(CN) - Citing Judge Henry Friendly's line that "there is no securities fraud by hindsight," the 7th Circuit bounced a class action alleging that mortgage loan insurer MGIC misled investors about the stability of mortgage security packager C-BASS.
The Fulton County Employees Retirement System alleged that MGIC Investment Corporation executives fraudulently misled investors on a July 19, 2007 conference call by saying that Credit-Based Asset Servicing and Securitization LLC, of which MGIC owned 46 percent, had "substantial liquidity to cover margin calls in the event of substantial declines in the value of its mortgages and securities."
The institutional investor based the claim on the fact that just a week later, C-BASS faced $470 million in margin calls as the market for subprime mortgage backed securities tanked and MGIC decided to write off its $516 million investment in the company.
Writing for a three judge panel Chief Judge Frank Easterbrook agreed with the district court that had originally dismissed the retirees' argument that the claim of "substantial liquidity" was false. "The district court wrote (and we concur) that the 'substantial Liquidity' statement was true, both absolutely ($150 million is a lot of money) and relative to the needs of C-BASS's business," he wrote.
Beyond the prudence of the claim, Easterbrook said that MGIC covered its bases by immediately warning in a press release that it was possible, if the market for subprime mortgages got really bad, that C-BASS's reserves might not be sufficient.
Which of course it did, and the retirees argued that MGIC must have seen the margin call coming. Easterbrook dismissed this claim, noting that had MGIC known a significant decline in the markets was coming, it would have stopped funding C-BASS much sooner and it would have had to know something that the rest of the market didn't know.
As a result the best that the retirment system could argue is that MGIC should have seen the crash looming, Easterbrook said. But, he continued, "Even 'should have seen' may be too strong. The subprime market had been in decline during the first half of 2007, but that did not necessarily imply a continuing slump, let alone a collapse. For every seller of subprime loans in 2007 who thought them overpriced, there was a buyer who expected to make a profit when the market went back up."
Moreover, Easterbrook said, by July 2007 "the whole world knew that firms that had issued, packaged, or insured subprime loans were in distress. Nothing MGIC said, or didn't say, could conceal that fact."
"Judge Friendly famously said that there is no securities fraud by hindsight ... Issuers need not be prescient. The July 19 press release did not misrepresent the past or C-BASS's current condition, and MGIC had no duty to foresee the future." [Elipsis omits citation].
Turning to the narrow grounds that kept the case alive on appeal, Easterbrook also rejected plaintiff's argument that MGIC was responsible for allegedly fraudulent statements made by the chief executive and chief operating officer of C-BASS.
Under section 20(a) of the Securities Exchange Act a person or organization with a controlling interest in a company can be held vicariously liable for the fraudulent acts of the company or its representatives.
Easterbrook noted that C-BASS was structured precisely so that it was controlled neither by MGIC, nor by another mortgage insurer Radian Group which also held a 46 per cent stake in C-BASS.
"The point of such equal positions is to prevent both MGIC or Radian from exercising unilateral control. Unless MGIC and Radian agreed, C-BASS could operate as it pleased, since its own managers held the balance of power (the last 8%)," Easterbrook said.
During oral arguments the panel asked the plaintiff if there were any cases on point where either of two equally invested bloc holders was treated as a controlling party under the act, but the retirment system didn't know of any and Judge Easterbrook said the panel couldn't find any either.
As a result Easterbrook said, "It would be inappropriate to hold MGIC liable under section 20(a) for statements made by managers of a different firm that MGIC could not control without the assent of a third party holding and equally large bloc."
Similarly, Easterbrook rejected the retirees' argument that because MGIC had asked the C-BASS executives to speak during its quarterly earning conference call it was as though MGIC made the statements itself.
Control of the statements rested with the C-Bass executives who, given the structure of the company, were solely responsible for their statements, Easterbrook found.