Since the bursting of the sub-prime mortgage bubble, the Securities and Exchange Commission  has brought many securities fraud enforcement actions against many defendants. Of these defendants, Federal National Mortgage Association (FNMA), commonly known as Fannie Mae and the Federal Home Loan Mortgage Association (Freddie Mac) are among the most notorious. 

As of January 2012, the SEC had filed around 38 crisis-related actions.

In 2006, at the beginning of the crisis, the SEC and the Office of Federal Housing Enterprise Oversight reached a $400 million settlement with Fannie Mae.  The OFHEO acting director described the environment as one where senior management masked impairment losses, eliminated or deferred current expenses and incomes, and minimized earnings volatility so they were able to achieve announced earnings per share goals year after year. 

 In December 2011 in complaints filed in the U.S. District Court for the Southern District of New York,  the SEC charged six former executives from Freddie Mac (SEC v. Syron), and Fannie Mae (SEC v. Mudd) over  “alleged misstatements about entities exposure to subprime mortgage loans between 2006-2008.” Both firms were charged with understating their exposure to risky mortgages by hundreds of billions of dollars. 

As the cases reach fruition, it is interesting to observe how the judges are applying the scienter standard from the 1934 Securities Exchange Act Section 10(b) to various defendants .

Section 10(b) prohibits any person from using or employing “any manipulative or deceptive device or contrivance in contravention” of SEC rules. To state a claim under this section, plaintiffs must allege that misstatements or omissions of material fact were made with scienter, in connection with the purchase or sale of securities upon which plaintiffs relied and which was the proximate cause of their injury.

In March 2012, in SEC v. Mudd, the defendants moved to dismiss the case for, among other reasons, failure to allege an actionable misrepresentation or omission and for failure to adequately allege scienter.

In August 2012, Paul Crotty, United States District Judge, denied  the motion to dismiss.

He agreed with the SEC that the scienter standard had been met.  Citing the precedent of the Novak case, he stated that:
“[S]ecurities fraud claims typically have sufficed to state a claim based on recklessness when they have specifically alleged defendants’ knowledge of facts or access to information contradicting their public statements.  Under such circumstances, defendants knew or, more importantly, should have known that they were misrepresenting material facts related to the corporation.” 

In November 2012,  in two separate cases against Deloitte & Touche in New York (In re Longtop Financial TechnologiesLtd ) and California (In re Diamond Foods Inc. Securities Litigation ) the judges dismissed the auditors as defendants, finding that the auditors lacked scienter.

In the Longtop case, Deloitte resigned after Longtop deliberately obstructed their efforts to follow up with certain Longtop banks  and then refused  to allow Deloitte’s staff to leave bank premises before relinquishing  the audit files.

Discussing  the standard in the Longtop opinion, the Honorable Shira Scheindlin  points out that very often the financial records have been tampered with before the auditor receives them and so while auditors  have an obligation not to ignore red flags they are not held to the same standard of culpability as chief executive officers and other financial officers.  

An auditor is not expected to be clairvoyant, concluded the judge. The strongest inference from the facts was that Deloitte was duped by Longtop, not that it recklessly enabled them.  The recklessness standard of scienter cannot be met by alleging “fraud by hindsight.”  If an auditor conducts an adequate audit, in good faith,  it is not sufficient to establish recklessness.

By Laura Salisbury, BNA Tax Management Legal Editor