In early December 2010, Judge Preska of the Southern District Court of New York dismissed federal claims against Merrill Lynch and other related parties based on the plaintiffs’ failure to adequately plead that alleged misstatements and manipulative conduct proximately caused plaintiffs’ losses. In re Merrill Lynch Auction Rate Securities Litigation, No. 09MD2030 (S.D.N.Y. 2010). The claims alleged securities fraud involving auction rate securities (ARS).
The Louisiana Stadium and Exposition District (LSED) and the State of Louisiana brought claims against Merrill Lynch alleging misrepresentations under Section 10(b) and Rule 10b-5, and for market manipulation, arising from Merrill’s ARS marketing. In early 2005, LSED engaged Merrill to serve as broker-dealer for the auctions of ARS bonds that LSED issued. Despite touting the liquidity of the ARS market, Merrill had previously placed supporting bids in every ARS auction.
In early 2006, the US Securities and Exchange Commission (SEC) conducted an investigation into the auction practices and procedures of numerous investment banks, including Merrill. As a result, the SEC found that Merrill had violated the prohibition on material misstatements and omissions in the offer and sale of securities by failing to disclose its role in the ARS auctions. In August 2006, as part of its settlement with the SEC, Merrill posted on its website a written description of its auction practices and procedures that would be available to all issuers of ARS.
In this action, the plaintiffs alleged that Merrill’s previous failure to disclose its bidding practices in the ARS market misled them in making investment decisions, resulting in damages when ARS auctions froze in early 2008. Merrill first argued that plaintiffs’ claims were barred by the statute of limitations because they were brought later than “two years after the discovery of facts constituting the violation,” which Merrill maintained was in August 2006 after the SEC investigation and website disclosures. The court determined that, because plaintiffs suffered no economic loss prior to the collapse of the ARS market in February 2008, their securities fraud claims could not have accrued before that time.
While this finding helped the plaintiffs establish the timeliness of their claims, it doomed their lawsuit on the merits. Judge Preska noted that the plaintiffs were well informed of the risks involved in the ARS market at least as of August 2006, when Merrill disclosed its auction practices on its website. The plaintiffs had the option to convert their ARS to traditional fixed rate instruments—alleviating the risk of ARS market failure—but failed to do so. As a result, Judge Preska found that plaintiffs “cannot demonstrate that the alleged misstatements and manipulative conduct were proximate causes of their losses.”
Applying the Second Circuit’s definition of proximate cause, or loss causation, in the context of alleged misstatements or omissions, Judge Preska held that “a misstatement or omission is the ‘proximate cause’ of an investment loss if the risk that caused the loss was within the zone of risk concealed by the misrepresentations and omissions alleged by a disappointed investor.” To establish loss causation, therefore, plaintiffs must allege “that the subject of the fraudulent statement or omission was the cause of the actual loss suffered.” And while Merrill may have acted “reprehensibly” when advising LSED to continue with the ARS auctions, Judge Preska reminded plaintiffs that “the securities laws were not designed to prevent investment risks from materializing or to provide investment insurance.”
Though Judge Preska dismissed plaintiffs’ federal securities law claims, she held that plaintiffs adequately alleged claims for breach of fiduciary duty, intentional and negligent misrepresentation and fraud under Louisiana state law to the extent they are predicated on misstatements or omissions that occurred prior to the August disclosures.
Learn more about our Securities Litigation & Enforcement practice.