A Major Securities Misselling Claim Arising From The Global Financial Crisis
18 April 2023
The trial that commenced in the Commercial Court in London this week must surely be one of the very last law suits arising from the global financial crisis of 2008 [Loreley Financing (Jersey) No 30 Limited - v - (1) Credit Suisse Securities (Europe) Limited; (2) Credit Suisse International; (3) Credit Suisse Securities (USA) LLC; and (4) Credit Suisse AG (FL-2018-000019)]. Credit Suisse entities are accused by the claimant, Loreley, of having fraudulently sold to it US$100 million of CDOs (Collateralised Debt Obligations) in 2007. The CDOs (issued by an Irish-incorporated special purpose vehicle, Magnolia Finance II plc) referenced a portfolio of US RMBS dating from the mid 2000's. The value of that reference portfolio collapsed and the CDOs defaulted. They were redeemed with a total loss of their principal amount - less than 3 years after their issue date.
Loreley’s claim is based on the findings by the US Department of Justice in January 2017 of fraudulent behaviour by Credit Suisse. The press release accompanying the publication of the Department of Justice report stated: “Credit Suisse claimed its mortgage-backed securities were sound, but in the settlement announced today the bank concedes that it knew it was peddling investments containing loans that were likely to fail”. The claimant alleges that the Department of Justice findings demonstrate that Credit Suisse committed the tort of deceit in structuring and selling the Magnolia Finance II CDOs and in failing to act honestly in securitising a number of RMBS deals that were included in the Magnolia reference portfolio.
In particular, Loreley alleges that Credit Suisse represented to investors and rating agencies that the mortgage loans which it securitised into RMBS had particular characteristics which were material to the value and credit quality of the RMBS and made further representations regarding its RMBS processes (e.g. (i) that the mortgage loans were originated generally in accordance with applicable underwriting guidelines (except where sufficient compensating factors were demonstrated by a prospective borrower) and (ii) that the loan pools had particular loan-to-value ratios. Loreley claims that the Department of Justice settlement shows that those representations were false and made with fraudulent intent.
Complex legal arguments
This case will deal with a number of complex legal issues including the question of whether Loreley‘s claim is time-barred, or whether, on the contrary, the applicable limitation period, in this case, only began to run from the date on which the claimant discovered, or could, with reasonable diligence have discovered, the frauds that the settlements reached with the Department of Justice exposed, and which Credit Suisse then acknowledged.
It is expected that the Court will also consider the issue of the requisite state of mind (“contemporaneous, conscious thought”) of any claimant alleging fraudulent breach by the defendant of an implied representation, which question has been the subject of some considerable judicial attention in recent times.
In this case, Loreley brings claims in deceit and fraudulent misrepresentation, with the main remedy sought being rescission, entitling it to the repayment to it of the entire principal amount of its investment (US$100 million) plus lost interest. A particular point of legal interest will be the Court's finding on whether the remedy of rescission is possible where the Notes, having defaulted and been extinguished, can be returned to the defendant.
Why have so few such claims come before the English courts?
Perhaps one of the more remarkable aspects of this case is that it appears to be one of a kind in bringing fraud mis-selling claims based on the findings of Department of Justice investigations into the behaviour of the major global banks in the aftermath of the global financial crisis. Indeed, the Department of Justice had completed, by early 2017, investigations into seven of those banks, resulting in aggregate fines being levied of almost US$60 billion (Note 1).
This dearth of law suits brought in the English courts should be considered in light of the huge volume of CDOs created in the run-up to the global financial crisis. It was reported in a New York Times article in April 2008 ("Triple-A Failure") that: "As the [credit rating} agencies endowed CDO securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of CDO’s backed by lower-rated mortgage paper." And, indeed, this is not the entire picture because it does not take account of CDOs backed by higher-rated RMBS paper, as indeed, were the Magnolia Finance II CDOs.Why then, given the volume of failed CDOs linked to US RMBS (and related products such as Credit Linked Notes, often privately-placed) that were manufactured and distributed by the London operations of the global banks, have there been so relatively few attempts by investors to seek redress in the English courts?
Different from the current Credit Suisse AT1 Notes furore
Lest anyone wonder whether the claim being pursued by Loreley is not simply another case in which the principle of “caveat emptor” should apply (as is being discussed more widely in the context of another Credit Suisse story of current interest - the wipe-out of its AT1 bonds) let us be clear that no amount of reasonable due diligence in 2007 could have revealed the fraud that is set out in the Department of Justice settlement of 2017.
Note 1. The DoJ has reached the settlements with the following banks:
November 2013 - JPMorgan
July 2014 - Citibank
August 2014 - Bank of America/Merrill Lynch
February 2016 - Morgan Stanley
April 2016 - Goldman Sachs
January 2017 - Credit Suisse
January 2017 - Deutsche Bank
The terms of each DoJ Settlement include broad acknowledgements by the relevant bank that it knew that representations made in its RMBS offering documents were false and misleading.