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Cremi v. Alex. Brown & Sons

December 30, 1997

BANCA CREMI, S.A., INSTITUCION DE BANCA MULTIPLE, GRUPO FINANCIERO CREMI; BANCA CREMI GRAND CAYMAN, PLAINTIFFS-APPELLANTS,

v.

ALEX. BROWN & SONS, INCORPORATED; JOHN ISAAC EPLEY, DEFENDANTS-APPELLEES.

SECURITIES & EXCHANGE COMMISSION; PSA THE BOND MARKET TRADE ASSOCIATION, AMICI CURIAE.



Appeal from the United States District Court for the District of Maryland, at Greenbelt. Frank A. Kaufman, Senior District Judge.

(CA-95-1091-K)

Before LUTTIG and WILLIAMS, Circuit Judges, and MAGILL, Senior Circuit Judge of the United States Court of Appeals for the Eighth Circuit, sitting by designation.

MAGILL, Senior Circuit Judge

Argued: September 29, 1997

Affirmed by published opinion. Senior Judge Magill wrote the opinion, in which Judge Luttig and Judge Williams joined.

OPINION

Banca Cremi, S.A., Institucion de Banca Multiple, Grupo Financiero Cremi and Banca Cremi Grand Cayman (together, the Bank) purchased a number of collateralized mortgage obligations (CMOs) through John Isaac Epley, a broker with the brokerage firm of Alex. Brown & Sons, Incorporated (Alex. Brown). Although most of its CMO purchases were profitable, the Bank lost money on six CMO purchases after the market in CMOs collapsed in 1994. The Bank brought suit in the district court against Epley and Alex. Brown, alleging that Epley and Alex. Brown had committed securities fraud in violation of Section(s) 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. Section(s) 78j(b), and Rule 10b-5, 17 C.F.R.Section(s) 240.10b-5, by making material misrepresentations and omissions regarding the CMOs, by selling securities that were unsuitable, and by charging excessive markups. The Bank also alleged Texas state common-law tort claims for fraud, negligence, negligent misrepresentation, and breach of fiduciary duty, and a claim based on the Maryland Securities Act. The district court granted Epley and Alex. Brown's motion for summary judgment on all of the Bank's claims, *fn1 and the Bank now appeals. We affirm.

I.

A.

CMOs, first introduced in 1983, are securities derived from pools of private home mortgages backed by U.S. government-sponsored enterprises. *fn2 From 1987 to 1993, U.S. government-sponsored CMO issuances grew dramatically, from $900 million to $311 billion per year. The market in CMOs largely collapsed in 1994, and in 1995 new issuances fell to $25.4 billion.

Historically, investments in fixed-rate home mortgages have not been attractive to institutional investors. Investors in most fixed-rate securities benefit when interest rates fall. The fixed-rate security then earns interest at a rate higher than decreased prevailing rates. However, unlike other fixed-rate investments such as U.S. treasuries, fixed-rate home mortgages do not benefit from declines in interest rates. Because home mortgages may be freely prepaid, home owners frequently refinance their homes to take advantage of a drop in interest rates. When the mortgage is prepaid, the investor's funds are returned. If the investor seeks to reinvest those funds, as would be the case with most institutional investors, they must be reinvested at the low prevailing rate, rather than earning interest at the higher rate of the original mortgage. This is called the "prepayment risk." If interest rates rise, home mortgages are generally not refinanced, and they lose value just like any other fixed-rate security. Thus, investments in home mortgages perform poorly both when interest rates rise and when they fall.

CMOs concentrate the prepayment risk in some securities in order to reduce that risk in other securities. In so doing, CMOs were designed to make home mortgage investments more attractive to institutional investors, increase the liquidity in the secondary home mortgage market, and reduce the interest costs to consumers buying homes.

A CMO issuer begins with a large pool of home mortgages, often worth billions of dollars. Each pool of home mortgages generates two streams of income. The first income stream is the aggregate of all interest payments made on the underlying mortgages. The second income stream is the aggregate of all principal payments made on the underlying mortgages. These income streams are divided into numerous CMO "tranches," which are the securities sold to investors. To determine what portion of the two income streams are received by an investor in a CMO tranche, each tranche has two unique formulae: one that determines the tranche's interest rate, and the other that determines the tranche's principal repayment priority.

The interest rate on a CMO tranche can be a fixed rate, a floating rate, or a rate that floats inversely to an index rate. Floating interest rates can also be leveraged, meaning that the interest rate shifts more dramatically than the index rate. For example, where a floating rate CMO is leveraged by a multiplier of two, the CMO's interest rate will increase by two percent when the index rate increases by one percent.

The tranche's principal repayment priority determines when the tranche will receive principal payments made on the underlying mortgages. Each principal payment is divided among all of the tranches in a CMO issuance. High priority tranches receive principal payments first. Support tranches receive principal payments last. Because of this, support tranches are the most sensitive to"extension risk." Extension risk is the opposite of prepayment risk: when interest rates rise, the expected maturity of the support tranche CMO increases, often dramatically.

CMO tranches are categorized into classes which have similar properties and risks. The least risky is the planned amortization class (PAC). PACs have little prepayment risk, and appeal to institutional investors for this reason. Two of the riskiest classes of CMOs, inverse floaters and inverse interest-only strips, are at issue in this litigation.

Inverse floaters have a set principal amount and earn interest at a rate that moves inversely to a specified floating index rate. Inverse floaters will often be leveraged, so a small increase in interest rates causes a dramatic decrease in the inverse floating rate. Usually, inverse floaters are also support tranches, so an increase in interest rates causes their maturity date to extend. Inverse floaters earn high returns if interest rates decline or remain constant, but lose substantial value if interest rates increase.

Inverse interest-only strips (inverse IOs) do not receive principal payments. The interest rate for an inverse IO floats inversely to a specified index rate, like an inverse floater. Interest is calculated by reference to the outstanding principal amount of another reference tranche. As the reference tranche is paid off, the principal on which the inverse IO earns interest decreases accordingly. Like an inverse floater, a rate increase reduces the inverse IO's floating rate. According to some investors, a rate increase also reduces prepayment of the reference tranche, extending the maturity of the inverse IO and, ultimately, increasing the total interest payments made on the inverse IO.

Inverse floaters were first introduced in 1986. Inverse IOs were introduced in 1987. Markets for both of these securities remained strong in the environment of decreasing or stable interest rates that predominated between 1986 and the beginning of 1994. On February 4, 1994, the Federal Reserve Board increased short-term interest rates for the first time in five years. Over the next nine months, short-term rates increased by a total of 2.5 percent, from 3 percent to 5.5 percent. In response to the rate increases, a wave of selling hit bond markets and investors in all types of bonds suffered significant losses. *fn3

CMOs were particularly hard hit, for a variety of reasons. The jump in rates halted mortgage prepayments. This in turn extended the average maturity of all CMOs, including, most dramatically, support tranche CMOs such as inverse floaters. Because of their degree of leverage, certain CMOs were extremely sensitive to the interest rate jumps, and their holders flooded the market after the first interest rate increase. CMO liquidity, which had never been a problem in the stable or declining interest rate environment that had existed since their introduction, dried up as all CMO holders tried to sell. The fear of liquidity problems built on itself, reducing the number of willing purchasers during the critical period after the Federal Reserve Board increased interest rates. In April 1994 an investment fund which primarily invested in CMOs filed for bankruptcy, reporting near total losses of its $600 million CMO investment. As a result of these incidents, the market in CMOs virtually collapsed in 1994.

B.

Alex. Brown is a securities brokerage firm, incorporated under the laws of Maryland, with its principal place of business in Baltimore, Maryland. Alex. Brown is registered as a broker-dealer under Section(s) 15 of the Securities and Exchange Act of 1934, 15 U.S.C.Section(s) 78o. Beginning in April 1993, John Isaac Epley was employed by Alex. Brown in its Houston, Texas office as a vice president. Prior to his employment by Alex. Brown, Epley had worked in Houston as a securities broker for MMAR Group.

Banca Cremi, S.A., is a credit institution incorporated under the laws of Mexico. Banca Cremi Grand Cayman is its wholly owned subsidiary, incorporated under the laws of the Cayman Islands. Both institutions have their principal place of business in Mexico City, Mexico. On June 30, 1993, the Bank had assets of nearly $5 billion and an annual operating income in excess of $36 million.

The Bank's Nuevos Negocios Internacionales (NNI) unit specialized in international investment transactions. The unit engaged in Eurobond issuances, interest rate swaps, investments in Brady Bonds, and various other esoteric investments. According to the NNI monthly reports, the NNI unit held investments with a face value of up to $115 million during 1993 and accumulated income of over $6 million that year. J.A. at 482.

Three individuals had primary oversight responsibilities for the NNI unit's operations and investments. The NNI unit director, Jose Luis Mendez, held a degree in economics, and primarily advised the Bank on U.S. dollar-denominated investments. The NNI unit subdirector, Armando Aguirre, also held a degree in economics. Prior to joining the Bank in 1981, Aguirre served as an economics teacher, a currency investment adviser, and a developer of accounting systems. Aguirre approved all of the NNI unit's CMO trades. The NNI unit assistant director, Monica Buentello, held a degree in international relations, had completed postgraduate course work in international commerce and analysis, and had participated in seminars on derivatives and CMOs while working at the Bank.

C.

The relationship between Epley and the Bank began in June 1992 when Epley, then an MMAR Group employee, made an unsolicited phone call to sell CMOs to the Bank. Over the next few months, Epley discussed CMOs with Buentello and others in the NNI unit. The Bank allegedly told Epley that it wished to"invest in securities that: [(1)] had low risk to capital; [(2)] were highly liquid; [(3)] would be held for short periods (generally 90-180 days); and [(4)] could reasonably be expected to provide a good yield." J.A. at 1537 (Buentello Aff.). The Bank also allegedly told Epley that it would be "beneficial if" the investments met the liquidity coefficient requirement of a Mexican banking regulation, Circular 292. *fn4 Id. at 1538.

Epley provided the Bank with general background materials describing the functioning and risks of CMOs. First, Epley provided the Bank with the MMAR Group Guide to CMO Structures (Group Guide). The Group Guide dedicated two pages to a description of inverse floaters and inverse IOs, calling them each volatile. Second, Epley provided the Bank with the MMAR Group Guide to Inverse IOs, which described the risks and benefits of inverse IOs. *fn5 Third, Epley wrote a letter to Buentello dated July 22, 1992 (risk letter), outlining four types of risks of inverse floaters: credit risk, coupon risk, price volatility, and liquidity risk. Describing the coupon risk, the risk letter stated that in "most cases" the index would need to increase by six percent before the yield of the inverse floater became zero. See J.A. at 1437. As for price volatility, the risk letter stated that the price had an inverse relationship to interest rates, "as with all fixed income securities." Id. As for liquidity risk, the letter claimed that many firms would bid on inverse floaters and that demand "currently" far exceeded supply. Id. at 1438.

During the summer of 1992, the Bank's NNI unit independently investigated the benefits and risks of CMOs. The Bank discussed the potential investment in CMOs with its counsel and established a fourteen-step review procedure to be followed prior to each CMO purchase. The review procedure was later formalized into a written manual. See J.A. at 1254-79. Buentello, with assistance from Epley, authored a lengthy analysis entitled "Banca Cremi Investment System in Inverse Floater." See id. at 643-71. The analysis concluded that inverse floaters are leveraged "to obtain extraordinary returns" of around twenty percent. Id. at 645-46.

The Bank's analysis explained that since the market for inverse floaters began, high returns and decreasing interest rates had given rise to "a more and more liquid market." J.A. at 657-58. The analysis described the interest rate structure of inverse floaters in detail, using charts and graphs to illustrate the sensitivity of inverse floaters to shifts in the index rate. Similar to Epley's risk letter, the Bank's analysis recognized that if the index rate increased by six percent, the yield of an inverse floater CMO would dwindle to nothing. The analysis noted that, "[l]ike all fixed rate securities, there is an inverse relationship between interest rates and bond price," and that interest rates ultimately "influenc[e] returns on the bonds." Id. at 649. Finally, while the analysis indicated that investments in CMOs complied with Circular 292, the Bank also reasoned that if these investments did not comply with Circular 292, they would be like any other international investment. Id. at 645, 659.

Between August 1992 and August 1993, the Bank made additional efforts to refine its knowledge of CMO investing. In October 1992 NNI unit director Mendez purchased several lengthy treatises that described mortgage investments and CMOs in extensive detail. These books were made available to the NNI unit staff. In May 1993 Buentello attended a seminar on derivatives investing. Buentello also attended a seminar at which CMO investing and pricing methods were discussed.

Throughout this period, the Bank was courted by other brokerage houses who sought to obtain the Bank's CMO business, and the Bank authorized the NNI unit to engage in CMO transactions with these brokerage houses. Each brokerage house provided the Bank with their own internal documents describing the benefits and risks of CMO investing. In January 1993 one of these brokerage houses forwarded to the Bank an article warning of what could occur to CMO investments if interest rates were to rise: "[i]f interest rates rise . . . what investors thought was a safe, secure medium-term maturity can suddenly be transformed into a highly risky long-term security." Randall W. Forsyth, The Pinocchio Security: Here's the Awful Truth About CMOs, Barron's, Jan. 18, 1993, at 15. The article suggested that, in these circumstances, a CMO's price would drop ten to twenty percent "if you can get a bid for it at all." Id. Epley indicated to the Bank that he disagreed with the Barron's article, and wrote in a letter that the risks of a CMO were "less of a concern" for an institutional investor. J.A. at 1441. Epley included a different Barron's article by Andrew Bary, who "specialize[d] in covering the institutional investor's capital markets." J.A. at 1442. *fn6

The Bank purchased its first CMO in August 1992. For the next year and a half, the Bank purchased a total of twenty-nine CMOs. Epley was in continual contact with the Bank during its period of CMO trading. Epley sent numerous faxes and letters to the Bank encouraging the Bank to make additional CMO purchases. Most of these suggested purchases were not pursued by the Bank. Epley introduced the NNI unit to a leading CMO expert and finance professor, Frank J. Fabozzi. Fabozzi was made available to the Bank for technical consultation and sent the Bank textbooks he had written which described CMOs and other financial instruments. Additionally, on request, Alex. Brown would perform a "portfolio analysis" of the Bank's holdings. *fn7 Prior to each CMO purchase, Epley provided the Bank with the yield matrix for that CMO. The yield matrix set forth the formula of the CMO's floating interest rate. It also provided a table that indicated how the CMO's yield and average maturity changed when interest rate and prepayment conditions changed. Although the yield matrix indicated the average maturity of the CMO, it did not specify the formula that was used to calculate the precise maturity of the CMO.

The CMOs initially earned interest at rates as high as twenty-four percent. The Bank played the CMO market aggressively, trading CMOs frequently to take advantage of short-term market swings. The Bank sold eight CMOs within three weeks of purchasing them, including one trade made within twenty-four hours of the Bank's purchase. The Bank sold a total of twenty-three CMOs, each at a profit, prior to the CMO market downturn in March 1994. The aggregate price of these twenty-three CMOs exceeded $96 million. The Bank's profits exceeded $2 million.

Alex. Brown never charged the Bank a commission for the Bank's CMO purchases. Rather, Alex. Brown purchased the securities and then sold them to the Bank with a markup. The Bank never asked Epley or Alex. Brown what markup it placed on the CMOs, and Alex. Brown never disclosed the amount of markup. Although Alex. Brown found purchasers for each of the twenty-three CMOs sold by the Bank, Alex. Brown never charged the Bank a markdown on the sales.

The Bank held six CMOs at the time of the market downturn in March 1994. *fn8 These six CMOs are the subject of the instant suit. After the market downturn in February 1994, the price of the six CMOs dropped precipitously. The Bank claims losses on the six CMOs of around $21 million of the original purchase price of around $40 million. *fn9

The Bank filed a complaint for securities fraud against Epley and Alex. Brown in the United States District Court for the District of Maryland. The Bank claimed that Epley and Alex. Brown violated Section(s) 10(b) and Rule 10b-5 by: (1) making material misstatements and omissions regarding the CMOs sold to the Bank; (2) selling the Bank the CMOs which it knew to be unsuitable investments for the Bank; and (3) failing to disclose fraudulently excessive markups totaling $2 million on the CMO sales. The Bank also claimed violations of the Maryland Securities Act, common law breach of fiduciary duty, negligence, negligent misrepresentation, and fraud.

In support of their claim that Epley and Alex. Brown made numerous material omissions and misstatements, the Bank alleged that Epley and Alex. Brown failed to provide the Bank with material information about the functioning of each of the CMOs, including: (1) the impact of interest rates on CMO price; (2) the precise principal repayment priority; and (3) the impact of interest rates on CMO liquidity. The Bank also alleged that the defendants failed in their duty to provide: (1) information normally included in a CMO prospectus *fn10; (2) sophisticated computer software to reverse engineer new issue CMOs to reveal their performance in various market conditions; (3) information regarding the CMOs' qualification under Mexico's Circular 292; and (4) information regarding the CMOs' qualification under U.S. banking regulations. The Bank also alleged that Epley and Alex. Brown made material misstatements when they: (1) downplayed the impact of a change in interest rates on CMO prices by comparing it to that of other fixed income securities; (2) stated that demand for CMOs currently far exceeds supply; (3) claimed that CMOs had relatively low risk levels; (4) claimed that the inverse IOs sold to the Bank had a self-hedging feature; and (5) told the Bank that the criticisms in the Barron's Pinocchio Security article should be less of a concern for institutional investors than for individual investors.

After discovery, the district court granted summary judgment to Epley and Alex. Brown on all claims. The district court concluded that the Bank had failed to raise a genuine issue of material fact as to three of the four elements that must be proved to establish a violation of Section(s) 10(b). First, the district court reasoned that Epley and Alex. Brown had made no material omissions or misstatements regarding the risks of the CMOs because they made general disclosures of yield, price, and liquidity risks. Further, the district court found that the Bank's allegation that scienter existed because Epley and Alex. Brown encouraged purchases in order to earn excessive markups to be based only on speculation. Finally, the district court concluded that several factors, including the Bank's size and its sophistication and the expertise of the NNI unit employees, did not allow the Bank to justifiably rely on any misstatements that Epley and Alex. Brown might have made. *fn11

The district court rejected the Bank's suitability claim as a subset of the rejected Section(s) 10(b) claim. The district court also rejected the Bank's claim that the markups were excessive, concluding that most of the markups were within standards provided by the National Association of Securities Dealers (NASD), and that no evidence had been submitted to establish that the higher markups were not justified by special circumstances.

The district court also rejected the Bank's state law claims, holding that the Maryland Securities Act did not apply to Alex. Brown because it was a broker-dealer, and that, based on either Texas or Maryland state law, the Bank's tort claims failed as a matter of ...


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