Securities and Exchange Commission v. Bank of America, N.A. et al

Filing 36

ORDER affirming and adopting 29 Memorandum and Recommendations; Defendant's 30 Objection is Overruled; denying without prejudice 14 Motion to Dismiss as to reasserting such arguments at the appropriate time in the form of a Motion for Summary Judgment. Signed by District Judge Max O. Cogburn, Jr on 6/19/2014. (tmg)

UNITED STATES DISTRICT COURT
WESTERN DISTRICT OF NORTH CAROLINA
CHARLOTTE DIVISION
DOCKET NO. 3:13-cv-00447-MOC-DSC
SECURITIES AND EXCHANGE
COMMISSION,

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Plaintiff,
Vs.
BANC OF AMERICA MORTGAGE
SECURITIES, INC.
BANK OF AMERICA, N.A.
MERRILL LYNCH, PIERCE, FENNER &
SMITH, INC.,

Defendants.

ORDER

THIS MATTER is before the court on review of a Memorandum and Recommendation
issued in this matter.

In the Memorandum and Recommendation, the magistrate judge

recommended denial of defendants’ Motion to Dismiss under Rule 12(b)(6), Federal Rules of
Civil Procedure, and advised the parties of the right to file objections within 14 days, all in
accordance with 28, United States Code, Section 636(b)(1)(c). Objections have been filed within
the time allowed, oral arguments have been heard on those objections, and the court has
considered the underlying Motion to Dismiss de novo.
FINDINGS and CONCLUSIONS
I.

Applicable Standard
The Federal Magistrates Act of 1979, as amended, provides that “a district court shall

make a de novo determination of those portions of the report or specific proposed findings or
recommendations to which objection is made.” 28 U.S.C. § 636(b)(1); Camby v. Davis, 718 F.2d
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198, 200 (4th Cir.1983). However, “when objections to strictly legal issues are raised and no
factual issues are challenged, de novo review of the record may be dispensed with.” Orpiano v.
Johnson, 687 F.2d 44, 47 (4th Cir.1982). Similarly, de novo review is not required by the statute
“when a party makes general or conclusory objections that do not direct the court to a specific
error in the magistrate judge’s proposed findings and recommendations.” Id. Moreover, the
statute does not on its face require any review at all of issues that are not the subject of an
objection. Thomas v. Arn, 474 U.S. 140, 149 (1985); Camby v. Davis, 718 F.2d at 200.
Nonetheless, a district judge is responsible for the final determination and outcome of the case,
and accordingly the court has conducted a careful review of the magistrate judge’s
recommendation.
II.

Factual Setting
For the limited purpose of considering the Motion to Dismiss, the court has considered as

true the well-pled facts contained in the Complaint. Fed.R.Civ.P. 12(b)(6). In the interests of
judicial economy, the court has summarized the facts as alleged in this case and in the ‘446 case
together. Such recitation is not intended to bind this court or the parties in any way in this case
or in the ‘446 case.
According to the Complaint, defendants originated, securitized, and sold billions of
dollars in home loans by late 2007.

By that same date, however, senior employees and

management of the defendants knew that despite such uptick in its mortgage loan origination
business, a significant percentage of the mortgages originated by the bank failed to materially
comply with the bank’s underwriting standards.

Not only did they know that there were

problems in loan origination, there were problems in servicing those loans as a significant
percentage of those loans were performing poorly.

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According to the SEC, the problem with the loans was one created by the bank: rather
than reward its employees for originating quality loans (to wit, loans that were taken out by
qualified borrowers who brought equity and collateral to the table), the bank was rewarding
quantity by giving bonuses to employees who surpassed mortgage production targets.
Apparently, these employees were able to surpass goals by bringing in unqualified borrowers
who took out loans they either could not pay back because they lacked sufficient income or had
no incentive to pay back because they had no skin in the game, or both. Thus, by the end of
2007, the bank knew the loans it was repackaging for sale to others in the form of “Residential
Mortgage Backed Securities” (“RMBS”) were not the investment grade products investors were
looking to add to their portfolios. The SEC contends that the bank’s pre-2008 zealousness in
originating loans and earning fees was so fervent that it resulted in the bank directing its
employees that it was not their job to look for fraud when originating home mortgage loans.
The SEC contends that not only were underwriting practices critical in originating loans,
those practices were a critical factor for investors tasked with deciding whether to purchase
RMBS. As securities, representations and disclosures made to prospective buyers of RMBS are
regulated by the United States Securities and Exchange Commission (“SEC”).

While an

oversimplification, the SEC requires that those who undertake to sell securities to the public
provide potential investors with truthful financial statements and other significant information.
More specifically, the Securities Act of 1933 prohibits deceit, misrepresentations, and other
fraud in the sale of securities and requires those offering securities to register the securities and
provide offering information to the SEC .
With those obligations in mind, the SEC contends that senior bank employees knew that
these poor quality loans were not performing well, but were being bundled into RMBS that they

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were representing to be high quality securities. It further contends that these same employees
produced “Offering Documents and Preliminary Marketing Materials” for what would become
Defendants’ last RMBS offering – the BOAMS 2008-A securitization. In those materials, the
SEC contends that defendants made representations about the quality of the mortgages
collateralizing the BOAMS 2008-A securitization, how the bank originated those mortgages, and
the likelihood that the borrowers behind those mortgages would make their scheduled payments
in a timely fashion. The SEC contends that all of these representations were knowingly false.
Further, the SEC contends that these employees failed to undertake the required due diligence in
researching the performance of the loans underlying the securities.
While the submission of fraudulent offering statements to the public could certainly form
the basis of private claims against defendants by those who relied on those statements to their
detriment (which is not at issue in this action), the Offering Documents were filed with the SEC
and, the SEC contends, were relied on by two “covered institutions”: the Federal Home Loan
Bank of San Francisco (“FHLB-San Francisco”); and two entities affiliated with Wachovia
Bank. The BOAMS 2008-A Certificates were backed by $855 million in home loans and the
purchasers were lead to believe they were purchasing high quality, prime securities. In the end,
BOAMS 2008-A suffered significant losses.
The SEC contends that the securitization at issue was simply defendants’ way of
transferring the risks of these toxic loans to investors in order to avoid any losses associated with
the loans comprising BOAMS 2008-A. The SEC alleges that defendants misled potential
investors by failing to disclose that seventy-two percent of the mortgages originated in the
wholesale channel, as well as the risks associated with those types of loans, and that investors
were directed to information in prior RMBS offerings as indicative of the characteristics of
BOAMS 2008-A. Wachovia and FHLB-SF bought approximately ninety-eight percent of the
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securities offered.

On August 6, 2013, the SEC filed this Complaint. The SEC seeks an

injunction, civil penalties and other relief for violations of Sections 17(a)(2) and (a)(3) of the
Securities Act, 15 U.S.C. §§ 77q(a)(2) & 77q(a)(3), and Section 5(b)(1) of the Securities Act, 15
U.S.C. § 77e(b)(1).
III.

Discussion
A. Rule 12(b)(6) Standard
Until 2007, a complaint could not be dismissed under Rule 12(b)(6) unless it appeared

certain that plaintiff could prove no set of facts which would support its claim and entitle it to
relief. Neitzke v. Williams, 490 U.S. 319 (1989); Conley v. Gibson, 355 U.S. 41 (1957). This
“no set of facts” standard was specifically abrogated by the Supreme Court in Bell Atlantic Corp.
v. Twombly, 550 U.S. 544 (2007), where the Court held that the “no set of facts” standard first
espoused in Conley, supra, only describes the “breadth of opportunity to prove what an adequate
complaint claims, not the minimum adequate pleading to govern a complaint’s survival.” Id., at
563. The Court specifically rejected use of the “no set of facts” standard because such standard
would improperly allow a “wholly conclusory statement of claim” to “survive a motion to
dismiss whenever the pleadings left open the possibility that a plaintiff might later establish some
‘set of [undisclosed] facts’ to support recovery.” Id., at 561 (alteration in original).
Post Twombly, to survive a Rule 12(b)(6) motion to dismiss, a plaintiff must allege facts
in his complaint that “raise a right to relief above the speculative level.” Id., at 555.
[A] plaintiff’s obligation to provide the “grounds” of his “entitle[ment] to relief”
requires more than labels and conclusions, and a formulaic recitation of the
elements of a cause of action will not do . . . .
Id. (second alteration in original; citation omitted). Further, a complaint will not survive Rule
12(b)(6) review where it contains “naked assertion[s] devoid of further factual enhancement.”

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Id., at 557. Instead, a plaintiff must now plead sufficient facts to state a claim for relief that is
“plausible on its face.” Id., at 570 (emphasis added).
While the Court was clear in Twombly that Conley was no longer controlling, it again
visited the Rule 12(b)(6) pleading standard in Ashcroft v. Iqbal, 556 U.S. 662 (2009). In Iqbal,
the

Court

determined

that

Rule

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“demands

more

than

an

unadorned,

the

defendant-unlawfully-harmed-me accusation.” Id. at 678. The Court explained that, “to 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.’” Id. (citing Twombly, supra; emphasis added). What
is plausible is defined by the Court:
[a] claim has facial plausibility when the plaintiff pleads sufficient factual content
that allows the court to draw the reasonable inference that the defendant is liable
for the misconduct alleged.
Id.
This “plausibility standard” requires “more than a sheer possibility that a defendant has
acted unlawfully.” Id. Thus, a complaint falls short of the plausibility standard where a plaintiff
pleads “facts that are ‘merely consistent with’ a defendant’s liability . . . .” Id. While the court
accepts plausible factual allegations made in a complaint as true and considers those facts in the
light most favorable to plaintiff in ruling on a motion to dismiss, a court “need not accept as true
unwarranted inferences, unreasonable conclusions, or arguments.” Eastern Shore Mkt.’s Inc. v.
J.D. Assoc.’s, LLP, 213 F. 3d 175, 180 (4th Cir. 2000).
In sum, when ruling on a Rule 12(b)(6) motion, “a judge must accept as true all of the
factual allegations contained in the complaint.” Erickson v. Pardus, 551 U.S. 89, 94 (2007) (per
curiam) (citations omitted). A complaint “need only give the defendant fair notice of what the
claim is and the grounds upon which it rests.” Id. at 93 (alteration and internal quotation marks

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omitted). However, to survive a motion to dismiss, the complaint must “state[] a plausible claim
for relief” that “permit[s] the court to infer more than the mere possibility of misconduct” based
upon “its judicial experience and common sense.” Iqbal, 129 S. Ct. at 1950. While a plaintiff is
not required to plead facts that constitute a prima facie case in order to survive a motion to
dismiss, see Swierkiewicz v. Sorema N.A., 534 U.S. 506, 510-15 (2002), “[f]actual allegations
must be enough to raise a right to relief above the speculative level,” Bell Atlantic Corp. v.
Twombly, 550 U.S. at 555.
B. Motion to Dismiss Section 17 Claims
Section 17(a)(2) makes it unlawful for any person, in the offer or sale of securities, to
obtain money or property by means of any untrue statement of a material fact or any omission to
state a material fact necessary in order to make the statements made, in light of the circumstances
under which they were made, not misleading. 15 U.S.C. § 77q(a)(2). Section 17(a)(3) prohibits
any person, in the offer or sale of any security, from engaging in any transaction, practice, or
course of business which operates or would operate as a fraud or deceit upon the purchaser. 15
U.S.C. § 77q(a)(3). Claims under these provisions do not require proof of scienter. Negligence is
sufficient. Aaron v. SEC, 446 U.S. 680, 697 (1980). Defendants contend that the Complaint fails
to plead sufficient facts to establish materiality or negligence.
Materiality is determined based upon whether “there is a substantial likelihood that a
reasonable purchaser or seller of a security (1) would consider the fact important in deciding whether
to buy or sell the security or (2) would have viewed the total mix of information made available to be
significantly altered by disclosure of the fact.” Longman v. Food Lion, Inc., 197 F.3d 675, 683 (4th
Cir. 1999). An omission is misleading if it creates an impression of a state of facts that differs in a

material way from the one that actually exists. Brody v. Transitional Hosps. Corp., 280 F.3d 997,
1006 (9th Cir. 2002). General disclaimers are insufficient to overcome the effect of more specific
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material misstatements or omissions. La Grasta v. First Union Sec., Inc., 358 F.3d 840, 851 (11th
Cir. 2004).

Judge Cayer held that the Complaint alleges sufficient facts to establish that Defendants
negligently made material misrepresentations and omissions here and recommended denying
defendants’ motion. Defendants have interposed no objections and did not argue against the
recommendation at the hearing. Having carefully considered Judge Cayer’s recommendation
and finding that it is consistent with current case law, adopts such recommendation.
C. Motion to Dismiss Section 5 Claims
Section 5(b)(1) requires that any “prospectus” communicated in interstate commerce
comply with the requirements of Section 10 of the Securities Act. 15 U.S.C. § 77e(b)(1).
Specifically, Section 10(b) requires that all prospectuses be filed with the Commission as part of
the registration statement. Id. § 77j(b). Section 2(a)(10) of the Securities Act defines
“prospectus” broadly to include “any … communication … which offers any security for
sale….” Id. § 77(b)(a)(10). Section 2(a)(3) further defines “offer” and “offer for sale” to include
“every attempt to offer or dispose of … a security or interest in a security….” Id. § 77(b)(a)(3).
Once an investor indicates that it will purchase an asset-backed security, “all materials relating to
such class that are or have been provided to such prospective investor … must be filed.”
Securities Act Rule 426(b) (emphasis added). “Filing also is required of such materials relating
to a class of securities, whether or not final terms of all classes had been established, as to which
a prospective investor had indicated an interest.” Securities Offering Reform, Sec. Act. Rel. No.
33-8591, at p. 118 (2005).

Judge Cayer held that the Complaint adequately alleges that

defendants violated Section 5 of the Securities Act by disclosing the information about the
wholesale channel loans to Wachovia and FHLB-SF who later purchased a portion of BOAMS

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2008-A in the public offering. It is undisputed that defendants elected not to file this
“preliminary information” with the Commission.
Defendants raise two objections to Judge Cayer’s Recommendation. First, defendants
argue that under 17 C.F.R. § 230.426 they had no obligation to file preliminary loan tapes.
Second, defendants contend that even if the loan tapes were required to be filed, the Complaint
does not allege that the loan tapes concerned a “security.”
As to the First Objection, the language of Rule 426 does require such filing. To read
Rule 426 as defendants would read it would make the rule internally inconsistent and is contrary
to the disclosure based rules comprising the Securities Act. Rule 426 requires those who offer
such securities to file the preliminary loan tapes where they were provided to prospective
investors who ultimately indicated an intent to invest in BOAMS 2008-A. More specifically,
defendants argue that Rule 426(b) does not apply to the preliminary loan tapes because of the
exception provided in Rule 426(c). Rule 426(c) cannot, however, be read without first reading
Rule 426(b). United States v. Fisher, 58 F.3d 96, 99 (4th Cir. 1995) (holding that courts must
give meaning to all statutory provisions and seek an interpretation that permits them to be read
with consistency). When read together, Rule 426(c) clarifies what material is included in the
second category of information that must be filed under Rule 426(b). Rule 426(c) simply
provides that issuers of securities are not required to file any material provided to prospective
investors prior to the finalization of the offering terms if those prospective investors never
indicate an intention to invest; however, when a prospective investor indicates an intention to
invest, the first category of information is implicated, and that category is governed by Rule
426(b), not Rule 426(c). Thus, Rule 426(c) only applies to information provided to entities that
do not indicate an intention to invest. To interpret Rule 426(c) as defendants suggest would

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encourage mischief in the sale of securities that would ultimately allow issuers a backdoor to
providing information to some investors that it did not provide to all investors.

The first

objection is overruled.
As to the Second Objection, defendants contend that even if the loan tapes were required
to be filed, the Complaint does not allege that the loan tapes concerned a “security.” Review of
the Complaint does not support such Objection. The SEC alleged that the loan tapes were
“written communications constituting free writing prospectuses under the Securities Act.”
(Compl. ¶ 187.) The Commission further alleged that a free writing prospectus is an offer to sell
a security. (Id. ¶¶ 42-44.) Additionally, the Commission alleged that BOAMS 2008-A was an
RMBS, or investment vehicle made up of residential mortgage-backed securities. (Id. ¶¶ 2 & 4.)
Finally, the Commission alleged that the preliminary loan tapes concerned “the proposed RMBS
transaction that would become BOAMS 2008-A.” (Id. ¶¶ 179-182.) The court finds that these
allegations are sufficient to plausibly allege that a security existed when the loan tapes were
provided to prospective investors. As to whether the physical embodiment of BOAMS 2008-A
was in existence at the time the offer was made, the SEC has long provided guidance to issuers
or potential issuers, as follows:
the publication of information and publicity efforts, made in advance of a
proposed financing which have the effect of conditioning the public mind or
arousing public interest in the issuer or in its securities constitutes an offer.
Guidelines for the Release of Information by Issuers Whose Securities are in Registration,
Securities Act Release No. 5,180, 36 Fed. Reg. 16506 (Aug. 16, 1971). The second objection is
overruled.
***

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While overruling each Objection as to the Motion to Dismiss, defendants are not
foreclosed from seeking summary judgment at an appropriate time by arguing that the quantum
of the government’s evidence does not support a finding in favor of the government on such
claims.

ORDER
IT IS, THEREFORE, ORDERED that defendants Objection (#30) to the Memorandum
and Recommendation (#29) is OVERRULED, the Memorandum and Recommendation of
Judge Cayer is AFFIRMED and ADOPTED, and the Motion to Dismiss (#14) is DENIED
without prejudice as to reasserting such arguments at the appropriate time in the form of a
Motion for Summary Judgment.

Signed: June 19, 2014

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