In re Countrywide Financial Corp.
| Decision Date | 14 May 2008 |
| Docket Number | Lead Case No. CV-07-06923-MRP (MANx). |
| Citation | 554 F.Supp.2d 1044 |
| Parties | In re COUNTRYWIDE FINANCIAL CORP. DERIVATIVE LITIGATION. |
| Court | U.S. District Court — Central District of California |
Before the Court are several motions to dismiss Plaintiffs'1 derivative claims in In re Countrywide Financial Corp. Derivative Litigation ("Arkansas Teachers"). Nominal Defendant Countrywide Financial Corporation ("Countrywide" or "Company") moves to dismiss on the grounds that Plaintiffs' have not made pre-suit demand or adequately pled that demand is excused in this case.2 Individual Defendants3 move to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), 9(b), 8(a)(2), and the provisions of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. §§ 78u-4(b)(1), 78u-4(b)(2), 78u-5(c)(1)(a), § 78u-5(c)(2)(a).
A complete procedural background of this and other related proceedings is provided in the Court's March 28, 2008 Order. Relevant here, Plaintiffs filed a Consolidated Complaint on February 15, 2008 alleging both derivative and class action claims. See Consolidated Shareholder Derivative Action and Class Action Complaint for Breaches of Fiduciary Duty, Aiding and Abetting Breaches of Fiduciary Duty, and Violations of the California and Federal Securities Laws ("Compl."). On March 28, this Court stayed the class action claims in favor of similar proceedings in the Delaware Court of Chancery. The instant motions seek to dismiss the nine remaining derivative claims.
Plaintiffs here are Arkansas Teacher Retirement System ("ATRS"), Fire & Police Pension Association of Colorado ("FPPAC"), Public Employees Retirement System of Mississippi ("MS PERS"), and Central Laborers Pension Fund ("CLPF").
Nominal Defendant Countrywide is a Delaware corporation with its principal executive offices in Calabasas, California. Id. ¶ 53.
The Individual Defendants consist of both director and non-director defendants. The Complaint names as director Defendants, Angelo R. Mozilo (Chairman of the Board since 1999 and Chief Executive Officer since 1998), David Sambol (Director since Sept. 2007, President and Chief Operating Officer, and various other executive positions), Jeffrey M Cunningham (Director since 1998), Robert J. Donato (Director since 1993), Martin R. Melone (Director since 2003), Robert T. Parry (Director since 2004), Oscar P. Robertson (Director since 2000), Keith P. Russell (Director since 2003), Harley W. Snyder (Director since 1991), Henry G. Cisneros (Director from 2001-Oct.2007), and Michael E. Dougherty (Director from 1998-Jun. 2007). Id. ¶¶ 54-64.
The Complaint names as non-director Defendants Stanford M. Kurland (President and Chief Operating Officer until 2006, and various other executive positions), Carlos M. Garcia (several executive positions and former Chief Financial Officer), and Eric P. Sieracki (Chief Financial Officer and Executive Managing Director). Id. ¶¶ 66-69.
Countrywide originates home loans, retaining a portion of these loans on its balance sheet as investments, and securitizing and selling the remainder. Id. ¶ 101. The Company services the loans that it produces. Id. ¶ 102. It produces both "conforming loans" which can be sold to government-sponsored entities Fannie Mae and Freddie Mac, and non-conforming ones, which can be sold only to private investors. Id. ¶¶ 106-108. Countrywide finances its operations in large part with capital from private parties—including the secondary mortgage market, where investors purchase mortgages and "mortgage-backed securities." Id. ¶¶ 103-104. In addition to retaining some in its portfolio for investment purposes, the Company holds "retained interests"—or residual interests in some mortgage-backed securities that have been passed along to investors. Id. ¶ 208. According to the Complaint, retained interest holders receive interest payments from a "real estate mortgage investment conduit" only after all required regular interest has been paid to investors in higher priority securities tranches. Id. ¶ 129. Finally, the Company maintains a catalog of "loans held for sale" composed of mortgages that will ultimately be sold to third party investors, and "mortgage servicing rights"4 on the mortgages, that it originates. Id. ¶ 210.
Countrywide must consistently produce quality mortgages, or at least mortgages "at levels that meet or exceed secondary mortgage market standards" to ensure that the secondary market will continue to provide capital to finance its operations. Id. ¶¶ 104-105. Moreover, if the Company originates and sells loans that are not in compliance with its own underwriting policies, in violation of the representations or warranties made to purchasers, those purchasers can require Countrywide to repurchase them. Id. ¶ 106.
Plaintiffs allege that from 2002-2006, the Company steadily increased the origination of "non-conforming" loans, which are inherently less safe than conforming loans because they cannot be sold to government-sponsored entities. Id. ¶¶ 106-108. Countrywide also "strategically" shifted away from traditional fixed-rate home loans to borrowers with "prime" credit scores, in favor of a variety of non-traditional higher-risk loans. Id. ¶ 109. The Complaint identifies several categories of these non-traditional loans: (1) adjustable rate mortgages (ARMs), which typically provided a low "teaser" interest rate during an introductory period, followed by higher rates; (2) interest-only mortgages, where require the borrower to pay only the interest during an introductory period; (3) "pay option" ARMs, which provide the borrower the option to pay a "minimum" monthly payment less than the interest accruing that month, and add any remaining interest to loan principal; (4) stated income loans, which rely on the borrower's representations of an ability to pay, and require little or no supporting documentation from the borrower; and (5) home equity lines of credit ("HELOCs"), which are second loans secured by the difference between the value of a home and the amount due on the first mortgage.5 Id. ¶ 110.
Plaintiffs allege that these types of loans are considerably more risky than traditional al conforming loans. Id. ¶ 119. For instance, with stated income loans, the borrower may overstate his income, resulting in a loan that is fundamentally at risk of default if the borrower's income is inadequate. Id. ¶ 110. In addition, HELOCs become a problem if housing prices decline: the HELOC lender's security interest decreases because the first lien-holder has priority to be paid in full the amount of the first mortgage. At the extreme, the HELOC becomes completely unsecured. Id. Plaintiffs contend that this can occur with a mere 10-20% reduction in the value of a home. Id.
Pay option ARMs raise other concerns. With pay option ARMs, a borrower's failure to pay at least the minimum monthly interest results in "negative amortization," whereby any interest that remains unpaid is added to the amount of principal outstanding on the loan. Id. ¶ 121. While accumulated negative amortization is reported as deferred interest earnings on the Company's income statement or with the loan on the balance sheet, it is particularly problematic where borrowers chose to skip payments out of necessity, as those borrowers very likely have an increased risk of default. Id. ¶ 122.
Significantly, according to Plaintiffs, Countrywide did not simply originate loans that were inherently risky. Id. ¶ 116. Rather, the Company exacerbated the risky nature of these loans by offering them to borrowers without requiring them to document their income. Id. For instance, the vast majority (78% in 2004, and 91% in 2006) of Countrywide's pay option ARMs fell into the "low documentation" category. Id. ¶¶ 12, 116-121. Without assurances of the credit-worthiness of its borrowers, Countrywide could not reasonably know how likely it was that deferred interest on pay option ARMs would ultimately be repaid. Id. ¶ 122. According to Plaintiffs, HELOCs, too, were provided to borrowers who were less credit-worthy than that instrument required. While HELOCs were often labeled as "prime" products, one observer in late 2007 commented that Countrywide's HELOCs were performing on par with a competitor's sub-prime loans. See id. ¶¶ 250-251 ().
Plaintiffs allege that in practice, the origination of these "riskier" loans often violated the Company's own loan underwriting policies. The Complaint offers the accounts of numerous confidential witnesses, who are mostly former employees such as underwriters and loan officers, relating how Countrywide departed from its strict underwriting standards by generating large numbers of loans without proper regard for their quality. See ¶¶ 147-158 (). The Complaint also provides the accounts of several former vice presidents at Countrywide who similarly attest that Countrywide was simply pushing through loans without adherence to underwriting standards. Id. ¶¶ 148-152.
Despite the changes to Countrywide's loan portfolio that resulted from the combination of increasingly risky loans...
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