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  • New York Appellate Division Sustains Fraud Claims Against RMBS Issuers and Underwriters
     
    08/22/2016
    On August 11, 2016, the New York Appellate Division, First Department, affirmed the New York Supreme Court’s denial of a motion to dismiss fraud claims asserted against sponsors and underwriters of twenty-three residential mortgage backed securities (“RMBS”).  IKB International, S.A. v. Morgan Stanley, 2016 WL 4217814 (1st Dep’t Aug. 11, 2016).  Defendants argued that the plaintiff had not adequately alleged its justifiable reliance on any alleged misrepresentation and that, when acting solely as underwriters of certain of the challenged transactions, they made no actionable misrepresentations.  The Court held that the plaintiff had adequately pleaded justifiable reliance on the purported misstatements and that the underwriters’ participation in the RMBS at issue, as pleaded, was sufficient to withstand a motion to dismiss.

    Plaintiff alleged that the defendants knowingly misrepresented in offering prospectuses the quality of the loans backing the RMBS purchased by plaintiff.  Plaintiff further alleged that the defendants acted with fraudulent intent because defendants’ own due diligence revealed that more than 39% of the securitized loans did not comply with their description in the offering documents.  Defendants countered that the plaintiff, as a sophisticated investor, did not justifiably rely on any alleged misrepresentation because it did not independently appraise the risks of the investments by, for example, requesting copies of the underlying loan files.  Defendants also asserted that plaintiff had not adequately pleaded fraudulent intent. 

    The Court held that the plaintiff adequately pleaded both justifiable reliance and fraudulent intent.  With respect to reliance, the plaintiff alleged that it had scrutinized the offering documents, which defendants had said was the only source of information about the securitization upon which investors should rely, and the plaintiff could not in any event have gotten access to the underlying loan files due to privacy laws.  The Court reasoned that the level of diligence advocated by the defendants would require a purchaser “to assume that the credit ratings assigned to the securities were fraudulent and to verify them through a detailed retracing of the steps undertaken by the underwriter and credit rating agency.”  The Court explained that “[w]e do not require this heightened due diligence standard to support justifiable reliance in a pleading concerning such sales of securities by prospectus.”  As for fraudulent intent, the plaintiff was only required to plead facts sufficient to support “a rational inference of actual knowledge.”  Plaintiff had done so by pleading, among other things, that the defendants’ own diligence performed at the time of the securitizations showed that 39% of the underlying loans were defective. 

    Defendants also argued that with respect to four certificates, they had acted as underwriters rather than sponsors and therefore made no actionable misstatements in the RMBS offering materials.  The Court rejected this argument, on the basis that plaintiff had alleged “that defendants’ role as an underwriter was significant, active and not passive.”  The underwriters had actively solicited investors, their names were on the offering documents (in one case the underwriter was allegedly described as the “lead manager”), and in some cases they had entered into lending relationships with the sponsors.  Their involvement in the securitization process was also sufficient, at the pleading stage, to support an inference that the underwriters “had a significant presence in many aspects of the securitization process and that they not only knew of the substandard quality of the loans being securitized, they actively participated in it.”  Accordingly, the Court concluded that the Supreme Court properly denied the defendants’ motion to dismiss.
    CATEGORIES: RelianceScienter

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