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PRIMAVERA FAMILIENSTIFUNG v. ASKIN
February 5, 2001
PRIMAVERA FAMILIENSTIFUNG, PLAINTIFFS
DAVID J. ASKIN, ET AL., DEFENDANTS. ABF CAPITAL MANAGEMENT, ET AL., PLAINTIFFS V. ASKIN CAPITAL MANAGEMENT, L.P., ET AL., DEFENDANTS. GRANITE PARTNERS, L.P., ET AL., PLAINTIFFS V. DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION, ET AL., DEFENDANTS. MONTPELLIER RESOURCES LIMITED, ET AL., PLAINTIFFS V. ASKIN CAPITAL MANAGEMENT, L.P., ET AL., DEFENDANTS. RICHARD JOHNSTON, AS TRUSTEE FOR THE DEMETER TRUST, ET AL., PLAINTIFFS V. ASKIN CAPITAL MANAGEMENT, L.P., ET AL., DEFENDANTS. BAMBOU INC., ET AL., PLAINTIFFS V. DAVID J. ASKIN, ET AL., DEFENDANTS. AIG MANAGED MARKET NEUTRAL FUND, ET AL., PLAINTIFFS V. ASKIN CAPITAL MANAGEMENT, L.P., ET AL., DEFENDANTS.
The opinion of the court was delivered by: Sweet, D.J.,
The defendants in seven related securities fraud actions have moved for
summary judgment as to various claims. The plaintiffs have opposed these
motions, and certain plaintiffs have made cross-motions for summary
Specifically, Kidder, Peabody & Co. ("Kidder") and Donaldson, Lufkin &
Jenrette Securities Corp. ("DLJ"), the broker defendants (collectively,
the "Brokers") in the six actions entitled ABF Capital Mgmt. v. Askin
Capital Mgmt., No. 96 Civ. 2978 (the "ABF Action"), Johnston v. Askin
Capital Mgmt., 97 Civ. 4335 (the "Johnston Action"), Primavera
Familienstiftung v. Askin, No. 95 Div. 8905 (the "Primavera Action"),
Montpellier Resources Ltd. v. Askin Capital Mgmt., No. 97 Civ. 1856 (the
"Montpellier Action"), Bambou Inc. v. Askin, No. 98 Civ. 6178 (the
"Bambou Action"), and AIG Managed Market Neutral Fund v. Askin Capital
Mgmt., No. 98 Civ. 7497 (the "AIG Action") (collectively, the "Investor
Actions"),*fn1 have moved for summary judgment against all plaintiffs
(the "Investors") on Count II of the complaint, which is the sole count
remaining against them and which alleges aiding and abetting fraud.
Kidder has also moved separately against certain Investors on statute of
limitations grounds, and against those Investors who invested in the
Quartz Hedge Fund ("Quartz") on grounds specific to those Investors (the
"Quartz Investors"). Defendants Askin Capital Management, L.P. ("ACM")
and David J. Askin ("Askin") (collectively, the "ACM Defendants") have
joined in the motions by DLJ and Kidder to the extent applicable.*fn2
In addition, defendants Merrill Lynch, Pierce, Fenner & Smith Inc.
("Merrill") and DLJ (collectively, the "Brokers")*fn3 have moved for
summary judgment in the seventh related action, entitled Granite
Partners, L.P. v. Bear Stearns & Co., Inc., No. 96 Civ. 7874 (the "Funds
Action"), against Granite Partners, L.P. ("Granite Partners), Granite
Corporation ("Granite Corp."), and Quartz (collectively, the "Funds"),
suing by and through the Litigation Advisory Board (the "LAB"). DLJ has
moved for summary judgment on Count I of the Second Amended Complaint,
which count alleges breach of contract by DLJ for wrongful margin calls.
Merrill has moved for summary judgment on the three counts remaining
against it, namely, Count I, alleging breach of contract for improper
margin calls, Count II, alleging breach of contract for bad faith
Demonstration copy of activePDF Toolkit (http://www.activepdf.com)
liquidations, and Count VIII, alleging commercially unreasonable
liquidations in violation of Article 9 of the Uniform Commercial Code
(the "U.C.C."). Merrill has also moved to strike the expert reports
submitted by the Funds in connection with the motions for summary
judgment. The Funds have cross-moved against Merrill on Counts I, II and
VIII. In addition, the Funds have cross-moved against DLJ on Count X of
the Second Amended Complaint, which count objects to DLJ's deficiency
claim against the Funds in the related bankruptcy proceeding, and Count
IX, which count alleges that DLJ failed to turn over certain principal
and interest payments owed to the Funds.
Finally, the ABF Plaintiffs have moved for an order removing the
"confidential designation" from documents produced by DLJ and Kidder, and
from the deposition testimony of present or former employees of those
firms, in the Investor Actions.
For the reasons set forth below, the motions will be denied in part and
granted in part.
The Parties and Prior Proceedings
Previous proceedings are also set forth in the prior opinions of this
Court. Extensive discovery has been had in these actions, involving the
exchange of tens of thousands of pages of documents and the deposition of
dozens of witnesses. Proceedings relevant to the instant motions are set
The summary judgment motions in the Investor Actions were filed on or
about May 12, 2000, and submissions were received through September 1,
2000, at which time the matter was deemed fully submitted. The summary
judgment motions in the Funds Action were filed on or about June 6,
2000, and submissions were received through July 28, 2000, at which time
the matter was deemed fully submitted. Kidder's motion in the Funds
Action to strike the Funds' expert reports was filed on July 12, 2000,
and was heard and deemed fully submitted on September 20, 2000. The ABF
Plaintiffs' motion in the Investor Actions to strike the "confidential"
designation from discovery materials was filed by letter of September
20, 2000, and was heard and deemed fully submitted on October 11, 2000.
The following facts are drawn from the parties' Rule 56.1 Statements
and other submissions and, as required, are construed in the light most
favorable to the non-movant, as applicable. They do not constitute
findings of fact by the Court.
Overview of the Transactions and the Funds' Collapse
The Funds were "hedge funds" which made leveraged investments in the
mortgage-backed securities market, including collateralized mortgage
obligations ("CMOs"). CMOs are bonds created from and collateralized by
mortgage-backed securities formed from pools of residential mortgages or
securities backed by such mortgages. CMOs are not listed or traded on a
The Granite Partners and Granite Corp. Funds (collectively, the
"Granite Funds") were established in 1990. Between the time of their
creation and September 1991, the investment advisor for these Funds was
New Amsterdam, run by Tony Estep ("Estep"). In September 1991, Askin
joined the Funds as their president and investment advisor, and in
September 1993, ACM was created as the Funds' investment advisor. The
Quartz Fund was established in January 1994 with ACM as its investment
The Investors, who include both individuals and institutional
investors, were shareholders and/or limited partners in the Funds. The
earliest purchase of an interest in the Funds occurred in or about
September 1990, and the latest occurred in March 1994. A number of the
Investors acquired additional interests in the Funds after their initial
Askin and ACM purchased CMOs for the Funds from various brokers,*fn4
including Merrill, DLJ, Bear Stearns, and Kidder. The brokers created the
CMOs are created from and divided into various classes, or "tranches,"
each of which is entitled to a different portion of the principal and/or
interest payments made by the underlying mortgage obligors. The tranches
differ from one another with respect to their sensitivity to interest
rate changes and the certainty with
which their reaction to such changes can be predicted.
The mortgage-backed securities market is complex and relatively
illiquid. Although mortgage-backed securities, including CMOs, count
among their benefits relatively high yields, these securities also carry
with them certain risks. The two primary risks associated with these
instruments are interest rate risk and prepayment risk. The interest rate
risk is the risk that the price of the security will decrease in response
to interest rate increases. The prepayment risk is the risk that
homeowners may prepay their mortgages, with the result that cash flows
generated by a pool of mortgages may fluctuate as homeowners pay down
their mortgages at faster or slower rates. Movements in interest rates,
among other factors, affect prepayment speeds.
The Granite Funds were intended to take advantage of the
mortgage-backed securities' potential for high returns while being
market-neutral by constructing portfolios comprised of a balanced mix of
"bullish" and "bearish" securities. A bullish security is likely to
increase in value when interest rates fall and decrease in value when
interest rates rise, and is more volatile. A bearish security is likely
to decrease in value when interest rates fall and increase in value when
interest rates rise, and is more stable. The Quartz Fund was intended to
be market-directional, that is, it Demonstration copy of activePDF
Toolkit (http://www.activepdf.com) was to maintain a bullish or bearish
portfolio depending on the predicted direction of interest rates.
The Granite Funds purchased many of the most complex and esoteric CMOs
in existence. The more complex and esoteric CMOs are relatively
illiquid. Indeed, the Brokers referred to the riskiest tranches —
those most prone to large and unpredictable swings in value — as
"toxic" or "nuclear waste."
The Funds primarily acquired their CMOs pursuant to repurchase
agreements or "repos."*fn6 A repo is a financing mechanism that allowed
the Funds to pay only a fraction of the cost of each CMO in cash,
borrowing the balance from the brokers. In such a transaction, one party
to the agreement agrees to sell a security to a buyer/lender for a given
sum (the "repo amount") and to buy the security back from the
buyer/lender at a later date (the "buy- back date") for the repo amount
plus a market rate of interest (the "repo rate"). The buyer/lender holds
the security in a "repo account." Although repos were a means for the
Funds to acquire CMOs, in these transactions the Funds acted as a
"seller" and the broker acted as a "buyer" of CMOs.
In effect, repos are collateralized loans. The Brokers loaned the Funds
most of the purchase price for each CMO and took possession of the CMOs
as security, i.e., collateral, for the Funds' performing their
obligations to repurchase the CMOs, i.e., repay the loan, with interest,
on the buy-back date. The repo buyer (the broker) obtained a security
interest in the transferred securities.*fn7 The use of repos benefitted
the Brokers by allowing the Funds to increase their purchases of CMOs
from the Brokers.
If the value of the securities in a repo account fell below an amount
agreed upon by the parties, the "margin amount," then there was a "margin
deficit" and the broker had the right to make a "margin call," i.e., to
demand money or additional securities as collateral for the loan. If a
proper margin call was not met, the broker had the right to liquidate the
securities in the repo account.
On February 4, 1994, the Federal Reserve Board raised interest rates by
a quarter of a point, which was the first rate increase in approximately
five years. Interest rates were raised again on March 22, 1994. As
interest rates rose, prepayments on the underlying mortgage obligations
for mortgage-backed securities fell. ACM magnified the effect of these
market conditions by purchasing inappropriately bullish securities that
were particularly sensitive to these adverse market conditions. In
addition, the Funds were highly leveraged and had an excessive degree of
negative convexity.*fn8 The value of the Funds' portfolios plummeted
during this period.
Between March 28 and March 31, 1994, the various brokers with which the
Funds had entered into repo transactions issued a Demonstration copy of
activePDF Toolkit (http://www.activepdf.com) veritable blizzard of margin
calls on the Funds, beginning with a $30 million margin call from Bear
Stearns. Merrill and DLJ were two of eleven broker-dealers to make margin
calls on the Funds at this time. All told, the margin demands amounted to
more than $131 million. In response to the margin calls, the Funds
transferred approximately $49 million in cash or unencumbered collateral
to the various brokers, leaving a shortfall of almost $82 million. By
March 30, 1994, the Funds' short-term obligations exceeded their cash and
unencumbered securities by approximately $60.4 million. Indeed, two days
earlier, Askin had asked the Investors for an additional $120 million in
capital to use, in part, to pay rapidly- mounting margin calls. As the
Funds were unable to meet the margin calls, the brokers liquidated the
Funds' portfolios. The Funds collapsed and filed for bankruptcy under
Chapter 11 on April 7, 1994. The Investors allegedly lost approximately
$230 million in investments.
Between 1991 and 1993, the Funds' portfolios were managed by Askin and
John Contino ("Contino"). In 1993, Contino left ACM and was succeeded by
Richard John ("John").
Askin and, subsequently, ACM, actively marketed interest in the Funds
through written materials as well as in-person through presentations by
Askin and ACM's Director of Marketing, Geoffrey Bradshaw-Mack ("Mack").
Although the alleged misrepresentations constitute different aspects of
one multifaceted fraud, for ease of discussion they can be separated into
two categories, namely, the "valuations fraud" and the "operations
fraud." The valuations fraud pertains to representations concerning the
process by which the Funds' securities were valued, and, specifically,
whether valuations were based on broker marks, as well as representations
regarding the performance of the Funds' securities. The operations fraud
pertains to representations regarding the use of computer modeling to
manage the Funds' investments.
ACM's marketing materials represented that the Granite Funds would
achieve annual returns of 15% or more "by investing in a market-neutral,
risk-balanced portfolio of high return, high credit quality CMO
derivative securities." These materials further represented that, while
higher returns are "typically" associated with higher risk, the Granite
Funds were different because, due to their "risk-balanced strategy,
higher returns can be achieved with the same, or lower, levels of risk."
Thus, "stable rates of return with low risk" were promised.
Market neutrality was to be achieved by acquiring balanced holdings of
"bullish" and "bearish" bonds. Thus, by purchasing offsetting positions
in predictable securities, the Funds would enjoy the high returns
associated with rate-sensitive CMOs while hedging against the risk
attendant upon interest rate fluctuations. ACM represented through a
graph that the Granite Funds would earn over 10% per year even if
interest rates shifted over a 600 basis point range.
ACM further represented that, in order to manage the Granite Funds'
portfolios, ACM had "developed its own proprietary analytics system that
is used daily." ACM described an elaborate "structured five-step process"
whereby, for "each CMO bond under consideration":
Granite subjects the bonds to extensive financial
analysis. Granite imposes a variety of economic
scenarios on each security to identify how it would
perform should there be changes in interest rates or
prepayments. The results of this analysis are used to
generate cash flow models for each CMO. Granite assigns
probabilities to the possible outcomes for the CMOs under
a variety of possible interest rate, prepayment,
volatility and spread scenarios. With this information,
Granite ascribes total return profiles to each CMO bond.
ACM further described how it made use of its "analytic models" to
determine how each bond would combine with others to "form a hedged,
lower-risk portfolio," and to "continually" monitor the Demonstration
copy of activePDF Toolkit (http://www.activepdf.com) portfolio and
maintain its balance. ACM criticized other money managers for their lack
of internal "sophisticated analytics capabilities" and their need to rely
on third parties for analysis.
Each Investor executed a subscription agreement, or Private Placement
Memorandum ("PPM"), with respect to his investment. The PPMs made
similar, but less specific, representations as to the Granite Funds'
investment strategy and analytic tools.
The PPMs described the "investment objective" of the Granite Funds as
"earn[ing] a consistently high rate of return . . . that is relatively
stable over time . . . by using market-neutral mortgage investing." The
strategy was designed to produce these stable results "whether interest
rates are rising, falling or remaining essentially unchanged." The
investment advisor would use "carefully constructed and researched"
"computer models to project the investment performance of different
Mortgage-Backed Securities under different interest-rate scenarios and
[to] search for securities with appropriately offsetting return
profiles," and to "actively" manage the portfolios.
Mack and Askin testified that on numerous occasions they represented to
the Investors through in-person presentations that ACM valued and would
continue to value the Funds' portfolios and calculated returns based on
"marks" provided by the brokers. Many Investors have testified to
receiving such representations.
As mentioned previously, CMOs are not traded on a public exchange.
Therefore, when an institution that owns CMOs wishes to determine the
value of its CMO position, it marks that position to Demonstration copy
of activePDF Toolkit (http://www.activepdf.com) market. A mark is an
estimate of the price at which a security will sell.
The Funds' auditors, Price Waterhouse, issued annual audited financial
statements in which it was stated that "100% of the [Funds'] investments
were valued on the basis of a price quotation provided by principal
market makers." The market makers for CMOs are broker-dealers. The Price
Waterhouse statements also listed the use of such price quotations for
valuing the Funds' securities as the first of the Funds' "significant
accounting policies." Finally, the Price Waterhouse statements provided
that "other assets . . . for which market quotations are not readily
available are valued at their fair value as determined in good faith."
Askin ratified the 1992 audited financials as "accurate and complete."
Potential investors routinely received from ACM the audited financial
statements for the year prior to the contemplated investment, and then
received subsequent audited statements.
The Performance Letters also referenced the use of broker marks.
Askin's very first letter noted that poor performance in recent months
resulted from "unfavorable dealer marks." Another letter referenced
Askin's belief that there was "a disparity between the economic worth of
many of our security holdings and the marks placed on them by some of the
dealers." Similar representations were made in other letters.
The PPMs stated that securities traded "over-the-counter" would be
valued based on the "closing bid" price, while other unidentified
securities would be valued based on the "estimated fair value . . . as
determined in good faith by the General Partner," in the case of Granite
Partners, or "the fair market value . . . as determined by the Directors
in consultation with the Board of Advisors,"*fn9 in the case of Granite
Corp.*fn10 The General Partner for Granite Partners was Dashtar
Corporation, a company wholly owned by Askin. Askin was one of two
Directors of Granite Corp. Granite Partners also had a Limited
Partnership Agreement ("LPA") which provided for "good faith"
The PPMs made certain risk disclosures. The first page warned that
"[t]he shares offered herein involve a high degree of risk. No one should
invest who cannot afford to lose his entire investment." Like all
prospectuses, the PPMs
included a "Risk Factors" section, which section repeated that there
was a risk of complete loss of the investment, stated that "any
investment in securities" entails "substantial risks," and noted as
risk factors prevailing interest rates, the investment advisor's
ability to predict changes in those rates and in the real estate market,
and the use of leverage by the advisor. Part of the investment strategy
was described as using a "high rate" of leverage. The PPMs also
cautioned, "there can be no assurance that risks will actually be reduced
to the extent predicted by the [computer] models." Finally, the PPMs
disclosed that "the effect of fluctuations in interest rates on the value
of Mortgage-Backed Securities, particularly including Residuals, is often
complicated due to the prepayment characteristics of these instruments."
The PPMs disclosed that the Granite Funds were designed to exploit
mispricing opportunities growing out of the difficulties undergone by
thrifts that had purchased CMOs in the 1980's.
When Askin and Contino arrived in 1991, the Funds were using a computer
program called Wall Street Analytics. This program has some "option
adjusted spread" (OAS) capability.*fn11 OAS was developed as a technique
for capturing the complexities of mortgage-backed securities better than
had previous analytical Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) tools, in particular, the dynamic factors of
interest-rate changes and prepayment speeds. The extent to which OAS
analysis was used at that time by institutions and individuals analyzing
such securities is disputed.
Askin and Contino wanted some of the features of the program to be
proprietary to them, and worked with Andrew Chasen ("Chasen"), a
third-party consultant to develop a product. Ultimately, Chasen licensed
his "Amalgamated Bivariate" program (the "Amalgamator") to ACM. Whether
or not this product was proprietary to ACM is disputed.
Askin has testified that the output from the Amalgamator was used to
evaluate the sensitivity of individual securities and whole portfolios to
changes in market conditions, to measure investment worth, and to assess
the "tilt" of a portfolio and compliance with market neutrality. John,
however, found the Chasen product too cumbersome to be usable and
ineffective to monitor market neutrality. Chasen believed his product
provided only "basic analytics," not a CMO "model." John Richardson
("Richardson"), an expert for the Investors, opined that the Amalgamator
was incapable of running analyses which Richardson maintains are needed
to run a market-neutral portfolio, including OAS, effective duration, and
effective convexity, for each bond and the entire portfolio. Lawrence
Wiener ("Wiener"), however, also an expert for the Investors, concluded
that the Amalgamator was capable of computing present values of
securities in different interest scenarios, and of constructing different
prepayment scenarios — a description consonant with the PPMs'
Late in 1993, ACM updated Chasen's system with the Derivative Solutions
system. Weiner opined that, in combination, the Chasen and Derivatives
Solution systems are a powerful analytic tool that can perform
sophisticated analysis on both an individual security and portfolio-level
basis. However, many of the Funds' bonds were never input into the
Derivatives Solution system.
The valuation or marking of CMOs is a complex process which was
conducted by the brokers' traders. Marking requires the exercise of
informed judgment. The brokers marked the Funds' CMOs to market on a
monthly basis, devoting considerable time and effort to this process.
Askin believed that dealer marks should be scrutinized and challenged.
This belief was reflected in minutes of some of the meetings of the
Granite Funds' Investment Committee. The Performance Letters also
reflected that Askin was seeking to get the brokers to establish "more
consistent" marks or marks that better reflected what Askin believed to
be the true value of the Funds' portfolios. In meetings with investors in
1992 and 1993, Askin contrasted his approach with that taken by his
predecessor, Estep, which he characterized as unquestioning with respect
to the brokers' valuations.
Kidder began trading CMOs with Granite Partners and Granite Corp. in
1990. Kidder was one of at least 16 dealers trading CMOs with the Funds.
Over the course of its dealings with Askin, Kidder provided some 600
marks for the Granite Funds.
Beginning in May 1992, Askin placed monthly calls to challenge Kidder's
marks and request revised ones from William O'Connor ("O'Connor"), a
Kidder salesperson. The first time Kidder agreed to revise a mark for a
bond held by Granite Corp. was in May 1992, and the first time it agreed
to revise a mark for Granite Partners was in March 1993. Kidder did not
provide revised marks to Quartz. In total, Kidder provided ACM with 86
Recorded conversations between O'Connor and Askin reflect O'Connor's
readiness to provide Askin with revised marks. In one, O'Connor stated to
Askin, "[a]lright sir, I will adjust these." In another, O'Connor
stated, "I will remark these and send them over in five minutes." In a
third, O'Connor assured Askin, "[m]onth-end marks . . . are completely
negotiable . . . I will work with you, however you want, on month end
On March 3, 1994, O'Connor expressed concern regarding the revisions
sought by Askin for reporting February 1994 performance, stating, "If you
want it there I'll mark it there but I am going to go on record and say I
can sell you that bond cheaper. . . . [Although] as long as we are not,
you know, as I said hemispheres apart, it's not going to be an issue."
Ultimately, Kidder did not provide revised marks in March 1994. This was
the month the brokers made the margin calls and conducted the
liquidations that wiped out the Funds' accounts.
DLJ began trading CMOs with the Funds in late 1991. Beginning in
January 1992, and continuing through March 1994, Askin called DLJ
salesperson Betsy Comerford ("Comerford") on a monthly basis and
requested revised marks. After each call, DLJ supplied ACM with a revised
month-end mark sheet reflecting the prices specified by Askin. DLJ never
indicated in any way that the revised month-end mark sheets contained
something other than DLJ's Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) real month-end marks. DLJ revised
approximately 400 marks, or over half of all marks provided to ACM.
Kidder did not provide ACM with revised marks in March 1994. DLJ did.
Ultimately, Askin used many of his own, "manager marks" to report
performance for February 1994.
O'Connor, arguing with colleagues on March 25, 1994, whether Kidder
should "pull the plug" on ACM by making margin calls, warned that they
should not do that because "we are in bed with ACM."
O'Connor acknowledged to Askin his understanding that marks for
"performance purposes and repo purposes . . . are two different things,"
and discussed with Askin their mutual understanding that when Askin
sought revised marks he would not take those marks as "indications of
bids or offers [for] real trading."*fn12 O'Connor complimented Askin for
not "believ[ing] everything on the [revised mark] sheet." O'Connor also
told Eric Kieter ("Kieter"), a CMO trader at a buy-side firm, that Askin
didn't object when Kidder "mark[ed] things to the bone for repo" because
"then we'd have performance marks."
In a conversation on March 14, 1994, O'Connor explained to Michael
Vranos ("Vranos"), Managing Director and head CMO trader for Kidder,
"[t]his is where he [Askin] wants the marks to be. This is where you
marked them for month end. This is not for repo purposes. This is
performance marks." Vranos replied, "I don't want to be defrauding his
investors." On March 21, 1994, O'Connor, Vranos, and David Barrett
("Barrett"), also of Kidder, discussed the issue again. O'Connor
[T]he beautiful thing about Askin [is that] he doesn't
sit there and make us use the performance marks as his
repo marks. From a credit perspective we're covered.
Right. Just from a liability standpoint we're not
because we are defrauding investors. But, other than
that, it's no big deal. Remember, Dave, you're an
officer so your ass is going to be on the line.
Kidder's largest revision occurred when it agreed to "schmear" a downward
correction in valuation for a particular CMO, the "Pru-Home" bond, over
November and December 1993, where the value of that bond had been
dramatically, and erroneously, overstated in October 1993. If Kidder had
reported the Pru-Home bond's actual value in November 1993, the Funds'
would have reported a loss in net added value ("NAV") for that month
rather than, as was reported, a gain.
O'Connor cannot recall any customers other than Askin who regularly
asked for marks to be changed.
In Comerford's view, DLJ's initial marks were "correct," "market"
prices, whereas the revised prices sought by Askin were not. Other DLJ
personnel shared that view. Comerford did not believe Askin could price
CMOs better than DLJ, and never saw any evidence supporting Askin's
prices. Nonetheless, each month, DLJ provided ACM with another version of
the most recent month-end mark sheet, reflecting the precise prices that
Askin had requested.
Most of the time Askin sought upward revisions, but at times he also
sought — and obtained — downward ones. O'Connor reported that
Askin told him "I still got a lot of unrealized gains — why do you
think I call you back every month and make you write down some prices. .
. . I got a shit load of rainy day money if I need it."
ACM personnel knew that Askin challenged broker marks, but were aware
of neither the scope of the marks revisions obtained by Askin nor the
readiness with which the brokers supplied those revisions. Ronald
Augustin ("Augustin"), of ACM, knew that at times Askin obtained revised
marks but perceived these as corrections of substantive "mistakes." Mack
was "flabbergasted" by the "massive changes" involved, after hearing a
taped conversation between Askin and O'Connor. John considered the
process revealed by tapes of Askin's conversations with O'Connor to be
inconsistent with his understanding of the process. John felt "morally
compromised" in March 1994 when he learned of Askin's use of "manager
marks" to report performance for February 1994, because John had believed
the Funds used "broker-dealers' marks . . . for our performance").
Indeed, John and other senior ACM staff threatened to resign in March
1994 when they learned of Askin's intention to use his own prices.
Beginning with Askin's arrival, the reported returns for both Granite
Partners and Granite Corp. improved significantly. An Demonstration copy
of activePDF Toolkit (http://www.activepdf.com) expert for the
Investors, Jed Kaplan ("Kaplan"), concluded that the Brokers' revised
marks did not represent fair market value. Kaplan further concluded
that, if Askin had used DLJ's and Kidder's initial marks rather than the
revised ones, between January 1992 and February 1994, there would have
fifteen months of NAV for Granite Corp. and sixteen months of negative
NAV for Granite Partners. ACM reported no losing months for this period.
An expert for the Brokers, Lee Errickson ("Errickson"), quarrels with
these numbers, although Errickson's report also concludes that there
would have been losing months reported.
Kidder's revisions, standing alone, would have turned a losing month
into a winning month on only one occasion, November 1993, when it agreed
to "schmear" the Pru-Home bond correction between two months. In
addition, of themselves, Kidder's revisions would have had little or no
impact on the reported volatility, duration, "Sharpe Ratio" (a
performance/risk measure), leverage, or targeted annual returns.
The reported monthly returns were between positive NAV 1.1% and 2.8%
for Granite Corp., and between positive 1% and 3% for Granite Partners.
Price Waterhouse, in conducting its audits, took certain steps to
determine whether the marks provided by the Brokers were Demonstration
copy of activePDF Toolkit (http://www.activepdf.com) corroborated by
actual sales, and concluded that the valuations of the CMOs at year-end
were "reasonable." Andrew Carron ("Carron"), an expert for the Brokers,
concluded that Kidder's revised marks were "valid indicators of market
value." The Bankruptcy Trustee concluded that Kidder's initial marks and
revised marks were "[G]enerally . . . consistent," with a difference of
3% or less in most cases.
DLJ performed six analyses of the Funds' portfolios between January
1992 and September 1993, each of which showed the Funds to be bullish.
There is a dispute as to whether DLJ was provided with complete
information regarding the portfolios' composition before doing these
analyses. DLJ executives were aware the Funds' persistent lack of
neutrality. John Friel ("Friel"), head of DLJ's finance desk, concluded
that the portfolios were Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) "sensitive" to interest rate increases. Leon
Pollack ("Pollack"), head of DLJ's fixed income department, testified
that "anyone who had [the Funds'] position[s] would be in trouble [when]
rates were going up. Reynolds testified that DLJ's view was that the
Funds "had a fair amount of duration."
When Askin told O'Connor about the new Quartz Fund, he told O'Connor,
"[t]he main difference in Quartz relative to the Granite is it's not
constrained to being market neutral." Exchanges among Kidder personnel
and between Kidder and Askin personnel indicate Kidder's awareness that
the Granite Funds were persistently bullish, and that this was contrary
to the way they were supposed to be structured. O'Connor stated to other
Kidder personnel, "[t]his guy's made 35% or more for his investors in the
last two straight and he didn't do that by being . . . duration neutral.
. . . [M]y only danger is . . . my biggest guy blowing himself up."
Vranos laughed when he said the Granite Funds are "structured as  zero
duration." O'Connor stated to John, of ACM, "You and I both know that the
portfolios are not market neutral."
ACM was one of Kidder's biggest customers, and was DLJ's single largest
mortgage-backed securities customer. The Brokers recommended and sold
vast quantities of "inverse IO"*fn13 to ACM. In Demonstration copy of
activePDF Toolkit (http://www.activepdf.com) the third and fourth
quarters of 1993, for example, Kidder sold over $120 million in inverse
IO and over $300 million in other bullish securities to ACM.*fn14 As
O'Connor put it, "I try to shove inverse IOs down [Askin's] throat."
Wiener concluded that all of these securities were bullish. During the
same period, DLJ sold approximately $115 million in inverse IOs,
approximately the same amount in other securities which Wiener concluded
were bullish, and one $3.5 million straight IO that was bearish. The vast
majority of all the securities sold by the Brokers to ACM was bullish.
The Brokers represented the inverse IOs as bearish at a time when they
were bullish. Jeffrey Lewis ("Lewis"), DLJ's head derivatives trader,
characterized inverse IOs are "bullish when you want [them] to be bearish
and bearish when you want [them] to be bullish." Comerford testified that
inverse IOs are not a substitute for straight IOs, and that it required
"a lot of expertise" to understand what ACM purchased. Vranos testified
that Askin was buying "high risk" securities from Kidder. Vranos did not
think inverse IOs were bearish in February 1994, during which time Kidder
was selling inverse IOs to ACM and representing them as bearish. O'Connor
feared the Funds would "blow up" due to their bullish tilt.
ACM made it possible for the Brokers to sell their entire CMO offerings
by purchasing "deal-driver" tranches of exotic securities created by the
brokers themselves. In each of these deals, the Brokers sold hundreds of
millions of dollars worth of CMOs. The Brokers perceived Askin as one of
the few buyers in the market for these deal-driving tranches. Vranos
testified that Askin was a buyer of deal-drivers, and O'Connor stated,
"You can count the number of inverse IO buyers on three fingers." Richard
Whiting ("Whiting"), of DLJ, testified that Askin was a "very
significant" DLJ client due to his "unique" requests and willingness to
buy deal-driving "tranches . . . new issue CMO securities."
The commissions received by O'Connor and Comerford were related in part
to the riskiness of the security, with riskier securities generating
higher commissions. O'Connor described how he received increased
commissions on the "nuclear waste" sold to Askin. Comerford also
testified to the relationship between her commission rate and the nature
of the securities.
The Brokers provided very favorable financing for ACM's CMO purchases.
DLJ routinely loaned ACM 95% of the purchase price for CMOs in their
reverse repo transactions, creating a 19-to-1 debt/equity ratio. Kidder
provided ACM with a special type of credit facility. O'Connor described
this arrangement to Askin, stating, "[W]e have actually set up a
different credit facility for handling you where Vranos signs a sheet
that says . . . I absorb any losses here brought about by . . . an Askin
account blowing up and us not maintaining a haircut." Vranos testified to
the "special account facility pool" set up to do "asset-based lending"
and that ACM was a "large fund that fell under the special account
facility . . . policy."
Although the Funds' CMO holdings were complex and volatile, DLJ was
able to sell many of the Funds' securities within a two-day period
following the DLJ liquidation. Moreover, experts for the Funds, in the
Funds Action, have opined that the prices obtained by DLJ, as well as by
Merrill in its liquidation auction, were lower than what could have been
The brokers were aware of the claims made regarding computer modeling
in the PPMs, but did not see the marketing materials and were not present
at ACM's in-person presentations. O'Connor stated to Vranos, "Askin has
no model," and joked that the "model" consisted of "wett[ing] his finger
and put[ting] it in the air." On another occasion, ACM's John joked to
O'Connor, "I am matching up wits with Vranos on my HP."
DLJ's Comerford believed that DLJ had an obligation to "know [its]
customer." DLJ knew that several customers had advanced Demonstration
copy of activePDF Toolkit (http://www.activepdf.com) analytical
capabilities. DLJ knew that ACM was buying complex securities that could
be understood only with sophisticated modeling. DLJ personnel did not see
evidence that ACM had such modeling. However, DLJ personnel, unlike
Kidder, did not actually express a view that ACM had inadequate modeling
capabilities, or "no model" at all.
The Investors include wealthy individuals, money management firms,
hedge funds or "funds of funds" (established to institute in other hedge
funds), pension plans, and insurance companies. Unless otherwise
permitted by the Granite Funds, Investors in those funds were required to
invest a minimum of $1,000,000. The PPMs which each Investor signed,
stated, "[t]he undersigned has the necessary knowledge and experience in
financial and business matters to enable him to evaluate the merits and
risks of this investment." The PPMs also included a disclaimer that "no
representations or warranties have been made to [the Investor]," and "in
entering into this transaction [the Investor is] not relying upon any
information other than that contained in the Offering Memorandum [i.e.,
the PPM] and the results of [the Investor's] own independent
The PPM also confirmed that there was an opportunity for the Investor
to ask questions of ACM, and receive responses, as part of her
Potential and actual investors were given the opportunity to obtain
information about the Funds and how they were run. The Investors were
free to examine ACM's offices and its computer models, or to interview
its personnel, including Askin. They were invited to observe the computer
modeling on ACM's screens and were provided with printouts generated by
the Amalgamator. They were provided with the Performance Letters and had
access to lists of the Funds' holdings. The Price Waterhouse statements
also set forth each security owned by the Funds, broken down by type.
These statements were given to prospective as well as current investors.
Mack testified that an investor request "to see something or speak to
someone" was never denied. ACM also provided responses to due diligence
questions by those Investors who inquired. One such Investor,
Commonwealth/Providian, concluded that ACM had "sophisticated and
comprehensive computer capabilities."
The Price Waterhouse statements broke the Funds' securities into broad
categories, such as "interest only tranches," "principal only tranches,"
"other tranches," and "residual interests." These categories corresponded
with categories used in ACM materials, in which ACM represented that
interest-only CMOs and residuals were bearish, thus balancing (or
hedging) the bullish principal-only tranches. In the annual audited
statements, the reported market value of the bullish categories roughly
approximated the reported market value of the bearish ones. Some of the
tranches reported as "interest only" in the audited financials were in
fact inverse IOs, which are not bearish. The Price Waterhouse statements
did list the individual securities themselves, so that an Investor could
have obtained a prospectus for that security. In addition, some Investors
requested, and received, "Current Holdings Reports" which identified
securities in more detail, e.g., as "Interest Only Inverse Floater" or
"Super P/O." DLJ obtained statements containing this level of detail in
order to perform its portfolio analyses for ACM.
Investors testified that they read the Performance Letters and Price
Waterhouse statements as reflecting that ACM's market-neutral,
low-volatility approach was working. Each of the Investors has stated in
a sworn declaration that he would not have invested, or retained his
investment, if he had known of Askin's practice of obtaining revised
marks from the brokers.
DLJ's Comerford testified that the Funds' reported returns in 1992
would have led her to conclude that the portfolios were neutral.
However, an expert for Kidder, David Ross ("Ross"), opined that one
cannot draw conclusions about duration or market sensitivity from the
reported returns. Ross compared the Funds' reported returns to the
performance of benchmarks and concluded that the Funds' returns were more
volatile than Treasuries and were correlated with interest rate
movements. Matthew Richardson Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) ("Richardson"), an expert for the Investors,
performed a similar comparison and concluded that the Funds did not
achieve market neutrality. Richardson's use of regression analysis has
been criticized by a DLJ expert, Raj Mehra ("Mehra"), as inadequate for
making the measurements required to reach his conclusion. Wiener analyzed
the securities listed in the statements provided to DLJ for purposes of
the DLJ portfolio analyses. Wiener analyzed the effective duration and
effective convexity of each bond within the portfolios and concluded that
the Funds were never market-neutral.
Some Investors made their initial investment before Askin's arrival,
but made other investments during Askin's tenure: Lionel Sterling
("Sterling") and Antaeus Enterprises, Inc. ("Antaeus").
Investor Roma Malkani ("Malkani") invested after Askin's arrival but
did not have contact with Askin or anyone else at ACM before investing.
A number of Investors did not know and did not ask how the Funds'
portfolios were valued at the time they made their investments: L.H. Rich
Companies ("L.H. Rich"), Primavera Familienstiftung ("Primavera"),
International Asset Management Limited ("IAM"), ABF Capital Management
("ABF"), CoriFrance, Hedged Investment Partners ("HIP"), Global Hedge
Fund ("Global"), Malkani, 3M, Diversified Income Strategies, Excelsior
Investment Fund and Excelsior Qualified L.P. (collectively,
"Excelsior"), Oblingter, W Finance Arbitrage ("W France"), the Regency
Fund, Montpellier Resources Limited, Robert Johnston, Sofa Partners, the
Demeter Trust, Gilla (B.V.I.) Limited ("Gilla"), and Nemrod Leverage
Holdings Limited ("Nemrod").
Although all the Investors claim to have reviewed and relied upon the
Price Waterhouse statements, fewer than half of the sixty Investors were
able to produce copies of those statements, and only thirteen testified
to having seen the "100%" broker marks language, with only seven having
seen the language before making their investments.
Some Investors perceived, based on the PPMs or other information
provided by Askin, that Askin had some discretion in reporting the value
of the Funds' securities: Glenwood Balancing Fund, L.P. Glenwood Trust
Company as Custodian for Walker Art Center, Glenwood Trust Co. Group
Trust II, Glenwood Partners, L.P., Samta, Inc. ("Samta"), Bambou, Inc.
("Bambou"), Loukoum, Inc. ("Loukoum"), FIDR Investors 1996 Trust, HNM
First Investors 1996 Trust, HNM Second Investors 1996 Trust, SDI, Inc.,
Commonwealth Life Insurance Company, Providian Life & Health Insurance
Company ("Commonwealth/Providian"), Neutral Strategies, L.P., Pine
Equities, L.P., and the Chemerow Trust.
Some Investors knew that Askin talked to the brokers about revising
marks: Sterling, Commonwealth/Providian, Oakwood Associates, Rosewood
Associates, and the Chemerow Trust.
A number of Investors had little understanding of ACM's computer
modeling capabilities and never asked for a demonstration or
documentation: Levitt Family Trust, Spirit Debt Limited, Spirit Neutral
Limited, 3M, Neutral Strategies, L.P., Zimmerman Family Trust I,
Zimmerman Income Partners, IAM, Bambou, Loukoum, Samta, Hubert Looser,
L.H. Rich, Primavera, ABF, CoriFrance, HIP, Conservation Securities
Limited Partnership, Trans-Resources, Inc., Excelsior, Gilla, Nemrod,
Robert Johnston, William Monaghan, Oblingter, and W Finance.
Facts Relevant to the Statute of Limitations
On March 10, 1994, Askin reported a two percent loss to the Investors
for all three Funds. On March 25, 1994, ACM restated the February 1994
loss, acknowledging that the correct figure was approximately twenty
On March 24, 1995, Primavera filed a putative class action complaint in
the United States District Court for the Northern District of
California. This suit asserted federal claims Demonstration copy of
activePDF Toolkit (http://www.activepdf.com) and was brought "on behalf
of a class consisting of all persons and entities who purchased, directly
or beneficially, securities issued by any of the Granite Funds . . . from
January 26, 1993 through the date the Granite Funds went bankrupt."
In April 1995, the Funds' Chapter 11 trustee filed a preliminary report
with the bankruptcy court regarding his investigation of the Funds'
demise. This report indicated the possible involvement of the Brokers in
Askin's fraudulent scheme.
On September 20, 1995, the Primavera complaint was amended to add the
Brokers as defendants, and on October 18, 1995, the Primavera Action was
transferred to the Southern District of New York. On March 1998, class
certification in the Primavera Action and the later-filed Montpellier
Action was denied.
Providian Life & Health Insurance Company ("Providian") is an insurance
company with its principal place of business in Pennsylvania. Providian
is a plaintiff in ABF Action, filed on March 27, 1996.
Sterling is a Connecticut resident. Sterling is a plaintiff in the
Johnston Action, filed on June 9, 1997.
The Demeter Trust maintains its principal place of business in
Connecticut. The Demeter Trust is a plaintiff in the Johnston Action,
filed on June 9, 1997.
Cook is a Connecticut resident. Cook is a plaintiff in the AIG Action,
filed on October 21, 1998.
Arbor Place, L.P. ("Arbor"), maintains its principal place of business
in Massachusetts. Arbor is a plaintiff in the Montpellier Action,
pursuant to the amended complaint filed on June 2, 1997.
Global Hedge Fund ("Global") is domiciled in Jersey, Channel Islands.
Global is a plaintiff in the Montpellier Action, pursuant to the amended
complaint filed on June 2, 1997.
Malkani is a Maryland resident. Malkani is a plaintiff in the
Montpellier Action, pursuant to the amended complaint filed on June 2,
The Repurchase Transactions
DLJ and each of the Funds executed a standard industry agreement
referred to as the PSA ("Public Securities Association") Agreement (the
"PSA Agreement") with respect to their repo transactions.*fn16 Merrill
and Quartz executed the PSA Agreement, but Merrill and Granite Partners
and Granite Corp., respectively, did not.
The PSA Agreement provides with respect to the Funds' obligation as to
margin maintenance, and the brokers' right to demand additional
The "Buyer's Margin Amount," i.e., the amount of collateral which the
Fund was required to maintain in a repo account so as not to have a
margin deficit, is "the amount obtained by application of a percentage .
. . agreed to by Buyer and Seller prior to entering into the
transaction, to the Repurchase Price for such Transaction." PSA Agreement
The PSA Agreement provides that the Fund may obtain the return of
collateral that is in excess of the required margin amount:
If at any time the aggregate Market Value of all
Purchased Securities subject to all Transactions in which
a particular party hereto is acting as Seller [the Fund]
exceeds the aggregate Seller's Margin Amount for all such
Transactions at such time (a "Margin Excess"), then
Seller may by notice to Buyer [the broker] require Buyer
in such Transactions, at Buyer's option, to transfer cash
or Purchased Securities to Seller, so that the aggregate
Market Value of the Purchased Securities, after deduction
of any such cash or any Purchased Securities so
transferred, will thereupon not exceed such aggregate
Seller's Margin Amount .
PSA Agreement § 4(b).*fn17
The PSA Agreement defines "market value, with respect to any Securities
as of any date," as,
the price for such Securities on such date obtained from
a generally recognized source agreed to by the parties or
the most recent closing bid quotation from such a source,
plus accrued income to the extent not included therein
. . . as of such date (unless contrary to market practice
for such Securities).
If a margin call remains unsatisfied one business day after notice was
given, the buyer, i.e., the broker, has the right to liquidate the repo
positions of the seller, i.e. the Fund, in default. See PSA Agreement
¶ 11. In order to accomplish this liquidation the broker has two
options, referred to hereinafter as "Option A" and "Option B":
(A) immediately sell, in a recognized market at such
prices as the nondefaulting party may reasonably deem
satisfactory, any or all Purchased Securities subject to
such Transactions and apply the proceeds thereof to the
aggregate unpaid Repurchase Prices and any other amounts
owing by the defaulting party hereunder ["Option A"] or
(B) in its sole discretion elect, in lieu of selling all
or a portion of such Purchased Securities, to give the
defaulting party credit for such Purchased Securities in
an amount equal to the price therefor on such date,
obtained from a generally recognized source or the most
recent closing bid quotation from such a source, against
the aggregate unpaid Repurchase Prices
and any other amounts owing by the defaulting party
hereunder ["Option B"].
PSA Agreement ¶ 11(d)(i).
In the case of the DLJ repo transactions, the margin maintenance
requirement was set in relation to the haircut percentage. According to
the report of Funds' expert John Y. Campbell ("Campbell"), this
requirement was equal to the (repo amount) * (100% haircut
percentage).*fn18 For example, one of the securities held in Granite
Corp.'s repo account with DLJ was FHLMC 1415 S. The repo or loan amount
for this security was $1,951,000. The haircut was 10%. The margin amount
required to avoid a margin deficit was $2,146,100, which is 110% of the
repo amount. The haircut amounts for the securities held by DLJ ranged
from 5% to 25%. This margin maintenance obligation was not the same as
the repurchase obligation due on the buy-back date. As explained
earlier, the repurchase obligation was equal to the repo amount plus the
market rate of interest.
The PSA Agreement provides expressly that the parties "intend that all
Transactions hereunder be sales and purchases and not loans." PSA
Agreement ¶ 6.
As mentioned earlier, Merrill entered into a PSA Agreement with Quartz
but not with Granite Corp. or Granite Partners. Merrill and each of the
Funds — Granite Corp., Granite Partners, and Quartz — entered
into a "reverse repurchase confirmation" agreement (a "Repo Trade
Confirmation") for each repo transaction.
The Repo Trade Confirmations all have identical terms. With respect to
the level of collateral required to be maintained in the repurchase
accounts, the confirmations provide:
If on a business day the market value of the securities
for a transaction is less than the agreed upon percentage
of the outstanding purchase price, the purchaser may
demand a mark to market. . . .
Margin percentage shall at all times be equal to 102% of
the repurchase principal plus accrued repurchase interest
to date unless otherwise agreed.
Repo Trade Confirmation at 2.
The confirmations also contain certain provisions concerning adequate
assurance of performance:
If any time prior to the repurchase date, reasonable
ground for insecurity shall arise with respect to
performance by a party hereto, the other party may demand
from such party that adequate assurance of due
performance by such party be provided.
A party is in default if . . . it fails to provide
adequate assurance of due performance upon demand by
the other party. If either party is in default, the
other party may without notice . . . sell the
securities . . . .
Repo Trade Confirmation at 2.
Under the Repo Trade Confirmations, the Funds were to repurchase the
repoed securities from Merrill by April 25, 1994.
Unlike the PSA Agreement, the Repo Trade Confirmations do not provide
expressly that the transactions are intended to be sales and purchases
rather than loans.
Michael Aneiro ("Aneiro"), Augustin, John, Contino ("Contino"), Stephen
J. Dendinger ("Dendinger"), and Askin, all of whom were employees of
either Merrill or the Funds, testified that they were not aware of and
did not view there to be any differences between the Merrill/Granite
transactions, in which no PSA Agreement was executed, and the
Merrill/Quartz transactions, in which both a PSA Agreement and Repo Trade
Confirmations were executed — or between the Merrill/Granite
transactions and the transactions Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) between the Funds and the other
broker-dealers, in which only PSA Agreements were executed.
Some of these same witnesses also testified that they understood the
repo transactions as loan arrangements, with the securities serving as
collateral for those loans. Merrill's internal policy manual describes
repos as "collateralized loan[s]," and the internal documents used by
Merrill to monitor the repo account levels refer to the "loan amount" of
the repos. Merrill's financial statements refer to repos as
"collateralized financing transactions."
Merrill set the haircut amounts for its repo transactions at amounts
ranging from 15 to 20 percent. According to Merrill, the margin
maintenance requirements ranged, accordingly, between 118 and 125% of the
repo, i.e. the loan, amount. For example, if a security is valued at
$100,000, and the broker took a 20 percent haircut, resulting in a repo
payment to the Fund of $80,000, then the margin percentage was 125% of the
$80,000 purchase price, i.e., $100,000.*fn19 George C. Ellison
("Ellison"), a vice president and mortgage sales specialist at Merrill,
states in an affidavit that when he negotiated repo transactions with the
Funds the parties agreed that the applicable haircut percentage
determined the margin maintenance percentage for that transaction. Keith
Peckholdt ("Peckholdt"), a vice president in Merrill's Repo Operations
Department, testified that the haircut percentage was the threshold level
which would trigger a margin call. Dendinger states in an affidavit that
"when Merrill Lynch and the Funds agreed to a haircut for a repo
transaction, they also agreed to designate the same percentage as the
margin maintenance level for that transaction." However, Dendinger did
not speak directly to any representative of the Funds, and the alleged
agreement to base the margin requirement on the haircut percentage was
Merrill generated daily reports for the repo accounts which stated the
"Margin Percentage" as a comparison of the total value of the account
compared to the outstanding repo amount, Peckholdt testified that
Merrill's margin calls were dictated by the computer reports. The daily
reports stated "no margin call for this customer" when the value of the
collateral was greater than 102 percent of the repo amount. Some Merrill
employees have testified that Merrill's computer system always defaulted
to the 102 percent amount, rather than generating reports that were
specific to the types of securities or actual margin requirement for a
Industry practice is that broker-dealers may reserve discretion to make
margin calls any time the collateral depreciates Demonstration copy of
activePDF Toolkit (http://www.activepdf.com) in any amount, including by
the haircut percentage. However, it is also industry practice that the
parties may agree in advance to a "trigger point" for these calls, which
trigger point would not necessarily be the haircut percentage.
Peckholdt did not recall any occasions when Merrill had made a margin
call on other customers when the daily reports, which defaulted to
calculate margin requirements based on a 102 percent threshold, stated
"no margin call for this customer," or, specifically, when the value of
the customer's collateral was above the 102 percent threshold.
In-house counsel for Merrill, Michael McGovern ("McGovern") testified
as Merrill's corporate designee in a Rule 30(b)(6) deposition. The Rule
30(b)(6) notice sought a deposition of a witness who could testify
regarding "[t]he margin calls made by Merrill on the Funds in March of
1994, including the following subjects: a) the decision to issue margin
calls . . . b) determination of the amount of the margin calls ."
McGovern testified that he was unaware of any conversation in which the
parties agreed to apply a margin requirement percentage other than the one
referenced in the Repo Trade Confirmations.
The Margin Calls and Liquidations
The DLJ Margin Calls and Liquidation
In the beginning of the week of March 28, 1994, rumors circulated at
DLJ that other brokers were making margin calls on the Funds and that the
Funds were having difficulty meeting these calls. Pollack, head of DLJ's
Fixed Income Department, recalled that DLJ was concerned about these
rumors and that they created a "sense of urgency" at DLJ.
DLJ re-priced the Funds' securities on March 28, 1994. As of that date
there were no margin deficits in the Funds' accounts according to DLJ's
valuations. DLJ re-priced the Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) securities again on Tuesday, March 29. The
traders in DLJ's repo department did the re-pricing. There were
discussions within DLJ concerning the difficulty, or even impossibility,
of determining where the Funds' securities would trade on the market, and
DLJ believed it ought to be conservative in its pricing in order to
protect the firm's interests.
On March 29, 1994, a margin deficit existed in Granite Partners' repo
account with DLJ. There is a dispute as to the amount of this deficit.
According to DLJ, the deficit was in the amount of $9,243,077. According
to the Funds, the deficit was $5,362,166. The Funds contend that DLJ was
required to, but did not, calculate the deficit based on prices obtained
from a "generally recognized source agreed to by the parties or the most
recent closing bid quotation from such a source," plus accrued income not
included therein, as specified in ¶ 2(h) of the PSA Agreement.
DLJ made a margin call on Granite Partners on March 29, 1994 in the
amount of $9,243,077 and gave Granite Partners until 11:00am on March 30
to meet the call. Granite Partners did not meet the March 29 margin
call. On the morning of March 30, 1994, prior to the deadline for meeting
the March 29 call, and after recalculating Granite Partners' margin
deficit, DLJ made a new, revised margin call in the amount of
$14,534,189. Granite Partners did not meet the revised margin call.
On March 29, 1994, DLJ made a margin call on Granite Corp. in the
amount of $2,922,344 and gave Granite Corp. until 11:00am on March 30 to
meet the margin call. The Funds contend that if DLJ had properly
calculated the margin deficit, in accordance with its obligations under
the PSA Agreement, that there would have been no margin deficit on that
date. Indeed, the Funds allege that on March 29 there was a $2,250,344
surplus in the nGranite Corp. account. Granite Corp. failed to meet the
March 29 margin call. On the morning of March 30, 1994, prior to the
deadline for meeting the March 29 call, DLJ issued a revised margin call
on Granite Corp. in the amount of $12,328,885, which Granite Corp. also
failed to meet.
Earlier that same month, on March 2, DLJ had made a margin call which
the Funds considered excessive and to which they objected, although
without asserting that DLJ was in breach of the PSA Agreement. DLJ
reduced its March 2 margin call in response to the Funds' objection.
According to the Brokers' expert Errickson, on March 29, 1994, Granite
Partners had approximately $39.3 million in available cash and
securities, and on March 30, Quartz had approximately Demonstration copy
of activePDF Toolkit (http://www.activepdf.com) $24.4 million in
available cash and securities. Granite Partners and Quartz made payments
towards or satisfied certain margin calls by other brokers on March 28,
29 and 30. Under the PSA Agreements, the Funds were obligated to
re-purchase all repoed securities from DLJ for approximately $198 million
in April 1994.
At around 2:00pm on the afternoon of March 30, 1994, members of DLJ's
fixed income management team, together with Friel, head of the finance
desk, and Bruce Richards ("Richards"), DLJ's head CMO trader, met with
counsel and others to determine how to proceed. At that meeting, DLJ
decided to liquidate all repo positions held by Granite Partners and
Granite Corp. DLJ elected to liquidate the Funds' securities pursuant to
Option B, i.e., by deeming the securities as sold to itself and crediting
the Funds' accounts for the value of those securities. DLJ considered
this option to be in the best interest of both the Funds and DLJ, as
compared with Option A.*fn21
After the meeting on the afternoon of March 30, DLJ informed ACM,
Granite Corp., and Granite Partners by fax that "in light of [the Funds']
failure to meet the margin call[s] and in Demonstration copy of activePDF
Toolkit (http://www.activepdf.com) view of the fact that there does not
seem to be a ready market for the securities in [Corp.'s and Partners'
accounts], we intend to take the securities into inventory and hedge our
DLJ liquidated the repo position of Granite Partners instantaneously on
the afternoon of March 30, 1994, one business day after the initial
margin call on that account, and the same business day as the revised
margin call on that account. Inasmuch as DLJ liquidated the Granite
Partners' account before the deadline on the revised March 30 margin
call, i.e., before March 31, Granite Partners was not given an
opportunity to meet the revised margin call.*fn22
Immediately upon the conclusion of the March 30 meeting, DLJ sold short
a large volume of government and agency securities to hedge further
erosions in the value of the Funds' securities. Next, bid lists were
prepared and set to other major dealers as a check on the reasonableness
of DLJ's traders' prices. In addition, some of the bonds were marketed to
DLJ's institutional customers. There were 33 securities in the Funds
accounts as of the Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) liquidation. DLJ sold 12 of the securities on
March 30. The prices at which DLJ sold these securities were higher than
the values credited by DLJ to the Funds' accounts for these securities in
On March 31, one business day after the initial margin call on Quartz,
DLJ sent a fax to ACM and Quartz informing them that because of the
failure to meet the margin calls "and in view of the fact that there does
not seem to be a ready market for the securities in [Quartz's repo
account], we intend to take the securities into inventory and hedge our
positions." DLJ then immediately liquidated the repo positions of Quartz
by deeming the securities to itself and crediting the value of those
securities, as calculated by DLJ, to the Quartz account.*fn23
On March 31, DLJ sold 11 more of the Funds' securities, again at higher
prices than the values credited by DLJ to the Funds' accounts. On April 4
and 5, 1994, DLJ sold 8 more securities, and on May 18, 1994, and August
4, 1994, DLJ sold the remaining 2 securities out of the total number of
33. These later sales were at prices that were below the amounts credited
by DLJ to the Funds during the liquidation.
Also on March 30, 1994, DLJ set up a trading account, designated "T93,"
from which to conduct transactions related to its liquidation of the
Funds' securities. DLJ's traders did not make bookkeeping entries showing
the crediting of the securities from the Funds before the close of
business in March 30. Instead, these entries were recorded on trade
blotters and then into DLJ's trading system on the following day, March
31, "as of March 30." "As of" entry of trades is a common way of
recording trades that occurred on the preceding day. By the time these
entries were recorded on the late afternoon and evening of March 31, as
described above, DLJ had already sold 23 of the Funds' securities to its
institutional customers — at prices that were above the valuations
credited to the Funds' accounts.
The Funds voluntarily filed for bankruptcy on April 7, 1994. Some
brokers, including DLJ, filed deficiency claims in the bankruptcy
proceeding for alleged losses by the brokers in the Demonstration copy of
activePDF Toolkit (http://www.activepdf.com) liquidations. DLJ filed its
deficiency claim January 4, 1995. DLJ seeks reimbursement for the
difference between the prices it credited to the Funds for the securities
during the liquidation and the repurchase amounts owed by the Funds under
their respective PSA Agreements.
At the time of the liquidation, the Funds' outstanding repo obligations
were approximately $198.7 million. DLJ credited the Funds in the amount
of approximately $180.8 million, resulting in a $17.8 million
discrepancy. After adjusting this amount by certain pre-liquidation
obligations owed by the Funds to DLJ, and DLJ to the Funds, the net
deficiency according to DLJ's calculations was approximately $9.9
DLJ did not offset its deficiency claim by the amount of proceeds
received on the resales of the 23 securities carried out by March 31,
1994. If DLJ had credited the Funds with these proceeds, and with the
credited values for the remaining 8 securities sold at a later point, the
total amount credited would have been approximately $189.9 million
— as compared with the $180.8 million actually credited by DLJ.
After the additional adjustments for pre-liquidation obligations, the net
deficiency would have been $754,110 — as compared with $9.9
million. Finally, DLJ also realized $2.36 million in hedging profits on
the T93 account as a whole by March 31.
The Merrill Margin Calls And Liquidation
Between March 28 and 29, 1994, Merrill's valuations of the securities
in the Funds' accounts decreased from $43,536.568 to $37,303,782 for
Granite Corp., from $23,726,489 to $19,825,017 for Granite Partners, and
from $10,077,446 to $9,157,174 for Quartz. According to the March 29
valuations, Granite Corp. had collateral valued at 104% of the
outstanding repo obligation amount and Quartz had collateral valued at
114% of its outstanding repo obligation. At the time, Granite Corp.'s
collateral was valued at less than the outstanding obligation, but
according to a later correction is now conceded by Merrill to have been
slightly above 102% of that amount. According to the calculations of the
Funds' expert, Campbell, Merrill did not employ fair market prices in its
Demonstration copy of activePDF Toolkit (http://www.activepdf.com)
valuations, and if it had there would have been a margin excess in each
On the morning of March 30, 1994, Merrill made margin calls on Granite
Corp., Granite Partners, and Quartz in the amounts of $5,750,000,
$4,050,000, and $480,000, respectively. These margin calls were based on
a collateral requirement of 120% of the outstanding repo amounts for each
of the Funds' accounts. None of the Funds met these margin calls.
On March 31, 1994, Merrill liquidated the Funds' repo positions through
an auction. Merrill included other broker- dealers in the auction, but
not its institutional, retail customers. Dave Scaramucci ("Scaramucci"),
a DLJ trader, and Vranos, Managing Director and head CMO trader for
Kidder, testified that broker-dealers are in the business of buying
securities and then reselling them at a profit. Three of the other
broker-dealers who liquidated Fund securities through auctions included
retail customers in those auctions. Vranos testified that in Kidder's
auction the institutional customers, who were solicited for bids, "had
greater interest and submitted higher bids than the dealers did" in that
auction. Records of the Kidder auction confirm that retail customer bids
were higher than dealer bids for 13 of the 14 securities in which Kidder
received bids from both types of auction participants. Soltas testified
that it was unusual for broker-dealers to trade CMOs with each other.
However, Soltas also testified that it was not normal to seek bids
directly from customers, and Kronthal stated in an affidavit that Merrill
decided the best way to maximize proceeds was to solicit bids from the
most active dealers, and that the dealers included in the auction were
those dealers. Moreover, Askin testified that when he liquidated repo
accounts he solicited bids only from broker-dealers because he believed
that was the best way to maximize proceeds for the seller of securities.
Both Merrill and DLJ, when they later resold securities acquired in
their liquidations, did so to institutional customers rather than other
dealers. However, although Merrill garnered a profit of approximately
$500,000 on those resales which were conducted immediately following the
liquidation, it ultimately sustained a loss of approximately $700,000
with respect to the total number (nine) of resales of securities acquired
during the auction. Merrill allowed its own trading desk to participate
in the auction on a blind basis (i.e., without knowing the bids submitted
by other auction participants). The total number of brokers participating
in the Merrill auction, including Merrill itself, was six. Merrill knew
that ACM did most of its trading with four broker-dealers —
Kidder, Bear Stearns, DLJ, and Merrill Demonstration copy of activePDF
Toolkit (http://www.activepdf.com) and Merrill had already received
liquidation bid lists from Bear Stearns and DLJ, and was aware that
Kidder had outstanding
margin calls. One of the participating brokers, Lehman Brothers
("Lehman"), did not submit any bids. Another broker, Salomon
Brothers ("Salomon"), submitted two. However, Merrill obtained at
least three bids for each security.
Prior to the auction, one of Merrill's retail customers, TCW, had given
Merrill indications of interest in certain securities. Merrill bid on
these securities in the auction at prices below what TCW had indicated it
was willing to pay — in the hope, according to Soltas, of earning a
small profit. Merrill acquired three of these securities, which it then
resold to TCW at a mark-up of just under $500,000, or just over 2%, later
in the day on March 31. The prices TCW indicated it was willing to pay
were higher with respect to four securities than were any of the bids
received in the auction as to those bonds.
Merrill gave bidders less than a day to submit bids. However, it
extended the bidding period by one half hour when asked for more time by
one of the broker-dealers. Earlier in the month, Askin had offered
Merrill the opportunity to bid on certain securities but Merrill failed
to bid on them, asserting that the time allowed to respond —
approximately one day — was Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) insufficient for Merrill to evaluate the
securities and formulate bids.
According to an expert retained by DLJ, Leslie Rahl ("Rahl"), there was
no standard industry practice for the liquidation of CMOs in 1994. The
bankruptcy trustee also made a factual finding to this effect.
The prices obtained in the auction, and credited by Merrill to the
Funds, were on average 12 percent lower than what Campbell calculates
would have been fair market prices. Of the CMOs obtained by Merrill
itself in the auction on March 31, 1994, Merrill resold four on the same
day. Three were sold to TCW, all at prices that were lower than
Campbell's fair market valuations for these same CMOs. Merrill also
offered six CMOs of the nine CMOs it had acquired in the auction to the
Clinton Group, all at lower prices than Campbell's fair market
valuations, but the Clinton Group agreed to buy only one — at the
Kronthal testified at his deposition that he "assume[d]" that in
attempting to resell the Funds' CMOs that the Merrill traders treated
these CMOs like any others, but that it was the traders rather than he
who conducted these transactions. Kronthal did not recall any special
instructions given to the traders, e.g., to resell these CMOs as quickly
as possible. Jeffrey Gundlach Demonstration copy of activePDF Toolkit
(http://www.activepdf.com) ("Gundlach"), whose deposition testimony is
cited by Merrill, had no recollection of the process.
Merrill's margin calls represented approximately eight percent of the
$131 million demanded by the broker-dealer community.
Merrill did not make a deficiency claim in the Funds' bankruptcy
The DLJ Principal and Interest Payments
The bonds purchased by the Funds make principal and interest
distributions on a periodic basis. The PSA Agreement requires than when
the dealer holds securities at a time when an income payment is due, it
must transfer that payment to the Fund, credit the Fund's account, or
reduce the amount due on the loan at the end of the repo period.
Granite Corp. had FHLMC 1209-S on repo with DLJ after August 20, 1992,
and DLJ had possession of that security. The bond made principal and
interest payments on the 15th day of each month, and in December 1993 the
bond paid a total of $243,668.24. Granite Corp.'s portion of the bond was
45.624% of the total face. Therefore, Granite Corp. was entitled to that
percentage of the December 1993 payment, i.e., $111,170.*fn24 However,
that amount in a suspense account at the firm and did not credit
it to the Funds.
The Funds have submitted reports by three experts in support of their
opposition to Merrill's motion for summary judgment, and of their
cross-motion against Merrill. These experts are Campbell, ...