On June 13, 2014, New York Supreme Court Judge Charles Ramos dismissed a private fraud action brought by investors, or assignees of investors, in residential mortgage-backed securities (RMBS). The case is Phoenix Light SF Ltd. v. The Goldman Sachs Group, Inc., No. 652356/13 (N.Y. Sup. Ct. June 13, 2014) (see the decision here). It was the right result because sophisticated investors should vet their investments carefully and not expect to be bailed out when they fail to do so.
RMBS are essentially certificates entitling the owners to payments by borrowers on mortgage loans purportedly made in a manner consistent with stated underwriting guidelines and packaged together in a single security. When the financial crisis hit, borrowers failed to pay at expected levels and investors did not receive their expected returns. The RMBS at issue in this case involved 23 different offerings in the period 2005-2007 totaling more than $450 million.
Plaintiffs alleged the usual assortment of materially false and misleading disclosures or omissions in the sale of the RMBS certificates. These include: (1) the loan originators (e.g., New Century, Countrywide, and the like) failed to comply with stated loan underwriting guidelines for the borrowers’ ability to pay and the assessed value of houses serving as collateral; (2) loan to value ratios on the underlying loans were misstated because they were based on inflated appraisals; (3) offering documents misstated the percentage of homes that were occupied by their owners; and (4) credit ratings on the RMBS were inflated. Plaintiffs alleged that Goldman Sachs knew from its own due diligence efforts that the loans were of poorer quality than represented, and for that reason sold short the RMBS being sold to investors.
The buyers of these RMBS were highly sophisticated investors. The entity that assigned many of these securities to plaintiffs (likely after the financial crisis began, for payments well below the face value of the original certificates) was WestLB AG, an established German bank and investment bank.
Media coverage of the housing crisis tends to follow the lead of politicians who bemoan the greed that led investment banks like Goldman Sachs to sell mortgage-backed securities, or other collateralized debt obligations (CDOs), based on poor quality mortgage loans. It is plain, however, that the market for these securities was highly sophisticated. They promised higher yields than other debt obligations, and were thought to be well-collateralized and diversified. Investment funds, pension funds, and the like, whose investments are (or should be) vetted by professionals experienced in the analysis of such investments, provided an eager market for them. These were not widows and orphans … they were the leading institutional investors of our time. Part of the failure of these investments is explained by the unprecedented nature of the financial crisis that occurred, which caused many market participants – buyers and sellers alike – to discount the likelihood of disastrous declines in housing value. But part of the failure is attributable to sophisticated investors that simply did not do their jobs. When the crisis hit and these investors suffered serious losses, they did what we have come to expect in our society – they looked for other people to point fingers at.
This is just such a case. Judge Ramos gave short shrift to several of the defendants’ legal arguments, then turned to the one that was dispositive, at least under New York law: sophisticated investors who fail to do the basic work required to choose appropriate investments cannot turn to the courts to make others the guarantors of their losses.
It is important to understand that when these huge investments are made, investors typically have the right to obtain a full list of the loans underlying the securities so that they can conduct their own analysis of loan quality, how well the loans conform to the underwriting guidelines, and how well risk is reduced by packaging together loans from diversified geographic areas. Many investors eager to get the projected high yields never did that homework. Plaintiffs in this case carefully alleged that “there was no information available to plaintiffs at the time they bought the certificates – other than the loan files, which defendants did not share – that would have allowed plaintiffs or the assigning entities to conduct an investigation that would have revealed” that the loans did not conform to underwriting standards. But plaintiffs did not allege that they had sought and been denied this information. If they had done so, it was standard practice to provide that information on request. See slip opinion at 15-16.
In New York, sophisticated investors cannot do this and still show that they “reasonably relied” on the representations of others. Because such reliance is an element of a private damages claim, the claims had to be dismissed. Judge Ramos wrote:
Here, plaintiffs need to sufficiently allege that defendants were the ones who possessed peculiar knowledge about the misrepresentations and omissions, and that plaintiffs could not have uncovered the misrepresentations and omissions even with reasonable due diligence…. [They fail] to meet the second prong, as the allegations of the complaint itself, actually establish that plaintiffs could have uncovered defendants’ alleged misrepresentations and omissions if they had exercised due diligence by asking for the loan files, which plaintiffs admit was information available at the time they bought the Certificates.
… It does not matter if the failure to seek this information was because of blind faith in the proves of origination and/or securitization, or if it was attributable to the desire to quickly get on board of what the investors thought was a profitable bandwagon, the obligation of a sophisticated investor to inquire cannot be merely excused.
Slip opinion at 15-16.
It is strikingly refreshing to see the court recognize that sophisticated investors investing in highly sophisticated and complex securities have to act prudently under the circumstances, and if they fail to do so the courts are not there to prevent appropriate lessons from being learned.
June 17, 2014
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