In the first substantive decision handed down in any of the five major lawsuits by the Federal Home Loan Banks (FHLB) over RMBS losses, the Hon. Stanton Wettick, Jr. of the Court of Common Pleas of Allegheny County, Pennsylvania dealt a blow to JPMorgan Chase, Countrywide and other securitizers of subprime and Alt-A mortgage loans, while letting the ratings agencies largely off the hook. In the Order on Defendant’s Motion to Dismiss (full copy available here), Judge Wettick found that the FHLB’s claims for fraud, negligent misrepresentation and Securities Act violations could proceed against J.P. Morgan Securities, Inc., the entity that actually offered the mortgage backed securities for sale to investors and put together the securities’ offering documents.
The crux of the FHLB’s claims are that the securitizers (also known as depositors or sellers and sponsors) of various MBS offerings it purchased allowed those securities to be sold as AAA-rated or investment grade debt (which, according to the FHLB, indicated that they were virtually riskless), despite the fact that these securitizers knew that the ratings agencies had no way of determining the likely default rate of the underlying loans. Though the Court dismissed these claims as to the other JPMorgan entities that had acquired and transferred the loans earlier in the securitization chain, the Order was definitely a win for the FHLB because it confirmed that at least one investment bank entity would be on the hook for the sale of these toxic securities.
Meanwhile, the various ratings agency defendants were pleased with Judge Wettick’s Order, as it dismissed all claims against them except the claims of fraudulent (also known as intentional) misrepresentation. The Judge ruled that the plaintiff had stated a claim for fraud based on the theory that the ratings agencies did not actually believe their own ratings (note that considerable evidence has recently emerged to support this argument, in particular, the findings of the Financial Crisis Inquiry Commission that the ratings agencies ignored evidence that these loans were unsound, as testified by former Clayton president D. Keith Johnson). The Court further held that while the First Amendment protected the ratings agencies from liability for negligent misrepresentation, it did not protect the agencies from claims of fraud. The Court further dismissed the Securities Act claim against the ratings agencies based on Section 11 of the Act, finding that the defendants were not “underwriters” subject to the statute, as defined therein.
Judge Wettick’s Order is an important early bellwether in investor litigation over losses from RMBS, because it shows that plaintiffs should be able to survive a motion to dismiss and get into the discovery phase without having a ton of hard evidence. Indeed, as the first of the FHLBs to file suit (Pittsburgh’s suit was followed by the FHLBs of Seattle, San Francisco, Chicago and, most recently, Indianapolis), plaintiff’s counsel had not yet developed or taken advantage of the analytical tools used later in the Seattle and San Francisco complaints to show that specific representations made in the offering documents were false (see prior post on the Subprime Shakeout). As we are still very early in the timeline of investor RMBS litigation, and do not have much precedent for how judges will treat these types of loss-related claims, this opinion bodes well, not only for the FHLB lawsuits, but for other impending investor actions.
Without access to loan files, plaintiffs are often caught in a tough position of having to make claims that the loans did not meet guidelines or representations without having the evidence to support such claims. While the massive losses related to these products indicate investors were sold a defective bill of goods, servicers have largely refused to turn over documents that might confirm or disprove these claims. Indeed, that is what the discovery process is intended to do, but there has long been speculation as to whether plaintiffs had enough to go on to surmount a motion to dismiss. This Order reinforces my belief that the massive RMBS losses suffered by plaintiffs are enough to overcome this initial hurdle, meaning that plaintiffs will eventually get access to these treasure troves of misrepresentation fodder when banks are forced to turn over loan files in discovery. And this decision bodes especially well for the later-filed FHLB complaints, which cite stronger evidence of widespread breaches of reps and warranties, thanks to the analysis provided by due diligence firm, CoreLogic.
Another interesting aspect to note about this case is the Judge’s handling of defendants’ “sole remedy” argument. Namely, JPMorgan and the other defendants have argued, as have other banks in RMBS litigation, that plaintiffs may not assert claims for fraud, negligent misrepresentation, or other torts, because the language in the Pooling and Servicing Agreements (“PSA”) makes clear that the repurchase or replacement of a defective loan is the sole remedy for a breach of originators’ or underwriters’ reps and warranties. Judge Wittick dismissed this argument, finding that the repurchase remedy was only available to the Trustee, and not to investors, so this could provision could not have been intended to apply to bondholders. Though I have not reviewed these particular PSAs in detail, I would be surprised if they did not provide that investors could petition the trustee for such relief, should they amass a sufficient percentage of Voting Rights (generally 25%).
While I have often discussed the procedural hurdles investors face in taking advantage of this remedy, it is simply not the case that the repurchase re
medy is entirely unavailable to investors. Thus, Wettick reached the proper conclusion, but for the wrong reasons. I think the better-reasoned approach is to find that while repurchases are the sole remedy for contractual breaches of reps and warranties, the claims being made by the FHLB of Pittsburgh do not seek damages for breaches of reps and warranties in the underlying loans–they seek damages for material misrepresentations in the offering memoranda related to the ratings of the securities. While breaches of reps and warranties may be related to the reasons the securities underperformed their ratings, I think that what the securitizers knew about the ratings when they made these representations is an entirely different question, only tangentially related to breaches of reps and warranties. In fact, the securitizers could have been entirely unaware that there were breaches of reps and warranties, but still could have known that ratings agencies were not capable of estimating the risk of loss in these securities, and thus should have included disclaimers in the offering documents. Simply put, relief for misrepresentation in prospectus and other offering documents should not be limited by the “sole remedy” language applicable to breaches of reps and warranties made by the originators of these mortgages in separate contracts.
Update on Other FHLB Actions
Several readers have requested updates on the actions brought by the FHLBs of Seattle and San Francisco. The going has been slow in those cases (they are months behind the Pittsburgh case, which just now passed the motion to dismiss phase), but here is what I’m able to tell you: both cases were removed from state court to federal court by the defendants, in an attempt to obtain federal court jurisdiction over the plaintiffs’ claims. So far, most of the action in these cases has been related to adjudicating the removal issue. The way this works is that the cases are automatically moved to federal court upon the filing of a procedurally proper notice by a defendant. The plaintiff(s) may then file what’s called a Motion to Remand, arguing that the federal courts do not have jurisdiction over the claims and that the case should be remanded to state court.
The FHLBs filed Motions to Remand in both cases. The Motion was granted in the Seattle case in September, Case No. 2:10-CV-00148-RSM, and the case was remanded back to Kings County Superior Court. The San Francisco case is still before Judge Conti in the Northern District of California, Case No. 3:10-CV-03039-SC. The judge has taken the Plaintiff’s Motion for Remand under submission, and all other dates have been postponed pending the outcome of that decision. Note that the Pittsburgh case discussed above is proceeding in Pennsylvania state court, rather than federal court. I’ll keep readers apprised of any developments in these cases, as I become aware of them.