Introduction
This article examines the legal concept of “reasonable care” in the context of securities fraud, focusing on the case of Federal Housing Finance Agency v. Nomura Holding America. This case highlights the potential liability of securities offerors for material misstatements, even when they claim to have followed industry standards for due diligence.
Background: The Securities Exchange Act of 1934 and Reasonable Care
The Securities Exchange Act of 1934 plays a crucial role in regulating the securities market and protecting investors from fraudulent activities. Section 12(a)(2) of the Act provides a legal remedy for investors who have been sold securities based on false or misleading statements. However, the Act also offers a defense for offerors who can demonstrate that they acted with “reasonable care” and were unaware of the misstatements.
The concept of “reasonable care” is central to this defense. It essentially means that the offeror took all reasonable steps to ensure the accuracy of their statements, considering the circumstances and the industry standards for due diligence.
The Nomura Case: A Question of Due Diligence
The case of Federal Housing Finance Agency v. Nomura Holding America revolved around the sale of residential mortgage-backed securities (RMBS) in the lead-up to the 2007 housing market crash. Nomura, a financial institution, sponsored and underwrote these securities, which were then sold to government-sponsored enterprises Freddie Mac and Fannie Mae.
In the offering documents, Nomura asserted that the underlying mortgage loans backing the RMBS were originated following the relevant underwriting guidelines. These guidelines are essentially criteria used to assess borrowers’ creditworthiness and determine the risk associated with lending them money.
The Allegations and Nomura’s Defense
Following the collapse of the housing market, the value of the RMBS plummeted, leading to significant losses for Freddie Mac and Fannie Mae. The Federal Housing Finance Agency (FHFA), acting as conservator for the two entities, filed a lawsuit against Nomura, alleging violations of federal and state securities laws.
The FHFA argued that Nomura misrepresented the quality of the underlying loans and failed to conduct adequate due diligence. Nomura, in its defense, claimed that it had exercised reasonable care by conducting industry-standard due diligence, including a credit review of a sample of high-risk loans and an audit.
The Court’s Decision and the Importance of Thorough Due Diligence
The district court ruled in favor of the FHFA, finding that Nomura had not met the “reasonable care” standard. Despite Nomura’s claim of following industry norms, the court determined that the company had overlooked or ignored several “red flags” revealed during their audit, indicating potential non-compliance with underwriting guidelines.
This case emphasizes a crucial point: simply adhering to general industry practices for due diligence may not be sufficient to establish a “reasonable care” defense. The court emphasized the importance of a thorough and diligent investigation, going beyond superficial checks and addressing any potential warning signs that emerge during the due diligence process.
Conclusion
Federal Housing Finance Agency v. Nomura Holding America serves as a stark reminder of the critical importance of robust due diligence in securities offerings. The court’s decision underscores that offerors have a responsibility to conduct thorough investigations, address red flags, and ensure the accuracy of their representations to investors. This case serves as a valuable lesson for all participants in the securities market, highlighting the potential consequences of inadequate due diligence.
External Links
- Securities Exchange Act of 1934
- Federal Housing Finance Agency (FHFA)
- Due Diligence for Investors (SEC Investor Bulletin)
- Due Diligence (Investopedia)
- Securities Fraud (Legal Information Institute, Cornell Law School)