2nd Circuit delivers more bad news for sophisticated investors

By Alison Frankel
April 23, 2012

Remember U.S. District Judge Victor Marrero‘s opus last month in a hedge fund case against Goldman Sachs? The Manhattan federal judge refused to dismiss claims that Goldman duped the fund, Dodona, into investing in doomed-to-fail Hudson collateralized debt obligations. In 64 vivid pages, Marrero detailed the fund’s allegations that Goldman engaged in a sweeping effort, initiated by CFO David Viniar, to shed its exposure to subprime mortgages — and simultaneously to take advantage of clients who were slower to perceive the looming collapse of the mortgage-backed securities market. Marrero described the alleged scheme as “not only reckless, but bordering on cynical.”

What a difference a judge makes. Last September, in a parallel case involving Goldman’s Davis Square CDOs, U.S. District Judge William Pauley, also of Manhattan, needed only 19 pages to dismiss fraud and negligent misrepresentation claims by Germany’s Landesbank Baden-Wuerttemberg. On Thursday, without even bothering to write a precedential opinion, a three-judge panel of the 2nd Circuit Court of Appeals upheld the dismissal. Chief Judge Dennis Jacobs and Judges Rosemary Pooler and Susan Carney agreed with Pauley that the German bank was a sophisticated investor and received plenty of warnings about the risk of investing in the Davis CDOs.

“The relationship between Landesbank and the defendants was that of buyer and seller in a standard arm’s length transaction; and by its own representations Landesbank possessed sufficient expertise to evaluate the risks of its investment,” the 2nd Circuit wrote in a summary order. “The complaint therefore fails to plead justifiable reliance.” Landesbank’s counsel at Motley Rice had notified the 2nd Circuit of Marrero’s ruling, in a letter spelling out the judge’s conclusion that even if Dodona was a sophisticated investor, its reasonable reliance on Goldman’s representations isn’t precluded as a matter of law. By giving Landesbank’s argument such short shrift, the federal appeals court clearly believes the contrary.

The 2nd Circuit didn’t cite a New York state appeals court’s dismissal last month of HSH Nordbank’s $500 million fraud claim against UBS, even though Goldman’s lawyers at Sullivan & Cromwell notified the federal court of the state appeals ruling right after it came down. But there are distinct similarities in the two appellate decisions. Both the Landesbank and HSH Nordbank cases involved German banks investing in subprime mortgage-linked CDOs — and in both, the appeals courts held that sophisticated investors have an independent duty to assess the risks of their investments, particularly when offering documents disclaim the issuer’s responsibility.

Taken together, the state and federal rulings add up to very bad news for sophisticated investors who lost money in complex financial instruments. Big boys, the courts are saying, shouldn’t cry when they fall, even if Goldman Sachs or UBS stuck out a leg to trip them.

We’re still in the relatively early stages of mortgage-backed securities litigation, in which all kinds of foreign banks and sophisticated U.S. investors have sued for fraud. As Reuters noted in its coverage of the 2nd Circuit ruling Thursday, not many of these cases have reached appellate courts. So the state and federal precedent in the Goldman and UBS cases should surely embolden defendants.

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Attacks from the other hemisphere, homeowners, will be the next bank onslaught. Requirements in the AG ageement for foreclosing banks to affirm proper chains of ownership will be challenged visa vis New York Trust law and pooling and servicing agreement terms.

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