A federal appeals court has reinstated a class-action lawsuit that charges a defunct subprime lender and several banks with misleading investors in the run-up to the financial crisis.
The suit by the New Jersey Carpenters Health Fund, a pension fund, against representatives of NovaStar Mortgage, Royal Bank of Scotland, Deutsche Bank and other defendants can continue, the U.S. Court of Appeals for 2nd Circuit ruled on Friday.
The ruling overturned a decision last year by the U.S. District Court on Manhattan that dismissed the lawsuit for failing to state a claim that the defendants' conduct in connection with the sale of roughly $1.3 billion in residential mortgage-backed securities violated U.S. securities laws. The trial court also said the pension fund could not bring a lawsuit in connection with securities in which it had not invested.
Statements from former employees of NovaStar that the pension fund had cited in court papers "suggested that [NovaStar] — throughout the relevant time period and at different locations across the country — disregarded its underwriting guidelines, approving loan applications despite deficiencies in an effort to generate a large volume of mortgages it could sell to third parties," Judge Robert Katzman wrote for the appeals court. "These allegations are suggestive of, rather than merely consistent with, a finding of liability."
The lawsuit stems from an investment of $100,000 in 2007 by the fund in one of six trusts of securities backed by mortgage loans that NovaStar had originated. Deutsche Bank, Royal Bank of Scotland and other financial institutions underwrote and sold each of the trusts.
The fund charged that the underwriters failed to tell investors that NovaStar had allegedly abandoned underwriting guidelines the company told investors it followed. The fund based its allegations on decisions by both Moody's and Standard & Poor's to lower their ratings on the securities significantly and what the fund charged was an unusually large percentage of the mortgages in each trust that later defaulted.
To bolster its case, the fund, which alleges that its investment was worth roughly $350 two years later, cited comments by seven former NovaStar employees, who alleged that the pressure they felt to achieve performance targets resulted in a "systematic loosening" of underwriting standards.
"We're obviously gratified that the case can go forward with respect to the $1.3 billion offering and potentially with respect to each of the five other offerings," Joel Laitman, an attorney who represents the fund, told American Banker.
William Alderman, a lawyer for NovaStar, said in an email the "ruling ignores the undisputed fact that, for every category of risk affecting the loan pool at issue, the actual borrower metrics comfortably met the underwriting standards NovaStar Mortgage had disclosed to investors."
"We believe that this fact trumps the unsubstantiated conclusory allegation that underwriting standards were abandoned and that plaintiff's claims will remain unsubstantiated as the case continues in the district court," Alderman added.
Both Ed Canady, a spokesman for RBS, and Duncan King, a spokesman for Deutsche Bank, declined to comment.
As part of the ruling, Katzman returned the case to the trial court with instructions to consider whether the fund can bring a class-action lawsuit on behalf of investors in securities that the fund itself did not invest.
In November, Goldman Sachs asked the U.S. Supreme Court to toss out a ruling by the 2nd Circuit that permitted a pension fund for electrical workers to sue Goldman for allegedly misleading investors about mortgage-backed securities the fund itself did not own. In its appeal, which is pending before the court, Goldman argues the ruling could cost financial firms tens of billions of dollars.