, and moved on to consider whether issues that could be determined for the class as a whole predominated. As in IPO, the critical issue was knowledge.
In his decision, Judge Harold Baer Jr., detailed the evidence that one plaintiff’s investment advisor, Western Asset Management Company (“WAMCO”), had knowledge about lowered underwriting standards in the MBS market. A WAMCO representative testified that its analysts regularly met with mortgage originators, including the largest originator with respect to the certificates at issue, for the purpose of discussing their origination standards and field practices. According to the court, WAMCO’s witness testified that they had been closely following the deterioration in underwriting standards for years, and knew of the heightened risks. The court observed that many of the other putative class members were also “steeped in the mortgage-backed securities market.” On this basis, the court concluded that individual issues concerning knowledge would predominate over common issues, and denied certification to the proposed class.
A Southern District Decision Favors Certification
In June 2011, Judge Jed S. Rakoff certified a class of MBS investors in Public Employees’ Retirement System of Mississippi v. Merrill Lynch & Co., Inc., 08 Civ. 10841 (S.D.N.Y. Aug. 22, 2011) (“Miss.PERS”) (Judge Rakoff issued his written opinion in August). The case concerns pass-through certificates originally valued at around $16.5 billion, that allegedly fell in value after delinquency and default rates in its underlying loan pool rose in 2007. Relying on Residential Capital and IPO, defendants provided evidence suggesting that sufficient information was available at the time of the offerings for sophisticated plaintiffs to have learned of the deteriorating underwriting standards in the MBS market.
Defendants pointed to statements in newspapers and reports that implied that certain plaintiffs were suspicious about mortgage origination practices generally. In one such statement, a PIMCO executive allegedly told the Wall Street Journal that he “assume[d] that appraisals [in the MBS market were] a little lofty.” Defendants also submitted evidence that certain plaintiffs were experts in, and had independently profited from, mortgage-backed securities, or had conducted “old-fashioned shoe-leather research” into the “degradation of underwriting standards.” Evidence of similar quality had been persuasive for defendants in Residential Capital. Here, the court found the evidence “generic” and “weak at best,” concluding that a “broad indictment of the housing market as a whole” did not suggest knowledge of the particular conduct at issue in the case.
As if to highlight the two courts’ different approaches to the evidence, where the Residential Capital court had cited the WAMCO testimony that showed the firm’s knowledge of weak industry standards, the Miss.PERS court cited WAMCO testimony denying knowledge of specific false statements in the offering documents at issue. The court distinguished IPO, noting that in this case, there was no evidence of industry-wide knowledge or of plaintiffs participating in the scheme.
The Supreme Court’s Wal-Mart Decision Has Little Impact
Following the Miss.PERS decision, the United States Supreme Court decided Wal-Mart. At the time, MBS defendants may have hoped they had received a new weapon against class certification.
In Wal-Mart, three named plaintiffs sought to represent a class of up to 1.5 million women who alleged that they had suffered discrimination in promotion decisions and pay while employed at Wal-Mart. The Supreme Court observed that the employment decisions at issue were made by individual managers without corporate oversight, and that plaintiffs had failed to provide a credible general theory of discrimination. Because finding at least one common question to bind the class is a threshold requirement, the Court denied class certification.
In the context of securities litigation, however, it seems doubtful that Wal-Mart will serve as a significant impediment to class certifications. Judge Rakoff crisply distinguished the case when he issued his written opinion, holding that it had “little to no bearing” on his decision in Miss.PERS. Judge Rakoff explained that Wal-Mart turned on the threshold issue of commonality, a requirement that is easily met in securities cases where many common issues surround the content of the offering documents.
A Second Southern District Court Certifies a Class
On August 16, 2011, Judge Paul A. Crotty issued the third Southern District MBS class certification ruling of the year, New Jersey Carpenters Health Fund v. DLJ Mortgage Capital, Inc., No. 08 Civ. 5653 (S.D.N.Y. Aug. 16, 2011) (“DLJ Mortgage”). In that case, Lead Plaintiff New Jersey Carpenters Health Fund brought suit, alleging violations of Section 11 of the Securities Act by defendants in the sale of $2.39 billion of pass-through certificates.
Looking to IPO and Residential Capital, defendants argued that “sufficient information was publicly available” to raise the inference that sophisticated plaintiffs may have known about the troubles in the subprime market. Defendants pointed to “rising delinquency and default rates, three trustee reports which discussed the delinquency rates of the collateral pool, and news reports” regarding one loan originator’s practices.
In its ruling, the court distinguished IPO and Residential Capital, concluding that the evidence adduced here by defendants did not rise to the same level. In those cases, the court explained, there was explicit testimonial and documentary evidence suggesting knowledge by particular class members. Here, the evidence did not relate to the certificates at issue, and the mere fact that some members of the plaintiff class were sophisticated financial institutions could not defeat class certification.
These three Southern District cases dealt with very similar facts and differed somewhat on the quality of their evidentiary submissions, but they also appear to differ in their interpretation of the applicable standard. The Residential Capital court found that evidence of some plaintiffs’ expertise in the MBS industry was sufficient to raise the knowledge question and defeat class certification. The Miss.PERS and DLJ Mortgage courts insisted on a showing that plaintiffs had specific knowledge going to the offering at issue. The Second Circuit has now accepted an interlocutory appeal in the Residential Capital case, the outcome of which will likely shed further light on the level of knowledge required to defeat class action certification in MBS cases.