New York Appellate Division Clarifies Requirements for a Fraud Claim by a Sophisticated Investor

March 29, 2012

On March 27, 2012, a unanimous five-judge panel of the New York Appellate Division, First Department, issued a forceful 37-page opinion addressing a number of legal standards governing fraud claims by sophisticated commercial entities.

The First Department opinion, HSH Nordbank AG v UBS AG, 2012 NY Slip Op. 02276, 2012 WL 997166 (1st Dep’t Mar. 27, 2012), modified the trial court’s orders under review to dismiss the fraud claim asserted by HSH Nordbank AG (“HSH”) against UBS AG and UBS Securities LLC (collectively, “UBS”), relating to a synthetic collateralized debt obligation (“CDO”) transaction called North Street Referenced Linked Notes, 2002-4 Limited (“NS4”). The opinion also affirmed the dismissal of HSH’s cause of action for negligent misrepresentation and demand for punitive damages.

The Disputed CDO Transaction

In the NS4 transaction, HSH purchased $500 million of notes from the NS4 trust. UBS purchased $74 million of notes that were subordinate to the notes held by HSH. Through a credit default swap, UBS also purchased credit protection from NS4 on a $3 billion portfolio of securities related to the United States real estate market, in exchange for periodic premium payments. The interest payments due on the notes issued by NS4 were to be funded by the premium payments from UBS. UBS selected the securities in the initial reference pool and had the right to substitute assets in the pool within certain parameters defined in the transaction documents. If NS4 was obligated to make payments to UBS under the credit default swap, the principal of the notes would be reduced accordingly, with the junior notes purchased by UBS bearing losses first.

For the first six years after closing, no credit events occurred in the reference pool, and HSH received the full amount of interest due on its notes. However, in 2008, following the onset of the financial crisis, “credit events in the reference pool began to occur in abundance.”1 The complaint alleged that “HSH has experienced a near-total loss of its $500 million investment.”2

Insufficiency of the Fraud Claim

The Court found HSH’s fraud claim legally insufficient, pursuant to CPLR 3211(a)(1) and (7), for a number of reasons. First, the Court found that HSH could not satisfy the element of justifiable reliance. Second, the Court held that, based on the allegations of its complaint, HSH could have uncovered any of the alleged misrepresentations about the risk of the transaction through reasonable due diligence. Finally, the Court held that HSH’s fraud claim was duplicative of its claim for breach of contract (which was not at issue in the appeal).

The misrepresentations alleged by HSH in support of its fraud claim ultimately concerned “the level of risk attached to the securities in the reference pool, on which hinged the likelihood of credit events occurring that would reduce or eliminate the return on HSH’s notes. . . [T]he claim is that UBS knew that the published ratings of securities of the kinds to be used in the reference pool were not entirely reliable guides to the risk of these assets.”3  HSH alleged that, “as a German regional bank,” it had little experience relevant to assessing the risks in the NS4 transaction.

The Court found that “the undisputed documentary evidence establishes that HSH agreed that it was not relying on any advice from UBS; assented to the inherent conflicts of interest that would result from UBS’s multiple roles . . . ; and was explicitly warned of the risks it was undertaking . . .”4 The Court, assuming HSH’s allegations to be true, held that “a relative lack of expertise in transactions of this kind would not have given HSH any right to expect UBS to act as its advisor in the deal or to bring to HSH’s attention information that HSH could have obtained through its own efforts.”5

Failure of Negligent Misrepresentation Claim

The First Department also affirmed the dismissal of HSH’s cause of action for negligent misrepresentation based on the terms of the agreements between the parties:

The parties expressly agreed that they were dealing with each other at arm’s length, that UBS was not acting as HSH’s financial or investment adviser, and that HSH was “not relying (for purposes of making any investment decisions or otherwise) upon any advice, counsel or representations . . . of [UBS].” As a matter of law, therefore, HSH cannot allege that it had a “special relationship” with UBS upon which a negligent misrepresentation claim may be predicated.6


The HSH Nordbank opinion is significant in both its holding and its rationale. The First Department made clear that, as a matter of law, a sophisticated commercial entity cannot plead reasonable reliance where it could have discovered with due diligence the facts it claims were misrepresented. The Court credited the detailed disclosures of risk and potential conflicts of interest in the offering documents and ruled that contractual disclaimers of reliance among sophisticated parties will be enforced under New York law.7 In fact, the Court acknowledged that it was sending a message to the business community:

If we were to allow a fraud claim to go forward on this basis, it would render meaningless HSH’s agreement that it was not relying on UBS for “any advice, counsel or representations (whether written or oral)” and “had consulted with its own . . . business, investment, financial, accounting and other advisors to the extent it . . . deemed necessary” (emphasis added). Sustaining this claim would likewise nullify the offering circular’s caution that HSH “must rely on its own examination of . . . the merits and risks involved” (emphasis added). In effect, the message to the corporate and financial world would be that “it is impossible for two businessmen dealing at arm’s length to agree that the buyer is not buying in reliance on any representations of the seller as to a particular fact.” This is a message we decline to send.8

The decision is likely to have wide-ranging consequences for pending and future litigation between sophisticated commercial parties.

For more information about the subject matter of this alert, please contact the authors or any Bingham securities and financial institutions litigation partner.


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1 HSH Nordbank at 9. Page references in citations correspond to slip opinion.
2 Id. (quoting complaint).
3 Id. at 9-10.
4 Id. at 2.
5 Id. at 16.
6 Id. at 36 (quotations and ellipsis in original; citation omitted).
7 “Given its representation that it was not relying on any recommendation by UBS in purchasing the NS4 notes, HSH’s failure to undertake (either directly or through an advisor) an independent appraisal of the risks of the transaction necessarily leads to the conclusion that HSH was so lax in protecting itself that it cannot fairly ask for the law’s protection.” Id. at 17 (internal quotation marks omitted).
8 Id. at 27 (quotations, emphases and omissions in original; internal citations omitted).

This article was originally published by Bingham McCutchen LLP.