Freudenberg v. E*trade Financial Corp.
| Citation | 712 F.Supp.2d 171 |
| Decision Date | 11 May 2010 |
| Docket Number | No. 07 Civ. 8538.,07 Civ. 8538. |
| Parties | Larry FREUDENBERG, Individually and on Behalf of All Others Similarly Situated, Plaintiff,v.E*TRADE FINANCIAL CORPORATION, Mitchell H. Caplan, Robert J. Simmons and Dennis E. Webb, Defendants. |
| Court | U.S. District Court — Southern District of New York |
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Brower Piven, by: David A.P. Brower, Esq., Levi & Korsinsky, LLP, by: Eduard Korsinsky, Esq., New York, NY, for Plaintiff.
Davis Polk & Wardwell LLP, by: Amelia T.R. Starr, Esq., New York, NY, for Defendants.
Defendants E*TRADE Financial Corporation (“E*TRADE” or the “Company”), CEO Mitchell H. Caplan (“Caplan”), CFO Robert J. Simmons (“Simmons”) and Capital Markets Division (“EGAM”) President Dennis E. Webb (“Webb”) (collectively, the “Individual Defendants”) have moved to dismiss the Consolidated Amended Class Action Complaint for Violations of the Federal Securities Laws (the “Complaint”) 1 pursuant to Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act of 995 (the “PSLRA”), 15 U.S.C. §§ 78u-4 et seq. Based upon the conclusions set forth below, the motion is denied.
By the Fall of 2007, the collapse of the subprime mortgage and the housing markets and the decline in the housing market were widely recognized. At the close of the third quarter in October 2007, many of the world's largest financial institutions announced their first in a wave of crippling write-downs of mortgage-related assets, including $11 billion by Citigroup, $10 billion by UBS and $8 billion by Merrill Lynch. UBS Posts Fresh $10bn Write-Down, BBC News, Dec. 10, 2007; Remarks of Senator Barack Obama: Our Common Stake in America's Prosperity (Sept. 17, 2007), available at http:// www. barackobama. com/ 2007/ 09/ 17/ remarksof senator barackobam 24. php (indicating the connection between corporation's risky investments in the subprime mortgage market and the financial crisis). Class actions alleging securities act violations have followed particularly in this district, of which this case is one. See, also Kreysar et al. v. Syron et al, No. 09-CV-832 (MGC); In Re The Bear Stearns Companies, Inc. Sec. Litig., No. 08-CV-2793 (RWS); In Re Lehman Bros. Holdings, Inc., No. 08-CV-8869 (DLC); In Re Fannie Mae Sec. Litig., No. 08-CV-7831 (PAC); In Re Moody's Corp. Sec. Litig., No. 07-CV-08375 (GBD); In Re Morgan Stanley ERISA Litig., No. 07-CV-11285 (DAB).
Defendants, including the Defendants in this action, urge that the losses incurred were the result of a “worldwide economic catastrophe” (Def's Memo in Support of Mot. to Dismiss (“MTD”) at 1) and that the complaints set forth a case of fraud by hindsight rather than the violation of the securities laws.
Because the issue in this action is what the Defendants knew and when they knew it, a securities violation has been adequately alleged.
A class action complaint was filed by Larry Freudenberg on October 2, 2007, alleging violations of the securities laws by the Defendants. Additional related complaints were thereafter filed. An order consolidating the actions and appointing lead plaintiff and counsel was filed on July 17, 2008. The consolidated amended class action complaint (the “Complaint”) was filed on January 20, 2009.
The instant motion to dismiss the Complaint was heard on September 9, 2009.
According to the Complaint, the Defendants misrepresented the operation of E*TRADE's most important business sector, EGAM, and the Company's financial condition throughout the Class Period and thereby violated Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Securities and Exchange Commission (“SEC”) Rule 10b-5.
E*TRADE was originally an Internet discount brokerage firm. ¶¶ 42, 62. Discount brokerage yields steady and safe returns, but opportunities for growth are limited. By the beginning of the Class Period, EGAM had aggressively expanded into the highly profitable mortgage business. ¶¶ 66-67. Although Defendants represented that E*TRADE's mortgage business focused on “organic” loans, originating its own mortgages for its “mass affluent” brokerage customers, EGAM was actually purchasing large mortgage pool from other originators. ¶¶ 6, 62-66, 72, 101-18. As a result, internally, EGAM was recognized as E*TRADE's most profitable division. ¶¶ 12, 70. However, by the beginning of the Class Period, the era of safely purchasing such mortgages was at an end. Nevertheless, to continue its stream of income from its most profitable segment, Defendants acquired huge quantities of loans from the nation's worst subprime and below subprime mortgage originators ¶¶ 70-72, 74, and failed to publicly disclose that they had changed E*TRADE's business model from conservative investments in high quality loans to purchasing extremely high risk, facially low quality instruments. ¶¶ 17-18. Thus, throughout the Class Period, Defendants represented to the public that E*TRADE continued to follow conservative loan origination and acquisition practices, when, in fact, Defendants had consciously decided to secretly sacrifice safety for profits.
To mislead investors about the investment risk of E*TRADE, Defendants represented that the Company's business was generated organically from its traditional trading and banking services to E*TRADE customers, ¶¶ 65, 72, 131, 146-48, 160, 174-177, 182, that Defendants used discipline and conservatism in its risk management and monitoring of its loan portfolio, see ¶¶ 7, 10, 11, 13, 65, 68, 144-48, 160, 170, 174-77, 193, 225-29, and, to distinguish E*TRADE from the troubled lenders who were already experiencing severe problems, see, e.g., ¶¶ 209, 212, that E*TRADE's portfolio of mortgage loans was “superprime.” ¶¶ 11, 170-73, 185, 202, 211.
In fact, unable to organically generate significant numbers of its own mortgages, ¶¶ 88-93, in disregard of E*TRADE's own stated underwriting practices, ¶¶ 74-83, at the direction of the Individual Defendants, who oversaw E*TRADE's investments and financial reporting, Defendants used cash generated from its retail businesses to purchase high-risk asset-backed securities and pools of mortgages(“MBS” and “ABS”), ¶¶ 62-63, from problem-ridden originators, such as Countrywide, Opteum, GMAC, and National City. ¶¶ 18, 68, 78-79, 101-18, 209, 214, 225, 288. While publicly characterizing the loans in its portfolio as “superprime,” these loans were subprime or below subprime and did not meet E*TRADE's claimed “extremely conservative” credit standards. Id. See also ¶¶ 12, 70. To facilitate the steady influx of these low quality loans, Defendants decimated E*TRADE's due diligence apparatus by firing most mortgage loan and credit review personnel, ¶¶ 13, 67-68, 300, and all but eliminated any pre- or post-purchase review of these loan pools. ¶¶ 69, 81.
The Individual Defendants were alleged to have been fully aware of E*TRADE's risks and adverse consequences of this strategy. Even E*TRADE's de minimis review during the Class Period of only 1% of its bulk mortgages purchases demonstrated the extreme poor quality of those loans. ¶¶ 11, 13, 17, 75-82, 170-73, 202, 211. Indeed, 40% to 50% of sampled loans had negative discrepancies, such as unreported bankruptcies and overstated appraisals. ¶¶ 17, 78, 91. When one Confidential Witness (“CW”) asked why E*TRADE kept “bad” problem loans instead of returning the loans to their originators-as E*TRADE had the right to do for a grace period after the purchases-he was told by E*TRADE management that EGAM wanted to maintain its relationships with the loan originators because it was “getting great deals” on these loans. ¶ 78. Defendants knowingly retained bad loans to protect the steady flow of these lowcost (and low-quality) mortgages. Id.
By the beginning of the Class Period, Defendants spoke to new hires of their internal concerns with the excessive, unbalanced risks E*TRADE was taking. ¶¶ 14, 72. In December 2006, Caplan “confidentially” admitted to employees that the Company was experiencing losses and expected more losses in 2007, ¶¶ 16, 98, but Defendants made the opposite representations to the public. ¶¶ 174-77, 181-85. Contrary to Defendants' public statements regarding the impeccable AAA credit rating of the securities in E*TRADE's investment portfolio, see ¶¶ 20, 22, 224, 235, 244, 246, 254, 271-72, 279, 282, E*TRADE's overexposure to subprime mortgages was discussed among E*TRADE's senior management and led Caplan to internally voice hope that a “white knight” would rescue E*TRADE. ¶¶ 94-99. Defendants also knew that E*TRADE's mortgages were of very low quality because E*TRADE's attempts to resell purchased loan pools to other financial institutions failed because of the “terrible, low value,” below subprime, quality of the loans and loan documentation. ¶¶ 17, 76, 86. Consequently, E*TRADE was forced to retain these knowingly impaired, low quality mortgages. See ¶ 81; see also ¶ 84.
To conceal the high risk nature and deterioration of E*TRADE's portfolio, ¶ ¶ 21, 122-23, 138-40, 154-56, 164-65, 220-22, 243, Defendants ignored Generally Accepted Accounting Principles (“GAAP”) and SEC financial reporting and accounting rules, regulations and guidance, by inter alia, failing to adequately reserve for loan losses, failing to timely record securities' impairments, and overvaluing E*TRADE's securities portfolio, thereby rendering E*TRADE's financial statements to be materially inaccurate, reported net income and earnings to be materially overstated, and loss reserves to be materially understated. ¶¶ 21, 22, 333-37. Indeed, throughout the Class Period, as the mortgage crisis was reverberating across the country, E*TRADE actually reduced its reserve coverage ratio from 83% to just 33% as well as its reserve as a percentage of total loans from 0.20% to 0.19%, ¶¶ 220-22, thereby artificially reducing...
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