IN RE AMBAC FINANCIAL GROUP, INC.
| Decision Date | 29 April 2010 |
| Docket Number | No. 08 Civ. 411(NRB).,08 Civ. 411(NRB). |
| Parties | In re AMBAC FINANCIAL GROUP, INC. SECURITIES LITIGATION. |
| Court | U.S. District Court — Southern District of New York |
Frederic S. Fox, Esq., Melinda D. Rodon, Esq., Kaplan, Fox & Kilsheimer LLP, Steven B. Singer, Esq., Lauren A. McMillen, Esq., Bernstein, Litowitz, Berger & Grossman LLP, New York, NY, for Plaintiffs.
Peter C. Hein, Esq., Warren R. Stern, Esq., Joshua A. Naftalis, Esq., C. Lee Wilson, Esq., Wachtell, Lipton, Rosen & Katz, New York, NY, for Ambac.
Charles E. Davidow, Esq., Brad S. Karp, Esq., Joyce S. Huang, Esq., Douglas M. Pravda, Esq., Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, NY, for the Underwriters.
Michael R. Young, Esq., Antonio Yanes, Jr., Esq., Todd G. Cosenza, Esq., Willkie, Farr & Gallagher LLP, New York, NY, for KMPG.
Plaintiffs bring this securities class action under Sections 11, 12, and 15 of the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. §§ 77k, 77l and 77o; Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b) and 78t(a); and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. Plaintiffs filed a Consolidated Amended Class Action Complaint (the "CAC") on August 25, 2008.
Plaintiffs are investors in Ambac Financial Group, Inc. ("Ambac"), who purchased or acquired (1) Ambac stock during the period from October 25, 2006, through and including April 22, 2008 (the "Class Period"), or (2) securities issued pursuant to certain Ambac registration statements described below. Lead Plaintiffs, appointed pursuant to an order of this Court on May 9, 2008, 2008 WL 2073931, are a group of institutional investors comprised of the Public School Teachers' Pension and Retirement Fund of Chicago, the Arkansas Teachers' Retirement System, and the Public Employees' Retirement System of Mississippi, (collectively, "Lead Plaintiffs"). The CAC also names an additional plaintiff, Painting Industry Insurance and Annuity Funds, whose separately filed case was subsequently consolidated pursuant to our order of October 22, 2008.
Defendants are Ambac, several of Ambac's officers and directors (the "Individual Defendants"), Ambac's auditor (KPMG) and the underwriters of Ambac's securities offerings in February 2007 and March 2008 (the "Underwriter Defendants"). Before the Court are defendants' motions to dismiss pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, filed August 27, 2009. For the reasons stated below, the defendants' motions are granted in part and denied in part.
The following facts are taken from the CAC, written instruments attached to the CAC, statements or documents incorporated into the CAC by reference, public disclosure documents required to be filed with the SEC, and documents upon which plaintiffs relied in bringing the suit. The Court may consider such documents on a motion to dismiss. See ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir.2007). The Court assumes all alleged facts to be true for the purpose of deciding these motions to dismiss, and construes all alleged facts in the light most favorable to the plaintiffs. See Cleveland v. Caplaw Enters., 448 F.3d 518, 521 (2d Cir.2006).
Ambac is a holding company with numerous subsidiaries that provide financial guarantee products and other financial services to clients in both the public and private sectors. Its common stock is traded on the New York Stock Exchange. Ambac was founded in 1971 as the first company to offer insurance on municipal bonds. Ambac became known as a "monoline" insurer because it provided one type of insurance—a guarantee to protect against credit risk, i.e. the risk of default. Ambac's business model has always been based on establishing underwriting guidelines and procedures that enable the company to guarantee only those obligations that were "of investment grade quality with a remote risk of loss."1
In the years leading up to the Class Period, the focus of Ambac's business shifted from insuring municipal bonds towards providing insurance and default protection for structured financial products. While Ambac's exposure to municipal bonds remained roughly constant, Ambac's total insured portfolio grew rapidly, due mostly to the company's structured finance division. CAC ¶¶ 69-70. As a result, Ambac's exposures to public finance shrank from 85% of the company's insured portfolio in 1997, to 35% of the portfolio in 2007. Id.
An RMBS is a debt security that receives cash inflows directly from underlying pools of residential mortgages.2 CAC ¶ 43. Banks form RMBS by first purchasing mortgages from lenders or originating them directly, then compiling those mortgages into RMBS. The underlying mortgages are grouped into different classes, called "tranches," according to their expected risk of default. The riskiest tranches are, at least by design, the first to default, while the less risky—and thus higher rated—tranches are less likely to suffer losses caused by defaults within the underlying mortgage pool. RMBS are sold in these different tranches, priced according to the expected risk of default associated with the particular tranch. CAC ¶¶ 44-46.
The monthly interest and principal payments on the mortgages are pooled and paid to the holders of RMBS, i.e. the bondholders. If mortgage defaults cause losses in the pool, such losses are first allocated to "excess spread" and then to "overcollateralization" —mechanisms built into the securities to protect bondholders from facing losses. If losses exceed the amount of excess spread and overcollateralization, the losses are allocated to bondholders according to the risk profile of each tranch. The holders of bonds with the lowest credit rating face losses first, while AAA bondholders face losses last. CAC ¶ 45. If an entity holds less-risky, investment-grade tranches of RMBS, they are said to be protected by "subordination," i.e. the fact that subordinate bondholders will face losses first. CAC ¶ 47.
Ambac provided insurance against the risk of default on RMBS, but did not originate or underwrite mortgages or compile RMBS.
A CDO is a derivative security that receives cash inflows from asset-backed securities, including RMBS, or from other CDOs that are themselves funded by asset-backed securities. A CDO that receives cash inflows in part from other CDOs is known as a "CDO squared." CAC ¶ 48. To form CDOs, banks bought RMBS from mortgage originators and then created and issued CDOs. CAC ¶ 50. The CDO structuring process allowed lower-rated tranches of RMBS to be compiled into pools, thereby restructuring the cash flows so that other CDO tranches could be labeled as investment grade. A core assumption in this restructuring is that, between similarly rated RMBS tranches, there would be a limited correlation of defaults in the underlying mortgage collateral. If most or all of the similarly rated RMBS tranches supporting a CDO suffered defaults at the same time, the protective benefits of subordination would prove illusory.
Ambac issued default protection for CDOs in the form of credit default swaps ("CDS"). As a result, Ambac became the ultimate holder of risk for the mortgages at the bottom of these structured financial products. CAC ¶ 44. When Ambac wrote traditional insurance, regulation required it to allocate approximately 3% of the amount insured to support its capital cushion. CAC ¶ 65. However, when Ambac wrote CDS against CDOs, the amount of capital it had to allocate to the transaction was lower, even if the size of the deal and premium paid to Ambac were the same. Id. Thus, writing CDS was potentially more profitable to Ambac than traditional insurance. The danger to the company's viability of taking losses on CDO deals was also heightened, due to the smaller capital cushion in place relative to the amount of risk insured.
By the beginning of the Class Period, Ambac had increased its focus on guaranteeing CDOs. Looking at Ambac's "new business guaranteed" by bond type for 2004, 2005, and 2006, the percentage of CDO guarantees increased from 6% to 33% over the two year period.3 Additionally, Ambac's CDO deals contained increasing amounts of RMBS collateral. Ambac's net exposure to CDOs with greater than 25% RMBS as the underlying collateral increased from $900 million in 2004 (5.8% of Ambac's domestic CDO exposure) to $29 billion as of December 31, 2007 (57.5% of domestic CDO exposure).4 CAC ¶ 66. Most of the CDOs Ambac was exposed to were "synthetic CDOs." CAC ¶ 54. A synthetic CDO magnifies the risk of underperformance of the underlying RMBS because payment to the CDO depends in part on cash flows from complex derivatives whose value depends on the performance of the same underlying collateral. Thus, investments in synthetic CDO instruments lowered Ambac's diversification by "doubling down" on the same underlying securities. Id.
Generally Accepted Accounting Principles ("GAAP") required Ambac to record the total value of its CDS contracts at fair value as part of the company's quarterly financial disclosure.5 CAC ¶¶ 270-71. The price of a CDS is set by the expected likelihood of a default and the probable amount of the loss, or the "loss severity." CAC ¶ 272. The "value" of the swap is the difference between the premiums the issuer —here, Ambac—will receive and the likely default payments it will make; as the amount of the anticipated default payments increases, the value of the swap decreases. Id. GAAP required Ambac to take "write-downs" based on any increased chance that Ambac would have to perform on its obligation. CAC ¶¶ 273-76.
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