Commercial Division Blog

Posted: January 2, 2014 / Categories Commercial, Fraud/Misrepresentation, Securities, Damages

Decision Explores the Distinction Between Transaction Causation and Loss Causation

On December 24, 2013, Justice Kornreich of the New York County Commercial Division issued a decision in Loreley Fin. (Jersey) No. 4 Ltd. v. UBS Ltd., 2013 NY Slip Op. 33262(U), explaining the distinction between transaction causation and loss causation.

In Loreley Fin., the court decided a motion for reconsideration of a decision dismissing a complaint relating to the purchase of residential mortgage-backed securities. Part of that decision explained the distinction between transaction causation and loss causation, and how the failure to show loss causation was fatal to the plaintiff's claim. We quote it at length because of the important distinction it draws, one to which counsel in complex ligitation often are not--but should be--sensitive.

Judge Sweet's opinion [in Fin. Guar. Ins. Co. v Putnam Advisory Co., 2013 WL 5230818 (SDNY Sept. 10, 2013)] is especially notable given the recent trend of attorneys conflating transaction ("but for") causation and loss causation. Under New York law, a common law fraud claim must be dismissed if loss causation is not pled with particularity. In [Laub v Faessel, 297 AD2d 28, 31 (1st Dep't. 2002)], the First Department explicitly set forth the following standard in a fraud case:

To establish causation, plaintiff must show both that defendant's misrepresentation induced plaintiff to engage in the transaction in question (transaction causation) and that the misrepresentations directly caused the loss about which plaintiff complains (loss causation).

As the Second Circuit explained [in First Nationwide Bank v Gett Funding Corp., 27 F3d 763, 769 (2d Cir. 1994)]:

In the context of predicate acts grounded in fraud, the proximate cause requirement means that the plaintiff must prove both transaction and loss causation. Thus, in addition to showing that but for the defendant's misrepresentations the transaction would not have come about, the defendant must also show that the misstatements were the reason the transaction turned out to be a losing one . . . . The purpose of the proximate cause requirement is to fix a legal limit on a person's responsibility, even for wrongful acts. Central to the notion of proximate cause is the idea that a person is not liable to all those who may have been injured by his conduct, but only to those with respect to whom his acts were a substantial factor in the sequence of responsible causation, and whose injury was reasonably foreseeable or anticipated as a natural consequence.

Ergo, transaction causation and loss causation are separate elements, and each must be adequately pled with particularity to survive a motion to dismiss. Therefore, though an investor may be able to prove that he would not have invested but for the misrepresentation, if the investor lost his money for wholly unrelated reasons (say, the market crashing), the investor cannot get his money back via rescission. This makes perfect sense and is the law in this state. If this were not the law, for instance, one could sue for a stock's depreciation on the grounds that the company represented an earnings expectation that proved to have no basis in fact when the stock's depreciation occurred during a massive economic downturn, when all stocks in a particular asset class declined, regardless of their individual forecasted earnings. There is a litany of precedent firmly establishing that the loss causation element exists precisely to prevent opportunistic investors from getting their money back when their losses had nothing to do with the subject representations. Indeed, if loss causation was not a required element, every market downtown would subject every investment to a fraud claim.

That is what this case is about. IKB and the Loreley funds bet wrong on the housing market, and it cost them dearly. Yet, they astutely observed that many on Wall Street had an unfortunate habit of playing fast and loose with various aspects of structured finance deals, ranging from the very underpinnings of an investment (e.g., RMBS based on fraudulent loans) to greyer areas (e.g., the process of procuring a rating for a synthetic CDO). Misconduct may have occurred, but if the misconduct was not the basis for the loss, a viable claim is not pled.

(Internal quotations and citations omitted).