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Posted: August 12, 2016

First Department Clarifies Fraud Pleading Standards

On August 11, 2016, the First Department issued a decision in IKB International, S.A. v. Morgan Stanley, 2016 NY Slip Op 05779, clarifying the pleading standards for investment fraud.

An unsettled area in New York law is the extent to which a sophisticated party must engage in due diligence before its reliance on a fraudulent misrepresentation is reasonable. In IKB International, the First Department helped clarify that standard in affirming the denial of a motion to dismiss a fraud action brought by an investor in RMBS. The court explained:

Where a plaintiff is a sophisticated entity, if the facts represented are not matters peculiarly within the defendant’s knowledge, and the plaintiff has the means available to it of knowing, by the exercise of ordinary intelligence, the truth or the real quality of the subject of the representation, the plaintiff must make use of those means, or it will not be heard to complain that it was induced to enter into the transaction by misrepresentations. In other words, a sophisticated investor claiming that it has been defrauded has to allege that it took reasonable steps to protect itself against deception by, for instance, examining available financial information to ascertain the true nature of a particular transaction or facts averred.

Plaintiffs allege that defendants knowingly misrepresented the credit quality and characteristics of the pool of residential mortgage loans that comprised the securitizations. For instance, defendants represented that rigorous loan underwriting standards had been employed in the loan origination process, and that if a particular loan did not comply, there were other compensating factors, when in fact the originators had systematically abandoned their underwriting standards, selling loans that they knew were defective. There were also misrepresentations about loan to value ratios, the appraised values of the underlying loans, owner occupancy of the mortgaged properties, and credit ratings.

Specifically on the issue of justifiable reliance, the complaint alleges that plaintiffs’ investment advisors analyzed the RMBS based upon information in the prospectuses, prospective supplements and other offering documents and that plaintiffs lacked access to the underlying mortgage loan files. They further claim that they would not have received the loan files even if they had been requested because of applicable regulations protecting the borrowers’ personal information (see 17 CFR 248.1, SEC Privacy of Consumer Financial Information). Plaintiffs further allege that defendants cautioned investors to rely only on the offering documents and expressly warned that anyone offering conflicting information about the investment was unauthorized to do so. These allegations are sufficient to allege justifiable reliance under the circumstances of this case.

Defendants argue that in order to establish justifiable reliance, plaintiffs were required to allege that they sought additional information from defendants about the truthfulness of the representations made in the offering documents or that they requested the loan files for the loans underlying the RMBS. The level of due diligence advocated by defendants requires a prospective purchaser to assume that the credit ratings assigned to the securities were fraudulent and to verify them through a detailed retracing of the steps undertaken by the underwriter and credit rating agency. We do not require this heightened due diligence standard to support justifiable reliance in a pleading concerning such sales of securities by prospectus.

(Internal quotations and citations omitted).

NOTE: Schlam Stone & Dolan LLP, along with John J.D. McFerrin-Clancy, were counsel for IKB on this appeal.

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