Loss Causation Outside the Securities Context

G THE B IN EN V C R H E

S

A N 8 8 D 8 B 1 AR SINCE Web address: http://www.nylj.com Volume 238—no. 81 thursday, october 25, 2007 Second Circuit Review

By Martin Flumenbaum and Brad S. Karp Loss Causation Outside the Securities Context

n Merrill Lynch & Co. v. Allegheny Energy, Moreover, Allegheny alleged that Merrill failed Inc.,1 a decision of potentially great to disclose material facts about GEM’s Chief significance, the U.S. Court of Appeals Executive Officer, Dan Gordon. Mr. Gordon Ifor the Second Circuit distinguished “loss had embezzled $43 million from Merrill and causation” in the context of securities fraud from was later convicted and jailed for his conduct. “proximate cause” in the context of common Although there was no direct evidence that law fraud. Merrill’s officers knew of the embezzlement Although acknowledging that the two concepts prior to Allegheny’s acquisition of GEM, some are closely related, the court refused to extend the officials within Merrill allegedly were aware that prodefendant doctrine of loss causation set forth Martin Flumenbaum Brad S. Karp Mr. Gordon had intentionally evaded Merrill’s by the U.S. Supreme Court in Dura2 beyond the internal controls on credit and knew that he had securities fraud context. lied about the evasion. After the sale of GEM Consequently, the court ruled that the was complete, Mr. Gordon admitted that he however, refused to honor Merrill’s sell-back traditional doctrine of “proximate cause” must knowingly had given Allegheny false financial option, questioning the accuracy of representations be used by district courts in evaluating common information about GEM. that Merrill allegedly had made during the earlier law fraud damages claims. The district court ruled in favor of Merrill in negotiations for Allegheny’s purchase of GEM. this dispute, awarding $115 million to Merrill for Merrill sued to enforce its sell-back option, and its two-percent stake in Supply and finding that Background and Procedural History Allegheny filed counterclaims for fraudulent Allegheny had failed to prove its counterclaims. The dispute in Allegheny Energy arose from inducement and breach of warranty. The district court found that Allegheny was Allegheny Energy’s January 2001 acquisition Allegheny’s counterclaims turned on Merrill’s “never in the dark” about the Williams contract of Global Energy Markets (GEM), an energy- alleged representations about GEM’s finances in or the September and October financial reports,3 commodities trading business. Upon purchasing fall 2000, just before Allegheny’s acquisition of and, based on the information it received, GEM from Merrill Lynch, Allegheny created a GEM and the subsequent formation of Supply. Allegheny “could visualize the wild fluctuations” wholly owned subsidiary called Allegheny Energy Merrill allegedly represented that it had recognized and should have “realized the incredible difficulty Supply Co. LLC (Supply), which assumed all $32 million in revenues from a particular GEM in nailing down any sort of concrete value” for the of GEM’s assets. Under the terms of the deal, contract (the “Williams contract”) in October Williams contract.4 Allegheny paid $490 million for GEM and gave 2000, even though an expert hired by Merrill Merrill a two-percent interest in Supply. The deal supposedly calculated that Merrill had suffered a also permitted Merrill to sell back this interest $10.5 million loss from the Williams contract in Second Circuit Decision for an agreed price of $115 million, if Allegheny the same month. The September 2000 financial • Subject Matter Jurisdiction. Before failed to contribute certain assets to Supply. report that Merrill provided to Allegheny allegedly addressing the merits, the Second Circuit, in a After the stock market dropped in fall 2001, reported inflated revenues and income from the decision written by Judge Richard J. Cardamone Allegheny failed to contribute the assets required Williams contract. In addition to these asserted and joined by Judges John Walker and Reena by the agreement, so Merrill exercised its option inaccuracies, Allegheny complained that the Raggi, first addressed whether the district court’s to sell back its interest in Supply. Allegheny, financial reports it received from Merrill were joinder of a nondiverse party (Supply) destroyed not prepared by Merrill’s finance department diversity or whether the district court appropriately and differed significantly from the financial exercised supplemental jurisdiction over the numbers represented in Merrill’s own books. claims of that party. Although Supply and Merrill According to Allegheny, when Merrill realized were both Delaware citizens, the district court Martin Flumenbaum and Brad S. Karp are the discrepancies between the fall financial reports had joined Supply’s claims earlier in the dispute, members of Paul, Weiss, Rifkind, Wharton & Garrison 5 LLP. They specialize in complex commercial litigation and its own internal numbers, it partially corrected finding that Supply was a necessary party. The and white-collar criminal defense matters. Larry A. them, but the reports allegedly still overstated Second Circuit found the district court’s joinder Coury, a litigation associate at the firm, assisted in revenues derived from sources other than the to be inappropriate, relying on the intervening the preparation of this column. Williams contract. Supreme Court decision in Exxon Mobil Corp. New York Law Journal thursday, october 25, 2007

6 v. Allapattah Servs., Inc., and holding that a not foreclose it from proving reliance on Merrill’s Breach of Warranty “failure of diversity…contaminates the action, material misrepresentations, on remand. so to speak, and takes away any justification for • Fraudulent Inducement: Proximate Finally, the court determined that Allegheny’s providing a federal forum.”7 Despite this failure Cause. Even if Allegheny could prove justifiable fraudulent inducement claim was not duplicative of diversity and apparent lack of jurisdiction, reliance on remand, it still must demonstrate that of its breach of warranty claim. The court the Court retroactively dismissed Supply from Merrill’s misrepresentations caused its damages. explained that breach-of-contract claims generally the case, finding that Allegheny had implicitly The district court relied heavily on securities involve promises of prospective performance, consented to Supply’s characterization as a fraud cases in evaluating the proximate cause while fraudulent inducement claims generally dispensable party and noting that “the retroactive of Allegheny’s alleged damages. In particular, involve misstatements and omissions of present absence of Supply…is not prejudicial to Supply, the district court noted that Dura and other facts. Notwithstanding this distinction, the court defendant or plaintiff.”8 cases “have repeatedly shown that overpayment held that a breach of contractual warranties does • Fraudulent Inducement: Reliance on a alone does not prove causation and a claimant not necessarily require prospective performance Misrepresented Material Fact. The court next to collect on such a theory must prove that the and may simultaneously represent a misstatement addressed the merits of Allegheny’s counterclaims breach or misrepresentation resulted in an actual or omission of present facts. The court also held for fraudulent inducement and breach of injury or loss not attributable to other factors.”16 that the required proof of proximate cause is the warranty. The court explained that Allegheny The district court expressly rejected Allegheny’s same for the fraudulent inducement and breach must prove that Merrill “knowingly or recklessly argument that Dura is distinguishable because it of warranty claims. misrepresented a material fact, intending to induce involved a securities fraud claim in connection [Allegheny’s] reliance, and that [Allegheny] relied with a publicly traded company. The district court Conclusion on the misrepresentation and suffered damages found that inasmuch as Allegheny received a The Second Circuit’s holding in Allegheny 9 as a result.” In addition, because Allegheny was substantial benefit from GEM in the year following Energy, distinguishing the requirement to prove alleging fraud by omission, the court ruled that the acquisition and may not have overpaid as a “loss causation” in securities fraud cases from it must prove that Merrill “had a duty to disclose result, Allegheny consequently failed to prove the requirement to prove proximate cause in 10 the concealed fact.” loss causation under Dura. common-law fraud cases, may be quite significant. The contract contained two warranties that The Second Circuit rejected the district The business community is closely monitoring “imposed a duty on Merrill Lynch to provide court’s reasoning, and ruled that Dura was not how this case plays out on remand. accurate and adequate facts and entitled Allegheny controlling and that Allegheny could pursue its to rely on them without further investigation damages claim. The court explained that “Dura’s •••••••••••••• •••••••••••••• or sleuthing.”11 The court noted that New York conclusion that overpayment alone cannot prove • law allows a party to rely on misrepresentations loss causation, as the district court incorrectly if they “relate to matters peculiarly within the believed, is based on the tailored application of 1. No. 05-7689-HB, —F.3d—, 2007 WL 2458411 (2d Cir. Aug. 31, 2007). other party’s knowledge.”12 In this case, the court these principles set out by the Supreme Court 2. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 determined that Merrill’s warranties represented in the securities context. Such application does (2005). 17 contractual stipulations that the information not govern here.” Because Allegheny purchased 3. Merrill Lynch & Co. v. Allegheny Energy, Inc., 2005 at issue was exclusively within its knowledge. a business pursuant to a contractual agreement, WL 1663265, at *4 (S.D.N.Y. July 18, 2005). Even so, Allegheny could not justifiably rely on New York law governs the construction of the 4. Id. representations it knew were false, so the court agreement and any proximate cause analysis. 5. Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., required Allegheny to prove, on remand, “that The court further explained that, under New 2003 WL 21254420, at *3 (S.D.N.Y. May 30, 2003) (citing Viacom Int’l, Inc. v. Kearney, 212 F.3d 721 (2d its reliance on the alleged misrepresentations was York law, “fraud damages represent the difference Cir. 2000)). not so utterly unreasonable, foolish or knowingly between the purchase price of the asset and its 6. 545 U.S. 546 (2005). blind as to compel the conclusion that whatever true value.”18 The court reasoned that Allegheny’s 7. Merrill Lynch, 2007 WL 2458411, at *5. injury it suffered was its own responsibility.”13 purchase of GEM at the agreed price must have 8. Id. at *6. The court noted that GEM’s CEO, Dan resulted from the value placed on the intrinsic 9. Id. at *7. Gordon, misrepresented financial information qualities of the company at the time of the 10. Id. that was given to Allegheny and committed sale and distinguished this situation from the 11. Id. at *8. 12. Id. crimes against Merrill, thereby harming both acquisition of securities, which “are purchased 13. Id. parties. Nonetheless, the court held that, as his for the purpose of investment and their true value 14. Id. at *7 (citing Grumman Allied Indus., Inc. v. employer, Merrill must accept the responsibilities to the investor is the price at which they may Rohr Indus., Inc., 748 F.2d 729, 737 (2d Cir. 1984)). and risks arising from Mr. Gordon’s actions. later be sold.”19 15. Id. at *7. The court explained that “New York courts are Therefore, if Allegheny can prove that Merrill 16. Merrill Lynch, 2007 WL 1663265, at *7. generally skeptical of claims of reliance asserted fraudulently misrepresented the value of those 17. Merrill Lynch, 2007 WL 2458411, at *9. 18. Id. by ‘sophisticated businessmen engaged in major intrinsic qualities, Allegheny may show that it 19. Id. at *10. transactions [who] enjoy access to critical acquired an asset at a price that exceeded the true information but fail to take advantage of that value. In other words, if Allegheny purchased GEM access’”14—and stressed that both parties in this at an inflated price because Merrill made fraudulent litigation are “sophisticated business entities misrepresentations about GEM’s financials, then, that are held to a high standard of conduct.”15 according to the Second Circuit, it may have

The court noted that, in this case, inasmuch suffered damages that were the proximate cause of Reprinted with permission from the October 25, 2007 edition as Merrill failed to recognize Mr. Gordon’s the misrepresentations, even if it cannot otherwise of the New York Law Journal © 2007 ALM Properties, Inc. misrepresentations or his evasion of Merrill’s prove damages under the loss causation standard All rights reserved. Further duplication without permission is prohibited. For information, contact 212-545-6111 or visit credit controls, Allegheny’s sophistication may set forth in Dura. www.almreprints.com. # 070-10-07-0044