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.

Diamond Food Board Sued over Financial Problems and Botched Merger Plans

We previously reported on Diamond Food’s SEC investigation into certain crop payments the company made to walnut growers at the end of its 2010 fiscal year.  See Diamond Foods SEC Investigation. 

On Wednesday, shareholders filed a lawsuit against the board of Diamond Foods for costing it the chance to buy its rival Pringles from The Procter & Gamble Co.  In the midst of the accounting scandal in which crop payments allegedly were improperly reported to inflate the company’s 2010 earnings and shift costs into its 2011 fiscal year, Diamond’s stock price fell from last year's high of $96.13 to Wednesday's close of $17.49, a loss of about 80 percent.    

The lawsuit, being held in Delaware, is a derivative complaint, meaning the shareholders seek permission to step into the shoes of the company and hold directors and officers responsible for harm they caused.

Class Arbitration: Are Investment Advisers Representatives Excluded?

Investment Adviser agreements typically contain provisions which require all disputes between the Registered Investment Adviser (“RIA”) and Investment Adviser Representative (“IAR”) to be determined in a final and binding arbitration.  These agreements also preclude class claims from being brought to arbitration.  In effect, RIAs have thereby evaded being the subject of class actions brought by IARs, at least for now. 

At the beginning of the year, the National Labor Relations Board (“NLRB”) decided a case which outlaws contract provisions in which the employer conditions employment upon signing an agreement that precludes employees from filing joint, class, or collective claims in any forum.  However, the claims must address issues such as wages, hours, or other working conditions. 

D.R. Horton v. Michael Cuda involved an employment contract where the employee was required to submit all claims to arbitration.  The agreement also prevented employees from consolidating or bringing class claims.  The NLRB determined that these agreements prohibit the exercise of substantive rights that are protected under Section 7 of the National Labor Relations Act (“NLRA”).  The NLRB’s decision specifically outlines certain limitations to its holding.  In particular, the decision is only applicable to “employees” as defined in the NLRA.  This definition specifically excludes independent contractors.

It should be noted that the US Supreme Court recently ruled in AT&T Mobility LLC v. Conception that the Federal Arbitrations Act (“FAA”) permits companies to require customers to arbitrate their complaints individually, precluding class action claims.  D.R. Horton differs in that it involved employee class actions, which is protected by statute, versus customer or consumer class actions.  However, since D.R. Horton has been appealed to the 5^th Circuit Court of Appeals, it will be interesting to see the outcome, and whether or not the Supreme Court will grant certiorari.  My guess is that it will.   

That being said, the hurdle for IARs is that they are often classified as “independent contractors” rather than employees.  Not only is this usually set forth in their investment advisor agreements, but the type of relationship between the employer and the IAR has some characteristics of an independent contractor.  However, they also have employer-employee characteristics that could be crucial in determining the type of employment relationship. 

There are various factors that determine whether one is considered an employee versus an independent contractor.  These factors include but are not limited to the following: (1) the level of control the employer has over the work performed by the individual; (2) whether the employer or worker furnishes the tools, materials, supplies, or equipment needed to perform the job; (3) whether the worker provides services for more than one firm or company at a time; (4) whether the worker can realize a profit or loss as a result of his services; (5) whether the employer set the work schedule; and (6) whether the employer hires, supervises, or pays assistants of the worker.

Perhaps one of the more determinative factors in defining an employment relationship is the level of control and supervision the employer has over an individual.  By design, RIAs are required to supervise the conduct and activities of any IAR that represents it, whether the IAR is an employee or an individual that provides investment advice on behalf of the RIA.  An RIA’s legal duty to supervise its IARs emanates from a number of sources.  For instance, Section 203(e)(6) of the Investment Advisers Act of 1940 permits the SEC to take action against an RIA for failing to supervise its IARs.  Pursuant to SEC Rule 206(4)-7 under the Advisers Act, RIAs are required to adopt policies and procedures that are reasonably designed to prevent violations of securities laws by the adviser and its supervised persons.   Furthermore, SEC Rule 204A-1 requires RIAs to adopt a code of ethics which sets forth the standard of business conduct to be exhibited by IARs. 

Generally, investment advisory agreements authorize RIAs to monitor and evaluate the IAR and subject the IAR to the supervision of the adviser.  Moreover, the duty to supervise an IAR may also stem from the fiduciary duty the RIA owes to its clients.  This supervisory duty and level of control is often implemented with periodic or annual compliance audits of each IAR.  Despite this level of control, the IAR is often contractually defined as an independent contractor.   

Therefore, as it stands, IARs could face a substantial but perhaps surmountable hurdle in bringing class arbitration claims if the investment advisor agreement defines the representative as an independent contract and precludes class actions.  Since the NLRA definition of employee precludes traditional independent contractors, there may be no statutory protection granted to some IARs. 

The Privilege Defense to U-5 Defamation Claims

Cosgrove Law previously blogged on the topic of U-5 defamation. We noted that broker-dealers that are members of the FINRA are required to file a Form U-5 when terminating their relationship with a registered representative.  Broker-dealers must also describe the specific reason(s) that the rep was discharged or permitted to resign.  If the reasons disclosed on the U-5 were false, exaggerated or misleading, the firm can be subject to a claim for defamation.

One defense frequently raised by defendant broker-dealers is that the statements made on the form U-5 are subject to an "absolute privilege."  This means that a broker-dealer cannot be held liable for defamation for anything it puts on the U-5, even if it knows the statements were false or misleading.  If that defense is unavailable, a broker-dealer will argue that the statements are subject to a "qualified privilege."  A qualified privilege is usually revoked by proof of malice or by a showing of reckless disregard as to the truth of the statements.  Frequently, the falsity of the statements could arguably show the malice required to revoke whatever privilege the U–5 might enjoy.

Unfortunately for the broker-dealers raising the absolute privilege defense, it is rarely available.  State law, not federal law, determines whether an absolute privilege applies.  So far, only the state of New York has adopted the absolute privilege standard.  Rosenberg v. MetLife, Inc., 866 N.E.2d 439, 445 (N.Y. 2007) (finding that statements made by employer on form U-5 are subject to absolute privilege in suit for defamation).

In fact, many states have explicitly rejected the absolute privilege defense or have found that only the qualified privilege applies. See Dawson v. New York Life Ins. Co., 135 F.3d 1158, 1163-64 (7th Cir. 1998) (holding that reports of customer complaints on Form U-5 are not protected by absolute privilege under Illinois law); Glennon v. Dean Witter Reynolds, Inc., 83 F.3d 132, 136-37 (6th Cir.1996) (holding that statements on Form U-5 are not entitled to absolute privilege under Tennessee law); Moreland v. Perkins, Smart & Boyd  240 P.3d 601, 609 (Kan.App. 2010) (rejecting absolute privilege and holding that the statements in the Form U–5 were entitled to a qualified privilege at most, both under case law and under Kansas statutory law); Dickinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc.  431 F.Supp.2d 247, 261-62 (D.Conn. 2006) (finding that statements made on form U-5 were not subject to absolute privilege from defamation liability under Connecticut law, but were instead subject to qualified privilege); Boxdorfer v. Thrivent Financial for Lutherans, No. 1:09-cv-0109-DFH-JMS, 2009 WL 2448459, *4 (S.D.Ind. Aug. 10, 2009) (noting that statements on the Form U-5 are entitled to a qualified privilege under Indiana law); Wietecha v. Ameritas Life Ins. Corp., No. CIV 05-0324-PHX-SMM,  2006 WL 2772838, *11 (D.Ariz. Sept. 27, 2006) (finding that Arizona law comports with the application of a qualified privilege to statements published in the U-4 and U-5 Forms).

If you are a registered representative and feel you have been harmed by false or misleading statements published on your Form U-5 or to third parties, Cosgrove Law, LLC has substantive experience representing reps and advisers in such matters. 

SEC Takes a Closer Look at Real Estate Investment Trusts

A Real Estate Investment Trust (“REIT”) is generally a company that owns income producing real estate.  To qualify as a REIT, a company must have the majority of its assets and income connected to real estate investments and must annually distribute at least 90 percent of its taxable income to shareholders in the form of dividends.  To review additional qualifications of a REIT, See SEC - REIT Information. 

REITs have really come under intensifying scrutiny by securities regulators since many non-traded REITs have been forced to cut their estimated value and have ceased making distributions.  Furthermore, many of these REITs have attracted retirees as investors by promising steady and dependable distributions.  For example, the SEC has recently taken interest in the activities of Inland American Real Estate Trust to determine if it committed violations relating to management fees, the timing and amount of distributions paid to investors, determination of property impairments and transactions with affiliates.  The investigation was announced by Inland last week in its quarterly report.  Executives from Inland have stated that they intend to fully cooperate with any investigation and that they do not believe it has committed any violations. 

Inland holds around $11.2 billion in property, including retail hotels, offices, industrial buildings and apartment complexes.  It is the largest REIT in an industry of around 90 non-traded REITs.

FINRA has recently proposed new guidelines on adviser disclosure of REITs.  See FINRA Regulatory Notice.   Furthermore, the SEC has been pressing non-traded REITs to provide better disclosure on their share valuations because these valuations can vary due to some REITs relying on outside appraisals and others relying on their own management.  For instance, FINRA sued David Lerner Associates Inc., last year, alleging that the Apple REIT seller “unreasonably valued their shares at a constant price of $11, notwithstanding market fluctuations, performance declines and increased leverage.”  The case is still pending. 

In June, 2011, another REIT, Retail Properties of America Inc., estimated its value at $6.95 per share.  However, in its initial public offering last month, the shares were listed at $3.20 per share. 

REITs, however, may be appropriate for the savvy and experienced investor, particularly since many REITs have been investing in the global market.  Several U.S. REITs that have invested abroad believe the future is promising.  For instance, New York and Toronto based Brookfield Office Properties entered into its first London deal on a development site known as 100 Bishopgate.  Many of these investments are good for the patient investor because income is usually not realized until further down the road. 

If you have suffered losses as a result of purchasing non-traded REITs, contact us to discuss your legal rights.

FINRA Bars Pinnacle Partner Financial Corp. and its President Over Allegedly Fraudulent Sales

On April 25, Financial Industry Regulatory Authority (“FINRA”) expelled broker-dealer Pinnacle Partners Financial Corp. and its president, Brian Alfaro, from membership after they failed to respond to allegations that they made fraudulent sales involving oil and gas private placements and unregistered securities in violation of Section 10(b) of the Securities Exchange Act of 1934.  In addition to expulsion, Pinnacle and Alfaro also were ordered to offer rescission to investors who were sold fraudulent offerings, and to refund all sales commissions to those who do not request rescission. See FINRA Order

 

According to FINRA, from August 2008 to March 2011, Alfaro and Pinnacle operated a “boiler room” from which approximately 11 brokers placed thousands of cold calls per week attempting to persuade investments in oil and gas drilling joint ventures that Alfaro owned or controlled.  FINRA claims the operation raised more than $10 million from more than 100 investors.  Alfaro allegedly misrepresented or omitted material facts regarding the offerings they sold to investors. 

FINRA also alleges that from around January 2009 through March 2011, Alfaro used customer funds: “(1) to meet obligations for previous offerings; (2) cover Alfaro’s personal expenses; and (3) make cash payments to Alfaro personally.”  See FINRA Order
 
The disciplinary proceedings began on November 23, 2010.  Alfaro and Pinnacle subsequently entered in Temporary Cease and Desist Consent Orders (“TCDO”).  Approximately two months after entering into the TCDO, Alfaro and Pinnacle allegedly violated the orders and were suspended from FINRA on March 8, 2011.  The hearing was scheduled for February 27, 2012 but Alfaro informed his counsel that he would not be attending the hearing and planned on defaulting.  As a result, Pinnacle and Alfaro were expelled from FINRA. 

Has the SEC Stepped Up to the Plate on Fraud Enforcement Actions?

The Securities and Exchange Commission’s (“SEC”) mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  The SEC believes that its “investor protection mission is more compelling than ever” since more first-time investors have turned to the market to invest in their future.  Therefore, it goes without saying that the SEC’s enforcement authority is crucial in maintaining investor protection.  But, has the SEC stepped up to the plate considering the negative impact the 2008 financial crisis has had on investors?

The 2008 financial crisis had devastating effects on our economy which caused massive job losses and a growing number of American families at risk of foreclosure and poverty.  However, some companies made substantial profits from the financial collapse and many top executives received considerable bonuses (some from government bailout money) after millions of families’ investments dwindled or even disappeared. 
Most recently, the SEC filed civil fraud charges in Texas against former Chief Executive Anthony Nocella and former Chief Financial Officer J. Russell McCann of Franklin Bank Corp. for concealing the deterioration of the bank’s finances during the mortgage crisis.  Specifically, the SEC alleged that in 2007, Nocella and Man used aggressive loan modification programs to hide the bank’s non-performing loans and artificially boost profits.  See SEC Complaint. 

Despite having charged over 100 people and firms with fraud tied to the financial crisis, critics of the SEC believe the agency hasn’t buckled down hard enough.  Yet SEC enforcement chief, Robert Khuzami, believe these numbers show the agencies effectiveness in “tackling financial-crisis wrong-doing.”  Of the 74 cases filed against individuals, 55 are chief executives, finance chiefs or other top officers.  Khuzami believes this “sends a strong deterrent message.”  

Many of the SEC critics note that about 24 of the people charged by the SEC have avoided trial by reaching “weak” settlements.  Senator Grassley from Iowa stated, “The lack of accountability from Wall Street encourages recidivism.” 

For instance, Angelo Mozilo, Chief Executive of Countrywide Financial Corp., agreed to a settlement of $67.5 million ($22.5 million penalty and $45 million disgorgement), while denying any wrongdoing.  These sanctions are supposed to compensate investors for their losses.   However, the repayment of illegal profits is tax-deductible and can be covered by some corporate insurance policies.  In Mozilo’s case, nearly half of the $45 million payment came from Countrywide's current owner, Bank of America Corp.  It can be difficult for the SEC to challenge indemnification rights in employment contracts or insurance policies.

According to The Wall Street Journal, in the 24 crisis-related cases where the SEC reached a settlement with an individual, the median sanction was $203,751.  These same defendants paid a combined $80.7 million in penalties.  Most of those penalties came from executives at collapsed mortgage lenders such Countrywide, American Home Mortgage Investment Corp. and New Century Financial Corp.; yet, their investors sustained losses of about $31 billion based on the three companies' peak stock-market value before the financial crisis began.  These penalties arguably pale in comparison to investor losses. 
Even some federal judges have criticized the large gaps between investor losses and the penalty.  For example, U.S. District Judge Frederic Block in New York, said $1.05 million in penalties paid by two former Bear Stearns Cos. hedge-fund managers, Ralph Cioffi and Matthew Tannin, in a proposed settlement of civil-fraud charges against them was “chump change” compared with the $1.8 billion lost by investors. The judge has not yet approved the proposed settlement.

While to some, the above penalties may seem like an inadequate punishment for the charges, Cioffi and Tannin have agreed to a temporary ban from the securities industry.  Khuzami believes the SEC’s power to expel people from the securities industry or from serving as directors of public companies is “probably one of the most powerful sanctions [it has].” 

Furthermore, when reaching settlements, the SEC has to weigh the likelihood of losing to a jury, along with the amount the agency can show was a direct result of the wrongdoing.  In some cases, it can be hard to say with certainty how much of investor losses were caused by fraud or illegal conduct, or if any fraud or illegal conduct actually took place.  Usually, defendants argue the financial losses were due to a failure to predict the meltdown, rather than any fraud on their part.  The answer is not always clear cut and pushing for stricter penalties across the board may not be appropriate for each case. 

Nevertheless, we can only hope that Americans’ trust in our banking and financial systems can once again be restored.