CDO investors continue to crowd courts: UBS charged for selling "crap" to Connecticut Hedge Funds

This is only one of the several rulings either already out of the legal press, or under publication. Law courts all over the US and some even in Europe are currently considering CDO/ MBS/ ABS investors’ claims as to fraud, mis-selling, misrepresentations and so on. In a ruling dated 8^th Sept 2009, Justice Blawie of the Stamford’s  Superior Court ordered UBS to set aside money for pre-judgment damages, or face garnishee orders for recovery. 

In this case  brought by Pursuit Partners, a Connecticut-based hedge fund, UBS was charged for selling CDO tranches that were described in internal emails as “crap” and “vomit”, and were sold shortly before Moody’s downgraded the securities. All the CDOs were so-called bespoke CDOs structured to meet Pursuit’s needs of a triggerless, investment-grade piece that could be available at significant discount on face value. 

Moody’s and S&P have also been charged in the case, as there were allegations that UBS was privy to forthcoming changes in the rating methodology of Moody’s whereby the notes that were sold to Pursuit would cease to be investment grade. The change in methodology was the correlation assumption in CDO pools. 

The offer document, as is quite usual with transactions, said the transaction will be governed by New York law. However, the Connecticut court still assumed jurisdiction, ignoring the choice of law clause, on the ground that a choice of law by parties can  be ignored on ground of public policy. The Judge said: “To allow securities to be marketed, offered and sold in any or all of the 49 states outside of New York, and hold that no other jurisdiction’s laws can be enforced or invoked, or that Connecticut law must be ignored, even if a plaintiff can establish, as it has here, probable cause to support a cause of action under Connecticut law, the state where the solicitation was made, simply because of this choice of law provision, is not a proposition this court will or may accept, both as a matter of statute and public policy”. If this ruling is finally accepted at higher forums, then CDO marketers would have a real tough time defending suits all over the country. 

The notes were sold to Pursuit between 26^th July 2007 and Oct 1, 2007. This was the beginning of the avalanche of CDO downgrades. Obvious enough, UBS would have sensed the impending downgrades, and therefore, internal emails of UBS indicated the need to clear the inventory of CDO tranches that UBS was carrying. This evidence led the court to find “probable cause to sustain the claim that UBS sold the Notes to Pursuit without disclosing the following material non-public information: (1) that the Notes would soon no longer carry an investment grade rating, as the ratings agencies intended to withdraw these ratings as a result of a change in methodology; and (2) that once the investment grade rating was withdrawn, the CDO Notes sold by UBS to Pursuit, being valued in the tens of millions of dollars, would thereby become worthless”. 

The court on analysis of facts, primarily emails of the CDO marketing team of UBS, that UBS was in superior knowledge of the facts, which were concealed from the buyer, which the buyer relied upon and was thus unduly affected by the representations of the seller.  Internal emails of UBS said they had sold more “crap” to Pursuit, etc., which led the court to apply the “superior knowledge” doctrine. The court noted that risk is something that attaches to all such investments. However, (t)hat is the difference between a risk that something might happen to change the value of an investment, which is both a fact of life and a risk shared by all parties to any securities transaction, and the undisclosed knowledge that something will happen. That type of nondisclosure, whether it is on the part of a seller or a buyer, can cross the line into actionable securities fraud, and the court finds probable cause to sustain a finding that it this instance, it did”. 

Vinod Kothari comments: The ruling above is a flavor of the times. Judges, like the financial press, common people and others, have been affected by the wave of sentiment that goes against people who marketed and sold CDOs. On objective analysis of the ruling above, the question to be asked is – if UBS sold crap to Pursuit, what else do you sell to someone who comes to buy crap? Pursuit wanted to buy investment grade, being sold at steep discount on face value. Which investment grade notes would sell at steep discount on face value, given the high return on face value itself that they carry? The notes in question were bought between July and October, 2007 when the subprime crisis had already started surfacing. Bear Stearns’ hedge funds had already imploded by then. Rating agencies had also started downgrading several CDOs. On our website here, on June 20, 2007, we had reported that securitisation market was looking like a sinking ship, and there was fire everywhere. The purchases were made by Pursuit in tranches upto 1 October, 2007, by which time the subprime story, and the impact of that on CDOs was spread all over the financial press. So, can Pursuit really contend that there was a “superior knowledge” that UBS had, which Pursuit could have had? Pursuit, as a matter of investment strategy, might have projected that that was the right time to buy CDOs at deep discount, as its investment team might have projected that the crsis will not last long. 

Offer documents contained a detailed description of what were the assets of the pools, and what risks they carried. The impending change in rating methodology of Moody’s was  in public domain as rating agencies had come up with public statements on the same. Pursuit has affirmed before the court that it had read the offer documents and understood the same. A hedge fund is not a lay investor – its sole USP lies in being able to make money by taking risks that lay investors do not or cannot take.  

If this ruling leads UBS to pay damages for the losses that Pursuit faced, almost every seller who sold bonds that went bad would, sooner or later.

[Reported by: Vinod Kothari]

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