South Ferry Lp, No. 2 v. Killinger

• Decision Date: 09 September 2008
• Docket Number: No. 06-35511.,06-35511.
• Citation: 542 F.3d 776
• Parties: SOUTH FERRY LP, # 2, individually and on behalf of all others similarly situated, Plaintiff-Appellee, v. Kerry K. KILLINGER; Deanna W. Oppenheimer; Washington Mutual, Inc., Defendants-Appellants.
• Court: U.S. Court of Appeals — Ninth Circuit

542 F.3d 776

SOUTH FERRY LP, # 2, individually and on behalf of all others similarly situated, Plaintiff-Appellee, v. Kerry K. KILLINGER; Deanna W. Oppenheimer; Washington Mutual, Inc., Defendants-Appellants.

No. 06-35511.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted April 8, 2008.

Filed September 9, 2008.

Stephen M. Rummage, Davis Wright Tremaine LLP, Seattle, WA, and Jay B. Kasner (argued), and Scott D. Musoff, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY, for the appellants.

Melvyn I. Weiss, Lori G. Feldman, and John Rediker, Milberg Weiss & Bershad LLP, New York, NY, and Stuart J. Guber and James Evangelista, Motley Rice LLC, Atlanta, GA, and Clifford A. Cantor, Law Offices of Clifford A. Cantor, P.C., Sammamish, WA, and Professor Arthur R. Miller (argued), New York University School of Law, for the appellee.

Appeal from the United States District Court for the Western District of Washington; John C. Coughenour, District Judge, Presiding. D.C. No. CV-04-01599-JCC.

Before: RAYMOND C. FISHER, RONALD M. GOULD, and SANDRA S. IKUTA, Circuit Judges.

GOULD, Circuit Judge:

Defendants-Appellants Kerry Killinger ("Killinger"), Thomas Casey ("Casey"), Deanna Oppenheimer ("Oppenheimer") and Washington Mutual, Inc. ("WAMU", collectively, "Defendants") appeal the district court's partial denial of their motion to dismiss a securities fraud action brought by Plaintiffs-Appellees South Ferry LP et al. ("South Ferry"), who allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a), and its underlying regulations, found at Rule 10b-5, 17 C.F.R. § 240.10b-5. Defendants argue that the district court erred by inferring that Defendants had knowledge of "core operations" at WAMU based on their management positions and argue that such an inference does not satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b)(2) ("PSLRA"). The district court certified for interlocutory appeal its order granting in part and denying in part defendants' motion to dismiss. We have jurisdiction pursuant to 28 U.S.C. § 1292(b), vacate the district court's order, and remand.

I

WAMU is a publicly-traded financial services company that serves individuals and small businesses, offering consumer banking, mortgage lending, commercial banking, and other services. Defendants Killinger, Casey, and Oppenheimer all served as officers of WAMU during the class period, with Killinger serving as the Chairman of WAMU's Board of Directors, President, and CEO, Casey serving as Executive Vice-President and CFO, and Oppenheimer as President of WAMU's consumer group. Thus, they held not merely nominal but rather key officer positions at relevant times.

Plaintiffs are WAMU shareholders who seek to represent a class of individuals who owned WAMU stock between April 15, 2003 and June 28, 2004. The complaint relates to several related aspects of WAMU's mortgage lending business. That business involves originating home loans, buying and selling home loans in the secondary markets, mortgage servicing, and providing mortgage-insurance products.

When WAMU originates a home loan, it may later sell that loan to another institution on the secondary market. However, WAMU typically retains the mortgage servicing rights ("MSRs") for the loans that it sells. The holder of MSRs, WAMU here, provides billing and other services to mortgage customers for the life of the loans even though a different entity may actually own them. MSRs have an independent value to WAMU because WAMU is paid a portion of each loan payment for the services it provides.

This case relates to two types of risk present in WAMU's mortgage lending business, both of which are exacerbated by nationwide interest rate fluctuations. The first, "MSR-related risk," is the risk that WAMU will lose MSR-related revenue due to the pre-payment of loans that it services. MSR-related risk is greatest in an environment in which interest rates are falling, because falling rates make it more likely that borrowers will refinance their loans to take advantage of cheaper financing. When they do so, the original mortgage loan is paid in its entirety and replaced with a lower-interest loan, often from a different lender. Because WAMU's MSR-related revenue from a given loan comes from the services that it provides over the life of that loan, a loan that is fully repaid at an early date due to refinancing causes WAMU to lose future MSR-related revenue.

The second type of risk, "pipeline risk," is the risk that WAMU will commit to fund a loan at a certain interest rate only to see market interest rates change by the time the loan is finalized. This may occur whenever interest rates change. Borrowers typically "lock in" an interest rate on their home mortgage loan several weeks before they actually close a mortgage deal. A loan in this lock-in period is referred to as a loan "in the pipeline." When mortgage rates are falling, borrowers may find that the rate that they have locked in is higher than the prevailing rates at the time of their closing. Those borrowers may abandon a lender with a loan in the pipeline, such as WAMU, to take a mortgage from a different lender at the lower then-current rate. Conversely, when rates are rising, borrowers may lock in rates that turn out to be below market by the time of their closing, leaving WAMU to fund at below market rates all loans that were in the pipeline at the time that rates rose.

To manage MSR-related and pipeline risk, WAMU hedges its expected MSR and mortgage-origination revenues with securities and derivative instruments. In a rising interest rate environment, WAMU also relies on an important "natural hedge" to protect its revenues. When rates are rising, WAMU faces greater pipeline risk because market rates are more likely to exceed the locked-in rates at the time mortgage deals close. However, MSR revenues provide some protection from this pipeline risk, because borrowers are less likely to refinance and pre-pay their mortgages when the rates that would apply to their refinancing loans are higher than the rates they pay on their existing mortgage. Accordingly, WAMU receives more stable MSR-related revenues when it suffers increased pipeline risk. This natural hedge, in theory, allows WAMU to have a more steady revenue stream despite volatility of interest rates.

South Ferry alleges that the individual defendants made materially false or misleading statements concerning WAMU's ability to manage MSR-related and pipeline risk during the class period. South Ferry also alleges that the individual defendants repeatedly assured investors that the natural hedge and additional securities and derivative hedges would allow WAMU to thrive in an environment where interest rates were increasing, and that the individual defendants assured investors that WAMU had fully integrated the information systems that are central to WAMU's ability to maintain and update their various hedges in a timely fashion during periods of interest rate volatility. According to South Ferry, WAMU was unprepared for the interest rate volatility that occurred later because it failed to integrate its information systems to permit it to keep a close watch on the hedges that it maintains.

Defendants moved to dismiss South Ferry's complaint on May 17, 2005, and the district court granted the motion to dismiss as to defendants Chapman, Longbrake, and Vanesek, but denied the motion as to the remaining defendants. South Ferry LP No. 2 v. Killinger, 399 F.Supp.2d 1121 (W.D.Wash.2005). The district court found that South Ferry satisfied the PSLRA's heightened pleading standard¹ by inferring that the remaining defendants had knowledge of WAMU's difficulties with their information systems "because of the nature of the statements they [Defendants] were making and the nature of these specific alleged operational problems," relying on In re Northpoint Communications Group, Inc. Securities Litigation, 184 F.Supp.2d 991, 998 (N.D.Cal.2001), for the principle that it may be inferred that facts critical to a business's "core operations" or important transactions are known to key company officers (sometimes referred to in this opinion as the "core operations inference"). South Ferry, 399 F.Supp.2d at 1141. Defendants moved for reconsideration or, alternatively, for a certification from the district court that interlocutory appeal was appropriate under 28 U.S.C. § 1292(b) to determine whether the district court properly imputed scienter in the complaint's allegations based on the inference that key officers had knowledge of the "core operations" of the company.

The district court denied the motion for reconsideration, but granted the certification motion. In the order granting the certification motion, the district court recognized that "the complaint does rely on circumstantial evidence and an inference of knowledge arising from the connection between Defendants' job roles and the core operations of the business," and that "[s]hould the Ninth Circuit rule that the core operations inference is improper, even Defendants' specific statements indicating first-hand knowledge of WAMU's technological and operational systems may be insufficient to support a strong inference of scienter." Defendants timely pursued this interlocutory appeal.

II

The decisions of a district court on motions to dismiss are reviewed de novo. In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 983 (9th Cir.1999). We must accept as true all well-pleaded allegations in the complaint. Id.

III

Under the PSLRA, South Ferry must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). "Under this provision, the mental state required for securities fraud liability is distinct from the level of pleading required to...