The Effects of Assured Guaranty on Securities Law

Since its passage, the Martin Act (like other blue-sky laws) had progressively given way to federal securities regulations and enforcement. That situation changed dramatically in 2001, when then-New York State Attorney General Eliot Spitzer recognized its broad powers and re-established the Martin Act as among the strongest securities fraud statutes in the country. Since that time, New York's top prosecutors have used the Martin Act to bring actions against virtually every large financial institution, extracting billions in settlements and fines.

The Martin Act was not, however, all gloom and doom for the industry. Few outside the securities bar appreciated it, but the Martin Act served a pivotal role in shielding issuers and financial institutions from exposure to private causes of action for non-fraud securities claims under New York law. Although investors could bring claims under the federal securities laws, such claims could generally be brought only in federal court and are subject to rigorous pleading and liability standards.

For cases governed by New York law, conventional wisdom had been that the Martin Act precluded private investors and other affected parties from bringing parallel securities claims under traditional “common-law” standards of negligence or breach of fiduciary duty. Although the law was not completely settled, most state and federal courts (including the federal appeals court for the Second Circuit) had held that such common-law claims were preempted and that only the attorney general could enforce the Martin Act.

That changed late last year, when New York's highest court issued an opinion in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, NYLJ 1202536232292, at *1 (Ct. of App., Decided Dec. 20, 2011), that turned conventional wisdom on its head. The Court of Appeals unanimously ruled (with one recusal) that the Martin Act does not, as previously thought, bar common-law claims for negligence and breach of fiduciary duty relating to the distribution, exchange, sale, and purchase of securities.

The Effects

Some plaintiffs' lawyers, like Robert Wallner of Milberg, NY, believe the decision creates a “landmark change in the law,” one that could open the floodgates for a new wave of high-stakes litigation. This decision (and the warm welcome it received from plaintiffs' lawyers) will cause justifiable concern within the financial services community ' although there is reason to question the ultimate impact it will have on litigation recoveries.

What can reasonably be expected, then, in the short-term wake of Assured Guaranty?

First, at least some new and amended complaints have already been filed, and more are surely forthcoming, although whether to expect a downpour or a drizzle remains to be seen. For years, private plaintiffs seeking questionable damages for securities losses have been squeezed from many sides.

The heightened pleading and proof requirements of the federal Private Securities Litigation Reform Act of 1995 and Securities Litigation Uniform Standards Act of 1998 ' together with recent U.S. Supreme Court decisions in Stoneridge, Twombly, and Morrison ' have frustrated plaintiffs' efforts to use the courts as a tool for extending the reach of securities laws in support of dubious claims. Although far from a silver bullet, these laws and decisions at least filter out lawsuits premised on paper-thin allegations of misconduct.

Now, however, the Court of Appeals has cleared a path that was, prior to this development, uncertain at best. Given the first inning, there is good reason to expect the plaintiffs' bar to swing for the fences. Indeed, in the several months since the decision in Assured Guaranty was issued, numerous actions sounding in common-law negligence have been filed in New York state court in an effort to recover for losses in connection with residential mortgage-backed securities.

Second, the Court of Appeals has effectively deputized private investors and trial lawyers to bring actions similar to those that, until now, could be brought only by the State. As a result, Attorney General Eric Schneiderman (who filed an amicus brief advocating for the court's decision in Assured Guaranty) and his staff will continue to focus on select matters while keeping an eye on private plaintiffs as they go toe-to-toe with financial institutions.

Undoubtedly, the work of litigious investors and their lawyers will draw the attorney general's attention to cases that might otherwise have flown under the radar. We anticipate the attorney general will launch new investigations as he sees fit during or in the aftermath of such litigation.

Third, we can expect an initial measure of inconsistency in the case law issued from New York's lower courts; for while Assured Guaranty answers one question, it also asks ' and leaves unresolved ' many more.

Until now, the majority of courts have assumed that the Martin Act preempts non-fraud common-law claims. As a result, many plaintiffs who asserted such claims only to have them dismissed prior to discovery or trial may feel that they did not have their day in court. Whether these claims will be revived through motions for reconsideration may depend in large part on the discretion of individual judges and lead to divergent outcomes.

A more interesting procedural question may involve plaintiffs who, based on the reasonable view that the Martin Act preempted non-fraud common-law claims, declined to assert common-law claims altogether. Will they get another turn at bat? In our view, they should not ' the decision in Assured Guaranty did not purport to change the law, only to clarify that a private litigant could pursue non-fraud securities claims that are not “predicated solely on a violation of the Martin Act.” Without doubt, securities plaintiffs will clamor to revisit past claims, and the results may be inconsistent.

Practicalities

From a practical perspective, the waters grow even murkier. The court of appeals appears to be willing to subject public disclosures and investment advice to a negligence test. Such tests require the determination of an “objective standard of care” that must be met in order to avoid liability. How will courts applying New York law determine what is “reasonable” in connection with statements made in securities offerings? On this issue, we suspect that, as with Assured Guaranty itself, each question a lower court asks will beg yet another. Instead of arriving at an “objective standard of care,” myriad subjective standards of care will emerge and ultimately need to be reconciled by the Court of Appeals ' if such reconciliation is even possible.

These are questions that plaintiffs' lawyers and investors will be quite willing to ask in lawsuit after lawsuit. Increasingly, these questions will be put to a state judicial system already underfunded, understaffed, and overwhelmed. Just six days before the decision in Assured Guaranty, a survey conducted by the New York County Lawyers' Association revealed that the $170 million in reductions to the state court system's budget “are having a profound effect on those who work with and in the courts, and are adversely affecting access to justice.”

To make matters worse, many common-law causes of action that purport to arise from the recent global financial crisis will soon run up against New York's three-year statute of limitations for negligence actions. In order to preserve the rights conferred upon them by Assured Guaranty, many plaintiffs will be racing to the courthouse. The combination of overburdened courts and an overeager plaintiffs' bar makes this perhaps the worst imaginable time to invite an onslaught of new and revived litigation.

Finally, for the financial institutions themselves, this decision will likely bring increased headaches and cost. Even before considering how to respond to actual litigation, institutions may need to address whether to alter their day-to-day operations in order to immunize themselves more effectively against negligence and breach of fiduciary claims. Any steps taken are likely to incur substantial cost in terms of time and resources.

Once litigation is filed, it will likely last longer and cost more; for although non-fraud common-law claims present unique issues of proof and additional defenses (such as contributory or comparative negligence, the economic loss doctrine, etc.), such claims are fact-intensive and notoriously difficult to dismiss prior to trial.

Even the process of selecting counsel may have to be re-evaluated. Because their respective legal interests are often aligned, financial institutions can, in many instances, pool their resources to retain one “lead” counsel to combat private fraud claims. If, however, each institution is forced to prove its own adherence to a standard of reasonable care, it may be more difficult to take a “one for all” approach to retaining counsel. Each additional layer of cost will adversely affect investors in the form of higher fees, higher transaction costs, and lower returns.

Conclusion

In Assured Guaranty, the Court of Appeals has paved the way for extensive and costly litigation, further burdening our already strained judicial system, adding yet another layer of uncertainty in our financial services industry, and ultimately bringing lower returns to investors.

Unfortunately, given that Assured Guaranty is now the final word from the State of New York, any hopes for a judicial remedy are slim. The legislature is thus likely the best and only hope to re-level the playing field in cases governed by New York law ' and there is reason to believe it might. After all, the legislature watched as a consistent body of state and federal case law was written, ignoring repeated calls from trial lawyers to expand the scope of the Martin Act. Now, it can no longer afford to stand idle.

The legislature is uniquely positioned to clarify this issue and return us to the status quo. If it refuses, the clouds hanging over our financial services institutions may grow darker. Now that the Court of Appeals has done what the plaintiffs' bar failed to do for two decades, it is time for the legislature to amend the Martin Act to restore the preemption of non-fraud common-law claims.

Michael Simes is a partner in the New York office of McGuire Woods, where he routinely represents leading financial institutions in complex commercial and bankruptcy litigation, securities litigation, and government investigations. He can be contacted at [email protected]. Laurent Wiesel, also a partner in the New York office, has advised major corporations, financial institutions, and individuals in a broad range of matters, including commercial and corporate disputes, securities class actions, international arbitration, regulatory and criminal investigations, antitrust litigation, and actions involving the interests of foreign sovereigns. He can be contacted at [email protected]. This article also appeared in Corporate Counsel, an ALM sister publication of this newsletter.

When prominent plaintiffs' lawyers applaud a “landmark change in the law,” prudence calls for reflection. Such is the case with the recent New York Court of Appeals decision clarifying the scope of the Martin Act ' a decision that does, in fact, settle a longstanding question regarding securities-related claims by private litigants under New York State law.

Background

For financial industry professionals, the Martin Act is widely known as the sword brandished by the New York Attorney General's office to investigate and prosecute fraud in the financial services sector. Passed by the state legislature in 1921, the act is New York's version of a “blue-sky” law. The law was enacted to “create a statutory mechanism in which the attorney general would have broad regulatory and remedial powers to prevent fraudulent securities practices by investigating and intervening at the first indication of possible securities fraud on the public and, thereafter, if appropriate, to commence civil or criminal prosecution.”

Since its passage, the Martin Act (like other blue-sky laws) had progressively given way to federal securities regulations and enforcement. That situation changed dramatically in 2001, when then-New York State Attorney General Eliot Spitzer recognized its broad powers and re-established the Martin Act as among the strongest securities fraud statutes in the country. Since that time, New York's top prosecutors have used the Martin Act to bring actions against virtually every large financial institution, extracting billions in settlements and fines.

The Martin Act was not, however, all gloom and doom for the industry. Few outside the securities bar appreciated it, but the Martin Act served a pivotal role in shielding issuers and financial institutions from exposure to private causes of action for non-fraud securities claims under New York law. Although investors could bring claims under the federal securities laws, such claims could generally be brought only in federal court and are subject to rigorous pleading and liability standards.

For cases governed by New York law, conventional wisdom had been that the Martin Act precluded private investors and other affected parties from bringing parallel securities claims under traditional “common-law” standards of negligence or breach of fiduciary duty. Although the law was not completely settled, most state and federal courts (including the federal appeals court for the Second Circuit) had held that such common-law claims were preempted and that only the attorney general could enforce the Martin Act.

That changed late last year, when New York's highest court issued an opinion in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, NYLJ 1202536232292, at *1 (Ct. of App., Decided Dec. 20, 2011), that turned conventional wisdom on its head. The Court of Appeals unanimously ruled (with one recusal) that the Martin Act does not, as previously thought, bar common-law claims for negligence and breach of fiduciary duty relating to the distribution, exchange, sale, and purchase of securities.

The Effects

Some plaintiffs' lawyers, like Robert Wallner of Milberg, NY, believe the decision creates a “landmark change in the law,” one that could open the floodgates for a new wave of high-stakes litigation. This decision (and the warm welcome it received from plaintiffs' lawyers) will cause justifiable concern within the financial services community ' although there is reason to question the ultimate impact it will have on litigation recoveries.

What can reasonably be expected, then, in the short-term wake of Assured Guaranty?

First, at least some new and amended complaints have already been filed, and more are surely forthcoming, although whether to expect a downpour or a drizzle remains to be seen. For years, private plaintiffs seeking questionable damages for securities losses have been squeezed from many sides.

The heightened pleading and proof requirements of the federal Private Securities Litigation Reform Act of 1995 and Securities Litigation Uniform Standards Act of 1998 ' together with recent U.S. Supreme Court decisions in Stoneridge, Twombly, and Morrison ' have frustrated plaintiffs' efforts to use the courts as a tool for extending the reach of securities laws in support of dubious claims. Although far from a silver bullet, these laws and decisions at least filter out lawsuits premised on paper-thin allegations of misconduct.

Now, however, the Court of Appeals has cleared a path that was, prior to this development, uncertain at best. Given the first inning, there is good reason to expect the plaintiffs' bar to swing for the fences. Indeed, in the several months since the decision in Assured Guaranty was issued, numerous actions sounding in common-law negligence have been filed in New York state court in an effort to recover for losses in connection with residential mortgage-backed securities.

Second, the Court of Appeals has effectively deputized private investors and trial lawyers to bring actions similar to those that, until now, could be brought only by the State. As a result, Attorney General Eric Schneiderman (who filed an amicus brief advocating for the court's decision in Assured Guaranty) and his staff will continue to focus on select matters while keeping an eye on private plaintiffs as they go toe-to-toe with financial institutions.

Undoubtedly, the work of litigious investors and their lawyers will draw the attorney general's attention to cases that might otherwise have flown under the radar. We anticipate the attorney general will launch new investigations as he sees fit during or in the aftermath of such litigation.

Third, we can expect an initial measure of inconsistency in the case law issued from New York's lower courts; for while Assured Guaranty answers one question, it also asks ' and leaves unresolved ' many more.

Until now, the majority of courts have assumed that the Martin Act preempts non-fraud common-law claims. As a result, many plaintiffs who asserted such claims only to have them dismissed prior to discovery or trial may feel that they did not have their day in court. Whether these claims will be revived through motions for reconsideration may depend in large part on the discretion of individual judges and lead to divergent outcomes.

A more interesting procedural question may involve plaintiffs who, based on the reasonable view that the Martin Act preempted non-fraud common-law claims, declined to assert common-law claims altogether. Will they get another turn at bat? In our view, they should not ' the decision in Assured Guaranty did not purport to change the law, only to clarify that a private litigant could pursue non-fraud securities claims that are not “predicated solely on a violation of the Martin Act.” Without doubt, securities plaintiffs will clamor to revisit past claims, and the results may be inconsistent.

Practicalities

From a practical perspective, the waters grow even murkier. The court of appeals appears to be willing to subject public disclosures and investment advice to a negligence test. Such tests require the determination of an “objective standard of care” that must be met in order to avoid liability. How will courts applying New York law determine what is “reasonable” in connection with statements made in securities offerings? On this issue, we suspect that, as with Assured Guaranty itself, each question a lower court asks will beg yet another. Instead of arriving at an “objective standard of care,” myriad subjective standards of care will emerge and ultimately need to be reconciled by the Court of Appeals ' if such reconciliation is even possible.

These are questions that plaintiffs' lawyers and investors will be quite willing to ask in lawsuit after lawsuit. Increasingly, these questions will be put to a state judicial system already underfunded, understaffed, and overwhelmed. Just six days before the decision in Assured Guaranty, a survey conducted by the New York County Lawyers' Association revealed that the $170 million in reductions to the state court system's budget “are having a profound effect on those who work with and in the courts, and are adversely affecting access to justice.”

To make matters worse, many common-law causes of action that purport to arise from the recent global financial crisis will soon run up against New York's three-year statute of limitations for negligence actions. In order to preserve the rights conferred upon them by Assured Guaranty, many plaintiffs will be racing to the courthouse. The combination of overburdened courts and an overeager plaintiffs' bar makes this perhaps the worst imaginable time to invite an onslaught of new and revived litigation.

Finally, for the financial institutions themselves, this decision will likely bring increased headaches and cost. Even before considering how to respond to actual litigation, institutions may need to address whether to alter their day-to-day operations in order to immunize themselves more effectively against negligence and breach of fiduciary claims. Any steps taken are likely to incur substantial cost in terms of time and resources.

Once litigation is filed, it will likely last longer and cost more; for although non-fraud common-law claims present unique issues of proof and additional defenses (such as contributory or comparative negligence, the economic loss doctrine, etc.), such claims are fact-intensive and notoriously difficult to dismiss prior to trial.

Even the process of selecting counsel may have to be re-evaluated. Because their respective legal interests are often aligned, financial institutions can, in many instances, pool their resources to retain one “lead” counsel to combat private fraud claims. If, however, each institution is forced to prove its own adherence to a standard of reasonable care, it may be more difficult to take a “one for all” approach to retaining counsel. Each additional layer of cost will adversely affect investors in the form of higher fees, higher transaction costs, and lower returns.

Conclusion

In Assured Guaranty, the Court of Appeals has paved the way for extensive and costly litigation, further burdening our already strained judicial system, adding yet another layer of uncertainty in our financial services industry, and ultimately bringing lower returns to investors.

Unfortunately, given that Assured Guaranty is now the final word from the State of New York, any hopes for a judicial remedy are slim. The legislature is thus likely the best and only hope to re-level the playing field in cases governed by New York law ' and there is reason to believe it might. After all, the legislature watched as a consistent body of state and federal case law was written, ignoring repeated calls from trial lawyers to expand the scope of the Martin Act. Now, it can no longer afford to stand idle.

The legislature is uniquely positioned to clarify this issue and return us to the status quo. If it refuses, the clouds hanging over our financial services institutions may grow darker. Now that the Court of Appeals has done what the plaintiffs' bar failed to do for two decades, it is time for the legislature to amend the Martin Act to restore the preemption of non-fraud common-law claims.

Michael Simes is a partner in the New York office of McGuire Woods, where he routinely represents leading financial institutions in complex commercial and bankruptcy litigation, securities litigation, and government investigations. He can be contacted at [email protected]. Laurent Wiesel, also a partner in the New York office, has advised major corporations, financial institutions, and individuals in a broad range of matters, including commercial and corporate disputes, securities class actions, international arbitration, regulatory and criminal investigations, antitrust litigation, and actions involving the interests of foreign sovereigns. He can be contacted at [email protected]. This article also appeared in Corporate Counsel, an ALM sister publication of this newsletter.