In a recent decision, Judge Shira A. Scheindlin of the United States District Court for the Southern District of New York denied defendant Morgan Stanley’s motion to dismiss fraud claims brought by two institutional investors in connection with the collapse of a structured investment vehicle (SIV) called Rhinebridge. King County, Washington, et al. v. IKB Deutsche Industriebank AG, et al., 2010 U.S. Dist. LEXIS 115351 (S.D.N.Y. Oct. 29, 2010). As alleged in the complaint, Morgan Stanley, in conjunction with defendants IKB Deutsche Industriebank AG (IKB) and ratings agencies Moody’s, S&P and Fitch (the “Rating Agencies”), designed, structured, marketed and maintained Rhinebridge. The crux of plaintiffs’ fraud claims is that Morgan Stanley, along with IKB and the Rating Agencies, caused Rhinebridge’s senior debt securities (the “Notes”) to receive false and misleading ratings such that investors believed the Notes were a safe, secure and reliable investment, despite the allegation that, as alleged, Rhinebridge was loaded with toxic assets.
Judge Scheindlin denied Morgan Stanley’s motion, holding that although plaintiffs had not alleged that Morgan Stanley had communicated directly with plaintiffs or that any of the alleged misrepresentations were directly attributable to Morgan Stanley, the allegations of Morgan Stanley’s extensive involvement in creating the documents containing the alleged misrepresentations were sufficient to meet the standard for pleading fraud under the group pleading doctrine.
Allegations of Fraud
According to the complaint, in addition to working with IKB to structure, market and maintain Rhinebridge, Morgan Stanley (with IKB) also engaged the Rating Agencies to rate Rhinebridge and to structure the Notes, which plaintiffs alleged were assigned ratings that did not reflect the true quality of the collateral. Morgan Stanley allegedly provided these purportedly false and misleading ratings through core deal documents. Plaintiffs alleged that Morgan Stanley, the Rating Agencies and IKB achieved these false and misleading ratings by knowingly designing a model that used outdated, incorrect and irrelevant historical information and did so because, without high ratings, the Notes would be unsaleable. Plaintiffs further alleged that Morgan Stanley sought these false and misleading ratings so that it would not lose its $15 million fee for Rhinebridge’s successful launch or its portion of Rhinebridge’s net distributable profits.
In addition to allegations specifically concerning the ratings, the complaint alleged that Morgan Stanley (1) caused Rhinebridge to acquire hundreds of millions of dollars of toxic assets that IKB was trying to unload, (2) coerced the Rating Agencies to allow risky Home Equity Loans (HELs) to constitute a disproportionately large percentage of Rhinebridge’s liquid eligible assets, and (3) caused Rhinebridge to acquire Countrywide securities in an amount that was three times higher than the permissible limit set forth in the operating documents for exposure to a single obligor. Plaintiffs also alleged that Morgan Stanley knew that Rhinebridge had failed its capital loss test prior to Rhinebridge’s issuance in June 2007.
Applicable Legal Standards
To plead fraud adequately under Federal Rule of Civil Procedure 9(b), a complaint must (1) detail the statements (or omissions) that the plaintiff contends are fraudulent, (2) identify who made those statements, (3) state where and when the statements (or omissions) were made, and (4) explain why the statements (or omissions) are fraudulent.
Despite the extensive allegations of fraud, plaintiffs did not allege in the complaint that any of the alleged misrepresentations were directly attributable to Morgan Stanley or that Morgan Stanley had ever communicated directly with plaintiffs. For that reason, Morgan Stanley argued that plaintiffs failed to meet the requisite pleading standard, or, at best, had pled that Morgan Stanley was a secondary actor in the perpetuation of the Rating Agencies’ or IKB’s fraud. Morgan Stanley argued that, even under a secondary actor theory of liability, plaintiffs had failed to meet the requisite pleading standard because secondary actors can only be held liable for fraud for statements attributed to the secondary actor at the time of dissemination.
The court, however, found that the extensive allegations of Morgan Stanley’s involvement in the fraud rendered it an “insider” for purposes of the group pleading doctrine and that, therefore, plaintiffs had met their pleading burden. The court further held that, under the group pleading doctrine, it is not necessary that each individual defendant actually make the alleged misrepresentation where, as here, the documents containing the alleged misrepresentations—the private placement memoranda, the information memoranda and selling documents—constituted the collective work of individuals with everyday involvement with Rhinebridge. The court drew a distinction from the facts in this case from instances where the sole allegations of fraud are based on an affiliation with another defendant or a tenuous connection with a fraudulent scheme.
Applying that standard to the facts alleged, the court found that plaintiffs had met the requisite pleading standard as follows: First, the court held that, as a result of Morgan Stanley’s intimate involvement in creating the false and misleading ratings and the core deal documents disseminated to investors containing those ratings (private placement memoranda, information memoranda, and selling documents), those allegations were sufficient to allege a material misrepresentation by Morgan Stanley under the group pleading doctrine. Second, the court held that plaintiffs had adequately pled reasonable reliance because of allegations that (1) they relied on Rhinebridge’s ratings in purchasing the Notes and (2) Morgan Stanley had access to nonpublic information showing that the credit ratings were false, including that Rhinebridge had violated its operating instructions and its capital loss test, and that the ratings process was flawed in that the models were deliberately manipulated to produce inflated ratings. Third, the court held that plaintiffs adequately pled scienter because (1) Morgan Stanley had the motive and opportunity to commit fraud in that it stood to earn certain fees and distributions of Rhinebridge’s profits and (2) there was strong circumstantial evidence of Morgan Stanley’s conscious misbehavior or recklessness because it knew that Rhinebridge was not the safe, secure, and reliable investment it was touted to be.
The court also found that plaintiffs had stated a claim for aiding and abetting common law fraud because they had pled (1) facts showing the existence of the underlying fraud on the part of both the Rating Agencies and IKB, (2) Morgan Stanley’s knowledge of that underlying fraud, (3) that Morgan Stanley provided substantial assistance to advance the fraud’s commission, and (4) damages.