In re Fannie Mae 2008 Securities Litigation: CIS, Smith, and Liberty Pursue FNMA Alone Despite a Parallel Class Action

In In re Fannie Mae 2008 Securities Litigation, 2012 WL 3758537 (S.D.N.Y. Aug. 30, 2012), the U.S. District Court for the Southern District of New York addressed fourteen motions to dismiss by various defendants in response to amended complaints by Comprehensive Investments Services, Inc. (“CIS”), Edward Smith (“Smith”), and multiple entities related to Liberty Mutual Insurance Company (“Liberty”) (collectively, the “Plaintiffs”).

This matter is ancillary to a securities class action brought against the Federal National Mortgage Association (“FNMA”), its executives (collectively, the “Defendants”), and certain underwriters. The class action is premised on alleged material misstatements in regard to security offerings by FNMA concerning “(1) subprime and Alt A exposure; (2) risk management controls; and (3) core capital financials.”

CIS, Smith, and Liberty declined to join the class action and, instead, alleged individual claims against the Defendants. In 2008, CIS purchased 600,000 shares of Series T Preferred Stock in FNMA, and CIS now asserts claims under Section 10(b), Rule 10b-5, Section 20(a), and various state laws. In 2007, Smith purchased FNMA’s Series S Preferred Stock and also asserts Section 10(b), Rule 10b-5, Section 20(a), and state law claims against the Defendants. Finally, Liberty purchased FNMA’s Series P and S Preferred Stock and asserts Section 10(b), Rule 10b-5, and state law claims against only Goldman Sachs & Co. (“Goldman”), an alleged underwriter for the offering. 

Before addressing the substantive motions to dismiss, the court declined to find merit in the Defendants’ motion to strike parts of the complaints that repeated allegations set forth in both a parallel action by the Securities and Exchange Commission (“SEC”) and a Non-Prosecution Agreement with the SEC. The court found that factual allegations supported the Plaintiffs’ claims, and further, that the issue would not prejudice the Defendants.

In addressing the motions, the court first denied the Defendants’ efforts to dismiss the Section 10(b) and Rule 10b-5 claims of CIS and Smith premised on FNMA’s subprime and Alt A exposure. The court explained that the claims were identical to those made in an SEC action, which were upheld in a prior opinion.

Moreover, Chief Risk Officer (“CRO”) Enrico Dallavecchia’s claim that he did not “make” statements consistent with the Janus standard failed. The court found that the plaintiffs alleged the CRO made misstatements during conference calls with investors. In addition, the court found that plaintiffs had sufficiently alleged that the CRO had “ultimate authority” over company statements even though he had not signed the documents.  As the opinion described:

Given Dallavecchia's position as Chief Risk Officer, his knowledge of FNMA's subprime and Alt-A exposure, his participation in drafting relevant disclosures, his position on the disclosure committee, his review of draft filings, the fact that he had individual discussions with Mudd about the SEC filings, and his sub-certification (and, thus, approval) of the SEC filings, a question of fact exists as to whether Dallavecchia had ultimate authority over the misstatements, or ratified and approved the misstatements, contained in FNMA's SEC filings.

Second, the court granted the Defendants’ motion to dismiss CIS’s Section 10(b) and Rule 10b-5 claims premised on FNMA’s core capital financials. The court had previously dismissed a similar claim in the parallel class action; however, in amending their complaint, CIS and Smith produced additional information, including an email from a White House economist that referenced accounting “shenanigans” and a report by Morgan Stanley that concluded FNMA “overvalued its deferred tax assets.” The court, however, found that these allegations were insufficient. With respect to the reference to accounting shenanigans, the court concluded that the allegations did not “plausibly explain why FNMA's core capital financials were incorrect.” Nor did the contents of the Morgan Report warrant an inference of fraud. 

Third, the court denied the Defendants’ motion to dismiss CIS’s and Smith’s Section 10(b) and Rule 10b-5 claims based on FNMA’s risk management disclosures. The court held that the complaint contained sufficient allegations to plead that Defendants had made material misstatements with the requisite scienter. The court noted that “[p]roceeding headlong into an unfamiliar market and telling investors that risk controls are in place . . . without the internal ability to analyze the risks associated with that market is certainly enough of ‘an extreme departure from the standards of ordinary care.’” Furthermore, the Defendants’ warning to investors about future risk and losses did not, in the view of the court, overcome the allegations of inadequate risk control disclosure.   

Fourth, the court held that CIS and Smith satisfactorily pled all of the required elements of their Section 20(a) claims. CIS and Smith adequately alleged material misstatements as to FNMA’s subprime and Alt A exposure and risk management controls. The court explained that both the CEO and CRO could be viewed as having control since the CEO signed the 10-K and 10-Q reports and the CRO was responsible for internal control systems.

Fifth, the Defendants sought dismissal of all state law claims under the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”). As to FNMA, CEO Daniel Mudd, and Dallavecchia, the court found the claims preempted by SLUSA. State claims against executives Robert Levin, Stephen Swad, and related underwriters, however, did not trigger SLUSA because they did not involve more than fifty persons seeking damages, a required element of SLUSA preemption.

Sixth, Swad, and Levin moved to dismiss the Texas state law claims previously asserted by CIS. In its original complaint, CIS alleged both federal and state law claims against Swad and Levin. CIS, however, amended the complaint and voluntarily dismissed the federal claims. Because the federal claims were voluntarily dismissed, the court lacked pendent personal jurisdiction, which predicated the federal court’s jurisdiction over the state claims. The court held there was no other independent basis for personal jurisdiction; therefore, Levin and Swad’s motion to dismiss for lack of personal jurisdiction was granted.

Seventh, Goldman moved to dismiss Liberty’s Section 10(b), Rule 10b-5, and state law claims. Liberty asserted that Goldman violated subparts (a), (b), and (c) of Rule 10b-5. The court held that: (i) Liberty failed to allege facts showing misstatement of the offering material; (ii) Goldman had no “freestanding duty to disclose” the omitting of FNMA’s quantitative subprime and Alt A exposure; and (iii) Goldman did not defraud Liberty through market manipulation or any other avenue. Therefore, Liberty’s Rule 10b-5 (a) and (c) claims were invalid. As to Liberty’s state law claims, they also failed. “Liberty failed to allege an actionable misstatement contained in the offering circular [and] it cannot show that Goldman made or supplied false statements to Liberty.”          

Eighth, the Smith underwriters, which include many of the largest investment advisory firms on Wall Street, moved to dismiss Smith’s state law claim of negligent misrepresentation. The court held that Smith failed to plead necessary facts to show that the underwriters had “made a misrepresentation.”

Finally, the CIS underwriters, including Wachovia Capital Markets, LLC and Citigroup Global Markets, Inc., moved to dismiss multiple state claims under Texas law. The court concluded that each claim—statutory fraud, negligent misrepresentation, and violation of the Texas Security Act—was invalid for failure to correlate any material misrepresentation to the underwriters. 

The primary materials for this case may be found on the DU Corporate Governance website.

Julian Ellis