The New York Appellate Division, First Department recently addressed the limits on a sophisticated investor’s obligation to perform due diligence, holding that a purchaser of an unrated junior tranche of a collateralized debt obligation (“CDO”) offering who sued the investment banking firm that structured and marketed the CDO for fraud adequately plead justifiable reliance by alleging that it relied on the credit ratings of the seven higher tranches. In Basis Yield Alpha Fund Master v. Morgan Stanley, 2015 N.Y. App. Div. LEXIS 9647 (1st Dep’t Dec. 29, 2015), the First Department rejected defendant’s argument that the plaintiff failed to adequately plead justifiable reliance because it did not allege that it had conducted, or sought to conduct, any due diligence investigation into the matters allegedly misrepresented, specifically the methodology through which the higher tranches of the CDO offering had been rated and the underwriting standards used in the issuance of the residential mortgage backed securities (“RMBS”) constituting most of the CDO’s collateral portfolio. The court held that the plaintiff was not required to have looked behind the credit ratings of the higher tranches to verify that the securities in fact deserved the assigned ratings.
In Basis Alpha, the plaintiff purchased subordinated notes in a CDO offering structured and marketed by defendant known as STACK 2006-1 (“STACK”). After losing its entire investment, plaintiff sued defendant for fraud and fraudulent concealment, alleging that defendant knew that the credit ratings of the senior tranches of the STACK offering were unreliable, “which unreliability it allegedly misrepresented or concealed in marketing the CDO ….” Basis Yield, 2015 N.Y. App. Div. LEXIS 9647 at *5. While the subordinated notes were unrated, plaintiff allegedly relied on the credit ratings of the seven higher tranches (six of which were rated as investment grade) as indicative of the CDO’s overall stability. Plaintiff further alleged that defendant became aware that these ratings were unreliable not from publicly available information but rather from its roles in creating and marketing the CDO. Plaintiff alleged further that defendant knew, from the due diligence it conducted as the creator and marketer of the CDO, that many of the mortgage loans underlying the RMBS collateral did not meet the prevailing industry underwriting guidelines and that in putting together the STACK offering, defendant allegedly prevailed upon the credit rating agencies to use an outdated, generally disused rating model in rating the senior tranches, unbeknownst to plaintiff.
Affirming the Supreme Court’s denial of defendant’s motion to dismiss the fraud claims, the First Department rejected defendant’s argument that plaintiff failed to adequately allege that it had justifiably relied on the accuracy of the credit ratings of the higher tranches of the STACK offering. Defendant argued on appeal that the fraud claims were deficient because the amended complaint failed to allege that plaintiff had asked to review any documents or files in defendant’s possession relating either to (1) the underwriting standards that were used in originating the mortgage loans; or (2) the models the rating agencies used in assigning credit ratings to the higher tranches. In essence, defendant argued, plaintiff failed to take reasonable steps to protect itself from deception because “it did not seek to look behind the credit ratings of the STACK notes (or the credit ratings of the underlying RMBS collateral) to verify that the securities actually deserved those ratings by examining the rating agencies’ methodologies or the records of the underwriting of the RMBS in the collateral portfolio.” Basis Yield, 2015 N.Y. App. Div. LEXIS 9647 at **11-12. Observing that “[i]f accepted, Morgan Stanley’s position would require the prospective purchaser of a credit instrument to assume that the instrument’s credit rating is fraudulent until the rating has been verified through a detailed retracing of the steps of the underwriter and credit rating agency,” the First Department concluded that “[t]his would largely negate the utility of the credit ratings of negotiable bonds and notes that are published by accredited rating agencies.” Id. at **12-13. Holding that the plaintiff was not obligated to seek to investigate the basis for the credit ratings of the STACK notes or the RMBS, the First Department concluded that plaintiff’s failure to allege that it sought to conduct such an investigation does not “negate the element of justifiable reliance for its fraud claims….” Id. at *13. The court concluded that plaintiff sufficiently “plead that the relevant matters were peculiarly, even if not exclusively, within Morgan Stanley’s knowledge” and that “[n]othing alleged in the amended complaint, and none of the disclosures in the offering materials …, would have given Basis Yield reason to suspect these problems ….” Id. at **16-17.
Basis Yield demonstrates the limits on a sophisticated investor’s obligation to conduct due diligence in pleading justifiable reliance for a fraud claim. Under Basis Yield, a sophisticated investor‘s due diligence obligation generally extends no further than a review of publicly available documents and information. Basis Yield thus makes clear that only in unusual circumstances would such due diligence be inadequate for purposes of establishing justifiable reliance.