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In Re Mru Holdings Securities Litigation

February 17, 2011



I. Introduction

This is a putative class action against Edwin J. McGuinn, Jr., Vishal Garg, Yariv Katz, and Raza Khan ("Individual Defendants"), all senior executive officers and/or directors of MRU Holdings, Inc. ("MRU" or "the Company"); Merrill Lynch & Co., Inc. ("Merrill"), MRU's "multi-purpose banker"; and Bagell, Josephs, Levine & Company, LLC ("Bagell"), MRU's independent auditor (collectively, "Defendants").*fn1 Peter Gianoukis ("Gianoukis") and Alan Borkowski ("Borkowski," and collectively, "Plaintiffs"), who purchased MRU common stock beginning in May 2008, allege that Defendants violated the federal securities laws, including Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b) ("Section 10(b)"), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act, id. § 78t(a) ("Section 20(a)"), by issuing false and incomplete financial statements and press releases relating, among other things, to MRU's issuance of auction rate securities, and by employing manipulative and deceptive devices which artificially inflated MRU's stock price.*fn2

Specifically, Plaintiffs claim that between July 9, 2007 and September 19, 2008 ("Class Period"), "MRU [and Merrill] knew," and yet "hid from MRU's shareholders and the investing public," that "the Company's reliance on its ability to securitize its student loan pools [through the use of auction rate securities ('ARS')] . . . was . . . exceedingly risky and unrealistic," and that it would not be possible to generate the level of income from ARS claimed on MRU's financial statements; that "MRU and [Merrill] manufactured nearly $200 million worth of [ARS] for [Merrill] to trade in a market in which [Merrill] rigged the prices"; and that Bagell violated "precepts of fair value accounting" under Generally Accepted Accounting Principles ("GAAP"), and "closed their eyes to 'red flags,'" such as MRU "management's reckless assumptions" with respect to income from ARS, by "accept[ing] those assumptions and certif[ying] the Company's 2007 financial statements." (Second Am. Compl., dated Aug. 20, 2010 ("Complaint" or "SAC") ¶¶ 1, 9, 14, 25, 74, 101, 108, 123, 131, 228, 229.)*fn3 The Individual Defendants are also alleged to have acted as "controlling persons" of MRU within the meaning of Section 20(a). (SAC ¶ 238.)*fn4

On September 24, 2010, Defendants filed a joint motion to dismiss pursuant to Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure ("Fed. R. Civ. P."), and the Private Securities Litigation Reform Act of 1995 ("PSLRA"), arguing, among other things, that Plaintiffs' allegations fail because (1) MRU "more than adequately disclosed the risks and uncertainties inherent in its valuation" of expected income from ARS; (2) Plaintiffs' allegation that the "auction process was misleading and deceptive" because Merrill made purchases on its own proprietary accounts in order to conceal the riskiness of ARS, fails to pinpoint "even one specific statement [or omission] by [Merrill] that is alleged to be fraudulent," nor any manipulative and deceptive device; and (3) the Complaint fails adequately to plead scienter because neither the Individual Defendants nor Merrill foresaw the "collapse of the ARS market," and the Individual Defendants purchased stock (and did not sell stock) during the Class Period. (Mem. of Law in Supp. of Defs.' Joint Mot. to Dismiss SAC, dated Sept. 24, 2010 ("Defs. Mem."), at 14--15, 18, 21, 22, 27.) Defendants also argue that (4) "Plaintiffs identify so-called 'red flags,' . . . but they do not identify a single situation where Bagell did not obtain and review necessary audit evidence or did not properly investigate an area of concern." (Defs. Mem. at 32.)

On October 25, 2010, Plaintiffs filed an opposition, arguing, among other things, that (1) MRU concealed the terms of and the riskiness of ARS in numerous public filings, and overstated its expected income from ARS by, among other things, understating the "auction rate" it was required to pay to ARS investors; (2) "[e]very time Merrill traded or abstained from trading [ARS] for its own account, Merrill traded while in possession of material, non-public information" which Merrill should have disclosed to the public in "a description of its then-current material auction practices" posted on Merrill's website in 2006; and (3) the Complaint adequately pleads scienter because it alleges that the Individual Defendants and Merrill "knew that the business model they touted to investors was unsustainable," and, "in sharp contrast to the members of the [putative] Class, no [Individual Defendants] purchased any [MRU] stock for the last six months before the Class Period ended." (Mem. of Law in Opp'n to Defs.' Joint Mot. to Dismiss SAC, dated Oct. 25, 2010 ("Pls. Mem."), at 3, 4, 16--17, 19, 21--22.) Plaintiffs also argue that (4) Bagell knew or should have known that "MRU's assumptions [with respect to ARS] were unreasonably optimistic." (Pls. Mem. at 9.)

On November 9, 2010, Defendants filed a reply. (See Reply Mem. of Law in Supp. of Defs.' Joint Mot. to Dismiss SAC, dated Nov. 9, 2010 ("Defs. Reply").) On January 20, 2011, the Court heard oral argument. (See Tr., dated Jan. 20, 2011.)

For the reasons stated below, Defendants' motion to dismiss is granted.

II. Background

For purposes of this motion, the allegations of the Complaint are taken as true. See Slayton v. Am. Express Co., 604 F.3d 758, 766 (2d Cir. 2010). The Court may consider MRU's public disclosure documents, such as, among others, its July 9, 2007 press release; August 16, 2007 "investor presentation slides"; Annual Report on Form 10-KSB, dated September 28, 2007 for the fiscal year ending June 30, 2007 ("2007 Annual Report"); October 1, 2007 press release; November 14, 2007 10-Q ("November 2007 10-Q") and press release; February 7, 2008 Form 8-K and investor presentation; February 14, 2008 Form 10-Q ("February 2008 10-Q") and press release; May 15, 2008 Form 10-Q ("May 2008 10-Q") and press release; July 3, 2008 press release; July 7, 2008 Form 8-K and investor presentation ; and Annual Report on Form 10-K, dated September 15, 2008 ("2008 Annual Report"). (SAC ¶¶ 164, 165, 167, 171, 173, 176, 179, 182, 187, 192, 195); see ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir. 2007); Cosmas v. Hassett, 886 F.2d 8, 13 (2d Cir. 1989).

MRU, a Delaware corporation with its executive offices in New York City, was a purchaser, holder, and seller of federal and private student loans. (SAC ¶¶ 40, 50.) Its principal sources of revenue were loan origination fees and "interest accrued on its student loan portfolios." (SAC ¶ 53.) During the Class Period, MRU's common stock was listed on the NASDAQ under the symbol UNCL. (SAC ¶ 42.)

At all relevant times, Edwin J. McGuinn, Jr. was Chief Executive Officer of MRU and a member of MRU's board of directors; Vishal Garg was the Chief Financial Officer of MRU and a member of MRU's board of directors; Yariv Katz was the Vice President and General Counsel of MRU; and Raza Khan was President of MRU and a member of its board of directors. (SAC ¶¶ 31--34.)

Merrill is a Delaware corporation with its principal offices in North Carolina. (SAC ¶ 38.) During the Class Period, its principal executive offices were located in New York. (SAC ¶ 38.) Bagell is a New Jersey limited liability company with its principal offices in New Jersey. (SAC ¶ 39.)

MRU's First Securitization

In June 2007, MRU conducted the first securitization of its student loans portfolio, utilizing a special purpose trust ("MRU Trust") that pooled the student loans and issued securities backed by those loans to investors, including corporations and wealthy individuals.*fn5

(See, e.g., Decl. of Mor Wetzler in Supp. of Defs.' Joint Mot. to Dismiss SAC, dated Sept. 24, 2010 ("Wetzler Decl."), Ex. 8 ("New Trouble in Auction Rate Securities," N.Y. Times, dated Feb. 15, 2008).) This transaction accounted for 58% of MRU's revenue for fiscal year 2007, or $16.2 million. (SAC ¶¶ 102, 140.) The MRU Trust paid interest to holders of these ARS. (SAC ¶¶ 54--55.) MRU retained an interest in income from the underlying student loans less the interest it paid out to ARS purchasers (this difference referred to herein as "Residual Interest"). (SAC ¶ 167.) Accordingly, the lower the interest rate paid by the MRU Trust to purchasers of ARS, the greater the amount of MRU's Residual Interest. (SAC ¶ 60.)

Plaintiffs contend that MRU overvalued the Residual Interest by understating the projected interest it would be required to pay out on ARS (SAC ¶¶ 122--23 ("MRU knew . . . that it would not be possible for the trust to generate the residual [interest] claimed on its financial statements.")), and that "MRU and Merrill timed the [first securitization] so that the only observable information regarding the interest rate for the [ARS] was the initial purchase price" (SAC ¶ 133--34).

In the section of its 2007 Annual Report entitled "Risk Factors," MRU disclosed, among other things, the following:

 "We have a history of losses and, because we expect our operating expenses to increase in the future, we may not be profitable in the near term, if ever."

 "We expect to generate a significant portion of our income from gains on the sale of our student loans to securitizations; our financial results and future growth would be adversely affected if we are unable to securitize."

 "We are dependent on the securitization markets."  "The senior tranches of the Company's securitization are auction rate notes."*fn6

(2007 Annual Report at 2--3, F-27 (emphases in original).)

Regarding the first securitization, MRU also disclosed that:

 The sale of ARS by the MRU Trust was dependent upon such factors as "the size of the Company's student loan portfolios, the financial ability of the Company to hold this asset, the market at the time of the transaction for this asset class, and the ability of the Company to support the requirements for a sale or securitization transaction."

 "[In] August 2007, the rapid deterioration of subprime mortgages and collateralized debt obligations le[d] to disruptions in the money markets which in turn impacted the market for auction rate student loan notes."

 "The component in determining the fair value of the assets received that involves the most judgment is the Residual Interest."

(2007 Annual Report at 21, F-10.)

Merrill Auctions

Merrill managed the auction process for MRU (SAC ¶ 73), which Plaintiffs contend were not "true auctions" (SAC ¶ 84).

Instead, [Merrill] artificially manipulated the auctions, rigging the prices to prevent auctions from failing . . . . The much-touted liquidity [of ARS] was illusory because there were often not enough buy orders to purchase all of the ARSs at auction, which, if left unmanipulated, would have resulted in widespread auction failures, leaving investors with illiquid, long-term bonds. . . . In order to conceal the inherent illiquidity of the long-term bonds, [Merrill] made purchases on its own proprietary accounts to prevent the auctions from failing. (SAC ¶ 85.) "[W]hen [Merrill] stopped artificially propping up the market," Plaintiffs allege, the "[interest] rates were not high enough to compensate investors for the increased liquidity risk." (SAC ¶ 96.) Plaintiffs also allege that "Merrill's ...

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