Fraud Is Hard to Prove, and Should Be
(Bloomberg Opinion) -- A federal appellate court just made it a tiny bit harder for buyers of collateralized debt obligations to sue for fraud, and the contracts professor in me is pleased. No, I’m not an inveterate cheerleader for rich corporate defendants; I simply think it’s vital to the legal system that we not twist principles into pretzels to make sure the bad guys suffer.
The case in question, Loreley Financing v. Wells Fargo Securities, was decided this month by the U.S. Court of Appeals for the Second Circuit. The dispute stems from the mortgage meltdown, the effects of which continue to ripple through the courts. In 2006 and 2007 — as we now know, exactly the wrong moment — the plaintiffs purchased CDOs from various subsidiaries of Wachovia, at the time the fourth-largest bank in the U.S. The court states with useful precision the rest of the drearily familiar story: “When the financial crisis hit in 2008, cash flow into the CDOs ceased and the CDOs became worthless.”
That same year, facing collapse, Wachovia agreed to be acquired by Wells Fargo. Loreley sued. In the course of the litigation, the plaintiffs’ claim narrowed to the proposition that Wachovia, in offering the securities in question, made false representations. These included the assertion that the managers who chose securities for the CDOs would be independent of Wachovia’s control, where in fact (again, according to the plaintiffs), Wachovia pressured the managers to accept securities of dubious quality.
The court, however, pointed to the simplest of holes in that reasoning. Whether Wachovia’s statements were false or true, Wachovia made no representations to Loreley.
How, then, did Loreley come to invest in the CDOs at issue? Long story short: Loreley acted on advice from Deutsche Industriebank AG, and IKB Credit Asset Management GmbH provided investment advice. (IKB created Loreley, but the legal structure of the companies did not allow IKB to control Loreley’s decisions.) IKB, after what the court says was due diligence, recommended the Wachovia securities. Loreley — characterized by the court as a “sophisticated” investor — followed IKB’s advice.
Which leads to the tricky part. The misrepresentations, if any, were made not to Loreley but to IKB.
This is a distinction that matters. Successful fraud claims on the theory called “detrimental reliance” are made all the time, but only when plaintiffs are the parties to whom the representations were made. If I persuade you to buy my car by assuring you that the vehicle has had all required maintenance, I’m liable if it hasn’t.
But now suppose you’re buying a car that I originally bought from Bald Liar. When I bought the vehicle, Bald Liar assured me that all the required maintenance had been done. This was false. If you discover that the car hasn’t had all required maintenance, you can’t sue Bald Liar. Why not? Because Bald Liar never made a false representation to you.
This isn’t some exotic principle invented to protect sellers of risky securities. It’s long been the law pretty much everywhere. Just this past July, a federal judge presiding over a different lawsuit reviewed the case law and flatly concluded: “[T]he overwhelming majority of courts to have expressly considered claims based on a third-party reliance theory have rejected it.”
Although there exist a handful of narrow exceptions, fraud isn’t one of them. In the Loreley lawsuit, the court expressed skepticism that the plaintiffs had made out a case for fraud. But even if they had, wrote the panel, the result would have been the same: “The reliance element of fraud cannot be based on indirect communications through a third party unless the third party acted as a mere conduit in passing on the misrepresentations to a plaintiff.”
According to the court, however, IKB was not a “mere conduit.” Far from it. IKB went through a complex process that “included analyzing the CDO’s risk, evaluating the investment in terms of its financial structure, and vetting the experience and expertise of the collateral manager.” Only after IKB’s chief investment officer and investment committee signed off would the recommendation be forwarded to Loreley. There was, in short, separation aplenty between whatever Wachovia said and what IKB advised Loreley to do.
That the Second Circuit threw out the case doesn’t mean nobody was punished. Ten years ago, without admitting or denying the charges, Wells Fargo paid a fine of $11 million to settle regulatory claims related to Wachovia’s sales of CDOs. The settlement covered, among other things, alleged misrepresentations regarding one of the offerings at issue in Loreley’s lawsuit.
True, as any securities lawyer will tell you, the fact that the settlement was small in relative terms (Goldman Sachs paid $550 million) likely reflects the shakiness of the government’s evidence. In effect, Wells Fargo seems to have paid just to make the case go away.
Disclosure: A relative of mine, although in no way involved in the case, trades mortgage-backed securities.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stephen L. Carter is a Bloomberg Opinion columnist. He is a professor of law at Yale University and was a clerk to U.S. Supreme Court Justice Thurgood Marshall. His novels include “The Emperor of Ocean Park,” and his latest nonfiction book is “Invisible: The Forgotten Story of the Black Woman Lawyer Who Took Down America's Most Powerful Mobster.”
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