Reasonable Reliance Does Not Require Investor to Investigate CDO Credit Ratings

On December 29, 2015, the First Department issued a decision in Basis Yield Alpha Fund Master v. Morgan Stanley, 2015 NY Slip Op. 09645, explaining the scope of investigation required of a sophisticated investor for that investor's reliance on alleged misrepresentations to be reasonable.

In Basis Yield Alpha Fund Master, the First Department addressed "the question of whether a sophisticated investor has sufficiently alleged that it justifiably relied on credit ratings of securities that defendants, the organizers of the offering, allegedly had manipulated and otherwise knew, from nonpublic information, to be inaccurate." It held that the plaintiff's alleged reliance was reasonable, explaining:

Typically, the principle that a party to a transaction must take reasonable steps to protect itself against deception requires a plaintiff claiming to have been fraudulently induced to purchase a business, or to lend to a business, to allege that, before entering into the transaction, it availed itself of the opportunity to verify the seller's or borrower's representations through an examination of the business's books and records. As [the defendant] would have it, the principle operates to bar the fraud claims in this case because [the plaintiff] fails to allege that it asked [the defendant] any questions, or that it asked to review any documents or files in [the defendant's] possession, relating either to (1) the underwriting standards that were used in originating the loans backing the RMBS in the STACK collateral portfolio or (2) the models the ratings agencies used in assigning credit ratings to the STACK notes senior to [the plaintiff's] subordinated notes. We disagree.

In this case, the matters allegedly misrepresented — the standards used in underwriting the loans underlying the RMBS collateral and the methodology used in rating the senior tranches of the STACK CDO — both ultimately relate to the reliability of the credit ratings of the STACK notes. In essence, [the defendant] takes the position that, as a matter of law, [the plaintiff] failed to take reasonable steps to protect itself from deception because it did not seek to look behind the credit ratings of the STACK notes (or the credit ratings of the underlying RMBS collateral) to verify that the securities actually deserved those ratings by examining the rating agencies' methodologies or the records of the underwriting of the RMBS in the collateral portfolio. This amounts to an argument that the purchaser of a credit instrument is not entitled to rely on the accuracy of the credit rating assigned to that instrument by an accredited rating agency but, rather, must check that rating against the records of the underwriter's due diligence and, further, must inquire into the methodology by which the rating was generated. It appears to be [the defendant's] view that, if the investor fails to investigate such nonpublic information, it will have no claim against the underwriter or marketer of the instrument for having sold it with the undisclosed knowledge that the instrument's credit rating was based on an outdated methodology or on inaccurate information about the underlying assets.

If accepted, [the defendant's] position would require the prospective purchaser of a credit instrument to assume that the instrument's credit rating is fraudulent until the rating has been verified through a detailed retracing of the steps of the underwriter and credit rating agency. This would largely negate the utility of the credit ratings of negotiable bonds and notes that are published by accredited rating agencies. . . . We decline to hold that, based on the facts alleged, [the plaintiff] was obligated as a matter of law to seek to investigate the basis for the credit ratings of the STACK notes or of the RMBS in the collateral portfolio.

(Internal quotations and citations omitted).