Close analysis of a recent opinion by the U.S. Court of Appeals for the Third Circuit indicates that banks may have gained a stronger hand in disputes over the reporting of loan-loss reserves.

UJB Financial Corp. and some of its officers and directors were sued by shareholders for alleged violating federal and state laws and regulations.

As with the dozens of other shareholder actions filed within the past two years against financial institutions, the suit was filed after announcement of a dramatic decline in net income and an increase in loan-loss reserves. which resulted in a significant drop in the price of UJB's common stock.

Loan-loss Reserves in Question

The shareholders charged that the plaintiff class had purchased the New Jersey bank's securities after relying upon "fraudulent" public statements about the adequacy of loan-loss reserves.

While a district court dismissed most of the plaintiffs' federal securities claims for failure to state a claim of fraud - as opposed to mismanagement the appellate court reversed.

It ordered the plaintiffs to revise the complaint to make clear whether they were alleging mismanagement (merely failing to provide adequate reserves) or fraud (intentionally inaccurate reporting of reserve and income figures).

The circuit court observed that where a bank has represented that its practices are "adequate" or "conservative," "the securities laws are clearly implicated if it nevertheless intentionally or recklessly omits certain facts contradicting these representations."

Significantly, however, the appeals court reaffirmed that plaintiffs must specifically provide a factual basis for their allegations of fraudulent conduct: "Plaintiffs must accompany such an allegation with a statement of facts upon which their allegation is based."

The appeals court also:

* Did not specifically determine whether the plaintiffs in that case had pleaded their claim with the specificity required by Rule 9(b) of the Federal Rules of Civil Procedure.

* Made plain that "mere failure to provide adequate reserves (or to perform competently other management tasks) does not implicate the concerns of the federal securities laws and is not normally actionable.

Similar rules apply where a defendant has not commented on the nature and quality of management practices used to reach a statement of loan-loss reserves, earnings, assets, or net worth. It is not a violation of the securities laws to fail to characterize these practices as inadequate, meaningless, out of control, or ineffective.

* Confirmed that it is not actionable securities fraud for a bank (or holding company) to fail to predict the risk of noncollectibility of bad loans in its portfolio or that, in the future, it will be required to add to its loan-loss reserves.

* Validated the notion that certain statements are not statements of fact, but rather nonactionable "puffing."

Not an Insurance Policy

The court summarized its conclusion by noting that "it is not a violation of the securities laws to fail to characterize [managements'] ... practices" with adjectival descriptions. In contrast, though, the court pointed out that when such affirmative characterizations are made, "the subject is in play.' "

Rather than strengthening the hand of bank shareholders in alleging fraud, the Third Circuit court has reaffirmed that the securities laws are not insurance policies for those who lose money in the stock market and do not provide redress for managements' business judgments with which shareholders may disagree.

Indeed, the court's holding that the mere failure to provide inadequate loan-loss reserves does not state an actionable securities fraud claim may strengthen the hand of banks charged with reporting "inadequate" reserves.

For, as Judge Henry J. Friendly opined, there is no such thing as mere "fraud by hindsight."

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