Judge Loretta Preska of the United States District Court for the Southern District of New York recently denied a motion to dismiss federal securities law claims brought by investors in the Auction Rate Securities (“ARS”) market against underwriters and managing broker-dealers for ARS. Dow Corning Corp. v. Merrill Lynch & Co. (In re Merrill Lynch Auction Rate Sec. Litig.), Index No. 09-MD-2030, 2011 U.S. Dist. LEXIS 35363 (S.D.N.Y.). The district court concluded that the complaint’s allegations that the defendants made a series of “specific misrepresentations to reassure Plaintiffs about ARS after the ARS market began to crumble” were sufficient to state a claim, notwithstanding the defendants’ public disclosure of certain risks in the ARS market.  


ARS are long-term variable-rate debt instruments that are traded at periodic auctions, where buy orders are entered at interest rates selected by the bidder. The results of these auctions dictate the interest rates payable on the ARS. The highest bid accepted sets the interest rate for the ARS issuance as a whole (i.e., the “clearing rate”). If, at a particular auction, the buy and sell orders are insufficient to purchase all of the ARS offered for sale, the auction fails. In the event of auction failure, ARS holders are unable to sell the securities that they hold, and the interest rate rises to the “failure rate” until the next auction.  

Plaintiff Dow Corning Corporation, on its own behalf and as asset manager for plaintiffs Hemlock Corporation and Devonshire Underwriters Limited, allegedly purchased a total of $165 million of ARS between 2005 and February 13, 2008, from defendants Merrill Lynch & Company, Inc. and Merrill Lynch, Pierce, Fenner, & Smith Inc. The defendants served as the underwriters and managing broker-dealers for the ARS, and were often the only firms able to submit bids on behalf of others at their ARS auctions. They allegedly also “supported” their own ARS auctions by placing bids for their own account, which prevented auction failure and set an artificial clearing rate.  

The defendants allegedly had exclusive access to information concerning the ARS market, and did not disclose the identity of bidders, the number of bids placed, the rates at which bidders bid, or the total dollar amount of bids placed at their auctions. Defendants did, however, make public disclosures that “they may routinely bid in their own ARS auctions, that their bidding affects clearing rates, that Defendants are not obligated to bid, that the fact an auction clears does not mean there is no liquidity risk involved, and that auctions may fail if Defendants cease bidding.” According to the plaintiffs, by early 2007 the defendants “knew that the ARS market was teetering” and had internally “discussed withdrawing support bids for ARS entirely,” while they “increased their efforts to sell ARS to unwitting investors.”

Thereafter, plaintiffs allegedly questioned the defendants on several occasions concerning conditions in the ARS market and their affect on the liquidity of ARS, only to be reassured by defendants. Specifically, plaintiffs alleged that the defendants represented that “problems in the mortgage-backed securities market did not and would not affect the liquidity of Plaintiffs’ ARS,” that plaintiffs’ investments in ARS were “safe,” and that defendants would “continue to support their products and ensure that the auctions succeeded.” Beginning on February 13, 2008, however, the defendants allegedly stopped supporting their auctions, leading to auction failure and the inability of plaintiffs to sell their ARS from that date forward.

On November 20, 2009, plaintiffs filed their complaint, which was later consolidated into the multidistrict litigation pending before the district court concerning defendants’ alleged misconduct with respect to the ARS market. Plaintiffs’ complaint alleged violations of Section 10(b) of the federal Securities Exchange Act and Rule 10b-5, common law fraud, breach of fiduciary duty, negligent misrepresentation, and violation of the Michigan Uniform Securities Act. On April 23, 2010, defendants filed a motion to dismiss the complaint in its entirety for failure to state a claim.

Complaint States Federal Securities Law Claims

Plaintiffs’ claims under Section 10(b) of the Securities Exchange Act and Rule 10b-5 alleged that the defendants’ reassuring representations concerning the ARS market were fraudulent because defendants failed to disclose that “their bidding alone created the appearance of a liquid market” and that they were at the same time “contemplating ending their support bidding practice.” For these claims to survive a motion to dismiss, plaintiffs were required to allege that the defendants (1) made misstatements or omissions of material fact, (2) with scienter, (3) in connection with the purchase or sale of securities, (4) upon which the plaintiffs reasonably relied, and (5) that the plaintiffs’ reliance was the proximate cause of their injury. The district court concluded that the plaintiffs’ complaint satisfied each of these required elements.

The district court found that the complaint adequately alleged misstatements based on its allegations that “Defendants were the sole repositories of liquidity information” and “when asked about liquidity . . . Defendants did not disclose the ‘true state’ of the ARS market.” In particular, the district court identified five statements allegedly made by defendants in response to plaintiffs’ “questions about liquidity” that contained “untrue or only partially true reasons for ARS market changes when Defendants had specific and exclusive information about ARS demand.” With respect to each of those five statements, plaintiffs’ complaint had “identified the speaker, the date and place of the statements, the substance of the statements, and the reason why they were false or misleading.” According to the district court, “if the fate of Plaintiffs’ investments was exclusively in Defendants’ hands and if Defendants were contemplating ending their support for those investments or knew that the market was markedly different or impaired, Plaintiffs should have been told these facts in response to their inquiries.”

The district court emphasized that, “[u]nlike other ARS cases in this multidistrict litigation,” this was not a case founded on generic statements about audit risks found in public disclosures. Rather, this case involved allegations of “specific misrepresentations to reassure Plaintiffs about ARS after the ARS market began to crumble.” As a result, it was not dispositive of plaintiffs’ claims that they “were made aware of the general risks involved in ARS investments and the ability of Defendants to place (or not place) support bids.”  

The allegations in the complaint also gave rise to an inference of scienter (i.e., an intent to deceive, manipulate, or defraud). The district court explained that the mere desire to earn commissions was a common business motivation and, therefore, insufficient to show an intent to defraud. The district court did find sufficient, however, plaintiffs’ allegations “that Defendants sought to prop up the ARS market temporarily in order to preserve their ability to sell their ARS.” The district court rejected defendants’ argument “that Plaintiffs’ claim that Defendants increased their own inventory of ARS is incompatible with an inference of scienter because doing so knowing the market would fail is ‘economically irrational.’” Although that inference was possible, the competing inference that “Defendants sought to prop up the ARS market temporarily in order to preserve their ability to sell their ARS” was “equally compelling.” The plaintiffs’ allegations “suggest equally either recklessness or a motive and opportunity to commit fraud,” and no more was required to allege scienter.  

The reliance element was also satisfied by the plaintiffs’ allegations. The district court noted that “the bulk of Plaintiffs’ claims of misrepresentation sound in omission” and “[r]eliance is presumed in omission cases so long as the facts withheld are material.” Moreover, plaintiffs’ allegations indicate that their reliance was reasonable, because they tried to “exercise at least minimal diligence.” Plaintiffs attempted to conduct due diligence by questioning defendants concerning the ARS market, and “Defendants reassured Plaintiffs rather than warned them.” Given that the defendants allegedly had exclusive access to information concerning the ARS market, the plaintiffs had no further obligation to investigate, no matter how sophisticated they may have been.  

Finally, the plaintiffs adequately alleged an injury caused by defendants’ misrepresentations. Plaintiffs’ allegations of a loss of liquidity and inability to sell their ARS holdings were adequate to establish an economic loss, notwithstanding that plaintiffs have continued to receive interest payments. “Plaintiffs’ continued receipt of interest may reduce the overall damages they can claim,” but “it does not preempt the allegations of economic loss.” The district court was unconvinced by the argument that “broader market phenomena,” not defendants’ misrepresentations, could have been the cause of plaintiffs’ inability to sell their ARS holdings. In the context of a motion to dismiss for failure to state a claim, it is enough to “allege that the risk presented, a lack of liquidity, was precisely the risk concealed by the alleged misrepresentations.” Plaintiffs are not required to plead facts sufficient to exclude all other possible explanations for their injury.  

The district court denied defendants’ motion to dismiss with respect to plaintiffs’ claims under Section 10(b) of the Securities Exchange Act and Rule 10b-5.  

Split Decision on State Law Claims

Defendants’ motion also asked the district court to dismiss plaintiffs’ assorted state law claims, with partial success. The district court concluded that plaintiffs’ allegations in support of their federal securities law claims sufficed to make out claims for common law fraud and breach of the Michigan Uniform Securities Act, each of which share similar elements. With respect to plaintiffs’ breach of fiduciary duty and negligent misrepresentation claims, however, the district court granted the defendants’ motion to dismiss for failure to state a claim. A broker-customer relationship ordinarily does not create a fiduciary duty. The existence of a fiduciary duty owed by a broker is even less likely where, as in this case, the customers are sophisticated investors. The plaintiffs’ allegations concerning the nature of their relationship with defendants were “conclusory” and “therefore insufficient to show the existence of [a fiduciary] duty.” The plaintiffs’ failure to allege adequately the existence of a fiduciary relationship was also fatal to its negligent misrepresentation claim, which is only cognizable where “the defendant owes [the plaintiff] a fiduciary duty.” Finally, the district court noted that under New York law plaintiffs’ fiduciary duty and negligent misrepresentation claims would also be barred by that state’s Martin Act, which preempts certain common law tort claims in securities disputes.


Judge Preska’s recent decision in the In re Merrill Lynch Auction Rate Securities Litigation demonstrates that the challenging pleading standards to state a federal securities fraud claim, in appropriate circumstances, can be overcome by specific allegations of direct misrepresentations to an investor. Such allegations may survive a motion to dismiss even in the face of boilerplate public disclosures of potential risks facing investors in that security.