Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

Contacts: Diane E. Ambler, Michael J. Missal, Matt T. Morley, Mark D. Perlow

2009 brought a further transformation in the relationship between business and government. Regardless of political systems or philosophies, governments around the world became more dynamic and intrusive in response to the financial crisis.

This 2010 Annual Report, prepared by members of the K&L Gates Global Government Solutions initiative, contains concise articles that seek to forecast likely government actions and priorities regarding a broad spectrum of topics.

To view the report, click here.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

A recent decision of the Third Circuit Court of Appeals significantly bolsters the standard of proof that plaintiffs must satisfy in motions for class certification under Rule 23 of the Federal Rules of Civil Procedure (“Rule 23”).  In In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir. 2008, as amended Jan. 16, 2009), the Third Circuit emphasized that the broad discretion district courts have to control the class certification process does not “soften the rule” that each requirement of Rule 23 must be satisfied.  Class certification is a critical stage of any class action because it is the point at which the court decides whether the action may proceed on a classwide basis rather than simply as an individual case.  Rule 23(a) requires plaintiffs to demonstrate, in part, that there are questions of fact or law common to the class, and Rule 23(b)(3) requires plaintiffs to establish, in part, that those common questions predominate over questions affecting only individual members.  Because the class certification decision is often the defining moment of a class action – one that can signal the “death knell” for plaintiffs or place “unwarranted pressure” on defendants to settle meritless claims – the Third Circuit instructed that district courts must engage in a “thorough examination of the factual and legal allegations” raised by the action.  Further, because In re Hydrogen Peroxide was authored by Third Circuit Chief Judge Anthony J. Scirica, who as chair of the Standing Committee on Rules of Practice and Procedure oversaw extensive revisions to Rule 23, the decision is likely to impact federal courts’ class action jurisprudence nationwide.

With its decision, the Third Circuit clarified three aspects central to the class certification process, discussed in turn below. 

A Mere “Threshold Showing” of Predominance Does Not Satisfy Rule 23
In certifying a Rule 23(b)(3) class, which is a class that seeks primarily money damages, the district court stated that “[s]o long as plaintiffs demonstrate their intention to prove a significant portion of their case through factual evidence and legal arguments common to all class members, that will now suffice.”  Id. at 321.  The district court further stated that “plaintiffs need only make a threshold showing” that common questions predominate over individual ones.  Id.  The Third Circuit ruled, however, that neither plaintiffs’ expressed intentions nor a mere threshold showing could satisfy Rule 23.  Reversing the district court, the Third Circuit held that plaintiffs must actually set forth evidentiary proof, rather than a promise to do so at some future point, that class certification is warranted under Rule 23.  In addition, the court ruled that plaintiffs must establish the Rule 23 requirements by a preponderance of the evidence.  In other words, plaintiffs must demonstrate that the “evidence more likely than not establishes each fact necessary to meet the requirements of Rule 23.”  Id. at 320.  The Third Circuit criticized the district court for adopting a “lenient” burden, or presumption of deference, for the party seeking certification.

Courts Must Resolve Relevant Factual and Legal Disputes When Ruling on Class Certification Motions
In re Hydrogen Peroxide requires district courts to resolve all factual or legal disputes that would affect the court’s certification decision.  This may even require an analysis of the merits of the case at the class certification stage to determine whether certification is appropriate.  An analysis of the substantive elements of plaintiffs’ claims may also be necessary to evaluate whether plaintiffs have set forth a feasible trial plan where one is required by a court, namely one showing that the claims are susceptible to proof on a classwide basis.  Plaintiffs’ assurances that they intend or plan to devise a feasible trial plan at some future point do not meet their burden. 

Courts Must Weigh Expert Testimony
In conjunction with ruling that district courts must consider all relevant evidence necessary to decide class certification, the Third Circuit emphasized that this ruling encompasses consideration of expert testimony.  The court rejected the district court’s assumption that it could not weigh the parties’ competing expert testimony in deciding whether to certify a class.  Accordingly, under In re Hydrogen Peroxide, where expert testimony is necessary to the class certification decision, a district court must resolve disputes between competing expert testimony.  Furthermore, neither credibility issues nor concern for addressing the merits of a case can impede the rigorous analysis required to resolve such disputes.

Impact on Class Action Defense
The Third Circuit decision is likely to impact federal courts’ class action jurisprudence nationwide.   As noted, Chief Judge Scirica served from 1998 to 2003 as chair of the Standing Committee on Rules of Practice and Procedure.  In this role, the Chief Judge oversaw extensive revisions to Rule 23, which revisions support conducting a rigorous analysis of each class certification motion. 

For class action defendants, In re Hydrogen Peroxide heralds a welcomed bolstering of the standard of proof that plaintiffs must satisfy.  Other aspects of the decision will also likely benefit class action defendants, including the emphasis on courts understanding how the merits of class claims intersect with class certification and the role expert testimony can play in defeating class certification.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

In its recent decision, Amoche v. Guarantee Trust Life Insurance Co., --- F.3d ----, 2009 WL 350898 (1st Cir. Feb. 13, 2009), the First Circuit Court of Appeals joined a growing number of federal courts that have articulated defendants’ jurisdictional burden under the Class Action Fairness Act (“CAFA”).  CAFA allows defendants to remove a class action matter from state court to federal court if the matter meets certain jurisdictional prerequisites.  Eight federal circuits have now ruled that defendants must establish the existence of those prerequisites, at the very least, by a “reasonable probability” or by a preponderance of the evidence.  The Amoche opinion highlights potential pitfalls that defendants may face when trying to establish that a case meets the CAFA jurisdictional prerequisites.  For instance, CAFA requires a defendant to show that the amount-in-controversy placed at issue by a plaintiff’s claims exceeds $5,000,000 on a classwide basis.  The federal circuit courts warn that speculative assertions, unsupported by evidence, will not suffice to meet this jurisdictional burden.  Rather, courts exhort defendants to carefully develop the evidentiary support necessary to demonstrate that a plaintiff’s claims have placed more than $5,000,000 at issue.

In Amoche, the plaintiffs brought suit in state court on behalf of New Hampshire consumers who allegedly had not received refunds purportedly owed to them on credit insurance policies purchased in connection with auto loans.   After certifying a class of New Hampshire consumers, the state court allowed the plaintiffs to amend their complaint to propose an expanded class of consumers from other states.  On the basis of the proposed expanded class, the defendant removed the case from state court to federal district court under CAFA, and the plaintiffs moved to send the case back to state court.  Finding that the defendant’s assertions concerning the amount-in-controversy were speculative, the district court granted the plaintiffs’ request. 

On appeal, the First Circuit held that a removing defendant must establish CAFA jurisdiction by a “reasonable probability.”    Id. at *7.  The First Circuit found that the Amoche defendant had not demonstrated to a “reasonable probability” that the alleged damages exceeded the $5,000,000 amount-in-controversy threshold and affirmed the district court’s order sending the case back to state court. 

The defendant had submitted a declaration that the New Hampshire class involved approximately $450,000 in damages, and argued, by extrapolating the New Hampshire amount to the thirteen states named in the amended complaint, that the $5,000,000 jurisdictional minimum was satisfied.  The defendant, however, did not provide a basis for that extrapolation.  The court suggested that the defendant might have met its burden through introducing information regarding its market share and revenues in states other than New Hampshire.  Because the defendant failed to account for differences in its business practices among the relevant states, the First Circuit found it could not rely on the defendant’s assertions that the class members’ claims exceeded $5,000,000 in the aggregate.

While CAFA is a powerful procedural device that makes it easier for defendants to litigate class actions in federal court rather than state court, the Amoche opinion highlights the demands federal courts are placing on defendants to carefully develop the evidentiary support necessary to sustain removal, including addressing such areas as the number of potential class members and the alleged value of those members’ claims.  Fortunately, as the First Circuit held, the remand of a class action does not necessarily foreclose subsequent attempts to remove the action under CAFA.  Indeed, “[s]uccessive attempts at removal are permissible where the grounds for removal become apparent only later in the litigation.”  Id. at *11. 
 

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By: Irene C. Freidel,  Robert W. Sparkes, III

In addressing the enforceability of class action waiver provisions included in mandatory arbitration agreements, the majority of state and federal courts have followed a two-pronged, fact-intensive test that will operate to invalidate a class action waiver where: 1) the party to be bound did not have a meaningful opportunity to negotiate or reject the arbitration agreement portion of a contract (i.e., the agreement is one of adhesion); and 2) if enforced, the waiver would effectively eliminate a party’s right to seek redress because the expected recovery is not large enough to justify the risks and costs of individual litigation.   In practice, most courts employing this analysis have found class action waivers in consumer finance related agreements to be unconscionable, and thus unenforceable, under applicable state and federal law. 

The Third Circuit Court of Appeals, however, appeared to reject the majority trend in its 2007 opinion in Gay v. CreditInform, 511 F.3d 369, 378 (3d Cir. 2007).   In Gay, the Third Circuit panel upheld a mandatory arbitration clause in an agreement between a consumer and a credit repair organization, which clause required individual arbitration of all disputes arising out of the agreement.  The Third Circuit panel held that the right to proceed on a class-wide basis was merely a procedural right and was therefore waivable.  The court refused to consider whether the consumer would have a meaningful opportunity to recover if she were barred from pursuing the claim as a class action.  Instead, the court ruled that the arbitration provision was not, on its face, so unreasonable that it could be considered unconscionable under state law.  Any further inquiry into the effect of the provision, according to the Third Circuit panel (albeit in dicta), would violate the Federal Arbitration Act’s (“FAA”) prohibition on state laws which restrict or burden the enforcement of agreements to arbitrate.  In so holding, the Third Circuit panel did not discuss the apparently contrary holdings in other federal circuits. 

On February 24, 2009, a different three-judge panel of the Third Circuit, in Homa v. American Express Company, ---F.3d---, 2009 WL 440912 (3d Cir. Feb. 24, 2009), found that a class action waiver included in a mandatory arbitration provision in a consumer credit card agreement was unconscionable under New Jersey state law.  The Third Circuit held that New Jersey had a fundamental public policy against enforcing class action waivers in the context of “a low-value consumer credit suit.”  As such, the court held that “if the claims at issue are of such a low value as effectively to preclude relief if decided individually, then, under [New Jersey law] the class-arbitration waiver is unconscionable.” Id. at *7.    

The Third Circuit’s opinion in Homa suggests that the Third Circuit may be prepared to fall in line with the majority of state and federal courts in addressing class action waivers in arbitration agreements.  This development will likely not bode well for consumer finance and consumer credit entities that seek to include such class action waivers in their various consumer agreements.  On the other hand, the Homa court’s reliance on New Jersey state law – law not at issue in the Gay case – may not signify any change in the Third Circuit’s approach to class action waivers, but may merely stand as evidence of one court interpreting and applying two different states’ laws in similar situations.  The fluidity and importance of this area of the law, however, suggest that we will not have to wait long for the next court ruling to more fully direct the analysis and the Third Circuit’s approach to class action waivers in arbitration agreements.

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By: Irene C. Freidel, Gregory N. Blase

A federal court in Delaware recently held that shareholders of Mortgage Electronic Registration Systems, Inc. (“MERS”) – some of the country’s largest mortgage lenders – could not be held liable for the alleged activities of MERS.  Trevino et al. v. Merscorp., Inc., et al., No. 1:07-cv-00568-JJF (D. Del.).   MERS was created in 1996 by the real estate finance industry to eliminate the need to prepare and record assignments when trading residential and commercial mortgage loans.  MERS’s chief business purpose is to simplify and streamline the manner in which mortgage ownership and servicing rights are originated, sold and tracked. Recently, in light of its visibility in connection with mortgage defaults and foreclosures, MERS and its shareholders have come under attack by plaintiffs’ class action lawyers.  The court’s decision resulted in the dismissal from the putative class action of MERS shareholders Citigroup, Inc., Countrywide Financial Corp., Fannie Mae, Freddie Mac, GMAC-RFC Holding Company, LLC, HSBC Finance Corporation, JPMorgan Chase & Co., Washington Mutual Bank, and Wells Fargo & Company (the “shareholder defendants”).

In their complaint, plaintiffs alleged that MERS overcharged them and a class of similarly situated individuals for costs arising out of proceedings to enforce mortgage instruments, including foreclosures.  Plaintiffs asserted that MERS’s alleged actions constituted breach of contract, unjust enrichment, and breach of the duty of good faith and fair dealing.

Plaintiffs sought to hold the shareholder defendants liable for the alleged actions of MERS through the theory of “piercing the corporate veil.”  Specifically, plaintiffs contended that because of its alleged “diminutive size and meager asset base,” MERS is undercapitalized and would be unable to pay on any judgment that plaintiffs and the putative class may eventually obtain.  Plaintiffs contended that these facts stated the basis for their request to pierce MERS’s corporate veil and to hold the shareholder defendants liable for MERS’s alleged wrongdoing.

The shareholder defendants moved to dismiss the complaint arguing, among other things, that there was no allegation that MERS was set up for the purpose of committing fraud or some other injustice to borrowers, that MERS was established for a legitimate business purpose, and that its shareholders – all competitors in the marketplace – could not be considered a “single functioning entity” for veil-piercing purposes.   The court agreed, finding in part, that plaintiffs had failed to allege an overall element of injustice.  The court noted that the plaintiffs’ only substantive factual allegation in support of their claim against the shareholders was that MERS was undercapitalized.  But the court held that a shortage of capital is not a per se reason to pierce the veil.  This is particularly the case where there is no allegation that the alleged undercapitalization was undertaken to defraud a corporation’s creditors.  The court noted plaintiffs’ acknowledgment that MERS was established for a legitimate business reason, i.e., to “create a secondary mortgage market, internally administer the buying and selling of mortgages, and to simplify the administration of home mortgages.” 

Finally, the court found that plaintiffs had failed to allege any unfairness sufficient to ignore MERS’s corporate form.  Specifically, while plaintiffs alleged that MERS was created to facilitate its shareholders’ business interests and to limit their liability, neither of these factors shows unfairness, unless the attempt to limit liability was undertaken in order to avoid responsibility for a specific tort or class of torts.The Trevino decision is significant because it spared MERS’s shareholders from potential exposure to consumer class actions on the now rejected theory of indirect liability.  MERS is integral to the successful functioning of the secondary mortgage market.  Plaintiffs’ discredited legal theory, if not rejected by the court, could have exposed MERS shareholders to liability for the actions of third party investors and servicers, causing further stress to the already embattled mortgage market.

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By: Gregory S. Wright

I. Introduction
In 2007, the subprime mortgage crisis triggered a wave of litigation and regulatory action involving not only the lenders that sold subprime mortgages, but also the issuers, underwriters, and other financial institutions that participated in the securitization of the mortgages and the sale of securities backed by the subprime loans.  The credit crisis of the last few months has exacerbated (and likely will continue to exacerbate) this wave of litigation and regulatory action, not only by increasing the number of claims, but also by expanding the universe of targets to include companies and individuals that were not directly involved in the sale or securitization of subprime loans.

Given this expanding crisis, many corporations (as well as their officers and directors) will be forced to incur substantial sums to defend such claims, to settle such claims, and/or to pay judgments.  In many cases, insured companies and their officers and directors should be entitled to coverage for such costs under their Directors’ and Officers’ (“D&O”) liability policies.  While this article focuses on D&O coverage, policyholders also should consider the potential for coverage under other policies, such as Errors and Omissions liability policies and Fiduciary liability policies.

It should be noted that the terms of D&O policies vary widely.  In addition, one should assume that insurers will assert all available defenses to such claims based on the specific policy language and facts at issue.  Given the potential for coverage, policyholders facing claims and investigations should carefully review their D&O policies and should take appropriate steps in order to maximize their potential insurance recoveries.

II. Credit Crisis Litigation and Investigations
The subprime mortgage crisis, and the ensuing credit crisis, has produced a wide array of claims, lawsuits, and government investigations.  Companies and individuals in a rapidly expanding list of industries have been impacted.  Many of the claims at issue target individuals who are commonly insured under D&O policies (e.g., individual directors and officers), as well as the target entity itself, and allege conduct that often potentially triggers coverage under D&O policies, such as alleged misstatements in public filings, negligent misrepresentations, and/or breaches of fiduciary duties.  Merely to illustrate, this wave of litigation and investigations includes the following types of current claims, all of which potentially may trigger coverage under D&O policies:

• Lawsuits by shareholders against lenders and certain directors and officers alleging (in part) that defendants made false and misleading statements to the public about subprime lending activities.
  
   
• Lawsuits by shareholders against investment banks and certain directors and officers alleging misstatements about the value of and risks associated with subprime-backed assets.
  
   
• Lawsuits by investors against financial institutions and certain directors and officers alleging that the defendants that sold them mortgage-backed securities misrepresented the risks associated with such securities.
  
   
• Class action lawsuits against failed banks, related holding companies, and related officers and directors, alleging that the defendants misled investors about the financial status of the bank, violated securities laws, committed fraud, made negligent misrepresentations, etc.
  
   
• Class action lawsuit on behalf of preferred shareholders of Fannie Mae and Lehman Brothers alleging false statements by named officers and directors in connection with the offerings.
  
   
• Class action lawsuits against companies not directly involved in the subprime area (such as Constellation Energy), as well as their directors and officers, alleging failure to make appropriate disclosures about exposures arising from credit problems of trading partners (e.g., Lehman Brothers).
  
   
• Class action lawsuits and regulatory investigations against companies concerning auction rate securities.   The lawsuits allege in general that the companies failed to make appropriate disclosures about the risks associated with auction rate securities.  Some (but not all) of the lawsuits name individual directors and officers.  While most of the lawsuits have been filed on behalf of the purchasers of the auction rate securities, at least one lawsuit was filed on behalf of shareholders of the entity (Merrill Lynch) that sold the auction rate securities to other investors.  See also M. King, SEC and FINRA Focusing on Individuals in Auction Rate Securities Investigation, available here.
  
   
• SEC investigations into possible market manipulation in connection with short selling in the securities of financial institutions.  See B. Ochs, Manipulation Tied to Short Selling a Top Enforcement Priority, available here.
  
   
• FBI and DOJ criminal investigations regarding accounting, disclosure, and corporate governance matters.  See M. Ricciuti, DOJ Opens Criminal Investigations under New Guidelines for Prosecuting Corporate Entities, available here.

III. Potential Coverage under D&O Policies
In general, D&O policies afford coverage for “Claims” against an “Insured” alleging “Wrongful Acts” that result in a covered “Loss.”  The availability of coverage turns on the definitions of such terms (which vary widely), other policy terms and conditions, and the nature of the specific allegations in the claim at issue.

Claim.   D&O policies generally afford coverage for “claims.”  All (or virtually all) D&O policies include “lawsuits” within the definition of “claim,” but coverage for regulatory or criminal investigations varies widely.  For example, certain D&O policies define “claim” to include SEC investigations commenced by the service of a subpoena on an insured person or criminal proceedings commenced by the return of an indictment, information, or similar document.  Other D&O policies cover a broader array of informal investigations, while other policies limit coverage to investigations commenced by a “formal order” of investigation.  In any event, given the broad array of policy language available in the market, insureds should not wait for lawsuits to be filed before analyzing the potential for coverage.

Entity Coverage.    In addition to covering claims against insured directors and officers, many D&O policies afford coverage for claims against the insured entity itself (for example, many D&O policies cover so-called “Securities Claims” filed against the insured entity, including class action securities lawsuits).   The inclusion of “entity coverage” in D&O policies often helps insurers and policyholders avoid disputes on how to allocate defense costs and/or settlement payments among covered individuals and the entity itself.

Loss.   The definition of “loss” in D&O policies varies widely.  For example, some policies expressly cover fines, penalties, multiplied damages, and punitive damages, when permitted by law.  Some D&O policies do not.  In addition, insurers and policyholders frequently litigate (and courts recently have reached conflicting opinions on) the availability of coverage for so-called “disgorgement,” “restitution,” and/or for losses paid pursuant to Section 11 of the Securities Act of 1933.  See, e.g., Bank of America Corp. v. SR International Business Ins. Co., 2007 WL 4480057 (N.C. Super. 2007) (holding that settlement of Section 11 claim may be covered under D&O policy).

Conduct Exclusions.   Insurers also may seek to rely on various exclusions in the relevant policy to deny coverage for subprime-related claims.  For example, insurers may seek to rely on so-called conduct exclusions, which bar coverage for certain claims relating to criminal or fraudulent activity or for claims alleging that the insured received a profit to which he or she was not legally entitled.  Again, it should be noted that the terms of these exclusions vary widely.  Some exclusions arguably bar coverage when the excluded conduct is merely alleged.  However, in most policies, the exclusions do not apply unless the insurer meets its burden of proving that the excluded conduct “in fact” occurred or unless the excluded conduct is established via a “final adjudication.”  When the policy at issue includes the “in fact” test or “final adjudication” test, insureds are often entitled to coverage for defense costs and/or settlements that are made without any finding or admission with respect to the excluded conduct.  In addition, many D&O policies contain severability provisions that prevent the insurer from imputing the knowledge or conduct of one insured to other insureds, which in effect preserves coverage for the “innocent insureds” and/or the company itself.

Defense Issues.   In many D&O policies, the insurer is not obligated to defend a claim, but rather is required to reimburse the policyholder’s defense costs.  Nevertheless, certain D&O policies state that the policyholder should not incur defense costs or settle a claim without the consent of the insurer.   In addition, certain D&O policies require the policyholder to obtain the insurer’s consent with respect to the selection of defense counsel (such consent not to be unreasonably withheld).  To avoid potential insurer defenses, policyholders may wish to consider taking steps to address any conditions in the policy related to defense and/or cooperation with the insurer.

Rescission Issues.   In response to claims alleging misleading statements in a public filing, insurers often attempt to rescind the policy at issue entirely to the extent the public filing at issue was attached to or incorporated by reference into the insured’s “application” for coverage.  State law on this defense varies widely, but most courts impose a high burden of proof on insurers to demonstrate (among other things) that the alleged misrepresentation was material and that the insurer in fact relied on the alleged misrepresentation when it decided to issue the policy.  In addition, many current D&O policies make coverage non-rescindable for certain types of claims or certain insureds.  Further, many D&O policies contain strict severability clauses that limit the insurer’s right to rescind to only those individuals that had specific knowledge of the misstated facts.

Renewal Issues.   As noted above, the terms of D&O policies vary widely.  Further, insureds and insurers frequently negotiate certain terms of coverage during the renewal process.  With proper planning, insureds potentially may obtain coverage-enhancing changes to standard policy forms that may be outcome-determinative when a claim is filed.  Insureds frequently retain outside coverage counsel to review their D&O policies and participate in this renewal process.

IV. Conclusion
D&O policies offer a potentially valuable resource for policyholders facing claims arising from the subprime crisis and related credit crisis.  Policyholders should take steps now to preserve their rights to coverage.

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By: Michael J. King

Proclaiming that “we are an American court, not the world’s court,” the U.S Court of Appeals for the Second Circuit recently rejected an effort to extend U.S. jurisdiction over foreign securities transactions. The decision in Morrison v. National Australia Bank Ltd., – F.3d –, 2008 WL 4660742 (2d Cir. Oct. 23, 2008), arose in a so-called “foreign-cubed” securities class action case: an action brought by foreign investors, in foreign securities, purchased on a foreign securities exchange. Morrison, the first such case considered by the Second Circuit, offers a measure of reassurance to foreign issuers and investors who might otherwise avoid even tangential connections with U.S. capital markets due to fear of the U.S. legal system.

Australian investors sought to bring a class action suit in the U.S. District Court for the Southern District of New York against National Australia Bank (“NAB”) and others, alleging securities fraud under U.S. law in connection with purchases of NAB securities on an Australian securities exchange. According to the plaintiffs, NAB’s subsidiary, HomeSide Lending, Inc. (“HomeSide”), a U.S. mortgage service provider, used improper accounting methods that overstated the value of its mortgage servicing rights (“MSR”). These improper accounting methods led NAB to write down $2 billion in the value of HomeSide’s MSR in 2001, resulting in significant declines in the price of NAB’s securities. Plaintiffs alleged that the defendants made false and misleading statements concerning HomeSide’s operations and its contributions to NAB’s financial health in filings with the SEC, foreign securities exchanges, in statements to the press, and in corporate documents.

Since it was confronted with allegations of securities fraud involving foreign securities transactions, the district court looked to the “effects” and the “conduct” tests developed by the Second Circuit for deciding whether to exercise jurisdiction over such suits. Morrison v. National Australia Bank Ltd., -- F. Supp. 2d--, 2006 WL 3844465 (S.D.N.Y. 2006). Under the effects test, a district court may exercise jurisdiction over foreign plaintiffs where the alleged illegal activity causes a “substantial effect” on U.S. investors or markets. Under the conduct test, a district court may exercise jurisdiction if a defendant’s conduct in the United States was more than “merely preparatory” to the fraud, and particular acts or culpable failures to act within the United States “directly caused” losses to foreign investors abroad.

The district court quickly concluded that the effects test did not support exercise of subject matter jurisdiction since the alleged fraud had very little, if any, effect in the U.S. markets. Moving to the conduct test analysis, the district court concluded that HomeSide’s alleged misconduct in the United States was immaterial to a securities fraud claim given the much more significant extra territorial conduct of NAB. Thus, the district court found that the foreign actions, not the domestic actions, “directly caused” the alleged harm in this case and dismissed the complaint.

On appeal, the appellants relied solely on the “conduct” component of the conduct and effects tests in support of their jurisdictional argument. Reviewing prior precedent, the Second Circuit reaffirmed that pursuant to “the ‘conduct’ component, subject matter jurisdiction exists if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad . . .. Our determination of whether American activities ‘directly’ caused losses to foreigners depends on what and how much was done in the United States and on what and how much was done abroad.” Morrison, 2008 WL 4660742, at *4. The Second Circuit then reviewed the comparative significance of the conduct in the United States with those actions that occurred abroad and concluded that actions of NAB in Australia were significantly more central to the alleged fraud and more directly responsible for the harm to investors than the alleged manipulative accounting by HomeSide in the United States. In reaching its decision, the Second Circuit stressed that the responsibilities of NAB’s Australian headquarters included overseeing its own and its subsidiaries’ operations, and reporting to shareholders and to the financial community. The court also emphasized that NAB, not HomeSide, was the issuer of the securities and therefore was responsible for the public statements and filings and for relations with its investors. The Second Circuit also noted the absence of any allegation of harm to U.S. investors or markets and the lengthy chain of causation between HomeSide’s contribution to the misstatements and harm to investors. Based upon the totality of this analysis, the court concluded that it lacked subject matter jurisdiction and affirmed the dismissal. Id. at *7 & 8.

In addition to addressing for the first time the issues presented in a foreign-cubed class action case, the Second Circuit’s decision is significant because the court refused to replace the conduct test analysis with proposed alternative formulations for determining subject matter jurisdiction. Appellees and certain of the amici urged the court to adopt a bright-line rule that, in foreign-cubed cases, domestic conduct should never be enough and subject matter jurisdiction cannot be established where the conduct in question has no effect in the United States or on U.S. investors. The court flatly rejected this proposal. The court also rejected the SEC’s proposed alternative standard proffered in its amicus brief that the “antifraud provisions of the securities laws [should] apply to transnational frauds that result exclusively or principally in overseas losses if the conduct in the United States is material to the fraud’s success and forms a substantial component of the fraudulent scheme.” The court’s implicit rejection of the SEC’s materiality test – the decision does not even address it – is particularly important because the materiality standard would likely permit more cases alleging transnational frauds to stay in U.S. courts. For example, the SEC amicus brief urged that, under the materiality test, jurisdiction existed in Morrison.

The decision provides needed stability in an area of the law that is important to non-U.S. companies considering investing in the United States who are concerned about the risks and burdens of U.S. class action lawsuits, existing foreign investors in the United States with similar concerns, and the financial markets and intermediaries that service such investors and potential investors. At a time when the U.S. plaintiff’s bar is taking deliberate steps to cultivate foreign claimants for U.S. class action suits, these protections are welcome. Although the conduct and effects tests are very fact specific, the Second Circuit’s decision to adhere to these tests when considering subject matter jurisdiction in transnational fraud cases provides a reliable framework for disposing of cases at a preliminary stage. This is particularly important to firms concerned about exposure to class actions, where attendant disruptions and defense costs alone can prove very burdensome, even where defendants have fully complied with the law.

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By: Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

Through a spate of lawsuits, the plaintiffs’ class action bar has sought to articulate a novel theory of liability under the Real Estate Settlement Procedures Act (“RESPA”), 12 U.S.C. § 2601, et seq. Specifically, the plaintiffs’ bar has brought RESPA Section 8 claims against home builders and their affiliates who offer optional discounts on settlement costs if home buyers choose to use the affiliates’ services. In conflict with RESPA’s goal of lowering settlement costs, plaintiffs’ lawsuits challenge the ability of home builders, as well as of affiliated mortgage lenders, title insurance companies, and other settlement service providers, to offer meaningful discounts to consumers. Becoming the first federal appellate court to consider the issue, the U.S. Court of Appeals for the Eleventh Circuit recently rejected plaintiffs’ theory. See Spicer v. The Ryland Group, Inc., Appeal No. 07-15426, 2008 WL 4276909 (11th Cir. Sept. 16, 2008) (per curiam), aff’g 523 F. Supp. 2d 1356 (N.D. Ga. 2007).

Plaintiff Tanya Spicer sued The Ryland Group, Inc. (“Ryland”) and its affiliate Ryland Mortgage Company (“Ryland Mortgage”), alleging that defendants violated RESPA Section 8 through offering an optional settlement costs discount if Spicer chose to use Ryland Mortgage to finance the purchase of her home from Ryland. 523 F. Supp. 2d at 1358-59. Spicer attempted to articulate a theory of “economic coercion” in support of her claim. In particular, Spicer argued that because the amount of the discount allegedly was too great to pass up, she had “no viable economic option but to use the affiliated lender.” Id. at 1361.

RESPA Section 8 prohibits kickbacks in exchange for the referral of, and unearned fees received in connection with, real estate settlement services. The statute, however, provides a qualified exemption from Section 8 liability to affiliated business arrangements. Specifically, 12 U.S.C. § 2607(c)(4) provides that the referral of settlement services to an affiliated service provider is permitted if: (a) the existence of the affiliated business arrangement is disclosed to the person referred; (b) the person referred is not required to use any particular settlement service provider; and (c) the only thing of value that is received from the arrangement is the return on the ownership interest. Regulation X, promulgated by the Department of Housing and Urban Development to implement RESPA, permits affiliated service providers to offer “discounts or rebates to consumers for the purchase of multiple settlement services.” 24 C.F.R. § 3500.2. Such discounts do not constitute an impermissible “required use” if the discounts are “optional to the purchaser” and are “true discount[s] below the prices that are otherwise generally available, and must not be made up by higher costs elsewhere in the settlement process.”

Following the plain language of RESPA and Regulation X, the Spicer district court held that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA or Regulation X. 523 F. Supp. 2d at 1362. The court specifically rejected Spicer’s claim that offering an optional settlement costs discount amounted to “economic coercion.” After briefing and oral argument, the Eleventh Circuit affirmed, adopting the district court opinion as “well-reasoned.” Spicer, 2008 WL 4276909, at *1.

The federal district court decisions to date have rejected the “economic coercion” theory of required use, and the Eleventh Circuit’s affirmation of the dismissal of the Spicer matter reinforces the consensus among federal courts that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA. Changes to Regulation X’s definition of “required use” effective in January 2009, however, may alter the landscape for home builders and their affiliates.

Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass, and David D. Christensen of K&L Gates LLP represented The Ryland Group, Inc. and Ryland Mortgage Company.

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By: Irene C. Freidel

On September 24, the Seventh Circuit Court of Appeals in Andrews v. Chevy Chase Ban, 2008 WL 4330761 (7th Cir. Sept. 24, 2008), joined two other federal appeals courts and the California Court of Appeals in holding that a class action may not be maintained for rescission of mortgage loans under Section 1635 of the Truth in Lending Act (“TILA”), 15 U.S.C. §§ 1601, et seq.  (See also McKenna v. First Horizon Home Loan Corp., 475 F.3d 418 (1st Cir. 2007); James v. Home Constr. Co. of Mobile, Inc., 627 F.2d 727 (5th Cir. 1980); LaLiberte v. Pacific Mercantile Bank, 53 Cal. Rptr. 3d 745 (Cal. Ct. App. 2007), cert. denied, 128 S. Ct. 393 (2007)).  The Andrews decision is likely to have an immediate impact on pending cases seeking class-wide TILA rescission against creditors and loan assignees both within the Seventh Circuit and elsewhere, as plaintiffs’ class action attorneys have placed this issue front and center in the debate over what remedies are properly available to borrowers who obtained high-risk mortgage loans.  Unquestionably, class-wide rescission of tens of thousands of mortgage loans would result in substantial liability to any entity against which a judgment is entered.

Over the last year, more than 40 class actions have been filed on behalf of thousands of borrowers in California federal courts seeking damages and class-wide rescission of pay-option adjustable rate mortgage loans.   These loans are at the core of the current mortgage crisis.  None of the courts handling these cases has yet to decide whether the classes should be certified or whether class rescission under TILA is appropriate. 

In support of its decision against a class-wide rescission remedy, the Andrews court noted, among other reasons, that rescission requires a complete “unwinding [of] the transaction in its entirety and thus requires returning the borrowers to the position they occupied prior to the loan agreement.”  When a consumer exercises the right to rescind, the lender’s security interest in the real property becomes void and the lender is obligated to take steps within 20 days after receipt of notice to reflect termination of the security interest.  The consumer will not be liable for, among other charges, finance charges; thus, the creditor must return any money or property given to anyone in connection with the transaction.  When the creditor has complied with these obligations, the consumer must then repay the loan proceeds to the creditor.  Thus, the court concluded that this “purely personal” and “highly individualized remedy” involves a “transactional unwinding” process that makes it “an extremely poor fit for the class-action mechanism.”

With the Andrews decision, the Seventh Circuit is now the third federal appeals court to reject class-wide rescission as a remedy available under TILA, making it more likely that courts in other jurisdictions, including California, will adopt this ruling.  For a more detailed discussion of the Andrews case, see here.

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