In a recent decision, Terra Securities Asa Konkursbo v. Citigroup, Inc., Nos. 10-4712-cv and 10-4714-cv, 2011 WL 6067260 (2d Cir. Dec. 7, 2011), the United States Court of Appeals for the Second Circuit expanded upon prior Second Circuit precedent regarding the due diligence obligations of sophisticated plaintiffs and opened new avenues for potential defenses in securities fraud cases brought by sophisticated investors. Specifically, the Court held that before a sophisticated investor alleging common law fraud or misrepresentation can claim reasonable reliance upon a purported misrepresentation or omission, the investor must demonstrate that he or she undertook an independent investigation of any available information relevant to the alleged misrepresentation or omission. Alternatively, the investor must show that information that might have disclosed the misrepresentation or omission was unavailable or inaccessible through minimal diligence. Significantly, under the Second Circuit’s analysis, “available information” includes information that was available to the sophisticated investor both inside and outside the transaction. In many cases, this will be a difficult hurdle for a sophisticated investor to meet.
In Terra Securities, four sophisticated plaintiffs, a bank, two insurance subsidiaries, and a successor to a brokerage firm (collectively, the “Appellants”) and seven Norwegian municipalities (the “Municipalities”) (all, collectively, the “Plaintiffs”) brought federal securities fraud and common law fraud claims against Citigroup Inc. and various Citigroup affiliates (collectively, “Citigroup”), alleging over $47 million in losses from investments in fund-linked notes (“FLNs”) that were marketed and sold by Citigroup as an arbitrage opportunity and hedging strategy. See Terra Secs. Asa Konkursbo v. Citigroup, Inc., 740 F. Supp. 2d 441, 445-46 (S.D.N.Y. 2010). Plaintiffs alleged, among other things, that Citigroup materially misrepresented the hedging strategy through “false and misleading” representations of the correlation between long-term municipal bond rates and LIBOR swap rates on a graph contained within Citigroup’s marketing materials for the FLNs. Id. at 445-46. They also claimed that Citigroup’s marketing materials failed to disclose the credit risk and liquidity risk associated with the hedging strategy. Id. at 446.
In reviewing the District Court’s dismissal of Appellants’ common law fraud and misrepresentation claims under Rule 12(b)(6), the Second Circuit first recognized that under New York law1,in order to determine whether a party’s reliance upon an alleged misrepresentation was reasonable, the Court must consider the “entire context of the transaction,” including its “complexity and magnitude, the sophistication of the parties, and the content of any agreements between them.” Terra Secs., 2011 WL 6067260, at *1 (quoting Emergent Cap., 343 F.3d at 195). After affirming the District Court’s determination that Appellants were sophisticated investors2, the Second Circuit stated:
It is well established that [w]here sophisticated businessmen engaged in major transactions enjoy access to critical information but fail to take advantage of that access,New York courts are particularly disinclined to entertain claims of justifiable reliance . . . . In addition, this Court has made clear that “sophistication of the parties” factors into the determination of whether research, and how much, is reasonably required in any given case.3
Id. (emphasis added) (citations and internal quotations omitted).
Weighing these factors, the Court found that even though Appellants were sophisticated investors, they failed to conduct any “independent investigation” prior to making the investments at issue. Id. at *2. Appellants also failed to make an effort to “verify any of [Citigroup’s] alleged misrepresentations. Id. Finally, the Court recognized that Appellants failed to investigate “critical information . . . necessary to evaluate the allegedly concealed risks inherent in [their] investments.” Id. at *2 (citing Lazard Freres, 108 F.3d at 1541) (internal quotations omitted). Significantly, the Court found that this critical information — which included historical municipal bond yields and interest rate date — was available to Appellants and not solely within Citigroup’s knowledge.4 Id. For all of these reasons, the Second Circuit affirmed the District Court’s determination that Appellants’ purported reliance upon Citigroup’s alleged misrepresentations was unreasonable under the circumstances.
In sum, under Terra Securities, a sophisticated investor alleging common law fraud or misrepresentation must be prepared to show either that: (i) it undertook an independent investigation of accessible information relevant to its fraud and misrepresentation claims — in particular, any information that might have shed light upon the alleged misrepresentation or omission, or (ii) such information was unavailable or inaccessible to the sophisticated investor through minimal diligence, both inside and outside the transaction at issue. Notably, in Terra Securities, as in Emergent and Lazard Freres, the Second Circuit made no distinction between sophisticated corporate entities and sophisticated individuals. Therefore, these decisions can be cited in defense of fraud and misrepresentation claims brought by any sophisticated investor, including individuals.
1 See Emergent Capital Investment Mgt., LLC v. Stonepath Grp., Inc., 343 F.3d 189, 196 (2d Cir. 2003) (holding that sophisticated plaintiff’s failure to protect itself by including critical factual representation from defendant in stock purchase agreement precluded finding of reasonable reliance upon defendant’s alleged misrepresentations); Lazard Freres & Co. v. Protective Life Ins. Co., 108 F.3d 1531, 1543 (2d Cir. 1997) (holding that defendant’s failure to include protective condition in contract at issue precluded it from relying upon plaintiff’s alleged misrepresentation as a2
2 The District Court’s finding that Appellants were sophisticated investors was based upon admissions contained in their respective complaints and relevant agreements. 740 F. Supp. 2d at 449 (quoting Emergent Cap., 343 F.3d at 196 (“Representations by a plaintiff that it had ‘knowledge and experience in financial and business matters and that it could readily evaluate the risks of the transaction’ can indicate sophistication for the purposes of this analysis.”)) By contrast, the District Court found that the Municipalities were not sophisticated investors based on the parties’ agreement to this effect. Id. at 449 n. 5. Neither the Municipalities nor Citigroup appealed the District Court’s denial of Citigroup’s motion to dismiss the Municipalities’ common law fraud and misrepresentation claims.
3 Before the lower court, Appellants had attempted to argue that “available information” was limited to the information that was supplied to them by Citigroup. The District Court rejected this claim:
Plaintiffs mischaracterize what constitutes available information for the purposes of the present inquiry. The availability of information in this context is not whether the requisite material was made available to Plaintiffs by [Citigroup]. Rather, available in this context denotes accessible — would the information necessary to unmask the alleged fraud have been accessible to the sophisticated party through minimal diligence.
740 F. Supp. 2d at 449 (emphasis added).
4 The District Court had concluded that, as sophisticated investors, Appellants were in a position to acquire additional information regarding the alleged misrepresentations. 740 F. Supp. 2d at 450 (citation omitted). In particular, an explicit risk disclosure contained in Citigroup’s marketing materials specifically addressed the graph and hedging strategy at issue, stating that one of the funds to which the FLNs were linked “may experience substantial volatility due to dissentions in the relationship of the municipal bond investments and the hedging instruments.”Id. The District Court found that this disclosure “when viewed in tandem by a sophisticated appraiser, should have resulted in a dissonant picture that looked decisively like a red flag.” Id.The Court also determined that certain flaws in Citigroup’s marketing materials should have been readily apparent to sophisticated investors like Appellants, who could have requested and obtained additional information regarding the statistical analysis and bond investments reflected in the marketing materials. Id. at 450. This would have led Appellants to conduct an “independent appraisal” of the graph and hedging strategy. Id.