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Second Circuit: Securities Class Suit Failed to Plead Corporate Scienter Against Dynex and Merit
Local 445 Freight Division Pension Fund v. Dynex Capital Inc., et al.
No. 06-2902-cv, U.S. Court of Appeals for the Second Circuit, 06/26/2008
Companies Mentioned: Dynex Capital Inc., Merit Securities Corp., Teamsters Local 445 Freight Division Pension Fund
Holding
In this appeal, the U.S. Court of Appeals for the Second Circuit overturned a district court's ruling that plaintiff-appellee Local 445 Freight Division Pension Fund was able to adequately plead scienter in its securities fraud complaint. The district court earlier dismissed fraud charges against top officers of financial services companies Dynex Capital, Inc. ("Dynex") and Merit Securities Corp. ("Merit"), but found that a strong inference of scienter was demonstrated against these corporate defendants-appellants. On appeal, the Second Circuit rejected the notion that a failure to show scienter on the part of individual officers should likewise give rise to a finding of no-scienter against corporate defendants in a securities case. Congress has imposed strict requirements on securities fraud pleading, but the Second Circuit did not believe they have imposed the rule that in no case can corporate scienter be pleaded in the absence of successfully pleading scienter as to an expressly named officer. Nonetheless, the Second Circuit ruled in favor of Dynex and Merit, stating that plaintiffs-appellees failed to allege the existence of misleading information given out to investors, and the existence as well of a motive to mislead. The Second Circuit thus remanded the case with instructions to dismiss as to Dynex and Merit with leave to replead.
Detailed Summary
In this securities fraud class action, defendants-appellants Dynex and Merit appealed an order entered on February 10, 2006 in the U.S. District Court for the Southern District of New York denying a motion by Dynex and Merit to dismiss the action as to them. Opinion, p. 3. In this appeal, defendants argued that the district court erred when it found that plaintiff had successfully pleaded scienter against Dynex and Merit despite failing to find scienter pleaded as to any specific officer or employee of either company.
Dynex, a Virginia-based financial services company, invests in bonds secured by mortgages on manufactured housing. Merit is one of its subsidiaries. Stephen Benedetti served as president and CEO of Merit at all relevant times, and also held various officer and director positions at Dynex. Thomas Potts served as Dynex’s president and principal executive officer from 1997 to June 2002. Id., p. 4.
Between 1996 and 1999, Merit made thousands of loans to people seeking to buy manufactured homes. In March and August of 1999, Merit pooled these loans and issued two sets of asset-backed securities secured by the loans, the Series 12 Bonds and the Series 13 Bonds, with the income generated by the loans as collateral. Each series was backed by a separate pool of loans, and each was divided into several classes.
After the bond issue, the value of the collateral began a sharp decline. Increasing numbers of borrowers defaulted on their loans: in August 1999, 1.35% of Merit’s borrowers were delinquent, but, by November 2001, that figure had risen to 5.01%. During the same period, Merit’s “loss severities,” namely, the difference between amounts loaned to finance home purchases and the lesser amounts realized from the sale of those properties after foreclosure, also increased. Id. In other words, not only were more people defaulting on their loans, but each default was becoming more financially damaging to Merit.
In February 2005, plaintiff-appellee Teamsters Local 445 Freight Division Pension Fund (“Teamsters”), which had purchased approximately $450,000 worth of Dynex’s Series 13 Bonds in early 2002, filed an action in the Southern District of New York alleging violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”). Id. Teamsters named Dynex and Merit as corporate defendants, and Benedetti and Potts as individual defendants. Teamsters brought the class action “on behalf of all open market purchasers of Series 12 and 13 bonds between February 7, 2000 and May 13, 2004.” (the “class period”). Id., p. 6, citing In re Dynex Capital, Inc. Sec. Litig. (Dynex I), No. 05-civ-1897, 2006 WL 314524, at *1 (S.D.N.Y. Feb. 10, 2006). There was no allegation, however, that Teamsters purchased the Series 12 bonds.
The complaint alleged that Dynex, a late entrant to the manufactured homes financing market looking to increase its market share, had to purchase loans made to “uncreditworthy borrowers.” Id., citing Dynex I. In order to do so, they “overtly” told dealers that they were willing to buy “bad paper” (i.e., very risky loans) and failed to disclose these practices in the offering materials that accompanied the 1999 bond issues. Id.
After the initial offering and throughout the class period, Teamsters asserted, the defendants “misrepresented the cause of the bond collateral’s poor performance; misrepresented the reasons for restating its loan loss reserves; and concealed the loans’ faulty underwriting.” Id. The defendants moved to dismiss the complaint, claiming, inter alia, that Teamsters had failed to adequately plead scienter. The district court agreed with defendants that Teamsters “ha(d) failed to adequately plead scienter with respect to Potts and Benedetti,” the individual defendants. Id., citing Dynex I at *9.
As to the corporate defendants Dynex and Merit, however, the district court found scienter adequately pleaded. “A plaintiff may, and in this case has, alleged scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation.” Id., p. 7, citing Dynex I at *9.
The issue in this case is, does a failure to show strong inference of scienter against employees of corporate defendants-appellants also mean a failure to show corporate scienter against the companies?
The Second Circuit rejected the notion, raised by defendant-appellant Dynex and Merit that Teamsters failed as a matter of law to plead scienter against Dynex and Merit when it failed to plead scienter against Potts and Benedetti. Congress has imposed strict requirements on securities fraud pleading, but the Second Circuit did not believe they have imposed the rule urged by defendants, that in no case can corporate scienter be pleaded in the absence of successfully pleading scienter as to an expressly named officer. Id., p. 12.
In ruling in favor of defendants-appellants, the Second Circuit held that Teamsters failed to allege the existence of information that would demonstrate that the statements made to investors were misleading, e.g., information showing that the primary cause of the bonds’ poor performance was not the general weakness in the mobile homes market. They also failed to allege that anyone at Dynex or Merit had a compelling motive to mislead investors regarding the bonds. As a result, a number of competing inferences regarding scienter arise. One might infer that no one at Dynex or Merit found the statements misleading because they identified the cause of the bonds’ performance as accurately as possible, or that no one responsible for the statements made to investors had reason to believe that Dynex employees were systematically flouting its underwriting guidelines or giving them false information about the cause of the bonds’ poor performance. Id., p. 15.
Teamsters wanted the court to infer that someone whose scienter is imputable to the corporate defendants and who was responsible for the statements made was at least reckless toward the alleged falsity of those statements. The Second Circuit could not state that, based on the allegations in the complaint, this inference is “at least as compelling” as the competing inference, that the statements either were not misleading or “were the result of merely careless mistakes at the management level based on false information fed it from below.” Id., p. 15, citing Tellabs Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2504-05 (2007).
On the basis of the foregoing, the Second Circuit remanded the case with instructions to dismiss as to Dynex and Merit with leave to replead.
View a PDF of the judicial opinion.Service
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