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D.J. Wu, et al v. John Crumpton Stomber

August 13, 2012

D.J. WU, ET AL., PLAINTIFFS,
v.
JOHN CRUMPTON STOMBER, ET AL., DEFENDANTS.



The opinion of the court was delivered by: Amy Berman Jackson United States District Judge

MEMORANDUM OPINION

"We may employ leverage without limit, which may result in the market value of our investments being highly volatile, limit our range of possible investments, and adversely affect our return on investments and the cash available for distributions."

"An investment . . . is suitable only for investors who are experienced in analyzing and bearing the risks associated with investments having a very high degree of leverage."

"We cannot assure you that that the Liquidity Cushion will be sufficient to satisfy margin calls on our financed securities that may arise in connection with highly unusual adverse market conditions."

"While borrowing and leverage present opportunities for increasing total return, they have the effect of potentially increasing losses as well . . . . [A]ny event which adversely affects the value of our investments would be magnified to the extent leverage is employed."

Carlyle Capital Corporation ("CCC") Offering Memorandum [Dkt. # 52-3] at 13--14.

This case involves highly leveraged, highly speculative investment products. It raises the question of whether plaintiffs were defrauded under the following circumstances: they bought shares in a company whose sole business consisted of buying residential mortgage-backed securities on margin; the shares were made available only to a restricted group of sophisticated, wealthy investors; the shares were marketed with ominous warnings such as the ones above; and the very risks that were disclosed materialized when conditions in the real estate market and global economy deteriorated in 2008.

The consolidated complaint alleges claims of securities fraud under sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. The complaint includes common law fraud and negligent misrepresentation allegations, as well as claims under the laws of the United Kingdom and the Netherlands. As plaintiffs have explained it, the gravamen of the complaint is that the CCC Offering Memorandum was materially false and misleading because while it disclosed that liquidity issues that would threaten the company could occur, it omitted information that would have alerted investors to the fact that those events were already occurring. Plaintiffs also contend that after the Offering, defendants continued to conceal the worsening financial condition of the company until CCC collapsed in March of 2008.

Defendants have moved to dismiss the consolidated complaint pursuant to Federal Rules of Civil Procedure 9(b) and 12(b)(6) and the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u--4, for failure to state a claim upon which relief can be granted. [Dkt. # 51 and # 52]. For the reasons set forth in more detail below, the Court will grant the motions to dismiss.

Essentially, this complaint is an attack on how CCC was managed, and ultimately, it questions the wisdom behind the adoption of its business model in the first place. But chiding CCC with the benefit of hindsight for its failure to resist the stampede to purchase mortgage- backed securities is not the same thing as alleging fraud, particularly given the stringent standards of the PSLRA.

With respect to the counts related to the Offering, the complaint does not plausibly allege a securities fraud claim grounded on omissions because the Offering documents -- in particular, the Supplemental Memorandum issued after the initial Offering was postponed -- specifically placed buyers on notice of what CCC was doing and the fact that it had recently experienced the very reversals that plaintiffs claim should have been disclosed. So, this action lacks the defining element of fraud: a falsehood. The federal claims also fall short of supporting the necessary allegation that the alleged fraud caused the plaintiffs' losses. The common law claims related to the Offering suffer from the same flaws, and in addition, they fail to set forth facts that would support the element of actual reliance.

As for the claims based on sales of securities in the aftermarket, the federal claims are barred since the shares were purchased on a foreign exchange and not in the United States. And, if the Court were to go on to consider the common law aftermarket claims, it would find those allegations to be devoid of the necessary allegations of reliance as well.

I. BACKGROUND

A. The Parties

1. Plaintiffs

Plaintiffs bring this action pursuant to Federal Rules of Civil Procedure 23(a) and (b)(3) on behalf of two proposed classes. The first proposed class is the "Offering Class," which the complaint defines as "all persons who purchased or otherwise acquired Class B Shares or Restricted Depository Shares ("RDS") of CCC in its Offering and were damaged thereby" and a "U.S. Offering" subclass of U.S. residents. Compl. ¶ 30. The second proposed class is the "Aftermarket Class," which the complaint defines as "all persons who purchased or otherwise acquired Class B Shares of CCC in market purchases from July 4, 2007 through March 17, 2008 . . . and were damaged thereby," and includes a "U.S. Aftermarket Subclass" of U.S. residents. Id. Plaintiffs estimate that there are at least 500 members of the Class. See id. ¶ 31.

The named plaintiffs in this action are: x Plaintiff E.L. Phelps, a resident of Virginia who purchased (1) 15,789 RDSs in the Offering and (2) 15,000 Class B Shares listed for trading on the Euronext exchange in the aftermarket. Id. ¶ 4; x Plaintiff M.J. McLister, a resident of Virginia who purchased (1) 26,316 RDSs in the Offering, and (2) 54,225 Class B Shares listed for trading on the Euronext exchange in the aftermarket. Id. ¶ 5; x Plaintiff D.J. Wu, a resident of Washington, D.C. who purchased (1) 26,316 RDSs in the Offering, and (2) 25,000 Class B Shares listed for trading on the Euronext exchange in the aftermarket. Id. ¶ 6; x Plaintiff S.M. Liss, a resident of Maryland who purchased 15,789 RDSs in the Offering. Id. ¶ 7; x Plaintiff W.F. Schaefer, a resident of Maryland who purchased 7,895 RDSs in the Offering. Id.¶8; x Plaintiff Jonathan Glaubach who purchased 500 shares of CCC securities in the Offering. Glaubach Decl. ¶ 4 to Mot. for App't as Lead Pl. [Dkt. # 4-3];

2. Defendants

The consolidated complaint names the following institutional defendants: x Defendant Carlyle Investment Management, LLC ("CIM"), a Delaware limited liability company with its principal place of business in Washington, D.C. Compl. ¶ 9. Under an investment management agreement with CCC, CIM served as the investment manager of CCC and "had full discretionary investment authority." Id. According to the Offering Memorandum, CIM was responsible for "the day-to-day management and operations of [CCC's] business." CCC Offering Memorandum ("Off. Mem.") [Dkt. # 52-3] at 62--63;

x Defendant T.C. Group, LLC ("TCG"), a Delaware limited liability company with its principal place of business in Washington, D.C. Compl. ¶ 10. According to the complaint, TCG owned 75 percent of CIM. Id.;

x Defendant TC Group Holdings, LLC ("TCG Holdings"), a Delaware limited liability company with its principal place of business in Washington, DC. TCG Holdings was the holding company and managing member of TCG. Id. ¶ 11;

x Defendant CCC, a Guernsey limited company that is currently in liquidation.

Id. ¶ 22.*fn1

The complaint also names two groups of individual defendants. The first group of defendants, who are referred to as the "Carlyle Defendants," is: x Defendant William Elias Conway, Jr., a resident of Virginia who served as managing director of CIM, a director of CCC, and the Chief Investment Officer of TCG. Id. ¶ 14; x Defendant John Crumpton Stomber, a resident of Connecticut who served as the Chief Executive Offer, Chief Investment Officer and President, and a director of CCC, as well as Managing Director of CIM and TCG. Id. ¶ 15; x Defendant James H. Hance, a resident of North Carolina who served as a Director of CCC from September 14, 2006 and at all relevant times thereafter. Id. ¶ 16. He also served as Chairman of the Board until March 2007 and was a senior adviser to CIM. Id.; x Defendant Michael J. Zupon, a resident of New York who served as a Director of CCC from September 14, 2006 and at all relevant times thereafter. Id. ¶ 17. According to the complaint, Zupon was a founding member, Chief Investment Officer, and Managing Director and Head of Carlyle's U.S. Leveraged Finance Group and a Partner and Managing Director of Carlyle. Id.

The second group of individual defendants, who are referred to as the "Outside Directors," is:

x Defendant Robert Barclay Allardice, III, a resident of New York who served as a Director of CCC from September 14, 2006 and at all relevant times thereafter. Id. ¶ 19; x Defendant Henry Jay Sarles, a resident of Massachusetts who was a Director of CCC from September 14, 2006 and at all relevant times thereafter. Id. ¶ 20; x Defendant John Leonard Loveridge, a resident of Guernsey who was a Director of CCC from September 14, 2006 and at all relevant times thereafter. Id. ¶ 21.

B. Factual Background

1. CCC's business model

As the complaint sets forth, CCC was a closed-end investment fund that was formed as a limited company under the laws of Guernsey on August 29, 2006. Compl. ¶ 40.*fn2 Although CCC was technically a separate business entity, the complaint alleges that CCC was "an investment product created and managed at all times by [defendants]." Id. ¶ 23. CCC's business model involved using highly leveraged financing in the form of repurchase loan agreements ("repos") to invest in residential mortgage-backed securities ("RMBS"). Id. ¶ 41; Off. Mem. at 45.

CCC shares were initially sold to investors through a private placement of Class B shares, which was completed by December 31, 2006 and raised over $260 million. Compl. ¶ 50. A second private placement was completed by February 28, 2007, raising over $336 million. Id. ¶ 52. The total amount of capital raised through the private placements was approximately $600 million. Id.

2. The Offering and Offering Memoranda

a. Types of securities sold in the Offering

The Offering ("Offering") was initially scheduled to take place in early July 2007. Off. Mem. at cover. There were two types of securities to be sold: Class B Shares and Restricted Depository Shares ("RDSs"). Class B shares were issued from CCC and were sold only outside the United States to foreign investors. Off. Mem. at cover. RDSs were issued by the Bank of New York and sold to investors in the United States, as well as foreign investors. Id. The securities sold in the Offering were not widely available -- only certain types of investors and investors in certain locations were permitted to purchase the securities. In the United States, only qualified institutional buyers ("QIBs") and accredited investors were permitted to purchase RDSs.*fn3 Similarly, in order to purchase either type of security, an investor was required to be a "qualified purchaser," meaning a QIB with at least $25 million in qualifying investments or an individual with at least $5 million in qualifying investments. Id. at A-2. Both types of securities were subject to transfer restrictions. See, e.g., id. at 136, 138.

b. The period preceding the issuance of the Offering Memorandum In the months leading up to the Offering, the CCC Board of Directors ("the Board") reviewed drafts of the Offering Memorandum and took action on several issues related to the Offering. See, e.g., id. ¶¶ 53, 54, 56. The Memorandum was ultimately issued on June 19, 2007. Id. ¶ 74.

According to the Offering Memorandum, CCC had an investment guideline stating that the fund would maintain a "liquidity cushion" of 20 percent, meaning that "unrestricted cash and cash equivalents . . . [would be] equal to no less than 20% of [CCC's] [a]djusted [c]apital." Off. Mem. at 7. The liquidity cushion was set at 20% based on "extensive statistical testing of [CCC's] expected portfolio, including testing during periods of significant financial market volatility and stress . . . ." Id. at 50. The purpose of the liquidity cushion was to enable CCC "to meet reasonably foreseeable margin calls on [its] financed securities." Id. at 50. But CCC also informed potential investors that it could change its investment guidelines without a shareholder vote at any time with approval of a majority of directors. Id. at 7. In fact, the Offering Memorandum disclosed that it had already deviated from the guidelines in the past and "may do so again in the future." Id.

In its critique of the Offering, the complaint focuses on events that were occurring during the same time period. It alleges that at some point in April 2007, the Board approved a request made by defendant Stomber to use the liquidity cushion to buy certain RMBSs prior to the Offering, which resulted in a reduction of the liquidity cushion to 15 percent. Id. ¶ 58. Also, during this period, CCC entered into a term loan agreement with CitiGroup Global Markets, Inc., which was one of the brokerage firms that agreed to market the Offering to U.S. investors. Id. ¶ 60. CCC thus secured a bridge loan in the amount of $191 million, which was "obtained in contemplation of the Offering and was required to be repaid from the proceeds of the Offering." Id.

The complaint also alleges that on June 7, 2007, defendant Stomber informed the Board in an email that CCC had recently sustained substantial losses. Id. ¶ 63. It states:

Stomber told the Board that as a consequence of a change in the "5 years swap rate," a $25 million unrealized gain had become an $8 million unrealized loss on CCC's mortgage backed securities and that CCC's New Asset Value had declined as a result. Stomber stated that "[t]oday was a wild day" in the market "where rates went up materially" and that CCC could sustain further significant losses . . . . Most importantly, Stomber was aware and informed the Board that those events had negatively impacted CCC's Liquidity Cushion: " . . . . The Liq Cushion stands at 23 percent but could be called down close to 20 percent -- that is why we have it."

Id.

On June 13, 2007, Stomber announced to the Board that the Offering would be postponed because of "volatile market conditions" and the uncertainty of the valuation of CCC's balance sheet. Compl. ¶ 64. According to the complaint, he reported that "CCC's IFRS net income 'was on target for a 14.5% 2nd quarter, but he also noted that CCC's 'Fair Value Reserve was down $63.9MM from inception and $76.2MM for the year,' meaning that CCC had suffered unrealized losses in those amounts under IFRS." Id. *fn4 Stomber went on:

We are having a major liquidity event so I invoked "emergency powers" on the balance sheet. The liquidity cushion is currently at $148MM, which is technically above 20% of our current MTM equity position. But please take no comfort in that, we could be margin called for up to another $70MM and therefore bring the cushion down to about 11%. Therefore, we need independent Board Member approval to go under 20% -- that is the purpose of the liquidity cushion -- to be there so we don['t] not have to sell securities at depressed prices during a margin call. Therefore, I ask you for your formal approval.

Id. (alteration in original). The complaint alleges that on June 14, 2007, the Board approved a resolution to give Stomber the authority he requested to reduce CCC's minimum liquidity cushion. Compl. ¶ 66.*fn5

Shortly thereafter, on June 19, 2007, CCC issued the original Offering Memorandum. Id. ¶ 74; Off. Mem. at cover. The Offering Memorandum contained detailed information about the Offering, including explanations of the types of securities that were to be sold, CCC's business model and its associated risks, and the fund's financial status.

c. The description of CCC's business model and associated risks in the Offering Memorandum The Offering Memorandum set forth CCC's business model in detail, particularly its use of leverage and the risks associated with such an approach. The first page of the Memorandum summarized CCC's investment strategy in the following way:

Our objective is to achieve attractive risk-adjusted returns for shareholders through current income and, to a lesser extent, capital appreciation. We seek to achieve this objective by investing in a diversified portfolio of fixed income assets consisting of mortgage products and leveraged finance assets. Our income is generated primarily from the difference between the interest income earned on our assets and the costs of financing those assets as well as from capital gains generated when we dispose of our assets.

We use leverage to increase the potential return on shareholders' equity. The actual amount of leverage that we will utilize, although not limited by our investment guidelines, will depend on a variety of factors, including type and maturity of assets, cost of financing, credit profile of the underlying assets and general economic and market conditions.

Id. at 1. The Offering Memorandum emphasized that CCC would "utilize leverage extensively" and "without limit." Id. at 5. It noted that the fund's leverage ratio, which was defined as "debt directly incurred to finance investment assets to total equity," had already exceeded 26:1 by March 31, 2007, and that it was expected to exceed 29:1 after the Offering. Id.

The Offering Memorandum also discussed the risk factors associated with CCC's business model, explaining: x "We may change our investment strategy or investment guidelines at any times without the consent of shareholders, which could result in us acquiring assets that are different from, and possibly riskier than, the investment guidelines described in the offering memorandum." Id. at 10. x "We may change our investment strategy and/or capital allocation guidelines without a vote of our shareholders, provided that any change to our investment guidelines must be approved by a majority of our independent directors. In the past, we have deviated from these guidelines with the approval of a majority of our independent directors and we may do so again in the future." Id. at 7.

x "We cannot assure you that the Liquidity Cushion will be sufficient to satisfy margin calls.

Despite extensive statistical testing of relevant data, the Liquidity Cushion is not designed to protect us under all possible adverse market scenarios. Therefore, we cannot assure you that that the Liquidity Cushion will be sufficient to satisfy margin calls on our financed securities that may arise in connection with highly unusual adverse market conditions." Id. at 14 (emphasis in original).

x "Our organizational, ownership and investment structure may create significant conflicts of interest that may be resolved in a manner which is not always in our best interests or those of our shareholders." Id. at 10.

x "The price of Class B shares and the RDSs may fluctuate significantly and you could lose all or part of your investment." Id. at 11.

With respect to the use of leverage, the Offering Memorandum warned: x "We may employ leverage without limit, which may result in the market value of our investments being highly volatile, limit our range of possible investments, and adversely affect our return on investments and the cash available for distributions. An investment in the Class B shares or RDSs is suitable only for investors who are experienced in analyzing and bearing the risks associated with investments having a very high degree of leverage." Id. at 13.

x "Most leveraged transactions require the posting of collateral. The amount of collateral required to be posted may increase rapidly in the context of changes in market value of the assets to which we have leveraged exposure[.]" Id.

x "While borrowing and leverage present opportunities for increasing total return, they have the effect of potentially increasing losses as well . . . [A]ny event which adversely affects the value of our investments would be magnified to the extent leverage is employed. Increased leverage also increases the risk that we will not be able to meet our debt service obligations, and consequently increases the risk that we will lose some or all of our assets to foreclosure or sale." Id.

Finally, because CCC's business model depended heavily on RMBS assets and financing with repo agreements, the Offering Memorandum outlined the risks related to those circumstances: x "If residential and/or commercial real estate property values decrease materially . . . we may realize material losses related to foreclosures or to the restructuring of our mortgage loans and the mortgage loans that back the mortgage-backed securities in our investment portfolio." Id. at 12.

x "The adverse effect of a decline in the market value of our assets may be exacerbated in instances where we have borrowed money based on the market value of those assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we would have to sell the assets at a time when we might not otherwise choose to do so." Id. at 15.

d. The description of CCC's financial status in the Offering Memorandum The Offering Memorandum provided information regarding CCC's financial status as of March 31, 2007, which was the end of the latest financial reporting period. Id. ¶ 77; Off. Mem. at 8. But in a section entitled "Recent Developments," the document also supplied updated financial information that was current as of June 13, 2007. In particular, this section disclosed that prior to the Offering, CCC's fair value reserves had declined by $28.9 million between April and June 2007:

As a result of changes in interest rates, we estimate that from April 1, 2007 to June 13, 2007, our fair value reserved declined by approximately $28.9 million (unaudited), from approximately $24.0 million (unaudited) as of March 31, 2007 to an estimated $(4.9) million (unaudited) as of June 13, 2007.

Off. Mem. at 8.

Ultimately, the Offering did not take place as scheduled.

e. Postponement of the Offering and the Supplemental Offering Memorandum On June 28, 2007, CCC announced that it had postponed the Offering and that it would issue a Supplemental Offering Memorandum ("the Supplement") setting forth a revised timetable and changing the terms of the Offering. Compl. ¶ 83. The next day, CCC issued the Supplement, which stated that it was "supplemental to, forms part of and must be read in conjunction with the Offering Memorandum" and that it "amends and updates" any information in the Offering Memorandum. Compl. ¶ 84; Supplemental Offering Memorandum ("Supp. Off. Mem.") [Dkt. # 52-6] at 1. The Supplement specifically notified investors that where it contained information inconsistent with Offering Memorandum, the Supplement superseded the earlier document. Supp. Off. Mem. at 1.*fn6

The Supplement stated that the number of Class B shares available in the Offering would be reduced from 19,047,620 to 15,962,673 and that the price of the shares would be reduced to $19, from the price range of $20--$22 stated in the Offering Memorandum. Supp. Off. Mem. at

5. In a section entitled "Recent Developments," the Supplement also disclosed:

[F]rom April 1, 2007 to June 26, 2007, our fair value reserves declined by approximately $84.2 million (unaudited), from approximately $24.0 million (unaudited) as of March 31, 2007 to an estimated ($60.2) million (unaudited) as of June 26, 2007.

Supp. Off. Mem. at 8--9.

The Offering was completed on July 11, 2007. Supp. Off. Mem. at 9. More than 18 million Class B Shares and RDSs were sold in the Offering, raising over $345 million in proceeds for CCC. Compl. ¶ 85.

f. The subsequent financial crisis and collapse of CCC In the months following the Offering, CCC experienced a decline in the value of its investments. The complaint alleges that, in August 2007, several of CCC's repo counterparties made substantial margin calls and sought "haircuts,"*fn7 which required CCC to provide more collateral for the loans used to finance the RMBS assets. Id. ¶ 116. These demands negatively affected CCC's liquidity cushion. Id. ¶ 117. Around August 7, 2007, Stomber sought and received permission from the Board to reduce the liquidity cushion to 15 percent for a period of ninety days. Id. On August 23, 2007, the Board held an emergency meeting, at which defendant Hance informed Board members that the recent market events had "diminished [CCC's] liquidity cushion below zero." Id. ¶ 119. Stomber allegedly told the Board at the meeting that "[m]anagement believes it would be prudent to wind down the Company to its core level at this time." Id.

On August 27, 2007, Stomber informed shareholders in a letter that the recent market volatility had resulted in increased margin calls and that "CCC's liquidity cushion has not been sufficient to meet recent margin calls." Id. ¶ 122. On September 11, 2007, the Carlyle Investor Conference took place in Washington, DC, at which Stomber said that "fundamental revisions to CCC's business model were required and would be implemented." Id. ¶ 126. He acknowledged that "CCC's business model needed to be thoroughly restructured to reduce leverage and increase minimum liquidity cushion to at least 40%." Id. According to the complaint, defendants made a commitment to (1) "employ less leverage"; (2) "have more diversified asset classes"; and (3) "improv[e] and stabiliz[e] sources." Id. But plaintiffs allege that despite these promises, defendants did not take any steps to maintain or increase the liquidity cushion, which had been reduced to 3 percent of CCC's adjusted capital by November 13, 2007. Id. ¶ 130.

At a meeting on November 13, 2007, the Board approved amendments to the definition of the term "liquidity cushion" to include undrawn debt from Carlyle as liquid assets. Id. ¶ 131. Plaintiffs allege that this revision made "CCC's position appear more favorable than it was" because "the Board did not take any steps to actually address CCC's precarious liquidity problems and over-accumulation of RMBS-based assets." Id. The Board met again on February 27, 2008, and voted to suspend the 20 percent liquidity cushion until September 2008. Id. ¶ 137. The same day, CCC issued its annual report for the year ending December 31, 2007, which reported that "[d]uring the fourth quarter our portfolio stabilized and we were able to generate returns consistent with our near term targets." Id. ¶ 138; see also Ex. 3 to CD Mem. at 4 [Dkt. # 52-5].

But on March 5, 2008, CCC issued a press release announcing that "since filing its annual report on February 28, 2008, the Company ha[d] been subject to margin calls and additional collateral requirements totaling more than $60 million." Id. ¶ 140; Ex. 9 to CD Mem. at 1. The press release went on to say:

Until March 5, the Company had met all of the margin requirements imposed by its repo counterparties. However, on March 5, the Company received additional margin calls from seven of its [thirteen] repo counterparties totaling more than $37 million. The Company has met margin calls from three of these financing counterparties that have indicated a willingness to work with the Company during these tumultuous times, but did not meet the margin requirements of the four other repo financing counterparties. From this group of four counterparties, one notice of default has been received by the Company and management expects to receive at least one additional default notice.

Id. One week later, on March 12, 2008, CCC issued another press release announcing:

[A]lthough it has been working diligently with its lenders, the Company has not been able to reach a mutually beneficial agreement to stabilize its financing. The Company expects that its lenders will promptly take possession of substantially all of the Company's remaining assets.

The only assets held in the Company's portfolio as of today are the U.S. government agency AAA-rated residential mortgage-backed securities (RMBS). During the last seven business days, the Company received margin calls in excess of $40 million. As the Company was unable to pay these margin calls, its lenders proceeded to foreclose on the RMBS collateral. In total, through March 12, the Company has defaulted on ...


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