Latham & Watkins Litigation Department

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1 Number 681 March 4, 2008 Client Alert Latham & Watkins Litigation Department US Federal Court Upholds Claims Against Subprime Lender In Accredited, the case turned on disclosure, not on the company s lending practices themselves. On January 4, 2008, the Federal Court for the Southern District of California permitted a securities fraud class action to proceed against a mortgage finance company dealing in the subprime credit market. 1 The Atlas v. Accredited Home Lenders Holding Co. decision is one of the first rulings to come out on the subprime credit crisis. While the decision is limited to the adequacy of disclosures made by a mortgage finance company to its shareholders, it nevertheless demonstrates how plaintiffs are converting stock-price declines ostensibly due to the larger, macroeconomic problems that led to the subprime meltdown into putative actions for securities fraud. Thus, it serves as a warning flag regarding the current litigation climate for companies engaged in originating, financing, securitizing, buying or selling subprime mortgage loans. In Accredited, a mortgage finance company was sued for securities fraud after a sharp decline in its stock price. The drop in the company s stock price was attributable, in large part, to external, macroeconomic factors namely, the increasing number of defaults on the subprime loans that the company underwrote. In the absence of some of the more common predicates for securities class actions i.e., any delay in Securities and Exchange Commission (SEC) filings, internal investigation, financial statement restatement or regulatory investigation plaintiffs instead predicated their claim on alleged deficiencies in the company s disclosures, asserting that Accredited disclosed one thing about its lending practices to the public, while at the same time it did another. Specifically, the plaintiffs asserted that Accredited employed internal policies, procedures and documentation that were at odds with the underwriting practices and strategies that it allegedly disclosed to its investors. Additionally, even in the absence of any financial-statement restatement, plaintiffs claimed that Accredited failed to set aside sufficient reserves to account for potential losses associated with subprime loans. The court found the plaintiffs complaint to be sufficient under both theories, and denied Accredited s motion to dismiss. I. Background Accredited Home Lenders Holding Co. is a mortgage finance company that deals in the subprime credit market. 2 On the heels of a subprime meltdown that caused a sharp decline in Accredited s stock price, several shareholders filed a class action lawsuit. The lead plaintiff claimed, among other things, that Accredited and its officers and directors violated federal securities laws by underwriting loans that did not meet the Latham & Watkins operates as a limited liability partnership worldwide with an affiliated limited liability partnership conducting the practice in the United Kingdom and Italy. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2008 Latham & Watkins. All Rights Reserved.

2 company s publicly stated underwriting standards, and by understating the company s reserves for risky subprime loans. 3 Generally speaking, the plaintiffs took issue with the defendants failure to disclose a shift in Accredited s business strategy one that called for less stringent underwriting guidelines to increase the volume of the company s mortgage loan business. According to the plaintiffs, the defendants caused Accredited to underwrite loans to individuals who did not meet Accredited s stated underwriting guidelines and then failed to set aside adequate reserves for the higher risks associated with these loans. These practices allegedly impacted Accredited s earnings by hundreds of millions of dollars. II. The Challenged Practices A. Underwriting Standards and Practices The plaintiffs contended that the defendants represented that Accredited was focused more on credit quality than merely increasing the volume of loans it originated and that Accredited s underwriting procedures were better and more conservative than those of other sub-prime mortgage lenders. 4 The defendants allegedly caused Accredited s employees to disregard the company s stated underwriting guidelines in an effort to increase the volume of loans originated by Accredited. 5 According to the statements of confidential witnesses (whose allegations the court apparently accepted at the pleading stage), there were pervasive, widespread exceptions to Accredited s underwriting policies and substantial pressures to approve such loans at the end of reporting periods to meet financial projections. 6 Moreover, the plaintiffs alleged that the defendants not only knew of these practices, but affirmatively mandated or encouraged them. 7 defendants continued to represent to the public that Accredited was committed to a disciplined approach that focused on credit quality. The defendants allegedly made these representations knowing that they had caused the company to abandon adherence to its own underwriting policies. 8 B. Reserve Amounts The plaintiffs also claimed that the defendants manipulated Accredited s earnings by failing to maintain adequate reserves in three areas. First, the plaintiffs claimed that the defendants manipulated earnings by inadequately reserving for defaults on mortgage loans held by the company for investment. 9 Under the Generally Accepted Accounting Principles (GAAP), Accredited had to establish a reserve for potential credit losses on mortgage loans held for investment (MLIs). Such losses would occur when borrowers defaulted on their obligation to make mortgage payments. This type of reserve is known as an allowance for loan losses (ALL). defendants failed to increase Accredited s ALL after the defendants caused Accredited to deviate from its own underwriting guidelines. 10 In fact, Accredited s ALL allegedly decreased as a percentage of the company s delinquent loans, even though the amount of MLI was increasing due to the higher volume of loan origination. 11 defendants understatement of the company s ALL totaled hundreds of millions of dollars. 12 Second, the plaintiffs claimed that the defendants manipulated Accredited s earnings by inadequately reserving for real estate owned (REO) by the company. 13 In general, Accredited sold the mortgage loans it originated to

3 third parties. However, under some circumstances that third party could require Accredited to repurchase the loan. If Accredited could not re-sell a repurchased loan in the scratch and dent market, it would foreclose on the loan and acquire the property. Accredited was required to maintain a reserve (REO reserve) for potential losses on the eventual sale of REO assets. Increased defaults and foreclosures, however, caused Accredited s gross REO to increase significantly. According to the plaintiffs, the defendants failed to increase the company s REO reserve, and allegedly decreased the reserve as a proportion of gross REO. 14 Finally, the plaintiffs claimed that the defendants manipulated earnings by inadequately reserving for repurchase losses on mortgage loans sold to third party investors. 15 Accredited realized gains or losses when it sold mortgage loans to third parties depending on whether the sale proceeds exceeded the book value of the loan. Often the terms of sale required Accredited to repurchase a loan if the underlying borrower defaulted or if Accredited originated the loan in violation of the company s underwriting representations and warranties. Because of the possibility of such repurchases, the plaintiffs claimed that Accredited was required to maintain a reserve account on its balance sheet for potential future losses and expenses incurred when Accredited was required to repurchase a loan. According to the plaintiffs, Statement of Financial Accounting Standards (SFAS) No. 140 required such reserves to be estimated using factors such as the company s historical repurchase experience, industry repurchase experience, projections regarding the future volume of repurchases and the expected value of the underlying property serving as collateral. Further, the plaintiffs claimed that GAAP required such reserves to be estimated and recorded on Accredited s balance sheet in the period in which the loans were sold. Thus, according to the plaintiffs, the amount reserved affected Accredited s reported income by reducing Accredited s gain on loan sales. defendants caused Accredited to maintain an inadequate reserve for repurchase losses. 16 The defendants allegedly failed to increase Accredited s reserve for repurchases in response to the declining quality of Accredited s loan portfolio; the company began to lend money to an increasing number of borrowers that could be expected to default. Moreover, according to the plaintiffs, the company began to repurchase an increasing number of loans. 17 understatement of these three reserve accounts the ALL reserve, the REO reserve and the repurchase reserve resulted in a $ million overstatement of Accredited s pre-tax income. 18 C. The Defendants Response From a substantive standpoint, two arguments raised by the defendants in response to the plaintiffs allegations are particularly noteworthy. First, the defendants argued that the alleged misstatements concerning the company s reserves were forwardlooking in nature and accompanied by meaningful cautionary statements. Thus, according to the defendants, the alleged misstatements were covered by the statutory safe harbor for forward-looking statements. 19 The defendants argued that Accredited issued cautionary statements to investors, noting among other things, that a number of its loans originated pursuant to Accredited s exception policy. In other words, the defendants argued that Accredited disclosed the fact that it originated a number of loans to borrowers that did not meet Accredited s underwriting guidelines.

4 Second, the defendants argued that the alleged misstatements concerning Accredited s underwriting practices were not actionable because they were mere statements of corporate optimism and mere puffery. 20 In other words, the defendants argued that statements such as Accredited s overarching goals... to produce high quality loans, or its portfolio quality were generalized statements that were incapable of verification. For that reason, the defendants argued that the alleged misstatements were not actionable. As set forth in the following text, the court rejected both of the defendants arguments. III. The Court s Holding 21 A. False and Misleading Statements As noted previously, the plaintiffs alleged two theories of liability: (1) that the defendants manipulation of reserves rendered Accredited s financial results and projections false and misleading; and (2) that the defendants statements regarding Accredited s underwriting practices were false and misleading because the defendants caused Accredited to deviate from its publicly disclosed standards. The court held that both of these theories adequately alleged: (1) false and misleading statements; and (2) the reasons those statements were false and misleading. 22 B. Materiality The court found that each of the alleged false and misleading statements was material. 23 The alleged manipulation of reserves caused Accredited to overstate its pre-tax income by hundred millions of dollars. 24 While the court recognized that false and misleading statements regarding Accredited s underwriting policies could not easily be quantified, the court nonetheless found these statements material. The court concluded that, as a mortgage lender, Accredited s underwriting practices would be among the most important information looked to by investors. 25 In support of this finding, the court pointed to: (1) the frequency with which the defendants emphasized Accredited s underwriting policies in press releases and other public statements; and (2) the fact that analysts frequently repeated and commented on the defendants statements regarding the company s standards. 26 C. Scienter The court also concluded that the plaintiffs adequately pled scienter, i.e., facts sufficient to give rise to a strong inference that the defendants acted knowingly or with deliberate recklessness. 27 The court referred to the plaintiffs allegations regarding the frequency with which the defendants affected the decisions of the company s underwriters concerning risky loans, and the degree to which Accredited s reserves were decreased when such reserves should have been increased. 28 According to the court, the plaintiffs pled in sufficient detail facts showing that the defendants knew about Accredited s deviation from its own underwriting standards, and that the defendants therefore knew that their public statements regarding Accredited s compliance with those standards were false and misleading. 29 The court noted the plaintiffs allegations that certain of the defendants had access to periodic reports that included detailed information regarding widespread deviations from company policy and the adverse effect those practices were beginning to have on Accredited. 30 Moreover, according to confidential witness statements that the court accepted as true for pleading purposes, the defendants directed these deviations from company policy. Former employees claimed that their managers had pressured them to approve loans that did not comply with the company s policies to boost loan volume. 31

5 The court also took the unusual step of finding a sufficient inference of scienter to survive dismissal based on alleged violations of GAAP, even though Accredited did not issue a restatement. 32 The court based its decision on the following allegations: In light of Defendants alleged awareness that the company had begun to deviate from its own underwriting policies and that the quality of the company s loan portfolio would begin to decrease, the fact that Defendants allegedly caused or permitted large decreases in several significant reserve accounts which would have been impacted by these changes also supports an inference of scienter. 33 The court considered other factors, as well. The court noted allegations that Accredited s auditor refused to approve the company s 2006 financial statements before the deadline to file the company s Form 10-K, and that the company s new auditor required the reserves for loan losses to be retroactively increased by more than $30 million. 34 The court also took into account the defendants level of financial sophistication and their experienced in the mortgage industry. 35 D. Reliance and Causation The court concluded that the plaintiffs adequately pled reliance and causation. First, the complaint alleged that the plaintiffs and the other members of the putative class purchased Accredited stock in reliance on the specific statements of the defendants, as well as the integrity of the market price for Accredited s shares. Second, the complaint alleged that Accredited s stock was artificially inflated due to accounting improprieties that had the effect of overstating the company s earnings and of false and misleading statements concerning the company s lending practices. Finally, the plaintiffs asserted that Accredited s stock price declined significantly when the truth was disclosed regarding Accredited s undisciplined lending practices. Taking these facts together, the court held that the plaintiffs adequately pled reliance and causation. IV. Implications From a securities fraud perspective, the Accredited decision is illustrative of the types of claims companies in the mortgage industry might face. The court sustained allegations of allegedly deficient disclosures despite the general nature of Accredited s disclosures, and Accredited s disclosure that the company made exceptions to its standards from time-to-time. The court also sustained plaintiffs accounting claims, even in the absence of any financial statement restatement. Endnotes 1 Atlas v. Accredited Home Lenders Holding Co., 2008 U.S. Dist. LEXIS 3863 (S.D. Cal. 2008) (Judge Marilyn L. Huff). 2 According to the complaint, Accredited focuses on borrowers that may not qualify for loans from traditional banking entities due to higher loan-to-value ratios, the nature (or absence) of income documentation, limited credit histories, or high levels of debt or credit problems. 3 The plaintiff also challenged Accredited s accounting for the acquisition of another company. 4 Atlas v. Accredited Home Lenders Holding Co., 2008 U.S. Dist. LEXIS 3863 at at at at at at at at at 19.

6 U.S.C. 78u-5(c). 20 See Glen Holly Entm t, Inc. v. Tektronix, Inc., 352 F.3d 367, 379 (9th Cir. 2003). 21 This discussion is limited to the plaintiff s claim under Section 10(b) and Rule 10b Atlas v. Accredited Home Lenders Holding Co., 2008 U.S. Dist. LEXIS 3863 at at at at at at at 32 ( Violations of GAAP standards can also provide evidence of scienter ) (citing In re Daou Sys., 411 F.3d 1006, 1016 (9th Cir. 2005)). Reserves are estimates that are revised under GAAP each quarter as circumstances change. A later higher reserve does not necessarily mean that an earlier lower reserve was wrong. The court, however, may have been swayed by Accredited s change of auditors, followed by a reserve increase. 33 at

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