On September 28, 2017, the United States Court of Appeals for the Second Circuit affirmed a judgment, entered after a bench trial by Judge Denise Cote of the United States District Court for the Southern District of New York, awarding $806 million for claims brought under Sections 12(a)(2) and 15 of the Securities Act of 1933 (the “Securities Act”) and provisions of the D.C. and Virginia “blue sky” laws in connection with the sale of residential mortgage backed securities (“RMBS”) to the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Fed. Hous. Fin. Agency for Fed. Nat’l Mortg. Ass’n v. Nomura Holding Am., Inc., —F.3d—, 2017 WL 4293322 (2d Cir. 2017). The trial court found that the RMBS prospectus supplements falsely stated that the underlying loans had been originated generally in accordance with the mortgage originators’ loan underwriting guidelines. In a 151-page opinion, the Second Circuit affirmed Judge Cote’s legal rulings and factual findings. Many of the issues addressed in the opinion relate specifically to RMBS and the RMBS securitization process and are beyond the scope of this summary. Several of the Second Circuit’s key holdings regarding the interpretation and application of the Securities Act may be of broader applicability and are highlighted below, although many such holdings also appear to have been informed to some degree by the specific context of the decision.

First, the Second Circuit stated that it had “[f]ollow[ed] the parties’ lead” and assumed that Merck & Co., Inc. v. Reynolds, 599 U.S. 633 (2010) (which involved Section 10(b) of the Securities Exchange Act of 1934) applied to the limitations period under Section 13 of the Securities Act. See 2017 WL 4293322, at *21 n.37. The Court held that, under Merck, the Securities Act statute of limitations begins to run only when, in the course of an investigation into “storm warnings” suggesting the probability of a securities law violation, a reasonable plaintiff would have discovered sufficient information to adequately plead a claim. The Court further held that mere “[g]eneralized knowledge” that originators issued defective loans was not a “storm warning” that would have caused a reasonable investor to believe necessarily that its particular RMBS certificates were backed by such loans, id. at *22, and that defendants bore the burden of proving how long it would have taken a reasonable investor to conduct an investigation to uncover sufficient information to plead a plausible securities law violation, id. at *23.

Second, the Court held that although a Section 12(a)(2) plaintiff must prove that it did not “know[]” of the material misstatement, a plaintiff is not required to undertake an affirmative factual investigation or to prove that it could not possibly have known the falsity of the misstatement at issue, and is required to prove only that it in fact lacked actual knowledge that the specific statement at issue was false. Thus, although a defendant can make out an “actual knowledge” defense for a Section 12(a)(2) claim based on circumstantial evidence, the Court stressed that this should not be viewed as creating a constructive knowledge standard. Id. at *23. Here, the Court found that although Fannie Mae and Freddie Mac knew generally of deteriorating conditions in the housing market, defendants did not prove that they knew that the specific loans backing the Certificates they purchased were not originated in accordance with the applicable underwriting guidelines. In this regard, the Court stressed that defendants could not establish plaintiffs’ actual knowledge of the relevant specific fact (that the loans in their Certificates were defective) by drawing a “reasonable inference” from plaintiffs’ generalized knowledge about the mortgage loan industry. Id. at *24-*25.

Third, the Second Circuit stated that Section 12 imposes negligence liability and affirmed the District Court’s grant of summary judgment precluding defendants from asserting a reasonable care defense at trial. The Court noted that “[t]he reasonable care standard adapts to the context of each transaction,” but cited four considerations as bearing on the consideration of a defendant’s due diligence defense: (1) the nature of the securities transaction, (2) the defendant’s role in that transaction, (3) the defendant’s awareness of information that might suggest a securities violation and its response(s) upon learning of such information (which the Court stated is perhaps the most important consideration in assessing reasonable care), and (4) industry practices. Id. at *30. The Court stressed that industry standards and customs are highly persuasive in setting the standard of care but are not controlling, particularly when the industry is comprised of only a few participants and where their practices have not previously undergone judicial scrutiny. The Court opined that the RMBS industry prior to the financial crisis, specifically, was “a textbook example of a small set of participants racing to the bottom to set the lowest possible standards for themselves.” Id. at *33. The Court found that there was ample evidence that defendants knew of and disregarded multiple red flags, and therefore no reasonable jury could have found that they had exercised reasonable care.

Fourth, the Court held that the misstatements in the RMBS prospectus supplements could be material even though those ProSupps were issued after plaintiffs had agreed to purchase the securities (based on their description in free writing prospectuses) and after the trades had settled. The Court reasoned that the ProSupps “confirm[ed] that the loan quality representations in those initial offering documents were truthful in all material respects,” and in that way “assumed the material role of convincing the [plaintiffs] to finalize the transactions.” Id. at *47. A contrary ruling, the Court concluded, would “undermine the Securities Act’s philosophy of full disclosure.” Id. (internal quotation omitted).

Fifth, the Court stressed that materiality must be measured using an “objective” standard asking what would be significant to a “reasonable investor.” Thus, although a court must consider the statement at issue in the context of the objective features surrounding the sale and the seller, a court is not required to consider “subjective facts about the the buyers and their motives for engaging in the transaction” in assessing materiality. Id. at *48. Thus, plaintiffs’ particular interest in acquiring RMBS backed by certain types of loans was irrelevant.

Sixth, the Court observed that for Section 12 claims, a defendant bears the “heavy” burden of showing a lack of loss causation (“negative loss causation”) to escape liability. Id. at *50. The Court found that defendants “failed to break the link between the Certificates’ reduction in value and the ProSupps’ misstatements.” Id. at *51. In this regard, the Court observed that when the plaintiff bears the burden of proving loss causation (such as with respect to a Section 10(b) claim), “[a] financial crisis may stand as an impediment to proving loss causation because it can be difficult to identify whether a particular misstatement or macroeconomic forces caused a security to lose value in the fog of a coincidental market-wide downturn.” Id. at *52. Here, however, because defendants bore the burden of proving negative loss causation, it was defendants, not plaintiffs, who confronted the difficulty in separating loss attributable to a specific statement from loss attributable to macroeconomic forces. Although it was “uncontested that the housing market and related macroeconomic forces were partial causes of the Certificates’ losses,” here, in seeking to meet their burden of disproving causation, the defendants faced the challenge that, according to the Court, “those macroeconomic forces and the ProSupps’ misstatements were intimately intertwined.” Id. (emphasis in original). Nor did it matter, the Court held, that the ProSupps’ contribution to the financial crisis was “tiny,” because defendants’ misstatements purportedly “contributed to the systemic risk” in the RMBS market at the time. The Court stated that: “Defendants may not hide behind a market downturn that is in part their own making simply because their conduct was a relatively small part of the problem.” Id.

This lengthy and important decision undoubtedly will be relied upon by Securities Act class action plaintiffs outside of the RMBS context, even though it is arguable that much of the Second Circuit’s decision was peculiar to, and perhaps affected by, the RMBS and financial crisis context. Some of the commentary in the decision arguably went beyond what was necessary to the Court’s specific holdings and appeared to be linked to the RMBS and financial crisis context — for example, the description of the negative causation defense as presenting a “heavy” burden and the specific approach taken to the Merck/discovery rule statute of limitations analysis — are difficult to reconcile with the text of the statute and many precedents. We would not be surprised to see Second Circuit decisions clarifying, distinguishing, or limiting this broadly worded opinion in Securities Act cases outside of the RMBS and financial crisis context.

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