The folks at Merrill Lynch have discovered that even clouds as big and ugly as the recent meltdown in the mortgage industry can sometimes have the glimmer of a silver lining.
A federal judge has dismissed a securities fraud suit against Merrill Lynch and six of its subsidiaries citing the "profound" downturn in the mortgage market as the more likely cause of the plaintiffs' woes.
In his 40-page opinion in Luminent Mortgage Capital Inc. v. Merrill Lynch & Co., U.S. District Judge R. Barclay Surrick of the Eastern District of Pennsylvania said the plaintiffs "allege no facts to support their assertion that defendants' misrepresentations in 2005 -- rather than the market dislocation that occurred in 2007 -- caused an economic loss."
The ruling is a victory for a five-lawyer defense team -- Marc J. Sonnenfeld, Jill Baisinger and Karen Pieslak Pohlmann of Morgan Lewis & Bockius, along with Jay B. Kasner and Paul J. Lockwood of Skadden Arps Slate Meagher & Flom.
The suit was brought by a pair of real estate investment trusts that said they were duped by Merrill Lynch's false statements into investing $26 million into mortgage-backed securities that later proved to be riddled with problem accounts.
But Merrill Lynch moved for dismissal, arguing that the plaintiffs' case suffered from a series of fatal flaws, including their inability to prove that any alleged fraud by Merrill Lynch or its brokers -- as opposed to the economic downturn -- was the cause of their losses.
Surrick agreed, comparing the case to a previous suit against Merrill Lynch in which the 2nd U.S. Circuit Court of Appeals tossed out securities fraud claims filed in the wake of the turn-of-the-century bursting of the dot-com bubble.
In that case, Lentell v. Merrill Lynch, Surrick quoted the 2nd Circuit's conclusion: "When the plaintiff's loss coincides with a market-wide phenomenon causing comparable losses to other investors ... the prospect that the plaintiff's loss was caused by the fraud decreases."
In the Luminent case, the defense team argued in its brief that the plaintiffs' losses, if any, "are not the result of 'fraud' but stem from the unexpected collapse of the real estate and mortgage markets, which has caused all mortgage backed securities to suffer dramatic losses."
Surrick agreed, saying: "We are satisfied that the one-and-a-half year time period between the alleged misrepresentation and the injury, combined with the market downturn in the mortgage industry that developed in early to mid-2007, is sufficient to undermine the inference of a nexus between defendants' misrepresentations and the performance of the [mortgage portfolio]."
In the suit, plaintiffs' attorneys Sean F. O'Shea, Michael E. Petrella, Tom Stein and Jonathan R. Altschuler of O'Shea Partners in New York, along with Alan E. Denenberg of Abramson & Denenberg in Philadelphia, contended that Merrill Lynch hid the truth about the risks involved when it sold a package of mortgage-backed certificates to Luminent Mortgage Capital Inc. and Mercury Mortgage Finance Statutory Trust.
The suit said Merrill Lynch "falsely represented" that the underlying mortgage loans were predominantly composed of loans with "hard" prepayment penalties -- a characteristic that would have provided a steady income stream.
Merrill Lynch was also accused in the suit of promising that the loans were "of a high quality with a low likelihood of default."
For loans that did default, the suit said, Luminent claims it was falsely promised that it would have "special foreclosure rights" that would allow Luminent to mitigate potential losses. In reality, the suit said, as individual loans have defaulted, Luminent has never been accorded its promised "special foreclosure rights."
In a motion to dismiss, Merrill Lynch argued that the plaintiffs failed to properly allege scienter -- proof that a misstatement was made knowingly.
In response, the plaintiffs' lawyers pointed to a slew of discrepancies between the facts disclosed to them prior to the sale and the facts they learned on receiving the actual mortgage files.
Merrill Lynch also had the motive and opportunity to engage in the fraud, they argued, because it would have been stuck holding the certificates in its own accounts if they didn't sell.
In their brief, the plaintiffs' team argued that they had "sufficiently alleged defendants' fraudulent intent, showing that defendants had motive (dumping their low quality loans) and opportunity (by having exclusive access to the actual loan information, allowing Defendants to communicate false information to Luminent)."
But Surrick found that plaintiffs in securities fraud cases "must do more than show motive and opportunity" to prove scienter.
"Plaintiffs' allegations of motive and opportunity, considered with the rest of the allegations in the amended complaint as a whole, fail to plead with particularity facts that give rise to a strong inference of scienter," Surrick wrote.
Calls to O'Shea Partners seeking comment from any of the lawyers on the plaintiffs' team were not immediately returned.