Commercial Division Justice Eileen Bransten recently concluded that plaintiff bondholders lacked standing to bring fraud claims against the bond obligor and trustee after having sold their interests in the bonds. One William St. Capital Mgmt. L.P. v. U.S. Educ. Loan Tr. IV, LLC, No. 652274/2012, 2017 BL 1700030 (Sup. Ct. N.Y. Co. May 16, 2017), involved a group of investment firms that purchased $10 million in notes backed by government-guaranteed student loans from the U.S. Education Loan Trust IV (“ELT”). The notes were part of a larger $30 million package.[1]

The investment firms alleged that conduct by ELT and its agent, Bank of New York Mellon (“BNY Mellon”), amounted to breach of the terms of the notes and fraud. The notes required ELT and its agent, BNY Mellon, to hold monthly auctions for the notes. The auctions were structured to match buyers who were willing to buy the bonds at par value with sellers who were willing to sell at par value. The interest rate was the lowest rate at which buyers were willing to purchase all the available notes. If no auction was held, the notes would automatically bear an interest rate of LIBOR plus 2.5%.

From 2007 to 2011, ELT did not hold any auctions. When the investment firms purchased the notes in 2011, ELT allegedly held an auction because it learned that the interest rate at auction would be lower than LIBOR plus 2.5%. ELT allegedly concealed the auction from the investment firm.[2] Based on the auction results, ELT concluded that the interest rate on the notes was zero, making the notes worthless to the recent purchasers.

The investment firms sued ELT, BNY Mellon, and a principal of ELT, alleging breach of contract and seeking payment of the principal and interest on the notes. In early 2016, while the case was pending, the investment firms sold the notes. The plaintiffs dropped their contract claims but continued to pursue fraud and aiding and abetting claims against the defendants.[3]

ELT and BNY Mellon moved to dismiss, arguing that the investment firms lacked standing to sue in tort because they sold their stake in the notes. There was no dispute that plaintiffs indeed had sold their notes and that the contract claims for payment of the notes passed to the purchaser of the bonds.[4] The issue was whether the tort claims should similarly pass along to the bond purchaser.

Justice Bransten pointed out that General Obligations Law § 13-107 provides that “when a bond is sold the buyer receives exactly the same claims or demands as the seller held before the transfer.”[5] She concluded that this “automatic assignment” rule applies to any claims against the trustee of the notes or the original obligor.[6] Justice Bransten noted prior cases that had concluded that a purchasing noteholder could not bring fraud or other tort claims against a placement agent or rating agency because those claims were not explicitly assigned with the purchase of the notes.[7] According to Justice Bransten, those cases were not controlling because the statute specifically mentions a trustee, obligor, and guarantor of the obligation, so that the automatic assignment rule applies to any claims against such parties, including tort claims.

Justice Bransten further observed that in a previous case interpreting General Obligations § 13-107, the New York Court of Appeals had not distinguished between contract claims and tort claims. In BlueBird Partners, L.P. v. First Fidelity Bank, N.A., the Court of Appeals held there was no prerequisite that a transferee claimant show its own injury before bringing a claim following the purchase of a bond. The Court of Appeals determined that under General Obligations Law § 13-107, a bond transfer “vests in the transferee certain bond-related claims” absent an express writing to the contrary.[8] Justice Bransten took a very broad view of the phrase “bond-related claims” as used in BlueBird Partners—according to the Court, “bond-related claims” includes tort claims, not just claims arising from the bond terms themselves.[9]

Justice Bransten also dismissed the fraud claims against ELT’s principal and the ELT servicing agent for failure to state a claim. The defendants argued that the plaintiffs could not allege fraud simply by arguing that they would have sold their bonds at a higher interest rate if the defendants had proceeded with auctions as required by the bonds.

Justice Bransten concluded that the plaintiffs had failed to allege that the defendants’ actions had been the proximate cause of the claimed losses. The Commercial Division Justice noted that New York follows the “out-of-pocket” rule for tort losses. The plaintiffs’ alleged that they could have sold the bonds at a higher interest rate and should have received more interest during the period when they held the bonds, a damages theory Justice Bransten deemed speculative.[10] Justice Bransten rejected the notion that plaintiffs could allege injury because they allegedly relied on defendants’ misrepresentations to refrain from selling the bonds.[11] Moreover, Justice Bransten noted that plaintiffs sold the notes pursuant to a standing order to sell at an auction at par value. Their argument that they could have sold the bonds in a private sale was not supported by the allegations in the complaint.

Based on the One William St. Capital decision, parties purchasing or selling bonds or notes should carefully consider whether to include explicit assignment or reservation of claims provisions in their contracts and should consider outlining the types of claims that the seller wishes to assign or retain. The decision also indicates that a theory of injury based on what the value of an investment could have been may be met with skepticism by the Commercial Division. Courts will closely scrutinize the causal connection between an alleged fraud and the possible injury.