| ACA Fin. Guar. Corp. v Goldman, Sachs & Co. |
| 2013 NY Slip Op 03429 [106 AD3d 494] |
| May 14, 2013 |
| Appellate Division, First Department |
| ACA Financial Guaranty Corp.,Respondent, v Goldman, Sachs & Co., Appellant. |
—[*1] Kasowitz Benson Torres & Friedman LLP, New York (Marc E. Kasowitz ofcounsel), for respondent.
Order, Supreme Court, New York County (Barbara R. Kapnick, J.), entered April 24,2012, which, to the extent appealed, denied defendant's motion to dismiss the causes ofaction for fraudulent inducement and fraudulent concealment, reversed, on the law,without costs, and the motion granted. The Clerk is directed to enter judgment dismissingthe amended complaint.
Plaintiff alleges that it was fraudulently induced to issue a financial guaranty for aportion of an investment by defendant's misrepresentation that a nonparty hedge fundwas taking a long position in the investment when in fact, such fund was actually a shortseller, which was influencing the selection of the reference portfolio it was effectivelybetting against.
The motion court erred when it denied defendant's motion to dismiss plaintiff'scauses of action for fraud. While we agree that plaintiff adequately pleaded all of therequisite elements comprising a fraud claim (Dembeck v 220 Cent. Park S., LLC, 33 AD3d 491, 492[1st Dept 2006] ["To make a prima facie claim of fraud, the complaint must allegemisrepresentation or concealment of a material fact, falsity, scienter on the part of thewrongdoer, justifiable reliance and resulting injury"]), plaintiff's amended complaintnevertheless fails to establish justifiable reliance as a matter of law. Indeed, plaintiff failsto plead that it exercised due diligence by inquiring about the nonpublic informationregarding the hedge fund with which it was in contact prior to issuing the financialguaranty, or that it inserted the appropriate prophylactic provision to ensure against thepossibility of misrepresentation (see Centro Empresarial Cempresa S.A. v AmÉricaMÓvil, S.A.B. de C.V., 76 AD3d 310, 320-321 [1st Dept 2010],affd 17 NY3d 269 [2011]). In Centro Empresarial Cempresa S.A., wedismissed plaintiffs' complaint alleging, inter alia, fraud, holding that the fraud claim wasbarred by the omission of necessary language in the release between the parties(id.). Specifically, we stated that "[i]f plaintiffs did not intend to release claims offraud . . . , they should have insisted on access to . . . internalbooks and records . . . [and] if plaintiffs did not wish to forgo suing on afraud claim they might discover in the future, these sophisticated and well-counseledentities should have insisted that the release [barring future claims] be conditioned on thetruth of the financial information provided by defendants (whether directly or throughpublic filings) on which plaintiffs were relying. In essence, by entering into the 2003 saleof their interests in reliance on defendants' unverified [*2]representations concerning [defendant's] financialcondition, without inserting into the agreement a prophylactic provision to ensure againstthe possibility of misrepresentation plaintiffs may truly be said to have willingly assumedthe business risk that the facts may not be as represented" (id. [internal quotationmarks, citations and ellipsis omitted]; see also Graham Packaging Co., L.P. v Owens-Illinois, Inc., 67AD3d 465 [1st Dept 2009]; Permasteelisa, S.p.A. v Lincolnshire Mgt., Inc., 16 AD3d352 [1st Dept 2005]; cf.DDJ Mgt., LLC v Rhone Group L.L.C., 15 NY3d 147, 154 [2010]).
Here, in agreeing with the motion court's denial of defendant's motion, the dissentattempts to distinguish our holding in Centro Empresarial Cempresa S.A. (76AD3d 310), where we held that a fraud claim is barred where a sophisticated andwell-counseled entity fails to include an appropriate prophylactic provision in theagreement governing the transaction from which the legal dispute arises to ensure againstthe possibility of misrepresentation (id. at 320-321). Since the release in thataction was part and parcel of the agreement between the parties, we reject the dissent'sattempt to limit our holding in Centro Empresarial Cempresa S.A. to cases wherecontracting parties fail to insert in a release appropriate prophylactic provisions to ensureagainst the possibility of misrepresentation. Proof that our holding in CentroEmpresarial Cempresa S.A. is not so limited is found in Graham PackagingCo. (67 AD3d 465), where we affirmed the dismissal of defendants' counterclaim forfraudulent concealment since they failed to, inter alia, insert "a prophylactic provision inthe settlement agreement to limit their exposure" (id. at 465 [emphasisadded]). Similarly, in Permasteelisa, S.p.A. (16 AD3d 352), we affirmeddismissal of plaintiff's cause of action for fraud when, inter alia, it failed to insert "aprophylactic provision in the purchase agreement to ensure against the possibilityof misrepresentation" (id. at 352 [emphasis added]).
Equally unavailing is the dissent's attempt to distinguish this case from CentroEmpresarial Cempresa S.A. on the ground that the relationship between the partieshere was not adversarial, thereby implying that our holding in Centro EmpresarialCempresa S.A. was limited to transactions between adverse parties. Notwithstandingthat in that case we noted that the parties were in an adversarial and hostile relationship(id. at 320-321), nothing in Centro Empresarial Cempresa S.A. limited itsholding to adverse transacting parties; nor could it, since parties are seldom, if ever,adversaries at the outset of a transaction, when the terms of an agreement are ordinarilycrafted. Instead, parties amicably transacting business often become adversaries when, ashere, they meet in court averring that one party wronged the other. A well craftedagreement should protect against this very eventuality. More specifically, because partiescan seldom be certain that the representations made by other contracting parties areindeed true, they must—lest their cause of action for fraud be barred—insertthe requisite prophylactic provision to ensure against the possibility of misrepresentation.Notably, the dissent's attempt to characterize the nature of the relationship between theparties here as one of trust and good faith is belied by the allegations in plaintiff's owncomplaint, which, as noted by the dissent, evinces that prior to the execution of theagreement between the parties, plaintiff, via email, sought confirmation from defendantregarding the nonparty hedge fund's role and position in the transaction. Accordingly, itis clear that notwithstanding plaintiff's understanding as to the nature of the transactionand the roles of all parties concerned, it nevertheless sought assurances from thedefendant presumably to prevent a misunderstanding and/or the very fraud for which itnow sues.
Moreover, the dissent's position is particularly unpersuasive insofar as plaintiff couldhave, upon further inquiry, uncovered the nonparty hedge fund's actual position, butapparently [*3]chose not to (Centro EmpresarialCempresa S.A., 76 AD3d at 319-320; Graham Packaging Co., 67 AD3d at465; Permasteelisa, S.p.A., 16 AD3d at 352). Specifically, plaintiff received,inter alia, the offering circular for the transaction, which expressly disclosed that no onewas investing in the first-loss tranche. This information should have alerted plaintiff thatcontrary to the representations made, the nonparty hedge fund was not funding a portionof the transaction at all, let alone in the manner represented (i.e., by taking the equity orlong position). Therefore, plaintiff should have questioned defendant or the nonpartyhedge fund; such an inquiry would have likely informed plaintiff that the nonparty hedgefund was taking a short rather than the long equity position represented. We reject thedissent's assertion that the absence of any funding of the first loss tranche wasattributable to the fact that the nonparty hedge fund was purportedly funding thefirst-loss tranche by taking the long position on a credit default swap. This assertion doesnot explain why the tranche was completely unfunded, since even the fundingmechanism perceived by plaintiff—the credit default swap—should havehad a value and thus should have been listed in the offering circular.
In sum, plaintiff's fraud claims based on the allegation that plaintiff, a highlysophisticated commercial entity, was misled into believing that a nonparty hedge fundwould take a long position in the first-loss tranche of the collateral debt obligation, inalignment with plaintiff's interests, must be dismissed because: (1) suchmisrepresentations were specifically contradicted by the offering circular's disclosure thatno such equity position was being taken; (2) plaintiff's alleged reliance on suchmisrepresentations would have been contrary to its acknowledgment (as set forth in theoffering circular) that, in entering into the transaction, it was "not relying (for purposes ofmaking any investment decision or otherwise) upon any advice, counsel orrepresentations (whether written or oral) of [defendant] . . . other than in thefinal offering circular for [the transaction] and any representations expressly set forth in awritten agreement with such party," and that defendant was not "acting as a fiduciary orfinancial or investment adviser for the purchaser"; and (3) the hedge fund's intentionswith regard to this investment were not peculiarly within defendant's knowledge andplaintiff, although it was in direct contact with the hedge fund, failed to ask the hedgefund what position it intended to take in this investment (see Danann Realty Corp. vHarris, 5 NY2d 317 [1959]; HSH Nordbank AG v UBS AG, 95 AD3d 185 [1st Dept2012]).
In view of the foregoing, it is unnecessary to address defendant's remainingcontentions. Concur—Friedman, J.P., Renwick, and Román, JJ.
Manzanet-Daniels and Clark and, JJ., dissent in a memorandum by Clark, J., asfollows: Plaintiff has adequately alleged justifiable reliance, inasmuch as thedocumentary evidence established that plaintiff performed an exercise of reasonable duediligence. I would therefore affirm the order of the motion court denying defendant'smotion to dismiss.
ACA Financial Guaranty Corp., plaintiff herein, issued a financial guaranty policythat "wrapped" ABACUS 2007-ACI, a financial product known as a syntheticcollateralized debt obligation (CDO).[FN1]A financial guarantor insurer such as plaintiff issues a policy guaranteeing [*4]payment of senior notes in or above a specified tranche inthe capital structure, known as the "attachment point."
Plaintiff alleges that defendant, Goldman, Sachs & Co. (Goldman), conceived andmarketed ABACUS based on a portfolio of investment securities selected by its hedgefund client, Paulson & Co., Inc. (Paulson). Plaintiff alleges that ABACUS was designedto fail so that Paulson could reap large profits by shorting the portfolio and Goldmancould in turn reap huge fees.
It is standard industry practice for a "transaction sponsor," as Paulson is alleged tohave been, to precommit to invest in the CDO by investing in the equity tranche. Theequity tranche suffers the first loss in the event the portfolio performs poorly. As a directresult, the transaction sponsor has a strong economic incentive to have a high-qualityreference portfolio.[FN2]The transaction sponsor normally takes the "long" position, betting that the portfolio willperform well.
Plaintiff alleges that defendant deceived it into believing that Paulson was a longinvestor in ABACUS, whose interests "aligned" with those of plaintiff as insurer. In fact,however, defendant knew that Paulson intended to take an enormous short position inABACUS, i.e., that it stood to profit if the portfolio performed poorly.
The complaint alleges that by 2006, Paulson was convinced that the market forsubprime residential mortgage-backed securities (RMBS) was on the verge of collapse.Paulson allegedly sought a way to make a billion dollar profit on the failure of a portfolioof RMBS through a single transaction. The complaint alleges that Paulson did not wantto take the short position in just any portfolio of RMBS, but in one that it had selected inthe belief that it was most likely to default.
The complaint further alleges that Paulson set out to find an investment bank thatwould structure, underwrite and sell the portfolio of RMBS, and broker Paulson'spurchase of protection on the portfolio. The complaint notes that at least one investmentbank approached by Paulson, Bear Stearns, declined to assist Paulson, fearing for itsreputation. Scott Eichel of Bear Stearns, who met with Paulson several times, allegedlywas quoted as saying that Paulson wanted[*5]"especiallyugly mortgages for the CDOs, like a bettor asking a football owner to bench a starquarterback to improve the odds of his wager against the team." Eichel stated that thetransaction "didn't pass ethics standards . . . We didn't think we should selldeals that someone was shorting on the other side."
Paulson thereafter approached defendant's structured products correlation tradingdesk. Despite an acknowledged "reputational risk," defendant agreed to underwrite thetransaction on behalf of Paulson, with which defendant had done $7 billion intransactions prior to ABACUS. Defendant's internal memos plainly identified Paulson,and Paulson's economic interest in ABACUS, stating that defendant was "effectivelyworking an order for Paulson to buy protection on [i.e., short] specific layers of the[ABACUS] capital structure."
The complaint alleges that defendant soon learned that if it were disclosed thatPaulson, the transaction sponsor, intended to take a massive short position against theportfolio, it would not be able to find a portfolio selection agent for the product, muchless a financial guaranty insurer who would wrap the super-senior portion of the capitalstructure. Less than a week before approaching plaintiff, defendant approached GSCPartners to act as the portfolio selection agent for ABACUS, explicitly disclosing thatPaulson intended to short the reference portfolio. GSC declined to act as portfolioselection agent, informing defendant, "I do not have to say how bad it is that you guysare pushing this thing."
On January 8, 2007, a subsidiary of plaintiff met with Paulson at Paulson's offices todiscuss the proposed transaction including, inter alia, the RMBS to be included in thereference portfolio. In contrast to the candid disclosure made to GSC regarding Paulson'sshort interest, Paulson did not disclose to plaintiff's representatives that it intended toshort the reference portfolio.
In response to plaintiff's emails seeking clarification regarding how Paulson intendedto "participate" in ABACUS, defendant, in an email dated January 10, 2007, purported tosupply a "Transaction Summary." This summary not only failed to disclose Paulson'sshort position, but, as alleged, it affirmatively misrepresented that Paulson hadprecommitted to take a long position. Defendant identified Paulson as the "transactionsponsor"—which, as noted above is typically the equity investor. Further, in anemail dated January 10, defendant stated that the economic interests of Paulson andplaintiff in ABACUS were "align[ed]." In summarizing the capital structure, defendantdescribed the 0% to 9% tranche, i.e., the equity tranche, as "pre-committed first loss."The CDO had not been launched, or marketed to prospective investors, making Paulsonthe only possible entity "pre-committed" to invest in the equity tranche. The amendedcomplaint further alleges that on February 23, 2007, defendant again misrepresented thatPaulson had agreed to be the equity investor in ABACUS during a telephone callbetween Goldman and ACAM (plaintiff's subsidiary), where Goldman allegedlyrepresented that Paulson was "looking 0-10%," which describes the equity tranche, along position.
Plaintiff alleges that defendant engaged in this misconduct notwithstanding anacknowledgment that its participation constituted a "reputational risk," and has sincesettled Securities and Exchange Commission (SEC) civil charges arising out of the verysame conduct, agreeing to pay $15 million in restitution and a civil penalty in the amountof $535 million (see S.E.C. v Goldman Sachs & Co., 790 F Supp 2d 147 [SDNY 2011]).[FN3]In denying in part codefendant Fabrice Tourre's motion to dismiss the [*6]SEC complaint, the Federal District Court held that thecomplaint sufficiently alleged a material misrepresentation by defendant (i.e., thatPaulson was an equity investor), a duty on defendant's part to disclose the truth (i.e., thatPaulson was in fact taking a short position), and scienter (id. at 162-163).
Plaintiff notes that the United States Permanent Subcommittee on Investigations,following an 18-month investigation, cited defendant as one of the "self-interestedpromoters of risky and complicated financial schemes that helped trigger the [2008financial] crisis." With respect to ABACUS, the investment at issue, the Subcommitteeconcluded that defendant knew that Paulson would "profit only if [ABACUS] lostvalue," yet allowed Paulson to "play a major role in selecting the assets," while failing todisclose his true "investment objective."
To make a prima facie claim of fraud, a complaint must allege misrepresentation orconcealment of a material fact, falsity, scienter on the part of the wrongdoer, justifiablereliance and resulting injury (see Dembeck v 220 Cent. Park S., LLC, 33 AD3d 491, 492[1st Dept 2006]).
Even in the absence of any affirmative misrepresentation or any fiduciary obligation,a party may be liable for nondisclosure where it has special knowledge or informationnot attainable by plaintiff, or when it has made a misleading partial disclosure (see Williams v Sidley AustinBrown & Wood, L.L.P., 38 AD3d 219, 220 [1st Dept 2007]; see also L.K. Sta. Group, LLC vQuantek Media, LLC, 62 AD3d 487, 493 [1st Dept 2009]).
This appeal turns on whether plaintiff has adequately alleged the element ofreasonable reliance. The majority finds that plaintiff cannot establish reasonable relianceas a matter of law because plaintiff allegedly failed to make an inquiry concerningnonpublic information regarding the investment prior to issuing the financial guaranty,and failed to insert an "appropriate prophylactic provision" to protect itself againstdefendant's deception.
I am compelled to disagree with this line of reasoning. It neither comports with thefactual record nor the law on this issue. The offering circular, the document alleged tohave triggered plaintiff's duty to inquire, merely states that the hedge fund did not issueequity notes. It does not imply that there was no equity investor or that "no one wasinvesting in the first-loss tranche." It simply lists $50 million in original principal amountfor class A-1 notes, $142 million for class A-2 notes, and $0 for "FL" (first loss) notes.
The complaint alleges that long investors can participate in the capital structure of asynthetic CDO such as ABACUS either by purchasing notes or by selling protection on aspecified tranche in the capital structure (see amended complaint ¶ 18).Given this description, there is a reasonable inference that plaintiff understood theabsence of equity notes to mean that Paulson intended to "take a long position in theequity tranche of ABACUS through a [credit default swap]," by selling protection on the0% to 10% tranche instead of purchasing notes (see amended complaint ¶60).
Although plaintiff is a sophisticated business entity, based on the unique set of factspresented in this appeal, the duty to perform due diligence was fulfilled, when, as here,plaintiff asked defendant about Paulson's position, defendant made specific and detailedrepresentations that conformed with the industry standard for a similarly situatedtransaction, and defendant's [*7]misrepresentation wasnot discoverable through any public source of information. This Court held in HSH Nordbank AG v UBSAG (95 AD3d 185 [1st Dept 2012]) that the misrepresentation of risk relating tothe notes at issue was discoverable through an exercise of reasonable due diligencewithin the means of a financial institution of the plaintiff's size and scope, because "theunreliability of credit ratings" was "common knowledge among participants in [therelevant] market" (id. at 193). Thus, "[f]ar from being peculiarly within [thedefendant's] knowledge, the reliability of the credit ratings could be tested against thepublic market's valuation of rated securities" (id. at 196).
In this matter, defendant concealed the credit default swap whereby Paulson becamethe undisclosed protection buyer in ABACUS with interests adverse to plaintiff. Far frombeing "common knowledge," this interest was not discoverable through any publiclyavailable source of information. As such, the allegations presented do not establish thatplaintiff failed to exercise reasonable due diligence to protect itself from defendant'smisrepresentation.
The majority's reliance on Centro Empresarial Cempresa S.A. v AmÉrica MÓvil,S.A.B. de C.V. (76 AD3d 310 [1st Dept 2010], affd 17 NY3d 269[2011]) to support the proposition that plaintiff failed to exercise due diligence ismisplaced. In that action, plaintiffs alleged that they were induced to sell their minorityinterest in a mobile telephone company based on misrepresentations made by defendantsconcerning the value of the venture (76 AD3d at 311). This Court held that plaintiffs'claims alleging fraud were barred by the broad general release plaintiffs granted todefendants in connection with the sale of their interest (id. at 318-322).Moreover, we held that plaintiffs chose to cash out their interests without insisting ondefendants' verification of the value or conditioning the deal on the accuracy of theinformation, thereby assuming a business risk, especially in light of the adversarialrelationship between the parties (id. at 320-321).
Here, in contrast, there is no general release or similar agreement at issue. Themajority does not rely on general disclaimers to preclude the claims of misrepresentation.Further, the relationship between plaintiff, a monoline bond insurance company (thefinancial guarantor insurer), and defendant, an investment bank, is not an adversarial one.The investment bank's role is to provide a structure, orchestrate the transaction, andmarket the CDO to investors. It is important to note that plaintiff alleges that defendantstructured this transaction as if it were a typical CDO where the transaction sponsor is along investor. While plaintiff did not condition participation based on verification ofGoldman's representations, plaintiff did not assume a business risk since the proposedtransaction and alleged misrepresentation/concealment conformed to the industrystandard for this particular type of transaction. Goldman had peculiar knowledge ofPaulson's role in the transaction, and the misrepresentation was not detectable throughany public information. Plaintiff sought to protect its interest in the transaction byconfirming Paulson's role via email and telephone calls. Thus, given the structure of thetransaction and the financial instrument at issue, plaintiff's fraud claim does not fallwithin the purview of cases holding that such a claim is barred where the parties failed toinsert an appropriate prophylactic provision in their agreement stating that theirrepresentations were true (contra Graham Packaging Co., L.P. v Owens-Illinois, Inc., 67AD3d 465 [1st Dept 2009]; cf. [*8]DDJ Mgt., LLC v Rhone GroupL.L.C., 15 NY3d 147, 153, 156 [2010] [reasonable reliance sufficiently allegedwhere plaintiff obtained representations and warranties that financial statements were notmaterially misleading]). [Prior Case History: 35 Misc 3d 1217(A), 2012 NY Slip Op50723(U).]
Footnote 1: To establish a CDO, aninvestment bank like defendant incorporates a special purchase vehicle (SPV) to whichequity investors contribute capital. In a synthetic CDO, the SPV acts as the protectionseller in one or more credit default swaps referencing a portfolio of collateral. Theprotection seller takes the long position, i.e., it profits if the reference portfolio performswell, and the protection buyer takes the short position, i.e., it profits if the referenceportfolio performs poorly.
Footnote 2: The complaint allegesthat defendant accomplished this result through a separate credit default swap betweendefendant and Paulson, which defendant concealed from plaintiff. Plaintiff's position isthat Paulson, by purchasing from defendant the protection on the reference portfolio thatdefendant had purchased from the SPV, became the ultimate and undisclosed protectionbuyer, i.e., a short investor in ABACUS with an economic incentive to select referenceobligations that would default.
Footnote 3: Although defendantsettled the SEC action without admitting or denying the substantive allegations of thecomplaint, defendant acknowledged that it was a "mistake" not to include in theABACUS marketing materials a reference to Paulson's role in the portfolio selectionprocess and that Paulson's economic interests were adverse to CDO investors.