Fifth Circuit Affirms Dismissal of Federal Securities Fraud Case Arising From Alleged Overvaluation of Mortgage-Backed Securities


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, 2015 WL 3649823 (5th Cir. June 12, 2015). Owens illustrates that (i) subjective accounting principles are less likely to give rise to federal securities fraud liability than objective accounting principles, and (ii) a company can potentially mitigate the risk of federal securities fraud liability by providing adequate cautionary disclosures regarding its subjective valuation models.


Owens arose out of the failure of Guaranty Bank (the “Bank”), one of the largest bank failures in United States history. In July 2009, Guaranty announced that, at the direction of the Office of Thrift Supervision (“OTS”), it had amended its Thrift Financial Report for the period that ended March 31, 2009 and had recorded a $1.62 billion impairment on its mortgage-backed securities (“MBS”) portfolio. Soon after, the OTS closed Guaranty, the Federal Deposit Insurance Corporation 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 overvaluing Guaranty’s MBS portfolio and undervaluing 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.

The district court dismissed the plaintiffs’ complaint on grounds including the plaintiffs’ failure to adequately allege that the defendants had acted with a wrongful state of mind, also known as scienter. The Fifth Circuit affirmed on appeal.

Allegations Common to More Than One Defendant

The plaintiffs made only circumstantial allegations of fraud. In evaluating whether these allegations gave rise to a “strong inference” of scienter, as required under federal securities law governing Section 10(b) cases, the Fifth Circuit first considered the allegations common to more than one defendant and discussed the appropriate inference, if any, to be drawn from them. The court characterized the scienter issue as whether the plaintiffs had “state[d] with particularity facts giving rise to a strong inference that each defendant was severely reckless.”

  • Knowledge of Undercapitalization and Motive to Raise Capital

Temple-Inland, Inc. (“Temple”) was a holding company that operated, among other businesses, a financial services business known as Guaranty Financial Group (“GFG”).  GFG in turn owned the Bank. Shortly before the start of the class period, Temple announced a spin-off transaction that left GFG as independent owner of the Bank. The plaintiffs alleged that Temple did not provide Guaranty with sufficient capital at the time of the spin-off. The defendants allegedly knew of Guaranty’s undercapitalization and were motivated by the knowledge that, absent fraud, Guaranty would not have time to procure capital necessary to continue as a going concern.

The Fifth Circuit held the plaintiffs had pled with particularity that some of the defendants – including Guaranty’s CEO and CFO – were aware of Guaranty’s need for capital. The plaintiffs’ allegations were derived from similar allegations by Guaranty’s bankruptcy trustee in a separate lawsuit alleging that Temple and various other defendants had stripped Guaranty of assets and had left it insolvent. Although the plaintiffs’ allegations constituted some indication of scienter on the part of these defendants, they were insufficient, without more, to give rise to the required “strong inference” of scienter.

  • Knowledge of “Red Flags” Regarding MBS Valuation

The plaintiffs also alleged that several “red flags” alerted each defendant that Guaranty’s MBS valuation, and its decision not to recognize losses as OTTI, violated GAAP. The red flags included (i) a 250 percent increase in the average delinquency rate on Guaranty’s non-agency (i.e., privately-issued) MBS portfolio, (ii) a decrease in the value of the non-agency MBS portfolio to 60 percent of its cost, and (iii) the downgrading of ten securities in Guaranty’s portfolio. The Fifth Circuit held that these alleged red flags added little inference of scienter because documents referenced in the plaintiffs’ complaint and attached to the defendants’ motion to dismiss demonstrated that the defendants had publicly disclosed the alleged red flags, and had provided investors with explanatory and cautionary information regarding the uncertainty underlying Guaranty’s asset pricing models. These disclosures neutralized any scienter inference that the plaintiffs sought to draw from the alleged red flags.

  • Magnitude of Alleged Misstatements

The Fifth Circuit was not persuaded by the plaintiffs’ argument that the magnitude of the defendants’ valuation errors contributed to a strong inference of scienter. Although the magnitude of the errors was large in terms of the dollar amount and the percentage of overvaluation, its contribution to an inference of scienter was small because the accounting errors arose from the application of subjective accounting concepts. In other words, “[a]n inference of severe recklessness is more likely when a statement violates an objective rule than when GAAP permits a range of acceptable outcomes.”

Allegations Unique to Individual Defendants

The Fifth Circuit also reviewed the plaintiffs’ scienter allegations defendant by defendant, adding any allegations unique to that defendant, to holistically determine if the plaintiffs had alleged facts giving rise to a strong inference of scienter as to any defendant.

For example, the plaintiffs alleged that Guaranty’s Senior Vice President of Investments responsible for purchasing its MBS – whom the plaintiffs alleged to be a confidential witness – had sent an email to Guaranty’s CEO and CFO warning of several deficiencies in Guaranty’s internal MBS pricing model. In light of the subjective nature of the GAAP requirements at issue, the Fifth Circuit held the plaintiffs’ allegations failed to show that the CEO’s and CFO’s alleged decision to disregard the confidential witness’s warnings was unreasonable.

Also, the CEO and CFO had relied on outside ratings agencies, which rated Guaranty’s MBS as “AAA.” This reliance on AAA ratings, when the confidential witness did not caution that reliance on major outside ratings agencies was unwarranted, was not severely reckless. In sum, the plaintiffs’ allegations did not raise a strong inference of severe recklessness that was equally as likely as the competing inference that Guaranty’s CEO and CFO negligently relied on the AAA ratings and believed that Guaranty’s internal models were accurate.


Owens illustrates that federal securities fraud cases premised on alleged violations of subjective accounting principles are more difficult for plaintiffs to prosecute. Also, a company’s disclosure of explanatory and cautionary information regarding its subjective valuation models can potentially assist in neutralizing a plaintiffs’ future scienter allegations based on purported accounting “red flags” related to such models. The case also serves as a reminder that even where some specific allegations tend to support a finding of scienter, without more they may not invariably lead to a finding of the required “strong inference.”

For more information, please contact the lawyers listed below:

Carrie L. Huff


Thad Behrens

Daniel H. Gold


Odean Volker

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