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Richard Gulbrandsen, Derivatively On Behalf of Wells Fargo & Company v. John H. Stumpf

May 9, 2013

RICHARD GULBRANDSEN, DERIVATIVELY ON BEHALF OF WELLS FARGO & COMPANY PLAINTIFF,
v.
JOHN H. STUMPF, ET AL.,
DEFENDANTS.



The opinion of the court was delivered by: Jacqueline Scott Corley United States Magistrate Judge

United States District Court Northern District of California

ORDER GRANTING MOTION TO DISMISS

In this shareholder derivative action, Plaintiff seeks to hold Defendants liable for Wells Fargo & Company's alleged misconduct in misreporting the health of the home mortgage loans it sought to 23 have insured through the Federal Housing Administration ("FHA"). Presently before the Court is 24 Defendants' motion to dismiss. (Dkt. No. 39.) After carefully reviewing the parties' submissions, 25 and having had the benefit of oral argument on May 9, 2013, the Court GRANTS the motion. Among 26 other things, Plaintiff has failed to allege sufficient particularized facts to excuse demand on Wells 27 Fargo & Company's Board of Directors. 28

3 improperly certified to the United States Department of Housing and Urban Development ("HUD") 4 that over 100,000 of its high-risk residential mortgage loans met HUD's requirements for proper 5 origination and underwriting, and therefore were eligible for FHA insurance. Under the FHA Direct 6

ALLEGATIONS OF THE COMPLAINT

From May 2001 through December 2010, Wells Fargo & Company ("Wells Fargo")

Endorsement program, HUD insured the loans that Wells Fargo was originating. This program is 7 intended to help low- to moderate-income families become homeowners by encouraging mortgage 8 lenders to make loans to creditworthy borrowers who nevertheless might not meet conventional 9 underwriting requirements. In the event that a borrower defaults on an FHA-insured mortgage, the 10 lender or other party holding the mortgage submits a claim to HUD for the costs associated with the 11 defaulted mortgage and the sale of the property. HUD then pays off the balance of the mortgage and 12 other related costs and may assume ownership of the property. The Direct Endorsement program grants the lender the authority to decide whether the borrower represents an acceptable credit risk for 14

The Individual Defendants*fn1 -all current or former members of Wells Fargo's Board of Directors ("Board") or Wells Fargo executives -"knew or recklessly disregarded" that a very 17 substantial percentage of Wells Fargo's loans had not been properly underwritten, contained 18 unacceptable risk, and were ineligible for FHA insurance. (Dkt. No. 1 ¶ 2.) In addition, the 19

Individual Defendants "caused Wells Fargo to conceal" from HUD that it was having very serious 20 loan quality problems and failed to self-report, as required, loans that did not qualify for FHA 21 insurance. (Id. at ¶ 70.) The Individual Defendants engaged in this misconduct in an effort to 22 increase loan volume. 23

24 internal reviews of its mortgage portfolio. (Id. at *27.) Wells Fargo's home mortgage division's 25

Kovacevich, and Howard I. Atkins. The remaining 21 Individual Defendants are or were outside directors. Collectively, the Individual Defendants and Wells Fargo are the "Defendants." For 28 diversity jurisdiction purposes, Wells Fargo is considered a defendant. See In re Digimarc Corp. Derivative Litig., 549 F.3d 1223, 1237-38 (9th Cir. 2008).

HUD, and to certify loans for FHA mortgage insurance without prior HUD review or approval. 15

Further, the Individual Defendants were alerted to "multiple red flags" through Wells Fargo's quality control function comprised both the Fraud Risk Management ("FRM") and Quality Assurance 2

("QA") departments. The QA department's procedures included the following with respect to FHA-3 insured loans: monthly reviews of a random sample of loans originated and sponsored within the prior 4 sixty days, reviews of at least some portion of its loans that were in early default, and preparation and 5 circulation of internal reports of the reviews' findings. The FRM department also reviewed loans 6 referred to it as potentially involving fraud or misrepresentations. Between 2001 and 2010, Wells 7

Fargo's monthly reviews identified over 6,000 "materially deficient" loans, i.e., loans that did not 8 qualify for FHA insurance. These reports were made to "senior management," and then "shared with 9 the Board because as explained in Wells Fargo's Corporate Governance Guidelines, '[t]he business of 10

[Wells Fargo] is managed under the direction of its Board' and the Board 'delegates the conduct of 11 business to the Company's officers, managers and employees.'" (Id. at ¶ 78 (alterations in original).) 12

dipped below 42% and reached as high as 48%, meaning that nearly one out of every two retail FHA 14 loans that Wells Fargo certified to HUD did not qualify for insurance. Wells Fargo's internal 15 benchmark for material violations was set at 5%. 16

According to a memorandum dated April 8, 2004, the Vice President of Division Quality 18

During a seven-month stretch from April 2001 through October 2002, the material violation rate never Despite these reports, no effective action was taken to correct the business practice.

Management indicated that a working group would convene to address reporting the material 19 violations to HUD. However, no self-reporting of the material violations occurred. Rather, the 20 working group narrowed Wells Fargo's reporting obligations, determining that only instances of 21 systemic fraud need to be reported to HUD. Wells Fargo did not report a single material violation 22 prior to October 2005. 23

Home Mortgage assured HUD that the company would follow HUD's interpretation of the reporting 25 requirements, which demand that the lender report individual instances of material violations. (Id. at 26 ¶ 121.) Although Wells Fargo began to self-report its deficient loans following HUD's inquiry, the 27 company self-reported fewer than 250 loans in a five-year period. From 2002 through 2010, Wells 28

In early 2006, "in response to questioning by HUD," the Division Presidents of Wells Fargo Fargo failed to report 6,320 materially deficient loans, resulting in FHA's payment of nearly $190 2 million in FHA benefits on defaulted mortgage loans. 3

Wells Fargo on October 9, 2012, seeking to recover damages in connection with Wells Fargo's 5 participation in the FHA insurance program. 6 7 fiduciary duty; 2) waste of corporate assets; and 3) unjust enrichment. 8 Defendants move to dismiss the Complaint on four grounds 1) failure to plead particularized

10 facts demonstrating that a pre-suit demand on the Board would have been futile; 2) failure to plead 11 non-speculative harm to Wells Fargo; 3) lack of standing; and 4) failure to allege an underlying cause 12 of action. 16 derivative action to, among other things, "state with particularity: (A) any effort by the plaintiff to 17 obtain the desired action from the directors or comparable authority and, if necessary, from the 18 shareholders or members; and (B) the reasons for not obtaining the action or not making the effort." 19

"The purpose of the demand requirement is to afford the directors an opportunity to exercise their 20 reasonable business judgment and waive a legal right vested in the corporation in the belief that its 21 best interests will be promoted by not insisting on such right." Kamen v. Kemper Fin. Serv., Inc., 500 22

U.S. 90, 96 (1991) (internal quotation marks and alterations omitted). Rule 23.1, however, does not 23 establish the circumstances under which demand would be futile. See id. For these standards, courts 24 turn to the law of the state of incorporation; in this instance, Delaware. In re Silicon Graphics Inc. 25

Delaware law provides two demand-futility tests, as set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984) and Rales v. Blasband, 634 A.2d 927 (Del. 1993). When a plaintiff challenges one or 28 more specific transactions authorized by the board of directors, or other express decisions or conduct

The United States Attorney's Office for the Southern District of New York filed suit against

The present Complaint includes three causes of action against Defendants: 1) breach of

DISCUSSION

I. Demand Futility

A. Legal Standard

Rule 23.1(b)(3) of the Federal Rules of Civil Procedure requires a plaintiff bringing a Sec. Litig., 183 F.3d 970, 990 (9th Cir. 1999), superseded by statute on other grounds. 26 of the board, a court should employ the Aronson test. Aronson evaluates whether, under the 2 particularized facts alleged, a reasonable doubt is created that1) the directors are disinterested and 3 independent, or 2) the challenged transaction was otherwise the product of a valid exercise of business 4 judgment. Aronson, 473 A.2d at 812; see also In re Oracle Corp. Derivative Litigation, 2011 WL 5 5444262, at *2 (N.D. Cal. Nov. 9, 2011). Rales provides an alternative test that applies "[w]here 6 there is no conscious decision by directors to act or refrain from acting." Rales, 634 A.2d at 934.7

Under Rales, demand is futile when "the particularized factual allegations of a derivative stockholder 8 complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors 9 could have properly exercised its independent and disinterested business judgment in responding to a 10 demand." Id. 11

12 connection between the corporate trauma and the board such that at least half of the directors face a

substantial likelihood of personal liability." South v. Baker, 62 A.3d 1, 9 (Del. Ch. 2012). A plaintiff 14 can plead the necessary connection by alleging with particularity either: 1) "actual director 15 involvement in a decision or series of decisions that violated positive law;" 2) "that the board 16 consciously failed to act after learning about evidence of illegality-the proverbial 'red flag;'" 3)

"To plead demand futility, a stockholder plaintiff must plead facts establishing a sufficient "that a board of directors is dominated or controlled by key members of management, who the rest of 18 the board unknowingly allowed to engage in self-dealing transactions;" or 4) that the board failed to 19 engage in adequate oversight as required under In re Caremark Intern. Inc. Derivative Litig., 698 20

A.2d 959 (Del. 1996). Id. Plaintiff's Complaint grounds demand futility on the first two bases. 21 As a threshold matter, the Individual Defendants argue that Wells Fargo's Restated Certificate 23 of Incorporation contains an exculpatory provision that further increases Plaintiff's pleading 24 requirement, even for Plaintiff's breach of the duty of loyalty claim.*fn2 The Court is unpersuaded. 25

51.) The Court does not rely on the documents included in the RJN except the Renewed Certificate of 27

Incorporation. Plaintiff objects to the Court taking judicial notice of this document only to the extent the Court accepts as true the statements contained therein. (Dkt. No. 51 at 2.) Because the Court is 28 merely taking notice of the document, and not accepting as true the facts contained therein, Plaintiff's objection is denied.

B. Whether the Certificate of Incorporation Affects Demand Futility

The relevant provision limits a director's personal liability for a breach of fiduciary duty to

"any breach of the director's duty of loyalty to the corporation or its stockholders . . . , acts or 3 omissions not in good faith or which involve intentional misconduct or a knowing violation of law, 4

[unlawful payment of a dividend], or . . . for any transaction from which the director derived an 5 improper personal benefit." (Dkt. No. 41-1 at 8.) This exculpatory clause exempts director liability 6 to the extent allowed under Delaware law. 8 Del. C. § 102(b)(7). "[I]n the event that the charter 7 insulates the directors from liability for breaches of the duty of care, then a serious threat of liability 8 may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on 9 particularized facts." Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003). Plaintiff has alleged a 10 non-exculpated claim-breach of the duty of loyalty-and he agrees that he must allege particularized 11 facts to support that claim. See In re Verifone Holdings, Inc. Shareholder Derivative Litigation, 2009 12 connection with claims for breach of duty of loyalty). 14

15 individual liability to fraudulent, illegal, or bad faith conduct, demand is excused only if the complaint 16 pleads specific facts that 'the directors acted with scienter, i.e., that they had actual or constructive 17 knowledge that their conduct was legally improper.'" (Dkt. No. 39 at 9 (quoting In re Citigroup Inc. 18

S'holder Deriv. Litig., 964 A.2d 106, 125 (Del. Ch. 2009).) The exculpatory clause at issue here, 19 however, does not limit individual liability to merely "fraudulent, illegal, or bad faith conduct;" 20 rather, the clause specifically allows directors to be held liable, without qualification, for "any breach 21 of the director's duty of loyalty to the corporation or its stockholders." Thus, the Individual 22

Defendants' authority is inapposite. In Wood v. Baum, 953 A.2d 136, 141 (Del. 2008), the court held 23 that allegations of scienter were required where an exculpatory provision in an LLC's operating 24 agreement exempted directors from all ...


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