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On April 24, the U.S. Securities and Exchange Commission announced that it filed and simultaneously settled a suit alleging that an H&R Block subsidiary engaged in the fraudulent sale of subprime residential mortgage-backed securities (RMBS). The complaint alleges that during a short period at the beginning of 2007, Option One Mortgage, now known as Sand Canyon Corporation, sponsored over $4 billion of RMBS and represented to investors that it would repurchase or replace any pooled mortgage for which there was a breach of a representation or warranty. The SEC alleges that at the time it sponsored the RMBS at issue, Option One was experiencing financial difficulties related to the broader decline of the subprime mortgage market and faced substantial margin calls from its creditors. As such, Option Ones condition would have prevented the company from meeting its obligations to repurchase faulty loans. Further, according to the SEC, (i) Option One failed to disclosure that it was reliant on a line of credit from its parent, (ii) H&R Block was under no obligation to provide that funding, and (iii) Option Ones losses threatened H&R Blocks credit rating at a time when the parent was negotiating the sale of Option One. The SEC did not immediately make the settlement available, but it announced that without admitting or denying the allegations Option One agreed to (i) disgorge over $14 million, (ii) pay prejudgment interest of nearly $4 million, and (iii) pay a $10 million penalty. The SEC touts this latest action as part of financial crisis-related enforcement efforts that collectively have obtained more than $1.98 billion in penalties, disgorgement, and other monetary relief. Though the investigation likely precedes the state-federal Residential Mortgage-Backed Securities Working Group and appears to have been conducted by the SEC alone, the SEC notes its role as co-chair of that group, which seeks to leverage resources to pursue alleged misconduct in the RMBS market. This settlement, comments from the SEC, and the still developing efforts of the RMBS Working Group indicate that institutions should expect continued aggressive pursuit of alleged wrongdoing in the RMBS market. This was made clear by comments from Kenneth Lench, Chief of the SEC Division of Enforcements Structured and New Products Unit that the SEC intends to "take action against those who fail to disclose or downplay important facts that make an investment riskier, even if those risks do not materialize. We remain committed to uncovering misconduct involving complex financial instruments including RMBS. Also of note, the SEC has shown a continued willingness to employ so-called "no-admit" settlements, notwithstanding a challenge to that long-standing practice issued last year by Judge Rakoff of the Southern District of New York. Last month, the U.S. Court of Appeals for the Second Circuit issued an interim decision staying Judge Rakoff's order that denied a significant no-admit settlement and required the SEC to pursue its claims at trial. In doing so, the circuit court stated that it had a significant problem with the district court's decision to dictate policy to an executive administrative agency. Instead, the Second Circuit stated, courts should defer to the agency's judgment on discretionary policy. A final decision on the district court's ruling is still pending with the Second Circuit.
On February 27, the United States Court of Appeals for the Second Circuit held that a residential mortgage-backed securities (MBS) case that had been removed from New York state court fell within the securities exception to both original and appellate jurisdiction under the Class Action Fairness Act of 2005 (CAFA). BlackRock Financial Management Inc. v. Segregated Account of Ambac Assurance Corp., No. 11-5309, 2012 WL 611401 (2nd Cir. Feb. 27, 2012). The case arose out of claims that the originator and servicer of MBS breached obligations owed to the trusts. After the trustee reached an $8.5 billion settlement agreement, it initiated an Article 77 proceeding in New York state court to confirm that it had authority to enter the settlement under the trust documents and that entry into the settlement did not violate its duties under the agreements and state law. Certain investors intervened and removed the case to federal court under the Class Action Fairness Act (CAFA). The district court denied a motion to remand to state court on the grounds that the case fell within CAFA's securities exception. On this interlocutory appeal, the court concluded that the case was one that solely involved a claim that "relates to the rights, duties (including fiduciary duties), and obligations relating to or created by or pursuant to any security." The courts rationale was that, based on prior precedent, it did not have jurisdiction over claims that were based "either on the terms of the instruments that create and define securities or on the duties imposed on persons who administer securities," although it did have jurisdiction over "claims based on rights arising from independent sources of state law." Because the underlying Article 77 case sought a declaration authorizing the exercise of the trustee's power to enter a settlement, the trustee was seeking construction of its rights under the Pooling and Servicing Agreement (PSA) and an instruction from the court as to whether it complied with its duties and obligations arising under the PSA. Therefore, the court (i) held that the securities exception of CAFA applied, (ii) dismissed the appeal for lack of jurisdiction, (iii) reversed the district court's order, and (iv) directed the district court to vacate its decision and order and remand the case to state court.
On January 27, the U.S. Attorney General officially introduced a special unit that will coordinate federal and state government investigations into residential mortgage-backed securities (RMBS). The unit is being co-chaired by multiple senior officials from the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), as well as New York Attorney General Eric Schneiderman. It will consist of at least fifty-five DOJ attorneys and other investigative staff, and will include the active participation by numerous additional federal and state entities, including the Consumer Financial Protection Bureau. According to a memorandum issued by Attorney General Holder, the working group will focus on, among other things, (i) alleged misrepresentations concerning the quality of mortgages backing the RMBS; (ii) alleged failures by trustees to manage adequately the assets within securitized pools of loans; and (iii) alleged failures by RMBS sponsors to repurchase problematic loans or remit loan proceeds to RMBS trusts. In his remarks introducing the new unit, Attorney General Holder noted that civil subpoenas recently have been issued to eleven financial institutions in connection with this new group's efforts.
The announcement follows President Obama's January 24 State of the Union Address during which he announced this and other mortgage-related and financial fraud initiatives. In his speech, the President publicly asked the U.S. Attorney General to create a special investigative unit comprised of federal prosecutors and state attorneys general to expand existing government investigations of “the abusive lending and packaging of risky mortgages that led to the housing crisis.” The President also outlined a plan he will submit to Congress to expand government support for mortgage refinancing. The costs of the program would be covered by a fee imposed on large financial institutions. Finally, the President announced his intention to establish a “Financial Crimes Unit of highly trained investigators to crack down on large-scale fraud,” and called for Congress to enhance statutory penalties for financial fraud. Previously, Securities and Exchange Commission (SEC) Chairman Mary Shapiro wrote to Congress seeking higher fraud penalties (see InfoBytes, December 2, 2011)