The opinion of the court was delivered by: Honorable Paul A. Crotty, United States District Judge
Defendants move, pursuant to Fed. R. Civ. P. 12(b)(6), to dismiss Charter Township of Clinton Police and Retirement System's*fn1 ("Plaintiff") securities class action against Defendants KKR Financial Holdings LLC ("KFN") and three of its current and former officers and directors ("Individual Defendants"), asserting claims under Sections 11 and 15 of the Securities Act of 1933, 15 U.S.C. §§ 77k, 77o.*fn2 KFN's predecessor, KKR Financial Corp. ("KKR Financial"),*fn3 operated as a real estate investment trust ("REIT").*fn4 As a REIT, KKR Financial was heavily invested in real estate. KKR Financial underwent a corporate reorganization in 2007 in order to diversify its holdings and decrease its real estate related investments. On April 2, 2007, KFN issued a registration statement offering to exchange its securities for those of the publicly traded KKR Financial. After the share exchange, KFN became a publicly held company with KKR Financial as its subsidiary. In August, 2007, approximately four months after the registration statement became effective, KFN announced that due to disruptions in the residential mortgage and commercial paper markets, it had been forced to sell billions of dollars of real estate assets at a loss, and was exposed to hundreds of millions of dollars of other potential losses. The price of KFN stock declined substantially. Plaintiff's primary contentions are that the April registration statement failed to disclose material facts regarding KFN's exposure to losses in the asset backed commercial paper ("ABCP") market; and included financial statements which were not prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). Plaintiff's Section 11 claim is alleged against all Defendants. Plaintiff's Section 15 complaint is asserted only against the Individual Defendants.
In support of its motion to dismiss, Defendants contend that the registration statement does not contain any misstatements or omissions, and even if it did, any misstatements or omissions were, as a matter of law, immaterial. Defendants contend that the complaint is a textbook example of hindsight pleading.
For the reasons that follow, the Defendants' motion to dismiss is GRANTED. In its briefing on the motion to dismiss, Plaintiff does not challenge, and apparently concedes, that many of the omissions alleged in the Amended Complaint are not actionable. The alleged omissions and failings Plaintiff relies on in responding to the Rule 12(b)(6) motion are derived solely from hindsight and fail to state a viable Section 11 claim. Since Section 15 liability is derivative of Section 11 liability, the entire Amended Complaint must be dismissed.
A. Facts*fn5 as Alleged in Complaint and SEC Filed Documents
KFN's predecessor, KKR Financial, was founded by Fanlo and Netjes in 2004 and went public in 2005. (Amended Complaint ("Am. Compl.") ¶ 22.) Since its inception, KKR Financial operated as a REIT. (KKR Financial Holdings LLC Form S-4/A filed April 2, 2007 ("Registration Statement") at 4-5, Declaration of Michael J. Chepiga ("Chepiga Decl."), Ex. A.) The company was engaged in various lines of business, including corporate lending and commercial real estate finance. (Am. Compl. ¶ 22.) KKR Financial also invested in debt and equity securities, as well as residential mortgage loans and residential mortgage backed securities ("RMBS"). (Id.) Since KKR Financial was a REIT, at the end of each calendar quarter at least 75% of its assets were required to be "real estate assets" as defined in the Internal Revenue Code and each year 75% of its gross income had to be derived from real estate sources. (KKR Financial Corp. 2006 Form 10-K ("2006 Form 10-K") at 68, Chepiga Decl., Ex. B.)
In 2005 and 2006, KKR Financial made significant investments in "jumbo mortgage loans" and "no documentation mortgage loans." (Am. Compl. ¶ 24.) So-called "jumbo" and "no-doc" mortgages are both types of "non-conforming mortgage loans." (Id.) A "conforming mortgage loan" meets the standards required for purchase by the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"), see David Schmudde, Responding to the Subprime Mess: The New Regulatory Landscape, 14 Fordham J. Corp. & Fin. L. 709, 716 (2009), while a non-conforming mortgage loan does not. "Jumbo mortgages" have loan balances in excess of the purchasing authority of Fannie Mae and Freddie Mac. See In re Cmty. Bank of N. Va., 418 F.3d 277, 284 (3d Cir. 2005). "No-doc mortgages" lack the underwriting documentation needed to qualify as conforming mortgage loans. (Am. Comp. ¶ 24.) KKR Financial also invested in, and held, "non-agency RMBS." Non-agency RMBS are not guaranteed by federally chartered entities such as Fannie Mae and Freddie Mac. (Registration Statement at 34-35.)
According to the Amended Complaint, "[d]uring 2006, [KKR Financial] reported $12.6 billion in residential mortgage loans and RMBS investments." (Am. Compl. ¶ 24.) KKR Financial would securitize its investments in residential mortgage loans and hold the securities. (Id. at ¶ 24 n.1.) The residential mortgages invested in by KKR Financial were not "sub-prime." Defendants point out that as of December 31, 2006, 98% of the RMBS held by KKR Financial were rated AAA by Standard & Poor's and the company's portfolio did not contain any loans to sub-prime borrowers. (2006 Form 10-K at 56-57.)*fn6 KKR Financial's 2006 Form 10-K states:
We expect that a material portion of our investment portfolio of residential mortgage loans and RMBS will consist of, or in the case of RMBS be backed by, non-conforming residential mortgage loans. We expect that the residential mortgage loans will be non-conforming due to non-credit factors including, but not limited to, the fact that the (i) mortgage loan amounts exceed the maximum amount for such mortgage loan to qualify as a conforming mortgage loan, and (ii) underwriting documentation for the mortgage loan does not meet the criteria for qualification as a conforming mortgage loan. Non-conforming residential mortgage loans may have a higher risk of delinquency and foreclosure and losses than conforming mortgage loans. We may realize credit losses on our investment in non-conforming residential mortgage loans and RMBS backed by non-conforming residential mortgage loans. (2006 10-K at 20.)
A majority of KKR Financial's investments were financed through the ABCP market. (Am. Compl. ¶ 24.) The company would issue short-term debt instruments called "asset-backed secured liquidity notes," pledging its RMBS and residential mortgage loans as collateral. (Id.; 2006 10-K at F-22-23.) In 2005 and 2006, KKR Financial created two asset-backed secured liquidity note facilities (the "Facilities" or "ABCP Facilities") that issued short-term notes secured by KKR Financial's RMBS and residential mortgage loans. (Id. ¶¶ 24-25; 2006 10-K at F-22-23.) The company's 2005 10-K disclosed that:
On September 30, 2005, we closed a $5.0 billion asset-backed secured liquidity note facility. This facility provides us with an alternative source of funding our residential mortgaged-backed securities by issuing asset-backed secured liquidity notes that are rated A-1, P-1, and F1, by Standard and Poor's, Moody's and Fitch Inc, respectively. Issuance of asset-backed secured liquidity notes are recorded as borrowings on our Consolidated Balance Sheet. At December 31, 2005, we had $2.0 billion of asset-backed secured liquidity notes outstanding. (2005 10-K at 62; Am. Compl. ¶ 25.)
KKR Financial's 2006 10-K explains that as of December 31, 2006, the secured liquidity note facility which closed on September 30, 2005 had $4.7 billion of asset backed secured liquidity notes outstanding. (2006 10-K at 65; Am. Compl. ¶ 25.) The 2006 10-K also disclosed that:
On March 30, 2006, we closed our second $5.0 billion asset-backed secured liquidity note facility. This facility provides us with an alternative source of funding our investments in residential mortgage-backed securities by issuing asset-backed secured liquidity notes that are rated A-1, P-1, and F1, by Standard & Poor's, Moody's and Fitch, Inc, respectively. Issuances of asset-backed secured liquidity notes are recorded as borrowings on our Consolidated Balance Sheets. At December 31, 2006, we had $4.0 billion of asset-backed secured liquidity notes outstanding under this facility. (2006 10-K at 65; Am. Comp. ¶ 25.)
As of December 31, 2006, the $8.7 billion of outstanding ABCP issued by the Facilities was secured by approximately $9.0 billion of RMBS and residential mortgage loans held by KKR Financial. (Am. Compl. ¶ 24; 2006 10-K at F-22-23.) Plaintiff alleges that the descriptions of the Facilities in KKR Financial's 2005 and 2006 Form 10-Ks "failed to apprise investors that the Company held a $200 million 'equity interest' in the Facilities that was subject to loss and that KFN could be liable for an additional $50 million of losses if KFN defaulted or delayed the repayment of its ABCP outstandings." (Am. Compl. ¶ 26.)
At a meeting in late 2006, KKR Financial's board of directors explored the possibility of changing the company's business strategy. (Registration Statement at 59.) In order to obtain more favorable returns, the board considered increasing investments in non-real estate related assets. (Id.) Since KKR Financial was a REIT, however, an increase in non-real estate related assets would have required a commensurate increase in real-estate related assets. (Id. at 62-63.) On January 17, 2007, the board of directors voted in favor of seeking shareholder approval for a proposed "merger," "conversion transaction," and "merger agreement" (the "Reorganization").*fn7
(Id. at 61.) Upon shareholder approval of the Reorganization, KKR Financial shareholders were to exchange one share of KKR Financial for one share of the recently formed KFN. (Id. at 1.) The Reorganization would result in KKR Financial becoming a wholly-owned subsidiary of KFN, with KFN as the publicly traded company. (Id. at 57.) KFN was not to operate as a REIT, and so after the Reorganization, the Company would no longer be obligated to meet the real-estate assets and income requirements imposed on REITs.
KKR Financial announced the proposed reorganization on January 30, 2007. (Jed Horowitz, KKR Financial to Sell Residential Mortgage Investments, Dow Jones Newswires, Jan. 30, 2007, Chepiga Decl., Ex. D.) The announcement had no material impact on KKR Financial's stock price. A day before the announcement, the stock closed at $27.40; the day of the announcement, the stock closed at $27.10. (Yahoo! Finance, Historical Prices for KKR Financial Corp., Chepiga Decl., Ex. E.)
On April 2, 2007, KFN filed a Form S-4/A with the SEC (the "Registration Statement").*fn8
The Registration Statement, which became effective the day it was filed, asked KKR Financial shareholders to approve the Reorganization. (Registration Statement at 1; Am. Compl. ¶ 30.)*fn9
Under the heading, "Our Reasons for the Conversion Transaction and the Merger," the Registration sets forth the advantages and disadvantages presented by the Reorganization. (Registration Statement at 62-63.) One of the listed advantages is, that the conversion transaction is expected to provide us with additional flexibility to allocate our capital, including reducing, or eliminating, our real estate investments which we are currently required to hold to maintain our qualification as a REIT and which have lower [returns on equity] than our non-real estate investments. (Id. at 62.)
The Registration Statement describes how the Reorganization will affect the Company's business and operations. (Id. at 53; Am. Compl. ¶ 32.) It states that the Reorganization will provide the Company with the flexibility to reallocate capital to non-real estate investments which may be more lucrative. (Registration Statement at 53; Am. Comp. ¶ 32.) It explains that "[w]e are evaluating various alternatives to reducing our real estate investments after the conversion transaction, including allowing our real estate assets to pay down in the ordinary course, selling KKR Financial Corp. or selling all or a portion of KKR Financial Corp.'s real estate assets." (Registration Statement at 54; Am. Compl. ¶ 32.) Assuming KFN chose to allow its real estate assets to liquidate in the ordinary course, the Registration Statement notes that "we expect that the reallocation of capital will occur over three or four years as our residential real estate investments pay down as a result of both scheduled amortization and prepayments." (Id.) The Registration statement cautions that the sale of KKR Financial's "real estate assets will result in a loss. As of December 31, 2006, the carrying value of our real estate assets exceeded the estimated fair value for those real estate assets by $49.9 million." (Id.)
Under the heading "Secured Liquidity Note Subsidiaries," the Registration Statement provides:
KKR Financial Corp. has established two asset-backed secured liquidity note facilities. These facilities provide us with an alternative source of funding our RMBS by issuing asset-backed secured liquidity notes that are rated A-1, P-1, and F1, by Standard and Poor's, Moody's and Fitch, Inc., respectively, through special purpose trust subsidiaries. The subsidiaries that have issued secured liquidity notes will remain subsidiaries of KKR Financial Corp. after the conversion transaction. (Registration Statement at 57; Am. Compl. ¶ 33.)
KKR Financial's 2006 Form 10-K, with its description of the Facilities, is incorporated by reference into the Registration Statement. (Registration Statement at 150; Am. Compl. ¶ 34.) The 2006 Form 10-K makes various representations about KKR Financial's business and operations, including representations regarding the value of KKR Financial's real-estate assets. (Am. Compl. ¶ 34.) As noted in the Amended Complaint, the 2006 Form 10-K states that "[a] material portion of our residential [adjustable rate mortgage] loans are non-conforming mortgage loans, not due to credit quality, but because the mortgage loans have balances that exceed the maximum balances necessary to qualify as a conforming mortgage loan." (Id.; 2006 Form 10-K at 57.)
The Registration Statement also incorporates various KKR Financial financial statements (the "Financial Statements"), including: KKR Financial's audited consolidated balance sheets as of December 31, 2005 and 2006 (with related consolidated statements of operations, changes in stockholders' equity, and cash flows for 2004 though 2006) and KKR Financial's unaudited consolidated balance sheet as of March 31, 2007 (with related consolidated statements of operations, changes in stockholders' equity, and cash flows for the three months leading up to March 31, 2007). (Am. Comp. ¶¶ 44-45.) The Registration Statement represents that the Financial Statements were prepared in conformity with GAAP. (Id. ¶ 46.)
i. Risk Factors Disclosed In Registration Statement
While completely ignored in the Amended Complaint, the Registration Statement contains 29 pages of "Risk Factors." (Registration Statement at 19-47.) Among numerous other risks, the Registration Statement discloses that "[a]ll, or a significant portion, of our investment portfolio is invested in non-agency RMBS and non-conforming residential mortgage loans." (Id. at 34.) The Registration Statement explains that "non-agency RMBS" and "non-conforming residential mortgage loans" may have higher risks of loss and delinquency than agency RMBS and conforming mortgage loans. (Id. at 35.) After stating that "[m]any of our investments are illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions," the Registration Statement states that,
[a] majority of the mortgage-backed securities that we purchase are traded in private, unregistered transactions and are therefore subject to restrictions on resale or otherwise have no established trading market. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. (Id. at 38-39.)
The Registration Statement discloses the Company's reliance on the availability of adequate financing. (Id. at 29.) It states that "[f]ailure to obtain adequate capital and financing would adversely affect our results and may, in turn, negatively affect the market price of our shares and our ability to make distributions to holders of our shares." (Id.) The fact that the Company's assets were leveraged through the issuance of asset-backed secured liquidity notes is also disclosed. Under the heading, "[w]e leverage our portfolio investments, which may adversely affect our return on our investments and may reduce cash available for distribution," the Registration Statements provides:
We expect to leverage our portfolio investments through borrowings . . . . Our return on our investments and cash available for distribution to our stockholders may be reduced to the extent that changes in market conditions cause the cost of our financing to increase relative to the income that can be derived from the assets acquired. Our debt service payments reduce cash flow available for distributions to holders of our shares. We may not be able to meet our debt service obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to foreclosure or sale to satisfy our debt obligations. We leverage certain of our investments through repurchase agreements, total rate of return swaps and asset-backed secured liquidity notes. A decrease in the value of the assets may lead to margin calls that we will have to satisfy. We may not have the funds available to satisfy any such margin calls. (Id.)
Under the heading "[d]eclines in the market values of our investments may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to holders ...