Circuit Courts Uphold Dismissal Of Securities Claims Based On Alleged Fraud In Sale Of Auction Rate Securities

Two recent opinions from separate federal courts of appeal upheld the dismissal of lawsuits by sophisticated investors that suffered losses in the auction rate securities ("ARS") market against the securities broker-dealers that allegedly fraudulently induced the purchase of the ARS.1

The plaintiffs in the two separate lawsuits were identical: Ashland, Inc., a diversified global chemical company, and AshThree LLC, the special purpose entity that the company solely owned and operated (collectively, the "Company"). The Company contended that the securities broker-dealers had assured it that the ARS were safe, liquid instruments suitable to the Company's conservative investment policies.2 Furthermore, the Company maintained that not only did the securities broker-dealers represent that auction failures were very rare, but also that, should the need arise, the broker-dealers would act to prevent auction failures by placing sufficient proprietary bids. When the ARS market collapsed in February 2008, the Company was left with millions of dollars in illiquid ARS and, unable to sell most of these holdings, discounted them by millions of dollars and lost similar amounts in the few sales it did execute.

1. The Second Circuit Holds That "Sophisticated Investors" Cannot Plead Reasonable Reliance on Alleged Misrepresentations Contradicted by the Securities Broker-Dealer's Publicly Filed Disclosure Statements.

   To sustain a claim for securities fraud under section 10(b) of the Securities Exchange Act, a plaintiff needs to prove, among other things, that it reasonably relied upon the broker-dealer's alleged ARS misrepresentations. According to the Second Circuit in Ashland, Inc. v. Morgan Stanley & Co., "An investor may not justifiably rely on a misrepresentation if, through minimal diligence, the investor should have discovered the truth."3 Among other factors relevant to this "minimal diligence" analysis are the investor's sophistication and expertise in financial and securities matters, and whether the investor had access to the relevant information. (Slip op. at 9).

   The Second Circuit held that the Company, which admitted to being a "sophisticated investor," could not have reasonably relied on the alleged misrepresentations, which were contradicted by the broker-dealer's publicly available statements. Those SEC-mandated statements disclosed the very liquidity risks about which the Company claimed to have been misled. For example, the Company could not...