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In re Radian Securities Litigation

April 9, 2009


The opinion of the court was delivered by: McLaughlin, J.

This document relates to: All Actions



In this consolidated class action, the plaintiffs allege that the defendants, Radian Group, Inc. ("Radian"), Sanford A. Ibrahim, C. Robert Quint, and Mark A. Casale, committed securities fraud in violation of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("Exchange Act"), and Securities and Exchange Commission ("SEC") Rule 10b-5, 17 C.F.R. § 240.10b-5. The action is brought on behalf of purchasers of Radian securities between January 23, 2007, and August 7, 2007.*fn1

Radian provides credit protection products and financial services to financial institutions, including mortgage lenders. Credit-Based Asset Servicing and Securitization ("C-BASS"), a corporation in which Radian held a 46% equity interest during the class period, invested in the credit risk of subprime residential mortgages. The plaintiffs allege that the defendants made false and misleading statements about C-BASS's profitability and liquidity position and thus, the value of Radian's investment in C-BASS, during the class period. These statements are alleged to have artificially inflated Radian's stock price, which led to losses to shareholders when Radian announced an impairment of its investment on July 30, 2007.

The defendants have moved to dismiss the consolidated class action complaint ("CCAC"). Their main arguments for dismissal of the plaintiffs' § 10(b) claim are: (1) that the plaintiffs' allegations of fraud do not satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act ("PSLRA"), 15 U.S.C. § 78u-4, particularly with respect to the required showing of a "strong inference of scienter"; and (2) that the defendants' statements constitute forward-looking statements that are non-actionable under the PSLRA's safe harbor provision, 15 U.S.C. § 78u-5(c). They further argue that because the plaintiffs have not stated an independent securities violation under § 10(b), they have also failed to state a § 20(a) claim. Because the Court finds that the plaintiffs have not carried their burden of showing a strong inference of scienter, the Court will grant the defendants' motion.

I. Facts as Alleged in the Complaint*fn2

Radian is a credit enhancement company that offers mortgage insurance and other financial services and products to mortgage lenders and other financial institutions. Sanford A. Ibrahim, at all relevant times, was Radian's CEO, and a member of Radian's Board of Directors. C. Robert Quint was Radian's CFO and Executive Vice President. Mark A. Casale served as President of Radian Guaranty, Inc., a Radian subsidiary, and was also a member of C-BASS's Board of Managers during the class period. CCAC ¶¶ 2, 12, 13.*fn3

During the class period, Radian's operations were divided into three business segments: (1) mortgage insurance; (2) financial guaranty; and (3) financial services. In 2006, the mortgage insurance segment represented 49% of Radian's net income, and 55% of its equity; the financial guaranty segment represented 23% of Radian's net income, and 34% of its equity; and the financial services segment represented 28% of Radian's net income, and 11% of its equity. Id. ¶ 44.

During the class period, Radian's financial services segment consisted mainly of interests held in Sherman Financial Services Group, LLC ("Sherman"), and C-BASS. Sherman purchases and services charged-off and bankruptcy plan consumer assets at discounts from national financial institutions and major retail corporations. Sherman also originates nonprime credit card receivables through a subsidiary. Id. ¶ 48.

C-BASS, on the other hand, is a mortgage investment and servicing company that specializes in subprime residential mortgage assets and mortgage-backed securities ("MBS"). During the class period, Radian held a 46% equity interest in C-BASS, and had invested approximately $500 million in it. C-BASS was a joint venture between Radian and MGIC Investment Corporation ("MGIC"), another provider of private mortgage insurance that also held a 46% interest in C-BASS.*fn4 During the class period, C-BASS serviced loans through a wholly owned subsidiary, Litton Loan Servicing, LP ("Litton"). Id. ¶¶ 4, 49, 51.

A. Radian, C-BASS, and the Subprime Market

The CCAC alleges that prior to and during the class period, the MBS securitized by C-BASS became particularly risky because they were backed by subprime loans, which themselves had become risky. In addition, the largest proportion of mortgages that had been purchased by C-BASS were located in California and Florida, two locations which the New York Times had reported as accounting for about 21% of all mortgages nationally, and 30% of new foreclosures. Further compounding the riskiness and volatility of C-BASS's assets was the fact that C-BASS did not originate the loans it serviced and securitized, which, according to the plaintiffs, increased the risk that these loans were fraudulently originated. C-BASS also retained the most risky interests in the securitizations it created, including, for example, by accepting the first risk of payment default. Id. ¶¶ 52, 56, 57, 61, 63.

Prior to the class period, interest rates began to rise nationally, which adversely affected subprime borrowers' ability to pay and increased the default risk of subprime mortgage loans.*fn5 According to the plaintiffs, the deterioration of the subprime market gave rise to a material increase in mortgage loan defaults, thus significantly impairing the value of C-BASS's subordinated securitized interests. Because C-BASS had been heavily dependent on bank credit lines for its liquidity, the impaired value of C-BASS's subordinated securitized interests, which had served as the collateral for its bank loans, caused "a monumental liquidity crisis" for C-BASS. Id. ¶¶ 65-67.

The CCAC lists additional factors that it claims contributed to "an increasingly difficult operating environment at C-BASS." First, it states that C-BASS began to experience an increase in early payment defaults by borrowers, indicating that the borrowers of the loans purchased by C-BASS had not been properly qualified. Second, there was an increase in investor rejections of loans that C-BASS sought to securitize, which was primarily the result of defective appraisals, incorrect credit reports, and missing documentation. This forced C-BASS to find other investors, who often offered less attractive terms for the loans, or to place the loans in its own portfolio. C-BASS further experienced an increase in mortgage delinquency rates, but also purchased "increasingly risky mortgage products." Finally, the subprime market had become increasingly competitive, as evidenced by shrinking margins between the interest rates on purchased loans and the rates offered to the purchasers of CBASS's securitizations. Id. ¶ 78.

According to the CCAC, a number of former employees of C-BASS and Radian Guaranty, a Radian subsidiary, stated that the deteriorating conditions experienced generally by subprime market participants prior to and during the class period caused the quality of the subprime mortgage pools securitized by C-BASS to decline.*fn6 CW 3, a former C-BASS employee, said that default rates increased during 2006 into 2007. CW 2, another former C-BASS employee, stated that there was a continuous decline in the quality of loans C-BASS purchased beginning in 2005, and that from 2005 to 2007, C-BASS purchased increasing amounts of high-risk loans. Id. ¶¶ 79-81.

The CCAC further claims that C-BASS's management knew how poor its mortgage pools were performing during the class period because Litton's website states that "Litton services every C-BASS issued deal." Nonetheless, C-BASS was intent on securitizing defective mortgages so that it could procure the liquidity necessary to purchase more subprime loans. CW 1 also stated that C-BASS was so eager to purchase mortgages that, in many instances, C-BASS would "eat" bad loans it purchased even though it had the right to "put" loans back to the originators. Id. ¶¶ 82, 87.

CW 1, a former C-BASS employee, "indicated" that Radian was "knowledgeable" about loans in C-BASS's portfolio because it maintained a systematic process for monitoring instances when borrowers defaulted on mortgage loans. CW 4, a former Vice President of Radian Guaranty, stated that beginning in 2006, he and other senior members of Radian's management readily witnessed a higher rate of loan delinquencies. CW 5, another former Vice President of Radian Guaranty, acknowledged an increase in riskier residential mortgage loans in the market in 2006 and stated that Radian was hesitant to insure such loans. CW 5 further recalled that defaults and foreclosures began to rise in the 2005-2006 time frame, which resulted in an increase in claims filed against Radian. Id. ¶¶ 84-86.

The plaintiffs claim that the combination of adverse subprime conditions and high-risk operations resulted in margin calls to C-BASS from its creditors. These calls significantly drained C-BASS of liquidity, leaving C-BASS without sufficient cash to operate and impairing the value of Radian's investment in C-BASS. The CCAC further alleges that the defendants knew or recklessly ignored the situation at C-BASS based on the fact that Radian and C-BASS maintained a close business relationship. Id. ¶¶ 93-94.

Various statements made by the defendants are alleged in support of the CCAC's contention that Radian and C-BASS maintained a close business relationship. These statements include: (1) a statement in a letter from Ibrahim to Radian's shareholders in the Company's 2005 Annual Report, which stated that "[i]n holding board seats . . . Radian maintains an active involvement in strategic activities at both C-BASS and Sherman Financial"; (2) another statement in the 2005 letter that "Mark [Casale], who sits on the boards of C-BASS and Sherman Financial . . . , has the additional responsibility of driving growth for the mortgage credit risk business"; (3) a statement by Ibrahim in a letter in the Company's 2006 Annual Report that Radian's "relationships with C-BASS and Sherman . . . provide timely and valuable insights into the consumer-credit marketplace." The defendants also point to a statement on Litton's website that Litton aims to "ensur[e] the interests of C-BASS, Litton, Litton's customers, and . . . investors are aligned. This integration of what were traditionally separate mortgage business lines is what makes [Litton] unique . . . ." Id. ¶¶ 94-97.

B. Allegedly Misleading Statements Made During the Class Period

The class period begins on January 23, 2007. On that date, Radian issued a press release announcing its financial results for the fourth quarter and fiscal year of 2006. For fiscal year 2006, the company reported a net income of $582.2 million and diluted net income of $7.08 per share. Ibrahim commented:

Radian delivered record net income and grew book value by 16.1 percent, despite a challenging operating environment . . . This performance demonstrates that our strategy to focus on diversification while maintaining a strict risk management culture continues to deliver long-term value.

Forecasts for interest rate stability, strong employment and improved persistency bode well for the mortgage insurance industry. In this environment, we believe we are well positioned to benefit over the long term from both cyclical and structural opportunities in the mortgage market.

Id. ¶ 131. With respect to C-BASS, Ibrahim further stated that "[i]n the Financial Services segment, both C-BASS and Sherman continued to be important and steady contributors to Radian's results." Id.

The next day, January 24, 2009, Radian held a conference call with analysts and investors to discuss Radian's earnings and operations. During the call, Quint stated:

During the fourth quarter, C-BASS recovered most of the hedge losses that had been booked in prior quarters. While the subprime origination business is in a state of uncertainty, an environment like this typically creates opportunities for C-BASS to purchase mispriced assets. We feel good about C-BASS's prospects for 2007, although there is clearly some uncertainty around these expectations.

Id. ¶ 132. Following the statements on January 23 and 24, the price of Radian stock rose to $60.18 per share. Id. ¶ 133.

On February 6, 2007, Radian and MGIC announced that they had agreed to merge. They also announced that they had agreed to sell half of their combined interest in C-BASS. According to CW 1 - a C-BASS employee - the sale of C-BASS would add greatly to the value of MGIC and Radian shares because C-BASS's financial statements would not have to be consolidated with the combined entity, thereby excluding its debt from the combined entity's balance sheet. Id. ¶ 121.

On March 1, 2007, Radian filed its form 10-K for the fiscal year ending December 31, 2006. This form reported that Radian's net income attributable to its financial services segment was $257.0 million for 2006, of which C-BASS accounted for $133.9 million. The form further reported that:

As a holder of credit risk, our results are subject to macroeceonomic conditions and specific events that impact the credit performance of the underlying insured assets. We experienced generally positive results throughout the business for the year ended December 31, 2006, led by strong credit performance and good production despite the challenging business production environment for mortgage insurance and financial guaranty insurance.

For 2006, the financial services segment showed another year of strong earnings and return on investment, which was, in part, a result of the relatively low interest rate and favorable credit environment . . . In addition, both C-BASS and Sherman were positively impacted in the fourth quarter of 2006 . . . and C-BASS recovered most of the hedge losses that had been incurred in prior quarters. Despite the significant credit spread widening that has occurred in the subprime mortgage market during the first quarter of 2007, which could produce . . . losses for C-BASS during the first quarter, we expect that both C-BASS's and Sherman's results for 2007 will remain fairly consistent with their 2006 results, as both companies stand to benefit from recurring sources of earnings . . . and, while the sub-prime origination business is currently uncertain, C-BASS typically looks for opportunities to purchase mispriced assets in such an environment.

Id. ¶ 134. Included in this filing was a certification that Radian's CEO and CFO had "evaluated the effectiveness" of the company's disclosure controls," and that "there was no change in [Radian's] internal controls over financial reporting that occurred during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, [Radian's] internal control over financial reporting." Id. ¶¶ 126-27.*fn7

On April 24, 2007, Radian issued a press release announcing its financial results for the first quarter of 2007, ending March 31, 2007. The company reported net income of $113.5 million and diluted net income per share of $1.42. Ibrahim commented:

Our primary book was not significantly affected by the disruptions in the subprime market in recent months. I believe this is a validation of our long-term approach to risk management in all areas, including sub-prime and Alt A, where we have remained disciplined in diversifying our book of business across geographies, products, clients and origination years.

Id. ¶ 136. With regard to C-BASS, the company stated that "In the financial services segment, net income was $10.8 million, down from . . . the same period last year, primarily as a result of an operating loss at C-BASS." Id.

The next day, April 25, 2007, Radian held a conference call with analysts and investors. During the call, Ibrahim stated:

C-BASS reported a disappointing first quarter. As most of you learned from Bruce Williams, co-founder and CEO of C-BASS, who joined the MGIC earnings call earlier this month, C-BASS reported a pre-tax loss for the first quarter. As Bruce mentioned, the company expects a return to profitability in the second quarter and a pre-tax return for the year of 15% to 20%, which translates into $150 to $200 million in pre-tax earnings for the full year, of which Radian's share is 46%. The full transcript of Bruce's remarks is available on our website in the SEC filings.

Id. ¶ 138. During the call, Quint also remarked:

You have obviously heard a lot about C-BASS's first quarter, along with the expectation for improvement over the rest of the year as they expect the market to stabilize at current levels. We have started to see some evidence of this stabilization in the second quarter.

Id. In addition, the following exchange took place between the individual defendants and Bruce Harting, an analyst from Lehman Brothers:

HARTING: On the C-BASS, understanding that Bruce Williams said that, but is it just simply that the inventory of loans had to be repriced; and now we move forward at a tighter bid? I didn't quite follow the logic on why the immediate return to profitability. QUINT: The portfolio is marked-to-market based on the changed spread. So at this point, they are comfortable that they can resume profitability.

HARTING: Have they seen real-time signs of bids for their securitizations?

CASALE: Oh, yes. Remember, Bruce, they executed securitizations through that, even through the turmoil, which is a testament to their name and reputation in the market. It is just when, at the end of the quarter, when they had to mark this stuff it was at an all-time wide. Spreads were at an all-time wide. IBRAHIM: Again, Bruce, as you know, when these kind of market conditions occur, while everybody gets hurt, the most respected players in the market enjoy better executions than the others. The differentiation widens. So being the best player in a tough group of peers means you get hurt, but you also get hurt less.

Id. ¶ 140.

On May 10, 2007, Radian filed its Form 10-Q for the first quarter of 2007, the period ending March 31, 2007. This form reported that Radian's net income attributable to the financial services segment for the first quarter of 2007 was $10.0 million and that "equity in net income of affiliates" decreased 61% to $22.8 million for the quarter, which was driven by a $6.8 million loss related to C-BASS. The form stated:

As a holder of credit risk, our results are subject to macroeconomic conditions and specific events that impact the production environment and credit performance of our underlying insured assets. We experienced mixed results during the first quarter of 2007. Positively, we had strong production in both mortgage insurance and financial guaranty insurance. However, mortgage insurance losses incurred were higher than expected and our financial services segment results were negatively impacted by the subprime mortgage market disruption which significantly affected C-BASS' financial performance in the quarter. . . . .

For the quarter ended March 31, 2007, the financial services segment had mixed results. Sherman continued its consistent strong earnings; however, C-BASS incurred a loss of approximately $15 million as credit losses and credit spread widening in the subprime mortgage market impacted their results. . . . C-BASS is expected to return to profitability over the balance of the year, assuming the subprime mortgage stabilizes at current levels.

Id. ¶ 142. The report also deemed the fair value of C-BASS to be greater than $967 million. The CCAC alleges, however, that the decline in the value of C-BASS's securitizations and other assets, which had collateralized C-BASS's loans, resulted in massive margin calls from lenders that left C-BASS on the "verge of bankruptcy" by March 31, 2007. The fair value of Radian's investment in C-BASS at that point, according to the CCAC, was "materially less" than the $445 million carrying value reported by the May 10, 2007, Form 10-Q. This filing also stated: "We have presented our condensed consolidated financial statements on the basis of accounting principles generally accepted in the United States of America." Id. ¶¶ 109, 113, 117, 118.

On July 24, 2007, Radian issued a press release announcing its financial results for the second quarter of 2007. The company reported net income of $21.1 million and diluted net income per share of $0.26. Ibrahim commented:

Our second quarter results clearly illustrate the credit challenges in today's mortgage market, but I believe they also reflect long-term positive trends for our business. Market conditions, particularly in California and ...

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