Judge Barbara S. Jones of the United States District Court for the Southern District of New York recently dismissed claims of fraud and unjust enrichment against Morgan Stanley, the arranger of a collateralized debt obligation (“CDO”) that allegedly had a hand in procuring a false and misleading Triple-A rating for the CDO. Emps. Ret. Sys. of Gov’t of V.I. v. Morgan Stanley & Co., Inc., No. 09 Civ. 10532 (BSJ) (THK), 2011 U.S. Dist. LEXIS 112300 (S.D.N.Y. 2011). In dismissing the claims, Judge Jones focused heavily upon the missing link between Morgan Stanley and allegedly fraudulent statements made to the plaintiff. The opinion reemphasizes that, although a plaintiff may see the scope of a fraudulent scheme as encompassing multiple actors, New York’s law generally limits fraud liability to those who actually made the fraudulent statements to the plaintiffs.
The plaintiff’s allegations revolved around the sale of notes issued by the Libertas CDO investment fund. Libertas CDO notes were created by entering into credit default swaps built upon residential mortgage-backed securities. Morgan Stanley arranged and promoted the Libertas CDO.
The plaintiff alleged, however, that Morgan Stanley knew that the lenders originating the underlying mortgages applied poor underwriting standards, and the mortgages were thus “far riskier than presented and were impaired when the Libertas CDO was created.” The complaint buttressed its allegation of Morgan Stanley’s knowledge of the risk by alleging that Morgan Stanley took a short position on the assets included in the Libertas CDO.
Notwithstanding the risk involved in the mortgages, the complaint alleged that Morgan Stanley collaborated with the ratings agencies Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poors (“S&P”) to produce false Triple-A ratings for the CDO. Further, the plaintiff alleged that Morgan Stanley circulated an Offering Memorandum, prepared by the issuers of the CDO, that promoted the false ratings.
The Fraud Claims
Judge Jones first addressed the heart of the complaint, the claim for common-law fraud under New York law. To establish such a claim for fraud, a plaintiff must allege that: (1) the defendant made a misrepresentation or material omission of fact that was false and known to be false by the defendant; (2) the misrepresentation or omission was made for the purpose of inducing the other party’s reliance; (3) the other party justifiably relied upon the misrepresentation or omission; and (4) injury resulted.
The court first rejected the plaintiff’s argument that Morgan Stanley was somehow legally responsible for the issuance of allegedly false Triple-A ratings. The court observed that the plaintiff’s complaint made only general statements that a relationship existed between Morgan Stanley and the ratings agencies, none of which pertained specifically to the Libertas CDO. Absent such specific factual allegations, the plaintiff could not support the inference of Morgan Stanley’s involvement in creating the ratings sufficient to comply with the pleading requirements of Ashcroft v. Iqbal, 129 S. Ct. 1937 (2009), or Federal Rule of Civil Procedure 9(b).
Judge Jones disagreed that the Offering Memorandum containing the allegedly false ratings constituted a statement by Morgan Stanley. Judge Jones noted that the Memorandum stated that it was prepared by the CDO’s issuer, Libertas, and further that Morgan Stanley had not verified the information therein. Judge Jones therefore ruled that, as a matter of law, the Offering Memorandum was not a statement by Morgan Stanley.
Finally, the court found that, although the plaintiff alleged that Morgan Stanley made false statements during a presentation to investors, the complaint did not allege that the plaintiff had received the presentation. Because common law fraud requires the defendant itself to make a fraudulent statement to the plaintiff, the court dismissed the claim.
The court also dismissed the plaintiff’s unjust enrichment claims. Under New York’s Martin Act, any common law claim based on deceptive practices in the sale of securities that does not require proof of scienter is preempted. Judge Jones therefore found that the plaintiff’s unjust enrichment claims—which did not require a showing of scienter—preempted by the Martin Act.
In sum, Judge Jones’s decision in Morgan Stanley & Co. demonstrates that mere involvement in the allegedly fraudulent sale of securities may be insufficient to support a claim for fraud under New York law. Instead, a defendant itself must have made the misrepresentations at issue to the plaintiff; only then can such a claim survive.