United States: Changing Winds: The First Department On Securities Fraud

Originally appeared in Law360 on January 23, 2016.

Co-authored by Brian Isaac

When Eugene O'Neill wrote in A Moon for the Misbegotten that, "there is no present or future, only the past, happening over and over again, now," he surely never contemplated practicing law before New York's Appellate Divisions. The famous futurist Alvin Toffler, also no New York lawyer, would have been stymied by the Appellate Divisions had he reviewed a series of recent First Department decisions involving fraud in residential mortgage-backed securities transactions. Toffler wrote in Future Shock:

Rational behavior ... depends upon a ceaseless flow of data from the environment. It depends upon the power of the individual to predict, with at least a fair success, the outcome of his own actions. To do this, he must be able to predict how the environment will respond to his acts. Sanity, itself, thus hinges on man's ability to predict his immediate, personal future on the basis of information fed him by the environment.

The following cases demonstrate that, in the absence of en banc review, predicting the "immediate, personal future," is a task not for the faint of heart when the stakes in the litigation are very high. It is not necessary to analyze the complex legal and factual scenarios that the cases

present in order to take a few snapshots of the changing decisional landscape. Rather, the cautious appellate practitioner should find that a carefully constructed and easily understandable narrative may ultimately be the single most important factor in complex commercial cases dealing with securities.

All of the following cases involve litigation over fraud claims in the institutional sale of residential mortgage-backed securities (RMBS). All of the cases were commenced in the Commercial Division of New York County Supreme Court, after the financial crisis of 2007 where investors lost billions as the assets were rendered worthless. Since Wall Street is in New York County, which in turn is under the jurisdiction of the First Department, it is only to be expected that that appellate court would see a vast swath of securities cases.

In HSH Nordbank AG v. UBS AG, 95 A.D.3d 185 (1st Dept. 2012) (Friedman, J.),[1] the First Department was confronted with fraud claims premised on the rating guides for the securities utilized by defendant UBS. Plaintiff claimed that the rating guides were not reliable, that UBS knew that the guides were not reliable, and engaged in "ratings arbitrage" to defraud plaintiff as to the value of the securities.

The court, in an opinion authored by Justice David Friedman, dismissed the claims on the grounds that plaintiff, a sophisticated investor, having disclaimed reliance on any representations by defendant, was barred from making any claim for fraud.

Later, in ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 106 A.D.3d 494 (1st Dept. 2013) appeal dismissed, 22 N.Y.3d 909 (2013), the First Department began to signal that all may not be a unanimity of opinion. The majority of the court (Justices Friedman, Renwick and Roman) held that the non-reliance clauses again barred a sophisticated entity from making a claim for fraud where that party failed to insert into the offering memorandum "an appropriate prophylactic provision" to ensure against the possibility of misrepresentation. The dissent (Justices Clark, Manzanet-Daniels) argued that the defendant actively concealed certain information concerning the transactions at issue, and that defendant had "peculiar knowledge" that should have allowed the fraud claim to go forward.

The tide turned the following year in Basis Yield Alpha Fund (Master) v. Goldman Sachs Group, Inc., 115 A.D.3d 128 (1st Dept. 2014). Basis Yield is the second of the Goldman Sachs cases to reach the First Department. Even though the non-reliance clauses or disclaimers were substantially the same as those described by the court in HSH and ACA, the factual allegations of Basis Yield complaint were different in one very significant and material respect, and it is this difference that seems to have been the tipping point for the court: Plaintiff alleged that Goldman was secretly getting rid of assets it knew to be toxic.[2]

Justice Renwick, writing for a unanimous court,3 held that "this is a case of a Wall Street firm (Goldman Sachs) being accused of selling mortgage-backed securities it knew to be 'junk' and then betting against the same securities as the 2007 financial crisis unfolded." 115 A.D.2d at 131. Justice Renwick quoted plaintiff's complaint at length wherein plaintiff described Goldman's scheme to construct the transactions (CDOs) from assets likely to fail and included many from its own inventory. Plaintiff alleged that Goldman then shorted those assets to its clients' detriment. 115 A.D.3d at 136.

Despite the fact that the First Department had previously found similar disclaimers sufficient to bar a sophisticated investor's fraud claims, in Basis Yield the court held the opposite, with Justice Renwick now writing for the majority.

Furthermore, the court found that even if the disclaimers were sufficiently specific, the special facts doctrine would allow plaintiff's claim to go forward because "Goldman had access to non public information regarding the deteriorating credit quality of subprime mortgages." Id. While the court attempted to distinguish the disclaimers from those in HSH, the real difference in the cases which, for the court now justified a completely different outcome, seems to be the court's invocation of the special facts doctrine (relied on by the dissenting justices in ACA, supra), and the claim that Goldman was trying to secretly get rid of its own toxic assets.

By now, the proverbial handwriting would seem to be on the wall. In Loreley Fin. (Jersey) No. 3 Ltd. v. Citigroup Global Mkts. Inc., 119 A.D.3d 136 (1st Dept. 2014),[3] (Loreley No. 3) plaintiff made the claim (following the Basis Yield winning formula), that defendant Citigroup was using CDOs to get rid of the Bank's own toxic assets.

Justice Renwick, again writing for a unanimous court, quoted extensively from Loreley's complaint (119 A.D.3d at 139-142) and summarized the allegations: "the gravamen of the complaint is essentially that Citigroup secretly selected its riskiest mortgage for sale to its investors as CDOs and purchased credit default swaps to short the issuance." 119 A.D.3d at 142. Justice Renwick quoted her previous opinion in Basis Yield extensively in holding that "Citigroup's disclaimers and disclosures do not preclude, as a matter of law, a claim of justifiable reliance on the seller's misrepresentations or omissions, as an element of fraud." 119 A.D.3d at 146.

Loreley Fin. (Jersey) No. 28 v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 117 A.D.3d 463 (1st Dept. 2014)[4] was released by the First Department the same day as Loreley No. 3, above. The court again extensively quoted plaintiff's complaint in an unsigned opinion. Merrill Lynch was the arranger "integrally involved in the structuring and sale of [the CDO,] . . . was the initial purchaser of the securities, provided the initial financing, and acted as a counterparty by purchasing the CDS." 117 A.D.3d at 467. In that context, the court noted the plaintiff alleged that defendants "concealed from plaintiff and other investors that [the CDO] had been designed to meet the specifications of an undisclosed hedge fund whose interests as a net-short investor were diametrically opposed to the deal's success." 117 A.D.3d at 466.

The No. 28 decision is far more abbreviated in its examination of precedent and the First Department made no mention of its previous decisions in HSH, ACA and Loreley No. 3. The holding rests on an alleged false statement as to who had in fact selected the collateral as well as the selection of the collateral itself. The court's only citation to Basis Yield is on a point not germane to this issue.

The most recent decision from the First Department involving allegations of fraud in a CDO utilizing RMBS is Basis Pac-Rim Opportunity Fund (Master) v. TCW Asset Mgt. Co., 124 A.D.3d 538 (1st Dept. 2015).[5] The essential facts are set out at length in the Supreme Court opinion. Basis Pac-Rim Opportunity Fund (Master) v. TCW Asset Mgmt. Co., 40 Misc. 3d 1240 (A), 2013 N.Y. Misc. LEXIS 4032 (Sup. Ct. N.Y. Cnty. Sept. 10, 2013), (Kornreich, J.S.C.), aff'd, 2015 N.Y. App. Div. Lexis 655 (1st Dep't Jan. 26, 2015). The Supreme Court (the motion court) did not dismiss the fraud claim, allowing discovery to go forward to afford plaintiff the opportunity to better develop its theory.

The motion court then held that plaintiff's claim for negligent misrepresentation must be dismissed because, "where . . . the parties entered into an arm's-length RMBS transaction, no special relationship exists." Id. This appeal to the First Department solely involved the dismissal of the negligent misrepresentation claim. The Appellate Division affirmed the motion court's dismissal of that claim on the grounds that plaintiffs "failed to establish the existence of a special relationship of trust or confidence between the parties." 2015 N.Y. App. Div. Lexis 655, at *1-2. Furthermore, the First Department held that, "the involvement of a collateral manager in an arm's-length transaction does not establish a special relationship as a matter of law." Id. (citing Zohar CDO 2003-1, Ltd. v. Xinhua Sports & Entertainment Ltd., 111 A.D.3d 578, 579 (1st Dep't 2013)).

The single most interesting factor in this series of cases is that Justice Renwick was the author of the court's opinions in Basis Yield and Loreley No. 3, and participated in the appeals of ACA and No. 28. There are several conclusions that can be drawn when the decisions are viewed with the microscope of hindsight and when we endeavor to read the tea leaves, we come to the following:

Recognizing that the court sits in five-judge panels, and thus three Justices need agree on a position to carry the day, one Justice of the court, Justice Renwick, became the pivot for the court's majority view on this issue.

The facts of all of the cases are similar and the distinctions should not necessarily have been sufficient to produce such contrary results in so short a time period. For example, the disclaimers and non-reliance clauses in the transaction documents were largely the same in all of the cases. In the first case, HSH, those clauses operated as a complete bar to the fraud claims. The court went so far as to suggest that the plaintiff itself would be committing a fraud if it negotiated the clauses, the CDO went forward in reliance on the clauses, and then plaintiff pressed a claim for fraud against the defendant Bank after the investment went south.

Within a year, Justice Renwick held the majority with a narrative sufficient to overcome a unanimous court opinion that should have barred the claims. More importantly, perhaps, is that the issue appears to have been resolved by the Court of Appeals in line with Justice Renwick's views. In ACA Financial Guaranty Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1045 (May 7, 2015), the court held that plaintiff "sufficiently pleaded justifiable reliance for the causes of action for fraud in the inducement and fraudulent concealment."

Judge Read, joined by First Department alumni Judge Abdus-Salaam, authored a vigorous dissent that comports with the early First Department cases, in rejecting ACA's claims of justifiable reliance.

If Toffler was right, that sanity hinges on the ability to predict the immediate future "on the basis of information fed him by the environment," most of the litigants might have been searching for therapy from the Court of Appeals. That finally arrived when the court accepted Justice Renwick's narrative in ACA.

» Click here to read more articles from our latest Securities & Derivative Litigation Report


[1] The panel consisted of Gonzalez, P.J., Friedman, Moskowitz, Freedman and Roman.

[2] The panel consisted of Tom, Acosta, Renwick, DeGrasse and Richter.

[3] The panel consisted of Mazzarelli, Sweeny, Renwick, Freedman and Gische.

[4] The panel was the same panel as Loreley Fin. No. 3; see note 3.

[5] The panel consisted of Mazzarelli, Renwick, DeGrasse, Richter and Clark.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.