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In re Countrywide Financial Corp. Derivative Litigation

May 14, 2008


The opinion of the court was delivered by: Mariana R. Pfaelzer, District Judge.


Before the Court are several motions to dismiss Plaintiffs'*fn1 derivative claims in In re Countrywide Financial Corp. Derivative Litigation ("Arkansas Teachers"). Nominal Defendant Countrywide Financial Corporation ("Countrywide" or "Company") moves to dismiss on the grounds that Plaintiffs' have not made pre-suit demand or adequately pled that demand is excused in this case.*fn2 Individual Defendants *fn3 move to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), 9(b), 8(a)(2), and the provisions of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. §§ 78u-4(b)(1), 78u-4(b)(2), 78u-5(c)(1)(a), § 78u-5(c)(2)(a).


A complete procedural background of this and other related proceedings is provided in the Court's March 28, 2008 Order. Relevant here, Plaintiffs filed a Consolidated Complaint on February 15, 2008 alleging both derivative and class action claims. See Consolidated Shareholder Derivative Action and Class Action Complaint for Breaches of Fiduciary Duty, Aiding and Abetting Breaches of Fiduciary Duty, and Violations of the California and Federal Securities Laws ("Compl."). On March 28, this Court stayed the class action claims in favor of similar proceedings in the Delaware Court of Chancery. The instant motions seek to dismiss the nine remaining derivative claims.

A. Plaintiffs

Plaintiffs here are Arkansas Teacher Retirement System ("ATRS"), Fire & Police Pension Association of Colorado ("FPPAC"), Public Employees Retirement System of Mississippi ("MS PERS"), and Central Laborers Pension Fund ("CLPF").

B. Nominal Defendant

Nominal Defendant Countrywide is a Delaware corporation with its principal executive offices in Calabasas, California. Id. ¶ 53.

C. Individual Defendants

The Individual Defendants consist of both director and non-director defendants. The Complaint names as director Defendants, Angelo R. Mozilo (Chairman of the Board since 1999 and Chief Executive Officer since 1998), David Sambol (Director since Sept. 2007, President and Chief Operating Officer, and various other executive positions), Jeffrey M Cunningham (Director since 1998), Robert J. Donato (Director since 1993), Martin R. Melone (Director since 2003), Robert T. Parry (Director since 2004), Oscar P. Robertson (Director since 2000), Keith P. Russell (Director since 2003), Harley W. Snyder (Director since 1991), Henry G. Cisneros (Director from 2001-Oct.2007), and Michael E. Dougherty (Director from 1998-Jun.2007). Id. ¶¶ 54-64.

The Complaint names as non-director Defendants Stanford M. Kurland (President and Chief Operating Officer until 2006, and various other executive positions), Carlos M. Garcia (several executive positions and former Chief Financial Officer), and Eric P. Sieracki (Chief Financial Officer and Executive Managing Director). Id. ¶¶ 66-69.

D. Countrywide's Business

Countrywide originates home loans, retaining a portion of these loans on its balance sheet as investments, and securitizing and selling the remainder. Id. ¶ 101. The Company services the loans that it produces. Id. ¶ 102. It produces both "conforming loans" which can be sold to government-sponsored entities Fannie Mae and Freddie Mac, and non-conforming ones, which can be sold only to private investors. Id. ¶¶ 106-108. Countrywide finances its operations in large part with capital from private parties-including the secondary mortgage market, where investors purchase mortgages and "mortgage-backed securities." Id. ¶¶ 103-104. In addition to retaining some in its portfolio for investment purposes, the Company holds "retained interests"-or residual interests in some mortgage-backed securities that have been passed along to investors. Id. ¶ 208. According to the Complaint, retained interest holders receive interest payments from a "real estate mortgage investment conduit" only after all required regular interest has been paid to investors in higher priority securities tranches. Id. ¶ 129. Finally, the Company maintains a catalog of "loans held for sale" composed of mortgages that will ultimately be sold to third party investors, and "mortgage servicing rights" *fn4 on the mortgages that it originates. Id. ¶ 210.

Countrywide must consistently produce quality mortgages, or at least mortgages "at levels that meet or exceed secondary mortgage market standards" to ensure that the secondary market will continue to provide capital to finance its operations. Id. ¶¶ 104-105. Moreover, if the Company originates and sells loans that are not in compliance with its own underwriting policies, in violation of the representations or warranties made to purchasers, those purchasers can require Countrywide to repurchase them. Id. ¶ 106.

E. Plaintiffs' Allegations

1. Increased Origination of Non-conforming Loans

Plaintiffs allege that from 2002-2006, the Company steadily increased the origination of "non-conforming" loans, which are inherently less safe than conforming loans because they cannot be sold to government-sponsored entities. Id. ¶¶ 106-108. Countrywide also "strategically" shifted away from traditional fixed-rate home loans to borrowers with "prime" credit scores, in favor of a variety of non-traditional higher-risk loans. Id. ¶ 109. The Complaint identifies several categories of these non-traditional loans: (1) adjustable rate mortgages (ARMs), which typically provided a low "teaser" interest rate during an introductory period, followed by higher rates; (2) interest-only mortgages, where require the borrower to pay only the interest during an introductory period; (3) "pay option" ARMs, which provide the borrower the option to pay a "minimum" monthly payment less than the interest accruing that month, and add any remaining interest to loan principal; (4) stated income loans, which rely on the borrower's representations of an ability to pay, and require little or no supporting documentation from the borrower; and (5) home equity lines of credit ("HELOCs"), which are second loans secured by the difference between the value of a home and the amount due on the first mortgage.*fn5 Id. ¶ 110.

Plaintiffs allege that these types of loans are considerably more risky than traditional conforming loans. Id. ¶ 119. For instance, with stated income loans, the borrower may overstate his income, resulting in a loan that is fundamentally at risk of default if the borrower's income is inadequate. Id. ¶ 110. In addition, HELOCs become a problem if housing prices decline: the HELOC lender's security interest decreases because the first lien-holder has priority to be paid in full the amount of the first mortgage. At the extreme, the HELOC becomes completely unsecured. Id. Plaintiffs contend that this can occur with a mere 10-20% reduction in the value of a home. Id.

Pay option ARMs raise other concerns. With pay option ARMs, a borrower's failure to pay at least the minimum monthly interest results in "negative amortization," whereby any interest that remains unpaid is added to the amount of principal outstanding on the loan. Id. ¶ 121. While accumulated negative amortization is reported as deferred interest earnings on the Company's income statement or with the loan on the balance sheet, it is particularly problematic where borrowers chose to skip payments out of necessity, as those borrowers very likely have an increased risk of default. Id. ¶ 122.

2. Origination of Loans in Violation of the Company's Underwriting Standards

Significantly, according to Plaintiffs, Countrywide did not simply originate loans that were inherently risky. Id. ¶ 116. Rather, the Company exacerbated the risky nature of these loans by offering them to borrowers without requiring them to document their income. Id. For instance, the vast majority (78% in 2004, and 91% in 2006) of Countrywide's pay option ARMs fell into the "low documentation" category. Id. ¶¶ 12, 116-121. Without assurances of the credit-worthiness of its borrowers, Countrywide could not reasonably know how likely it was that deferred interest on pay option ARMs would ultimately be repaid. Id. ¶ 122. According to Plaintiffs, HELOCs, too, were provided to borrowers who were less credit-worthy than that instrument required. While HELOCs were often labeled as "prime" products, one observer in late 2007 commented that Countrywide's HELOCs were performing on par with a competitor's subprime loans. See id. ¶¶ 250-251 (citing analyst who observed that Countrywide's "definition of `prime' was [apparently] loosened in the recent boom").

Plaintiffs allege that in practice, the origination of these "riskier" loans often violated the Company's own loan underwriting policies. The Complaint offers the accounts of numerous confidential witnesses, who are mostly former employees such as underwriters and loan officers, relating how Countrywide departed from its strict underwriting standards by generating large numbers of loans without proper regard for their quality. See ¶¶ 147-158 (noting standards were also loosened with respect to loans labeled and marketed as "prime"). The Complaint also provides the accounts of several former vice presidents at Countrywide who similarly attest that Countrywide was simply pushing through loans without adherence to underwriting standards. Id. ¶¶ 148-152.

3. Failure to Effectively Hedge and Adjust Loan Loss Allowance and Impairment Charges

Despite the changes to Countrywide's loan portfolio that resulted from the combination of increasingly risky loans offered by Countrywide and increasingly lax adherence to loan underwriting standards, Plaintiffs contend that Individual Defendants improperly maintained the Company's "loan loss allowances" for loans held for investment at depressed levels from 2003-2006. Id. ¶¶ 16, 194. Loan loss allowances are set aside to absorb the estimated amount of probable losses in the loan portfolio. Id. ¶ 194. Viewed as a percentage of the overall loan portfolio, Plaintiffs observe, the allowances in 2003-2006 were less than half their 2002 levels. Id. (noting reserves of 0.69% in 2002, but an average reserve of just over 0.30% in the following four years). By maintaining such low reserves, Plaintiffs allege, Defendants improperly boosted profits and deceived the market as to the true risk of their portfolio. They point to the sudden rise in loan loss allowances from 0.33% in 2006 to 1.84% by the end of 2007 as evidence that the allowances for this whole period had been inadequate.

Similarly, it is alleged that proper Board oversight would have led to increased impairment charges on residual interests held by the Company with respect to pay option ARMs that were securitized. Id. ¶ 204.

Plaintiffs also contend that the Company's "hedges" for retained interests *fn6 and Mortgage Servicing Rights ("MSRs")-devices which serve to mitigate negative valuation changes in these various interests-were ineffective. Id. ¶¶ 210-212. They also contend that the valuations of these interests were based upon improper assumptions, which caused them "to fluctuate wildly without any basis." Id. ¶ 230. Plaintiffs also provide the testimony of a Vice President-level confidential witness who reports that the hedge he worked on failed to meet the requirements of "FAS 133," a standard metric for hedging activities, and furthermore, that he was asked by Countrywide management to improperly remove bad loans retroactively from the portfolio. Id. ¶¶ 221-229.

F. Duties of Individual Defendants on Board Committees*fn7

The Board's Committees were tasked with the duties to actively monitor and control all of these aspects of the Company's business.*fn8 Id. ¶ 26. The Audit and Ethics Committee was obliged to oversee the integrity of financial statements and reports and discuss, manage, and monitor the Company's exposure to risk. Id. ¶¶ 79-81. The Credit Committee was responsible for overseeing credit objectives and policies, including review of the Company's credit exposures and loan loss allowances. Id. ¶¶ 86-87. The Finance Committee was required to assess the Company's access to liquidity, both long and short term, and review "equity repurchases." Id. ¶ ¶ 92, 29. The Compensation Committee was responsible for the overall compensation structure for employees, and executive compensation. Id. ¶¶ 29, 82-85. Lastly, the Operations and Public Policy Committee was charged with oversight of "operational risk" and other matters relating to responsible lending. Id. ¶ 95. The Complaint sets forth the membership of director Defendants on these committees as well as the frequency of committee meetings. See, e.g., id. ¶ 77.

Plaintiffs also cite other examples indicating that Individual Defendants were aware of their duties to monitor the Company's practices, including (1) public statements made in 2007 that the Board "has always been actively engaged" in overseeing business strategy; and (2) signatures by director Defendants and Defendant Sieracki on the Company's Form 10-K filings with the United States Securities and Exchange Commission ("SEC"), id. ¶¶ 132-135.

G. Red Flags

Throughout the Complaint, Plaintiffs identify numerous "red flags" that would have invariably provided warnings to the Individual Defendants, including those on the relevant Board Committees above, to increasingly serious problems with loans generated by the Company: (1) the shift to riskier loan products; (2) the rising delinquencies in pay-option ARMs and HELOCs, id. ¶ 198; (3) sharply rising rates of negative amortization and associated "phantom earnings," id. ¶¶ 121, 139; (4) the "dramatic increase in retained interests held on Countrywide's balance sheet," id. ¶ 130; (5) the fact that the Company's valuation of MSRs, retained interests and loans held for sale "fluctuate[d] wildly without any basis," id. ¶ 230; (6) the pitfalls of other mortgage lenders, id. ¶ 299; and (7) industry publications about nontraditional loans, including those that were critical of low-documentation pay option ARMs, id. ¶ 139.

H. Defendants' False and Misleading Statements

In view of Countrywide's loan origination practices and failure to monitor, Plaintiffs allege that Individual Defendants caused Countrywide to issue false and misleading statements. These statements reassured investors as to the quality of loans originated by Countrywide and the procedures and policies for underwriting and managing risk. Plaintiffs contend that these statements were misleading because they failed to inform the public about the true nature of the loans originated by the Company and the risk to the Company's long term prospects. Plaintiffs identify several different categories of public statements:

1. Press Releases and Conference Calls

Plaintiffs point to allegedly misleading press releases, including releases as early as 1Q04 and 3Q04, in which Mozilo stressed "the strength and flexibility of [Countrywide's] business model and risk management strategies." Id. ¶¶ 276-277. Similarly, at the end of 3Q05, Countrywide announced that it was "well-positioned with a ... high quality credit profile in our loan portfolio." Id. ¶ 279. Similarly, with its 1 Q06 results, Countrywide touted its "time-tested business model" in this "challenging environment." Id. ¶ 278.

Plaintiffs also provide excerpts of conference calls with analysts. For example, in April, 2004, Mozilo stated that "Countrywide has ... very strong discipline in the origination of sub-prime loans" and specifically assured an analyst that "[i]t is well over 720 FICO average on HELOCs" so as to be mostly prime or better. Id. ¶¶ 281-282. Similarly, Mozilo in April, 2005 characterized pay option ARMs as a "very good product" that is a "time tested," and in May, 2005 Sambol explained that risks were mitigated in those products by "different underwriting criteria ... such as maybe higher credit scores or lower loan to value ratios." Id. ¶¶ 284-285.

2. SEC Filings

The Complaint also references filings with the SEC where Countrywide made similar disclosures. For example, the Form 10-Q for 1Q04 stated that the Company "only retain[ed] high credit quality mortgages in [its] loan portfolio" and the Form 10-K for the 2004 fiscal year stated that the Company "actively manage[d] credit risk" and described in detail underwriting guidelines and loan origination standards. Id. ¶¶ 287-289. See also ¶ 295 (identifying similar statement that the Company manages credit risk related to pay option ARMs, and describing underwriting requirements). In the Company's Form 10-Q filed on November 8, 2005, it indicated that its "pay-option loan portfolio has a very high initial loan quality, with original average credit rating (expressed in terms of FICO scores) of 720" and that it originated pay-option loans to borrowers who can qualify at the loan's fully-indexed interest rates. Id. ¶ 293. See also ¶ 293 (citing statement repeated in Form 10-Q filed on May 9, 2006). The director Defendants and Sieracki represented, in the Company's Form 10-K for 2006, that they were "actively monitoring the delinquency and default experience of ... homogenous pools by considering current economic and market conditions" and that "the senior management [was] actively involved in the review and approval of our allowance for loan losses." Id. ¶ 204.

3. Proxy Statements

The Complaint alleges that proxy statements for the annual shareholder's meetings in 2005, 2006, and 2007 were likewise materially false and misleading. The 2005 statement, for example, filed April 29, 2005, sought a vote in favor of re-election of Mozilo, Kurland, Robertson and Russell to the Board as well as approval of an amended Annual Incentive Compensation Plan. Id. ¶ 307. It did not, however, disclose that reported figures were boosted by reliance on risky products to inflate short-term performance. Id. ¶¶ 307-309. Had shareholders known of these "undisclosed fundamental changes to the Company's business model," Plaintiffs contend, the relevant Defendants would not have been re-elected. Id. ¶¶ 308-309. The 2006 and 2007 statements were similarly misleading, and, in addition, contained misleading statements about the effectiveness of Countrywide's compensation policies and financial performance. Id. ¶¶ 310-318.

4. 2007 Statements About Countrywide's Position

Plaintiffs also allege that Individual Defendants continued to make misleading statements to the public in 2007, at which point the demise of many competing lenders was largely evident. For example, in March 2007 Mozilo stated that Countrywide was "more diversified" than competing subprime lenders, and that only 7% of the Company's originations, and only ".2 percent of [Countrywide's] assets" were in the sub-prime category. Id ¶ 299. Mozilo went on to state that subprime issues "will be great for Countrywide at the end of the day because all the irrational competitors will be gone." Id. ¶¶ 299-301. On August 23, 2007, Mozilo reassured the market that "there is no more chance for bankruptcy [then] than [there] was six months ago, two years ago, when the stock was $45 per share" and that "Countrywide's future is going to be great." Id. ¶ 303.

I. Insider Selling

Plaintiffs allege that Individual Defendants enriched themselves by selling vast quantities of stock in "illegal, insider sales." Id. ¶ 29. Sales in the Relevant Period were made at inflated prices because of the "a whole host of associated false and misleading statements" that deceived investors as to the true financial condition of Countrywide and the nature of the loans that were being originated by Countrywide. Id. ¶ 30. In the aggregate, these sales were substantial: Individual Defendants realized proceeds of about $850 million between 2004 and the end of 2007, with Mozilo selling some $474 million worth of shares. Id. ¶ 322. During this period, Plaintiffs place particular emphasis on a $2.4 billion stock repurchase program in which Countrywide repurchased several million shares in 4Q06 and 2Q07. Id. ¶¶ 325-326. They argue that it is suspicious that several directors and officers sold some $150 million of their personal shares during these repurchase periods.

The Complaint also alleges that Mozilo frequently revised his "passive" Rule 10b5-1 stock sale plan to sell additional shares each month during the repurchase periods. Id. ¶¶ 331-332. It seeks to tie the sales of other directors and officers to those of Mozilo, alleging for example, that other insiders' sales doubled in November 2006 as compared to October 2006, and after Mozilo's February amendment to his 10b5-1 plan, "[insiders] sold more the week of February 2 [2007] through February 9 than they had the previous two months." Id. ¶¶ 339-340.

J. Countrywide's Significant Collapse in Value

The Complaint describes a drastic drop in common stock value, from $45 in February 2007 to less than $5 in January 2008, government investigations into lending practices and accounting, significant liquidity constraints that limit its ability to conduct business, and damage to goodwill and reputation. Id. ¶¶ 3, 231. Plaintiffs attribute the collapse in share value primarily to "a number of shocking disclosures" in July 2007 and later when the Company was forced to disclose (1) that it took large loan loss provisions to offset delinquencies in home equity lines of credit ("HELOCS") and pay-option adjustable rate mortgages ("pay-option ARMs"); and (2) that the fair value of the Company's mortgage servicing rights ("MSRs") and retained interests dropped considerably, and the losses could only be partially offset by the Company's hedging. Id. ¶¶ 3-7. The Complaint asserts that these disclosures shocked investors both because of the magnitude of the "miscalculations" and because they reflected previous misrepresentations of the quality of the loans originated by Countrywide. Id. ¶ 5.

On July 24, 2007, Countrywide reported second quarter earnings below its estimates, in large part because (1) Countrywide took $417 million of impairment charges on credit-sensitive retained interests (including a $388 million to its retained interest in the securitization of HELOCs); (2) Countrywide took a $293 million loan loss provision on its loans held for investment (including $181 million for HELOCs). Id. ¶¶ 241-244. Countrywide's stock dropped 10% on that day to $30.50. Id. According to Plaintiffs, the July 24, 2007 disclosure was so surprising because it related principally to the Company's prime loan portfolio. Id. ¶ 245.*fn9

Plaintiffs allege, however, that until July 2007, Countrywide had misled investors that its HELOCs were prime loans, when in fact the risk associated with HELOCs was on par with other lenders' subprime loans. Id. ¶ 245. Following these disclosures, "a steady flow of analyst and news reports ... suggested that Countrywide hid its true default risk of exposure" and changed analysts' beliefs that Countrywide was poised to "outperform weaker competitors due [to] its limited (and well-managed) credit risk." Id. ¶ 245. Analysts explained that "[management] made serious miscalculations (and possibly misrepresentations) about the quality of loans added to the bank," id. ¶ 249, and that Countrywide's "home equity securitizations are performing roughly in line with [competitors'] sub-prime deals." Id. ¶ 250.

On August 9, 2007, Countrywide filed its quarterly report for 2Q07, confirming the reports from July 24, and also warning that Countrywide was facing liquidity issues. Id. ¶ 254. Credit rating agency Moody's downgraded Countrywide on both August 2 and August 16, and on August 15, a Merrill Lynch analyst raised concerns that Countrywide could be forced into bankruptcy. Id. ¶¶ 253-254. On August 16, Countrywide "drew down" an $11.5 billion credit from its bank lines. Id. ¶ 254. Countrywide's share price dropped over several days from $27.75 to $18.95. Finally, on August 22, 2007, Bank of America purchased $2 billion of preferred stock that pays a 7.25% interest coupon and is convertible at a strike price of $18 per share.

K. Plaintiffs' Claims

Plaintiffs make nine derivative claims. Claims 1-3 assert that Individual Defendants breached their fiduciary duties, including their duties to act in good faith, loyalty, and with due care and diligence in the management of the Company; and that they committed corporate waste in awarding Mozilo's compensation and instituting the stock repurchase.

Claim 4 alleges insider trading against Mozilo, Kurland, Garcia, Sambol, Robertson, Dougherty, Snyder, Cisneros, Donato, Cunningham, Russell, and Sieracki pursuant to Cal. Corp.Code § 25402. Id. ¶¶ 506-511. Claim 5 asserts that the director Defendants aided and abetted the "insider trading" defendants in their breaches of fiduciary duties. Id. ¶¶ 512-516. Claims 6-9 allege violations of the federal securities laws, including § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and SEC Rule 10b-5, for "participat[ing] in a scheme with the purpose and effect of defrauding Countrywide ... to purchase at least $2.4 billion in shares ... at an artificially inflated" price. Id. ¶¶ 517-528.


The Court begins with two observations that are relevant to the entire analysis. First, as the parties recognized at oral argument, the standard for stating a claim under Exchange Act § 10(b) and Rule 10b-5 overlaps considerably with the standard implicated in analyzing demand. Under the Private Securities Litigation Reform Act ("PSLRA"), the Court evaluates whether the facts pled give rise to a strong inference of scienter. See Dura Pharm. v. Broudo, 544 U.S. 336, 341-42, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005). Similarly, the Court applies a "scienter-based" standard in evaluating the Plaintiffs' claim that demand is excused in this derivative case on a failure of oversight theory. See Desimone v. Barrows, 924 A.2d 908, 935 (Del.Ch.2007). Here, the highly repetitive briefing of the motions is an affirmation that the two issues are inextricably linked.

Second, the Court is able to draw no support from the conclusory portions of the prolix and sprawling Complaint, as they cannot satisfy the various statutory and common law requirements at issue. However, in evaluating scienter, the Court notes that its job is "is not to scrutinize each allegation in isolation but to assess all the allegations holistically." Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. ----, 127 S.Ct. 2499, 2511, 168 L.Ed.2d 179 (2007). Thus, the Court proceeds by evaluating Defendants' Motions to Dismiss for failure to meet the requisite pleading standards under the PSLRA and Fed.R.Civ.P. 12(b)(6), 9(b), and 8(a)(2). It then assesses Countrywide's motion to dismiss for failure to make pre-suit demand.

A. Exchange Act § 10(b)

Count VI of the complaint pleads a violation of § 10(b) of the Exchange Act. A § 10(b) claim requires the following elements: (1) a material misrepresentation or omission; (2) scienter; (3) reliance; (4) economic loss; and (5) loss causation, which is "a causal connection between the material misrepresentation and the loss." Dura Pharm. v. Broudo, 544 U.S. 336, 341-42, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005); 15 U.S.C. ยง 78u-4(b)(4). Together, the Individual Defendants' and Defendant ...

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