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In re Merrill Lynch Auction Rate Securities Litigation

February 15, 2012


The opinion of the court was delivered by: Loretta A. Preska, Chief United States District Judge


Plaintiff, Louisiana Pacific Corporation ("LPC" or "Plaintiff"), brings this action alleging various state and federal causes of action against Defendants Merrill Lynch & Co., Inc.; errill Lynch, Pierce Fenner & Smith Incorporated ("MLPFS"); and Money Market 1 Institutional Investment Dealer ("MM1").*fn1 The action alleges that Defendants' activities related to certain auction rate securities ("ARS") purchasedd by Plaintiff ran afoul of the law. Defendants Merrill Lynch & Co. Inc. and MLPFS (together, "Merrill") are the underwriter for the initial offering of ARS at issue and its parent company. Defendant MM1 is Plaintiff's broker-dealer for the ARS at issue. Both the Merrill Defendants and MM1 move separately to dismiss under Federal Rule of Civil Procedure 12(b)(6). Defendant MM1 also moves to strike those portions of Plaintiff's First Amended Complaint ("Compl.") seeking punitive damages. For the reasons stated below, Defendant Merrill's motion to dismiss is GRANTED in its entirety and with prejudice. Defendant MM1's motion to dismiss is GRANTED in part with prejudice and DENIED in part. Finally, Defendant MM1's motion to strike is GRANTED.


The Court takes as true the following factual allegations in the complaint and draws all reasonable inferences in favor of Plaintiff. Goldstein v. Pataki, 516 F.3d 50, 56 (2d Cir. 2008).

A. Auction Rate Securities

In short, ARS are variable-rate debt instruments with interest rates set by way of periodic auctions in which potential buyers submit bids at various interest rates. (Compl. ¶¶ 21-26.) The highest bid accepted sets the interest rate for the ARS issuance as a whole -- the "clearing rate." (Id.) Holders may sell ARS at these auctions, but auctions with insufficient buy bids result in auction failure; then, prospective sellers are unable to sell ARS. (Id.)

The details and operation of the ARS here are not materially different from the ARS described in other opinions in this Multidistrict Litigation. The Court thus presumes familiarity with the ARS structure as previously discussed. See generally In re Merrill Lynch ARS Sec. Litig. (Merrill III), No. 09 MD 2030, 2011 WL 536437 (S.D.N.Y. Feb. 9, 2011) (ARS practices disclosures); In re Merrill Lynch ARS Sec. Litig. (Merrill II), 758 F. Supp. 2d 264, 271 (S.D.N.Y. 2010) (ARS mechanics).

B. Merrill's Conduct

In 2003 and 2004, MLPFS underwrote and acted as placement agent in private offerings of ARS tranches of collateralized debt obligations ("CDOs")*fn2 including six at issue in this matter:

(1) Alesco Preferred Funding I, Ltd. ("Alesco I"); (2) Alesco Preferred Funding II, Ltd. ("Alesco II"); (3) Lakeside CDO I, Ltd. ("Lakeside CDO I"); (4) Lakeside CDO II, Ltd. ("Lakeside CDO II"); (5) Cascade Funding CDO I, Ltd. ("Cascade Funding CDO I"); and (6) South Coast Funding V, Ltd. ("South Coast Funding V"). (Compl. ¶¶ 58-64.) These ARS could be purchased only by "Qualified Purchasers," as defined by the Investment Company Act of 1940, meaning that such purchasers are presumptively financially sophisticated. (Id. ¶¶ 56, 137; see also Merrill Memorandum of Law in Support of Motion to Dismiss ("Merrill Mem.") Exs. A-F (CDO ARS offering circulars); Exs. G-L (CDO ARS offering supplements).) Plaintiff made the following purchases through its broker, MM1: (1) on February 5, 2007, $3.7 million worth of Cascade Funding CDO I; (2) on April 4, 2007, $5 million worth of Lakeside CDO II; (3) on May 8 and June 8, 2007, $14.675 million worth of Lakeside CDO I; (4) on June 20, 2007, $2.2 million worth of South Coast Funding V; (5) on July 16, 2007, $20 million worth of Alesco I; and (6) on July 30, 2007, $10 million worth of Alesco II. (Compl. ¶ 140.)

MLPFS was the sole broker-dealer for those issuances. (Id. ¶ 66.) As broker-dealer, MLPFS selected the agent to conduct the auction; received and transmitted all buy, hold, or sell orders; participated in the preparation of ARS offering statements; and entered into remarketing agreements with other broker-dealers, including non-Merrill broker-dealers (such as MM1), who then sold those securities to their own eligible customers, like Plaintiff here. (Id. ¶¶ 7, 50, 66-68.) MLPFS received fees both for its underwriting and its broker-dealer services. (Id. ¶¶ 27-28, 52.)

MLPFS also participated as a buyer and seller in the auctions for its own account in an effort to ensure that the auctions would not fail. (Id. ¶¶ 3, 29, 73.) It placed bids -- called "support bids" -- for one-hundred percent of the Alesco I, Alesco II, Lakeside CDO I, Lakeside CDO II, Cascade Funding CDO I, and South Coast Funding V securities auctions through July 2007. (Id. ¶ 73; App. B.) When placing the bids, MLPFS bid for the entire notional value of the securities being auctioned. (Id.) Plaintiff alleged that the extent of this practice was not fully disclosed to investors, and MLPFS knew that demand for ARS absent its bidding was insufficient to feed the auctions. (See id. ¶¶ 66-70, 73-74, 76-77, 169.)

The support bids cleared the auctions and established the clearing rate in "a significant percentage" of the auctions. (Id. ¶ 73.) That clearing rate was lower than the rates "otherwise would have been," meaning that Plaintiff earned less interest on its ARS than it otherwise would have earned. (Id. ¶ 84.) Additionally, the support bids were undisclosed and therefore "injected false information into the marketplace" about the liquidity of these ARS. (Id. ¶ 74.) The consequences related to these allegations constitute the primary injuries MLPFS allegedly caused here. (See id. ¶¶ 74, 76-78, 83-86, 169.)

In August 2007, MLPFS discontinued its practice of submitting support bids, and the auctions for the six ARS here failed. (Id. ¶ 8, 76.) The market for these ARS "completely evaporated." (Id.) Because every auction for these securities has failed since August 2007, Plaintiff has been unable to sell the Merrill ARS currently held in its operating capital portfolio. (Id. ¶ 11.) Plaintiff claims it relied on the appearance of a liquid market (allegedly manufactured by MLPFS) when deciding to make its ARS purchases. (Id. ¶¶ 10, 74, 77, 171.) It says it never would have permitted MM1 to purchase the ARS for its account had it known the truth and that it now holds "toxic," "illiquid and significantly devalued" securities at a fraction of their par value. (Id. ¶¶ 9, 11, 171.)

C. SEC Order and Website Disclosure

In May 2006, following an investigation, the Securities and Exchange Commission ("SEC") reached a settlement with several investment banks that participated in the ARS market, including MLPFS. (Id. ¶¶ 34-35.) The SEC issued a cease-and-desist order (the "SEC Order") on May 31, 2006.*fn3 (Id. ¶ 34 and n.4.) The SEC Order concluded that the banks violated the securities laws by intervening in ARS auctions without adequate disclosure. (Id.) The SEC determined that disclosures indicating that a broker-dealer "may submit orders in Auctions for its own accounts" and that it "might have an advantage over other bidders" were inadequate. (Id.) The SEC Order enumerated several violative practices, including bidding to prevent auction failures or to affect the auctions' clearing rates but did not specify which banks engaged in which practices. (Id.; Stern Decl. Ex. N, at 6.) Nevertheless, MLPFS was ordered to pay a larger penalty than other banks because it was among the banks that "engaged in more types of violative practices than" others. (Compl. ¶ 35.) The SEC Order required the banks to post their ARS practices on their websites and provide all first-time purchasers and broker-dealer purchasers with a written description of the bank's ARS practices at or before the completion of each transaction. (Id.)

In August 2006, Merrill posted a document disclosing its ARS practices on its website (the "Website Disclosure"). See Merrill II, 758 F. Supp. 2d at 273-74 (discussing the same disclosure). The Website Disclosure states that "Merrill Lynch may routinely place one or more bids in an auction for its own account to acquire [ARS] for its inventory, to prevent an auction failure . . . or an auction from clearing at a rate that Merrill Lynch believes does not reflect the market for the securities." (Stern Decl. Ex. P, at 16; see also id. at 15 ("Merrill Lynch is permitted, but not obligated, to submit orders in auctions for its own account either as a bidder or a seller, or both, and routinely does so in its sole discretion.") (emphasis added).) It states that MLPFS's bids "are likely to affect the clearing rate." (Id. at 16.) The Website Disclosure also discusses the risk of auction failures and the consequent liquidity risk in the ARS market:

Because of [MLPFS's ARS practices], the fact that an auction clears successfully does not mean that an investment in the securities involves no significant liquidity or credit risk. Merrill Lynch is not obligated to continue to place such bids. . . . Investors should not assume that Merrill Lynch will do so or that auction failures will not occur. (Id.; see also id. at 18 ("There may not always be enough bidders to prevent an auction from failing in the absence of Merrill Lynch bidding in the auction for its own account or encouraging others to bid. Therefore, auction failures are possible, especially if the issuer's credit were to deteriorate, if a market disruption were to occur or if, for any reason, Merrill Lynch were unable or unwilling to bid.").) Finally, the Website Disclosure states that MLPFS had conflicts of interest; "it would likely have an advantage over other bidders because Merrill Lynch would have knowledge of some or all of the other orders placed through Merrill Lynch in that auction . . . . Merrill Lynch's interests in conducting an auction may differ from [investors] who participate in auctions." (Id. at 15-18.)

D. MM1's Conduct

From 1999 through August 2007, MM1 served as Plaintiff's broker-dealer and investment adviser. (Compl. ¶¶ 127-28.) As part of their relationship, Plaintiff provided MM1 with detailed investment guidelines and objectives indicating its desire to have relatively liquid investments to fund its ongoing business operations. (Id. ¶ 128.) As a result, Plaintiff specifically advised MM1 that speculative instruments, as well as structured finance products such as swaps, derivatives, and CDOs, all fell outside of Plaintiff's target investments. (Id.) Plaintiff's primary contacts at MM1 throughout this period were Senior Vice President Hal Johnson ("VP Johnson"), Vice President Will Longstreth, and Chief Executive Officer Lee Epstein ("CEO Epstein"). (Id. ¶ 134.) Representatives of MM1, including these high-level officers, communicated with Plaintiff on a near-daily basis, recommending specific investments consistent with Plaintiff's investment strategy. (Id. ¶ 134-35.) MM1 represented that it had reviewed all relevant offering materials and that it understood the securities it was recommending. (Id. ¶ 135.)

Between February and July 2007, MM1 recommended the six ARS tranches of the various MLPFS CDOs described above in Part I.B., supra. (Id. ¶ 140.) As part of its recommendations, MM1 represented that it had reviewed the offering memoranda, was familiar with the securities, and that they were fully consistent with Plaintiff's investment goals. (Id. ¶ 135.) In late 2006, VP Johnson represented that ARS were "safe and liquid money market equivalents," that "there was virtually no risk of auction failure," and therefore, "auction rate securities should be considered as safe as cash." (Id. ¶ 138.) MM1 further represented that the Merrill CDOs paid higher rates of interest than other money market funds because they were private placements only available to a subset of the investing public. (Id. ¶ 137.) In reliance on MM1's representations, Plaintiff made the following ARS purchases: (1) on February 5, 2007, $3.7 million worth of Cascade Funding CDO I; (2) on April 4, 2007, $5 million worth of Lakeside CDO II; (3) on May 8 and June 8, 2007, $14.675 million worth of Lakeside CDO I; (4) on June 20, 2007, $2.2 million worth of South Coast Funding V; (5) on July 16, 2007, $20 million worth of Alesco I; and (6) on July 30, 2007, $10 million worth of Alesco II. (Id. ¶ 140.) On MM1's monthly account statements to Plaintiff, these investments were categorized as "CashEQ," signifying that they were cash equivalents. (Id. ¶ 131.) The same monthly account statements identified the "stated maturity date" for the Lakeside, Cascade, and South Coast securities as no longer than one month and for the Alesco securities as no longer than three months. (Id.)

MM1 made further representations to Plaintiff during and after the ARS were purchased and auctions subsequently failed. On July 11, 2007, after Standard & Poors ("S&P") announced it would potentially downgrade some $12 billion in sub-prime mortgage-backed securities and in response to Plaintiff's inquiry, VP Johnson represented to Plaintiff that its investment portfolio had no sub-prime exposure. (Id. ¶ 143.) After the initial ARS auction failures in August 2007, Plaintiff had additional conversations with MM1 in which it assured Plaintiff that the Merrill ARS had no sub-prime exposure. (Id. ¶ 148-49.) It was only after Plaintiff demanded from MM1 a complete list of the ARS CDOs' holdings that it became clear to Plaintiff that all of the Merrill ARS had sub-prime exposure. (Id. ¶ 149.) When Plaintiff pointed out the disparity between the actual holdings and the ARS as characterized by MM1, MM1 then claimed that the sub-prime exposure was irrelevant because "none of the CDOs was in a state of default." (Id.) As late as December 2007, two months after the market for ARS completely evaporated, CEO Epstein continued to advocate the ARS investments, stating that "notwithstanding the market failure, the actual value of the now illiquid auction rate securities in [Plaintiff's] account exceeded their par value." (Id. ¶ 150.) Plaintiff also learned that ARS were not the cash equivalents MM1 had promised them to be and were instead long-term instruments with 30 to 40-year maturities. (Id. ¶¶ 65, 142.)

Unbeknownst to Plaintiff at the time MM1 was recommending the purchase of the Merrill ARS, MM1 had entered into a re-marketing agreement with Merrill to create a distribution channel for Merrill's products. (Id. ¶¶ 7, 50.) Pursuant to the agreement, MM1 was paid commissions in return for placing Merrill-underwritten securities with its investment clients, including Plaintiff. (Id.) For the ARS at issue in this case, MM1 was paid a commission each time an auction occurred, so long as MM1's client purchased or held the security. (Id.) MM1 continues to earn these fees upon each Merrill ARS auction, despite the fact that there is no ARS market and every auction since August 2007 has failed. (Id. ¶¶ 145-46.) MM1 never disclosed this arrangement to Plaintiff. (Id. ¶ 7.) Plaintiff claims that had it known the true nature and characteristics of the ARS securities, it would never have followed MM1's recommendation to acquire them for its working capital account. (Id. ¶ 142.) Further, had MM1 responded truthfully to Plaintiff's July 11, 2007 inquiry regarding sub-prime exposure, Plaintiff would have been able to sell at least some of the Merrill ARS in the then-functioning market. (Plaintiff's Memorandum of Law Opposing MM1 Motion to Dismiss ("Pl. MM1 Mem.") at 5.)

E. Procedural History

Plaintiff filed this suit in the Northern District of California. On December 1, 2009, the Judicial Panel on Multidistrict Litigation ("JPML") transferred this action here for inclusion in coordinated or consolidated pretrial proceedings pursuant to 28 U.S.C. § 1407. The JPML simultaneously ordered that "claims regarding" ARS underwritten by Deutsche Bank Securities, Inc. ("Deutsche Bank") be remanded to the Northern District of California. By Order dated January 5, 2010, the Northern District of California clarified that claims "arising from" the Deutsche Bank-underwritten ARS would proceed before it while claims "arising from" the Merrill-underwritten ARS would proceed before this Court. On February 11, 2010, this Court ordered that claims arising from the Merrill-underwritten ARS as alleged against Defendant MM1 were to proceed here. Plaintiff filed its First Amended Complaint on March 8, 2010. On April 9, 2010, and April 26, 2010, respectively, the Merrill and MM1 Defendants filed motions to dismiss for failure to state a claim. See Fed. R. Civ. P. 9(b), 12(b)(6), and the Private Securities Litigation Reform Act of 1995 ("PSLRA") (15 U.S.C. § 78u-4(b)(1)). On April 26, 2010, MM1 also filed its motion to strike.


There are two separate motions to dismiss sub judice, and they raise different substantive claims. Therefore, the Court first discusses Merrill's motion and then moves to MM1's motion. First, it outlines the law governing the analysis of both motions.

A. Legal Standard

In assessing a motion to dismiss, the Court must accept all non-conclusory factual allegations as true and draw all reasonable inferences in the Plaintiff's favor. Goldstein, 516 F.3d at 56. To survive such a motion, "a complaint must contain sufficient factual matter, accepted as true, to 'state a claim to relief that is plausible on its face.'" Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). A pleading that offers "labels and conclusions" or "a formalistic recitation of the elements of a cause of action will not do." Twombly, 550 U.S. at 555. "Where a complaint pleads facts that are 'merely consistent with' a defendant's liability, it 'stops short of the line between possibility and plausibility of entitlement to relief.'" Iqbal, 129 S.Ct. at 1949 (quoting Twombly, 550 U.S. at 557) (internal quotation marks omitted). For securities law violation claims, the complaint also must meet the heightened pleading requirements under Federal Rule of Civil Procedure 9(b) and, for federal claims, the PSLRA, 15 U.S.C. § 78u-4(b). ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007).

B. Merrill's Motion to Dismiss

Plaintiff asserts claims against MLPFS for market manipulation and material misstatements or omissions under section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. See 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. It also asserts a control-person liability claim against Merrill Lynch & Co. under section 20(a) of the Exchange Act. See 15 U.S.C. § 78t(a). It finally asserts claims against Merrill Lynch & Co. and MLPFS under California law and common law. Merrill moves to dismiss all of these claims. The Court addresses them in the order outlined above.

1. Section 10(b) Claims

To state a misrepresentation claim under section 10(b) and Rule 10b-5, Plaintiffs must "allege that the defendant[s] (1) made misstatements or omissions of material fact, (2) with scienter, (3) in connection with the purchase or sale of securities, (4) upon which the plaintiff relied, and (5) that the plaintiff[s'] reliance was the proximate cause of its injury." Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 157 (2008). To make out a market manipulation claim, the complaint must "allege (1) manipulative acts; (2) damage (3) caused by reliance on an assumption of an efficient market free of manipulation; (4) scienter; (5) in connection with the purchase or sale of securities; (6) furthered by the defendant's use of the mails or any facility of a national securities exchange." ATSI, 493 F.3d at 101. A failure on any one of these elements necessitates dismissal. See, e.g., Good Hill Partners L.P. v. WM Asset Holdings Corp., 583 F. Supp. 2d 517, 520-21 (S.D.N.Y. 2008).

These two claims are interrelated here because Plaintiff's market manipulation claims involve a failure to disclose fully MLPFS's ARS market activities. See In re Merrill Lynch ARS Litig. (Merrill I), 704 F. Supp. 2d 378, 390-91 (S.D.N.Y. 2010), aff'd, No. 10-1528, 2011 WL 5515958 (2d Cir. Nov. 14, 2011) (discussing interrelated claims); see also Merrill Mem. at 24-26 (arguing that Plaintiff alleged no manipulative act because disclosures were adequate). And "nondisclosure is usually essential to the success of a manipulative scheme." Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477 (1977). The Court thus addresses the legal elements common to both claims. It begins with an analysis of the alleged misstatements or omissions and then turns to scienter.

a. Misstatements or Omissions

A misstatement or omission claim must include allegations of a material misstatement or omission. ECA & Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 197 (2d Cir. 2009). "[T]o be material, 'there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.'" Id. (quoting Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)). "Therefore, the determination of whether an alleged misrepresentation is material necessarily depends on all relevant circumstances." Id.

Plaintiff's misstatement and market manipulation claims predicated on purchases that followed the Website Disclosure fail because the Website Disclosure adequately disclosed MLPFS's ARS practices. (See Stern Decl. Ex. P, at 15-16, 18.) The Website Disclosure disclosed the "advantages that Defendants would have if they did engage in such conduct, the ability of such conduct to affect clearing rates[,] and the possibility that the auctions would fail if Defendants did not intervene in them." In re Citigroup ARS Litig., 700 F. Supp. 2d 294, 307 (S.D.N.Y. 2009) (involving similar disclosures); see also Merrill I, 704 F. Supp. 2d at 390-92, 396-97 (same disclosures as here).

Indeed, Plaintiff's misstatement and manipulation claims boil down to two basic points: (1) MLPFS's support bidding affected the clearing rate of the auctions and (2) MLPFS's ARS market activities created a false appearance of liquidity and thereby artificially inflated prices paid for ARS. (Plaintiff's Memorandum of Law in Opposition to Merrill Motion to Dismiss ("Pl. Merrill Mem.") at 6.) But the Website Disclosure was sufficient to apprise Plaintiff of MLPFS's activities. See Merrill I, 704 F. Supp. 2d at 392. It stated that MLPFS "may routinely" place bids in its own auctions and that it "routinely does so in its sole discretion." (Stern Decl. Ex. P, at 15-16.)

It stated that MLPFS's bids "are likely to affect the clearing rate" (id. at 16) and would "cause lower clearing rates to occur" (id. at 17). And it disclosed that auction failures are possible, that a cleared auction does not mean ARS have no liquidity risk, that there may be insufficient third-party demand, and that "auction failures are possible . . . if, ...

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