In a decision which could have significance in other cases in which investors in failed banks seek to recover their losses, on January 14, 2011, the United States District Court for the Northern District of Georgia dismissed an investor class action against the directors of the holding company which owned Haven Trust Bank, a Duluth Georgia based bank which was closed by the Georgia Department of Banking on December 12, 2008. Patel v. Patel, et al., U.S.D.C., ND of Ga., Civil Action No. 1:09-cv-3684-CAP (Order, 1/14/11). In dismissing the case at the pleadings stage, the Court identified several difficult obstacles that plaintiffs in such cases will have to overcome in order to proceed with a claim, including the difficulty of establishing that their losses were caused by something other than the catastrophic turmoil felt by the banking industry as a whole, which has resulted in hundreds of bank failures to date, with more to come.

Haven Trust Bancorp, Inc. was organized as a holding company for Haven Trust Bank and had no business operations other than the bank, which was its wholly owned subsidiary. The named defendants in the case were the directors of the holding company, and also served as the directors of the bank itself. The bank had grown very rapidly, from $29 million in assets in its first full year of operation in 2000 to approximately $575 million by 2008. Like many community banks operating in this time period, Haven’s rapid growth was based in large part on the use of non-core funding, including brokered deposits, which were then used for acquisition, development, and construction (ADC) loans and other types of commercial real estate (CRE) lending.

The defendants solicited investors through the use of private placement memoranda (PPMs). When, on December 12, 2008, the bank was closed and the FDIC was appointed as Receiver, Haven Trust stock became worthless. Subsequently, the plaintiff’s brought this lawsuit alleging that the 2006 and 2008 PPMs hid the true financial condition and business operations of the bank, and specifically failed to disclose the bank’s risky lending practices, self-dealing transactions, violations of laws and regulations, and other failures to correct improprieties. The defendants moved to dismiss the complaint for failure to state a legally cognizable claim.

The Court based its dismissal of the complaint on two primary grounds. First, the Court found that the plaintiffs had failed to adequately allege scienter, which means essentially that the plaintiff had failed to put forth allegations of intentional or reckless conduct that were at least as compelling as plausible non-culpable inferences. The Court noted that plaintiffs had failed to allege any of the traditional indicia of potential fraudulent intent, such as insider stock sales. The Court held that plaintiffs’ reliance on the mere fact that the defendants were directors, that they attended meetings, and that they had access to internal documents and reports were insufficient to allege the required strong inferences scienter. The court also held that allegations that the defendants were motivated to commit fraud in order to maintain the dividend stream were legally insufficient.

The Court also found that dismissal was warranted because of the plaintiff’s failure to adequately allege loss causation. The Court pointed out that even if there were misconduct, if the loss suffered by plaintiff was caused by “supervening general market forces or other factors unrelated to the defendant’s misconduct that operated to reduce the value of the plaintiff’s securities, the plaintiff is precluded from recovery”. The Court specifically referenced the sub-prime mortgage and financial crises and their inevitable effect on the bank’s loan portfolio and real estate collateral. The Court stated that: “when the plaintiff’s loss coincides with a market wide phenomenon causing comparable losses to other investors, the prospect that the plaintiff’s loss was caused by the fraud decreases, and a plaintiff’s claim fails when it has not adequately pled the facts which if proven would show that its loss was caused by the alleged misstatement as opposed to intervening events.”

Finally, the Court dismissed the plaintiff’s negligent misrepresentation claims. The Court found that, under the applicable law, in order to support a claim for negligent misrepresentation, there must be a direct communication between the defendants and the plaintiff. The Court held that the PPMs of the holding company were not direct communications by the individual defendants to the plaintiff, and therefore could not support a claim for negligent misrepresentation.

Interestingly, weeks before, on December 29, 2010, the Court had denied a motion by the FDIC to intervene in this case, holding that the claim was separate and distinct from any claim that the FDIC might have on behalf of the failed institution, and holding that the mere fact that the FDIC may ultimately seek to assert its own claim targeting the same source of recovery, i.e., the directors and officers insurance policy, was not a sufficient “interest” in the case to allow the FDIC to intervene. It remains to be seen whether the FDIC will in fact commence its own lawsuit against the defendants on some kind of negligence theory.

The Haven Trust decision makes clear that the mere fact that a bank has failed is not sufficient basis for investors in the failed bank to state a cognizable legal claim. The Court is going to require the same specific allegations of fraudulent intent, as well as the establishment of a causal link between any misconduct and actual loss suffered, that are required in any other investment fraud cases in order for the claims to proceed beyond the pleadings stage.