Among the more hotly contested issues facing structured finance investors and insurers bringing fraud claims in New York is the requirement that plaintiffs establish that they reasonably relied upon the alleged fraudulent misrepresentations. Commonly, the first defense of banks or other defendants in such suits is to seek dismissal of the claims on the ground that, regardless of any misrepresentation they may have made, the plaintiff’s reliance was not reasonable because the truth could have been ascertained on the basis of due diligence conducted at the time of the investment. Given the large amount of information that was theoretically—but often not practically—available to investors or insurers in structured finance transactions, this standard has presented an unfair and insurmountable bar in some cases. But that standard may be changing. The New York State Supreme Court (Justice Bransten), recently held in MBIA v. Countrywide that an insurer is not required to meet a “reasonable reliance” standard to show that it would not have issued a policy. In addition, two recent appellate decisions from the First Department have suggested some softening and clarification of New York’s reasonable reliance standard.
First, in CIFG Assurance North American v. Goldman, Sachs & Co., the plaintiff insurer, CIFG claimed that Goldman Sachs fraudulently induced it to provide guaranty insurance on an RMBS securitization by misleading CIFG as to the quality and origination of the mortgage loans backing the securitization. The lower court dismissed the fraud claims on the pleadings reasoning that CIFG could not show reasonable reliance because it failed to review the underlying mortgage loans. On appeal, however, the First Department recently reversed the trial court’s decision. See CIFG Assur. N. Am., Inc. v. Goldman, Sachs & Co., — N.Y.S.2d —, 2013 WL 1876243 (1st Dep’t May 7, 2013). In reinstating the fraud claims, the First Department found that the alleged misrepresentations concerning the characteristics of the underlying loans “were not demonstrably known by plaintiff to be false when made.” Id. at *1. It thus concluded that the plaintiff “was not required, as a matter of law, to audit or sample the underlying loan files” and that whether CIFG’s reliance on Goldman Sachs’ representations was reasonable was a question of fact, precluding dismissal. Id.
Second, in ACA Financial Guaranty Corp. v. Goldman, Sachs & Co., the plaintiff insurer, ACA, alleged that it was fraudulently induced by Goldman Sachs to issue a financial guaranty on CDO notes on the basis of misrepresentations that a hedge fund, Paulson & Co. (“Paulson”), that was involved in selecting the CDO’s collateral was taking a long position through investing in the CDO’s equity when in fact it was short. In a 3-2 decision, the First Department affirmed the lower court’s dismissal of ACA’s claim. See ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., — N.Y.S.2d —, 2013 WL 1953751 (1st Dep’t May 14, 2013). The Court reasoned that ACA could not have reasonably relied on Goldman’s alleged misrepresentation because the deal’s offering materials disclosed that “no-one was investing in the first-loss tranche” of the CDO and that, despite this fact, ACA failed either to investigate Paulson’s role or to include in its guaranty policy an “appropriate prophylactic provision to ensure against the possibility of misrepresentation.” ACA, 2013 WL 1953751, at *1-2. While seemingly in tension with the CIFG decision only one week prior, the ACA decision can be reconciled with CIFG in that the Court in ACA took note of ‘red flags’ that it concluded triggered heightened duties of investigation which the Court in CIFG expressly found did not exist in that case. In any event, the ACA decision included an unusual and vigorous dissent by two of the Court’s justices which makes it likely that the case will be reviewed by the New York Court of Appeals, which may very well reverse on grounds that the decision sets too high a threshold for showing reasonable reliance, even in the face of arguable ‘red flags.’