A divided state appellate panel has dismissed a lawsuit accusing Goldman Sachs & Co. of tricking insurer ACA Financial Guarantee Corp. into insuring a complex mortgage-backed security that the bank had designed to fail, ruling that ACA should have done more to protect itself.

The 3-2 Appellate Division, First Department, panel yesterday reversed Manhattan Supreme Court Justice Barbara Kapnick’s (See Profile) April 2012 decision in ACA Financial Guaranty v. Goldman Sachs, 650027/11, allowing the case to go forward.

Justices David Friedman (See Profile), Dianne Renwick (See Profile) and Nelson Roman (See Profile) joined in the unsigned majority opinion. Justice Darcel Clark (See Profile) dissented, joined by Justice Sallie Manzanet-Daniels (See Profile).

The dispute goes back to 2007, when hedge fund Paulson & Co., anticipating the collapse of the subprime mortgage market, asked Goldman to package residential mortgages into a type of security known as a collateralized debt obligation that was designed to fail so that Paulson could short it.

Goldman hired ACA Management LLC to choose the securities that were to go into the collateralized debt obligation, called ABACUS. Paulson also helped choose the securities that would go into ABACUS.

ACA Management affiliate ACA Financial Guarantee Corp. agreed to insure ABACUS, which meant ACA had a long position in the security.

ACA claims it was misled into believing that Paulson also had a long position on ABACUS. It claims that if it had known that Paulson had a short position, it would never have insured ABACUS.

When ABACUS was finally marketed to investors, the promotional materials said that ACA had selected the securities, without disclosing Paulson’s role. By the end of 2007, the mortgage-backed securities market had collapsed, and investors in ABACUS lost nearly all of their investments, putting ACA on the hook for insurance payouts. Paulson made about $1 billion from shorting ABACUS.

In 2010, Goldman agreed to pay the U.S. Securities and Exchange Commission $515 million to settle a complaint over ABACUS. As part of that settlement, Goldman admitted that it was a "mistake" to market ABACUS to investors without disclosing that Paulson helped create it and was shorting it.

In 2011, ACA Financial Guaranty sued Goldman for fraud in connection with ABACUS. Kapnick denied Goldman’s motion to dismiss ACA’s suit (NYLJ, April 26, 2012).

The First Department, however, found that while ACA had "adequately pleaded all of the requisite elements comprising a fraud claim," the complaint "nevertheless fails to establish justifiable reliance as a matter of law."

"Indeed, plaintiff fails to plead that it exercised due diligence by inquiring about the nonpublic information regarding the hedge fund with which it was in contact prior to issuing the financial guaranty, or that it inserted the appropriate prophylactic provision to ensure against the possibility of misrepresentation," the majority said.

In support of that finding, the panel cited the First Department’s 2010 decision in Centro Empresarial Cempresa v. América Móvil, 76 AD3d 310, 320-321, which was affirmed by the Court of Appeals.

The plaintiffs in that case alleged they were fraudulently induced to sell their interest in an Ecuadorian telecommunications company. The First Department ruled that the suit was barred by a release of claims included in the sale agreement.

If the plaintiffs in Centro wanted to preserve their ability to sue for fraud in the future, they should have included a provision in the release that said the release would only apply if the information provided by the defendant was true, the court held in Centro.

Unlike the agreement in Centro, the agreement between ACA and Goldman includes no general release. Nonetheless, the First Department majority ruled that the Centro logic applies, and that ACA should have included a "prophylactic provision" in its agreement with Goldman preserving that right.

The majority also wrote that ACA could have found out that Paulson was shorting ABACUS by conducting its own inquiry, "but apparently chose not to."

ACA "should have questioned defendant or the non-party hedge fund; such an inquiry would have likely informed plaintiff that the nonparty hedge fund was taking a short rather than a long equity position represented," the majority wrote.

Clark, in her dissent, said that given the "unique set of facts" in the case, ACA had shown both fraud and justifiable reliance.

She said that Paulson was described to ACA as the "transaction sponsor," and that normally the transaction sponsor in a collateralized debt obligation is an equity investor—that is, it takes a long position.

Furthermore, she said, when ACA asked Goldman about what role Paulson would have, Goldman affirmatively said that Paulson’s interests were aligned with ACA’s. Goldman also said that it had a "pre-committed" investment in the highest-risk tier of ABACUS. Since ABACUS had not been publicly marketed at that time, the only possible pre-committed investor was Paulson, Clark wrote.

"Although plaintiff is a sophisticated business entity, based on the unique set of facts presented in this appeal, the duty to perform due diligence was fulfilled, when, as here, plaintiff asked defendant about Paulson’s position, defendant made specific and detailed representations that conformed with the industry standard for a similarly situated transaction, and defendant’s misrepresentation was not discoverable through any public source of information," Clark wrote.

She said that Centro does not apply because there was no general release agreement between ACA and Goldman.

Sullivan & Cromwell partner Richard Klapper represents Goldman.

A Goldman spokeswoman said the company was "pleased" with the decision.

Marc Kasowitz of Kasowitz Benson Torres & Friedman, who represents ACA, said, "As the two-judge dissent makes clear, the majority’s line of reasoning neither comports with the factual record nor the law on this issue."

He also said ACA would pursue an appeal to the Court of Appeals and is considering whether to move for reconsideration before the Appellate Division because of the facts "apparently overlooked by the majority."

Kasowitz noted that this decision relates to the first amended complaint, and that a second amended complaint, which added Paulson as a party as well as other allegations, is pending before Kapnick.