Tuesday, July 7, 2015

Disclosure, or What You Will

Seven years after the demise of Lehman Brothers, lawsuits on related financial products are heating up, with a number of RMBS and CDO cases seeing reversals of fortune. 

But first, some background. 

This may seem odd – but so far most of the arguments have had little to do with whether the defendants did anything wrong.[1]  

Rather, the focus has been on peripheral issues, like: (1) jurisdiction; (2) whether the plaintiffs had standing to sue; (3) whether the plaintiffs sued within the permissible time frame; (4) whether the defendants were indeed obligated to fulfill any of the duties they are accused of violating; and (5) whether the investment risks were appropriately disclosed. 

Recent rulings have focused on this final element, and have been rendered in a way largely favorable to the plaintiffs. This is the focal point of today’s post. 

Disclosures and Disclosures – Five Shades of Grey 

Disclosures are subjective issues; they are forms of art. And, most importantly, they are not Boolean – they are not simply present or absent. 

There are various shades of grey. Consider for example the following possible disclosures regarding a bridge: 
  1. Cross bridge at your own risk 
  2. We have performed one or more tests and happen to believe that this bridge is particularly risky, or more risky than other bridges 
  3. This bridge fails to satisfy the criteria set for bridges by the relevant architectural/building standards and safety boards 
  4. We built this bridge and know that it suffers from certain structural flaws 
  5. This may look like a bridge, but it is made of straw and has simply been dressed up to look like a bridge. Do not cross! 

These disclosures differ greatly, and one cannot reasonably argue that all provide the same informational content. 

Of course, it may be okay to sell a distressed asset or a structurally flawed house, as long as its known shortcomings are appropriately disclosed; but when a particular risk is known to one party (often the seller) we argue that the material information needs to be properly disclosed. 

For our purposes, it may be helpful to break disclosures down into three broad categories: 
  1. Those that are general (non-specific) and describe overall risk
  2. Those that describe particular risk(s)
  3. Those that describe the advanced knowledge that one party to an agreement has (over the other) pertaining to particular risk(s) 

Reliance – A Practitioner’s Perspective[2] 

The recent rulings, which we’ll get to in a moment, give us some confidence that the legal system is supporting the essence of what investing in the US financial markets is all about. 

The defenses that “it was disclosed that the investment contained risk” or that “we warned the investor to perform his own due diligence” seem to us to be off-point and insufficient. 

From a practitioner’s perspective, it should be noted that investors are just about always warned that investments contain risks. Of course they do – there’s seldom a reason to invest without the expectation of a positive return[3], and risk and return go hand in hand. And due diligence can often be impractical or prohibitively expensive, and even if it can be performed it may not uncover the true nature of hidden risks, especially if they are known only to certain insiders. 

But in this “trust -but-verify” bargain, is the “trust” element still there? 

Let’s suppose that due diligence could be performed. Should investors have to check everything – every piece of data represented to them to be true and accurate, every potential conflict disclosed or undisclosed, every legal opinion upon which the transaction’s solidity is based, and every accounting record? What is the purpose of a representation or warranty, if the onus remains on the person accepting the representation or warranty? 

In short, shouldn’t investors be allowed to rely on some things? 

Buying a new car encourages some level of diligence too – one may want to take it for a test-drive. But is it healthy to expect or require each car buyer to have advanced engineering or mechanical skills and to test each part for herself? 

We argue it isn’t: such due diligence, while commendable, defeats the purpose. When buying a new car, a purchaser ought to be able to rest easy, relying on her property rights and on the manufacturer’s name and representations, and fairly assume that the parts used are new, in working order, and are expected (certainly by the manufacturer) to last. 

Similarly, when buying a financial product that has been structured by a bank, it would promote market efficiency and be most expedient if investors were able to freely rely on representations and warranties made to them by the banks about the collateral supporting the product. And when a representation turns out to have been faulty, investors could then expect to have recourse through the court system – one of the very reasons overseas investors invest in US-based financial products! 

Decisions, Decisions… 

On the RMBS/CDO side, a recent lower court ruling and a slew of higher court rulings have ended favorably for plaintiffs, finding that the disclosures and disclaimers[4]  provided were not specific enough – reversing decisions made by lower courts that those disclosures had been sufficiently specific. 

Various groups of defendants, in different litigation matters, had regularly made the argument that they had disclosed that some of the thousands of loans that made their way into the mortgage pool may fail to comply with the representations and warranties made of them. Well that’s fair enough – there may have been a data error here or there that is yet to be discovered. 

But at the time of writing this disclosure that “some” loans “may” fail, the truth was very different. Often some loans were already failing (and known to have been failing) to meet one or more of the criteria needed to pass. Moreover, and importantly, it was even the expectation of some defendants at that time that several other loans would imminently be found to fail too. 

In other words, several defendants made the weakest possible disclosure: that something may possibly happen. Meanwhile, defendants often already knew that it was happening, and often en masse. Disclosing that a violation may occur is different from disclosing (1) that violations are known to be occurring, or (2) that the procedures employed leave ample room for the occurrence of violations (and so forthcoming violations should be expected).[5] 

As it happens, in some cases defendants had set up tests to identify noncompliance in loans sampled within the pool. When they found that a high percentage of the sampled loans failed to comply with the representations and warranties, they failed to re-examine the non-sampled loans, but waived them into the securitization trusts anyway. Thus, they knew, or should have known, that a high percentage of the non-sampled loans would fail to meet the criteria upon which they were being purchased into the trusts. In FHFA v Nomura, the court examined the true nature of the mortgage loans being waived into the trust as conforming collateral: 
"Measured conservatively, the deviations from originators’ guidelines made anywhere from 45% to 59% of the loans in each [supporting loan group] materially defective, with underwriting defects that substantially increased the credit risk of the loan."[6] 

Some Examples – Decisions Favorable to Plaintiffs 

     Basis Yield v Goldman (CDO) [7]

The First Department decided that the disclosures were “boilerplate statements” that failed to put the investors on notice of the nature of the risks inherent in the investment (as alleged by the plaintiffs) [8]. The court held that if “plaintiff's allegations are accepted as true, there is a ‘vast gap’ between the speculative picture Goldman presented to investors and the events Goldman knew had already occurred.”[9]  

     ACA v Goldman (CDO) 

In May 2015, the New York Court of Appeals – the state’s highest court – reversed an order by the Appellate Division, holding that “plaintiff here claims that defendant knew that [co-defendant] Paulson was taking a position contrary to plaintiff's interest, but withheld that information, despite plaintiff's inquiries.”[10] 

     FHFA v Nomura (RMBS) 

In this bench trial, the court honed in on the direct issue at hand, ruling in favor of the plaintiff: 
“This case is complex from almost any angle, but at its core there is a single, simple question. Did defendants accurately describe the home mortgages in the Offering Documents for the securities they sold that were backed by those mortgages?”[11] 
     Basis Yield v Morgan Stanley (CDO) 

The court leaned heavily on several prior rulings[12] of the First Department which had recently rejected most of the contentions raised by Morgan Stanley, similar to those advanced in the same court. 

In the court’s words, “The First Department held that New York law is ‘abundantly clear’ that ‘a buyer’s disclaimer of reliance cannot preclude a claim of justifiable reliance on the seller’s misrepresentations or omissions unless (1) the disclaimer is made sufficiently specific to the particular type of fact misrepresented or undisclosed; and (2) the alleged misrepresentations or omissions did not concern facts peculiarly within the seller’s knowledge.” 

In denying Morgan Stanley’s motion to dismiss, the court held that, assuming plaintiff’s allegations to be true, the disclosures “did not apprise investors that Morgan Stanley had deliberately sabotaged assets in the CDO to profit from its short positions.”[13] 

Some Examples – Decisions Favorable to Defendants 

     HSH Nordbank v UBS AG (RMBS) 

HSH Nordbank is one example of an RMBS ruling that went the way of defendants. 

The court ruled that “Here, the core subject of the complained-of representations was the reliability of the credit ratings used to define the permissible composition of the reference pool. The reliability of those ratings was the premise on which the entire deal was sold to HSH. Far from being peculiarly within UBS's knowledge, the reliability of the credit ratings could be tested against the public market's valuation of rated securities.” 

In other words, plaintiff HSH could reasonably have uncovered that the ratings were misrepresented had HSH exercised the necessary due diligence.[14] 

     Lanier v BATS (HFT) 

Lanier, a case concerning high-frequency trading (or HFT), presents a more recent set-back for plaintiffs. 

Lanier’s argument, to a degree, is this: Lanier paid for time-sensitive trading information from NASDAQ; NASDAQ has other clients who paid more, and so they got this time-sensitive information before Lanier did, rendering the information stale and inaccurate by the time it arrived at Lanier’s desk. Lanier argues that he was not appropriately informed that he was being trumped – and that the spirit of the agreement was that nobody would get information before him. 

To use the court’s words, Lanier’s argument is that “when defendants make market data available to preferred data customers more quickly than other customers, they violate Regulation NMS, which is incorporated by reference into contracts between plaintiff Lanier and defendants.” In his words, he seeks “redress for a violation of a contractual commitment prohibiting defendants from providing earlier access to market data to Preferred Data Customers” and as a result, the sale of stale data to him. 

In Lanier’s words, “The Preferred Data Customers are then able to cancel orders and execute trades before Subscribers [like Lanier] even receive the market data.” 

But the court sympathized with the provision of what seems to us to be an extraordinarily weak form of disclosure. The court viewed the following paragraph in the subscription agreement to have been, in the court’s words, “pertinent.” 
“Neither NYSE, any Authorizing SRO nor the Processor (the “disseminating parties”) guarantees the timeliness, sequence, accuracy, or completeness of Market Data or other market information or messages disseminated by any disseminating party. No disseminating party shall be liable in any way to Subscriber or to any other person for (a) any inaccuracy, error or delay in, or omission of, (i) any such data, information, or message, or (ii) the transmission or delivery of any such data, information or message, or (b) any loss or damage arising from or occasioned by (i) any such inaccuracy, error, delay or omission, [or] (ii) non-performance . . . .” (emphasis added by the court) [15]
The court also took particular comfort in the provision within the Nasdaq Subscriber Agreement of a disclosure that reads “STOCK QUOTES MIGHT NOT BE CURRENT OR ACCURATE” and grants the motion to dismiss, preventing any further discovery.[16] 

 Indeed Nasdaq warranted to Lanier that it would “endeavor to offer the Information as promptly and accurately as is reasonably practicable.” If we take plaintiff’s allegations to be true, as we must at the motion to dismiss stage, then clearly NASDAQ did not provide it to Lanier as promptly as reasonably practicable, and it knew it wasn’t doing so. 

The court asserted that Lanier’s “argument misreads the Subscriber Agreements, which promise one thing: the provision of consolidated market data to Lanier and other subscribers like him. The contracts do not prohibit provision of the same data in different forms to different kinds of customers, whether in consolidated or unconsolidated form. And in general the duty of good faith and fair dealing does not provide a cause of action separate from a breach of contract claim, as “breach of that duty is merely a breach of the underlying contract.” 

Sadly, in rendering its opinion the court ignores the spirit of the agreement – the intent – and probably the content too. 


[1] For example, in a bench trial (FHFA v Nomura), the court noted that no real defense was presented as to the inappropriateness of defendants’ actions. “Today, defendants do not defend the underwriting practices of their originators. They did not seek at trial to show that the loans within the SLGs were actually underwritten in compliance with their originators’ guidelines. At summation, defense counsel essentially argued that everyone understood back in 2005 to 2007 that the loans were lousy and had not been properly underwritten.” Opinion at page 267. 

[2] Our goal here is to share a practitioner’s perspective. We do not provide advice of any kind –certainly not legal advice. 

[3] As scientists we must disclose our awareness of several situations in which investments are made without the expectation of a directly positive return, above 0%. While such examples exist, they are in the great minority of investments. For example, 5-year Swiss government bonds currently yield negative 0.539%, and there do exist rational arguments for investing in a negative yielding instrument, including for lack of available alternatives.) 

[4] Hereafter, we will use the short-hand “disclosures” to describe both disclosures and disclaimers. 

[5] An argument could be made that disclosure is faulty when it describes an occurrence as a remote possibility, when it’s known to be likely or inevitable – akin to a form of false advertising. Such disclosure disguises the true nature of the possibility. 

[6] Opinion at page 171 

[7] First Department decision and opinion at page 9 (1/30/2014) 

[8] In the court’s words “These disclaimers and disclosures, in our view, fall well short of tracking the particular misrepresentations and omissions alleged by plaintiff.” 

[9] A similar finding was made by the First Department in Loreley v Citigroup

[10] ACA Financial Guaranty Corp., Appellant, v. Goldman, Sachs & Co., Respondent, Paulson & Co., Inc. et al., NY INDEX NO. 650027/2011; Court of Appeals, No. 49, at page 4 (5/7/2015). Importantly, the court notes that ACA’s case differs from a prior case, in which the plaintiffs "knew that defendants had not supplied them with the financial information to which they were entitled, triggering 'a heightened degree of diligence.'" (Pappas v Tzolis, 20 NY3d 228, 232-233 [2012], quoting Centro Empresarial Cempresa S.A. 17 NY3d at 279). 

[11] Opinion and order at page 7

[12] Specifically, Loreley v Citigroup; Loreley v Merrill Lynch; Basis Yield v Goldman; and CDIB v Morgan Stanley 

[13] For example, the court specifically notes that the disclosure that Morgan Stanley would be acting in ‘its own commercial interest’ was … insufficient to put the Fund on notice of Morgan Stanley’s intent to offload low-rated RMBS from its books.” 

[14] For what it’s worth, our opinion is that it is impractical to have to second guess every party to a transaction; and having tried to, we can argue that it is very difficult if not impossible for a non-rating agency expert (and possibly even for a ratings expert) to effectively reverse-engineer ratings agencies’ complex models – which are often black-boxes, driven by and reliant on internal assumptions that cannot be seen by the most sophisticated of users. Having said that, the court raised its concern that, according to its reading of the amended complaint, HSH may not have provided sufficient factual information to support such the allegation, in the court’s words, “that the credit rating conferred on a security by a rating agency did not necessarily correspond to the security's risk level as perceived by the market.” 

[15] Ruling at page 26

[16] Here we have the same issue: Does disclosing the potential for delays in data distribution appropriately notify the subscriber that the data provided to him was always or regularly or intentionally being delayed? Aside from the omissions complained of, this disclosure, itself seems untruthful. Is it not misleading to state that “a quote might not be current,” when knowing that it is not current? If one wanted to be honest, one would disclose: “quotes are not current – beware!” 

CASE CAPTIONS (links can be clicked to download opinions)

ACA v Goldman: ACA Financial Guaranty Corp., Appellant, v. Goldman, Sachs & Co., Respondent, Paulson & Co., Inc. et al., NY INDEX NO. 650027/2011 

Basis Yield v Goldman: Basis Yield Alpha Fund (Master) v Goldman Sachs Group, Inc., NY INDEX NO. 652996/2011; 2014 NY Slip Op 00587 

Basis Yield v Morgan Stanley: Basis Yield Alpha Fund Master v Morgan Stanley, NY INDEX NO. 652129/2012 

CDIB v Morgan Stanley: China Development Industrial Bank v Morgan Stanley & Co. Incorporated et al, NY INDEX NO. 650957/2010 

FHFA v Nomura: Federal Housing Finance Agency (“FHFA”) v Nomura Holding America, Inc., et al, 11-cv-06201-DLC 

HSH Nordbank: HSH Nordbank AG v UBS AG et al, 2012 NY Slip Op 02276 

Lanier v BATS: HAROLD R. LANIER, on behalf of himself individually and on behalf of others similarly situated v BATS Exchange, Inc. et al, 14-cv-03865-KBF 

Loreley v Citigroup: Loreley Financing (Jersey) No. 3 Ltd., et al v Citigroup Global Markets Inc., et al, NY INDEX NO. 650212/2012; 2014 N.Y. Slip Op. 03358 (N.Y. App. Div. 2014) 

Loreley v Merrill Lynch: Loreley Financing (Jersey) No. 28, Limited v Merrill Lynch, Pierce, Fenner & Smith Incorporated, et al., NY INDEX NO. 652732/2011; 2014 NY Slip Op 03326 (N.Y. App. Div. 2014) 

DISCLAIMER:  This blog has been posted for informational purposes only.  PF2 does not provide advice of any kind.

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