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Loreley Fin. (Jersey) No. 3 Ltd. v. Wells Fargo Sec., LLC

United States Court of Appeals, Second Circuit

July 24, 2015


Argued February 5, 2014

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[Copyrighted Material Omitted]

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Appeal from the judgment of the United States District Court for the Southern District of New York (Sullivan, J.) dismissing, with prejudice, Plaintiffs' complaint for failure to state a claim. In late 2006 and early 2007, Plaintiffs invested millions of dollars in the notes of three financial products known as collateralized debt obligations (" CDOs" ). After those notes became worthless during the recent financial crisis, Plaintiffs brought this action against several parties responsible for structuring, marketing, and managing the CDOs (collectively, " Defendants" ), alleging, inter alia, fraud by Defendants in connection with disclosures made in the offering materials. Because we conclude that the district court erred in aspects of its dismissal under Rule 12(b)(6) and also exceeded the bounds of its discretion in denying Plaintiffs' request to replead, we reverse in part, vacate in part, and remand for further proceedings consistent with this opinion.

Sheron Korpus, Kasowitz, Benson, Torres & Friedman LLP (James M. Ringer, Meister Seelig & Fein LLP; Marc E. Kasowitz and David M. Max, Kasowitz, Benson, Torres & Friedman LLP, on the brief), New York, NY, for Plaintiffs-Appellants.

Jayant W. Tambe, Jones Day (Todd R. Geremia, Howard F. Sidman, and Alexander P. McBride, Jones Day; David C. Bohan and William M. Regan, Katten Muchin Rosenman LLP; Joseph J. Frank, Matthew L. Craner, Agnès Dunogué, and Kelly M. Daley, Orrick, Herrington & Sutcliffe LLP, on the brief), New York, NY, for Defendants-Appellees.

Before: LEVAL, CALABRESI, and LYNCH, Circuit Judges.


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GUIDO CALABRESI, Circuit Judge :

This case, like so many others of late, concerns liability for investment losses. Specifically, it asks who, if anyone, ought to shoulder legal blame for losses suffered as part of the recent financial crisis. Plaintiffs-Appellants--whose names are all numbered variants of " Loreley Financing" (collectively, " Plaintiffs" )--are special-purpose investment entities operated by the German bank IKB Deutsche Industriebank AG and domiciled in the Bailiwick of Jersey, Channel Islands. In late 2006 and early 2007, Plaintiffs invested millions of dollars in the notes of three financial products known as collateralized debt obligations (" CDOs" ). Two of the CDOs were named for constellations: Octans CDO II (" Octans" ) and Sagittarius CDO I (" Sagittarius" ) (together, the " constellation CDOs" ). The third was Longshore CDO Funding 2007-3 (" Longshore" ). Each CDO was created and sold by three Wachovia subsidiaries (collectively, " Wachovia" ). Between late 2007 and mid-2008, all three CDOs went into default, failing to make payments owed to Plaintiffs.

In April 2012, in the wake of these losses and the larger financial crisis, Plaintiffs filed suit in New York state court against several parties responsible for structuring, offering, and managing the CDOs (collectively, " Defendants" ). Plaintiffs allege, among other things, fraud in connection with disclosures about the construction of the three CDOs. According to the complaint, Defendants represented to " long" investors like Plaintiffs that the constellation CDOs would be handled by judicious collateral managers, even though Defendants knew that, in reality, these CDOs had been built at the direction of a powerful " short" investor who stood to profit massively if the CDOs failed. As to Longshore, the non-constellation CDO, Plaintiffs allege that despite similar representations

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it was used to dump toxic assets from Wachovia's own balance sheets at above-market prices.

After this case was removed to federal court, the United States District Court for the Southern District of New York (Sullivan, J. ) dismissed the complaint under Rule 12(b)(6), denying Plaintiffs' request to replead. See Loreley Fin. (Jersey) No. 3 Ltd. v. Wells Fargo Secs., LLC, 12 Civ. 3723 (RJS), 2013 WL 1294668 (S.D.N.Y. Mar. 28, 2013). Because we conclude that the district court erred in aspects of its dismissal of Plaintiffs' fraud claim and also exceeded the bounds of its discretion in denying Plaintiffs leave to amend the complaint as to the remaining claims, we reverse in part, vacate in part, and remand the case for further proceedings consistent with this opinion.


Plaintiffs' fraud allegations are only intelligible if one has some understanding of the basic structure and function of CDOs. We offer a brief description before turning to the particulars of this case.

A. The Structure of a CDO[1]

The construction of a CDO begins, at least conceptually, with asset-backed loans, such as mortgages or car loans. These loans are, of course, contracts in which the lender trades capital up front for the borrower's promise, secured by the borrower's asset, to make monthly payments. Banks frequently sell their secured rights to the monthly payments to the makers of financial products known as " asset-backed securities," the most prominent of which are mortgage-backed securities (" MBSs" ).

An MBS is created when a financial institution bundles a large number of mortgage loans into a special-purpose entity. The resulting entity owns the rights to a large pool of borrowers' monthly payments. The institution simultaneously sells notes backed by the MBS, i.e., by the bundle of loans, and may also sell equity interests in the MBS. When the maker of an MBS does this--when it sells the rights to the cash flow generated by the mortgages in its bundle--it may do so by creating different classes, or " tranches," of notes. " Tranching" allows the bank to create notes with different risk-and-return profiles and thereby to attract a variety of buyers, from the most risk-averse to the least. Such tranches are often classified by letter, with first priority in receiving payment given to the holders of tranche " A" notes, second priority to " B," and so on. The riskier, lower-priority notes will receive higher interest rates. (Although lettering conventions differ across MBSs, the mechanics are roughly the same, regardless of how the various tranches are denominated.) At the bottom of the hierarchy is a small class of investors who have purchased equity interests in the MBS.

The payment scheme for the different tranches is typically known as a " waterfall." As mortgage payments come into the MBS entity, they cascade, " watering" tranche A noteholders first, then B, and so on down to the equity. No part of the

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borrowers' payments will go to the holders of equity in the MBS unless those payments exceed what the MBS must pay to its noteholders. The brunt of any borrower's default on one of the underlying mortgages is therefore borne first by the equity interest, then by the most junior notes, intermediate notes, and so on. It takes a large number of defaults to impair the cash flow to holders of tranche A notes--which is what makes those notes the least risky. If, however, the MBS performs well, receiving full payment, the holders of the riskier tranches (and especially the equity) will receive higher returns.

By bundling large numbers of mortgages together into tranched MBS notes, a bank can achieve a number of goals. For one, it can create securities that enable non-lending institutions to invest in the housing market. In addition, it can create relatively safe investment opportunities through the senior tranches, because it takes widespread mortgage defaults to impair the cash flow to those tranches. Needless to say, the word " relatively" bears emphasizing in light of the real estate market collapse that lies behind this case and the many other cases like it.

In the same way that an MBS comprises a bundle of mortgage notes, a CDO comprises a bundle of MBS (or other asset-backed security) notes. Thus, where an MBS is a financial product backed by mortgages, a CDO is, in a sense, simply a second-order MBS, backed by those first-order financial products. A CDO is likewise built by creating a special-purpose entity that takes possession of a large group of notes--say, tranche B notes of various MBSs. The CDO will then sell to investors tranches of notes with diminishing priority, paying out the funds collected on the securities held by the CDO to noteholders in the order of the tranches' relative priority.

A related type of derivative security available to investors in the mortgage market is a " credit default swap" (" CDS" ). A CDS is known as a " derivative" because it transfers the risk associated with owning a particular security without necessarily transferring ownership of that security. In general, derivatives are purely financial contracts that call for payment by one contracting party to the other based on a specific event, such as fluctuation in the value of a selected security, interest rate, market index, or the like. Investment in a mortgage-based CDS is the opposite of investment in mortgage notes, in that it benefits the investor only if the borrowers do not make their mortgage payments. More precisely, the purchaser of the CDS promises to make regular monthly payments to the issuer in exchange for the issuer's promise to pay the purchaser in the event--and roughly to the extent--that borrowers default in making payments on the selected category of mortgage notes. Unless such defaults occur, the CDS buyer gets nothing in return for her regular payments.

Investment in mortgage-based CDSs can serve two purposes. First, it may function as a speculative bet against the mortgage market. In other words, an investor who believed the housing market to be unrealistically inflated could purchase a CDS in anticipation of borrowers' defaults. Such an investor is essentially shorting the mortgage market, while the issuer of the CDS is taking a " long" position in that market.[2] Indeed, an investor eager to

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capitalize on an expected downturn in the market could increase its short position by purchasing multiple CDSs, thereby placing what amounts to a very large bet on impending defaults by borrowers. A second use for a CDS is as a hedge, or insurance against such defaults. Thus, investors in MBSs or CDOs, whose cash flow and value depend on borrowers' making their payments, can lessen the consequences of defaults by purchasing CDSs keyed to a similar class of mortgages.

As pertinent here, some CDOs contain--in addition to asset-backed securities like MBSs--derivative securities like CDSs. A CDO might contain, for instance, not only specific tranches of MBS notes but also the long side of CDS contracts related to those tranches. In that case, the cash flow into the CDO would come from the regular payments by the CDS buyers--the short investors--as well as payments on the underlying mortgages. The CDO would also bear the corresponding risk both of defaults by borrowers and of the payouts to CDS buyers triggered by such defaults.

Given that CDOs consist of a portfolio of assets, a crucial matter for the makers of a CDO is deciding who will pick the assets, e.g., the MBSs and CDSs that will be bundled together to form the CDO's collateral. Generally, this job is performed by a " collateral manager," an entity or person who has discretion to select assets that further the goals, and fulfill the requirements, of the CDO. Such requirements may concern various characteristics of the collateral securities, including their ratings by credit ratings agencies, their contractual structure, and their performance to date.

With that basic structure in mind, we turn to the particulars of this case.

B. Plaintiffs' Fraud Allegations

Plaintiffs invested millions in three CDOs created and offered by Wachovia: Octans, Sagittarius, and Longshore. Wachovia marketed these CDOs to Plaintiffs and also sold CDSs on each CDO. Structured Asset Investors, LLC (" SAI" ), a Wachovia subsidiary, and Harding Advisory LLC (" Harding" ), an independent company, served as collateral managers--Harding for Octans, SAI for Sagittarius and Longshore. All three CDOs held MBS notes as well as the long side of CDS contracts.

With respect to Octans and Sagittarius, Plaintiffs allege that, contrary to representations made to investors, Harding and SAI selected shoddy, high-risk assets at the urging of Magnetar Capital LLC (" Magnetar" ), a hedge fund that stood to profit massively if the CDOs failed. As to Longshore, Plaintiffs allege that, without telling investors, Wachovia used it to dump, at above-market prices, riskier MBS notes that had been on Wachovia's own balance sheets. Each alleged scheme is recounted more fully below.

1. The Constellation CDOs: Octans and Sagittarius

According to the complaint, Magnetar colluded with several banks and collateral managers to " orchestrate" at least 27 CDOs named after constellations, including Octans and Sagittarius. J.A. at 112. Magnetar would purchase the equity

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tranches in exchange for clandestine influence over the selection of assets. Although, as an equity holder, Magnetar thus stood to benefit from the CDOs' success, it used its position and influence to advance a contrarian investment strategy. In reality, Magnetar was betting heavily against the CDOs and the underlying MBSs by buying the short side of CDS contracts, which it had the ability to purchase at below-market prices from banks like Wachovia as a condition of its equity investment in the CDOs. Magnetar was simultaneously able to fund these short positions with payments from its equity stake for a longer period of time, until the CDOs actually went into default, because the CDOs had been structured--at Magnetar's insistence--so that they would not divert cash from the equity holders to senior tranches in the face of early warning signs that the value of the portfolio collateral was deteriorating.

Plaintiffs, however, did not bring this suit against Magnetar. The instant litigation concerns Magnetar's helpmeets, Defendants, who are alleged to have conspired in structuring the deals and attracting long investors like Plaintiffs by masking Magnetar's central and adverse role.

As to Octans, the offering documents touted Harding's experience and skill as a collateral manager, stating that Harding would " [i]nvest in high quality assets with stable returns" and " minimize losses through rigorous upfront credit and structural analysis, as well as ongoing monitoring of asset quality and performance." Id. at 121. The documents also specified numerous procedures to be used by Harding in asset selection, including " detailed loan-level analysis." Id. at 121-22.

Harding, however, allegedly acted entirely contrary to these representations. It acceded to Magnetar's requests, knowing that Magnetar's interests were directly at odds with the CDOs' success. In support of this claim, Plaintiffs assert several facts regarding particular email exchanges between Magnetar and Harding in August and September 2006, as assets were being selected. In one such exchange--between James Prusko, Magnetar's Senior Vice President, and Wing Chau, Harding's founder and president--Prusko requests to be copied on the trade approval process and updated daily if any trading activity occurred, adding, " We should also discuss CDO exposure as I will source the CDO CDS." Id. at 124. Chau responds, " Sounds good." Id. In another such exchange, a Harding employee asks Prusko " to let [them] know if [Magnetar] plan[s] on shorting any names into any of the [Octans] transactions." Id. at 125. An email to Prusko three days later from the same employee lists shorting opportunities that Harding was " able to source for [Magnetar]." Id. Based on these and other such exchanges, Harding is alleged not only to have known of Magnetar's shorting activities but also to have facilitated and concealed them.

Ignorant of Magnetar's role, Plaintiffs invested $94 million in October 2006 in the notes of various Octans tranches. All of these notes became virtually worthless when the respective tranches went into default in May 2008.

Plaintiffs' factual allegations regarding Sagittarius are similar. The Sagittarius term sheets outlined the same type of goals as the Octans term sheets, detailing similarly rigorous procedures for managing the CDO. The " conservative approach" of the chosen collateral manager, SAI, was a key selling point, as Defendants knew. Id. at 128. With respect to both CDOs, Defendants stressed the collateral manager's expertise and its approach to asset selection because, as acknowledged in the

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offering documents, each CDO's performance ultimately turned on these two variables.

Plaintiffs allege that, despite these representations, Magnetar exerted control over SAI's asset selection, as it did over Harding's, and that Magnetar's strategy of betting against Sagittarius was known to SAI. For example, Prusko assertedly emailed Wachovia's managing director early on, stating that while he " didn't mean to kill [SAI] off," he did want it to be " more user friendly." Id. at 131. A few months later, a Wachovia trader allegedly emailed Prusko with a list of especially weak MBSs that were proposed for inclusion in the CDO, inviting him to express " any thoughts or concerns." Id. at 132. Prusko responded, " Let[']s test the waters!" Id. Finally, in March 2007 Prusko sent Wachovia an email to which he attached a document that graphed Magnetar's returns for different projected loss scenarios. The graph showed that the worse the CDO performed, the larger Magnetar's profit. In the body of the email Prusko himself described Sagittarius as " not a pretty bond." Id. at 134.

In March 2007 Plaintiffs invested $5 million in Sagittarius Class A and B notes each. Both tranches defaulted in October of that year.

2. Longshore

The third CDO at issue, Longshore, was not among the constellation CDOs created as part of Magnetar's so-called " long-short" strategy. As with the other two CDOs, however, the Longshore offering documents highlighted the high quality of the asset selection and due diligence procedures that would be used by the collateral manager--here SAI. Contrary to these representations, Wachovia allegedly used Longshore as a dumping ground for MBS assets that it knew faced an imminent and steep decline in value, including assets on Wachovia's own books that were being transferred into Longshore from the warehouse of another, canceled CDO deal.

As detailed in the complaint, these allegations were the subject of a fraud investigation by the SEC. In an order issued as part of the settlement of that investigation, the SEC found that while Wachovia represented in its offering documents that Longshore assets would be acquired in deals resembling arm's-length transactions, the assets from the collapsed CDO were transferred at their original cost basis despite, according to Wachovia's own internal valuations, a significant decline in their fair market value.

In April 2007 Plaintiffs bought notes of various Longshore tranches with a total face value of $59.1 million. In February 2008 these notes went into default.

C. Procedural History

In April 2012, in the wake of these losses and the larger financial crisis, Plaintiffs filed suit in New York state court against Defendants--namely, the CDO entities, SAI and Harding, and certain subsidiaries of Wells Fargo, which acquired Wachovia in 2008. The case was removed to federal court pursuant to the Edge Act. See 12 U.S.C. § 632; 28 U.S.C. § 1441(a).[3]

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In July 2012, following the voluntary dismissal of certain defendants, but before the remaining defendants moved to dismiss, the district court held a " pre-motion conference." In three-page letters and at oral argument, the parties previewed their arguments in support of and opposition to the remaining defendants' anticipated Rule 12(b)(6) motion. At that conference, the district court also inquired of Plaintiffs whether they wished to amend the complaint in light of this preview, stating that it was not necessarily the court's practice to " give them another opportunity later." J.A. at 415. The court indicated that it considered Defendants' pre-motion letter and the points raised at conference to provide " fair warning" of Defendants' arguments and the potential need for amendment. Id. Plaintiffs declined the court's invitation to amend, arguing that the complaint was legally sufficient to state a claim for fraud.

Shortly thereafter, Defendants moved to dismiss the complaint for failure to state a claim under Rule 12(b)(6).[4] While vigorously opposing the motion, Plaintiffs also requested leave, in the alternative, to amend the complaint. See J.A. at 584 (citing Fed.R.Civ.P. 15(a)(2)). In February 2013, the district court held oral argument on the motion, at the end of which Defendants raised the issue of amendment, reading back the relevant portions of the pre-motion conference transcript. Plaintiffs' counsel twice sought to be heard on the issue and was twice denied a chance to respond. See J.A. at 732 (" THE COURT: All [defense counsel] did was quote to me what I said at the premotion conference. I was there. And the time to respond was then." ).

In March 2013 the district court issued a memorandum opinion dismissing the complaint in its entirety, with prejudice. See Wells Fargo, 2013 WL 1294668, at *16 & n.3. The instant appeal followed.


Plaintiffs challenge on appeal the district court's determination that they inadequately pleaded their fraud claim as well as the court's concomitant denial of their request to replead. We review de novo the district court's dismissal under Rule 12(b)(6), accepting all factual allegations in the complaint as true and drawing all reasonable inferences in Plaintiffs' favor. Adelson v. Harris, 774 F.3d 803, 807 (2d Cir. 2014). We review the district court's denial of leave to amend the complaint for abuse of discretion. See Lotes Co. v. Hon Hai Precision Indus. Co., 753 F.3d 395, 403 (2d Cir. 2014).


Before turning to particular aspects of Plaintiffs' complaint, we briefly address the law that applies to pleading fraud in general, including a threshold ...

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