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

• Decision Date: 24 July 2015
• Docket Number: Docket No. 13–1476–cv.
• Parties: LORELEY FINANCING (JERSEY) NO. 3 LIMITED, Loreley Financing (Jersey) No. 5 Limited, Loreley Financing (Jersey) No. 15 Limited, Loreley Financing (Jersey) No. 28 Limited, Loreley Financing (Jersey) No. 30 Limited, Plaintiffs–Appellants, v. WELLS FARGO SECURITIES, LLC, Wells Fargo Securities International Limited, Wells Fargo Bank, N.A., Harding Advisory LLC, Structured Asset Investors, LLC, Longshore CDO Funding 2007–3 Ltd., Defendants–Appellees, Octans II CDO Ltd., Defendant.
• Court: U.S. Court of Appeals — Second Circuit

797 F.3d 160

LORELEY FINANCING (JERSEY) NO. 3 LIMITED, Loreley Financing (Jersey) No. 5 Limited, Loreley Financing (Jersey) No. 15 Limited, Loreley Financing (Jersey) No. 28 Limited, Loreley Financing (Jersey) No. 30 Limited, Plaintiffs–Appellants

v.WELLS FARGO SECURITIES, LLC, Wells Fargo Securities International Limited, Wells Fargo Bank, N.A., Harding Advisory LLC, Structured Asset Investors, LLC, Longshore CDO Funding 2007–3 Ltd., Defendants–Appellees

Octans II CDO Ltd., Defendant.

Docket No. 13–1476–cv.

United States Court of Appeals, Second Circuit.

Argued: Feb. 5, 2014.

Decided: July 24, 2015.

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, N.Y., 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, N.Y., for Defendants–Appellees.

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

Opinion

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 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.

BACKGROUND

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 CDO¹

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 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 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...