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In re Dynex Capital

October 30, 2009


The opinion of the court was delivered by: Hon. Harold Baer, Jr., United States District Judge


This putative securities class action, filed by lead plaintiffs Teamsters Local 445 Freight Divisions Pension Fund ("Teamsters" or "Plaintiffs") more than four years ago, concerns asset-backed securities. Specifically, bonds collateralized by several thousand mobile home loans originated and initially serviced by Defendant Dynex Capital, Inc. ("Dynex") and its affiliates. Plaintiffs allege that Dynex, its subsidiary Merit Securities Corporation ("Merit"), and two senior executives of the companies, Thomas H. Potts ("Potts") and Stephen J. Benedetti ("Benedetti") made false and misleading statements about the bonds in violation of Section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b) (the "Act"). Plaintiffs also assert claims for "control person" liability against Potts and Benedetti (collectively, "Individual Defendants") under Section 20(a) of the Act, 15 U.S.C. § 78t(a), which are derivative of their Section 10(b) claims. In 2006, I granted Defendants' motion to dismiss the then-operative First Amended Complaint ("FAC") against the Individual Defendants for a failure to adequately allege scienter, butI denied the motion with respect to Dynex and Merit (collectively, "Corporate Defendants"). In re Dynex Capital Inc. Sec. Litig., No. 05 Civ. 1897, 2006 WL 314524 (S.D.N.Y. Feb. 10, 2006) ("Dynex I"). Because at the time there was a difference of opinion in this Circuit as to whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite state of mind, I certified the matter for interlocutory appeal. In re Dynex Capital Inc. Sec. Litig., No. 05 Civ. 1897, 2006 WL 1517580 (S.D.N.Y. Jun. 12, 2006). In 2008, the Court of Appeals held that in appropriate circumstances allegations of corporate scienter may be sustained "in the absence of successfully pleading scienter as to an expressly named officer," but concluded that Plaintiffs had not done so in this case. Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 531 F.3d 190 (2d Cir. 2008) ("Teamsters"). The Court of Appeals thus vacated my decision in Dynex I and remanded with instructions to dismiss the FAC against the Corporate Defendants and to grant Plaintiffs leave to replead. Plaintiffs have since filed a Second Amended Complaint ("SAC") and Defendants have again moved to dismiss pursuant to Fed. R. Civ. P. 12(b)(6). As set forth below, Defendants' motion is GRANTED IN PART and DENIED IN PART.


A. Factual Background and General Allegations of Securities Fraud

Dynex is a financial services company in the business of packaging mortgage loans into securities (i.e. "securitizing" loans), including the two series of bonds at issue here: the $336 million offering of Series 12 bonds issued on April 2, 1999 and the $303 million offering of Series 13 bonds issued on September 2, 1999 (collectively, "Bonds"). Together with its affiliates, Dynex was responsible for all aspects of the loan securitization process. Through its subsidiary Dynex Financial, Inc. ("DFI"), between 1996 and 1999 Dynex originated or purchased the 13,000 manufactured housing (i.e. mobile home) loans that collateralized the Bonds ("Collateral Loans" or "Bond Collateral"). Dynex subsidiary Merit served as issuer of the bonds, purchasing the Collateral Loans from another Dynex subsidiary, Issuer Holding Corp. ("IHC"), and packaging them into securities. Merit retained the most junior, or subordinated "tranche" or class of securities within each series of Bonds-i.e. the class of Bonds that bore losses first and received payments last-and also committed to provide "overcollateralization" in the form of, inter alia, lines of credit, reserve funds, insurance policies, or additional loans to be drawn upon in the event of losses in the Bond Collateral, thereby providing "credit enhancement" to the Bonds themselves. SAC ¶¶ 36-39; Decl. of Terrence Rasmussen ("Rasmussen Decl."), Ex. 3 ("Series 13 Prospectus Supplement"), at 32. Finally, until 1999, Dynex's loan servicing affiliate serviced the Collateral Loans, collecting and remitting payments that ultimately found their way to bondholders.*fn1 Dynex sold its loan servicing operation in 1999, but retained its role as "Master Servicer" with respect to the Bonds. In fulfilling that role, Dynex published a monthly report that summarized the performance of the Bond Collateral, listing number and dollar value of delinquent loans ("Monthly Collateral Reports"). SAC ¶ 21. During the relevant time periods, Potts was president and principal executive officer of Dynex and Benedetti served as president and CEO of Merit and was an officer and director of Dynex. The Teamsters bring this putative class action on behalf of persons who purchased the Bonds between February 7, 2000 and May 13, 2004 ("Class Period").

It was not long after the Bonds were issued that the Collateral Loans began to perform poorly. For example, whereas Merit represented in the Series 13 Prospectus Supplement that, as of August 1999, 1.36% of the Collateral Loans were delinquent, by December 2000 the delinquency percentage had jumped to 4.92%. SAC ¶ 8; Rasmussen Decl. Ex. 4 ("Series 13 Prospectus Supplement"), at S-5. In October 2003, Dynex's Monthly Collateral Report disclosed that cumulative repossessions in the Series 13 Collateral Loans had been understated by approximately 34% or $15.92 million. SAC ¶ 134. Between November 2003 and May 2004, the Bonds were reviewed by rating agencies Moody's Investor Service and Fitch Ratings ("Rating Agencies") and ultimately downgraded. SAC ¶¶ 10-12. In announcing its downgrade of the Series 12 Bonds, Fitch noted that "relaxed credit standards, overbuilding by manufacturers, and the difficulties relating to servicing this unique asset have all contributed to poor performance of [manufactured housing] securities." SAC ¶ 94. In April 2004, Merit disclosed an "internal control deficiency" with regard to recording losses on the Collateral Loans and restated its earnings for the second and third quarters of 2003. SAC ¶ 149. Following the downgrades by the Rating Agencies, the value of the Bonds dropped by as much as 85%. SAC ¶ 11.

The gravamen of Plaintiffs' claims-the central theme of both the earlier and instant complaints-are allegations that Defendants engaged in a fraudulent scheme to artificially inflate the price of the Bonds by misrepresenting that the poor performance of the Bond Collateral resulted from "market conditions," thereby concealing what Plaintiffs contend was the true cause of the poor performance: namely, that Defendants' aggressive and reckless loan underwriting and origination practices generated a pool of Collateral Loans of poor credit quality and impaired by inherent defects. FAC ¶¶ 2, 10; SAC ¶¶ 2-8.More specifically, Plaintiffs' theory is that Dynex was a late entrant to the market for originating and securitizing mobile home loans and as a consequence overtly expressed to mobile home dealers a willingness to "buy bad paper," i.e. to originate or purchase uncreditworthy loans in order to gain market share and generate a sufficient volume of new loans to permit the issuance of mortgage-backed securities ("MBS"). FAC ¶ 5; SAC ¶ 58. Thus, in both their earlier and instant pleadings, Plaintiffs allege that Defendants "systematically disregarded" their own underwriting guidelines relative to borrower creditworthiness and minimum documentation requirements, originated a large volume of so-called "buy-for" loans (i.e. loans where the signatory to loan documents was not the mobile home's owner or occupant, which frustrated repossession),*fn2 "repeatedly purchas[ed] loans from mobile home dealers known to regularly submit falsified loan applications," and failed to obtain releases from landowners ("no-release loans"), which also frustrated repossession of the mobile home collateral located thereon. FAC ¶ 10; SAC ¶¶ 89, 91.

As a consequence of Defendants' questionableunderwriting and origination practices, Plaintiffs contend that certain of Defendants' statements in the Bonds' prospectuses (collectively, "Offering Documents") were materially false and misleading, as were public statements that purported to attribute losses on the Bond Collateral primarily to market forces instead of Defendants' own practices in originating and underwriting the Bond Collateral. See, e.g., FAC ¶ 13, SAC ¶ 93.

B. First Motion to Dismiss: Dynex I

In Dynex I, I found Plaintiffs' allegations of scienter lacking with respect to the Individual Defendants. Although I concluded the FAC "aptly described a pattern of reckless corporate behavior," I found that Plaintiffs "failed to link that behavior to any culpable individuals" and did not allege that "Potts or Benedetti saw or had access to specific reports or statements that indicated malfeasance or that contradicted their public statements." Dynex I, 2006 WL 314524, *9. With respect to the Corporate Defendants, however, I noted that a plaintiff may allege scienter "on the part of the corporate defendants without pleading scienter against any particular employees of the corporation." Id. (citing In re Worldcom, 352 F.Supp. 2d 472, 497 (S.D.N.Y. 2005)). Specifically, I found that the FAC adequately alleged that officers and employees of the Corporate Defendants "had the motive and opportunity to commit fraud" and that Plaintiffs' allegations that the Corporate Defendants "systematically originated defective loans . . . constitute[d] 'strong circumstantial evidence of . . . recklessness.'" Id. (quoting Novak v. Kasaks, 216 F.3d 300, 307 (2d Cir. 2000)).

Defendants moved for reconsideration or, in the alternative, for interlocutory appeal. I concluded that the question of whether scienter could be successfully alleged against a corporation without also alleging that specific corporate officers or employees acted with fraudulent intent was "a controlling question of law as to which there is substantial ground for difference of opinion." 28 U.S.C. § 1292(b). I thus certified the matter for interlocutory appeal. In re Dynex Capital Inc. Sec. Litig., 2006 WL 1517580, *3.

C. Second Circuit Opinion: Teamsters

On appeal, the Second Circuit confirmed that "there are circumstances in which a plaintiff may plead the requisite scienter against a corporate defendant without successfully pleading scienter against a specifically named individual defendant." Teamsters, 531 F.3d at 192. However, the Circuit reviewed my denial of Defendants' motion to dismiss de novo and concluded that the allegations of the FAC were insufficient to raise the requisite "strong inference" of scienter against Dynex and Merit, rejecting each of Plaintiffs' three arguments as to why the FAC's allegations of scienter were adequate. Id. at 196. In conclusion, the Court of Appeals stated that Plaintiffs had "fail[ed] to allege the existence of information that would demonstrate that the statements made to investors were misleading, e.g., information showing that the primary cause of the bonds' poor performance was not the general weakness in the mobile homes market." Id. at 197. As a consequence, the panel could not conclude that Plaintiffs' proffered inference-namely, that someone responsible for the statements made them with at least a reckless disregard for their truth-was "'at least as compelling as the competing inference'; i.e. that the statements either were not misleading" or were the result of careless mistakes based on erroneous information." Id. (quoting Tellabs v. Makor Issues & Rights, Ltd., 551 U.S. 308, 313 (2007)) (internal citation omitted). The Circuit vacated the Dynex I opinion and remanded with instructions to dismiss the FAC against the Corporate Defendants and to grant Plaintiffs leave to replead.

D. Second Amended Complaint

The SAC attempts to remedy the pleading deficiencies identified by the Court of Appeals by supplementing the allegations in the FAC in two primary ways. First, the SAC describes nine confidential witnesses whose statements form the basis of many of the substantive allegations. The confidential witnesses ("CWs") include three district sales managers who were involved in the origination of the Bond Collateral and who generally describe Dynex's loan underwriting practices, a credit underwriter at a Dynex regional office during a portion of the period in which the Bond Collateral was underwritten, four Dynex employees who worked in Dynex's loan servicing and collection departments, and a "senior accountant" at Dynex's Virgina headquarters.

Second, the SAC identifies and describes for the first time the following four categories of reports that Plaintiffs contend put the Defendants on notice that their public statements were materially misleading.*fn3

1. Manufactured Housing Dealer Performance Reports ("MHDP Reports")

The SAC alleges that during the period of loan origination (i.e. 1996 -- 1999) data from Dynex's regional and district offices were collected and synthesized into monthly MHDP Reports that inventoried the number and dollar amounts of loans from each manufactured housing dealer and assessed the loans' creditworthiness on a scale of "A" (superior), "B" (good), or "C" (poor), "based on borrower credit scores and other indicia of creditworthiness." SAC ¶¶ 4, 66. The MHDP Reports were prepared by Dynex management in Virginia and disseminated to the company's regional offices. SAC ¶ 4.

2. Manufactured Housing Regional Performance Reports ("MHRP Reports")

During thesame period, Dynex also prepared and circulated MHRP Reports that listed the number and dollar amount of mobile home loans by region, and also rated the loans' credit quality on the "A" to "C" scale. SAC ¶¶ 5, 66. Plaintiffs allege that the MHRP Report for Dynex's Northeast Region for the first quarter of 1997 revealed that 64% of the $8.3 million in loans funded in that region in that quarter were assigned a "C" rating. SAC ¶ 66. Plaintiffs allege that both the MHDP and MHRP Reports were reviewed by the Individual Defendants and used to evaluate and compensate regional management in accordance with a corporate culture "completely focused on achieving high loan volume." SAC ¶¶ 6, 66.

3. "Basis Reports"

According to the SAC, during the Class Period Benedetti reviewed monthly "Basis Reports" that summarized Dynex's balance sheet and valued its assets, a substantial portion of which were its own debt securities including the Bonds. SAC ¶ 85. Benedetti allegedly attended monthly accounting meetings "approximately one hour in duration" at which the Basis Reports were discussed. Id.

4. "Audit Reports"

Finally, Plaintiffs allege that quality-control audits of the Bond Collateral were prepared in Dynex's Fort Worth, Texas servicing headquarters and summarized into "Audit Reports" that "revealed true rates of first payment defaults and dealer fraud" and "uncovered that borrower's creditworthiness was not consistent with underwriting guidelines." SAC ¶ 53(i). Additionally, the SAC contains allegations that employees in Dynex's Fort Worth servicing center prepared "foreclosure reports" for every loan that went into default. Such reports, together with all of the underlying documentation for the defaulted loan were sent to Dynex's Virginia headquarters by means of a computerized imaging system called "Polaris." SAC ¶¶ 53(g), 84.

Like the FAC, the SAC depicts Dynex and Merit entering the mobile home loan market in a particularly aggressive fashion by, among other things, consistently agreeing to purchase or fund poor quality loans, often without sufficient documentation, although the instant pleading adds detail to the allegations of the central role played by Dynex's management in Virginia. For example, the SAC alleges that in 1999 Dynex adopted a computer-based underwriting system named "Portal" that centralized loan underwriting decisions and led to approval of loans that would not have been approved under the prior manual underwriting process. SAC ¶¶ 63-65. The SAC alleges that in 1996 Dynex's senior management implemented the "225 Program" which streamlined the process by which Dynex reviewed mobile home dealers in order to expedite growth in the dealer base, SAC ¶ 68, and authorized an underwriting directive to approve loans to senior citizens with repayment terms that exceeded normal life-expectancy statistics. SAC ¶ 74.


According to the Supreme Court's most recent pronouncements, "[t]o survive a motion to dismiss, a complaint must contain sufficient factual matter, accepted as true, to 'state a claim to relief that is plausible on its face.'" Ashcroft v. Iqbal, 129 S.Ct. 1937, 1949 (2009) (quoting Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 570 (2007)). "A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." Id. (citing Twombly, 550 U.S. at 556). The requirement that the court accept all factual allegations as true does not apply to "[t]hreadbare recitals of the elements of a cause of action, supported by mere conclusory statements." ...

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