The opinion of the court was delivered by: Friedman, J.
Published by New York State Law Reporting Bureau pursuant to Judiciary Law § 431.
This opinion is uncorrected and subject to revision before publication in the Official Reports.
Decided on March 27, 2012
SUPREME COURT, APPELLATE DIVISIONFirst Judicial Department
Luis A. Gonzalez, P.J. David Friedman Karla Moskowitz Helen E. Freedman Nelson S. Roman, JJ.
Cross appeals from the orders of the Supreme Court, New York County (Richard B. Lowe III, J.), entered October 1, 2009 and October 15, 2009, which, to the extent appealed from, denied defendants' motion to dismiss the cause of action for fraud and granted defendants' motion to dismiss the cause of action for negligent misrepresentation and the demand for punitive damages. Paul, Hastings, Janofsky & Walker LLP, New York (Barry G. Sher, James R. Bliss, James B. Worthington and Kevin P. Broughel of counsel), for appellants- respondents. Quinn Emanuel Urquhart & Sullivan, LLP, New York (Philippe Z. Selendy, Peter E. Calamari, Sandford I. Weisburst and Isaac Nesser of counsel), for respondent- appellant. FRIEDMAN, J.
The primary question on this appeal is whether plaintiff HSH Nordbank AG (HSH), a German commercial bank, has stated a cause of action for fraud against defendants UBS AG and UBS Securities LLC (collectively, UBS), an investment bank. The dispute arises from what was essentially a credit default swap transaction, in which, to simplify, HSH, in exchange for a stream of premium payments, assumed the risk of the first half billion dollars of losses on a $3 billion portfolio of securities related to the United States real estate market (the reference pool). In sum and substance, HSH alleges that UBS induced it to enter into the transaction by misrepresenting the risk involved and the manner in which UBS intended to manage the composition of the reference pool.
For a number of reasons, we find that the fraud claim must be dismissed as legally insufficient pursuant to CPLR 3211(a)(1) and (7). First, HSH -- a sophisticated commercial entity -- cannot satisfy the element of justifiable reliance, inasmuch as the undisputed documentary evidence establishes that HSH agreed that it was not relying on any advice from UBS; assented to the inherent conflicts of interest that would result from UBS's multiple roles with regard to the reference pool; and was explicitly warned of the risks it was undertaking in this highly leveraged and complex transaction. Moreover, the allegations of the amended complaint itself establish that HSH could have uncovered any misrepresentation of the risk of the transaction through the exercise of reasonable due diligence within the means of a financial institution of its size and sophistication. Finally, the fraud claim is duplicative of HSH's claim for breach of contract (which is not at issue on this appeal) to the extent it is based on allegations that UBS misrepresented how it intended to manage the reference pool. Accordingly, we modify the orders under review to dismiss the fraud claim, and, upon HSH's cross appeal, affirm the dismissal of the cause of action for negligent misrepresentation and the demand for punitive damages.
The relevant facts are alleged in the amended complaint and established by the undisputed documentary evidence. In March 2002, UBS entered into a financial transaction known as a collateralized debt obligation (CDO) with HSH's predecessor-in-interest, Landesbank Schleswig-Holstein, a German bank with reported assets of billion as of December 31, 2001 [FN1]. As a result of this highly complex transaction, HSH was to receive (indirectly) a stream of premium payments from UBS and, in exchange, to assume a portion of the risk of defaults in the reference pool, a $3 billion securities portfolio assembled by UBS, comprised predominantly of assets linked to the United States real estate market (for example, mortgage-backed securities and instruments issued by real estate investment trusts).
The CDO was structured around a special-purpose entity formed by UBS, North Street Referenced Linked Notes, 2002-4 Limited (NS4), which entered into a credit default swap with UBS on the closing date. In a credit default swap, the "protection buyer" pays a periodic fee (resembling an insurance premium) to the "protection seller" to cover the credit risk on an underlying security or group of securities. The protection seller becomes obligated to compensate the protection buyer if a "credit event," usually defined as a payment default, a credit rating downgrade, or other credit-related loss of value, occurs with respect to an underlying security. While a credit default swap is in some respects analogous to an insurance policy (with the protection seller corresponding to the insurer and the protection buyer to the insured), it differs from conventional insurance in that the protection buyer need not own the underlying security or securities or otherwise have any insurable interest therein. Concomitantly, the protection buyer need not suffer an actual loss to be entitled to a payment in the event of a credit event.
Under the credit default swap at issue here, NS4, as protection seller, in exchange for UBS's agreement to pay premiums, agreed to make certain payments to UBS, as protection buyer, upon the occurrence of defined adverse "credit events" affecting securities in the aforementioned reference pool. While the securities in the reference pool were required to meet certain ratings specifications, UBS selected the initial securities for the pool, and also had the right to substitute assets in and out of the pool during the life of the credit default swap, within defined parameters and through the use of internal procedures specified in a reference pool side agreement between UBS and HSH [FN2]. The governing documents required that by March 2004, 70% of the reference pool would be comprised of asset-backed securities, real estate investment trust assets, and commercial mortgage-backed securities.
At the same time that UBS and NS4 entered into the credit default swap, HSH purchased $500 million of notes (divided into four classes) issued by NS4 (the NS4 notes)[FN3]. Two classes of NS4 notes subordinate to HSH's notes, with aggregate face value of $74 million, were purchased by UBS. This use of multiple classes of debt obligations, or "credit tranches," is a standard feature of CDOs, with senior classes afforded greater security, but lower interest rates, than junior classes. In the NS4 transaction, the interest payments on the notes issued by NS4 were to be funded by the cash flows from UBS's premium payments under the credit default swap. At the same time, the proceeds of the notes were held to secure NS4's potential obligations to UBS under the credit default swap. In the event of NS4's becoming obligated to make payments to UBS under the swap, there would be corresponding reductions in the principal balance of each class of NS4 notes, in reverse order of seniority. HSH's exposure to the risk of credit events in the reference pool was cushioned by the junior notes purchased by UBS, which were to bear losses first. Because of the leveraged nature of the transaction -- which provided $574 million of protection against credit events in a $3 billion portfolio -- the entire investment in the NS4 notes would be wiped out by a decline of approximately 19% in the value of the reference pool.
The contractual documents governing this heavily negotiated transaction, and the offering circular (i.e., prospectus) for the NS4 notes, are replete with detailed disclosures of the considerable risks involved and of the conflicts of interest arising from UBS's multiple roles (to be more fully discussed below). In addition, the documents contain disclaimers establishing that, not only were UBS and HSH dealing with each other at arm's length, but that HSH was not entering into the deal in reliance on any advice from UBS. In particular, section 2.06(i)(x) of the indenture pursuant to which the notes were issued provides that each holder of notes, "by its purchase thereof, will be deemed to have represented and agreed" to terms including the following: "[The noteholder] acknowledges and agrees that: (A) none of [UBS] or [its] affiliates is acting as a fiduciary or financial or investment advisor for it; (B) it is not relying (for purposes of making any investment decision or otherwise) upon any advice, counsel or representations (whether written or oral) of [UBS] or any of [its] affiliates; and (C) it has consulted with its own legal, regulatory, tax, business, investment, financial, accounting and other advisors to the extent it has deemed necessary and has made its own investment decisions based upon its own judgment and upon any advice from such advisors as ...