Republic Bank & Trust Co. v. Bear Stearns & Co.

• Decision Date: 20 June 2012
• Docket Number: No. 10–5510.,10–5510.
• Citation: 683 F.3d 239
• Court: U.S. Court of Appeals — Sixth Circuit
• Parties: REPUBLIC BANK & TRUST COMPANY, Plaintiff–Appellant, v. BEAR STEARNS & COMPANY, INC.; Frederick W. Barney, Jr.; The Bear Stearns Companies, JP Morgan Chase & Company, Defendants–Appellees.

683 F.3d 239

REPUBLIC BANK & TRUST COMPANY, Plaintiff–Appellant,

v.BEAR STEARNS & COMPANY, INC.; Frederick W. Barney, Jr.; The Bear Stearns Companies, JP Morgan Chase & Company, Defendants–Appellees.

No. 10–5510.

United States Court of Appeals,Sixth Circuit.

Argued: Nov. 16, 2011.

Decided and Filed: June 20, 2012.

ARGUED:Laurence J. Zielke, Zielke Law Firm PLLC, Louisville, Kentucky, for Appellant. Andrea Likwornik Weiss, Levi, Lubarsky & Feigenbaum LLP, New York, New York, for Appellees. ON BRIEF:Laurence J. Zielke, Lester I. Adams, Jr., Zielke Law Firm PLLC, Louisville, Kentucky, for Appellant. Andrea Likwornik Weiss, Levi, Lubarsky & Feigenbaum LLP, New York, New York, Dustin E. Meek, Tachau Meek PLC, Louisville, Kentucky, for Appellees.

Before: MERRITT, BOGGS, and CLAY, Circuit Judges.

OPINION

BOGGS, Circuit Judge.

Republic Bank & Trust Company bought more than fifty million dollars worth of residential-mortgage-backed securities from Bear Stearns. It did not read the relevant offering documents before investing. As the national economy crumbled in 2007 and 2008, so did the value of Republic's investments. In response, Republic brought this suit in 2009, alleging that Bear Stearns and one of its employees (“Appellees”) fraudulently induced it to buy, and then to retain, the securities. It claimed that a series of misrepresentations and omissions, both oral and in the written offering documents, were actionable under common-law theories of fraud and negligent misrepresentation,and under the Blue Sky Law, Kentucky's securities statute. The court below dismissed Republic's suit with prejudice. This timely appeal, which raises questions of Kentucky fraud law and federal pleading standards, followed.

I

Frederick W. Barney, Jr., a senior manager at Bear Stearns, attempted to sell securities to Republic Bank & Trust throughout the late 1990s and early 2000s. He succeeded. On March 31, 2003, Republic purchased twenty million dollars of mortgage pass-through certificates, issued by the ABFS Mortgage Loan Trust 2003–1. Republic did not review the prospectus supplement for these certificates before making its purchase.¹ Nor could it have done so: Bear Stearns did not file the prospectus supplement until March 31, 2003, and Barney did not provide Republic with an advance copy. On October 2, 2006, Republic again bought mortgage-backed securities from Bear Stearns. This time, it purchased more than thirty-two million dollars of mortgage pass-through certificates from four separate issuing trusts, the Bear Stearns ALT–A Trust 2005–10, the Bear Stearns ARM Trust 2006–2, the Bear Stearns ARM Trust 2006–4, and the IndyMac INDX Mortgage Loan Trust 2006–AR11. Republic did not review prospectus supplements for any of these investments, even though such documentation was available for each at the time of purchase. Bear Stearns underwrote all of the securities that Republic bought; all had either AA or AAA credit ratings at the time of purchase.

The securities that Republic acquired were a species of asset-backed security known as mortgage pass-through certificates, or mortgage-backed securities. These investment vehicles consist of thousands of individual home loans, pooled together in a trust. The trust then issues certificates, sold primarily to large institutional investors, entitling the holder to periodic distributions based on mortgage payments by the borrowers.

The process of creating such a security is complex. First, an originator lends money directly to consumers. The securities in this case are residential-mortgage-backed securities, meaning that the originators' loans were home-mortgage loans. Originators of mortgage-backed securities often issue home loans to borrowers who could not obtain financing from other sources because of prior bankruptcies, outstanding judgments, or poor credit. These loans frequently do not conform to established underwriting standards, which require good-faith evaluation both of the borrower's ability to repay the loan and of the value of the property offered as collateral. After making or acquiring enough loans, the originator sells part or all of its portfolio to a sponsor, which structures securities by pooling the loans that it bought. Next, the sponsor sells the loans to a depositor. The depositor has two functions. First, it places the pooled-and-structured assets into an independently constituted trust, which, in return, issues the depositor certificates entitling the holder to distributions of principal and interest from the trust's assets. The depositor then transfers the certificates to underwriters such as Bear Stearns, who sell the certificates to investors. Often, a single trust issues different levels, or “tranches,” of certificates, normally based on subordination rights or some type of insurance against the risk of default.

In early 2007, the media began to report problems with mortgage-backed securities. The market for such securities had expanded in 2006. As demand rose, underwriting standards declined. Originators began to make riskier loans, and the number of defaults skyrocketed. The value of mortgage-backed securities plummeted and helped fuel a nationwide economic crisis in 2007 and 2008. As the national economy declined, so did the value of the certificates Republic bought. As of December 31, 2008, Republic had lost over fourteen million dollars, and the rating agencies had downgraded or withdrawn each security's credit rating.

Republic filed suit on March 20, 2009. It alleged that Bear Stearns, through Barney and in the prospectus supplements it issued, made a number of misrepresentations and omissions, which induced Republic first to purchase, and then to retain, the mortgage pass-through certificates. The complaint alleged common-law fraud and deceit, common-law negligent misrepresentation, and violation of Kentucky's Blue Sky Law. It supported these claims through ten specific accusations:

a. Defendants represented that the certificates were reasonably safe investment products backed by mortgage loans made according to reasonably prudent underwriting standards.

b. Defendants omitted to state that prudent underwriting standards were not followed in making a substantial number of the mortgage loans that back the certificates.

c. Defendants omitted to state that the loan originators' own underwriting standards were not followed in making a substantial number of the mortgage loans that back the certificates.

d. Defendants omitted to state that a substantial number of the mortgage loans backing the certificates were made to borrowers whose creditworthiness did not support the amounts loaned to them or whose creditworthiness was not adequately examined or documented.

e. Defendants omitted to state that a substantial number of the mortgage loans backing the certificates were not adequately secured due to inaccurate and unsound valuation of the real properties securing the mortgages or otherwise.

f. Defendants omitted to state that the originators of the mortgage loans that back the certificates were engaging in predatory lending practices and were encouraged to make mortgage loans without adherence to prudent underwriting standards for the purpose of pooling and securitizing mortgage loans to generate sales of investment products like the certificates sold to Republic.

g. Defendants omitted to state that the risk of default and resulting losses was unreasonably high for a substantial number of the mortgage loans that backed the certificates.

h. Bear Stearns stated in the prospectuses or prospectus supplements that it intended to make a secondary market for the certificates. However, Bear Stearns lacked the ability to make a secondary market in the securities due to its own financial weakness. Bear Stearns omitted to state that its own financial weakness precluded it from making a secondary market in the securities.

i. Bear Stearns stated in the prospectus supplement that the Class M certificates issued by ABFS Mortgage Loan Trust 2003–1 will be unconditionally and irrevocably guaranteed as to the timely distribution of interest and as to specified distributions of principal pursuant to the terms of a financial guaranty insurance policy to be issued by Radian Asset Assurance, Inc. However, the alleged credit enhancement provided by the insurance policy is illusory because of the poor quality of the underlying mortgage loans and because of Radian's heavy involvement in insuring collateralized debt obligations and asset-backed securities. Radian's financial strength ratings have been downgraded and it ceased writing new financial guaranty business.

j. Bear Stearns stated in the prospectus supplements for [the certificates purchased in 2006] ... that credit enhancement would be provided by subordination. However, the alleged credit enhancement provided by such subordination is illusory because of the poor quality of the underlying mortgage loans.

Republic also claimed that Bear Stearns “made the [same] misrepresentations and omissions ... to the ratings agencies to obtain favorable ratings as a means of inducing persons to purchase the certificates.” Although it did not read the prospectus supplements before purchasing the certificates, Republic asserted, without explanation, that it “acted with reasonable diligence in connection with its purchase of the certificates.”

Bear Stearns moved to dismiss; the district court granted the motion in full, dismissing all claims with prejudice. It held that Republic's claims based on affirmative misrepresentations failed, either because the alleged misrepresentations were statements of opinion, not fact, or because the prospectus supplements expressly warned purchasers of the risks that caused Republic's loss. The district court similarly rejected Republic's claims for fraud by omission. It reasoned that some of the alleged omissions dealt with subjective, not factual, matters; that others were discussed in...