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Public Employees' Retirement System of Mississippi v. Merrill Lynch & Co. Inc.

June 2, 2010

PUBLIC EMPLOYEES' RETIREMENT SYSTEM OF MISSISSIPPI ET AL., PLAINTIFFS,
v.
MERRILL LYNCH & CO. INC. ET AL., DEFENDANTS.



The opinion of the court was delivered by: Jed S. Rakoff, U.S.D.J.

OPINION AND ORDER

This purported class action, consolidating four cases, asserts claims for violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the "1933 Act"), 15 U.S.C. §§ 77k, 77l(a)(2), 77o, in connection with the sale of mortgage pass-through certificates ("certificates") that were offered for sale by means of documents that allegedly contained untrue statements and material omissions. The first of the cases was filed by plaintiffs Connecticut Carpenters Pension Fund and Connecticut Carpenters Annuity Fund (collectively "Connecticut Carpenters") on December 5, 2008. Plaintiffs Iron Workers Local No. 25 Pension Fund ("Iron Workers"), Public Employees' Retirement System of Mississippi ("MissPERS"), and Wyoming State Treasurer filed actions on December 12, 2008, February 17, 2009, and March 27, 2009 respectively. On April 23, 2009, the Court selected MissPERS as lead plaintiff. See 4/23/09 Order. After the cases were consolidated under the Iron Workers docket number (08 Civ. 10841), a consolidated Class Action Complaint ("Complaint") was filed on May 20, 2009, using that number but altering the order of the parties in the caption,*fn1 and naming the Los Angeles County Employees Retirement Association as an additional plaintiff.

According to the Complaint, the certificates were issued by Merrill Lynch Mortgage Investors, Inc. ("Merrill Depositor"), a subsidiary of Merrill Lynch & Co., Inc. ("Merrill"). See Compl. ¶¶ 18, 20. Matthew Whalen, Paul Park, Brian T. Sullivan, Michael M. McGovern, Donald J. Puglisi, and Donald C. Han (collectively the "individual defendants") were officers or directors of Merrill Depositor who signed allegedly false registration statements for the certificates. Id. ¶¶ 30--35. Several other Merrill subsidiaries ---Merrill Lynch Mortgage Lending, Inc. ("Merrill Sponsor"), First Franklin Financial Corporation ("First Franklin"), and Merrill Lynch, Pierce, Fenner & Smith Inc. ("Merrill PFS") -- served as sponsors or underwriters of the issue, id. at ¶¶ 19, 21-22, as did non-Merrill co-defendants Credit-Based Asset Servicing and Securitization LLC ("C-BASS"), J.P. Morgan Securities, Inc. ("J.P. Morgan"), and ABN AMRO Inc. ("ABN AMRO"), id. ¶¶ 23-25. McGraw-Hill Companies, the parent company of Standard & Poor's, and Moody's Investors Service, Inc. (collectively, the "ratings agencies") provided ratings of the securities. Id. ¶¶ 26--27.

All defendants filed motions to dismiss on June 17, 2009. Thereafter, the Court received extensive briefing, including voluminous exhibits, and heard oral argument on August 18, 2009, followed by still further briefing. On March 31, 2010, the Court issued a "bottom line" Order resolving these motions in the manner set forth below.*fn2 See 3/31/10 Order. This Opinion and Order gives the reasons for those rulings and schedules a conference call to plan further proceedings.

Defendants first contend that, as a global matter, all of plaintiffs' claims are time-barred. Under Section 13 of the 1933 Act, claims under Sections 11 or 12(a)(2) are subject to a one year statute of limitations, which begins to runs upon "the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence." 15 U.S.C. § 77m.*fn3

Defendants do not contend that plaintiffs are barred under the first clause (so-called "actual notice"), but rather under the second clause (so-called "inquiry notice"), that is, when "circumstances would suggest to an investor of ordinary intelligence the probability that she has been defrauded." Staehr v. The Hartford Fin. Serv. Group, Inc., 547 F.3d 406, 411 (2d Cir. 2008) (quoting Dodds v. Cigna Sec., 12 F.3d 346, 350 (2d Cir. 1993)). Defendants contend that such inquiry notice arose prior to December 5, 2007, that is, a year before the filing of the first of the cases here consolidated, and was even more evident before March 27, 2008, that is, a year before the filing of the last of the cases here consolidated.

Inquiry notice is assessed under an objective standard, evaluated on a "totality-of-the-circumstances analysis." Staehr, 547 F.3d at 427; see also Shah v. Meeker, 435 F.3d 244, 249 (2d Cir. 2006). However, "[i]nquiry notice may be found as a matter of law only when uncontroverted evidence clearly demonstrates when the plaintiff should have discovered the fraudulent conduct." Staehr, 547 F.3d at 427. Thus, while defendants have proffered substantial evidence that prior to December 2007, let alone prior to March 27, 2008, questions about the bona fides of mortgage-backed securities were the subject of news reports, government investigations, public hearings, and civil complaints, plaintiffs argue that virtually none of this evidence references Merrill or the certificates at issue here and that statements made by the defendants in contemporaneous and subsequent documents would reasonably have had the effect of reassuring an investor that the doubts raised about other companies' offerings were not applicable here. See Pl. Opp. to Merrill Defs. et al. at 65-68, ECF No. 81. Tellingly, the certificates at issue were not downgraded below investment grade until April 2008, that is, after the March 27, 2008 limitation date, and, even then, the downgrade was not premised on the discovery of fraud but only on a perceived increase in risk. See Transcript 8/18/09 ("Tr.") at 29; Pl. Opp. to Merrill Defs. et al. at 55.

Although extraneous evidence from both sides may be considered on a motion to dismiss that is premised on statute of limitations grounds, see, e.g., Staehr, 547 F.3d at 425, nonetheless, where there are plausible inferences to be drawn in either direction, the issue of "whether a plaintiff had sufficient facts to place it on inquiry notice is 'often inappropriate for resolution on a motion to dismiss under Rule 12(b)(6),'" LC Capital Partners, LP v. Frontier Ins. Group, Inc., 318 F.3d 148, 156 (2d Cir. 2003) (quoting Marks v. CDW Computer Centers, Inc., 122 F.3d 363, 367 (7th Cir. 1997)). The competing materials referenced above show that this is such a case, and the Court therefore denies defendants' motion to dismiss on the basis of statute of limitations.

It should also be noted that the Supreme Court, in very recently construing 28 U.S.C. § 1658(b), a statute of limitations applicable to the Securities Exchange Act of 1934, was critical of the use of "inquiry notice" as a basis for determining when a reasonably diligent plaintiff should have discovered the facts constituting a violation. See Merck & Co., Inc. v. Reynolds, --- S.Ct. ---, No. 08-905, 2010 WL 1655827, at *13 (Apr. 27, 2010). Although the Second Circuit has not yet had occasion to determine whether Merck requires a change in how the Circuit interprets Section 13 of the 1933 Act, Merck, if anything, favors the plaintiffs here. Indeed, in Merck, the Court rejected arguments of the defendants quite similar to the arguments made by defendants here and held, in effect, that even if a plaintiff had "inquiry notice" sufficient to warrant beginning to investigate, a plaintiff would not be barred by the statute of limitations unless a reasonably diligent plaintiff similarly situated would have actually discovered the facts showing the violations alleged in the plaintiff's complaint. See Merck, 2010 WL 1655827, at *15.

Defendants next contend, with more force, that while plaintiffs assert claims based on eighty-four offerings, they lack standing to sue on all but the nineteen offerings in which the named plaintiffs purchased securities. See Compl. ¶¶ 13--17, 42--44. Plaintiffs contend that because "at least one named plaintiff . . . can assert a claim directly against each defendant," id. ¶ 179, and because they seek to bring a class action under Federal Rule of Civil Procedure 23, therefore, if the class is certified, they can bring claims on behalf of those who purchased certificates in every one of the defendants' similar eighty-four offerings. Tr. at 73; Pl. Opp. to Merrill Defs. et al. at 14-19. But it is black letter law that a rule of procedure cannot create standing. See 28 U.S.C. § 2072(b) (procedural rules "shall not abridge, enlarge or modify any substantive right"). As the Supreme Court stated in Lewis v. Casey, 518 U.S. 343 (1996), "[t]hat a suit may be a class action . . . adds nothing to the question of standing, for even named plaintiffs who represent a class 'must allege and show that they personally have been injured, not that injury has been suffered by other, unidentified members of the class to which they belong and which they purport to represent.'" 518 U.S. at 357 (quoting Simon v. Eastern Ky. Welfare Rights Org., 426 U.S. 26, 40 n.20 (1976) (internal quotation marks omitted)). Standing therefore is a threshold question --- antecedent to class certification --- that requires plaintiffs to have been personally injured, and plaintiffs thus have no standing to assert claims in relation to "funds in which [plaintiffs] did not personally invest." Hoffman v. UBS-AG, 591 F. Supp.2d 522, 532 (S.D.N.Y. 2008).

Here, therefore, because the named plaintiffs only purchased securities in nineteen offerings, any claim based on the other sixty-five offerings must be dismissed with prejudice. Nor will leave be granted for plaintiffs to add additional, as yet unnamed plaintiffs who purchased certificates related to the additional sixty-five offerings; this addition would at this point be futile, since plaintiffs themselves concede that the one-year limitations period began to run at some point in 2008 (i.e., more than a year ago), see Tr. at 29, and so the claims of any such new plaintiffs would be time-barred.

With these threshold matters resolved, the Court turns to the portions of defendants' motions to dismiss addressed to particular claims, beginning with the claims brought under Section 11 of the 1933 Act. Section 11 provides that a person acquiring a security may sue if the registration statement "contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading." 15 U.S.C. § 77k(a). Liability under Section 11 is strict liability, but this is tempered, not only by the short statute of limitations, but also by the fact that such liability is limited to a defendant who (1) signed the statement at issue; (2) was a director, person performing similar functions, or partner in the issuer at the time the statement was issued; (3) was named in the statement, with that party's consent, as being or about to become a director, person performing similar functions, or partner; (4) was an expert whose involvement was, with that party's consent, listed in the statement; or (5) was a statutory underwriter of the security. Id. § 77k(a)(1)--(5).

Despite plaintiffs' allegations that the ratings agencies were generally complicit in creating the "bubble" in mortgage-backed certificates that subsequently burst, the only claims here asserted against the ratings agencies are Section 11 claims, based on the allegation that such agencies served as statutory underwriters of the offerings here in issue. "Underwriter" is statutorily defined in the 1933 Act as one "who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking." Id. § 77b(a)(11). Plaintiffs argue that the ratings agencies effectively functioned as underwriters here because their evaluations and ratings of the securities here in issue were "steps necessary to the distribution of [the] securit[ies]." SEC v. Kern, 425 F.3d 143, 152 (2d Cir. 2005) (quoting SEC v. Chinese Consol. Benevolent Ass'n, Inc., 120 F.2d 738, 741 (2d Cir. 1941) (internal quotation marks omitted)).

This extremely broad view of what constitutes an underwriter is contradicted both by the interpretation of "underwriter" espoused by the Securities and Exchange Commission ("SEC") and by the statutory definition itself. SEC Rule 436(g)(1) states that "the security rating assigned . . . by a nationally recognized statistical rating organization . . . shall not be considered a part of the registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the Act." 17 C.F.R. ยง 230.436(g)(1). As the SEC has stated, the rule was intended to "exclude any nationally recognized statistical rating organization whose security rating is disclosed in a registration statement from civil liability under Section 11." SEC Release No. 33-6336, 46 Fed. Reg. 42024-01, 42024 (Aug. 18, 1981). This Rule and Release, which are entitled to ...


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