David Dodds in Law360: Lessons From 5th Circ. Application Of Scienter Standard

07/30/2015

The Fifth Circuit recently affirmed a district court’s dismissal of a federal securities fraud class action on the basis that the plaintiffs had failed to adequately plead facts establishing that the defendants, the executives of a failed bank, were severely reckless in their overvaluation of the bank’s portfolio of mortgage-backed securities. See Owens v. Jastrow, No. 13–10928, ___ F.3d ___, (5th Cir. June 12, 2015). Owens illustrates that (1) violations of subjective accounting principles are more likely to be dismissed on scienter grounds than violations of objective accounting principles, and (2) a company can potentially mitigate the risk of federal securities fraud liability by providing adequate cautionary disclosures regarding its internal valuation models...

Owens arose out of the failure of Guaranty Bank, one of the largest bank failures in United States history. Guaranty’s asset portfolio contained a significant amount of “nonagency” (i.e., privately-issued) mortgage-backed securities (MBS) that had higher risks than their government-sponsored counterparts. In July 2009, Guaranty announced that, at the direction of the Office of Thrift Supervision, it had amended its thrift financial report for the period ended March 31, 2009, and had recorded a $1.62 billion impairment on its MBS portfolio. Soon after, the OTS closed Guaranty, the Federal Deposit Insurance Corp. was appointed as receiver, and Guaranty’s parent company filed for bankruptcy.

The plaintiffs in Owens represented a putative class of former Guaranty stockholders whose equity interests were wiped out when Guaranty failed. They brought federal securities law claims, including claims under Section 10(b) of the Securities Exchange Act and Rule 10b–5, against four former Guaranty executives. The plaintiffs alleged that the defendants violated generally accepted accounting principles (GAAP) by using flawed internal asset pricing models that overvalued Guaranty’s MBS portfolio and undervalued its losses. The defendants allegedly compounded this problem by failing to properly record Guaranty’s losses as “other than temporary impairment” (OTTI). The defendants reported these allegedly erroneous accounting figures in Guaranty’s public filings, which the plaintiffs alleged were materially false and misleading.

Excerpted from Law360. To read the full article, click here (subscription required).

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