Last month, the U.S. Court of Appeals for the Second Circuit upheld a 2014 ruling holding issuers of residential mortgage-backed securities (RMBS) liable for securities fraud. In the opinion by U.S. Circuit Judge Richard C. Wesley, the court emphasized the policies underlying the passage of the Securities Act of 1933 and related state laws, which aim to protect securities purchasers by imposing a duty on sellers of securities to disclose all material information before such public offerings.

The plaintiff-appellee Federal Housing Finance Agency (FHFA) brought suit in the Southern District of New York on behalf of government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac against Nomura Holding America Inc. (Nomura) and Royal Bank of Scotland Securities Inc. (RBS, and together, Defendants). From 2005 to 2007, Defendants sold RMBS certificates to the GSEs while knowingly making false representations in the accompanying offering materials that the mortgage loans underlying the RMBS were originated in accordance with the applicable underwriting guidelines.

The FHFA initially brought 15 similar actions against other financial institutions, but these all settled, allowing the FHFA to recover more than $20 billion in total. The case against Nomura and RBS proceeded to trial before Judge Denise Cote, who held that Defendants made material misstatements to the GSEs and thus awarded the agency rescission.

Affirming Judge Cote’s decision, the Second Circuit saw “no merit in any of [Defendants’] arguments” and held that Defendants violated the Securities Act. Dismissing Defendants’ assertions that the FHFA should have been aware of the misstatements, the court found that because Nomura had access to the mortgage loan files before the securitization, it was uniquely positioned to have the most knowledge about the loans. The court also agreed that Defendants’ partial compliance with widespread industry custom was no defense, because RMBS industry standards prior to the financial crisis generally fell far short of satisfying the duty of reasonable care.

The Second Circuit further held that neither the GSEs’ general knowledge about the mortgage loan industry nor their awareness that the market contained numerous poorly underwritten loans constituted actual knowledge of any specific problems with the loans underlying the RMBS they purchased. The court agreed that the GSEs were not required to investigate the truth of Defendants’ representations; rather, it was reasonable for the GSEs to rely on Defendants’ diligence in selecting and reviewing these loans.

The appellate court also affirmed that the statement in Defendants’ offering materials that the loans underlying the RMBS “were originated generally in accordance with the underwriting criteria,” was both false and material. Expert evidence revealed that vast numbers of these loans materially deviated from the mortgage originators’ underwriting criteria to an extent that negatively affected the value of the loans. The court recognized that such defects greatly affect credit risk and that these underwriting guidelines statements are crucial to a reasonable investor’s decision to move forward in making that investment.

Finally, the court dismissed Defendants’ loss causation defense, stating that Defendants’ irresponsible practices, in aggregation, were precisely what caused the housing bubble that created the financial crisis. Echoing the trial court, the Second Circuit held that Defendants failed to disprove that their misconduct contributed to the very problem they attempted to hide behind.

The case is Federal Housing Finance Agency v. Nomura Holding America, 15-1872-cv(L).

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