Attorney: Michael Grunfeld
Pomerantz Monitor November/December 2017
In Federal Housing Finance Agency v. Nomura Holding America, Inc., the Second Circuit recently upheld the $806 million judgment handed down by the district court after a bench trial in 2015. This is one of the few cases arising out of the recent financial crisis to have gone all the way to trial.
The judgment was entered in favor of the Federal Housing Finance Agency (“FHFA”) against Nomura and Royal Bank of Scotland. This case related to residential mortgage -backed securities (“RMBS”) that defendants sold to Fannie Mae and Freddie Mac (which FHFA is the conservator for) between 2005 and 2007, shortly before the housing market collapsed. The district court held that defendants made material misrepresentations in RMBS offering documents in violation of the Securities Act and analogous state securities laws (also known as “Blue Sky laws”), by stating that the mortgages underlying the RMBS had been issued in conformity with underwriting guidelines when, in fact, they had not. Defendants appealed several legal rulings that the district court made prior to and at trial. The Second Circuit ruled in FHFA’s favor on all issues, concluding that the “district court’s decisions here bespeak of exceptional effort in analyzing a huge and complex record and close attention to detailed legal theories ably assisted by counsel for all parties.”
This massive case involved many legal issues and resulted in a district court opinion of more than 300 pages, and a Second Circuit opinion of over 100 pages. The most interesting issues revolved around the question of “negative loss causation.” One of defendants’ main arguments was that their misrepresentations did not “cause” the disastrous decline in value of the securities they sold, and that the broader market collapse was entirely to blame.
Section 12 of the Securities Act provides an affirmative defense to defendants who can establish that some or all of the investor’s losses were not caused by the defendant’s misrepresentations. Here, defendants argued that they were not liable for the decrease in value of FHFA’s RMBS because the entirety of their losses “were attributable to macroeconomic factors related to the 2008 financial crisis and not attributable to [defendants’] misrepresentations.” The Second Circuit rejected this argument because it determined that this was a case where a “marketwide economic collapse is itself caused by the conduct alleged to have caused a plaintiff’s loss.” As the district court determined, the “shoddy mortgage loan origination practices” that defendants misrepresented “contributed to the housing bubble” that created the financial crisis that, in turn, contributed to defendants’ losses.
The Second Circuit also rejected defendants’ argument that their misstatements could not have caused FHFA’s losses because the securities sold here played only a “tiny” role in causing the financial crisis. As the Second Circuit explained, “[f]inancial crises result when whole industries take unsustainable systemic risks. … 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.”
This loss causation ruling was based in part on the “heavy” burden that defendants have under the Securities Act to prove that their actions did not cause the plaintiff’s losses. Courts should therefore “presume[e] absent proof to the contrary that any decline in value is caused by the misstatement or omission in the Securities Act context.” Under this “negative causation” standard, “any difficulty separating loss attributable to a specific misstatement from loss attributable to macroeconomic forces benefits the plaintiff.” The court’s decision here thus helpfully explains how difficult it is for defendants to avail themselves of the negative causation defense under the Securities Act.
The Second Circuit also rejected defendants’ attempt to raise the reasonable care defense that is available under the Securities Act. The court held that “no reasonable jury could find that Defendants exercised reasonable care.” This decision was based in part on the deficiencies in the particular due diligence practices that defendants used to review the loans underlying the RMBS at issue in this case. Defendants argued that their due diligence efforts were no worse than procedures being applied at the time across the entire mortgage securitization industry. The court rejected that argument, explaining that “[t]he RMBS industry in the lead up to the financial crisis was a textbook example of a small set of market participants racing to the bottom to set the lowest possible standards for themselves.” Because of this danger, an industry is not allowed to set its own standards of care. Rather, “[c]ourts must in the end say what is required.” The Second Circuit’s analysis here was therefore “only informed by industry standards, not governed by them.” Because of the rampant irresponsible behavior of the mortgage industry that led to the financial crisis, the court concluded that “even if Defendants’ actions on the whole complied with that industry’s customs, they yielded an unreasonable result in this case.”
The issues of causation in the context of a marketwide downturn and compliance with mortgage industry standards that the court addressed here have been raised in many cases arising out of the financial crisis. In agreeing with the district court’s ruling in favor of FHFA, the Second Circuit ruled authoritatively that defendants’ arguments on these issues cannot shield them from liability under the Securities Act.