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July 2015: Structured Financial Product Victory

July 2015

On April 15, 2015, the United States Court of Appeals for the Second Circuit ruled that our client Financial Guaranty Insurance Company’s (“FGIC”) complaint was improperly dismissed under Rule 12(b)(6) and reinstated its claims for fraud, negligent misrepresentation and negligence against defendant The Putnam Advisory Group, LLC (“Putnam”). The decision is a significant victory for FGIC and constitutes an important precedent on the issue of loss-causation in the context of market-wide downturns. Under the Circuit’s published decision, a claim is adequately stated so long as the complaint alleges that the defendant’s activity “caused an ascertainable portion” of the plaintiff’s losses. Fin. Guar. Ins. Co. v. Putnam Advisory Co. LLC, -- F.3d -- (2d Cir.2015). The decision will make it significantly harder for parties who commit fraud resulting in losses that occur contemporaneously with market-wide downturns to shield themselves from liability.

The case arises out of a collateralized debt obligation (“CDO”) called Pyxis ABS CDO-2006-1 (“Pyxis”) for which Putnam served as collateral manager. A CDO is an investment vehicle that purchases and/or assumes the risk of a portfolio of assets and sells investment certificates to investors that entitle the investors to payment funded by the portfolio. Our client issued $900 million of insurance on a senior tranche of Pyxis, without which Pyxis would not have closed. The complaint alleges that Putnam induced FGIC to provide the insurance on the basis of misrepresentations that Putnam—and Putnam alone— would select the collateral for Pyxis, acting independently and in good faith. FGIC alleges that Putnam in fact allowed a hedge fund, Magnetar Capital LLC (“Magnetar”), which had taken a significant short position in Pyxis, to control collateral selection for the CDO. Putnam’s actions increased the riskiness of Pyxis’s portfolio, and the CDO ultimately defaulted in 2008, exposing FGIC to substantial liability. FGIC would not have provided insurance on FGIC—and would not have been exposed to that liability—if it had known the truth about Magnetar’s role in the collateral selection process.

Notwithstanding these allegations, the district court dismissed the complaint in full, reasoning that the complaint did not sufficiently establish that Putnam’s misrepresentations about Magentar’s role in the CDO caused FGIC’s losses, as opposed to the “global financial crisis.” On appeal, Quinn Emanuel successfully argued that the complaint plausibly alleged that Putnam’s conduct caused FGIC’s losses by, among other things, alleging that specific assets selected by Putnam at Magnetar’s direction performed worse than assets that Putnam would have selected acting independently. Thus, the complaint alleged that the fraud “caused an ascertainable portion” of FGIC’s loses, and the question of which losses would have occurred irrespective of the fraud presents a triable issue of fact.

The Circuit also reinstated FGIC’s claims for negligence and negligent misrepresentation, which the district court had dismissed on the basis that the complaint did not sufficiently allege a “special relationship” between FGIC and Putnam. Notwithstanding the lack of contractual privity between FGIC and Putnam, the Circuit held that FGIC’s allegations, including face-to-face meetings and e-mails with Putnam, and the importance of Putnam’s representations to FGIC’s risk-assessment decisions, overcame the lack of privity such that a duty of care existed between the parties.

The case now proceeds to discovery in the Southern District of New York.