Searching over 5,500,000 cases.


searching
Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.

Luminent Mortgage Capital, Inc. v. Merrill Lynch & Co.

August 20, 2009

LUMINENT MORTGAGE CAPITAL, INC., ET AL.
v.
MERRILL LYNCH & CO., ET AL.



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

MEMORANDUM

Presently before the Court is Defendants' Motion to Dismiss the Amended Complaint. (Doc. No. 13). For the following reasons, the Amended Complaint will be dismissed.

I. BACKGROUND

This is a securities fraud action brought by real estate investment trusts (collectively, "Plaintiffs") that purchased mortgage-backed securities in August 2005. (See Am. Compl. ¶¶ 1, 13.) Plaintiffs purchased the mortgage-backed securities from mortgage banking institutions associated with Merrill Lynch (collectively, "Defendants"), which underwrote and issued the securities. (Id. ¶ 14.) In general, mortgage-backed securities are long-term debt instruments that represent the income stream from a pool of mortgages. (Id. ¶¶ 24, 27.) Mortgage banking institutions issue mortgage-backed securities and sell them to investors who receive the income stream from the underlying pool of mortgage loans. See generally United States v. York, 112 F.3d 1218, 1219-20 (D.C. Cir. 1997) (explaining concept of mortgage-backed securities). In the time since Plaintiffs purchased the mortgage-backed securities from Defendants in August 2005, the mortgage industry and the financing methods that the industry has historically relied upon "have deteriorated significantly and in unprecedented fashion." (See Luminent Mortgage Capital, Inc., Quarterly Report (Form 10-Q), at 7 (Dec. 27, 2007).)*fn1 These "[c]hanged economic conditions," including "dislocations in the sub-prime mortgage sector" and "in the broader mortgage market," have "adversely affected" Plaintiffs' investment portfolio. (Id. at 52.) There can be no serious dispute that after Plaintiffs purchased the mortgage-backed securities at issue, the mortgage industry and mortgage-backed securities have faced historically unprecedented declines with widespread consequences. See generally Rachel D. Godsil & David V. Simunovich, Protecting Status: The Mortgage Crisis, Eminent Domain, and the Ethic of Home Ownership, 77 Fordham L. Rev. 949, 949-50 (Dec. 2008) (noting that "[t]he link between the mortgage crisis and the full-scale financial meltdown has led to bipartisan support for a degree of government intervention unseen since the Great Depression"); Helping Families Save Their Homes, The Role of Bankruptcy Law: Hearing before the Senate Judiciary Committee, 110th Cong. (Nov. 19, 2008) (testimony of Adam J. Levitin, Professor, Georgetown University Law Center) ("Because most residential mortgages are securitized into widely held securities, unprecedented default rates in the residential mortgage market affect not just mortgage lenders, but capital markets globally."). In short, "[t]he disruption in the [residential mortgage-backed securities market] is profound." (See Luminent Mortgage Capital, Inc., Quarterly Report (Form 10-Q, at 9 (Mar. 28, 2008).)

Plaintiffs brought this lawsuit alleging that Defendants misrepresented and failed to disclose material information relating to the mortgage-backed securities that Plaintiffs purchased. (See Am. Compl. ¶ 14.) Plaintiffs allege that because of Defendants' misrepresentations, the mortgage-backed securities that Plaintiffs purchased carry a higher risk and could offer less return than they expected. (Id. ¶¶ 44, 77.)

A. The Parties

Plaintiffs are Luminent Mortgage Capital, Inc., a Maryland corporation, and Mercury Mortgage Finance Statutory Trust, a Maryland business trust. (Id. ¶¶ 1-2.) Defendants are Merrill Lynch & Co., Inc. ("Merrill Lynch"), and six Merrill Lynch subsidiaries. (Id. ¶¶ 14-20.) Defendant Merrill Lynch is a publicly-traded Delaware corporation that underwrites and issues mortgage-backed securities through its subsidiaries. (Id. ¶ 14.) Defendant Merrill Lynch, Pierce, Fenner & Smith, Inc., is a registered broker-dealer and subsidiary of Merrill Lynch that underwrites and issues mortgage-backed securities. (Id. ¶ 15.) Defendants Merrill Mortgage Investors, Inc., and Merrill Lynch Mortgage Lending, Inc., are subsidiaries of Merrill Lynch that purchase and securitize residential mortgages. (Id. ¶¶ 16-17.) Defendants Merrill Lynch Mortgage Holdings, Inc., and Merrill Lynch Mortgage Capital, Inc., are Merrill Lynch subsidiaries that purchase residential mortgages. (Id. ¶¶ 18-19.) Defendant Merrill Lynch Mortgage Investors Trust (the "Issuing Trust") is a trust formed by Merrill Lynch that issued the mortgage-backed securities that Plaintiffs purchased. (Id. ¶¶ 20, 26.)

B. The Mortgage-Backed Securities that Plaintiffs Purchased

In August 2005, Plaintiffs purchased a class of Mortgage Loan Asset-Backed Certificates, Series 2005-A6 (the "Certificates"), a type of mortgage-backed security. (Id. ¶¶ 22-23.) Defendant Issuing Trust issued the Certificates pursuant to a Pooling and Servicing Agreement and backed the Certificates with nearly $1 billion of underlying mortgage loans. (Id. ¶ 23.) By investing in the Certificates, Plaintiffs effectively purchased a beneficial ownership interest in the pool of underlying mortgage loans that Defendant Issuing Trust acquired and securitized and that Defendant Merrill Lynch then purchased, as underwriter, and resold to investors. (Id. ¶ 24.) Defendant Issuing Trust issued fourteen classes of the Certificates. (Id. ¶ 26.) Each class had different characteristics relating to how and when the holders received payment distributions. (Id. ¶ 27.) Payment distributions for most of the Certificates resembled a cascade, or "waterfall," in which holders of the most senior class of Certificates received payments first, followed by holders of the next most senior class, and so on until holders of the most junior class of Certificates received payments. (Id.)

Plaintiffs purchased three classes of Certificates, referred to as the Class B-3, Class C, and Class P Certificates (collectively, the "Junior Certificates"). (Id. ¶¶ 26, 62.) None of the Junior Certificates was senior or high priority. On the contrary, the Class B-3 Certificates that Plaintiffs purchased were the most junior of all the Certificates and the last in line for payment distributions. (Id. ¶¶ 26-30.) Holders of the Class B-3 Certificates were not entitled to payments received on the mortgage loans until all of the more senior holders were paid. (Id. ¶ 28.) This made them riskier investments than the more senior Certificates. (Id. ¶ 32.) The other two classes of Certificates that Plaintiffs purchased, the Class C and Class P Certificates, were not in line for payment distributions at all since they represented a different source of income than the prioritized Certificates. The source of income for the Class C Certificates was limited to "excess cash-flow" resulting from the mortgage loans. (Id. ¶¶ 29, 32.) "Excess cash-flow" is the amount of interest received on the mortgage loans that remains after all the more senior holders have been paid and after certain losses have been taken into account. (Id.) Thus, the Class C Certificates represented a residual interest in the pool of mortgage loans. The source of income for the Class P Certificates was limited to a pool of "prepayment penalties" that homeowners made on the mortgage loans. (Id. ¶ 30.) Holders of the Class P Certificates were entitled to receive any prepayment penalties incurred by homeowners upon paying off all or a substantial portion of the mortgage loan in advance of the expiration of the prepayment penalty term. (Id. ¶ 30.) Like the Class C Certificates, the Class P Certificates were not in line to receive payments made on the underlying mortgage loans. For all of these reasons, the Junior Certificates as a whole were riskier investments than the higher prioritized Certificates. (Id. ¶ 29.)

C. Material Terms of the Junior Certificates

Investors valued the Certificates based on the characteristics of the underlying mortgage loan pool. Thus, material characteristics of the Class B-3 Certificates included the purpose of the mortgage loans, the type of properties being mortgaged, the original interest rates owed on the mortgage loans, the margin rates earned on the mortgage loans, and the homeowner's FICO score ("Fair Isaac's Credit Risk Score"). (Id. ¶ 33.) These factors were material to the investor because they predicted the likelihood of the homeowner prepaying, defaulting, or becoming delinquent on the mortgage loan, thereby affecting the value and risk of the loan. (Id. ¶ 34.) In addition to these factors, prepayment penalty terms were material characteristics of the Class C and Class P Certificates. (Id. ¶ 35.) The Class P Certificates depended on prepayment penalties as the only source of return on investment. (Id. ¶ 37.) The Class C Certificates likewise depended in part on prepayment penalties since greater prepayment activity and payments to holders of Class P Certificates resulted in a smaller pool of loans remaining to generate excess cash-flow to pay holders of Class C Certificates. (Id. ¶ 38.) Thus, for one who invested in both the Class C and Class P Certificates, the prepayment penalty revenues gained on the Class P Certificates offset the reduction in the residual cash-flow on the Class C Certificates, and vice-versa. (Id. ¶ 40.) In other words, the Class C and Class P Certificates hedged against each other. (Id. ¶ 41.)

The Class C and Class P Certificates described prepayment penalties of the "hard" or "soft" variety. (Id. ¶ 36.) "Hard" prepayment penalty terms impose penalties on a homeowner regardless of the reason for the advance payment. (Id.) "Soft" prepayment penalty terms, on the other hand, allow the homeowner to avoid a penalty when the prepayment is the result of the homeowner's sale of the property. (Id.) Payment distributions under the Class C and Class P Certificates could suffer if the underlying mortgage loans were weighted toward "soft" prepayment penalties. This is because "soft" prepayment penalties make it more likely that homeowners who are able to prepay without a penalty do so, which potentially results in smaller payments to holders of the Class C Certificates. (Id. ¶ 42.) In addition, "soft" prepayment penalties could mean fewer penalties collected, which potentially results in smaller payments to holders of the Class P Certificates. (Id.) A prevalence of "soft" prepayment penalty terms in the underlying mortgage loan pool could result in higher risk and less return to investors in the Class C and Class P Certificates. (Id. ¶ 44.)

The quality of the issuer's due diligence examination was another material characteristic of all the Certificates. (Id. ¶ 45.) The issuer's due diligence was important because the mortgage loans were the issuer's sole assets and investors did not have access to the underlying loan files and other documentation from which they could independently evaluate the quality of the mortgage loans. (Id.)

D. Marketing of the Junior Certificates to Plaintiffs

In July 2005, Defendants' salesperson in San Francisco, Keith Tomao ("Tomao"), contacted Plaintiff's CEO in Philadelphia, Trezevant Moore ("Moore"), to offer Plaintiff the Class B-3, Class C, and Class P Certificates as a "3 pack."*fn2 (Id. ¶¶ 46, 123.) On or about July 26, 2005, Tomao sent Moore an Excel spreadsheet (a "deal tape") that described characteristics of the mortgage loans underlying the Certificates. (Id. ¶ 47.) The deal tape listed the approximately 3200 mortgage loans in the pool and contained tens of thousands of specific factual representations concerning the mortgage loans underlying the Certificates, including where the loans originated and the existence of any prepayment penalties. (Id. ¶ 48.) Tomao also sent Moore a prepayment matrix that described on a state-by-state basis the prepayment penalty terms of 78.26% of the mortgage loans in the pool. (Id. ¶¶ 25, 47.) Tomao sent Moore a similar document that provided prepayment penalty information for another 18.76% of the mortgage loans in the pool. (Id. ¶¶ 47, 53-55.) In addition, Tamao sent Moore a document that provided a "detailed explanation" of the prepayment terms of the mortgage loans. (Id. ¶ 47.) On or about August 20, 2005, Tomao sent Moore a term sheet. (Id.)

1. Tomao's Representations Regarding Prepayment Penalties

Although the deal tape contained data about the prepayment penalty terms of the mortgage loans, it did not expressly address the distribution of "hard" and "soft" prepayment penalty terms. (Id. ¶ 49.) On August 15, 2005, Tomao advised Plaintiffs' Assistant Portfolio Manager in Philadelphia, Zheng Wang, that all loans on the deal tape featuring prepayment penalties had "hard" penalties unless the prepayment matrix specifically stated that such penalties were not permitted in the jurisdiction where the loan originated. (Id. ¶¶ 53, 123.) For example, if the prepayment matrix indicated that the Commonwealth of Pennsylvania permitted lenders to impose hard prepayment penalties and the deal tape indicated that a loan originated in Pennsylvania and featured a prepayment penalty, the prepayment penalty must be of the "hard" variety. (See id. ¶ 54.) According to the prepayment matrix, the vast majority of jurisdictions permitted "hard" prepayment penalties. (Id. ¶ 55.)

2. Tomao's Representations Regarding Loan Quality and Due Diligence

In August 2005, before Plaintiffs purchased the Junior Certificates, Tomao told Moore that the mortgage loans underlying the Certificates were "Alternate-A" loans, which are loans that involve prime quality collateral and are generally made to borrowers with strong FICO scores. (Id. ¶ 58.) Tomao also told Moore that "Merrill" (i.e., all of the Defendants) had performed due diligence on the loan portfolio consistent with industry custom, standards, and practice. (Id. ¶ 59.) As part of its due diligence, Defendant "Merrill" reviewed a large sample of the loan documentation and conducted a detailed statistical analysis to ensure that the quality of the loans was consistent with the expected yields. (Id.) Tomao told Moore that the due diligence confirmed that the information in the deal tape was accurate, that the mortgage loans met the underwriting criteria, and that the mortgage loans were of "Alternate-A" quality. (Id. ¶ 60.)

E. Issuance of the Certificates

The Issuing Trust issued eleven of the fourteen classes of Certificates to the public pursuant to a Prospectus and Prospectus Supplement dated August 26, 2005. (Id. ¶ 31; see also Doc. No. 13, Ex. D at 1 (noting that "[the Issuing Trust] will issue fourteen classes of certificates, eleven of which are offered by this prospectus supplement and the attached prospectus").) The Issuing Trust did not offer the Junior Certificates to the public. (See Doc. No. 13, Ex. D at S-71 (noting that the Junior Certificates "are not being offered hereby").) Rather, the Issuing Trust sold the Junior Certificates in a private offering.*fn3 On the front of each of the Junior Certificates that Plaintiffs purchased, it states in bold capital letters:

This Certificate has not been and will not be registered under the Securities Act of 1933, as amended, or the securities laws of any State and may not be resold or transferred unless it is registered pursuant to such Act and laws or is sold or transferred in transactions that are exempt from registration under such Act or under applicable State law and is transferred in accordance with the provisions of . . . the Agreement. (Doc. No. 13, Ex. 13 at unnumbered 1, 10, 18 (emphasis and capital letters omitted).) On August 30, 2005, based on the deal tape, term sheet, prepayment matrix, and Tomao's representations to Moore, Plaintiffs purchased the Junior Certificates as a "3 pack" for $26 million. (Id. ¶¶ 62, 165.) Plaintiffs do not specify from which of the seven Defendants they purchased the Junior Certificates. (See id. ¶ 62 ("Plaintiff acquired the Junior Certificates . . .").)

F. Post-Purchase Discoveries

Between April 1 and April 13, 2007, Plaintiff received and reviewed a sampling of approximately eighty loan files from Defendants concerning the mortgage loans. (Id. ¶ 63.) The files contained actual documentation underlying a subset of mortgage loans in contrast to the summary information contained in the deal tape, which omitted the documentation. (Id.) The loan documentation showed that fifty-six of the eighty loans in the sample had "soft" prepayment penalty terms. (Id. ¶¶ 66-67.) The deal tape -- in conjunction with Tomao's representation -- indicated that these loans had "hard" prepayment penalty terms. (Id.) The documentation also showed that five of the eighty loans had shorter prepayment penalty periods than the deal tape indicated, and that four of the eighty loans had no prepayment penalty terms at all while the deal tape indicated a three-year prepayment penalty period. (Id. ¶¶ 70-71.) In addition, there were five other inconsistencies between the deal tape and the actual loan documentation: (1) a condominium was classified on the deal tape as a single family residence; (2) a homeowner with a 593 FICO score was listed on the deal tape as having a 627 FICO score; (3) a mortgage at 6.875% appeared on the deal tape at 6.625%; (4) a cash-out for home-equity was classified on the deal tape as a refinancing for a better rate term; and (5) a loan on the deal tape with a 2.75% margin rate appeared in the documentation to have a 2.25% margin rate, meaning that there would be less excess cash-flow stemming from the loan for holders of Class C Certificates. (Id. ¶ 70.)

Plaintiffs allege that the characteristics of the loan portfolio as a whole "did not comport with the information provided in the deal tape and the term sheet," and as a result, "a review of the performance of the loan portfolio over time demonstrates an unusually high rate of early payment defaults, as well as unusually high rates of delinquencies." (Id. ¶¶ 77, 80.) Plaintiffs contend that the "performance [of the underlying loans] is so poor that any competent, industry-accepted level of due diligence on the underlying loans would have detected the inaccuracies." (Id. ¶ 81.) On September 21, 2007, Plaintiffs demanded rescission of the Junior Certificates. (Id. ¶ 86.) Defendants refused, and Plaintiffs then initiated this lawsuit. (See Doc. No. 1.)

The Amended Complaint sets forth ten causes of action based on federal and state laws. In Count I, Plaintiffs make a claim under Sections 10(b) and 20 of the Securities and Exchange Act of 1934, and Rule 10b-5 promulgated under Section 10(b), alleging that Defendants knowingly or recklessly misrepresented the composition of the pool of mortgage loans underlying the Junior Certificates and falsely represented that Defendants had conducted adequate due diligence. (Am. Compl. ¶¶ 91-92.) In Count II, Plaintiffs make a claim under Section 12(2) of the Securities Act of 1933, alleging that the Junior Certificates were "issued simultaneously with, and as an integral part of a public offering," and that Defendants misrepresented the characteristics of the underlying mortgage loans and adequacy of their due diligence. (Id. ¶¶ 107-08.) In Count III, Plaintiffs make a claim of common law fraud/deceit, alleging that Defendants made false statements and material omissions knowing that they were false and misleading or with reckless disregard as to whether the statements and omissions were false and misleading, and with the intent of inducing Plaintiffs to rely on them. (Id. ¶ 117.) In Count IV, Plaintiffs make a claim under the Pennsylvania Securities Act of 1972, alleging that Defendants misrepresented the composition of the pool of mortgage loans and falsely represented that they had conducted adequate due diligence in connection with Defendants' offer to sell the Junior Certificates to Plaintiffs in Philadelphia, Pennsylvania. (Id. ¶ 124.) In Counts V and VI, Plaintiffs make claims under the California Corporate Securities Law of 1968, alleging that Defendants' initial offer and subsequent misrepresentations ...


Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.