Loss causation has emerged as a central obstacle to post-financial-crisis fraud cases. The loss causation element of a fraud claim requires plaintiffs to show, in addition to detrimental reliance, that the facts or circumstances concealed by a fraudulent statement caused an ascertainable portion of their losses. In the aftermath of the 2008 financial crisis, plaintiffs have struggled at times to convince state and federal courts that their losses were caused by the alleged fraud, rather than the larger marketwide downturn. The most challenging cases have arisen from losses in asset classes that experienced a broad-based deterioration in value, such as mortgage-related securities and derivatives. If all assets in a particular class lose value during a financial crisis, how does a defrauded plaintiff distinguish the losses attributable to the fraud, as opposed to the crisis?
Two recent decisions out of the Second Circuit Court of Appeals have made the task easier for fraud victims. In Financial Guarantee Insurance Co. v. Putnam Advisory Co. and Loreley Financing (Jersey) No. 3 Limited v. Wells Fargo Securities, LLC, the Second Circuit has roundly repudiated strict requirements for pleading loss causation, deferring knotty causation issues out to later stages of the litigation where plaintiffs have the benefit of a more developed factual record. Quinn Emanuel represents the plaintiff in Putnam.
Background on Loss Causation in Fraud Cases
There are five elements to a fraud claim under New York common law and federal securities law. They are (1) a material misrepresentation or omission of fact, (2) knowledge of that fact’s falsity (also known as scienter), (3) a connection with the purchase or sale of securities,(4) reasonable reliance (sometimes referred to as “but for” or “transaction causation”), and (5) loss causation. See Dodona I, LLC v. Goldman, Sachs & Co., 847 F. Supp. 2d 624, 639 (S.D.N.Y. 2012) (federal and New York law). Historically, the loss causation element has come into focus in the aftermath of financial crises, where broad declines in market prices can make it more difficult to identify a causal relationship between an alleged fraud and losses sustained on a specific asset or investment.
In the late 1990s and early 2000s, courts in the Second Circuit endorsed a liberal reading of the loss causation requirement. So long as “the defendants’ misrepresentations spoke directly to the quality of the specific security or purchase at issue,” loss causation was satisfied at the pleading stage. Laub v. Faessel, 981 F. Supp. 870, 872 (S.D.N.Y. 1997). For example, in Suez Equity Investors, L.P. v. Toronto-Dominion Bank, the Second Circuit held that loss causation was satisfied by allegations that the defendant, a securities broker, altered a report about a company, for which it was soliciting investors, in order to conceal historical facts that called into question the general aptitude of a principal executive at that company for managing debt and maintaining adequate liquidity. 250 F.3d 87, 97-98 (2d Cir. 2001). Because that company’s ultimate losses were caused by a liquidity crisis at the company, the fraudulent concealment of facts related to the ability of its key personnel to manage liquidity was sufficiently tied to the loss to satisfy the element of loss causation. Id. at 98.
The pendulum swung back in defendants’ favor following the collapse of the dot-com bubble in 2001, which resulted in a wave of lawsuits over losses on internet stocks. In a key decision from this period, the Second Circuit affirmed the dismissal of a multidistrict litigation consolidating “some 140 class-action complaints” against Merrill Lynch for allegedly biased analyst reports recommending investment in internet companies that were actual or prospective investment banking clients of the firm, for failure to plead loss causation. Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 164-165 (2d Cir. 2005). The Court held that even if Merrill Lynch analysts had knowingly published overly optimistic reports about certain internet companies and caused unwarranted inflation in their stock prices, this conduct would not satisfy loss causation because plaintiffs had not alleged that the inflated stock prices caused the general collapse in the value of internet stocks. Id. at 177.
In the aftermath of the 2008 financial crisis, defendants quickly turned to Lentell and its progeny to defend against fraud allegations related to losses on mortgage-related securities. Defendants argued, with some success, that widespread losses on mortgage-related securities in the financial crisis could not be tied to misrepresentations as to any particular mortgage-related security. The district court decision in Putnam was a leading authority endorsing this reasoning.
District Court’s Dismissal of the Putnam Complaint
In 2012, the Financial Guaranty Insurance Company (“FGIC”) sued the Putnam Advisory Company, LLC (“Putnam”) for mismanagement of a collateralized debt obligation (“CDO”) called Pyxis ABS CDO-2006-1 (“Pyxis”). A CDO is an investment vehicle that purchases a portfolio of assets, which are financed by the investments of noteholders who are entitled to a portion of the cash generated by those assets. Pyxis invested exclusively in mortgage-backed securities (“MBS”).
Pyxis was conceived as a “managed CDO,” meaning a “collateral manager” with investing expertise was supposed to select its constituent assets, with an eye towards responsibly managing the CDO’s risk profile and overall performance. Putnam was the Collateral Manager for Pyxis. FGIC insured $900 million of senior notes issued by Pyxis, guaranteeing payment of interest and repayment of principal owed on those notes. It alleged that its agreement to supply insurance for the Pyxis notes was predicated on Putnam’s assurance that it would responsibly select collateral for Pyxis, driven by the best interests of Pyxis’s long-term investors.
Unbeknownst to FGIC, Putnam allegedly ceded control over collateral selection to Magnetar Capital LLC (“Magnetar”), a hedge fund that had placed significant bets that the Pyxis collateral would perform poorly. Magnetar’s bets against the collateral held by Pyxis placed its interests directly at odds with those of the CDO’s long-term investors and insurers. According to FGIC, Magnetar acted on these perverse incentives to fill Pyxis with high-risk MBS that it expected to perform poorly. Pyxis suffered an Event of Default just eighteen months after its formation, and was forced to liquidate at a significant loss in the midst of the 2008 financial crisis, causing FGIC to suffer losses on its insurance obligations. Unsurprisingly, FGIC claims that it would never have agreed to insure Pyxis had it known that Magnetar, and not Putnam, was selecting the collateral going into the Pyxis portfolio, and it sued Putnam for fraud.
Despite the compelling nature of FGIC’s fraud claim, the district court for the Southern District of New York dismissed it on the pleadings for failure to adequately allege loss causation. The court reasoned that all MBS-backed CDOs suffered significant losses during the 2008 financial crisis, and found that there were no allegations in the complaint tying the losses on the Pyxis CDO to Putnam’s misrepresentations, rather than the economic downturn that caused losses on other, similar investments. To plead loss causation in the backdrop of a marketwide downturn,” the Court wrote, “the complaint must allege facts that support an inference that plaintiffs would have been spared all or an ascertainable portion of that loss absent the fraud.” Fin. Guar. Ins. Co. v. Putnam Advisory Co., LLC, 2014 WL 1678912, at *10 (S.D.N.Y. Apr. 28, 2014) (internal citation omitted). On this standard, the complaint failed to show that any “pool of collateral … could have avoided default while still conforming to Pyxis’s detailed eligibility criteria.” Id. at *12. Thus, the Court concluded that the wider mortgage crisis would have caused Pyxis’s default regardless of who selected its collateral, so FGIC’s losses were not fairly attributable to Putnam’s misrepresentations.
Second Circuit’s Reversal and Reinstatement of FGIC’s Claims
On appeal, the Second Circuit reversed. While endorsing the district court’s definition of loss causation—FGIC had to plausibly allege it “would have been spared all or an ascertainable portion of [its] loss absent the fraud”—the Second Circuit held that it “misapplied the standard” by conflating pleading loss causation and proving it at trial. Fin. Guar. Ins. Co. v. Putnam Advisory Co. LLC, 783 F.3d 395, 404 (2d Cir. 2015). The Court clarified that, at the pleading stage, “[t]he purpose of the loss causation element is ‘to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind,’ not to make a conclusive proof of that causal link.” Id. at 404 (quoting Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 346 (2005)).
Applied to FGIC’s claims against Putnam, FGIC was “not required to establish that the collateral it has identified as selected by Magnetar was the exclusive cause of its losses; rather, it need only allege sufficient facts to raise a reasonable inference that Magnetar’s overall involvement caused an ascertainable portion of its loss.” Id. On a close reading of the complaint, the Second Circuit found that FGIC had adequately alleged loss causation, citing, among other things, FGIC’s claim that, notwithstanding the downturn across all MBS, specific assets Magnetar selected performed worse than assets that Putnam would have selected acting independently, and that assets selected by Magnetar defaulted more quickly than other assets in Pyxis’ portfolio. The holding suggests that allegations that an investment performed poorly relative to similar assets not subject to the misrepresentation will satisfy, at least at the pleading stage, the requirements of loss causation in the context of a marketwide downturn.
In an interesting footnote, the Court of Appeals also raised a possible alternative theory of loss causation for fraud victims whose losses coincide with a marketwide downturn. Noting that the Financial Crisis Inquiry Commission had concluded that the manipulation of CDOs by hedge funds like Magnetar “‘contributed significantly’ to the financial crisis,” the court “observe[d] that there may be circumstances under which a marketwide economic collapse is itself caused by the conduct alleged to have caused a plaintiff’s loss.” Id. at 404 n.2. Though it refrained from ruling on the issue, the court suggested that FGIC might have been able to show loss causation simply by demonstrating that Putnam’s specific misrepresentations in this case were a contributing cause of the wider mortgage crisis itself. Id. If adopted, this alternative theory of loss causation would excuse fraud victims from the burden of establishing a causal nexus between their loss and a fraudulent statement where a systemic downturn can be tied back to the type of fraud alleged in the complaint.
Just three months later, the Second Circuit issued a second impactful decision on loss causation, further liberalizing the pleading standard for such claims. The facts of Loreley Financing (Jersey) No. 3 Limited v. Wells Fargo Securities, LLC were remarkably similar to Putnam. Loreley involved two other CDOs for which Magnetar allegedly selected the collateral while simultaneously betting against it—despite representations that an expert, third-party collateral manager with aligned incentives with noteholders would be doing so—as well as a third CDO allegedly tainted by similar improprieties in the asset selection process. See Loreley, 2015 WL 4492258, at *4 (2d Cir. Jul. 24, 2015). Plaintiffs in Loreley were investors in these CDOs. Id. Their claims were dismissed on a number of grounds, but the district court did not address loss causation. Id. at *18. Nonetheless, the defendants raised loss causation arguments on appeal, which were addressed in detail by Judge Guido Calabrese, who prior to his ascendance to the federal bench was widely recognized as one of the world’s foremost experts on issues of causation in tort. See Guido Calabrese, Concerning Cause and the Law of Torts, 43 U. Chi. L. Rev. 69, 72 (1975) (a widely cited law review article by then Professor Calabresi, which he cites several times in the Loreley decision).
Judge Calabresi took the analysis from Putnam a step further, finding that plaintiffs at the pleading stage need only plead “causal tendency” to satisfy the requirements of loss causation. Causal tendency exists where the facts or circumstances concealed by a fraudulent statement “can … be shown to have made [an] investment, in fact, more disposed to suffer the alleged harm ...” Id. at *20. The Court then provided three examples of loss causation pleadings, each pertaining to the destruction of a house in an earthquake. Id. at *22-23. In the first example, Buyer purchases a house based on Seller’s misrepresentation that the house was once owned by Abraham Lincoln. Id. at *22. In the second example, Buyer purchases a house based on a misrepresentation regarding the sturdiness of the house—e.g., that the house was “well-built,” when it was not. Id. at *23. In the third example, Buyer purchases a house based on a misrepresentation that the house was “earthquake proof.” Id. The first of these examples is inadequate to satisfy loss causation, because Lincoln’s ownership in no way tends to increase the likelihood that the house could survive an earthquake. Id. The latter two examples, however, are sufficient at the pleading stage. Id. “It then falls to defendant to proffer facts indicating that a well-built house, or even an earthquake-proof one, would have been destroyed in this earthquake,” but these are “evidentiary matters for later in the litigation for later phases of [the] lawsuit.” Id.
Applied to the facts of Loreley, the Court found “that the allegations themselves give Defendants ‘some indication’ of the risk concealed by the misrepresentations that plausibly materialized in Plaintiffs’ ultimately worthless multimillion-dollar investments in these CDO notes.” Id. at *24. In particular, the Court credited plaintiff’s allegation “that Magnetar was actively undermining the constellation CDOs by selecting marginal collateral to capitalize on eventual defaults.” Id. This satisfied their pleading burden. The court rejected the idea that plaintiffs had to allege that the misrepresentations caused losses independently of the marketwide downturn: “[t]he requirement … to plead a causal link does not place on Plaintiffs a further pleading obligation to rule out other contributing factors or alternative causal explanations.” Id.
Impact of Putnam and Loreley on Pleading Loss Causation
Loss causation continues to be a sticky issue for fraud plaintiffs who experience losses during a marketwide downturn. Numerous unanswered questions remain: How does a plaintiff prove that an “ascertainable portion” of its losses were caused by the fraud, and not the financial crisis? Is the plaintiff’s recovery limited to that ascertainable portion, or once the loss causation box is checked, is the plaintiff entitled to all out-of-pocket losses? If the plaintiff’s fraud was a contributing cause to the financial crisis, does this do away with the loss causation requirement, as hinted at by the Second Circuit in Putnam?
Now, though, plaintiffs can proceed with greater certainty that these questions will be resolved at a later stage of the proceeding, with the benefit of fact development through discovery. Allegations showing that the concealed or misrepresented facts or circumstances tend to cause the losses alleged in the complaint, even absent allegations addressing the role of an intervening financial crisis in those losses, should be enough to survive a motion to dismiss. In addition, plaintiffs may wish to take up the Putnam court’s invitation and allege that the defendant’s misrepresentations partially caused the wider economic downturn, potentially obviating the need for separate loss causation analysis.