Florida St. Bd. of Admin. v. Green Tree Fin.

Decision Date11 December 2000
Docket Number99-3586 and 99-3587,PLAINTIFFS-APPELLANTS,Nos. 99-3536,s. 99-3536
Parties(8th Cir. 2001) FLORIDA STATE BOARD OF ADMINISTRATION, PLAINTIFF - APPELLANT, v. GREEN TREE FINANCIAL CORPORATION; LAWRENCE M. COSS; ROBERT D. POTTS; EDWARD L. FINN, DEFENDANTS - APPELLEES. SECURITIES AND EXCHANGE COMMISSION, AMICUS ON BEHALF OF APPELLANT. IN RE: GREEN TREE FINANCIAL CORPORATION, STOCK LITIGATION, VIVIAN CHILL, ON BEHALF OF HERSELF AND OTHERS SIMILARLY SITUATED,, v. GREEN TREE FINANCIAL CORPORATION: LAWRENCE M. COSS; ROBERT D. POTTS; RICHARD G. EVANS; EDWARD L. FINN; JOEL H. GOTTESMAN, DEFENDANTS - APPELLEES. IN RE: GREEN TREE FINANCIAL CORPORATION: OPTIONS LITIGATION JUNE SHAPIRO, ON BEHALF OF HERSELF AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFFS - APPELLANTS, v. GREEN TREE FINANCIAL CORPORATION; LAWRENCE M. COSS; ROBERT D. POTTS; ROBLEY D. EVANS; EDWARD L. FINN; JOEL H. GOTTESMAN, DEFENDANTS - APPELLEES. Submitted:
CourtU.S. Court of Appeals — Eighth Circuit

Appeals from the United States District Court for the District of Minnesota. [Copyrighted Material Omitted]

[Copyrighted Material Omitted] Before McMILLIAN and John R. Gibson, Circuit Judges, and Laughrey,1 District Judge.

John R. Gibson, Circuit Judge.

In this case we must assess the sufficiency of three complaints under the new pleading standards made applicable to securities fraud cases by the Private Securities Litigation Reform Act of 1995, P.L. No. 104-67, 109 Stat. 737. The Florida State Board of Administration, which invests state employees' pension funds, and two putative classes of investors, one for stock purchasers and one for option traders, have each brought Rule 10b-52 actions against Green Tree Financial Corporation, its CEO, Lawrence Coss, and other executives,3 on the theory that they fraudulently overstated Green Tree's financial value. The investors allege that they bought securities in a market affected by this fraud and that when the true facts came to light, Green Tree's stock price tumbled and they lost their money. The district court held that none of the three complaints pleaded facts giving rise to a strong inference of knowing or reckless misconduct, and so the court dismissed the complaints with prejudice. Florida State Bd. of Admin. v. Green Tree Fin. Corp. (In re Green Tree Fin. Corp. Stock Litig), 61 F. Supp.2d 860, 878 (D. Minn. 1999). The Florida Board and both investor classes appeal, contending that their complaints were indeed sufficient to plead securities fraud. We reverse.

I.

For the purpose of a motion to dismiss, we take the facts from the complaints. Green Tree is a financial services corporation that originally specialized in lending money on house trailers, referred to as "manufactured housing," although it later diversified into other kinds of lending. Because manufactured housing loans are classified as "sub-prime," the interest rates are very high-as much as 200 to 400 basis points (two to four percentage points) above residential mortgage rates. Green Tree rose to prominence by pioneering the securitization of manufactured housing loans, which means that it pooled large numbers of these loans and put them into a trust, which sold securities for which the loans served as collateral. The securities entitled the purchaser to fixed interest and principal payments under the loans. Importantly, Green Tree did not relinquish all rights under the securitized loans; instead, it retained the right to keep a portion of the loan payments and it retained the obligation to service the loans. Green Tree's profit was therefore the spread between the interest it charged the borrowers and the interest it promised the instrument-holders, minus Green Tree's costs of servicing the loans. However, Green Tree retained the risk of losses from loan defaults, as well as the risk that borrowers would prepay their loans before incurring interest charges, so that the expected interest would never materialize. By absorbing these risks, Green Tree could take high-interest-rate manufactured-housing loans and turn them into low-interest-rate securities, thereby creating the profitable spreads that fueled Green Tree's growth.

As it securitized each loan pool, Green Tree booked a current gain on the transaction, even though the expected profits would not actually come into its coffers until much later and even though the amount of those profits would fluctuate with Green Tree's success in collecting the loan payments. This "gain-on-sale revenue" was the force that drove Green Tree's reported earnings during the periods covered by the complaints. Gain-on-sale receivables made up 63.8% of the net revenue that Green Tree originally reported for 1996. In addition to the income, Green Tree also recorded the present value of the securitizations as balance sheet assets called "Excess Servicing Rights Receivable" or "Interest Only Securities." In 1996 "Excess Servicing Rights Receivable" was the greatest single asset on Green Tree's balance sheet.

In order to estimate the present value of the securitizations, Green Tree had to assume three things: (1) the discount rate (reflecting the lesser value of a dollar to be paid in the future than a dollar paid today); (2) the loan default rate; and (3) the loan prepayment rate. The numbers chosen for these assumptions played a crucial role in deciding the amount Green Tree would report as earnings on the securitizations and as the value of the Excess Servicing Rights Receivable. Choosing a figure for prepayment rate was especially difficult because if interest rates fell substantially or if other lenders competed aggressively, borrowers would be likely to refinance in large numbers. If that happened, the loans and consequently, the expected profit on them, would simply disappear. A discrepancy between assumed prepayment rates and actual prepayment experience could have a serious effect on Green Tree's earnings and balance sheet.

The crux of this suit is the investors' allegation that Green Tree used "unrealistic and unreasonable" assumptions in its gain-on-sale accounting, thus overvaluing its assets and overstating its earnings. In particular, the investors allege that the actual prepayment experience from 1995 to 1997 varied so much from the prepayment rate Green Tree assumed in its gain-on-sale accounting for 1994 and 1995 securitizations that Green Tree's financials and other publicly filed reports during the 1995-1997 period were materially false. The investors concede that Green Tree publicly disclosed its actual prepayment experience. However, they allege the defendants refused to disclose what prepayment assumptions Green Tree had used in its gain-on-sale accounting and that this constituted omission of a material fact necessary to prevent its financial reports from being misleading. Green Tree stated in its public filings with the SEC that its management regularly reevaluated Green Tree's prepayment assumptions in light of actual experience. According to the complaints, the defendants either knew that the discrepancy between the actual prepayment experience and the assumed rates rendered the financials materially false, or alternatively, recklessly disregarded this fact.

In any event, Green Tree's assumptions about prepayment rates turned out to be seriously inadequate. Green Tree announced on November 13, 1997, that it planned to increase the prepayment reserve in its 1997 financials by an estimated $125-150 million because of higher than expected prepayment rates on manufactured housing loans. This announcement caused a precipitous decline in Green Tree's stock price, from $42 to $30.75. The day after the announcement, in a conference call with industry analysts, CEO Coss disclosed the prepayment assumptions Green Tree had been using for the 1994 and 1995 pools.4 He assured analysts, "I don't see any set of circumstances that would cause us to [write down the 1994-1995 loan pools] again. And if we thought there was any set of circumstances that would, we would have provided more." He also stated that a revision of prior earnings was not appropriate.

On January 27, 1998, Green Tree took an addition to its reserves of $190 million, rather than the $125-150 million addition to reserves anticipated in the November announcement. At the same time, it took a $200 million reduction of its previously reported 1996 earnings. In the press release accompanying the financials, Green Tree explained the decision to make larger adjustments than it had announced before; in reviewing its financial modeling, it "determined it had not fully considered the effect upon its interest only securities of partial prepayments (principal curtailments) and the impact that higher prepayments have on projected future interest due to investors on a weighted average basis." Green Tree's stock fell as low as $18.

On April 7, 1998, about two months after the close of the class periods, Green Tree announced that it would be acquired by Conseco, Inc., in a merger. On July 6, 1998, Conseco took charges totaling $350 million to write down the carrying value of Green Tree's interest-only securities, reflecting adjustment to assumptions for prepayment rates, discount rates, and default rates.

The investors allege that several motives prompted the defendants to spread misleading financial information through the market. First, they allege that the compensation of defendant Coss and other Green Tree executives was tied to Green Tree's financial results, which made the defendants want to maximize Green Tree's reported earnings. In particular, CEO Coss had a remarkable contract awarding him 2.5% of Green Tree's pre-tax income (minus other executives' bonuses). Coss's contract was to expire December 31, 1996. Accordingly, it was in Coss's personal interest to report as much income as possible before the expiration of his lucrative contract. Other motives alleged are: (1) the...

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