Cremi v. Brown

• Citation: 955 F.Supp. 499
• Decision Date: 05 February 1997
• Docket Number: Civil No. K-95-1091.
• Parties: Banca CREMI, et al., Plaintiffs v. Alex. BROWN, et al., Defendants.
• Court: U.S. District Court — District of Maryland

Page 499

955 F.Supp. 499

Banca CREMI, et al., Plaintiffs v. Alex. BROWN, et al., Defendants.

Civil No. K-95-1091.

United States District Court, D. Maryland.

February 5, 1997.

COPYRIGHT MATERIAL OMITTED

Joseph D. Tydings, Howard Schiffman, and Howard N. Feldman, Washington, DC, for plaintiffs.

Michael R. Klein, and Robert F. Hoyt, Washington, DC, for defendants.

FRANK A. KAUFMAN, Senior District Judge.

Plaintiffs, Banca Cremi, S.A., Institucion de Banca Multiple, Grupo Financiero Cremi and its wholly owned subsidiary, Banca Cremi Grand Cayman (collectively "the Bank"), allege that their investment brokers, defendants Alex. Brown & Sons, Inc. ("Alex. Brown") and its employee, John Isaac Epley ("Epley"), wrongfully caused the Bank to lose over $23 million in connection with certain investments.¹ In this case the Bank has filed claims against Alex. Brown and Epley pursuant to Section 10(b) of the Securities and Exchange Act of 1934 (15 U.S.C. § 78a et seq.) ("Section 10(b)"); Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder by the Securities and Exchange Commission; under the Maryland Securities Act, MD. CORPS. & ASS'NS CODE ANN. § 11-302(c), and state common law theories of breach of fiduciary duty, negligence, negligent misrepresentation and fraud. Plaintiffs also seek relief against Alex. Brown under Section 20(a) of the Securities and Exchange Act of 1934, 15 U.S.C.A. § 78t. Both federal question and diversity jurisdiction exist in this case. Defendants have moved for summary judgment. For the reasons stated in this Opinion this Court will grant that motion.

I

A. Facts

Except where otherwise noted, the following facts are undisputed in all relevant and material respects.

B. The Parties

Banca Cremi is a credit institution incorporated under the laws of Mexico, with its principal place of business in Mexico City, Mexico. Banca Cremi Grand Cayman is a wholly owned subsidiary of Banca Cremi, incorporated under the laws of the Cayman Islands, with its principal place of business in Mexico City, Mexico.

Alex. Brown is a securities brokerage firm, incorporated under the laws of Maryland, with its principal place of business in Baltimore, Maryland. Alex. Brown is a registered broker-dealer. Epley, a citizen of Texas, was vice-president of Alex. Brown's Houston office from April, 1993 until 1995.

C. The Nature of the Securities at Issue

From 1992 to 1994, the Bank, through Alex. Brown, made a number of investments in what have become widely known as "derivatives." Derivatives are securities whose value are based on their relationship to other securities, such as stocks, bonds or commodities. Although derivatives have existed for years in certain forms, in the early 1990s both the trading and the complexity of derivatives increased dramatically.

The particular derivatives at issue in this case are collateralized mortgage obligations (CMO's). CMO's are securities in which mortgages are pooled, and the pool then is broken down into several cash flows and sold as separate entities or "tranches." The risk and reward can be allocated among tranches in a wide variety of ways. For example, CMO's typically include a formula for allocating "prepayment risk." When interest rates fall, borrowers tend to prepay their mortgages by refinancing, although a variety of factors make the exact rate of prepayment difficult to predict. When rates rise, prepayment tends to slow, but, again, at an unpredictable rate. Because prepayment can cause the interest which the mortgagee receives over the life of the mortgage to be less than expected, prepayment can cause a mortgage pool to drop in value. CMO's may distribute prepayment risk by giving certain tranches a priority position to the principal cash flows, meaning that in the event of prepayment, those "higher" tranches will receive a return of principal sooner than do "lower" tranches. The "coupon" in other CMO's — the interest received during the life of the bond — will vary from tranche to tranche and/or according to some factor such as interest rates. CMO issuers, which include both the private sector and government-sponsored entities such as the Federal Home Loan Mortgage Corp. (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae), combine those and other factors to create an array of securities with varying risk and return levels.

As will be discussed infra, the Bank purchased a variety of CMO's from Alex. Brown, but the six at issue were of two basic types: "inverse floaters" and "inverse IO's." Inverse floaters are floating rate securities with a coupon which moves opposite interest rates. Different inverse floaters have different structures, with key factors including any cap or floor on the coupon rate and the existence of a multiplier, which determines the sensitivity of the security to changes in interest rates. Inverse IO's are the interest-only portion of an inverse floater. An inverse IO is an especially complex, hybrid security, and investors apparently disagree as to its characteristics in times of rising or declining interest rates. One theory is that inverse IO's are "self-hedging" because, even though the coupon decreases in value when interest rates rise, that decrease is offset by an increase in value resulting from slowed prepayment. Another theory is that the decrease in coupon value will always outweigh the increase as a result of reduced prepayment.

D. The Decision to Invest and Defendants' Disclosures

Epley's first contact with the Bank came when he solicited the Bank's business in June, 1992. At that time, Epley was working for a different company, MMAR Group.² Over the next two to three months, Bank officials engaged in numerous discussions with Epley as they continued to study the possibility of investing in CMO's.

Plaintiffs allege that, before they made their first CMO trade, they told defendants of their conservative investment criteria, namely: (1) low risk to capital, (2) high liquidity for (3) short periods (generally, 90-180 days), (4) with a reasonable expectation of a good yield. Although defendants dispute those factual claims, for the purposes of summary judgment, this Court will assume that the Bank appropriately so communicated those criteria to Epley and Alex. Brown.

Defendants disclosed to the Bank's representatives both the general nature and riskiness of CMO's and, to a lesser extent, the characteristics of the particular securities purchased by the Bank. Those disclosures included the following:

• A pamphlet titled "MMAR Group Guide to CMO Structures," which described CMO's and, in particular, inverse floaters and inverse IO's in some detail. The pamphlet included the statement that inverse floaters "have the potential for significant yield volatility" and described the key factors of inverse floaters, including the cap and floor on the coupon rate and the effect of the multiplier on the sensitivity of the security to changes in interest rates.³ It described the basic characteristics of inverse IO's and said that they "can perform well in both rising and falling interest rate environments" because of a "self-hedging feature." The guide cautioned that "[p]rices of inverse IO's can be extremely volatile."⁴

• A pamphlet titled "Guide to Inverse IO's," which said that inverse IO's were suitable for the "aggressive investor."⁵

• A sample CMO prospectus with boiler-plate language describing various risks, including price, yield and certain liquidity risks.⁶

• A July 22, 1992 letter from Epley to Monica Buentello of the Bank discussing the four elements of risk commonly associated with inverse floaters: credit risk, coupon risk, price volatility and liquidity. That letter indicated that credit risk was nonexistent but that coupon, price and liquidity risk existed. The letter downplayed the extent of those risks — particularly liquidity risk.⁷

• Yield matrices, which typically were provided to the Bank with each proposal made by defendants. Those matrices demonstrated the expected change in yield with changes in interest rates.

The Bank received all those materials. The Bank also had available to it and to its employees a number of other books, pamphlets and articles describing CMO's in detail. One such item, a Barron's article titled "The Pinocchio Security: Here's the Awful Truth About CMOs," which was sent to the Bank by a concerned investor prior to the purchase of any of the CMO's at issue herein, described the dangers of CMO investments.⁸ Defendants also made Professor Frank J. Fabozzi, a leading expert on CMO's, available to the Bank as a consultant.

An internal Bank memorandum ("the Approval Memorandum"), which was prepared with Epley's assistance, also discussed the risks of CMO's, including credit, coupon and price risks.⁹ The memorandum acknowledged the existence of some coupon and price risks. Finally, the Approval Memorandum stated that both the price of the bond and the interest rates are guaranteed by the federal government, unless the holder sells before maturity, in which case the market price will prevail.

Although defendants made the aforementioned disclosures, on certain occasions Epley downplayed the risks and strongly encouraged the Bank to purchase additional CMO's. When Bank officials asked Epley about the "Pinocchio" article, for example, Epley replied with a letter contending that the article applied largely to individual, rather than institutional, investors, and touting MMAR's expertise in the CMO market.¹⁰

The record contains no indication that, at any time, the Bank requested, but did not receive, additional information from Epley or Alex. Brown as to the nature of the investments at issue in this case. For example, although more detailed information apparently was available as to both the likely yield of the CMO's purchased by the Bank and the potential price volatility of those securities, the Bank apparently did not request such information.

E. The Bank's CMO...