N.Y. Court Denies Summary Judgment In Unique RMBS Case Involving Sophisticated Investors

In Basis Pac-Rim Opportunity Fund (Master) v. TCW Asset Mgt. Co., 2015 BL 342991 (N.Y. Sup. Ct. Oct. 16, 2015), the Supreme Court of New York denied TCW Asset Management Company’s (“Defendant”) motion to dismiss securities fraud claims brought by two Cayman Island hedge funds, Basis Pac-Rim Opportunity Fund (Master) and Basis Yield Alpha Fund (Master) (collectively, “Plaintiffs”).

According to the allegations, Defendant promoted a system for “navigating” the residential mortgage backed securities (“RMBS”) market that could identify good investments from bad ones. The investment strategy operated through a collateralized debt obligation (“CDO”) known as Dutch Hill Funding II, Ltd. (“Dutch Hill”), which served as an investment vehicle for taking a net long position on risky RMBS. In May 2007, Plaintiffs invested in the riskiest parts of Dutch Hill, with over $28.1 million in total investments. Over the following months, however, the RMBS market declined and, by July 2007, Plaintiffs’ investment in Dutch Hill had lost most of its value, rendering it worthless.

On November 21, 2012, Plaintiffs filed a complaint, pursuant to NY law, alleging Defendant made fraudulent misrepresentations that persuaded Plaintiffs to invest in Dutch Hill. Specifically, Plaintiffs claimed Defendant failed to select Dutch Hill’s RMBS collateral in the manner represented and that Defendant allegedly marketed “an investment strategy in 2007 it did not believe it could profitably execute.” 

To prove securities fraud in New York, a party must show: (1) a material misrepresentation; (2) scienter; (3) reasonable reliance; and (4) proof of transaction causation and loss causation.

The court noted the issue was different from normal RMBS fraud cases because Plaintiffs were not “duped” into thinking that “RMBS were generally a sound asset class” but were aware of the risks associated with the RMBS market. Id. (“[T]his is a case where all parties recognized the problems in the housing market prior to [Basis'] investment.”). Instead, the allegations turned the “purported unique abilities” of the Defendant. Id. (“Hence, the issue in this case is not whether it was objectively reasonable for a sophisticated investor to make long RMBS bets in May 2007. Rather, the question is whether a sophisticated investor such as [Basis] could have reasonably believed in TCW's purported unique abilities.”). 

The court agreed that issue raised enough questions of fact to defeat summary judgment on the inherently fact-intensive inquiries into materiality, scienter, and reasonable reliance. With respect to the alleged misrepresentations, the court found that Plaintiff “has met its burden of proffering evidence from which a reasonable juror could conclude that TCW's internal views of the subject RMBS collateral differed from the representations made to Basis.” Evidence showing that Defendant’s “internal views” did not “align” with views “publicly expressed to investors was enough to create a question of fact as to intent. 

Satisfying causation required a showing of a casual link between the alleged misrepresentation and the economic harm. The court also held Plaintiffs alleged enough facts to raise a question of loss causation. Id. (“Since TCW's investment strategy was premised on navigating an admittedly problematic RMBS market, lying about navigating the market in the manner advertised would surely be causally related to Basis' loss, as Basis having its money invested in knowingly troublesome RMBS was precisely the risk Basis sought to avoid by investing with TCW.”). 

As for Defendant’s argument that the RMBS market crash was of such dramatic proportions that Plaintiffs’ losses would have occurred at the same time and extent regardless of the alleged fraud, the court disagreed. Id. (“TCW would have the court believe that the crash of the RMBS market is akin to the flood and the falling tree-that is, an unforeseen event that causes a loss, which occurrence was not made more likely by TCW misrepresentations. The court disagrees.”). As a result, it did “not matter what else [Plaintiff] would have done with its money if it did not invest with [Defendant].” 

Accordingly, the court denied Defendant’s motion for summary judgment.

The primary materials for the post are available on the DU Corporate Governance website.


John Ikard