The mess spewing from the collateralized debt obligations (CDOs) involving high-risk residential mortgage-backed securities (RMBSs) has spawned an awful lot of interesting case law concerning fascinating issues relating to common law fraud and misrepresentation.  See, e.g., my post — https://nyfraudclaims.com/fraud-claim-time-barred-fraud-detected-within-statute-limitations/;

Here we go again. …

The latest case is the Appellate Division, First Department’s decision in CIFG Assur. N. Am., Inc. v J.P. Morgan Sec. LLC, 2016 NY Slip Op 08029 (Decided on November 29, 2016 1st Dep’t).  This one involves misrepresentation to induce insurance.

Plaintiff CIFG Assurance North America, Inc., a stock insurance company, alleged that Bear Stearns & Co. Inc., a predecessor of defendant J.P. Morgan Securities LLC, made material misrepresentations that induced CIFG to provide financial guaranty insurance in connection with two CDOs. CIFG claimed that Bear Stearns had on its books a large number of RMBSs, and “embarked on a scheme to rid itself of these toxic assets by offloading them into the two CDOs, and marketing the CDOs’ securities to investors.”

In order to make the CDOs marketable, Bear Stearns needed to find an entity that would insure the CDOs’ senior tranches. In 2006, Bear Stearns solicited financial guaranty insurance from CIFG on two credit default swaps that would guarantee certain senior notes issued by the CDOs. To induce CIFG to issue the insurance, Bear Stearns repeatedly represented, both orally and in written pitchbooks and offering circulars, that the CDOs’ assets “would be selected by reputable collateral managers acting independently of Bear Stearns and in good faith in the interest of ‘long’ investors.” CIFG alleged that based on these representations, it agreed to issue the requested insurance, without which the CDOs would not have closed.

CIFG claimed Bear Stearns’s representations were false because “the collateral for the CDOs was not independently selected by the collateral managers. Instead, Bear Stearns persuaded the managers, through the promise of large fees and future business, to allow Bear Stearns itself to choose the collateral.” Bear Stearns alleged “loaded the CDOs with toxic RMBSs from its own books, and also profited from short positions it took against the CDOs’ portfolios.” Allegedly, “[b]ecause of the large volume of toxic RMBSs in the portfolios, both CDOs collapsed within approximately one year after closing. As a result, CIFG had to pay over $100 million to discharge its liabilities under the insurance. CIFG allege[d] that had it known that the purportedly independent managers would be taking direction from Bear Stearns, it would never have issued the insurance.”

Demanding Pleadings Requirements

The Court then focused on the demanding pleading requirements for fraud and misrepresentations claims.  While it found the allegations insufficient, it reversed the lower court by granting leave to amend the complaint.

The appeal concerned the claim for “material misrepresentation in the inducement of an insurance contract.”  The motion court dismissed the misrepresentation claim with prejudice for failure to state a cause of action, refusing to grant leave to amend.

Noting that CPLR 3016(b) requires the claim for misrepresentation to be “stated in detail,” the First Department observed that conclusory allegations are insufficient.”

The Court found that the claim was properly dismissed because the complaint contained “insufficient information about the insurance policies CIFG was allegedly fraudulently induced to issue, and the circumstances under which those policies were issued.”  The Court added the following instructive analysis of the pleadings requirement that had not been met:

As noted earlier, CIFG did not directly insure the CDOs, but rather, issued financial guaranty insurance on two separate credit default swaps that would, in turn, guarantee certain notes issued by the CDOs. A credit default swap is a commonly used type of credit protection somewhat analogous to an insurance policy (see generally HSH Nordbank AG v UBS AG, 95 AD3d 185, 189-190 [1st Dept 2012]). There are two parties to a credit default swap: the buyer of the credit protection (analogous to the insured) and the seller of the credit protection (analogous to the insurer) (id. at 189). “[T]he protection buyer’ pays a periodic fee (resembling an insurance premium) to the protection seller’ to cover the credit risk on an underlying security or group of securities” (id.). If a “credit event” occurs, such as a payment default on the underlying financial [*3]product, the protection seller is obligated to compensate the protection buyer (id.).[FN1]

The complaint asserts only that CIFG issued financial guaranty insurance on two credit default swaps, but contains no other information about the policies. It does not describe the terms of the insurance, the amount of the insurance, the dates the insurance was issued, or the time period the policies covered. The complaint also fails to identify the parties to the insurance contracts and the names of the insureds and/or beneficiaries. Although the complaint alleges that Bear Stearns “solicited” the insurance from CIFG, it does not contain any detail as to how Bear Stearns made the solicitation. Nor does the complaint provide any information about the underlying credit default swaps. It does not identify either the protection buyer or the protection seller, fails to describe the terms of the swaps, and does not explain the circumstances underlying the decision to utilize credit default swaps, including whether or not Bear Stearns had any involvement in that decision. Finally, the complaint merely states that CIFG paid over $100 million to discharge its liabilities under the insurance, but does not identify to whom those payments were made, or the events that triggered the payments. In light of these deficiencies, CIFG’s misrepresentation claim does not clearly inform defendant as to the complained-of incidents, and it was properly dismissed.

Interestingly, however, the First Department ruled that the lower court should have given the plaintiff another opportunity to replead the allegations, noting that leave to replead should be freely given.  I find it interesting because the First Department allowed the plaintiff to explain in its appellate briefs the “additional facts” it would allege in an amended complaint.  Query whether that had even been offered to the lower court.