Ruling in favor of Quinn Emanuel client the Federal Housing Finance Agency, Judge Denise Cote of the Southern District of New York recently shed new light on how courts should apply the statute of limitations to claims brought under Sections 11 and 12 of the Securities Act of 1933. These statutes, which hold defendants strictly liable for making false statements to investors in offering materials, have a short limitations period—one year “after the discovery of the untrue statement … or after such discovery should have been made by the exercise of reasonable diligence.” 15 U.S.C. § 77m. Before 2010, the Second Circuit interpreted the “should have been made” portion of this statute as requiring “inquiry notice”—a claim accrued “when public information would lead a reasonable investor to investigate the possibility of fraud.” City of Pontiac Gen. Emps.’ Ret. Sys. v. MBIA, Inc., 637 F.3d 169, 173 (2d Cir. 2011). But in 2010, in Merck & Co., Inc. v. Reynolds, the Supreme Court held that a claim under Section 10(b) of the Securities Exchange Act of 1934 accrued upon the earlier of actual discovery or “when a reasonably diligent plaintiff would have discovered the facts constituting the violation[.]” Merck, 559 U.S. 633 at 637. Since then, litigants have disagreed about whether the Merck standard applies to Securities Act claims.
A recent decision by Judge Denise Cote in Federal Housing Finance Agency v. Nomura Holding America, Inc.,--- F.Supp.3d --, 2014 WL 6462239 (S.D.N.Y. 2014) (“Nomura”), held that Merck does apply to Section 11 and 12 claims, and provides the most extensive example to date of how that standard governs Securities Act claims. Judge Cote issued this ruling in the blockbuster litigation brought by the Federal Housing Finance Agency, as conservator of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) (together referred to as the government-sponsored enterprises or “GSEs”) against the world’s largest banks over tens of billions of dollars of residential mortgage-backed securities (“RMBS”) that the banks sold to the GSEs. FHFA alleged that the banks falsely represented, among other things, that the loans underlying the relevant RMBS complied with originators’ guidelines.
Two years earlier, in a 2012 ruling, Judge Cote had held that Merck governed FHFA’s Securities Act claims, FHFA v. UBS Americas, 858 F. Supp. 2d 306, 320 (S.D.N.Y. 2012) (“UBS I”), but when FHFA moved for summary judgment on the statute of limitations defense in 2014, the remaining defendants argued that, after UBS I, the Second Circuit had refused to extend Merck to non-Exchange Act claims in Koch v. Christie’s Int’l, PLC, 699 F.3d 141, 152 (2d Cir. 2012). Judge Cote disagreed. She held that Koch “merely held that Merck did not disturb the discovery accrual rule applicable where the governing statute of repose does not address accrual”—as is the case the statute governing limitations for Section 10(b) claims under the Exchange Act. Nomura at *19, n. 34. The statute governing limitations for Section 11 and 12 claims under the Securities Act “is a similar statutory exception,” Judge Cote held, “as it provides that accrual is triggered by ‘the discovery of the untrue statement or omission.’” Id. (citing and quoting 15 U.S.C. § 77m).
Invoking Merck and its Second Circuit progeny, Judge Cote held that the limitations period for Securities Act claims “commences not when a reasonable investor would have begun investigating, but when such a reasonable investor conducting such a timely investigation would have uncovered the facts constituting [the] violation.” Nomura, 2014 WL 6462239, at *19 (citing City of Pontiac Gen. Emps. Ret. Sys. v. MBIA, Inc., 637 F.3d 169, 174 (2d Cir. 2011)) (emphasis added). For these purposes, a fact is “discovered” when “a reasonably diligent plaintiff would have sufficient information about that fact to adequately plead it in a complaint” that would “survive a motion to dismiss.” Id. (quoting City of Pontiac, 637 F.3d at 174). In applying this objective standard, it was irrelevant “whether the actual plaintiff undertook a reasonably diligent investigation.” Id. (citing Merck, 559 U.S. at 653).
Pre-Merck law still determined when a reasonably diligent would have begun an investigation—when information is “specific enough to provide [a reasonably diligence] investor with indications of the probability (not just the possibility) of misrepresentations. Id. at *20 (citing Staehr, 547 F.3d at 430). But the requirement that the misconduct “be probable, not merely possible” means that “information that does not, on its face, indicate the misconduct, and that is consistent with a perfectly likely innocent explanation, is unlikely to trigger a duty of inquiry.” Id. (citing Newman v. Warnaco Grp., Inc., 335 F.3d 187, 193 (2d Cir. 2003)).
Judge Cote’s application of this law in the Nomura case offers several lessons to clients interested in defending Securities Act claims against a limitations challenge.
First, non-specific information does not trigger accrual. The statute creating FHFA provided that the limitations period for their claims expired on September 7, 2007, Nomura, 2014 WL 6462239, at *4 and n.4, and Defendants argued that the GSEs should have begun investigating potential Securities Act claims based on upheaval in the RMBS market in the end of 2006 and 2007—specifically including public accusations of irresponsible origination practices by the mortgage lenders whose loans backed the RMBS at issue. Id. at *22. Judge Cote held that these general trends did not trigger a duty to investigate, because they did not indicate to the GSEs that the Defendants had failed to conduct due diligence on the specific loans backing the relevant bonds before securitizing them. Id. at *22.
Second, information reflecting disclosed risks does not trigger accrual. Defendants pointed out, after the GSEs bought the bonds but before the limitations date, the GSEs received reports of: (1) negative property variances (reports of a decline in value of the homes backing some of the underlying loans; (2) a high-level of early payment defaults (borrowers defaulting on mortgage payments in the first few months of the loans). These events also did not trigger a duty to investigate, Judge Cote held, because they did not “suggest anything more than that the disclosed credit risks of subprime and Alt-A loans were realized after the national housing bubble burst”—they did not indicate the undisclosed risks that the originators had not complied with their guidelines in making these risky loans. Id. at *23.
Third, negative information offset by other factors does not trigger accrual. Judge Cote also held that the GSEs’ duty to investigate was not triggered by credit analysts’ downgrades of other “tranches” of four of the RMBS at issue. Monthly payments by the borrowers of the loans underlying the RMBS were combined into a single cash flow that ran down through tranches within each RMBS that were ranked by order of seniority. The most senior tranche was entitled to full payment of principal and interest before the next most senior tranche, which was in turn entitled to full payment before the next tranche, and so on. In July 2007, the credit ratings agencies downgraded the ratings of some of the most junior tranches in the RMBS—those designed to take losses before the senior tranches. Judge Cote held that these downgrades also did not trigger a duty to investigate, because the downgrades did not indicate that the most senior tranches, which backed the GSE’s bonds, might suffer. As she put it, “the GSE’s’ Certificates had so much credit protection that the risk of loss was remote and their credit quality remained unchanged.” Id. at *25.
Finally, Defendants will have the burden of showing how long it would take for inquiry to turn into discovery and pleading. Judge Cote noted that “Defendants have offered no evidence of the length of time it took the GSEs to investigate its claims here, or of how long it would take a reasonably diligent investor in the GSEs’ position to investigate the claims such that it could adequately plead them.” Id. at *26. Accordingly, even if they had been able to point to some information that should have triggered an investigation, Defendants were not able to show when a reasonably diligent investor would have completed that investigation and prepared a complaint that would have survived a motion to dismiss—thus failing the Merck test. Id.