Judge Preska’s opinion in In re Merrill Lynch Auction Rate Securities Litigation, 2010 U.S. Dist. LEXIS 126076 (Nov. 30, 2010 S.D.N.Y.), has an interesting discussion of loss causation under the federal securities laws. The Louisiana state agency that owns the Superdome (“Superdome”) hired Merrill for debt refinancing advice in 2005. Merrill advised the Superdome to issue a form of auction rate security (“ARS”), convertible to a conventional bond at the Superdome’s discretion. The Superdome anticipated that its ARS would sell at auction with a lower interest rate than a conventional bond. But, if an auction failed and the ARS were not sold, then the Superdome would be required to pay a very high 12% “failure rate.”
Things went swimmingly until February 2008 when the ARS market collapsed along with the rest of the financial markets, and the Superdome’s ARS defaulted to the 12% rate. The Superdome sued Merrill for fraud under the federal securities law, and alleged state law claims under Louisiana law. The Superdome claimed that Merrill fraudulently failed to disclose that it regularly placed support bids to prop up its ARS auctions, and that absent Merrill’s support bids its auctions would have failed. That may sound like a pretty good claim, but it did not work.
In 2006, two years before the collapse of the ARS market, Merrill was required to post on its web site a detailed description of its ARS procedures as part of a settlement with the SEC. Sure enough, that description included a disclosure that Merrill placed support bids at ARS auctions, and that its ARS auctions could fail if Merrill decided not to place support bids. Merrill moved to dismiss the federal securities claims on the ground that the Superdome could not allege “loss causation” (proximate cause in the securities context) because the Superdome had a right to convert its ARS to a conventional bond, but chose not to exercise that right.
The court found that the Superdome’s decision not to exercise its right to convert after Merrill publicly disclosed its bidding practices was the “cause” of its loss. According to Judge Preska, “the Superdome, in effect, was presented with a choice. It could do nothing and accept the newly disclosed risks (along with a more attractive interest rate) or chart a safer course. [Superdome] chose the former.” As the court pithily stated: “To say otherwise would be akin to affirming that a sinking ship legally caused a passenger to drown even if the passenger had ready access to a seaworthy lifeboat.”
For those interested, the court did sustain certain of the Superdome’s state claims arising from the same events, noting that the federal securities laws’ loss causation requirement is not applicable “wholesale” to state common law claims.