In re Credit Acceptance Corp. Sec. Litigation

• Decision Date: 23 April 1999
• Docket Number: No. 98-70417.,98-70417.
• Citation: 50 F.Supp.2d 662
• Parties: In re CREDIT ACCEPTANCE CORPORATION SECURITIES LITIGATION.
• Court: U.S. District Court — Eastern District of Michigan

50 F.Supp.2d 662

In re CREDIT ACCEPTANCE CORPORATION SECURITIES LITIGATION.

No. 98-70417.

United States District Court, E.D. Michigan, Southern Division.

April 23, 1999.

COPYRIGHT MATERIAL OMITTED

COPYRIGHT MATERIAL OMITTED

Gerald Mantese, Troy, Starley Bernstein, NY, for Plaintiffs.

Andrew McGinness, Ann Arbor, Timothy Nelson, Chicago, IL, for Defendants.

OPINION & ORDER STRIKING AFFIDAVIT AND GRANTING DEFENDANTS' MOTION TO DISMISS

EDMUNDS, District Judge.

This matter comes before the Court on Defendants' motion to dismiss and Defendants' motion to strike the affidavit of Michele M. Stanton. As discussed below, the Complaint is insufficient to state a claim for securities fraud under the heightened pleading standard applicable in this area of law because it fails to adequately allege scienter. Therefore, the motion to dismiss is GRANTED. Likewise, the motion to strike the affidavit is GRANTED.

I. The Counts and the Parties

A. Complaint Alleges Two Counts

In this consolidated class action lawsuit,¹ the shareholder Plaintiffs allege that the Defendants, Credit Acceptance Corporation ("CAC"), and three of its individual officers, Messrs. Donald Foss, Richard Beckman, and Brett Roberts, engaged in securities fraud. Specifically, Plaintiffs' consolidated complaint alleges two Counts: (1) a violation of Section 10(b) of the Securities Exchange Act of 1934, ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5; and (2) a violation of Section 20 of the Exchange Act, 15 U.S.C. § 78t(a), for "controlling person" liability on the part of Foss, Beckman and Roberts.

B. The Parties

The Defendant Corporation, CAC, is a financial services company that generates revenue by providing sub-prime, high-risk, `D' grade loans to used car purchasers through car dealers. Specifically, CAC finances consumer used car purchases by accepting assignments of installment contracts entered into by the purchaser and the car dealer. The installment contract represents the amount financed, i.e., the purchase price of the car less any down payment received by the dealer from the customer.

Under its agreement with car dealers, CAC gets 20% of the payments received on an installment contract as its servicing fee, and the dealer is entitled to the remaining 80%. At the time it accepts a contract from a dealer, CAC advances the dealer a percentage of the amount the dealer is entitled to receive in the event that the consumer makes all the payments. The percentage advanced is allegedly dependent on several factors including the dealer rating, the percentage of the down payment to the total purchase price, the customer's credit rating, the car's value, and the value of add-on products, such as insurance.

When CAC accepts assignment of a contract, it records: (1) the gross amount of the installment contract as an installment contract receivable; (2) CAC's servicing fee as an unearned finance charge; and (3) the remainder of the amount due under the contract as a dealer holdback. If the contract meets the criteria for an advance, the dealer is advanced a portion of the amount due it, which is netted against the dealer holdback. (Defendants' App. Exb. A at 19).

In order to provide for potential losses resulting from installment contracts that are uncollectible, CAC maintains a reserve for future credit losses. If CAC cannot collect the entire amount of a contract, the uncollected balance is charged off against dealer holdbacks, unearned finance charges, and the allowance for credit losses. CAC also keeps a reserve for losses on dealer advances that may not be recovered. Dealer advance balances are reviewed monthly and those deemed to be uncollectible are charged against the reserve. (Complaint at ¶ 52). CAC's 10-k and 10-Q statements from June 1995 until June 1997 all warned, "Ultimate losses may vary from current estimates and the amount of the provision, which is a current expense, may be either greater or less than actual charge offs." (Complaint at ¶ 52).

The Plaintiffs owned, acquired, or purchased stock in CAC during the time period of August 14, 1995 through October 22, 1997, the designated "class period." They represent themselves and all others similarly situated.

II. A Summary of the Complaint's Allegations

A. Actions by Credit Acceptance Corporation

The precipitating event that led to the filing of this lawsuit occurred on October 22, 1997 when CAC issued a press release announcing a loss for the third quarter of 1997. This loss resulted from a decision by CAC management to increase its reserve for credit losses. CAC had recently installed new software that it claims allowed it to more accurately assess the credit risks it was undertaking by financing used cars. As a result of the new computer program, CAC determined that it must increase its credit loss reserves. Following an adjustment which added $60 million to the credit loss reserve pool, CAC's stock plummeted from $9.75 per share to $6.00 a share on October 23, 1997. (Complaint at ¶¶ 89-90). Prior to this drop, CAC had experienced five successive years of increases in quarterly earnings. (Complaint at ¶ 31).

The Plaintiffs' complaint alleges that Defendants knew its loan loss reserves were inadequate and that CAC's stock was fraudulently overvalued. Plaintiffs allege CAC deceived its shareholders in the following ways:

(1) CAC was positioning itself in such a way as to unreasonably risk not being able to recoup its large capital outlays to its dealer network;

(2) CAC was improperly refunding and thereby negating its highly touted, purportedly "non-refundable" new dealer enrollment fees, which fees were held out as a significant revenue generator for CAC as a quality check on its dealer base;

(3) CAC was improperly exaggerating the true value of its collateral in the financed cars by its use of invalid valuation methods, thereby grossly overstating the level of its security interest in those cars; and

(4) CAC overall, was failing to maintain and follow consistent underwriting criteria.

(Plaintiffs' Brief at 4).

Plaintiffs contend that as a result of these activities, discussed more fully below, CAC misrepresented that it had a stable business model, and overstated its financial results by grossly understating its reserves for credit losses. (Complaint at ¶ 6).

1. Improper Refunds of Dealer Enrollment Fees

The first source of alleged fraud involves CAC's dealer enrollment fees. Plaintiffs allege that the dealer enrollment fees were actually fictitious revenues because those amounts were paid back to dealers in the form of advances. When a dealer enrolls with CAC, it is required to pay an enrollment fee of $4,500. According to CAC, this fee was charged to create a barrier to entry for CAC competitors because a dealership that pays the enrollment fee will be less likely to enroll with a CAC competitor. The fee also discourages "fly-by-night" dealers from joining, and covers administrative costs.

Plaintiffs contend the fees were not actually revenue, as accounted for, because the fees were paid back in the form of dealer advances. Plaintiffs allege CAC failed to disclose that new dealers received as much as $5,000 in advance checks in excess of underwriting procedures. (Complaint at ¶¶ 61-62). "By instituting this pay-back scheme, [CAC] substantially increased its risk on its advance pool because the Company was advancing $5,000 more in advances to each new dealer than its `normal' underwriting standards would permit. The extraordinary advances, at a minimum, should have been expensed and treated as a deposit." (Complaint at ¶ 62). Plaintiffs claim CAC's failure to disclose the pay-back scheme improperly inflated revenues and misled the investing public regarding the amount of risk CAC undertook.

2. Overvalued Used Cars

Next, Plaintiffs contend that the value of the cars that CAC assisted in financing were grossly overvalued. One of the ways in which CAC justified low loan loss reserves and allayed fears concerning uncollectible D grade loans was by allegedly placing a high value on the security interest that CAC obtained in the vehicle as a result of the sale. Plaintiffs contend that in reality the cars were overvalued because the dealers intentionally disregarded and misused Kelley Bluebook value estimation standards. Plaintiffs allege CAC allowed dealers to (1) value "junk cars" in need of significant repairs as if they have already been reconditioned; (2) fail to deduct value for excessive mileage; (3) add amounts for worthless vehicle add-ons; (4) use Kelley Bluebook valuation methods for cars, failing to account for the harsh effects that Midwest weather has on them; (5) value cars based upon Kelley Bluebook valuation methods which are 28-45% higher than the NADA Guide even when the appropriate weather conditions are taken into account. (Complaint at ¶¶ 67-72).

3. Alleged Violations of Underwriting Standards

Further, Plaintiffs allege CAC engaged in risky and inconsistent underwriting practices. (Complaint at ¶ 73). CAC allegedly increased the amount advanced to the dealers on cars, although CAC knew the cars were of substandard collateral value and that the customers had a high risk of default. The Complaint alleges, "Initially, CAC based its advance amount on the lesser of two formulas — either 150% times the new down payment or 50% of the unpaid balance." At an unspecified time, however, CAC allegedly changed these percentages to 195% and 65% respectively. By December of 1995, CAC utilized an entirely new computation: "50% of the amount financed but no greater than 50% of the Kelley Blue Book retail value to the vehicle." (Complaint at ¶ 73).

4. Violations of GAAP

Plaintiffs contend that Defendants violated Generally Accepted Accounting Principles ("GAAP"), specifically, Financial Accounting Statement No. 5, which requires that all estimated losses be accrued and reported against current income. (Compla...