CAN A FINANCIAL ADVISER BE SUED BY A NON-CLIENT FOR NEGLIGENCE?

The answer to that question is “probably.” At least in Missouri, New York, and Iowa.

            Missouri courts apply a balancing test when determining if a “non-client” intended beneficiary of professional services can sue for negligence despite a lack of privity. The leading case in Missouri, at least as to accountants, is Aluma Kraft Manufacturing Co. V. Elmer, 493 S.W.2d 378(1973). The Aluma court stated: 

“The determination of whether in a specific case the defendant will be held liable to a third person not in privity is a matter of policy and involves the balancing of several factors: (1) the extent to which the transaction was intended to affect the plaintiff; (2) the foreseeability of harm to him; (3) the degree of certainty that the plaintiff suffered injury; and (4) the closeness of the connection between the defendant’s conduct and the injury suffered. Westerhold, supra, 419 S.W.2d at 81. We believe that these policy factors are satisfied with this case.” 

Aluma at 383. The court relied in part upon a New York accountant case, quoting the infamous Justice Cardozo.

The same principles of non-privity professional liability have been applied to attorneys in Missouri. See Donahue v. Shugart, 900 S.W.2d 624 (Mo. 1995). In Donahue the intended beneficiaries of a decedent’s trust that was declared invalid brought a legal malpractice and breach of fiduciary duty claim against the decedent’s attorneys. Id. At 626. Prior to the decedent’s death he directed Stamper, his attorney, to ensure that a specified sum of monies from his trust account be paid to Mary Donahue and Sundy McClung upon his death. Id. at 625. Donahue and McClung were not beneficiaries of Stockton’s trust. Id. Stockton also directed Stamper to prepare a deed to his home transferring a fifty percent interest in the home to Mary Donahue, effective on Stockton’s death. Id. Upon learning that Stockton’s death was imminent, Stamper sought advice from others in his law firm on how to make the checks and deed effective in accordance with Stockton’s wishes. Id.

Stamper attempted to effectuate the transfers, but they were later declared to be invalid by the Missouri Court of Appeals. Donahue, 900 S.W.2d at 625. The Court determined that the plaintiff’s breach of fiduciary duty claim was properly dismissed as being “dependent on the existence of attorney negligence, not on the breach of trust” because the conduct complained of was merely negligence in the performance of legal services. Id. at 630. 

But the Donahue court stated that the “Determination of whether attorney owed legal duty to non-clients so as to be liable to non-clients in legal malpractice action is determined by weighing factors in balancing test, including: existence of specific intent by client that purpose of attorney’s services were to benefit plaintiffs, foreseeability of harm to plaintiffs as result of attorney’s negligence, degree of certainty that plaintiffs will suffer injury from attorney misconduct, closeness of connection between attorney’s conduct and injury, policy of preventing future harm, and burden on profession of recognizing liability under circumstances. Pleadings were sufficient to establish that attorneys owed duty to non-clients who were intended recipients of client’s gifts causa mortis.”

Finally, the Supreme Court of Iowa applied these same basic principles to an insurance agent to allow a non-client to proceed against the agent. There is no reason to believe that the courts would not apply the same public policy to financial advisers and the intended beneficiaries of their services. Food for thought.

Second Circuit Finds Existence of Indirect Contract and Tort Liability by Adviser to Investors Under Investment Management Contract

In Bayerische Landesbank v. Aladdin Capital Management LLC, 11-4306-cv (2nd Cir. August 6, 2012), Plaintiffs-Appellants Bayerische Landesbank (“Bayerische”) and Bayerische Landesbank New York Branch (collectively “Plaintiffs”) filed an action against Defendant-Appellee Aladdin Capital Management LLC (“Aladdin”) for breach of contract and gross negligence based on Aladdin’s alleged disregard of its obligation to manage a portfolio in favor of investors.

Aladdin was the manager of an investment portfolio containing collateralized debt obligations ("CDOs").  A CDO is a financial instrument that sells interests (in this case, in the form of “Notes”) to investors and pays the investors based on the performance of the underlying asset held by the CDO.  The CDO at issue in this case, called the Aladdin Synthetic CDO II (“Aladdin CDO”), was a “synthetic” CDO, meaning that the asset it held for its investors was not a traditional asset like a stock or bond, but was instead a derivative instrument, i.e., an instrument whose value was determined in reference to still other assets.  The derivative instrument the Aladdin CDO held was a “credit default swap” entered into between the Aladdin CDO and Goldman Sachs Capital Markets, L.P. based on the debt of approximately one hundred corporate entities that were referred to as the “Reference Entities” and comprised the “Reference Portfolio.”

Aladdin's formal responsibilities were spelled out in the Portfolio Management Agreement (“PMA”), an agreement between Aladdin and the "shell issuer" created by Aladdin and Goldman Sachs.  The PMA was not signed by the "Noteholders," such as Plaintiffs.   In fact, Plaintiffs did not enter into any direct contract with Aladdin.  Plaintiffs purchased $60 million of the total $100 million worth of notes from Goldman Sachs, which underwrote the CDO.  Plaintiffs alleged that, following the issuance of the Aladdin CDO, Aladdin managed the portfolio in a grossly negligent fashion, causing Plaintiffs’ Notes to default.

On the basis of the foregoing, the Amended Complaint assertd two claims: (1) a claim in contract alleging that Aladdin breached its obligations under the PMA; and (2) a claim in tort alleging that Aladdin’s conduct was grossly negligent, resulting in harm to the Noteholders.

The district court held that, because of a provision of the contract limiting intended third-party beneficiaries to those “specifically provided herein,” Plaintiffs could not bring a third-party beneficiary breach of contract claim, and held also that plaintiffs could not “recast” their failed contract claim in tort. The Second Circuit Court of Appeals disagreed.

With regard to the breach of contract claim, the court noted that under New York law "a third party may enforce a contract when 'recognition of a right to performance in the beneficiary is appropriate to effectuate the intention of the parties and . . . the circumstances indicate that the promisee intends to give the beneficiary the benefit of the promised performance.'” Levin v. Tiber Holding Corp., 277 F.3d 243, 248 (2d Cir. 2002) (quoting Restatement (Second) of Contracts § 302).   The court found that portions of the PMA plausibly demonstrated an intent to benefit the Noteholders by defining Aladdin’s obligations and delineating the scope of its liability to the Noteholders.  Therefore, the Plaintiffs' breach of contract claim survived the motion to dismiss.

The court next turned to Plaintiffs' second, alternative, claim: that Aladdin breached a duty of care, in tort, to the Noteholders, by engaging in acts that amounted to gross negligence in its management of the Reference Portfolio. The court noted that, under New York law, a breach of contract will not give rise to a tort claim unless a legal duty independent of the contract itself has been violated. See, e.g., Clark-Fitzpatrick v. Long Island R.R. Co., 70 N.Y.2d 4 382, 389 (1987).  Such a “legal duty must spring from circumstances extraneous to, and not constituting elements of, the contract, although it may be connected with and dependent on the contract.” Id.  Where an independent tort duty is present, a plaintiff may maintain both tort and contract claims arising out of the same allegedly wrongful conduct.  See Hargrave v. Oki Nursery, Inc., 636 F.2d 897, 898-99 (2d Cir. 1980) (citing Channel Master Corp. v. Aluminum Ltd. Sales, Inc., 4 N.Y.2d 403, 408 (1958)).

The court found that the allegations in the Amended Complaint were sufficient to withstand a Fed. R. Civ. P. 12(b)(6) motion to dismiss.  In light of Plaintiffs allegations that it detrimentally relied on Aladdin's representations of how it would select the Reference Portfolio and manage the portfolio for the life of the CDO, Plaintiffs sufficiently established that “[a] legal duty independent of contractual obligations may be imposed by law as an incident to the parties’ relationship” in this case. Sommer v. Fed. Signal Corp., 79 N.Y.2d 540, 551 (1992). This legal duty, though assessed largely on the standard of care and the other obligations set forth in the contract, would arise out of "the independent characteristics of the relationship between Bayerische and Aladdin, and the circumstances under which Bayerische purchased the notes linked to the Reference Portfolio that Aladdin, under the PMA, was to manage."

While Aladdin argued that the noteholders failed to allege facts that plausibly show Aladdin’s conduct amounted to gross negligence, the court disagreed.  Specifically, the court found that accepting below-market spreads on risky entities appeared to have been contrary to how Aladdin explicitly represented it would manage the portfolio on behalf of the Noteholders.  After discovery, the court noted that facts could come to light which may show a different story.  But at the preliminary motion-to-dismiss stage, drawing all inferences in Plaintiffs' favor, Plaintiffs plausibly alleged that Aladdin’s gross negligence exposed Plaintiffs to greater risk that they would lose their entire investment than would have otherwise been the case.

This case is important in that it demonstrates how a poorly drafted provision in an investment management agreement can open the door to third-party beneficiaries claiming a breach of contract and, in addition, how advisers may be exposed to indirect tort liability in a securitization.