Saturday, December 4, 2021

Third Party Reliance

This case came out of the Second Circuit a couple of months ago, and it’s still bugging me, so it’s the subject of today’s blog post.  I speak of Loreley Financing (Jersey) No. 3 Limited v. Wells Fargo Securities, LLC, 13 F.4th 247 (2d Cir. 2021)

The case itself is one of the last arising out of the financial crisis, featuring familiar names like Magnetar and Wing Chau.  And the allegations were standard for cases of this type:  Loreley, a German investment vehicle, invested in CDOs, and alleged that the structuring bank – Wachovia at the time, Wells Fargo as its successor – did not tell it the truth about how the assets were selected.  Loreley claimed it was defrauded under New York common law (not Section 10(b), because if you’re not relying on the fraud-on-the-market theory and you’re not trying to bring claims as a class, state fraud law will almost always be more favorable).  The district court granted summary judgment to Wells Fargo, and Loreley appealed. 

Before the Second Circuit, there were two issues.  The first concerned whether there were any misrepresentations at all; the court agreed that there were arguably at least some misrepresentations alleged with respect to one of the CDOs.  The second concerned the element of reliance, because Loreley itself did not actually communicate with Wachovia and did not receive any false information.  Instead, its investment advisor did. 

Loreley was actually formed by the investment advisor, IKB.  And IKB was in charge of vetting assets for the fund.  IKB presented its recommendations, and Loreley made the actual purchase without doing any independent research.  Thus, it was IKB – not Loreley – that received the false information, and Wells Fargo argued that for that reason, Loreley itself did not “rely” on any misrepresentations under New York law.

Shockingly, to me, the Second Circuit held in favor of Wells Fargo.  The court, summarizing its understanding of New York law, held that  “Loreley—which did not communicate directly with the defendants—bases its fraud claims on IKB’s reliance. Yet New York law does not support such a theory of third-party reliance....The reliance element of fraud cannot be based on indirect communications through a third party unless the third party acted as a mere conduit in passing on the misrepresentations to a plaintiff.”

That is … nutty.  No fund ever reviews information directly; they always rely on investment advisors who act on their behalf.  That’s the whole point; funds themselves are shells, with the real work being done by an investment advisor.

But instead of recognizing that fact, the Second Circuit made a big deal out of the orthogonal point that IKB conducted significant independent analysis before passing its recommendation on to Loreley.  That’s not entirely irrelevant, for sure. If IKB’s recommendation was based on its own analysis and not the fraud, then IKB didn’t rely, and IKB’s nonreliance is imputed to the funds.

But that’s not what the Second Circuit held.  The Second Circuit’s point was that Loreley itself never received the false information because it only received IKB’s analysis, and from that concluded that even if IKB’s analysis on Loreley’s behalf was in fact influenced by the fraud, Loreley did not rely on that fraud itself.  If that is the rule, no fund would ever be able to bring a fraud claim.

For example, off the top of my head, consider the Volkswagen case, which I blogged about here.  Since that post, the Ninth Circuit on appeal rejected the district court’s conclusion the case involved omissions, and therefore held that Affiliated Ute’s presumption of reliance would not apply, but as relevant here, in that case, it was investment advisor, not the institutional investor itself, who reviewed the materials. 

After all, that’s part of the reason why qualified institutional buyers and accredited investors are permitted to invest in unregistered offerings; we assume wealthy investors are capable of hiring professional advisors who will vet things for them. 

The Second Circuit claimed that its decision was dictated by Pasternack v. Lab. Corp. of Am. Holdings, 27 N.Y.3d 817 (2015).  In that case, the plaintiff had to get a drug test to maintain flight certification and he alleged the lab misrepresented the results to the FAA.  When he couldn’t get his certification, he sued the lab for fraud.  In that context, the New York Court of Appeals held there was no reliance. 

The Second Circuit also cited Securities Investor Protection Corp. v. BDO Seidman, 95 N.Y.2d 702 (2001), which presented a similar kind of scenario.  BDO Seidman audited a broker-dealer and communicated its financial condition to the NASD.  The NASD was charged with, among other things, notifying SIPC of any problems with a regulated broker-dealer.  As it turns out, BDO Seidman gave the firm a clean audit even though the firm was engaged in shenanigans, and the firm ultimately went bankrupt.  SIPC was then forced to cover the claims of the broker-dealer’s customers, and it sued BDO Seidman for fraud and negligent misrepresentation.  The court held that because the audits were not performed for SIPC, and were never communicated to SIPC, SIPC had not relied on the audits.

Both Pasternak and SIPC present common problems in fraud claims: the plaintiff didn’t rely on the false information, but someone else did, and that third party reliance ended up harming the plaintiff.  It comes up a lot for short-sellers, for example: The defendant lies publicly about its financial condition, and the short-seller knows it’s lying, but because the market is fooled, the short-seller is still forced to cover its position at inflated prices.  Can the short-seller satisfy the element of reliance in a Section 10(b) claim?  That’s something of an unsettled question, see discussion in Christine Hurt & Paul Stancil, Short Sellers, Short Squeezes, and Securities Fraud

In fact, in a way, all of fraud-on-the-market is a kind of third party reliance.  The plaintiff did not necessarily hear the lie, but the market did, and that affected the plaintiff. 

But in these scenarios, the “market” is not acting on the investor’s behalf.  Just like NASD was not acting on SIPC’s behalf, and the FAA was certainly not acting on Pasternak’s behalf.  It is therefore a very different kind of problem than the one presented in Loreley Financing, where Loreley employed a financial advisor, the advisor relied on a misrepresentation, and then made a recommendations based on that misrepresentation.  The financial advisor should not even count as a third party in this context – the financial advisor is acting on Loreley’s behalf and therefore is an extension of Loreley itself.  It’s the “on Loreley’s behalf” that’s the key here and it’s a distinction that the Second Circuit completely elided.

Now, to be sure, IKB did not have discretion to actually make the investment decision for Loreley; Loreley ultimately made the investment decision.  (There does not appear to be any information about how often Loreley rejected IKB’s recommendations).  And in the briefing, there was some skirmishing among the parties about whether IKB was technically acting as Loreley’s agent – Loreley said it was, Wells Fargo said it was not – but what’s notable about the Second Circuit’s opinion was that it did not care.  The court’s holding was not based on some kind of hypothesized distance between IKB’s recommendation and Loreley’s investment; the court accepted that IKB was hired by the funds to vet investments (and in fact was Loreley’s sponsor), and that still was not enough for the Second Circuit to impute IKB’s reliance to Loreley.

Nutty.

https://lawprofessors.typepad.com/business_law/2021/12/third-party-reliance.html

Ann Lipton | Permalink

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