Alison Frankel

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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Last month, as U.S. banks began reporting their third-quarter financials, I noted that the banks had beefed up their disclosure of potential liability for mortgage-backed securities activity. Morgan Stanley revealed that it had received a demand letter from Gibbs & Bruns, the firm that represents the big funds that negotiated the proposed $8.5 billion MBS breach-of-contract settlement with Bank of America. Goldman upped its reported MBS exposure to $15.8 billion, from a mere $485 million in the second quarter. The new emphasis on disclosure, I said, was partly the result of more claims, but also partly due to pressure from the Securities and Exchange Commission and the Public Company Accounting Oversight Board to improve MBS disclosures.

The bond insurers’ trade group, the Association of Financial Guaranty Insurers, has also been agitating for banks to acknowledge their MBS exposure — and particularly their exposure to MBS breach-of-contract (or put-back) claims. In September 2010 AFGI sent a blistering letter asserting that Bank of America’s MBS put-back liability to its members was more than $10 billion. This September the bond insurers targeted Credit Suisse, which, according to AFGI, had failed to account for billions in put-back claims.

Late Wednesday AFGI struck again. The recipient this time was UBS. According to the letter AFGI sent to UBS CEO Sergio Ermotti, the Swiss bank has reported a $93 million reserve for put-back claims in its most recent financial report — even though it has received more than $800 million in put-back claims from just one bond insurer, and that insurer (presumably Assured Guaranty) has indicated its intention of demanding a total of $4 billion in put-backs from UBS.

UBS has included disclaimers about the uncertainty of the volume of put-back claims and its success in rebutting put-back demands, but AFGI asserts the boilerplate language is misleading. “AFGI submits that neither refusing legitimate repurchase requests nor failing to discharge legitimate liabilities constitutes ‘success’ nor in any way reduces or eliminates the liabilities,” the letter said.

The bond insurers also sent the UBS letter to the bank’s regulators, the Swiss Financial Markets Supervisory Authority and the New York State Department of Financial Services, as well as to UBS’s auditor, Ernst & Young.

In a statement, a UBS spokesperson said: “The letter from the AFGI — a trade association for monoline insurers — is inaccurate and we dispute AFGI’s numerous unfounded allegations. In particular, UBS stands behind its financial reporting, including its disclosures and provisions concerning its potential RMBS-related liabilities as entirely appropriate and fully compliant with all legal and regulatory requirements. We take issue with the quality and integrity of the industry loan reviews cited in the letter and note that UBS has received numerous unfounded loan repurchase demands — and these demands are fully reflected in UBS’s disclosures. Moreover, the AFGI’s membership includes ultra-sophisticated insurers that accepted significant premiums to insure risks and that now seek to evade these obligations. Today’s letter adds nothing new, and is merely the latest in a series of efforts by the Association and its members to shift responsibility for their actions.”

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The damages claims in Irving Picard’s pursuit of the banks that allegedly helped Ponzi schemer Bernard Madoff are so outsized that even a simple two-page letter from a federal judge can lead to a $2 billion kerfuffle. On Tuesday, Manhattan federal district court judge Colleen McMahon sent a letter to lawyers for Picard, the bankruptcy trustee for Bernard L. Madoff Investment Securities, and to lawyers for UBS, which is a defendant in two of Picard’s suits. UBS’s counsel at Gibson, Dunn & Crutcher had moved in June to transfer two Picard suits naming the bank as a defendant out of bankruptcy court and into federal court; Judge McMahon, who is overseeing Picard’s case against JPMorgan Chase, agreed to take the cases on July 7 and began requesting information, by letter, from Picard counsel at Baker & Hostetler and UBS counsel at Gibson Dunn.

To understand Judge McMahon’s July 19 letter — and how it was misinterpreted — it’s important to know that in the two actions naming UBS defendants, Picard is asserting different causes of action and seeking different amounts of money. In the case known as Luxalpha, Picard and Baker & Hostetler claim that UBS breached its fiduciary duty and aided and abetted fraud. That suit demands $2 billion from UBS and other defendants. The other case, known as LIF, is a clawback action demanding the return of all the money the bank and other defendants redeemed from Madoff or earned in fees, a total of $550 million, according to Picard. Though the press release announcing the LIF suit refers to “alleged financial fraud” by UBS, the suit actually claims only unjust enrichment and another common-law cause of action as an alternative to the clawback theory.

In a July 14 letter, Judge McMahon told Baker & Hostetler and Gibson Dunn that she needed more explanation of how the LIF and Luxalpha cases intersected and overlapped, and warned the lawyers that she wasn’t going to slow down the JPMorgan case to address complications in the UBS suit. In response, the Picard lawyers decided to simplify matters, reasoning that if they dropped the alternative-theory common law claims in the $550 million LIF case, there would be no reason for the case to stay in federal court. Picard could simply go after the $550 million in a bankruptcy court clawback action.

Baker & Hostetler’s letter explaining its decision to drop LIF claims to Judge McMahon isn’t in the docket. But the judge entered into the record her July 19 letter, in which she notes (rather cryptically unless you know the background) that Picard “has withdrawn his non-bankruptcy claims.”

On Wednesday morning, Bloomberg put out a hot story, reporting that Picard “may drop $2 billion in claims against UBS AG,” and quoting a bankruptcy lawyer who’s not involved in the Madoff litigation saying that Picard may have made a tactical decision to retreat from bigger claims. Bloggers who picked up the story reported that Picard was only going to pursue clawback claims against UBS. (See here and here.) Bloomberg updated its story to indicate that UBS’s shares were up in both Switzerland and the United States “after the withdrawal of Picard’s claims was reported.”

But according to Picard’s lawyers, he hasn’t given up a penny of his demands against UBS. Oren Warshavsky of Baker & Hostetler told OTC Wednesday that the common-law claims Picard dropped from the $550 million LIF suit “were alternative theories of recovery,” to the bankruptcy-court clawback theory. “By dismissing the two common-law causes of action, our goal is to streamline the case and effect judicial economy. We did not diminish the amount sought in any way,” he said.

Moreover, Picard hasn’t dropped any claims in the $2 billion Luxalpha fraud case against UBS, in which both sides will now presumably brief the very serious questions of standing and pre-emption that Judge McMahon is considering in Picard’s JPMorgan case.

I contacted the editor of the Bloomberg story, asking for comment on my reporting that Picard hadn’t, in fact, dropped any valuable claims. “Our story is based on Judge McMahon’s letter to counsel filed in the district court docket yesterday,” he replied in an e-mail. Bloomberg updated its story Wednesday afternoon to include a comment from Picard’s spokesperson stating that the dropped claims don’t impact the damages sought against UBS. Bloomberg also reports that the bankruptcy lawyer quoted in early versions of the story had reviewed “Picard’s original suit against UBS” (it doesn’t say which one) and concluded, “The trustee ‘will get large sums of money using garden bankruptcy law, but he is giving up at least $2 billion based on common and state law claims.’”

UBS’s lawyers at Gibson Dunn didn’t respond to requests for comment.

There’s going to be big news coming soon in Picard’s cases against the banks. Judge Jed Rakoff has promised to rule by the end of this month on the threshold question of whether the trustee has standing to sue the banks that allegedly abetted Madoff’s fraud. If Rakoff agrees with the banks, that’s a titanic defeat for Picard.

But the trustee dropping duplicative claims to keep his case in the friendlier confines of bankruptcy court? Not so much.

(Reporting by Alison Frankel)