Federal District Court Denies Questar's Motion to Vacate 3.25 Million Dollar Arbitration Award

On November 12, 2012, Senior Judge Thomas B. Russell of The United States District Court, WesternDistrict of Kentucky, issued a 60-page Opinion denying a Petition to Vacate and a Motion to Vacate filed by Questar Capital Corporation. Questar is a fully owned subsidiary of U.A. Allianz. Questar filed in federal court after a 3-arbitrator FINRA panel sitting in Louisville issued a $3.25 million Award to a client of St. Louis' Cosgrove Law Group, LLC. The client is a former independent contractor, broker-dealer agent, and investment advisor representative of Questar.

The Court spent the first 1/3 of its Opinion addressing the broker's contention that Questar had waived its right to file a Motion to Vacate by failing to comply with the 30-day post-Award deadline set forth in FINRA Rule 13904. The broker had filed a Motion to Dismiss Questar's Petition to Vacate because, while it was filed within 30 days of the Panel's Award, Questar subsequently filed a Motion to Vacate about 75 days after the Award. The Court denied the Motion to Dismiss, concluding that, despite conflicting legal precedent, Rule 13904 “did not establish a 30-day time limit for filing a Motion to Vacate.” (Opinion at 23). Specifically, Judge Russell concluded that it is sufficient if a movant files within the 90-day time limit set forth in Section 12 of the Federal Arbitration Act (FAA).

Approximately half-way through his meticulous Opinion, Judge Russell initiated his analysis of “the heart of this proceeding”--the merits of Questar's application for vacatur. He began by noting the limited grounds upon which an arbitration award may be vacated under the FAA, noting that the Sixth Circuit recognizes an extra non-FAA judicial basis-- “manifest disregard of the law” by the arbitrator. Finally, rather than proceeding to evaluate sequentially each and every specific claim set forth by Questar, the Court divided Questar's allegations and the Court's analysis into the four FAA grounds of vacatur, as well as the Sixth Circuit's manifest disregard basis.

As to FAA Section 10(a)(2)-- “evident partiality” --the Court concluded that Questar's challenge to the sufficiency of pre-hearing disclosures the Panel Chairman made was without merit. (Opinion at 29-39). The Court's detailed analysis in this regard notes, among other things, that “...a party cannot remain silent as to perceived or actual partiality or bias and then later object after the panel reaches an unfavorable decision.” (Opinion at 37).

Judge Russell proceeded on to address Questar's multi-layered contention that the Panel violated FAA Section 10(a)(3) in that it allegedly refused to hear evidence pertinent and material to the controversy. In this regard the Court noted that “the standard for judicial review of arbitration procedures is merely whether a party to arbitration has been denied a fundamentally fair proceeding.” (Opinion at 40). The Court observed that only two of Questar's myriad of claims fell within this category: 1) that despite allowing the broker to introduce evidence through the testimony of his former attorney, the Panel improperly allowed him to assert the attorney-client privilege on Questar's cross-examination, and 2) that the Panel improperly excluded testimony from the broker's former clients. (Opinion at 41-42).

As to the first, the Court concluded that the claim was factually without merit. As to the latter, the Court concluded that the Panel's provision of 10 subpoenas in response to Questar's request for 55 subpoenas in the middle of the five-months of hearing sessions was more than adequate, noting that “arbitrators are not required to hear all of the evidence tendered by the parties; they need only afford each party a fair opportunity to present their arguments and evidence.” (Opinion at 42-49).

As to FAA Section 10(1)(4), the Court evaluated Questar's general challenge to the sufficiency of the evidence to support Claimant’s claims for defamation, negligence or tortious interference. At the outset of this analysis, the Court noted:

“...the award is devoid of any rationale or explanation as to the factual basis for the Panel's decision, the particular theory or cause of action upon which the award is based, and/or how the Panel calculated the award figure. But, Importantly, this is precisely the outcome contracted for between the parties. Cf. United Steelworkers v. Enter. Wheel & Car Co., 363 U.S. 593, 598 (1960) (“Arbitrators have no obligation to the court to give reasons for an award.”); Dawahare v. Spencer, 210 F.3d 666, 669 (6^th Cir. 2000) (“Arbitrators are not required to explain their decisions.”). As the Sixth Circuit has stressed, where the arbitral agreement imposes no duty of explanation on the arbitrator, “remand for the purpose of having the arbitrator clarify his reasoning would be inappropriate.” Id. at 977 n.9.

(Opinion at 50-51).

Aptly enough, Judge Russell stated: “The Court will not be lured into reviewing the merits of the Panel's decision.” (Opinion at 51). The Court proceeded to rebuke Questar's sufficiency challenge after a careful review of the appropriate controlling precedent and standard of review for Motions to Vacate. Judge Russell cited a fundamental tenet on this point:

“The Supreme Court and this Circuit have both admonished courts that “as long as the arbitrator is even arguably construing or applying the contract [to arbitrate] and acting within the scope of his authority, that a court is convinced he committed a serious error does not suffice to overturn his decision”; accordingly, “courts must refrain from reversing an arbitrator simply because the court disagrees with the result or believes the arbitrator made a serious legal or factual error.” Misco, 484 U.S. At 38; Salvay, 442 F.3d at 476.

(Opinion at 56).

Finally, the Court evaluated Questar's Motion to Vacate under the Sixth Circuit's “manifest disregard of the law” standard. This analysis bore no fruit for Questar either. Judge Russell cited Coffee Beanery, Ltd. v. WW L.L.C., 300 F.App'x 415 (6^th Cir. 2008) for the proposition that vacatur is only appropriate under this standard if “the decision [flies] in the face of clearly established precedent.” Id. at 418. (Opinion at 57). The Court also made the insightful distinction between a manifest disregard of the law, and the manifest disregard of fact that Questar was essentially peddling. (Opinion at 58-59).

The attorneys at Cosgrove Law Group, LLC spent approximately five (5) months briefing the various post-Award issues in this matter. In doing so, they reviewed dozens upon dozens of FAA and vacatur opinions. Judge Russell's Opinion in this matter may be the most thorough and instructive. You would be remiss not to digest it and save it if you practice in this area.

FINRA Panel Awards Expungement in Unlikely Case

 A FINRA hearing Panel in Pittsburgh, Pennsylvania recently made an uncommon move when it expunged an arbitration from a broker’s CRD records despite finding the broker jointly liable to the customer. 

In Bordas v. Wells Fargo, FINRA ID # 11-00484, the Claimants, James and Linda Bordas filed an arbitration claim against Wells Fargo Advisors, LLC and Ernest Coffindaffer for unsuitability, unauthorized trading, forgery, misrepresentation, fraud, negligence, breach of fiduciary duty, violations of the Securities and Exchange Act of 1934 and Rule 10b-5, respondeat superior, failure to supervise, and breach of contract.  The causes of action relate to the alleged recommendation and purchase of municipal bonds and variable annuities against the Claimants’ express wishes. 

The Respondents asserted counterclaims for defamation per se, tortious interference with business relationships, and tortious interference with prospective business relationships. 

At the close of hearing, Claimants’ requested a total award of $10 million: $754,765.00 in lost capital; $707,200.00 in lost gain; and the balance in non-economic and punitive damages.  Respondents’ requested $2,000,000.00 in compensatory damages, plus attorneys’ fees of $381,561.60 and $65,564.63 in disbursements. 

The Panel found Wells Fargo and Coffindaffer jointly and severally liable to the Claimants in the amount of $97,250.00.  Since arbitration awards rarely discuss findings of fact, it is unclear which claim(s) the award relates to.  James Bordas was found liable to Coffindaffer for defamation in the amount of $1,000.00.  All other claims against Claimants were dismissed with prejudice. 

Despite finding Coffindaffer jointly and severally liable with Wells Fargo, the Panel made a specific finding of fact that Coffindaffer was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation, or conversion of customer funds.  Even though it is uncertain what claim(s) the award was based on, one can assume that Coffindaffer was probably not found liable for fraud or any claims involving an element of willful intent especially since the Panel found that Coffindaffer’s conduct was “not so egregarious as to warrant a permanent stigma on his CRD.”  

The Central Registration Depository (CRD) is a database used by FINRA and NASAA to store and maintain information on registered securities and broker firms.  CRDs contain qualification, employment, and disclosure histories of registered individuals and can be used like a background check on brokers.  FINRA also pulls information from CRDs for its BrokerCheck program, which provides background information on brokers and firms to investors. 

When a broker is named as a respondent in a customer-initiated arbitration, the claim and any alleged wrongdoing are required to be reported on the borker’s Form U4, which will eventually get recorded in the CRD system and become available to the public through BrokerCheck. Therefore, some information that can be disclosed on one’s CRD could be damaging to a broker’s reputation.   

Brokers may seek to expunge any reference to the allegations or involvement in the arbitration from the CRD system.  However, FINRA provides rules that arbitrators must follow before awarding expungement to a broker. 

FINRA Rule 2080 requires that a court of competent jurisdiction confirm an arbitration award granting expungement.  FINRA must be named as an additional party to these court proceedings.  In most cases, FINRA generally opposes the confirmation of an award to expunge.  However, upon request, FINRA may waive the requirement to be named as an additional party in these proceedings if the award directing expungement contains one of the following findings: (1) the claim, allegation or information is factually impossible or clearly erroneous; (2) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (3) the claim, allegation or information is false.

FINRA Rules 12805 and 13805 provide that in order to grant expungement, an arbitration panel must hold a recorded hearing session regarding the appropriateness of the expungement.  If the case involves a settlement, the panel must review the settlement documents and conditions of the settlement to determine whether concerns exist about the broker’s involvement in the alleged misconduct. The panel must also indicate which grounds exist under FINRA Rule 2080 to support expungement.  Finally, all hearing session fees must be assessed against the party requesting expungement for any hearings in which the sole topic is expungement. 

Therefore, although the panel awarded expungement, Coffindaffer will still have to obtain a confirmation of the expungement award by the courts.  While the Panel made a specific finding under FINRA Rule 2080, FINRA may still oppose the expungement since he was sheld jointly and severally liable to the customer.  The Panel’s finding that Coffindaffer’s conduct was “not so egregarious as to warrant a permanent stigma on his CRD” may not be enough.

If you are a broker named in a customer-initiated arbitration and would like to seek expungement of the allegations or involvement in the arbitration from your CRD, contact the experienced attorneys at Cosgrove Law Group, LLC.   

Eighth Circuit Finds Investors Are Not “Customer” of Managing Broker-Dealer of Securities Offering Under FINRA Rule 12200

In Berthel Fisher & Co. Financial Services, Inc. v. Larmon, No. 11-2877, 2012 WL 4477433 (8th Cir. Oct. 1, 2012), the controversy arose out of securities issued by a group of Minnesota limited liability companies (collectively, Geneva) and purchased by defendants-appellants (the Investors) in 2007 and 2008.  Berthel Fisher & Company Financial Services., Inc., et al. (collectively, Berthel), a licensed broker-dealer and member of FINRA, served as managing broker-dealer for the offering. As managing broker-dealer, Berthel assembled a group of FINRA-registered broker-dealers-Selling Group Members, or SGMs-who in turn offered the securities to their own customers, including the Investors.

Although Geneva prepared the private placement memoranda (PPMs) to be provided to prospective purchasers of the securities, Berthel reviewed at least two of the PPMs, suggesting changes that Geneva adopted.  Per the agreement between Berthel and the SGMs, Berthel collected investor payments from the SGMs and passed those payments along to Geneva. In addition, the contract between Berthel and Geneva obligated Berthel and the SGMs to determine each investor's eligibility to participate in the offering. Because of this, Berthel maintained a file on each investor that included the investors' names, dates of birth, and contact information.

The securities did not perform as anticipated, leading the Investors to file FINRA arbitration claims against Berthel. The Investors alleged that Berthel performed insufficient due diligence on the offering, leading to critical omissions in the PPMs. Berthel filed suit in the United States District Court for the District of Minnesota, seeking a declaratory judgment that the Investors were not Berthel's "customers" under the FINRA Code and that Berthel was therefore not obligated to arbitrate with the Investors. Further, Berthel moved for a preliminary injunction enjoining the arbitrations, and the Investors cross-moved to compel arbitration.

The district court held that the Investors did not qualify as Berthel's customers under the FINRA Code and that the Investors' claims against Berthel were therefore not arbitrable before FINRA. Accordingly, the court granted Berthel's motion to enjoin the pending arbitrations and denied the Investors' cross-motion to compel arbitration.

The Court noted that "the first task of a court asked to compel arbitration of a dispute is to determine whether the parties agreed to arbitrate that dispute." Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 626, 105 S.Ct. 3346, 87 L.Ed.2d 444 (1985). The Investors did not allege that Berthel explicitly agreed to arbitrate; rather, they allege that they qualified as Berthel's "customers" under the FINRA Code. The Court found that the FINRA Code, which Berthel signed as a FINRA member, constituted an agreement to arbitrate disputes between Berthel and its customers.

The court noted that Rule 12200 of the FINRA Code states:

Parties must arbitrate a dispute under the Code if:

o Arbitration under the Code is either:

(1) Required by a written agreement, or

(2) Requested by the customer;

o The dispute is between a customer and a member or associated person of a member; and

o The dispute arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company.

The Court of Appeals stated that the question of arbitrability turned on whether the Investors are Berthel's customers under the FINRA Code.

The FINRA Code defines "customer" in the negative, stating only that "[a] customer shall not include a broker or dealer." FINRA Rule 12100(i). In Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770, 772 (8th Cir.2001), the Court of Appeals construed "customer" to "refer[ ] to one involved in a business relationship with [a FINRA] member that is related directly to investment or brokerage services."

The Court noted that in the present case it was uncontested that the Investors had no contact with Berthel in the course of investing in the securities at issue.  The Investors argued, however, that they qualified as Berthel's customers under Rule 12200 because Berthel

provided "investment or brokerage services" to the investors in three ways. First, Berthel Fisher was responsible for conducting due diligence on the TIC interests. Second, Berthel Fisher was obligated to conduct a reasonable-basis suitability analysis on the TIC interests. Third, Berthel Fisher maintained customer files on the investors and was responsible for protecting the investors' privacy.

The Court determined that the provision of these services in the case before it failed to transform the Investors into Berthel's customers, because Berthel provided those services not to the Investors but instead to the SGMs and Geneva. The Court noted that if the provision of these services formed any customer relationships at all, it formed them between Berthel, Geneva, and the SGMs, not between Berthel and the Investors.

The Investors argued that Fleet Boston requires only "investment or brokerage related services." But the Court found that the provision of "investment or brokerage related services" is only half of the picture-not only must the FINRA member firm provide those services, but also must it provide those services to the customer either directly or through its associated persons. In Fleet Boston, the Court of Appeals had observed that "[a]lthough other cases interpreting the term 'customer' have in some ways taken a broad view of the term, in all of these cases there existed some brokerage or investment relationship between the parties." Id. at 772 (emphasis added). The Court concluded that, simply put, in the case before it there was no "relationship" between Berthel and the Investors as required by Fleet Boston. Because Berthel did not provide "investment or brokerage related services" to the Investors, the Investors were not Berthel's customers under FINRA Rule 12200. Accordingly, the Court affirmed the judgment of the district court.

THOSE THINGS YOU NEVER READ

There may be many documents that qualify for this blog entry, but I am writing specifically about your brokerage account statements. Sure, you may take a peek at the bottom line now and then, but actually reading the entire statement—who does that?! Let me suggest that next month it will be YOU! 

Brokerage statements hold information your brokerage firm is required to provide to you on a regular basis. They hold key information about your life investments and how they are being managed. The Financial Industry Regulatory Authority (“FINRA”) has provided helpful insight to consumers regarding understanding brokerage statements and the importance of the information contained in those statements. Additionally, most regulators are going to agree that staying on top of your brokerage accounts is extremely important in ensuring your accounts are being handled in an appropriate manner. 

This doesn’t mean you have to know a lot about investments, but, according to FINRA, “Not only do these documents help you stay on top of your investment holdings, but they also provide valuable information that can alert you to errors, or even misconduct by your broker or brokerage firm such as unauthorized trading or overcharging customers for handling transactions.” So, even if you don’t know everything a particular Mutual Fund holds, your statements can bring to light problems you might not otherwise notice in a timely manner. Some examples of “red flags” are: Information or transactions in the account summary that you did not authorize or expect, or income that appears on your statement, but has not been deposited in your account. 

FINRA has provided a helpful key information guide that breaks down sections of an account statement and provides information about why it is important and what activity might qualify as a red flag. 

Many consumers are overwhelmed by the thought of reviewing financial information on a regular basis. Either they lack confidence that they will understand the statements and their holdings, or they fear activity in the market may have decreased their balance so they just avoid opening the statement all together. If you start out slow, only focusing on certain portions of your statement until you feel like you have an understanding of what should be there and what it means, you can progress to fully reading the account statement. While it may be uncomfortable and time consuming, it is an important step in overseeing how your hard earned money is being managed. It is a way to protect yourself from fraud and other unsavory activity and, should you come across something on your statement you are concerned about, FINRA recommends that you “immediately call the firm that issued the statement or confirmation about any transaction or entry [you] do not understand or did not authorize, and re-confirm any oral communication in writing with the firm.” 

So the next time that statement comes in the mail, think positive—this is an opportunity to protect your assets and you can start out slow—just be sure to start!

SEC’s Whistleblower Rewards Program – Who are the Real Bounty Hunters?

The U.S. Securities and Exchange Commission (“SEC”) made its first payout of $50,000 to a whistleblower since a program was created last year to reward people who provide regulators with evidence of securities fraud. 

The SEC set up a whistleblower program in August 2011 to reward individuals who provide evidence of securities law violations which lead to SEC sanctions of more than $1 million. The program was authorized in the 2010 financial-regulation overhaul. Potential awards could range from 10 percent to 30 percent of the money collected. 

The unnamed whistleblower helped the SEC bring an enforcement action that resulted in more than $1 million in sanctions.  The SEC rewarded the anonymous whistleblower 30% of the recovery.  So far the SEC has only collected $150,000 but as more of the sanctions are recovered, the whistleblower’s reward will increase.  The SEC believes the announcement of its first reward payout will give the program a boost.  However a second person in the same matter was denied a whistleblower reward because the information provided by the person did not lead to or significantly contribute to the enforcement action. 

While the program is supposed to encourage individuals to come forward with information relating to securities fraud, Peter Sivere, a former compliance officer at JPMorgan Chase had a much different experience with his efforts to “do the right thing.”  To be clear, the story of Peter Sivere occurred from 2003 to 2005 before the whistleblower program was adopted by the SEC. 

During an SEC investigation of whether a New Jersey hedge fund, a big client of JPMorgan, was late trading mutual funds, Sivere was allegedly terminated from JPMorgan for turning over emails to the SEC and expressing concerns that JPMorgan was not fully cooperating with the investigation.  The emails indicated that JPMorgan had provided a $105 million line of credit to the hedge fund that it used to facilitate its late trading in mutual funds.  Late trading occurs when one buys shares at the day’s final price even though the market has closed. 

Before his termination, Sivere contacted SEC lawyer George Demos by email seeking to become a whistleblower and inquiring whether he would be able to collect a reward for his information.  Even though Demos informed him that a “bounty” would not be available, Sivere turned the emails over to the SEC anyways.  Sivere was later fired and JPMorgan reported on his U-5 that he was terminated for “accessing e-mails without authorization.”  JPMorgan later agreed in a settlement to amend his U-5 to state his employment ended as a result of a “disagreement regarding the scope of [Sivere’s] authority.” 

Sivere reported the alleged retaliation to the Occupational Safety and Health Administration (“OSHA”) and it was discovered during their investigation that Demos informed JPMorgan’s lawyers that Sivere had asked the SEC for a whistleblower bounty and Demos even encouraged JPMorgan to use this information in the lawsuit between Sivere and JPMorgan.  While Demos’ behavior violates SEC protocol, and the allegations were confirmed by the SEC’s inspector general, no disciplinary action was taken against Demos.  In fact, Demos held his position with the SEC until 2009.
 
More recently, a whistleblower’s identity was inadvertently revealed during an SEC investigation of Pipeline Trading Systems, LLC when an SEC lawyer shared the whistleblower's notebook with one of Pipeline’s executives.  The executive recognized the whistleblower's handwriting.  The whistleblower, Peter Earle, was a former employee of one of Pipeline’s trading affiliates and expressed his disappointment in the SEC’s failed efforts to keep his identify private.

The new whistleblower rewards program is supposed to guarantee anonymity, yet the SEC has scars from the past which might be counter intuitive for the program, especially since no action was taken against Demos for the confidentiality violation. 

If you think you have information that may lead to a recovery under the whistleblower program, contact the attorneys at Cosgrove Law Group, LLC to have your rights represented and your identity protected.

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.