Originally appeared in New York State Bar Association's Leaveworthy newsletter in the Fall/Winter 2015 edition
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 that it 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 ground 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 unanimous in 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 allow 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 nonreliance 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.
Justice Renwick, writing for a unanimous Court,2 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 seemed 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 the 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. There is a significant factual difference, though, between this case and Loreley No. 3. Plaintiff did not allege that defendant Merrill Lynch was trying to reduce its own toxic asset exposure, as with the claim advanced against Citigroup in Loreley No. 3.
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 that 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 ground 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 ZoharCDO 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 to 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 alumna Judge Abdus-Salaam, authored a vigorous dissent that comports with the early First Department cases in rejecting ACA’s claims of justifiable reliance. (Editor’s Note: In her interview in this issue of LEAVEWORTHY, Judge Read lists that dissent as among her best writings.)
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.