S.D.N.Y. Narrows Claims in Lehman Securities Class Action
Christina DeIasi | Bloomberg Law
The demise of Lehman Brothers Holdings Inc. (Lehman) in September 2008 had far reaching implications for the U.S. economy, as well as the company’s investors. Not surprisingly, those investors filed class actions on behalf of others who purchased Lehman common stock between June 12, 2007 and September 15, 2008. Plaintiffs have named as defendants five former officers of Lehman, nine former directors, 51 underwriters, and Lehman’s outside auditor (Defendants), but not Lehman itself, which filed for bankruptcy. On motions to dismiss, the U.S. District Court for the Southern District of New York allowed many of the claims to proceed, particularly those challenging Lehman’s use of Repo 105 transactions.
Plaintiffs’ claims center on Lehman’s use of Repo 105 transactions at the end of quarterly reporting periods to lower its net leverage—or ratio of net assets to tangible equity capital. A “repo,” or repurchase agreement, is used to obtain short-term funding. Lehman allegedly treated the collateral of its Repo 105 transactions as though it actually had been sold. In other words, the collateral was removed from Lehman’s balance sheet and Lehman used the cash that it received in exchange for the collateral to pay down other existing liabilities. Shortly after each quarter ended, however, Lehman allegedly transferred cash to its Repo 105 counter-parties “in the amounts it initially had paid plus the agreed-upon interest” and reacquired the collateral it had transferred. According to plaintiffs, Lehman then “restored the assets to its balance sheet, returning its net leverage to the pre-Repo 105 level.”
Plaintiffs claim that Defendants misrepresented Lehman’s use of Repo 105 transactions and their effect on Lehman’s reported net leverage. Defendants also allegedly misrepresented Lehman’s risk management policies, liquidity risk, concentrations of credit risk, and the value of Lehman’s real estate holdings. These representations, plaintiffs allege, were made in a May 31, 2006 shelf registration statement and prospectus for $31 billion in Lehman debt and equities, and various prospectus, product, and pricing supplements (collectively, Offering Materials). The Offering Materials incorporated by reference several of Lehman’s filings with the Securities and Exchange Commission (SEC).
As a preliminary matter, the Court held that plaintiffs do not have standing to bring claims related to 50 offerings in which they did not purchase securities.
The Court next turned to whether plaintiffs satisfied the heightened pleading requirements for securities fraud claims. The Court allowed most of the claims to proceed against Lehman’s former officers: Richard S. Fuld, Jr.; Christopher M. O’Meara; Joseph M. Gregory; Erin Callan; and Ian Lowitt (collectively, Officer Defendants). Conversely, the Court dismissed nearly all of the claims against Ernst & Young LLP (Ernst & Young), Lehman’s outside auditor.
Repo 105 and Net Leverage
The Court sustained three of plaintiffs’ four categories of alleged misstatements regarding the Repo 105 transactions and their effect on Lehman’s reported net leverage.
First, the Court determined that plaintiffs stated a violation of U.S. generally accepted accounting principles (GAAP). Specifically, the Officer Defendants allegedly violated the GAAP requirement that a company’s financial condition be presented accurately through the “repetitive, temporary, and undisclosed reduction of net leverage at the end of each quarter.” The Court rejected the Officer Defendants’ argument that the changes in net leverage from the Repo 105 transactions were immaterial. It explained that (1) net leverage allegedly was “a significant financial metric for ‘securities analysts, credit agencies and investors’ during the Class Period;” and (2) “the Repo 105 transactions resulted in net leverage differences more than fifteen times the difference that Lehman itself considered material.”
Second, the Court held that plaintiffs adequately stated that it was misleading for the Officer Defendants to disclose the Repo 105 transactions as financings when it treated them as sales. Third, the Court found that statements about Lehman’s net leverage ratios could have been materially misleading because the Officer Defendants failed to disclose the temporary and artificial reduction caused by the Repo 105 transactions.
However, the Court dismissed plaintiffs’ claim that Lehman violated Statement of Financial Accounting Standard (SFAS) 140 when it accounted for Repo 105 transactions as sales instead of financings. SFAS 140 requires a transferred asset to be recognized on the transferor’s balance sheet if the transferor retained control over the asset. Plaintiffs argued that Lehman retained such control because it was obligated contractually to repurchase the transferred Repo 105 assets. The Court disagreed and explained that control, within the meaning of SFAS 140, refers to the transferor’s ability to repurchase the assets “‘on substantially the agreed terms, even in the event of default by the transferee.’” An integral part of the Repo 105 transactions was that Lehman transferred at least $105 in assets in exchange for $100 in cash. The Court thus concluded that plaintiffs’ complaint fails to allege that “Lehman obtained funds in the Repo 105 transactions sufficient to replace the transferred assets from others. Indeed, it alleges the opposite. . . .”
The Court turned next to plaintiffs’ allegations that the Officer Defendants misrepresented Lehman’s risk management policies. The Officer Defendants allegedly stated that Lehman “‘monitor[ed] and enforc[ed] adherence to [its] risk policies,’” and that “‘[m]anagement’s Finance Committee oversees compliance with [risk] policies and limits.’” These statements were arguably misleading, the Court concluded, because Lehman allegedly “routinely exceeded various risk limits it had created.” Value-at-Risk (VaR) is one such limit that Lehman is alleged to have routinely exceeded. The Court thus allowed claims to proceed concerning statements specifically touting Lehman’s compliance with VaR limits.
Another actionable misstatement, the Court held, was the Officer Defendants’ representation that Lehman used “‘stress testing to evaluate risks associated with [its] real estate portfolios.’” Plaintiffs alleged that this statement was false and misleading because Lehman excluded some of its riskiest investments from the stress tests.
In contrast, the Court dismissed claims that Lehman falsely represented that it had appropriate risk mitigants in place. “The question whether a particular risk mitigant was appropriate when implemented is inherently a matter of judgment or opinion,” the Court explained, and plaintiffs failed to allege that Lehman did not believe its statement.
Plaintiffs further alleged that statements about the strength of Lehman’s liquidity violated Item 303 of Regulation S-K. Lehman was required under Item 303, the Court explained, to disclose the Repo 105 transactions “only if they were reasonably likely to affect its liquidity in a material way.” Plaintiffs failed to allege that the transactions had such a material impact on Lehman’s liquidity, and thus, the Court dismissed these claims. Moreover, plaintiffs failed to allege “any facts contradicting the statements that Lehman’s liquidity position was sufficient to cover its liquidity needs at the time any particular statement was issued.”
Concentrations of Credit Risk
Plaintiffs also sufficiently alleged that Lehman failed to disclose “significant” concentrations of credit risk in its Alt-A and commercial real estate holdings, but not in its leveraged loan holdings, in violation of SFAS 107. The Court limited the claims regarding Alt-A holdings to the period after February 20, 2008, and the claims regarding commercial real estate holdings to statements made in Lehman’s 2007 Form 10-K.
Finding no allegations that the Officer Defendants had the motive or opportunity to commit fraud, the Court considered plaintiffs’ allegations of conscious misbehavior or recklessness. It found that plaintiffs adequately alleged red flags regarding the Repo 105 transactions, including their size, temporary effect on net leverage, timing at the end of each reporting period, and lack of a true business purpose. They also alleged with particularity that the Officer Defendants received detailed reports about the Repo 105 transactions, and they “knew, or were reckless in not knowing, that use of the Repo 105 transactions and the manner in which they were accounted for painted a misleading picture of the company’s finances.” Plaintiffs also adequately alleged that the Officer Defendants “were involved in setting Lehman’s risk policies and knew that the statements concerning enforcement of risk management policies were false.”
The Court, however, found scienter allegations (1) lacking altogether for plaintiffs’ claims that the Officer Defendants misrepresented Lehman’s stress testing and concentration of credit risk regarding Alt-A holdings, and (2) lacking against Callan and Lowitt with regards to claims that the Officer Defendants misrepresented the credit risk of Lehman’s commercial real estate holdings.
— Loss Causation
The Court also rejected the Officer Defendants’ argument that plaintiffs’ losses were the result of the industry-wide crisis in the subprime markets. The Court acknowledged that Lehman may have been doomed “given the assets it held,” but it is not implausible that some of plaintiffs’ losses are the result of the alleged fraud. The Officer Defendants allegedly minimized through its misstatements and omissions various risks that the company faced, and plaintiffs adequately alleged that it was the materialization of these risks that destroyed whatever value remained in Lehman’s shares.
— Ernst & Young
Plaintiffs’ allegations against Ernst & Young concern the “clean” audit opinions that it issued in connection with Lehman’s 2007 Form 10-K and several quarterly financial statements. Plaintiffs claim that Ernst & Young’s statements were false and misleading because the financial statements did not comply with generally accepted auditing standards (GAAS) and GAAP.
The Court focused on allegations that Ernst & Young ignored or failed to respond to three red flags: (1) Lehman’s inability to obtain from a U.S. law firm a true sale opinion concerning its accounting treatment of the Repo 105 transactions; (2) a netting grid that identified and described the Repo 105 transactions; and (3) a June 12, 2008 interview with a Lehman employee in which he revealed that Repo 105 transactions had been used at the end of the second quarter of 2008 to remove more than $50 billion from the company’s balance sheet.
The Court rejected plaintiffs’ characterization of the first two events as red flags because they did not reveal that Lehman was using Repo 105 transactions to manipulate its quarterly numbers. The third event, however, was different. It explained that, after the interview, Ernst & Young was on notice that Lehman had used Repo 105 transactions “to portray its net leverage more favorably than its financial position warranted.” Plaintiffs thus sufficiently alleged a misstatement by Ernst & Young in connection with Lehman’s financial statement for the second quarter of 2008, but not for any earlier statements.
— Secondary Claims
Moving away from Exchange Act Section 10(b), the Court considered plaintiffs’ control person claims under Section 20(a) of the Exchange Act and insider trading claims under Section 20A. For the former, the Court held that, to the extent that plaintiffs had alleged scienter against the Officer Defendants, they had also alleged culpable participation. The Court dismissed the latter claims against Fuld because plaintiffs failed to allege that he possessed material, non-public information.
Securities Act Claims
In addition to their claims under the Exchange Act, plaintiffs alleged that the Offering Materials contained misrepresentations and omissions that violated the Securities Act. In addition to the Officer Defendants and Ernst & Young, plaintiffs filed these claims against the following additional remaining Defendants: nine former Lehman directors (Director Defendants); Ernst & Young; and 51 underwriters (Underwriter Defendants).
Defendants moved to dismiss the claims of 24 newly-added named plaintiffs as time-barred. The Court concluded that the one-year statute of limitations for Securities Act claims does not bar these claims because “the filing of a class action suspends the running of applicable statutes of limitations for all putative class members even where the putative class plaintiff did not have standing to assert the claims at issue.” In contrast, the Court continued, there were three offerings barred by the three-year statute of repose, which cannot be tolled.
— Statutory Standing
Next, the Court rejected an argument by UBS, one of the Underwriter Defendants, that plaintiffs failed to allege statutory standing in connection with their Section 12(a)(2) claims. It was enough for plaintiffs to allege (1) that they brought their claims on behalf of those “‘who purchased or otherwise acquired the Lehman/UBS Structured Products pursuant to the materially untrue and misleading Structured Note Offering Materials;’” and (2) the dates and amount of securities that they purchased.
— Misstatements and Omissions
To the extent that plaintiffs stated an actionable misstatement for purposes of the Exchange Act, the Court found that they also asserted a viable misstatement under the Securities Act. Plaintiffs’ claims of misrepresentations in the pricing supplements for Lehman’s principal protection notes (PPN) also survived dismissal. Although the PPN Offering Materials warned that investors might not receive their principal if Lehman went bankrupt, “the principal protection statements were displayed more prominently and frequently than the warnings.”
The Court, however, dismissed plaintiffs’ claim that Defendants misrepresented Lehman’s valuation of its commercial real estate holdings. The Offering Materials stated that these assets were measured at “fair value.” Plaintiffs claimed that this was untrue because Lehman failed to consider certain market information in the assumptions underlying its valuation models for certain assets. The Court rejected this argument, explaining that SFAS 157 “expressly contemplates that different models, based on different assumptions and the assignment of different weights to different inputs, may be used to determine fair value.” In addition, the Court noted that “Lehman’s determination that certain models, assumptions, and inputs were likely to provide accurate estimations of fair value was a matter of judgment.” And, the Court continued, the complaint lacks allegations that Lehman did not believe that its models, assumption, and inputs would produce fair values under SFAS 157.
Lastly, the Court considered the specific defenses against Securities Act liability from various Defendants. Callan, for instance, argued that the Section 11 claims should be dismissed because she did not sign the registration statement. The Court agreed with plaintiffs that Callan could be liable under Section 11 for signing Lehman’s filings with the SEC that were incorporated by reference in the registration statement.
Fuld, O’Meara, Callan, and the Director and Underwriter Defendants argued that they conducted a reasonable investigation and had a reasonable ground to believe that the Offering Materials did not contain any material misstatements or omissions. The Court concluded that it could not decide as a matter of law that their investigation was reasonable under the circumstances.
Ernst & Young
The Court further dismissed all Securities Act claims against Ernst & Young. It reiterated that the only actionable misstatements alleged against Ernst & Young were made in connection with Lehman’s quarterly report for the fourth quarter of 2008. This report contained unaudited interim financial information, and thus is not actionable under Section 11.
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