776 F.3d 94 (2nd Cir. 2015), 13-0627-cv, Stratte-McClure v. Stanley

Docket Nº:13-0627-cv
Citation:776 F.3d 94
Opinion Judge:Debra Ann Livingston, Circuit Judge :
Party Name:JOEL STRATTE-MCCLURE, Plaintiff, FJARDE AP-FONDEN, Plaintiff-Appellant, PLAINTIFF STATEBOSTON RETIREMENT SYSTEM, STATE-BOSTON RETIREMENT SYSTEM, Movant-Appellant, -v- MORGAN STANLEY, a Delaware Corporation, JOHN J. MACK, ZOE CRUZ, DAVID SIDWELL, THOMAS COLM KELLEHER, THOMAS v. DAULA, Defendants-Appellees, GARY G. LYNCH, Defendant
Attorney:David Kessler (Andrew L. Zivitz, Kimberly A. Justice, Richard A. Russo, Jr., Joshua A. Materese, on the brief) Kessler Topaz Meltzer & Check, LLP, Radnor, PA, for Plaintiff-Appellant Fjarde AP-Fonden and for the Class. JAVIER BLEICHMAR (Jonathan M. Plasse, Joseph A. Fonti, Wilson M. Meeks, on the...
Judge Panel:Before: CABRANES, WESLEY, and LIVINGSTON.
Case Date:January 12, 2015
Court:United States Courts of Appeals, Court of Appeals for the Second Circuit
 
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776 F.3d 94 (2nd Cir. 2015)

JOEL STRATTE-MCCLURE, Plaintiff, FJARDE AP-FONDEN, Plaintiff-Appellant, PLAINTIFF STATEBOSTON RETIREMENT SYSTEM, STATE-BOSTON RETIREMENT SYSTEM, Movant-Appellant, -v- MORGAN STANLEY, a Delaware Corporation, JOHN J. MACK, ZOE CRUZ, DAVID SIDWELL, THOMAS COLM KELLEHER, THOMAS

v.

DAULA, Defendants-Appellees, GARY G. LYNCH, Defendant

No. 13-0627-cv

United States Court of Appeals, Second Circuit

January 12, 2015

Page 95

Argued: December 10, 2013.

Appeal from April 4, 2011 and January 18, 2013 orders of the United States District Court for the Southern District of New York (Batts, J.), granting the Defendants' motions to dismiss. For the reasons stated here and in a summary order issued simultaneously with this opinion, we AFFIRM the order granting the Defendants' motion to dismiss.

David Kessler (Andrew L. Zivitz, Kimberly A. Justice, Richard A. Russo, Jr., Joshua A. Materese, on the brief) Kessler Topaz Meltzer & Check, LLP, Radnor, PA, for Plaintiff-Appellant Fjarde AP-Fonden and for the Class.

JAVIER BLEICHMAR (Jonathan M. Plasse, Joseph A. Fonti, Wilson M. Meeks, on the brief), Labaton Sucharow LLP, New York, NY, for Movant-Appellant State-Boston Retirement System and for the Class.

ROBERT F. WISE, JR. (Charles S. Duggan, Andrew Ditchfield, on the brief), Davis Polk & Wardwell LLP, New York, NY, for Defendants-Appellees.

Before: CABRANES, WESLEY, and LIVINGSTON.

OPINION

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Debra Ann Livingston, Circuit Judge :

Lead Plaintiffs State-Boston Retirement System and Fjarde AP-Fonden brought this putative securities fraud class action on behalf of themselves and other similarly situated investors (" Plaintiffs" ) pursuant to Sections 10(b) and 20(a), 15 U.S.C. § § 78j(b) and 78t(a), of the Securities Exchange Act of 1934. They allege that Morgan Stanley and six of its officers and former officers -- John J. Mack, Zoe Cruz, David Sidwell, Thomas Colm Kelleher, and Thomas Daula (collectively, " Morgan Stanley" or " Defendants" ) -- made material misstatements and omissions between June 20, 2007 and November 19, 2007 (the " class period" ) in an effort to conceal Morgan Stanley's exposure to and losses from the subprime mortgage market. As a result, Plaintiffs claim, they suffered substantial financial loss when Morgan Stanley's stock prices dropped following public disclosure of the truth about Morgan Stanley's positions and losses.

The United States District Court for the Southern District of New York (Batts, J.) dismissed all claims on the pleadings for failure to state a claim, and we affirm. For the reasons stated in this opinion, we conclude that the district court properly dismissed Plaintiffs' claim that Defendants' omission of information purportedly required to be disclosed under Item 303 of Regulation S-K, 17 C.F.R. § 229.303(a)(3)(ii) (" Item 303" ), violated Section 10(b). We also affirm its order dismissing Plaintiffs' other claims in a summary order issued simultaneously with this decision.

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BACKGROUND1

This case arises out of a massive proprietary trade executed by Morgan Stanley's Proprietary Trading Group in December 2006. The trade consisted of two components: a $2 billion short position (" Short Position" ) and a $13.5 billion long position (" Long Position" ). In the Short Position, Morgan Stanley purchased credit default swaps (" CDSs" ) on collateralized debt obligations (" CDOs" ) backed by " mezzanine tranches" of subprime residential mortgage-backed securities (" RMBSs" ).2 These CDSs operated like insurance policies -- Morgan Stanley paid annual premiums for the assurance that, if the housing market worsened and the mezzanine RMBS tranches backing its CDOs defaulted or declined in value, it would receive payments. In the Long Position, Morgan Stanley sold CDSs. These CDSs, like those it bought for the Short Position, referenced CDOs backed by mezzanine tranches of subprime RMBSs. But the CDOs referenced by the Long Position were super-senior tranches of CDOs that were higher-rated and lower-risk than the CDOs referenced by the Short Position. Through the Long Position, Morgan Stanley therefore received premium payments for the guarantee that it would pay the CDS purchasers in the event that these lower-risk CDO tranches defaulted or declined in value. Morgan Stanley could use the income from those premiums to finance the Short Position, but would have to make payouts if the CDO tranches referenced by the Long Position suffered defaults -- up to a maximum of $13.5 billion in the event of a 100 percent default in these CDOs. In essence, the company was betting that defaults in the subprime mortgage markets would be significant enough to impair the value of the higher-risk CDO tranches referenced by the Short Position, but not significant enough to impair the value of the lower-risk CDO tranches referenced by the Long Position.

According to the Plaintiffs, " [b]y mid-2006, the biggest housing bubble in U.S. history had popped." J.A. 465. Subprime mortgages issued in 2005 and 2006, like those backing Morgan Stanley's proprietary trade, rapidly began to suffer from delinquencies and defaults. " On February 12, 2007, Morgan [Stanley] economist Richard Berner acknowledged that these '[s]oaring defaults signal that the long-awaited meltdown in subprime mortgage lending is now underway[.]'" J.A. 469. Although Morgan Stanley's Proprietary Trading Group had correctly predicted the direction that the subprime housing market would turn, it apparently underestimated the magnitude of the collapse. The value of Morgan Stanley's swap positions declined substantially over the course of 2007, and Morgan Stanley ultimately lost billions of dollars on the proprietary trade.

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Plaintiffs allege that Defendants made numerous material misstatements and omissions from June 20, 2007 through November 19, 2007 to conceal Morgan Stanley's exposure to and losses from this subprime proprietary trade. The second amended complaint identifies two categories of misrepresentations and omissions: (1) misrepresentations and omissions regarding Morgan Stanley's exposure to credit risk related to the U.S. subprime mortgage market arising from its Long Position (the " exposure claim" ), and (2) misrepresentations regarding Morgan Stanley's losses arising from the Long Position (the " valuation claim" ). Plaintiffs allege that these misstatements and omissions fraudulently inflated Morgan Stanley's stock price during the class period and caused them to suffer financially when the market learned the truth about Morgan Stanley's exposure and losses.

A. Exposure Claim

The second amended complaint alleges that Defendants materially misrepresented Morgan Stanley's exposure to the subprime mortgage market. Plaintiffs rely on four statements from Morgan Stanley officers, and one alleged omission. First, on a June 20, 2007 call with market analysts about Morgan Stanley's second quarter earnings, Defendant Sidwell stated that " concerns early in the quarter about whether issues in the sub-prime market were going to spread dissipated." J.A. 498. Second, on that same call, Sidwell responded to a request to characterize Morgan Stanley's position in the mortgage market and to explain the decline in the company's fixed income revenues by stating that Morgan Stanley " really did benefit" from conditions in the subprime market in the first quarter of 2007, and " certainly did not lose money in this business" during the second quarter. J.A. 498, 499. Third, during another earnings call with market analysts on September 19, 2007, Defendant Kelleher stated that Morgan Stanley " remain[ed] exposed to risk exposures through a number of instruments [including] CDOs," without describing the extent of that exposure. J.A. 506-07. And fourth, Kelleher stated in an October 24, 2007 interview with CIBC World Markets analyst Meredith Whitney that he " [did] not see further write-downs to [Morgan Stanley's] carrying values over the near term." J.A. 516. Plaintiffs claim that each of these statements was materially false or misleading.

As pertinent here, Plaintiffs also allege that Defendants made material omissions in their 10-Q filings by failing to disclose the existence of the Long Position, that Morgan Stanley had sustained losses on that position in the second and third quarters of 2007, and that the company was likely to incur additional significant losses on the position in the future. They argue that Item 303 of Regulation S-K and related guidance requires companies to disclose on their 10-Q filings any " known trends, or uncertainties that have had, or might reasonably be expected to have, a[n] . . . unfavorable material effect" on the company's " revenue, operating income or net income." J.A. 465. Plaintiffs claim that " [b]y July 4[, 2007,] at the latest, Defendants knew that the Long Position was reasonably expected to have an unfavorable material effect on revenue." J.A. 482. It is not disputed that Morgan Stanley did not make this Item 303 disclosure on its 10-Q filings in 2007.

B. Valuation Claim

In a separate claim, the second amended complaint alleges that Morgan Stanley overstated its earnings in the third quarter of 2007 because it did not sufficiently write down the value of its Long Position. According to Plaintiffs, the Long Position's

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value was " inherently linked" to an index of RMBSs known as the ABX.BBB.06-1 Index (the " ABX Index" ). Thus, when the ABX Index declined by 32.8 percent in the third quarter of 2007, Morgan Stanley should have marked down the value of the Long Position by that same percentage and disclosed the loss in its quarterly statement. Instead of taking that $4.4 billion markdown, however, Morgan Stanley recognized only a $1.9...

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