Ten days ago, the 2nd Circuit stamped its approval on a district court’s denial of class certification in N.J. Carpenters Health Fund v. RALI Series 2006-Q01 Trust, a securities case involving mortgage-backed securities (MBS). The court upheld the determination that a class cannot exist if individual questions as to the investors’ knowledge of alleged misstatements dominate the claims common to all plaintiffs—a decision that was greeted with open arms by defendants in MBS class actions, and that may have an impact well beyond MBS litigation.

NJ Carpenters involved class certification in two related cases. Both asserted negligence-based securities claims. The plaintiffs alleged that defendants, issuers and underwriters of MBS, made material misstatements and omissions in offering documents, violating Sections 11, 12(a)(2) and 15 of the Securities Act of 1933.

Specifically, the plaintiffs alleged that the offering documents for securities were misleading about the underwriting guidelines applied to mortgages bundled into MBS. The defendants countered, arguing that issues regarding each investor’s knowledge of the misstatements or omissions predominated over issues of general liability. The defendants asserted that Section 11 created an affirmative defense that precludes liability if a plaintiff knew that the offering documents contained non-truths. Because the classes consisted primarily of sophisticated financial institutions, each had varying levels of knowledge about the underwriting guidelines.

The 2nd Circuit focused—appropriately—on whether common liability issues predominated over individual knowledge defenses. The 2nd Circuit agreed with the lower court that individualized issues would predominate and that knowledge defenses would require extensive individual proceedings. Although the defendants’ evidence of “knowledge” likely would not be enough to successfully plead the defense on the merits, they presented enough evidence to show that individual inquiries into each investor’s knowledge might be necessary.

In addition, the court agreed that the cumbersome class definitions, which the plaintiffs believed would improve their changes of class certification, ultimately doomed class certification. The various classes included MBS purchasers who made their investments at different times, and necessarily had different knowledge about alleged misstatements because of variations in publicly available information. For the 2nd Circuit, this alone eliminated the possibility that the knowledge issues could be handled on a class-wide basis.  

Although the decision seems obvious to many, it actually cut against the grain of several MBS actions in the Southern District of New York. The 2nd Circuit never distinguished those cases but, regardless, this case now provides the blueprint for counsel defending MBS securities class actions. And its impact may well go beyond MBS class actions.

Although the 2nd Circuit attempted to limit the significance of its holding—“[w]e note, however, that our review is limited to the class definition that the judge rejected, and to the record as it stood at the time of this motion to certify” —the rationale can apply equally in other knowledge-based securities claims.

Specifically, NJ Carpenters bolsters defense arguments that individual knowledge of misstatements among class members requires denial of certification. This was thought by some to be the case after the 2nd Circuit’s decision in In re Initial Public Offerings Securities Litigation (2006)—reversing class certification because issues of individual knowledge predominated over common issues—but it never turned out quite the way many legal experts expected.

Whether this new decision strikes a more permanent blow to class certification in securities class actions remains to be seen, but for now, this is good news for defendants.