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Financial Guaranty Ins. Co. v. The Putnam Advisory Co., LLC

United States Court of Appeals, Second Circuit

April 15, 2015

FINANCIAL GUARANTY INSURANCE COMPANY, Plaintiff-Appellant,
v.
THE PUTNAM ADVISORY COMPANY, LLC, Defendant-Appellee

Argued November 17, 2014.

As Amended April 20, 2015.

Page 396

Appeal from the judgment of the United States District Court for the Southern District of New York (Robert W. Sweet, Judge), granting defendant-appellee's motion to dismiss for failure to state a claim. The District Court dismissed plaintiff-appellant's fraud claim on the ground that the complaint did not adequately plead loss causation, and dismissed plaintiff-appellant's negligence claims on the ground that the complaint did not allege facts sufficient to establish a special relationship between the parties. For the reasons set forth below, we hold that the District Court erred in dismissing the complaint for failure to state a claim. We therefore VACATE the judgment of the District Court and REMAND for further proceedings.

Appeal from the United States District Court for the Southern District of New York. No. 12-cv-7372 -- Robert W. Sweet, Judge.

SANFORD I. WEISBURST (Peter E. Calamari, Sean P. Baldwin, Paul P. Hughes, on the brief), Quinn Emanuel Urquhart & Sullivan LLP, New York, New York, for Plaintiff-Appellant.

THOMAS A. ARENA (Sean M. Murphy, Robert C. Hora, Ian E. Browning, on the brief), Milbank, Tweed, Hadley & McCloy LLP, New York, New York, for Defendant-Appellee.

Before: KEARSE, STRAUB and RAGGI, Circuit Judges.

OPINION

Page 397

Straub, Circuit Judge:

Plaintiff-Appellant Financial Guaranty Insurance Company (" FGIC" ) appeals from a judgment of the United States District Court for the Southern District of New York (Robert W. Sweet, Judge),

Page 398

dismissing its second amended complaint (" SAC" ) for failure to state a claim. See FGIC v. Putnam Advisory Co., LLC, No. 12 CIV. 7372, 2014 WL 1678912 (S.D.N.Y. Apr. 28, 2014). FGIC filed this action against Defendant-Appellee Putnam Advisory Company, LLC (" Putnam" ) for fraud, negligent misrepresentation, and negligence. FGIC contends that Putnam misrepresented its management of a collateralized debt obligation (" CDO" ) called Pyxis ABS CDO 2006-1 (" Pyxis" ) in order to induce FGIC to provide financial guaranty insurance for Pyxis. According to FGIC's complaint, Putnam stated that it would select the collateral for Pyxis independently and in the interests of long investors (i.e., investors who profit when the investment succeeds), but in fact permitted the collateral selection and acquisition process to be controlled by a hedge fund, Magnetar Capital LLC (" Magnetar" ), which maintained significant short positions in Pyxis (i.e., investments that would pay off if Pyxis defaulted). In sum, FGIC alleges that Putnam misrepresented the independence of its management of a structured finance product, which, upon default, caused FGIC millions of dollars in losses.

On April 28, 2014, the District Court dismissed FGIC's fraud claim on the ground that the complaint did not adequately plead loss causation, and it dismissed FGIC's negligence claims on the ground that the complaint failed to allege a special or privity-like relationship between FGIC and Putnam. For the reasons set forth below, we find that FGIC has sufficiently alleged both its fraud and negligence-based claims. Accordingly, we VACATE the judgment of dismissal and REMAND to the District Court for further proceedings.

BACKGROUND

The allegations contained in FGIC's complaint have been comprehensively set forth in the District Court's opinion below. See FGIC, 2014 WL 1678912, at *1-7. We nevertheless provide a brief recitation of the most pertinent factual allegations, which are presumed to be true for purposes of considering a motion to dismiss for failure to state a claim.

I. The Pyxis CDO

This case arises out of Putnam's role as collateral manager of the Pyxis CDO. A CDO is a special purpose vehicle that purchases, or assumes the risk of, a portfolio of assets. To buy their portfolio of assets, CDOs raise money from investors by issuing notes and equity interests. The assets that comprise the CDO generate cash, which is then paid out to the CDO's investors. Investors in a CDO are not necessarily all subject to the same level of risk. Rather, CDO notes may be issued in " tranches" representing different levels of risk and potential reward. Generally, senior tranches carry the lowest risk, whereas investors in the equity tranche assume the greatest risk in the event of a default.

Pyxis was a " hybrid" CDO, in that its $1.5 billion portfolio included both " cash" assets (i.e., assets that Pyxis actually purchased) and " synthetic" assets (i.e., assets created through transactions that referenced securities not actually owned by Pyxis). About 23% of Pyxis's assets were cash assets and 77% were synthetic assets created by credit default swaps that referenced other asset-backed securities. In these credit default swaps, Pyxis sold credit protection to counterparties in exchange for premium payments to Pyxis. If the assets referenced in the swaps performed well, Pyxis would enjoy the premium payments without having to make credit protection payments. If the assets performed poorly, however, Pyxis would have to make credit protection payments to the credit

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default swap counterparty, potentially up to the full notional amount of the referenced obligation.

Calyon Corporate and Investment Bank (" Calyon" ), the structuring bank[1] for Pyxis, paid premiums to Pyxis under a credit default swap in exchange for protection payments in the event that a portfolio asset experienced a " credit event," such as a default or failure to pay a defined obligation. For most of the specified assets, Calyon acted only as an intermediary, meaning that the ultimate short positions were held by other market participants.

II. Putnam's Representations and the Pyxis Guaranty

In July 2006, Calyon contacted FGIC to solicit credit protection for the Pyxis CDO. Under the deal that Calyon proposed to FGIC, FGIC was to insure all payments owed by its subsidiary FGIC Credit Products LLC under a credit default swap which would provide credit protection on the $900 million " super senior" Pyxis tranche (" the Pyxis Guaranty" ). Without the Pyxis Guaranty, Pyxis would not have closed. Calyon represented that the CDO would be managed by Putnam, which would select the Pyxis asset portfolio independently, in good faith, and in the best interests of the investors.

FGIC alleges that it and investors were heavily dependent on Putnam's experience, independence, and integrity as collateral manager. Putnam represented to FGIC, orally and in writing, that it was an experienced and reputable collateral manager and that it would select the assets for the Pyxis portfolio diligently and independently. Putnam provided documents, such as a 52-page marketing pitchbook and an offering memorandum, containing extensive representations about Putnam's role as a " global leader in asset management" and the ...


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