Boyd v. Novastar Financial: Subprime Lending, the PSLRA, and the Need to Specify the Misstatements

The PSLRA imposes a number of procedural hurdles in bringing a class action fraud suit under Rule 10b-5.  The need for a "strong inference" of scienter is perhaps the best known, but there are others, including the need to plead fraud with particularly, as the plaintiff in this case discovered. 

Novastar Financial, Inc. (“Novastar”) was the subject of a class action suit alleging that the lending company violated various SEC rules, allegedly making misleading statements in press-releases and filings concerning their 2007-2011 fiscal years.  The Eighth Circuit affirmed the trial court’s decision to dismiss the complaint, finding that the lead plaintiff failed to satisfy the heightened pleading requirement of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4(b).  The Eighth Circuit also denied plaintiff the opportunity to amend his complaint.

Novastar is a publicly traded company that offers loans to borrowers who cannot satisfy the underwriting standards of conventional mortgage lenders.  They also raise additional capital by selling the rights to the income generated by groups of loans that are consolidated into mortgage-backed securities. 

On February 20, 2007, Novastar announced its financial results from fiscal year 2006.  These results were well below expectation.  Furthermore, Novastar stated that they expect an even greater financial loss in fiscal years 2007-20011.  Within days of this announcement, Novastar’s stock dropped significantly, trading at less than 30 percent of its high in May 2006.  Novastar investors who acquired Novastar securities between May 4, 2006 and February 20, 2007, filed a class action lawsuit.  The suit alleged that the defendants violated SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, and section 10(b) and 20(a) of the SEC Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a) by making false and misleading statements concerning the company’s financial status during the time they acquired Novastar securities. 

The complaint reproduced 19 press releases, SEC filings, and conference call transcripts in their entirety or in large part.  The complaint alleges that Novastar made false or misleading statements and that the company acted with the required state of mind to render their actions in violation of the stated rules. The trial court granted Novastar’s motion to dismiss, holding that the plaintiff did not state with any sort of particularity which statements in the 180-page complaint were false or misleading.

In its decision, this court agreed with the trial court’s determination that, despite the length of the complaint, plaintiff failed to meet the requirements of the PSLRA that they plead fraud with sufficient particularly by specifying the particular statements alleged to be misleading.  The plaintiff merely reproduced various public communications made by the company during the time they invested in Novastar securities.  The plaintiff therefore did not meet the burden of proof required by the PLSRA’s heightened pleading standards, requiring the plaintiff to prove with particularity the “who, what, where, when, and why.”  Cornelia I. Crowell GST Trust v. Possis Med., Inc., 519 F.3d 778, 782 (8th Cir. 2008) (quoting In re K-tel Int’l, Inc. Sec. Litig., 300 F.3d 881, 890 (8th Cir. 2002)). 

The dismissal was, therefore, based upon flaws in the pleading process.  Plaintiff unsurprisingly sought leave to amend his complaint.  The district court refused and the Eigth Circuit affirmed.  The court noted that plaintiff had "never submitted a proposed amended complaint to the district court, nor did he proffer the substance of such an amended complaint until he filed his appellate brief."  Moreover, after denial of leave to amend, plaintiff did not file a motion under FRCP 15(a)(2), 59(e), or 60(b) to seek leave to file an amended complaint.

The primary materials for this post are available on the DU Corporate Governance website.