Financial Reform Leaves Vile Law Intact

Are you ready to hear another reason why the financial reform bill is not the game-changer it's cracked up to be? Ready or not, here it comes: Congress decided that one of the most noxious anti-investor, anti-consumer laws since Hammurabi's Code deserved to be kept intact.


I refer to the Private Securities Litigation Reform Act of 1995. While it was "reforming the financial system," Congress failed to reform out of existence this most vile of laws.

In this space a couple of weeks ago I referred to this horrendous law as the Private Securities Litigation Castration Act, but I forgot to identify who gets castrated: You.

The reason is that the PSLRA sets a "high as an elephant's eye" standard for litigants trying to sue corporations and corporate officers, banks, hedge funds -anyone — who may have ripped them off.

One result is that the expected torrent of litigation over the financial crisis, beginning with the subprime crisis of 2007, failed to materialize and those that commenced were chopped down in a wave of dismissals. I'll be coming to that in a moment. But first let's wallow a bit in this latest congressional nonfeasance.

Before PSLRA, people suing bad actors in corporate America could sue on bare-bones facts, and use civil discovery to tear loose information that they could use to prove wrongdoing (or—and this is where it got gamey—a class-action settlement enriching the lawyers while the investors or customers got bupkis).

Thanks to PSLRA, investors must "state with particularity facts giving rise to a strong inference" that fraud was intentional. No laundry list of misdeeds, no discovery. If they win, investors still get bupkis, but they win far less than they used to, and corporate crime goes unpunished.

Congress didn't chop down the Christmas tree for overpaid lawyers. It planted one for Wall Street and corporations. That's become evident in the way judges throughout the country are falling over themselves to dismiss suits against the alleged perps of the financial crisis, in the dwindling number of cases in which plaintiffs have the gumption to try to leap over the PSLRA barrier.

As reported recently by D&O Diary, one of my favorite legal blogs, lawsuits claiming violation of the securities laws have actually declined in the first half of this year. Financial crisis? What financial crisis?

So far there have been a grand total of 13 class action settlements in cases involving the financial crisis, and the list includes some big names. One of the earliest was Merrill Lynch's January 2009 subprime settlement, $550 million in two suits, just before it was acquired by Bank of America . This year there are a grand total of four settlements related to the financial crisis: MoneyGram , General Growth Properties , and two companies people have heard of, Charles Schwab and Countrywide Financial (also acquired by Bank of America). The Countrywide settlement was just before Memorial Day. Nothing since.

In contrast to a mere baker's dozen settlements, the court dockets have been chock full of dismissals. Reams upon reams of dismissals. From IndyMac(IMB) back in 2007 to New Century (NCBC)right afterwards, Novastar Financial, Washington Mutual (acquired by JPMorgan Chase , Citigroup , the Blackstone. Just the other day, the Ninth Circuit Court of Appeals sustained a lower court's dismissal of one of those cases, brought against Impac Mortgage Holdings (IMH)and two of its officers. Impac vigorously fought the charges and won a resounding victory, with no small help from the PSLRA.

The plaintiffs contended that "Impac's executives committed fraud by representing that Impac's underwriting guidelines were strict and that its loans were high-quality, while in fact the executives were overriding the underwriting guidelines to originate and purchase poor-quality loans." It wasn't for lack of trying. The plaintiffs did their homework. They produced five former employees who backed up their case.

But the appellate court, citing the strict rules of the PSLRA, said the plaintiffs didn't meet the law's requirement that they "state with particularity facts giving rise to a strong inference" that the defendants intentionally or recklessly made false statements.

It's one hell of a barrier to surmount, and this case shows just how high it is.

The former employees "claim that Impac's officers received reports and spreadsheets detailing the poor-quality loans, and further that the officers themselves approved loans that did not meet the underwriting guidelines by overriding the underwriters' recommendations," the appellate judges said in their ruling.

Convincing? Not to the Ninth Circuit Court of Appeals. "The former employees' allegations, however, consist of general allegations of mismanagement that omit the necessary details of when or how the underwriting guidelines were ignored. No specific underwriting guidelines are discussed, and the alleged violations are not sufficiently tied to the class period," the court ruling said.

The court pointed out that the closest the plaintiff came to showing "scienter"--knowledge of wrongdoing--was when a former employee allegedly "heard that Impac's president overrode an underwriter's recommendation to reject a bulk loan purchase in April or May 2006 and caused the loan pool to be purchased."

The problem, the court found, is that "there is no allegation that this override necessarily occurred during the class period and in any event [the plaintiff] provides no specific information about how the underwriting guidelines were violated. Even crediting this allegation in full, it is 'not so indicative of fraudulent intent that it carries the weight of the entire . . . complaint.'" So the court ruled, citing yet another sage decision in another investor-castration case.

So out went the case. Despite those five ex-employees, the plaintiffs weren't able to conduct any discovery, thanks to Congress's gift to the shareholders of America.

I'm not pleading the cause of class action lawyers here, folks. Melvyn Weiss (no relation, thank God), the king of class action lawyers, was sent to prison a couple of years ago for illegal client kickbacks, and even before that scandal the class-action bar was rife with issues, chief among them was that they get paid too much and investors get paid too little. But in an era in which the SEC proves every day that it's simply not up to the task of enforcing the securities laws, securities fraud suits are one of the few ways private citizens can get some measure of justice.

The PSLRA needs to go, and a real reform measure needs to take its place. It's not happening, but that doesn't make it any less necessary.

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