U.S. Southern District Judge Deborah A. Batts shut down underwriter defendants’ attempt to avoid proceeding with discovery in a $7.7 billion mortgage-backed securities fraud action, by arguing that an automatic bankruptcy stay applied to the underwriter defendants in addition to the debtor defendants.
The current discovery dispute arises from a proposed class action lawsuit against the now bankrupt NovaStar Mortgage Inc. (“NMI”) and NovaStar Mortgage Funding Corporation (“NMFC”) and the investment banks that underwrote $7.7 billion of NovaStar mortgage-backed securities issued in 2006. The underwriter defendants include RBS Securities Inc., Deutsche Bank Securities Inc., and Wells Fargo Securities LLC. The class action alleges that the offering documents failed to disclose that NovaStar had abandoned its underwriting standards in the wake of the 2009 housing crisis, which caused significant losses for investors.
NovaStar initiated voluntary bankruptcy proceedings on July 20 in the U.S. Bankruptcy Court for the District of Maryland. The underwriter defendants then argued that the automatic bankruptcy stay bars them from continuing with discovery in the class action. They reasoned that the automatic stay applied because (1) continuation of the action would have an “immediate adverse economic consequence” for the debtor defendants’ reorganization and (2) the underwriter and debtor defendants are “inextricably woven” such that a finding of liability would necessarily implicate the debtor defendants.
Judge Batts rejected the underwriter defendants’ arguments, concluding that “the automatic stay provision of the bankruptcy code does not operate to stay this action except as to the Debtor Defendants [NovaStar].” The Court rejected the “immediate adverse economic consequence” argument, finding that “the mere possibility of a future indemnification claim [against debtor defendants] will not support application of the automatic stay” and neither will concerns about the creation of adverse precedent or collateral estoppel, given that the bankruptcy operates to deprive the debtor defendants of a full and fair opportunity to litigate the claims. Finally, Judge Batts rejected the “inextricably woven” rationale because the underwriter defendants and the debtor defendants, NMI and NMFC, are separate entities and the claims against them are legally distinct; therefore, “the concern that Debtor Defendants are the ‘real party defendant’ is not present in this Action.”
The case is captioned New Jersey Carpenters Health Fund v. Royal Bank of Scotland Group, PLC, et al., case number 1:08-cv-05310, in the U.S. District Court for the Southern District of New York.