Amicus Curiae Brief — UJB Financial Corp. v. Shapiro

“\ AP No. 92-267

IN THE

Supreme Court of the Anited States

OcCTORER TERM, 1992

\

UJB FINANCIAL CorRP.. ef al

¥

IRWIN SHAPIRO, ROBERT BASSMAN,

JEROME KATZ, NORMAN SALSITZ.

JEAN LEE and CHAPPAQUA FAMILY TRUST,

Re Sponderts

On Petition For A Writ Of Certiorari

To The United States Court Of Appeals

For The Third Circuit

MOTION FOR LEAVE TO FILE BRIEF

AND BRIEF OF THE AMICUS CURIAE

AMERICAN BANKERS ASSOCIATION

IN SUPPORT OF PETITIONERS

JOHN J. Gite IT

General Counsel

{ ‘ou mse ] of Re cord

MICHAEL F. Crorry

Deputy General Counsel

for Litigation

THOMAS J. GRECO

Assocvate (reneral € ounsel

AMERICAN BANKERS ASSOCIATION

‘ 1120 Connecticut Avenue, N.W.

Washington, D.C. 20036

(PO2) 668-5026

Attorneys for Amicus Cur

hive

September 11, 1992

PRESS OF BYRON S. ADAMS, WASHINGTON, D.C. (202) 347-8203

IN THE

Supreme Court of the Gnited States

OCTOBER TERM, 1992

No. 92-267

UJB FINANCIAL Corp., et al.,

Petitioners,

V.

IRWIN SHAPIRO, ROBERT BASSMAN,

JEROME Katz, NORMAN SALSITzZ.

JEAN LEE and CHAPPAQUA FAMILY TRUST,

Respondents.

es

On Petition For A Writ Of Certiorari

To The United States Court Of Appeals

For The Third Circuit

MOTION FOR LEAVE TO FILE BRIEF AS AMICUS

CURIAE

The American Bankers Association, a trade asso-

ciation representing the interests of the commercial

banking industry, respectfully moves for permission

to file the attached brief as amicus curiae in support

of the Petition for a Writ of Certiorari filed by UJB

Financial Corp., et al.

The consent of all parties to this action for filing

the attached amicus curiae brief has been requested.

The attorneys for the Petitioners have agreed to the

bo

filing of the attached amicus brief. The attorneys for

the Respondents have withheld consent.

The complaint in Shapiro v. UJB Financial Corp.,

964 F.2d 272 (8d Cir. 1992) is all too typical of the

cookie cutter pleadings filed against banks in the wake

of the downturn in the market for commercial real

estate. Among the oft seen claims is the charge that

a bank (or bank holding company) and its officers and

directors have committed securities fraud by failing

to ‘‘provide for adequate loan loss reserves.”’ Jd. at

276 n.6.

Because such suits—even when entirely meritless—

are tremendously expensive for both the parties and

the legal system as a whole, it is imperative that this

Court provide guidance and emphasize that the lower

courts must enforce Rule 9(b)’s requirements for ad-

equately pleading facts to support securities fraud

claims in the context of reserving against loan losses.

This amicus believes that the Third Circuit adopted

the wrong standard which will encourage the contin-

ued filing of such debilitating suits.

Amicus seeks to file the attached brief to emphasize

the importance of this case to the banking industry

and, in particular, to explain the accounting concept

of reserving against loan losses which forms one of

the central issues in the Respondents’ complaint.

Respectfully submitted,

JOHN J. GILL III

Counsel of Record

AMERICAN BANKERS ASSOCIATION

1120 Connecticut Avenue, N.W.

Washington, D.C. 20036

(202) 663-5026

September 11, 1992

QUESTION PRESENTED FOR REVIEW

Did the Third Circuit err in announcing a new,

“relaxed” application of Rule 9(b), Fed. R. Civ. P.,

which flatly conflicts with the standards of the First,

Second and Seventh Circuits, as well as the standard

previously established by the Third Circuit (including

as applied by a different panel of the Third Circuit

on the same day)?

TABLE OF CONTENTS

QUESTION PRESENTED FOR REVIEW

TABLE OF AUTHORITIES

INTEREST OF THE AMICUS CURIAE

REASONS FOR GRANTING THE WRIT

CONCLUSION ......

TABLE OF AUTHORITIES

Page

CASES:

Billard v. Rockwell International Corp., 688 F.2d

Bl Cid Cir... LOBD) ..cccccccecsssesrcncscscvecsvecsesenesssess 7

Blue Chip Stamps v. Manor Drug Stores, 421 U.S.

723, reh’g denied, 427 U.S. 884 (1975) .......... %

Christidis v. First Pennsylvonia Mortgage Trust,

717 F.2d 96 (3d Cir. 1983) ...........cceeesseneeeeeeees %

DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir

EOD avivccinpsoncancnsosevavensesavansasctenstnestntsnetncsennanves 7

Romani v. Shearson Lehman Hutton, 929 F.2d 875

(Lat Cir. L991) ......cccvccecescssvrosescececsssonssecessonssses 7

Shapiro v. UJB Financial Corp., 964 F. 2d 272 (3d

Cir. LOBB) ...ccncccscccnscnssssccccsscesnevnsensssesessarssocesess 3

Wool v. Tandem Computers, Inc., 818 F.2d 1435

Pe Cie, GGT) cisvsnsssvnssconssasevcuxsscnvecieccsssacecncesss 7

STATUTES:

Pad, BR, Civ. BP. QED) vcccsiccercncicecsecscscsessesscssssesnensenens passim

MISCELLANEOUS:

Accounting Standards - Current Test - General

Standards as Of 1989 .........sesersccersersesseoeeen au 5

American Institute of Certified Public Accountants

Banking Committee - Audits of Banks, (2d

ed. ROOD ssciscsnasscncsnsnsrnanasenssasscssvnerssnqsastapmesksinan 5

Brookes, Regulators Creating a Credit Crisis/,

Washington Times, May 3, 1990 ........:::::e 2

Financial Accounting Standards Board, Statement

of Financial Accounting Concepts No. 6 - Ele-

ments of Financial Statements (1985) ...........+- 4

Golembe Associates, The Adequacy of Bad Debt Re-

serves for Banks - A Preliminary Study

(LOTS) ssc: Soe csah ha ataculahauaGuoiian <eeaeeaRINSENENChENSD 4

T. Hardy, The Allowance for Loan Losses: Fact or

Bstson? Count, LOBB) occcccieccsscscesesesvecsscccocscivesns 4.5

Table of Authorities Continued

Office of the Comptroller of the Currency, Comp-

troller’s Handbook for National Bank Exam-

I ED uicedhucincesians ecsckomnaveonbmnasnesyenndenindibieres

Pitt and Groskautmanis, Shareholder Suits Suggest

Some Lessons, Nat’! L. J., August 10, 1992 ..

Robert Morris Associates, Managing the Allowance

for Loan and Lease Losses State of the Art

en Ssaseaain ea elk aoaNaaaliaaeNa a bresaaviens sedate

Sands, Lending Practices Land Banks in Court,

Washington Times, April 20, 1990 ........0....0..

Page

bo

IN THE

Supreme Court of the United States

OCTOBER TERM, 1992

No. 92-267

UJB FINANCIAL Corp., et al.,

Petitioners,

V.

IRWIN SHAPIRO, ROBERT BASSMAN,

JEROME Katz, NORMAN SALSITZ,

JEAN LEE and CHAPPAQUA FAMILY TRUST,

Respondents.

On Petition For A Writ Of Certiorari

To The United States Court Of Appeals

For The Third Circuit

MOTION FOR LEAVE TO FILE BRIEF

AND BRIEF OF THE AMICUS CURIAE

AMERICAN BANKERS ASSOCIATION

IN SUPPORT OF PETITIONERS

INTEREST OF THE AMICUS CURIAE

The American Bankers Association (“‘ABA”’) is the

principal national trade association of the commercial

banking industry in the United States. It has mem-

bers in each of the fifty states and the District of

Columbia and represents bank of all types (national

and state chartered banks) and sizes (money center,

regional and community banks). ABA members hold

approximately ninety percent of all domestic assets

in commercial banks located in the United States.

The matter decided by the Court of Appeals in-

volves a legal issue of the utmost concern to the

banking industry. As this Court is no doubt aware,

certain segments of the United States economy have

suffered through a lingering recession, particularly

with respect to real estate. Compounding this eco-

nomic downturn has been the widely reported per-

ception that the banking regulators, particularly the

Office of the Comptroller of the Currency, have be-

come extremely strict during their examinations and

have been requiring banks to increase their loan loss

reserves. See, e.g., Brookes, Regulators Creating a

Credit Crisis?, Washington Times, May 3, 1990. When

loan loss reserves are increased, it is as if the bank

spent or lost that money at the time the reserves are

set aside. That has an effect upon the net income of

the bank and, ultimately, upon the market value of

bank stock. It is easy, with benefit of hindsight, to

claim that ‘‘adequate’”’ loan loss reserves should have

been set aside earlier so as to present a more ‘“‘ac-

curate” picture of the true value of a bank’s stock.

In fact, numerous shareholder suits have been filed

against banks containing allegations of securities fraud

because of losses in the banks’ loan portfolio. See,

Sands, Lending Practices Land Banks in Court,

Washington Times, April 20, 1990, at Cl. See also,

Pitt and Groskautmanis, Shareholder Suits Suggest

Some Lessons, Nat’l L. J., August 10, 1992, n.7 at

27 (discussing proliferation of class actions alleging

securities law violations and noting Wall Street Jour-

nal article stating over 300 such suits had been filed

in 1990-91.)

Because of the expense of such lawsuits and be-

cause it is impossible to run a bank if honest and

reasonable business judgments are made into guar-

entees of positive investment results—or guarantees

of costly litigation from shareholders charging those

judgments were faulty—it is extremely important that

courts be able to dismiss such suits which fail to plead

facts demonstrating the fraudulent activity being

charged, as opposed to simply showing that manage-

ment failed to predict the future. The American Bank-

ers Association files this brief to explain the concept

of reserving against loan losses in order to help the

Court assess the correctness of the Court of Appeals’

decision.

REASONS FOR GRANTING THE WRIT

One of the key holdings below was that the

Respondents could plead defendants’ allegedly fraud-

ulent failure to provide for adequate loan loss reserves

without any supporting facts showing how such re-

serves were improperly set, and based solely on hind-

sight This presents an important question of federal

law which has not yet been addressed by the Court

but should be: What is the standard for adequately

pleading securities fraud under Fed. R. Civ. P. 9(b)?

The Third Circuit would permit plaintiffs in such

suits to state that the facts which form the basis of

the allegedly fraudulent activity lie exclusively within

the defendants’ control and thereby satisfy Rule 9(b)’s

requirement that the circumstances constituting fraud

be “stated with particularity.” Shapiro v. UJB F’'-

nancial Corp., 964 F.2d 272, 285 (3d Cir. 1992). Rather

than repeating the arguments made by the Petitioners

and other amici, this amicus believes that it would help

the Court to review the meaning and purpose of the

particular accounting concept involved in this case.

The allowance for loan losses appears on a balance

sheet as a deduction from the value of a loan port-

folio. Commentators have recognized several functions

which could be served by the reserve. These include

an experience function, catastrophe function, and a

valuation function. Golembe Associates, The Adequacy

of Bad Debt Reserves for Banks—A Preliminary Study

at 2 (1972). See, also, Finuncial Accounting Standards

Board, Statement of Financial Accounting Concepts

No. 6—Elements of Financial Statements. at 9134

(1985) (hereinafter FASB No. 6). The experience func-

tion assumes that the loan loss reserve is intended

to absorb losses which can be expected to occur in a

single average year and is achieved by averaging out

actual loss experience from past years. It is viewed

as producing ‘“‘the lowest benchmark’’ for the loss

reserve. T. Hardy, The Allowance for Loan Losses:

Fact or Fiction? at 8 (June, 1986) (unpublished theses

available at the American Bankers Association li-

brary).

In contrast to the experience function, a loan loss

reserve based on the catastrophe function assumes

that the allowance should enable the lender to with-

stand loan losses which would occur under unforeseen

economic crises such as a depression. Jd. This prob-

ably represents the upper limit on the amount of the

reserve but would “‘artificially inflate the allowance

amount and make it difficult for the public as well

as bank management to evaluate the problems inher-

ent in a loan portfolio.”’ Jd. at 9.

Somewhere between these two extremes is the no-

tion of the loan loss reserve serving a valuation func-

tion. For example, FASB No. 6 states that some

accounts on a balance sheet serve as valuation ac-

counts (i.e., a separate item which reduces or in-

creases the carrying amount of an asset). In this

context the loan loss reserve would ‘“‘represent a

measure of all losses expected in a given loan port-

folio through its liquidation in the ordinary course of

business.”’ T. Hardy, supra, at 10.

The guidance from the accounting profession makes

it clear that the loan loss reserve is to serve a val-

uation function for financial reporting purposes. ‘“The

amount of [the loss reserve] can be considered rea-

sonable when the allowance for loan losses ... is

considered by management to be adequate to cover

estimated losses inherent in the loan portfolio.”

American Institute of Certified Public Accountants—

Banking Committee, Audits of Banks at 61 (2d. ed.

1983).

As to when and in what amounts such losses need

to be identified, the accounting standards recognize

the difficulty of this undertaking. FASB Statement

No. 5, for example, requires that the loss be probable

and reasonably estimable before it is accrued. Finan-

cial Accounting Standards Board, Accounting Stand-

ards—Current Text—General Standards at § C59.105.

(Losses from uncollectible receivables, e.g., principal

and interest on loans, shall be accrued when both

conditions, probable and reasonably estimable, are

met.) The banking regulatory guidance is similar. “It

is not the examiner’s responsibility to initially ascer-

tain the amount of allowance, but rather to determine

that management has exercised its responsibility to

use reasonable judgment based upon reliable infor-

mation to arrive at an appropriate allowance.”’ Office

of the Comptrsller of the Currency, Comptroller’s

Handbook for National Bank Examiners § 217.1 at 2

(1984) (emphasis added).

What is readily evident from the discussion above

is the subjective process for arriving at the “‘correct”’

amount of loan loss reserves. Unlike such objective

entries on a financial statement as inventory and

sales, the amount stated for loss reserves is nothing

more than an educated prediction of future events.

Robert Morris Associates, Managing the Allowance for

Loan and Lease Losses State of the Art at 11 (1988).

This prediction will likely be based on a system which

sets forth a particular method of evaluation (e.g., fre-

quency of review, documentation, minimum allowable

allowance, identification of problem loans, allocation

of loss for specific loans, etc.) but the decision ulti-

mately remains a guess. Jd. at 55-60.

As events play themselves out, and with 20-20 hind-

sight, the correctness of the loan loss reserve cal-

culation can easily be evaluated. In today’s economy,

for example, it has become evident that some financial

institutions failed to anticipate the extent of the dif-

ficulty which would be encountered by certain regions

and within certain industries. But miscalculations of

the loss reserve, even by a significant amount, do

not, standing alone, represent fraudulent acts by the

lending institution.

Shareholder suits, such as the one at issue in this

case, typically make broad allegations of fraud based

on the inadequacy of loss reserves and are primarily,

if not exclusively, based on 20-20 hindsight. The ar-

gument made in such suits is that the bank’s financial

~]

disclosures state loan loss reserves which later prove

to be ‘“‘inadequate’”’ and, therefore, constitute fraud

under section 10(b) of the Securities Act of 1934.

Plaintiffs typically demand broad discovery orders

seeking the banks’ loan files in an effort (again with

the benefit of hindsight) to determine what the re-

serves ‘‘should have been.”

Because of the expense of this type of litigation, it

is extremely important for courts to hold plaintiffs to

the requirement of Rule 9(b) that fraud claims be

supported by allegations of fact pled with ‘“‘particu-

larity.” Billard v. Rockwell International Corp., 683

F.2d 51 (2d Cir. 1985) (Rule 9(b) will be strictly con-

strued to minimize strike suits). In this case, for ex-

ample, it is not an overwhelming burden to require

the plaintiffs to identify specifically in what respect

the loan loss reserves were false or misleading at the

time the estimates were made. “[MJere conclusory

allegations of fraud are insufficient, statements of the

time, place and nature of the alleged fraudulent ac-

tivities are sufficient.” Wool v. Tandem Computers

Inc., 818 F.2d 1433, 1439 (9th Cir. 1987) (emphasis

added). See, DiLeo v. Ernst & Young, 901 F.2d 624,

627 (7th Cir.1990) (plaintiffs’ complaint that bank’s

failure to increase reserves constituted fraud inade-

quate under Fed. R. Civ. P. 9(b) because circumstan-

ces of the fraud “the who, what, when, where and

how” not specified). As the court noted in Romani

y. Shearson Lehman Hutton, 929 F.2d 875 (1st Cir.

1991), ‘‘We have been especially rigorous in demand-

ing such factual support in the securities context to

minimize the chance ’that a plaintiff with a largely

groundless claim will bring a suit and conduct exten-

sive discovery in the hopes of obtaining an increased

settlement....”’ Jd. at 878 (citations omitted). See

also, Blue Chip Stamps v. Manor Drug Stores, 421

U.S. 728, 741, reh’g denied, 423 U.S. 884 (1975)

(threat of discovery may add ‘“‘in terrorem’”’ increment

to settlement value).

Ironically, the Third Circuit itself has recognized

the importance of meeting the pleading requirements

of Rule 9(b) where allegedly inadequate loan loss re-

serves form the basis of the plaintiffs’ securities fraud

suit. The court, in Christidis v. First Pennsylvania

Mortgage Trust, 717 F.2d 96, 100 (3d Cir. 1983), af-

firmed the dismissal of such a complaint because of

‘“‘the complete absence of any disclosure of the man-

ner in which, in establishing reserves for bad debts

... the defendants knowingly departed from reason-

able accounting practices.’’ In this case, however, the

Third Circuit merely plays lip service to Christidis

before announcing its lesser pleading standard. In

doing so the Third Circuit’s crafting of a reduced

pleading standard departs from the express require-

ments of Rule 9(b) and the application of the rule by

other courts, sends the wrong signal to the plaintiff

bar, and ignores the policies behind the heightened

pleading requirement of Rule 9(b).

CONCLUSION

The amicus urges this Court to grant the petition

for a writ of certiorari. The ruling below relaxes the

standards for pleading in fraud cases and allows

plaintiffs to pursue often groundless allegations and

engage in discovery ‘‘fishing expeditions.” If this

Court allows the Third Circuit’s rewriting of Rule 9(b)

to stand, banks and other commercial enterprises are

certain to continue to face unfounded charges of fraud

- ee

every time economic reversals cause investors to lose

money.

Respectfully submitted,

JOHN J. GILL

MICHAEL F. CRotTTy

THOMAS J. GRECO

Attorneys for Amicus Curiae

AMERICAN BANKERS ASSOCIATION

1120 Connecticut Avenue, N.W.

Washington, D.C. 20036

(202) 663-5026

September 11, 1992