In order to avail itself of the due diligence and reasonable care defenses under the Securities Act of 1933, a securities underwriter must independently and thoroughly investigate material representations made in the offering documents to determine their accuracy and may not ignore “red flags.”
Federal Housing Finance Agency vs. Nomura Holding America, Inc., No. 11cv6201 (S.D. N.Y., 12/18/14).
The Securities & the Motion
This 107-page opinion addresses what an underwriter of residential mortgage-backed securities (“RMBS”) must do to verify the representations of the loan originators regarding the underlying mortgage loans. RMBS is a security backed by a supporting loan group (“SLG”) of mortgage loans. They derive their value from the income stream generated by the principal and interest payments on those loans. The loan originators (financial institutions that created them) sell pools of loans to the issuer (or “sponsor”) of the RMBS, which then selects some of the loans to populate an SLG. In this case, brought, inter alia, pursuant to §§11 and 12(a)(2) of the Securities Act of 1933, FHFA alleges that two underwriters, Nomura Securities and RBS Securities, and the Nomura-controlled sponsor, misrepresented the characteristics of the loans comprising the SLGs of seven RMBS certificates.
In this opinion, the Court considers FHFA’s motion for partial summary judgment to bar defendants from asserting the statutory defenses of due diligence and reasonable care. The due diligence defense shields a defendant, “other than the issuer” from liability under §11 who, “after reasonable investigation,” has “reason to believe and did believe” that a registration statement was accurate and not misleading when it was registered with the SEC. An underwriter’s duty is heavy; its investigation must be “searching and thorough” and “reasonably calculated to reveal all those facts that would be of interest to a reasonably prudent investor.” An underwriter of RMBS must searchingly review the underlying loans. When an underwriter encounters a “red flag,” it must “look deeper and question more” to restore a reasonable belief in the accuracy of a statement. The reasonable care defense of §12(a)(2) is a negligence standard.
The Underwriters & the Ruling
The Court holds that no reasonable jury could find that either Nomura or RBS met the requirements of either defense and grants the motion. Nomura, it finds, relied almost entirely on the testing of samples from loan pools before it purchased them. That review revealed high “kick-out” (defective loan) rates; yet, Nomura never upsized any sample to determine if these problems might pervade the entire pool and never considered the implications of these red flags for the quality of the loans chosen for the SLGs, which included both reviewed and unreviewed loans. Nomura also took no account of an audit that revealed, before the issuance of four of the certificates, that Nomura could not trust its review process to identify defective loans.
RBS was underwriter for four certificates. The Court faults it for relying, with respect to two SLGs, on the results of Nomura’s pre-acquisition review of the loan pools – and, for one of them, on only a one-page summary of those results – without assuring itself that Nomura’s review was adequate. It did do its own study of the loan files in the other two RMBS issues, but it requested only a small sample; made no objection when it learned that many of the requested files were missing; and when a high number of loans were rated defective, it overrode those ratings in every instance.
(ed: *For those readers who want to learn more about this decision, but might be intimidated by the thought of reading more than 100 pages, we offer this helpful guide: The Court summarizes its findings on pages 4-9; reviews the facts in depth on pages 9-57, with emphasis on the parts played by Nomura (pages 12-36) and RBS (pages 37-45); defines the nature of the due diligence (pages 60-76) and reasonable care (pages 78-80); and applies those legal principles to the underwriting conducted by Nomura (pages 80-96) and RBS (pages 96-103). Finally, the Court addresses a few arguments made by defendants that it believes miss the point (pages 103-107). **The initial reviews of the loans were conducted by independent contractors for both Nomura and RBS, who then reviewed the results. In some cases, the Court finds, Nomura re-rated some of the loans that were initially rated defective as satisfactory (conforming or with minor problems or compensating factors) without explanation. It never rerated any in the opposite direction; yet the audit mentioned in the foregoing summary found that the initial review rated some loans too optimistically. ***We summarized three prior decisions in this case in SLAs 2014-39 (granting an extension of time for the filing of motions for summary judgment) and 2015-08 (the grant of FHFA’s motion for partial summary judgment on the statute of limitations defense and the grant of FHFA’s motion in limine addressing the scope of §12(a)(2)’s protections). The latter two decisions cast light on other aspects of this case and the applicable law. A summary of a later decision also appears in SLA 2015-09.)
(SLC Ref. No. 2015-09-10)
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