As of mid-2011, private plaintiffs and government regulators – most prominently, the SEC – continue to pursue fraud claims in connection with the marketing and sale of collateralized debt obligations (“CDOs”). These claims typically involve CDOs whose collateral assets consisted primarily of residential mortgage backed securities (“RMBS”), credit default swaps (“CDS”) referencing such securities, or other CDOs secured by such asset backed securities. These CDOs – commonly known as CDOs of ABS – experienced devastating losses in the wake of the U.S. housing market collapse. In this article we survey ten noteworthy CDO fraud cases brought by private litigants and the SEC in which there have been significant developments over the last 12 months.
In general, CDO fraud claims involve alleged misrepresentations and omissions concerning (1) the credit quality or price of a CDO’s underlying assets, (2) a CDO’s capital structure and “subordination” levels, (3) the involvement of “short” parties in asset selection, and/or (4) the ratings assigned to the debt securities issued by a CDO (often referred to as the CDO’s “liabilities”). CDO fraud claims have typically been asserted under the federal securities laws and/ or common law fraud theories.
Many CDO fraud cases are still at a relatively preliminary stage, and thus it is difficult to draw broad conclusions. However, it is notable that courts have sustained CDO fraud claims against CDO arrangers when faced with allegations that those arrangers knew of – and failed to disclose – material facts that could not have been discovered by sophisticated CDO investors with reasonable diligence. Recent examples include a New York Supreme Court decision that sustained fraud claims based on Morgan Stanley’s alleged improper influence over the ratings assigned to a Morgan Stanley-arranged CDO (see China Industrial Bank Development v. Morgan Stanley & Co., discussed below) and a decision by the United States District Court for the Southern District of New York sustaining federal securities fraud claims based on a Goldman employee’s failure to disclose the involvement of a “short” party in the collateral selection process for a Goldman-arranged CDO (see Securities and Exchange Commission v. Goldman Sachs & Co., discussed below).
To adequately plead fraud, a plaintiff must do more than allege that the CDO did not perform as promised or in accordance with its assigned credit rating. Courts have not hesitated to dismiss CDO fraud claims asserted by sophisticated investors that had the capability to understand the risks posed by CDO investments. A recent prominent example is MBIA Insurance Corp. v. Merrill Lynch (discussed below), in which a New York appellate court dismissed $5.7 billion in CDO fraud claims brought by MBIA, finding that the claims “failed to state a cause of action in light of the specific disclaimers in contracts” that were negotiated by “sophisticated business entities.”
Securities And Exchange Commission v. Goldman Sachs & Co., No. 10 Civ. 3229 (BSJ) (MHD), 2011 WL 2305988 (S.D.N.Y. June 10, 2011)
This federal securities fraud lawsuit concerned a CDO known as a ABACUS 2007-AC1 (“Abacus”) that was structured and marketed by Goldman Sachs & Co. (“Goldman”). The SEC alleged that Goldman and its employee Fabrice Tourre represented that Abacus’s collateral would be “selected” by an independent collateral manager, ACA Management LLC (“ACA”), yet failed to disclose to investors that a hedge fund that was shorting Abacus, Paulson & Co. Inc. (“Paulson”), played a significant role in the collateral selection process. In July 2010, Goldman, without admitting or denying liability, settled with the SEC for $550 million. The SEC is currently proceeding against the remaining defendant, Mr. Tourre.
In a June 2011 decision, the Court declined to dismiss fraud claims against Mr. Tourre in connection with the sale of Abacus notes to ACA’s parent, ACA Capital Holdings, Inc. (“ACA Capital”). In its decision, the Court noted that Mr. Tourre allegedly “caused [a] misunderstanding” that led ACA Capital to believe (mistakenly) that Paulson was an equity investor in Abacus. Id. at *11. The Court found that “having allegedly affirmatively misrepresented Paulson . . . was long . . . Goldman and Tourre had a duty to disclose Paulson had a different investment interest – [i.e., that] it was short.” Id. at *13.
China Dev. Indus. Bank v. Morgan Stanley & Co. Inc., No. 650957, 2011 Ny. Misc. LEXIS 1808 (Sup. Ct. N.Y. County Feb. 25, 2011)
In this case, plaintiff China Industrial Bank Development (“CDIB”) alleged that Morgan Stanley & Co. Incorporated and certain of its affiliates (together, “Morgan Stanley”) fraudulently induced it to invest in a CDS referencing a “Supersenior Swap” that was the senior debt security in a CDO known as “Stack.” Id. at *4. Morgan Stanley allegedly represented that the Supersenior Swap was “even more stable than a AAA bond” while failing to disclose that it “paid for the credit ratings” of the Stack CDO and “worked with the rating agencies to engineer the ratings.” Id.
In declining to dismiss CDIB’s fraud claims, the Court held that CDIB sufficiently alleged that Morgan Stanley knew that the Supersenior Swap was a “highly risky, if not troubled investment” and that the ratings process which made it appear to be safe and “even more secure than a ‘AAA’ rated security, was deeply flawed.” Id. at *9.
Notably, the Court rejected Morgan Stanley’s argument that CDIB could not have relied on Morgan Stanley’s statements since CDIB represented that it was relying on its own judgment in entering into the deal. The Court found that Morgan Stanley allegedly “suborned and corrupted the rating agencies so that they would rate investment securities with a higher rating than would have been warranted under application of then prevailing protocols and assumptions,” a “set of circumstances constituting fraud . . . that could not have been discovered by any degree of due diligence or analysis performed by the most sophisticated investors.” Id. at **14-15.
MBIA Insurance Corp. v. Merrill Lynch, 916 N.Y.S. 2d 54 (1st Dep’t 2011)
In this case, MBIA Insurance Corporation (“MBIA”) alleged that Merrill Lynch, Pierce, Fenner and Smith Inc. and its affiliate (together, “Merrill”) fraudulently induced MBIA to provide credit protection (or a “wrap”) for $5.7 billion in liabilities of Merrill-arranged CDOs.
According to MBIA, Merrill misrepresented the credit quality of the CDOs’ collateral as part of a scheme to offload its subprime exposure. MBIA also asserted a breach of contract claim based on Merrill’s representations that the CDO liabilities were rated “AAA” even though Merrill allegedly knew that they did not warrant the AAA rating.
In April 2010, the trial court dismissed all of MBIA’s claims except for its contract claim. Ten months later, in February 2011, an appellate court dismissed MBIA’s complaint in its entirety. The appellate court held that MBIA’s “fraud-related claims failed to state a cause of action in light of the specific disclaimers in contracts” that were negotiated by “sophisticated business entities.” Id. at 55. As to the breach of contract claim, the court found that MBIA failed to “state a cause of action for breach of the promise to provide AAA-rated securities since it is undisputed that [Merrill] in fact provided securities with AAA ratings” and “[n]owhere in the plain language of the documents does there appear a promise of credit quality.” Id.
MBIA Insurance Corp. v. Royal Bank of Canada, 28 Misc. 3d 1225(A) (N.Y. Sup. Ct. Aug. 19, 2010)
MBIA alleged in this case that Royal Bank of Canada (“RBC”) fraudulently induced MBIA to provide credit protection to RBC related to the “supersenior” debt securities issued by three RBC-arranged CDOs of ABS. MBIA asserted fraud and breach of contract claims based on allegations that (i) RBC had superior knowledge and expertise regarding the collateral underlying the CDOs and (ii) knew that the CDOs did not warrant their AAA rating.
Relying on the trial court’s (subsequently reversed) decision in MBIA v. Merrill (discussed above), the Court found that the complaint adequately pled a breach of contract claim based on allegations that RBC knew the collateral underlying the CDOs did not warrant a AAA rating. The court also sustained MBIA’s fraud claims. The Court held sufficient MBIA’s allegations that RBC possessed “access to crucial loan information” that the Plaintiff could only “discover through extraordinary effort or great difficulty.” Id. at *40. In reaching its decision the Court also found that “a duty to disclose arises where one party’s superior knowledge of essential facts renders a transaction without disclosure inherently unfair.” Id.
On January 4, 2011, the parties to the case filed a stipulation of voluntary discontinuance, with prejudice.
Noteworthy Government Enforcement Actions
Securities And Exchange Commission v. J.P. Morgan Securities LLC (S.D.N.Y. June 21, 2011)
This enforcement action, which the SEC filed and simultaneously settled, concerned a CDO known as “Squared” that J.P. Morgan Securities LLC (“JPM”) structured and marketed. In its complaint, the SEC alleged that JPM represented that an independent collateral manager, GSC Group, would select Squared’s collateral, yet failed to disclose that a hedge fund with economic interests adverse to the CDO’s investors (Magnetar Capital LLC) played a significant role in the collateral selection process.
More particularly, the SEC alleged that Magnetar was the short counterparty to approximately $600 million in synthetic CDO securities that comprised over half of Squared’s $1.1 billion collateral asset portfolio. According to the SEC, JPM’s conduct violated sections 17(a)(2) and (3) of the Securities Act of 1933 “by negligently misrepresenting a key deal term, namely, who selected the collateral.”
JPM agreed to a $153 million settlement of the SEC’s complaint, without admitting or denying the SEC’s allegations.
In The Matter of Wells Fargo Securities LLC (SEC Administrative Proceeding No. 3-14320, April 5, 2011)
This consent order concerned the conduct of Wells Fargo Securities LLC (f/k/a Wachovia Securities LLC) (“Wachovia”) in connection with two Wachovia-arranged CDOs known as Grand Avenue II and Longshore 3. The SEC alleged that in February and March 2007, Wachovia sold equity securities of Grand Avenue II at prices that were 70 percent above the price at which Wachovia carried those securities on its own books. According to the consent order, the sales involved “undisclosed excessive markups” and thereby violated sections 17(a)(2) and (3) of the Securities Act. Id. at 4-5.
The SEC further alleged that Wachovia caused Longshore 3 to purchase collateral from Wachovia’s own books at above-market prices (based on Wachovia’s own marks). According to the SEC, this transaction rendered false and misleading Wells’ representations that Longshore 3 would only acquire assets from Wachovia and its affiliates on an “arm’s-length basis” and at “fair market prices.” Id. at 7.
Without admitting or denying the SEC’s allegations, Wachovia consented to the entry of an administrative order directing it to cease and desist from future violations of sections 17(a)(2) and (3) of the Securities Act and agreed to pay disgorgement of $6.75 million and a penalty of $4.45 million.
Securities And Exchange Commission v. ICP Asset Management LLC et al., No. 10-cv- 4791 (LAK) (S.D.N.Y. 2010)
This still-pending SEC enforcement action concerns the alleged fraudulent conduct of ICP Asset Management LLC, certain of its affiliates, and its founder and president (together, “ICP”) in connection with ICP’s role as a collateral manager of four CDOs known as the Triaxx CDOs.
The SEC’s complaint alleges that ICP engaged in numerous fraudulent transactions designed to enrich itself at the expense of the Triaxx CDOs’ investors, including by causing the CDOs to pay inflated prices for collateral assets and altering trades in order to divert profits from the CDOs to ICP. ICP also allegedly orchestrated “cross-trades” in which the Triaxx CDOs would sell bonds to each other at inflated prices, with the goal of manipulating “overcollateralization” tests.
In December 2010, the Court denied the defendants’ motion to dismiss without issuing an opinion. The case is currently in the discovery stage.
Cases To Watch
Ge Dandong v. Pinnacle Performance Limited et al., No. 10- Civ-8086 (LBS) (S.D.N.Y. 2010)
This putative class action concerns the marketing and sale by Morgan Stanley & Co., Inc. and certain of its affiliates (together, “Morgan Stanley”) of credit linked notes issued by Pinnacle Performance Limited (the “Pinnacle Notes”) between August 2006 and December 2007. Plaintiffs alleged that their $154 million investment in the Pinnacle Notes was transferred “on a dollar-for-dollar basis, into Morgan Stanley’s coffers.” Compl. ¶ 3.
According to Plaintiffs, Morgan Stanley “crafted the Pinnacle Notes to appear to be near-riskless investments.” Id. ¶ 22. Morgan Stanley allegedly represented that the reference portfolio for the notes would consist of a basket of underlying assets, including cash deposits, certificates of deposit, commercial paper, and asset-backed securities. In fact, Morgan Stanley allegedly caused the reference portfolio to consist exclusively of Morgan Stanley-arranged synthetic CDOs that Morgan Stanley allegedly “designed to fail” and that it was allegedly shorting.
The reference portfolios for these synthetic CDOs allegedly included heightened concentrations of securities of “Icelandic banks at risk of default” and firms exposed to a real estate downturn, such as home builders and monoline insurers. Id. ¶¶ 172-75.
In February 2011, Morgan Stanley filed a motion to dismiss the class action complaint. The court has not yet resolved this motion.
Basis Yield Alpha Fund (Master) v. Goldman Sachs Group, Inc., No. 10- cv-4537 (S.D.N.Y. 2010)
This lawsuit relates to a Goldmanarranged CDO known as Timberwolf 2007-1. Plaintiff Basis Yield Alpha Fund (Master) (“Basis”) alleged that Goldman committed fraud in connection with the June 2007 sale to Basis of investments in Timberwolf that were structured as CDS.
According to Basis, Goldman represented that Timberwolf’s collateral assets would be selected by a third party, Greywolf Capital Management, in the interests of long investors. Basis claims that, in reality, Goldman “exercised substantial influence and control over every asset to be included in Timberwolf” and “decided to specifically exclude assets that were performing well.” Compl. ¶ 8. At the same time, Goldman allegedly took substantial short interests in the Timberwolf CDO. The complaint cites an e-mail – that was disclosed during a government investigation – in which a Goldman executive famously referred to Timberwolf as “one shi**y deal.” Compl. Id. ¶ 13.
In August, 2010 Goldman filed a motion to dismiss which is still pending.
Dodona v. Goldman, No. 10-civ- 7497 (S.D.N.Y. 2010)
This action arises from investments that the Dodona hedge fund made in two Goldman-arranged CDOs known as Hudson Mezzanine Funding 2006-1 and 2006-2. Dodona alleged that Goldman structured the Hudson CDOs to lose value so that Goldman could profit from its short positions referencing these CDOs. According to Dodona’s complaint, Goldman also used the Hudson CDOs to reduce Goldman’s exposure to subprime assets that it believed would decline in value.
Goldman’s pitch book for Hudson 2006-1 allegedly represented that “Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent.” Compl. ¶ 63. According to Dodona, these representations failed to disclose that Goldman (i) structured the CDO to lose value, and (ii) had substantial short positions in the CDO, so that its interests were adverse to those of the CDO’s debt (i.e., “long”) investors. Dodona alleges that Goldman’s marketing materials for both of the Hudson CDOs contained similar omissions.
In April 2011, Goldman filed a motion to dismiss the complaint. The court has not yet resolved this motion.