• January 17, 2009

Lester v. Novastar Financial Corp., 8th Cir. Civ. File No. 8452WM (oral argument, 1/16/09)

The Eighth Circuit has upheld the dismissal of several securities fraud class actions over the past two years. How will they react to the dismissal of a fraud claim against a subprime lender? The allegations in the class action plaintiffs complaint were essentially that the bottom was falling out of the subprime lending market, defaults were soaring, the internal quality control department was gutted, the lender’s fraud department was allegedly reporting up to 90% fraudulent loans, but shareholders were not informed that the company was on a highway to hell.

Judges Colloton, Gruender, and Bye (two “W” appointees and a Clinton appointee) were a silent bench during plaintiffs’ counsel’s opening argument. They were considerably more lively when defense counsel argued.

Defense counsel made much of the fact that the plaintiffs dropped their allegations of Novastar’s inadequate reserves for loan losses. It seemed clear that at least one of the judges on the panel noted this as a relevant part of their inquiry.

One judge on the panel asked defense counsel about the shrinking QC department. This fact, if true, answered defense counsel, would not have contradicted any statements by the company. The same judge later followed up on the issue of Novastar’s internal auditors. “Do they have the make or break if these loans go forward after a certain point?” “Is there someone else at the company who serves in that capacity?” Defense counsel’s answer was not entirely clear (though, in his defense, the questions did not lend themselves to clear answers).

“Was the increase in loss reserves disclosed?” asked another judge on the panel — a softball for defense counsel because it was clear that the answer was going to be yes and the inference would be that shareholders would have been on notice of the company’s assessment of a deteriorating loan pool performance.

One judge wondered aloud to defense counsel, “Maybe I am confused here but it almost sounds like you’re defending a summary judgment victory rather than a motion to dismiss.” The same judge asked plaintiffs’ counsel on rebuttal, “It seemed to me the district court’s trouble with your pleading was that there were broad swaths of company statements without a clear connection between particular statements and alleged frauds. Did you seek leave to amend?” Plaintiffs’ counsel answered, “The district court judge thought we had not asked for leave to amend, but we had.” (?)

Predicting from questions at oral argument is tempting but it is certainly not robust or reliable. That won’t stop me. I will predict reversal, ordering the district court to grant plaintiffs leave to amend. (And then, back to the Eighth Circuit after the next grant of the next motion to dismis???)

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