Pomerantz LLP

May/June 2014

Fannie Mae and Freddie Mac Secure $9.3 Billion Settlement With B of A

Pomerantz Monitor, May/June 2014

In March, Bank of America (“BofA”) agreed to pay $9.3 billion to settle four settle lawsuits filed by the Federal Housing Finance Agency (“FHFA”). The lawsuits alleged that the bank misrepresented risks inherent in billions of dollars in mortgage-backed securities that it sold to Fannie Mae and Freddie Mac. Under the terms of the settlement, BofA subsidiaries Countrywide Financial Corp and Merrill Lynch will pay $5.83 billion and repurchase another $3.2 billion in mortgage-backed securities, FHFA said. 

As many will recall, FHFA filed these lawsuits among seventeen similar cases in its capacity as conservator for Fannie Mae and Freddie Mac, after it was reported that Fannie and Freddie lost up to $30 billion in the subprime mortgage market. Cases were brought against all the big banks: JPMorgan, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, and UBS. To date, the lawsuits have recovered more than $20 billion. Seven of those cases are still pending. The recovery is impressive, but brings renewed scrutiny to the whole fiasco, including the unclean hands of some Fannie and Freddie executives, who had long insisted that Fannie and Freddie’s involvement with subprime loans was minimal. We now know that Daniel Mudd and Richard Syron, chief executives of Fannie and Freddie, were aware of the exposure and the risks. Internal documents released at Congressional hearings showed that both ignored repeated warnings from internal risk officers. In March 2006, Enrico Dallavecchia, Fannie Mae’s chief risk officer, wrote to CEO Daniel Mudd to say, “Dan, I have a serious problem with the control process around subprime limits.” 

Fannie’s role goes back to the beginning of the subprime phenomenon. The New York Times journalist Gretchen Morgenson reported that Fannie had actually recruited Countrywide to make the loans to help fulfill Fannie’s own “affordable housing” goals. In return, Countrywide was given a discount on fees. By 2004, Countrywide was Fannie’s top mortgage supplier, accounting for 26 percent of the loans purchased by Fannie. Fannie executives were also among the dozens of employees who enjoyed steeply discounted mortgage rates from Countrywide. The House Oversight and Government Reform Committee found that 153 “VIP loans” had been issued to 27 employees. 

When the government took over and ousted the executives, Fannie and Freddie appeared to be winding down and out. But wait. Mel Watt, head of FHFA, just signaled that Fannie and Freddie may not be exiting the mortgage industry, but instead might be enjoying something of a renaissance. As the Times reported, in a quote attributed to Jim Parrott of the Urban Institute, “(Watt’s) message was he will turn from focusing on the enterprises as institutions in intentional decline to institutions that should be better prepared to form the core of our system for years to come… this shift in focus ripples through the many decisions announced in the speech and signals a watershed moment in the brief history of the agency.” 

The BofA settlement plays a significant role in the appearance of renewal: of the $5.7 billion Fannie Mae reported as comprehensive income for the first quarter, $4.1 billion was revenue from legal settlements, nearly double the $2.2 billion that Fannie had garnered in 2013. Freddie Mac also reported $4.9 billion in benefits from legal settlements. 

This is only the latest in a seemingly endless cycle of banking industry misdeeds. In addition to misrepresentations about mortgage backed securities, we have money laundering, manipulations of LIBOR, aiding and abetting tax evasion, circumventing the sanctions on Iran, the London Whale fiasco, and a host of other high crimes and misdemeanors. That public outrage has somewhat waned on the matter might be attributed to sheer exhaustion. We have not seen the last of it. Not by a long shot.

The Struggle Over the Use of Confidential Witnesses

Pomerantz Monitor, May/June 2014

In 1995, Congress passed the PSLRA to eliminate what it considered to be abusive practices in federal securities litigation. Among other things, it raised plaintiffs' burden in pleading federal securities fraud actions. It heightened the standard to plead scienter, requiring that the complaint plead facts "giving rise to a strong inference that the defendants acted with the required state of mind." At the same time, it instituted an automatic discovery stay until resolution of the defendant's motion to dismiss. In combination, these requirements can pose a significant hurdle to securities plaintiffs in making sufficiently specific allegations of wrongdoing. 

Plaintiffs often attempt to meet this burden by relying on statements from former company insiders. Because they often are wary of the possibility of retaliation from their former employers, or because they are still employed, or hope to be employed, in the same line of business, they typically demand that their names be kept confidential, and complaints usually refer to them as “CWs,” or confidential witnesses. Ultimately, their names must be disclosed to defendants, which must be relayed to the CW at the time of the interview. In ruling on motions to dismiss, some federal judges have expressed discomfort in relying on statements of anonymous CWs, worrying that they may not be in a position to know what they are talking about, or that they may be disgruntled former employees looking for revenge while hiding behind a smokescreen of anonymity. Other federal judges believe that CWs are reliable where there is strength in the number of confidential witnesses, their corroborative aspects, and the specific descriptions of each of them. Many cases have required that allegations based on information from CWs must disclose enough about them to substantiate that they were in a position to know what they are talking about. This requirement, of course, makes it easier for the former employers to figure out their identity. Once that happens, defendants have often tried to discredit their allegations or even to contact them to pressure them to “recant.” Southern District of New York Judge Jed Rakoff, a leading jurist in securities litigation, has noted that heightened pleading standards in securities class actions have left confidential plaintiffs' witnesses in a tough spot—sometimes lured by plaintiffs lawyers to exaggerate wrongdoing, and/or unfairly pressured by defendants to recant truthful allegations. 

Defense attorneys have different theories on what can be done to alleviate these concerns; however, many of these “theories” are not practical, such as, for example, requiring plaintiffs’ lawyers to include a sworn declaration from a confidential witness verifying the allegations in the complaint. Such disclosures would reveal the name of the signatory, defeating the protection of confidentiality. As Judge Rakoff noted, once the identities of confidential witnesses are known, they can then be “pressured into denying outright the statements they had actually made.” In fact, fear of retaliation by the former employer accounts for most of witness recantation. Moreover, any requirement that former employees sign a formal legal document, especially under oath, would have a chilling effect on their willingness to reveal what they know. 

Defense attorneys have also suggested that plaintiffs’ lawyers themselves, and not just investigators, participate in the witness interviews. While this might help ensure that the complaint’s summary of CW allegations is accurate, it would be impractical. The involvement of a lawyer, rather than an investigator alone, would be a deterrent for some CWs. Investigators would have to coordinate meetings among counsel and the witnesses, making information collection much more burdensome and time-consuming. 

There are, however, some steps that plaintiffs’ counsel can take to make the CW process more reliable. Investigators should be required to state clearly that they work for a law firm adverse to the former employer, and that they do not represent the witness. They should also be required to ensure that the witness is not currently employed with the defendants and that there is no confidentiality agreement that precludes disclosure. Counsel should also make sure that the information from the CW is consistent with all of the other evidence gathered in the case. The court’s decision in Tellabs III provides that corroborating evidence is the key to CW allegations. Because the Reform Act requires plaintiffs to plead the details of the CW’s position and ability to know the facts alleged, the defendants often can figure out who the CWs are, and “reach out” to them. As Judge Rakoff has stated, the witness often feels pressure to recant or water down what s/he has said. If defendants succeed in this effort and the complaint is dismissed, defendants often file a Rule 11 motion seeking sanctions against plaintiff’s counsel. Such “recantation” should not be the basis for a Rule 11 motion. Plaintiffs’ attorneys should not be deterred by defendants’ latest attempt to dismiss valid securities fraud cases through Rule 11 motions. However, plaintiffs’ counsel should take care to ensure that the allegations in any complaint are accurate, and move for cross-sanctions where appropriate.


Lululemon Ordered to Produce Records of Its Stock Trading Plan

Pomerantz Monitor, May/June 2014

In a dishearteningly familiar scenario, a couple of years ago the chairman of lululemon athletica dumped a large number of company shares he owned, a few hours before the company announced that its CEO was resigning. By trading ahead of the news, the Chairman saved about $10 million. In defending himself from the charge that he traded the shares on inside information, the company’s chairman had publicly claimed that he had sold a big block of his company stock pursuant to his 10b5-1 stock trading plan, and not because he had inside information about impending bad news. 

Pomerantz represents a shareholder of lululemon, and we and our client were interested in finding out whether the chairman’s assertions were true. So we brought a “books and records” action, asking to inspect the company’s records relating to the plan and to this particular transaction. 

Deciding an issue of first impression in Delaware, the Chancery Court recently granted our request, holding that the circumstances of this transaction raised enough suspicion to warrant inspection. The importance of the inside information was beyond dispute. The company, which is known for its yoga apparel, had recently announced a highly embarrassing recall of approximately 17 percent of its women’s workout pants. News of the recall caused the price of lululemon common stock to drop almost 7% within two days, which, in turn, led to the resignations of several key executives and the termination of the company’s Chief Product Officer.

Then came the big blow: soon afterwards, the company’s Chief Executive Officer announced his resignation. That news caused lululemon’s stock to drop almost 22% in the span of a few days. The same day that the lululemon Board of Directors learned of the CEO’s imminent departure, but prior to any public announcement of it, lululemon’s chairman sold over 600,000 shares of company stock for more than $49.50 million. Had he waited to sell until after the public announcement, he would have received a little more than $39 million—approximately $10 million less. This looks a lot like insider trading.

Delaware law allows stockholders of public companies to inspect certain corporate documents, if the stockholder can assert a proper purpose and satisfy other technical requirements. After lululemon refused our requests, Pomerantz filed a complaint, known as a Section 220 action, to compel lululemon to produce certain documents relating to the stock trading plan. Delaware courts have encouraged stockholders to file Section 220 actions as investigatory tools before commencing other forms of litigation, such as derivative actions. 

In response to the Section 220 action, lululemon argued that stockholders had no basis to question the chairman’s stock sales because the trades were executed by the chairman’s broker, who was granted sole discretion under a trading plan to sell shares on behalf of the chairman over a period of time. The plan, known as a 10b5-1 stock trading plan, is implemented by corporate insiders in an attempt to insulate themselves from allegations of insider trading.

Pomerantz, on the other hand, pointed to the fact that the stock sale at issue here was the single largest stock sale conducted on the chairman’s behalf since the establishment of his pre-arranged stock trading plan in late 2012, raising suspicions as to both the timing and the size of the sale.

The Court found that the 10b5-1 stock trading plan did not preclude potential liability for insider trading. The Court also found that there were “legitimate questions as to the propriety” of the sale and ordered the production of certain related documents. In addition to acknowledging that the chairman’s sale was the single largest he had made under the 10b5-1 stock trading plan, the Court also inferred that the number of shares sold was the maximum amount that the chairman could have sold in any one month under the terms of the 10b5-1 plan. These facts allowed the Court to infer a “credible basis” that wrongdoing may have taken place in connection with the June 7, 2013 stock sale. Accordingly, the Court ordered lululemon to produce the 10b5-1 trading plan, as well as certain other documents relating to the stock sale.

The Court’s holding that the mere existence of a 10b5-1 trading plan will not serve as an absolute defense for defendants and will not preclude a finding of a credible basis for an inference of wrongdoing, was an important victory for stockholders of public companies.


Delaware Court Raises the Bar in Controlling Shareholder Transactions

Pomerantz Monitor, May/June 2014

It is long-established law that where a transaction involving self-dealing by a controlling shareholder is challenged, the transaction will be reviewed under a standard referred to as “entire fairness.” That standard places the burden on the defendant to prove that the transaction with the controlling shareholder was entirely fair to the minority stockholders, including not only a fair price but a fair process for negotiating the transaction. 

Twenty years ago, the Delaware Supreme Court was presented with the question of whether the business judgment rule might apply to transactions with a controlling shareholder if the transaction was approved either by a special committee of independent directors, or by an informed vote of the majority of the minority shareholders. The Court said no, but that in such cases the burden of proof on the issue of the entire fairness of the transaction would be shifted to the plaintiff shareholders. While this may sound like splitting hairs, in fact the question of which standard — entire fairness or business judgment — will be applied usually determines the outcome of the case.

Now, in Kahn v. M&F Worldwide Corp., the Delaware Supreme Court was presented with a case where the controlling shareholder had used both protective devices: the transaction had to be approved both by an independent special committee and by the minority shareholders. The question was: What is the appropriate standard of review now? 

The Court concluded that those provisions, taken together, neutralized the influence of the controlling shareholder and the highly deferential business judgment standard of review should apply. This creates a much higher barrier for plaintiffs to overcome. They will now have the burden of proving that the challenged transaction was so egregious that it could not have been a result of sound business judgment. 

To demonstrate that the business judgment rule should apply, the controlling shareholder will have to agree at the outset that the completion of the merger will be contingent on the approval of a special committee and approval of the majority of the minority shareholders. Then, defendant must show that: 

  • The special committee was composed of independent directors;
  • The special committee was empowered to reject the controlling shareholder’s proposal, and is free to engage its own legal and financial advisors to evaluate the proposal;
  • The special committee met its duty of care in negotiating a fair price; •    The majority of the minority shareholders was informed; and
  • There was no coercion of the minority. 

The Court reasoned that the dual protections of the special committee and the majority of the minority “optimally protects the minority stockholders in controller buyouts.” It concluded that the controlling shareholder knows from the inception of the deal that s/he will not be able to circumvent the special committee’s ability to say no, and that s/he will not be able to dangle a majority of the minority provision in front of the special committee in order to close the deal late in the process, but will have to make a price move instead. 

While this ruling may serve as a setback to plaintiffs in certain cases, the business judgment standard of review will only apply when all of the above criteria are met. Defendants may be unwilling to condition the completion of the transaction at the outset on the approval of a special committee and a majority of the minority shareholders, as this might create too much uncertainty and risk around the proposed transaction.


Court Strikes Down “Cross-Listed Shares” Theory

Pomerantz Monitor, May/June 2014

In 2010, the United States Supreme Court handed down its landmark decision in Morrison v. National Australia Bank, which held that United States federal securities laws only apply to transactions in securities listed on U.S. exchanges, or to securities transactions that take place in the U.S. The ruling has been interpreted to bar recovery under the U.S. federal securities laws by investors who bought shares on foreign exchanges. As previously reported in the Monitor (Volume 10, Issue 6, November/December 2013), Pomerantz has led the effort to seek alternative paths to recovery in the U.S. courts, including via pursuit of common law claims against issuers like British Petroleum and corporate executives charged with securities fraud. 

But what about instances where a security is listed both in the U.S. and on a foreign exchange, and the investor bought his shares overseas? A case in point is City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, No. 12-4355-cv (2d. Cir.), a securities class action against Swiss Investment Bank UBS AG by foreign and domestic institutional investors that bought shares of UBS stock on the SIX Swiss Exchange. 

The complaint alleged that UBS failed to disclose that its balance sheet had inflated the value of billions of dollars in residential mortgage-backed securities and collateralized debt obligations. It alleged that when the market for those securities dried up, UBS eventually had to recognize a loss of $48 billion. The complaint also alleged that the bank made misleading statements claiming that it was in compliance with U.S. tax laws, only to be forced to settle tax fraud claims with federal authorities for a penalty of $780 million.

Although the plaintiffs had bought UBS shares on a foreign exchange, they invoked the so-called “Listing Theory,” which posits that since shares of UBS are traded on both the Swiss Exchange and in the U.S. on the New York Stock Exchange, all purchasers of UBS shares should be protected by the U.S. federal securities laws, regardless of which exchange they used to purchase their shares. The plaintiffs also invoked the “Foreign-Squared Claims Theory,” which posits that the place where the buy order was placed should control, rather than the location of the exchange where the trade was ultimately executed. The buy orders for some of the purchases of UBS shares at issue had been placed in the U.S. Under this theory’s rationale, such transactions should satisfy the second prong in Morrison, which applies the U.S. federal securities laws to “transactions” that take place in the U.S.

However, the District Court rejected both theories, holding that (1) reading Morrison as a whole, the limitation precluding U.S. securities laws from applying on foreign transactions should apply even when the foreign issuer also lists shares on a U.S. Exchange, and (2) the mere placement of a buy order in the U.S. is too tenuous a connection for the U.S. securities laws to apply to claims for losses related to a securities trade. The Second Circuit affirmed that ruling on appeal on May 6, 2014, in an opinion that aligns with the dominant interpretations of Morrison, whereby investors that had purchased UBS securities on the NYSE could have sought remedies under the U.S. federal securities laws, while those who had purchased UBS securities on the Swiss Exchange could not do so. The decision, a victory for dual-listed issuers, further curtails investor rights and remedies under the U.S. federal securities laws barring an appeal to the U.S. Supreme Court. 

As their rights to seek recovery under U.S. law for foreign-listed securities evaporate in the wake of Morrison, investors can only try to convince Congress to revise the federal securities laws so as to restore, in whole or in part, the protections they once offered. Otherwise, under certain circumstances, they may seek to pursue common law claims such as those pursued by Pomerantz against BP. Until then, investors will have to further weigh the benefits of buying shares of dual-listed companies on foreign exchanges, which may include better prices or lower transaction costs, against the possibility of losing the protection of U.S. federal securities laws in the U.S. courts. The UBS ruling could have added significance if it is followed in other U.S. federal Circuits.