Eastern District of Pennsylvania Dismisses Claims Alleging Fraud in Connection with Purchase and Retention of Auction Rate Securities

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Raphael Rosenblatt | Bloomberg Law Fulton Bank, N.A. v. UBS Securities, LLC, No. 10-CV-01093, 2011 BL 286582 (E.D. Pa. Nov. 7, 2011) Attempting to allocate blame for its auction rate securities (ARS) losses after the global collapse of the ARS market, Fulton Bank, N.A., as successor to Fulton Financial Advisors, N.A. (Fulton Bank), brought an action against UBS Securities, LLC (UBS) alleging securities fraud and various common law claims. Finding that Fulton Bank failed to state a cognizable cause of action, the U.S. District Court for the Eastern District of Pennsylvania dismissed the complaint.

Auction Rate Securities

ARS are financial instruments with a long-term maturity that pay interest rates, which are set and reset by auctions conducted at certain pre-determined intervals. Using a "Dutch auction" process, potential investors indicate the number of shares they want to purchase and the lowest interest rate they will accept for such shares. Existing ARS holders specify the number of shares they wish to sell, and whether they will sell them on an unqualified basis or for a specific interest rate. The lowest bid at which all shares offered for sale can be sold will establish the interest rate to be paid until the next auction. The sale price is set at the security's par value (usually $25,000), while the interest rate, earned by the buyer until the next auction, is determined by the auction's outcome. ARS typically include bond-like investments called auction rate certificates (ARC). ARC issuers receive the proceeds from the original sale of the ARS and assume the obligation to pay principal and interest on the ARC. An issuer will engage one or more underwriters that will structure, underwrite and distribute the issue. An issuer also will engage an "auction agent" and "auction manager." The agent administers the auction at which rates on the ARC (underlying the ARS) are set, and the manager's duties and responsibilities will be dictated by a Broker-Dealer Agreement between the auction manager and issuer but typically involve receiving bids and offers, communicating the auction results, and facilitating settlement.

Proprietary Bids

First marketed in the 1980s, ARS gained popularity in the early 2000s when they were marketed as providing benefits to both issuers and investors. Securities firms earned fees for selling ARS, underwriting them, and managing auctions. However, if there was insufficient investor interest in a particular auction, in order to ensure that the auction did not fail and thus undermine investor confidence in the entire ARS market, securities firms allegedly would enter proprietary bids "to ensure that the auctions succeeded, thereby creating the illusion of an efficient, completely liquid market." In 2007, the credit crisis caused the market for ARS to suffer significantly. Fulton Bank claimed that in the face of this mounting crisis, securities firms dramatically increased their proprietary ARS purchases, and then pressured customers to purchase ARS in order to conceal the "downward spiral of the ARS markets and the skyrocketing ARS inventories held by securities firms." These pressures did not help, and in early 2008 the market for ARS collapsed entirely. Fulton Bank held more than $300 million ARC, more than $249 million of which was purchased through UBS. Overall, the value of ARC declined and resulted in losses of hundreds of millions of dollars to customers like Fulton Bank.


Fulton Bank claimed that UBS was retained by ARS issuers to manage their auctions, including those through which Fulton Bank purchased ARS on the recommendation of its securities brokers, PNC Securities (PNC) and NatCity Investments (NatCity). In a complaint filed in the Court of Common Pleas of Lancaster County, Pennsylvania (and subsequently removed to the Eastern District of Pennsylvania), Fulton Bank alleged that UBS acted as the underwriter and manager for the ARS and it distributed those ARS to the public. UBS knew that the ARS market was collapsing, but it manipulatively propped up the auction markets in order to conceal the risk of market failure.

Motion to Dismiss

Noting that liability may attach to a broker that solicits and executes securities sales, even if it does not own the securities, the Court explained that "[i]n this case, UBS is an auction manager, which means it is not Fulton's broker, but Fulton alleges that UBS did execute sales of its own ARCs, which Fulton purchased through its brokers." This, to the Court, was sufficient to create a relationship between UBS and Fulton Bank that required the Court to evaluate Fulton Bank's allegations on the merits. — Material Omissions A fact is material if there is a substantial likelihood that the omitted fact "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." Materiality is a mixed question of fact and law. Under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, an omission is material if a duty to disclose exists, or if the undisclosed facts are material. A duty to disclose, the Court explained, will depend on the relationship between the parties—generally, a lesser duty is required for those brokers having a non-discretionary account, rather than a discretionary account. Fulton Bank claimed that UBS failed to disclose its true role as supporter of the auctions despite insufficient investor demand and, had Fulton Bank known the true nature of UBS's involvement it would not have purchased ARS. The Court disagreed and found that UBS had no contractual relationship with Fulton Bank because it contracted only with NatCity and PNC. Moreover, to the extent any relationship between Fulton Bank and PNC existed, UBS had no discretion over Fulton Bank's accounts. The Court also noted that Fulton Bank is a sophisticated investor, so it should have understood the risks of the marketplace. UBS disclosed a fair amount of information regarding its role. As a result, the Court found no duty of disclosure by UBS, but even if such a duty existed, UBS satisfied that duty by the disclosures it made. — Scienter A plaintiff may properly plead scienter by alleging that a defendant's misrepresentations or omissions were "undertaken with the intent to defraud the plaintiff." According to the Court, "[w]hat Fulton fails to explain is how UBS could have intended to defraud Fulton when UBS had no direct contact with Fulton and no knowledge of what Fulton's retail brokers said to their clients about ARS." In fact, the Court determined, that Fulton Bank's allegations gave rise to the inference that UBS merely engaged in bad business judgment and not with intent to defraud investors. — Reliance Rule 10b-5 requires some causal nexus between the misrepresentation and plaintiff's injury. Thus, a plaintiff must show reliance on the alleged misrepresentation or omission. The U.S. Court of Appeals for the Third Circuit has set forth factors to determine when a plaintiff's reliance was reasonable, which include (1) plaintiff's opportunity to detect the fraud, (2) the sophistication of the plaintiff, (3) the existence of a longstanding business or personal relationship, and (4) plaintiff's access to relevant information. The Court found that Fulton Bank had failed to allege reliance on any statements or acts by UBS because "Fulton appears to have already made its decision to invest in ARS before it could have relied on UBS." Moreover, even if there had been reliance, it would have been unreasonable because Fulton Bank was a sophisticated investor with no longstanding relationship with UBS and with access to information about how the ARS process worked. — Loss Causation A plaintiff must establish loss causation—that its losses are attributable to defendant's fraudulent conduct. The Court found that although the UBS practice of bidding during auctions artificially inflated the value of the securities, the U.S. Supreme Court has rejected the argument that a Section 10(b) claim could satisfy the loss causation requirement simply by showing that the security price was artificially inflated because of the misrepresentation. Rather, the Court said, the ARS losses "were fundamentally caused by intervening macroeconomic phenomena, namely, a decrease in ARS demand ultimately stemming from a global credit crisis, which had its roots in the subprime mortgage crisis." As a result, "[m]arket activity like this decreases the likelihood that a plaintiff can succeed on a fraud claim." The Court dismissed Fulton Bank's securities fraud (and common law) claims. 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