The Appellate Division, First Department, at 27 Madison Ave.
The Appellate Division, First Department, at 27 Madison Ave. (NYLJ/Rick Kopstein)

Comprehensive disclaimers in collateralized debt obligation offerings do not necessarily shield sellers from liability, a unanimous state appeals panel has ruled, handing victories to investment firm Loreley Financing in two fraud lawsuits against Citigroup and Merrill Lynch.

Loreley’s suits allege that Citigroup and Merrill Lynch worked with Illinois-based hedge fund Magnetar Capital to put together collateralized debt obligations that were designed to fail, so that Magnetar could profit by taking a short position, while marketing them as legitimate long investment opportunities to others. In the years leading up to the financial crisis, Magnentar was allegedly behind a large number of such CDOs, sometimes called the “Constellation CDOs” because many were named after constellations.

An Appellate Division, First Department, panel heard Loreley’s suits—Loreley v. Citigroup, 650212/12, and Loreley v. Merrill Lynch, 652732/11—on the same day in February. In both cases, Manhattan Supreme Court Justice Jeffrey Oing (See Profile) had denied most of the defendants’ motions to dismiss.

Justices Dianne Renwick (See Profile), Angela Mazzarelli (See Profile), John Sweeny (See Profile), Helen Freedman (See Profile) and Judith Gische (See Profile) sat on the panel. Renwick wrote an opinion in Citigroup, which involved six CDOs that sold for nearly $1 billion. The panel issued a shorter, unsigned opinion in Merrill Lynch, which involved only one CDO that sold for about $60 million.

The facts in the two cases were similar. Loreley claimed that Citigroup and Merrill Lynch colluded with Magnetar to put together CDOs, using residential mortgage-backed securities as collateral, that were designed to fail.

Both banks’ CDO deals included disclaimers. The disclaimer in the Citigroup CDOs, which Renwick discussed in detail in her opinion, said that Loreley would not rely on “the advice or recommendations of or any information, representation … provided by” Citigroup; that the CDOs were subject to risks, including the default of the underlying residential mortgages; and that Loreley was willing to bear those risks.

Both Citigroup and Merrill Lynch argued that the disclaimers prevented Loreley from showing the reasonable reliance necessary to make a fraud claim.

Renwick acknowledged in Citigroup that such disclaimers often bar fraud claims. “But there is a limit to the efficacy of those disclaimers, as this case aptly demonstrates,” she said.

Renwick wrote that the First Department itself had set a “clear precedent” in January, in Basis Yield Alpha Fund v. Goldman Sachs Group, 115 AD3d 128, 137.

The court found in that decision that disclaimers only bar fraud claims if they are specific to the type of misrepresentation or omission being alleged, and those allegations do not concern facts known only to the seller.

In other words, she said, Citigroup’s disclaimers “did not encompass the secret risk that the seller had deliberately selected the riskiest assets.”

Renwick also rejected Citigroup’s argument that two earlier First Department rulings rejecting suits over CDOs, ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 106 AD3d 494, and HSH Nordbank AG v. UBS AG, 95 AD3d 185, did not apply. In ACA, the court found that buyer had information that should have led it, as a sophisticated party, to investigate further, and in HSH Nordbank, it found that the alleged misrepresentations did not involve any facts known only to the seller.

Loreley, on the other hand, had no reason to believe that Citigroup wasn’t offering its CDOs as a legitimate long investment.

“Thus, as the motion court correctly found, plaintiffs here allege a scheme that no investor, ‘sophisticated or not,’ could have discovered,” she wrote.

The shorter unsigned opinion in the Merrill Lynch case reached a similar conclusion.

The First Department did dismiss unjust enrichment claims in both cases, reversing Oing. The court ruled that unjust enrichment claims exist only in the absence of a written agreement.

Sheron Korpus, a partner at Kasowitz, Benson, Torres & Friedman, argued Loreley’s appeal in Citigroup and James Ringer, a partner at Meister Seelig & Fein, argued its appeal in Merrill Lynch. Both said they were pleased with the rulings.

Citigroup is represented by Susanna Buergel, Brad Karp amd Jane O’Brien, partners at Paul, Weiss, Rifkind, Wharton & Garrison, and by Donna Lee, an associate at that firm. They could not be reached for comment.

Merrill Lynch is represented by Michael Lazerwitz, a partner at Cleary Gottlieb Steen & Hamilton, who also could not be reached.