The opinion of the court was delivered by: Robert P. Patterson, Jr., U.S.D.J.
Ashland Inc. and AshThree LLC (collectively "Ashland" or "Plaintiffs") brought this action alleging securities fraud and related state law claims in connection with their purchase and retention of various Auction Rate Securities ("ARS"). Morgan Stanley & Co., Inc. ("Morgan Stanley" or "Defendant") moves this Court to dismiss the first amended complaint ("FAC") in its entirety.
I. Factual Allegations and Proceedings*fn1
A. The First Amended Complaint:
Plaintiffs filed the FAC on September 8, 2009. In it, they allege, "upon knowledge as to themselves, and otherwise upon information and belief," that Morgan Stanley made "false and misleading statements to, and material omissions from, Ashland aimed at inducing the company to purchase student loan auction rate securities ("SLARS") from Morgan Stanley, and to hold and to continue purchasing those securities at a time when Morgan Stanley knew the market for those ARS was collapsing." FAC, ¶1.
The Plaintiffs are Ashland, Inc. (incorporated and with its principal place of business in Kentucky) and AshThree LLC (created under the laws of Delaware). Id. at ¶¶16-17. Ashland Inc. is the only member of AshThree LLC. Id. at ¶17. AshThree LLC is the holder of the SLARS that are at issue in this case. Id. The Defendant is Morgan Stanley & Co., Inc. (incorporated in Delaware, with its principal place of business in New York). Id. at ¶18.
ARS are securities with interest rates that are set periodically by auction.*fn2 The auctions, which follow a Dutch auction format, are "typically held every 7, 14, 28, or 35 days." Id. at ¶35. At each auction, purchasers and holders can place one of four bids: buy, hold, hold-at-rate, or sell. Id. at ¶36. A bid to buy ARS will "include a stated rate and a quantity [the purchaser] will buy if the clearing rate is equal or greater than this stated rate." Id. A hold order allows a current holder to retain its holdings regardless of the auction's clearing rate, whereas a hold-at-rate bid will result in holdings being sold unless the clearing rate is equal to or greater than the stated rate. Id. ARS auctions are run by the "Lead Underwriters" -- a group described by the FAC as "the same large financial institutions that provide the issuers of the ARS with underwriting services." Id. at ¶39. If the supply of ARS at an auction exceeds demand, the auction fails and "none of the investors holding those ARS could sell their securities, and the instruments would be illiquid until the next scheduled auction." Id. at ¶41. However, investors holding ARS following a failed auction are entitled to a higher "penalty rate" of interest that is designed "to penalize issuers, compensate investors for the temporary illiquidity, and create new liquidity by inducing new investors to step in and purchase the ARS to benefit from the higher interest rate." Id. Bid information about ARS auctions was not publicly available. Id. at ¶43.
Plaintiffs allege that Ashland's business model "requires it to keep substantial funds readily available in the form of cash or highly-liquid assets" and that this was reflected in the company's written Investment Policy, which it provides or describes "to all financial institutions with whom the company conducts investment or cash management business." Id. at ¶¶21-24. In June 2005, a sales transaction resulted in Ashland Inc. receiving $1.3 billion in cash, which it earmarked for future acquisitions ("Acquisition Principal"). Id. at ¶25. Ashland Inc. transferred this $1.3 billion in cash "as capital to AshThree LLC, a special purpose entity wholly-owned and operated by Ashland Inc." Id. at ¶26. As the sole member of AshThree, Ashland Inc. made all of AshThree's investment decisions, in accordance with its Investment Policy. Id.
In the spring of 2007, Ashland's broker at Merrill Lynch, Thomas Byrne, moved to Morgan Stanley. Id. at ¶27. He continued to provide investment advice to Ashland from his new position at Morgan Stanley, and he remained in "constant contact" -- daily phone calls along with multiple in-person meetings each year -- with Ashland's Assistant Treasurer, Joseph Broce. Id. In mid-2007, Byrne and other Morgan Stanley employees approached Ashland to propose bundled services (investments, pension, and short term cash management). Id. at ¶28. In May 2007, Broce met with Byrne to discuss investment and cash management of the Acquisition Principal; at this meeting, Broce emphasized the need for both safety and liquidity in investing the Acquisition Principal. Id. at ¶29. Morgan Stanley marketed its investment and cash management services "aggressively" and represented that Morgan Stanley could provide "high quality SLARS." Id. at ¶¶30, 31. That same month, Byrne represented to Broce that there were "no liquidity issues" with SLARS and told Broce that SLARS were "the safest thing next to U.S. Treasuries because they are backed by the U.S. government." Id. at ¶32. Broce asked if auction failures were possible; Byrne responded by dismissing this possibility and affirmatively stated that in the event of a market failure, Morgan Stanley and other brokers "would 'come in and make the market' as they had always done in the past." Id. at ¶33. Based upon these representations, "Ashland engaged Morgan Stanley to provide investment advice and cash management services to" Ashland. Id. at ¶34. From May through August 2007, Ashland used Morgan Stanley's services to purchase Treasury instruments and various types of commercial paper. Id. at ¶45.
In August 2007, Byrne advised Broce by telephone and email that Ashland should be placing its cash into "taxable auction rate securities positions," which he represented would best protect Ashland's assets "from the growing crisis in subprime mortgages."
Id. at ¶46. Byrne represented repeatedly that instability and ARS market failures were rare and that Morgan Stanley would not allow an auction to fail. Id. at ¶51. Byrne emphasized that the SLARS tended to carry AAA ratings from the ratings agencies and that the student loans involved in the ARS were "backed by the United States government" and were not dischargeable in bankruptcy. Id. at ¶52. Byrne also repeatedly represented to Broce, in August 2007, that no SLARS auction had ever failed. Id. at ¶56.
The FAC makes a number of conclusory allegations about the ARS practices of brokers, and, in particular, Morgan Stanley. Id. at ¶¶35-44. Of note to this motion, the FAC alleges that "[t]he Lead Underwriters were . . . propping up an artificial market in ARS [by placing proprietary bids for large numbers of ARS] while leading investors like Ashland to believe that the market functioned with little or no intervention from the Lead Underwriters." Id. at ¶42.
The FAC also alleges that "[e]ach of Byrne's and Morgan Stanley's statements regarding the liquidity of Morgan Stanley -brokered SLARS was false and misleading at the time it was made because, contrary, to Morgan Stanley's misrepresentations, the continued 'liquidity' of Morgan Stanley -brokered SLARS was, as Morgan Stanley knew, unrelated to the underlying FFELP*fn3 -backed loans, AAA ratings or purported isolation from the subprime mortgage market." Id. at ¶58. Instead, the FAC alleges that the much-touted liquidity "depended solely on Morgan Stanley's continuing purchases of those securities because third party demand had already dried up." Id. Additionally, the FAC alleges that Morgan Stanley concealed from Ashland that: "(i) Morgan Stanley's 'market making' activities were essential to avoiding total illiquidity of those Morgan-Stanley brokered ARS; (ii) the financial burden upon Morgan Stanley from its SLARS 'market making' activities was increasing dramatically due to the rapid deterioration of investor demand for Morgan Stanley-brokered SLARS. . . ; and (iii) Morgan Stanley would not continue its purchases indefinitely and knew it would, contrary to its representations, leave Ashland stranded with Morgan Stanley-brokered ARS when it determined that purchasing those securities [to prop up the market] was no longer in its own interests." Id. at ¶59.
On September 25, 2007, in reliance on these representations and omissions, Ashland began purchasing Morgan Stanley-brokered SLARS. Id. at ¶49. In the months leading up to this purchase and at the time of the above misrepresentations and omissions, Morgan Stanley frequently had to make a market for otherwise illiquid ARS. Id. at ¶75. Ashland purchased SLARS from Morgan Stanley on two additional dates: October 2, 2007 and November 29, 2007. Id. at ¶¶ 61-63.
After Ashland's first purchase of the SLARS, Byrne and another broker at Morgan continued to make representations to Ashland about the strength of SLARS. Id. at ¶64. For instance, on December 11, 2007, Byrne represented to Ashland that the AAA ratings and the U.S. government guarantee of student loans made SLARS "one of the strongest backings in the asset-backed market." Id. at ¶53.
The FAC alleges that during this period Morgan Stanley failed to disclose that the high AAA ratings actually had an adverse effect on liquidity, contrary to Morgan Stanley's representations, and that this was known to Morgan Stanley. Id. at ¶¶69-70. More generally, the FAC alleges that "Morgan Stanley was aware of auction failures and significant disruptions in the ARS market," that Morgan Stanley was aware that the ARS market was closely linked to the subprime crisis, at least as early as August 2007 when "at least 96 auctions for ARS. . . failed," and Byrne's failure to disclose "that Morgan Stanley routinely had to rescue auctions and that the liquidity he touted was false and artificial" caused Ashland to hold its SLARS, rather than sell the SLARS. Id. at ¶¶64, 73, 75.
The FAC alleges that "Ashland was not provided with a prospectus for any of the SLARS sold to it by Morgan Stanley until after the auctions had concluded." Id. at ¶66 (emphasis in original). Later in the FAC, there is an allegation that "Morgan Stanley had imposed a limit on the number of SLARS it would purchase for its own inventory." Id. at ¶71. The FAC also alleges that Morgan Stanley did not disclose its own financial interest in maintaining the market for SLARS or the interest of its financial advisors, such as Byrne, in selling SLARS "rather than bona fide cash management instruments." Id. at ¶72.
In December 2007, Ashland learned of a failed SLARS auction (underwritten by Goldman Sachs, and not involving SLARS owned by Ashland). Id. at ¶83. Broce contacted Byrne to discuss how this would affect the SLARS issued by Morgan Stanley; Byrne's response (quoted in the complaint) depicted the Goldman Sachs SLARS as completely different from those brokered by Morgan Stanley and used this to attempt to sell more SLARS to Ashland. Id. at ¶¶83-85. The FAC alleges that another ARS auction failed on January 23, 2008, which was not disclosed to Ashland, even as Morgan Stanley continued to recommend that Ashland purchase additional SLARS. Id. at ¶88. The FAC alleges that Byrne and his co-worker, Susan Resnik, contacted Ashland by email at least fifty times from August 2007 through February 2008 "in an effort to market Morgan Stanley-backed SLARS." Id. at ¶89.
"As the implosion of the ARS market unfolded, Ashland directed Morgan Stanley to begin liquidating its holdings of Morgan Stanley-brokered SLARS." Id. at ¶91. Byrne told Broce that Morgan Stanley could not and would not provide or ensure liquidity for any Morgan Stanley ordered SLARS held by Ashland. Thereafter, Ashland discovered that its SLARS were illiquid. Id. at ¶¶91-92. As of February 12, 2008, Ashland was "trapped with over $66 million of illiquid Morgan Stanley-brokered SLARS." Id. at ¶92.
The FAC alleges that Morgan Stanley's actions have injured Ashland/AshThree: (1) "Morgan Stanley has steadfastly refused to provide any liquidity" for the SLARS held by Ashland; (2) "Ashland has already been forced to mark the value of its illiquid Morgan Stanley-brokered SLARS holdings down by millions of dollars"; and (3) the fact that the Acquisition Principal is tied up in these illiquid holdings meant that Ashland was "forced to borrow funds" to complete a long-sought acquisition of a specialty chemical company (Hercules, Inc.), thus incurring "millions of dollars in costs and fees associated with being forced to borrow funds." Id. at ¶¶94-96.
B. Defendant's Submissions
Morgan Stanley placed a statement of its ARS policies and practices online, "as a result of an Order entered into between the SEC and certain active broker-dealers in the auction rate securities market [on May 31, 2006]," and its clients were advised of this statement in trade confirmations.*fn4 Exh. B. to Musoff Decl.; Tr. 6. Morgan Stanley's statement provides an overview of the ARS market and describes the role of broker-dealers, like Morgan Stanley, in the ARS auctions. Exh. B. to Musoff Decl.
The document advises that "Morgan Stanley is permitted, but not obligated, to submit orders in auctions for its own account either as a bidder or a seller and routinely does so at its own discretion." Id. at 3. Similarly, the document advises: "Morgan Stanley routinely places one or more bids in an auction for its own account to acquire ARS for its inventory, to prevent a failed auction or to prevent an auction from clearing at a rate that Morgan Stanley believes is higher than the market for similar securities at the time it makes its bid." Id. It also warns of the illiquidity danger to an investor in a failed auction, namely that the "holders may be disadvantaged if there is a failed auction because they are not able to exit their position through the auction" and that "[b]ids by Morgan Stanley are likely to reflect (i) the rate on ARS -- including preventing the rate from becoming the Maximum Rate or otherwise causing bidders to receive a higher or lower rate than they might have received had Morgan Stanley not bid and (ii) the allocation of ARS being auction -- including displacing some bidders who may have had their bids rejected or receive fewer ARS than they would have received if Morgan Stanley had not bid." Id. at 4. The statement warned that, for these reasons: "the fact that an auction clears successfully does not mean that an investment in the ARS involves no significant liquidity or credit risk. Morgan Stanley is not obligated to bid in any auction to prevent an auction from failing or clearing at an off-market rate. Investors should not assume that Morgan Stanley will do so." Id. at 4. The document also included the disclaimer that "Morgan Stanley provides no assurance as to the outcome of any auction," and that "[t]here can be no assurance that a secondary market for these securities will develop or, if it does develop, that it will provide holders the ability to resell auction securities in the secondary market on the terms or at the times desired by a holder." Id. at 6-7.
Morgan Stanley also filed a copy of the prospectus for Ashland's first purchased SLARS, securitized bonds issued by the Pennsylvania Higher Education Assistance Agency, issued on May 9, 2006. Exh. C to Musoff Decl. The prospectus contains the same warnings about the SLARS securities as contained in the Morgan Stanley statement of ARS practices and procedures.
Additionally, Morgan Stanley has filed with this Court an amended complaint filed by Ashland in another case, Ashland Inc. and AshThree LLC v. Oppenheimer & Co., Inc., which was filed in the Eastern District of Kentucky.*fn5 Exh. D to Musoff Decl. The Complaint in that case alleged that Oppenheimer made fraudulent misrepresentations, causing Ashland to invest $194 million in Oppenheimer-brokered ARS, beginning on June 5, 2007, and Oppenheimer-brokered SLARS, beginning on July 17, 2007. Complaint at ¶¶28, 45, Ashland Inc. and AshThree LLC v. Oppenheimer & Co., Inc., No. 09-cv-135, 2010 WL 672106 ...