2nd Circuit Reinstates Subprime Fraud Suit

(CN) - A federal judge erred in dismissing the Federal Guaranty Insurance Co.'s lawsuit that clams it lost $900 million because a financial management firm let a hedge fund manage a collaterlized debt obligation it was in the process of shorting, the 2nd Circuit ruled Wednesday.

The FGIC sued Putnam Advisory Company for fraud, negligent misrepresentation, and negligence, alleging the firm misled the agency about its management of pooled mortgage and other assets called Pyxis ABS CDO 2006-1 to convince it to provide guaranty insurance for the financial product.

In the world of finance, a CDO or collateralized debt obligation, is so-called because the pooled assets that comprise it, most often mortgages, bonds and loans, are debt obligations that serve as collateral for the CDO.

At its most basic, "short selling" is the practive of selling a stock that the seller doesn't own, typically this is motivated by a belief that the security's price is about to decline.

FGIC claims Putnam indicated it would control Pyxis independently and manage the assets in CDO in the interest of long-term investors. It says company claimed it had considerable experience in the residential mortgage-backed securities market, particularly subprime securities, which made up the majority of Pyxis' assets.

But in fact, the agency says, a portion of Pyxis' assets was controlled by a hedge fund, Magnetar Capital, which also held considerable short positions on the CDO - ensuring that Magnetar would profit $105 million if the CDO failed, and only $21 million if it was successful.

The $1.5 billion CDO defaulted in April 2008, leaving its insurer FGIC with a $900 million liability.

A federal judge dismissed the complaint, finding that it did not adequately pleaded that Putnam caused the millions of dollars in losses FGIC experienced when Pyxis failed.

But the 2nd Circuit reversed Wednesday and reinstated the lawsuit.

"At this preliminary stage, the SAC [Second Amended Complaint] alleges a causal connection between Putnam's fraudulent misrepresentations and FGIC's losses under the Pyxis Guaranty such that FGIC 'would have been spared all or an ascertainable portion of that loss absent the fraud,'" U.S. Circuit Judge Chester Straub said, writing for the three-judge panel.

The lower court found that Magnetar's control of 11 percent of Pyxis' assets was not controlling enough to cause Pyxis to default regardless of the 2008 market downturn in mortgage-backed securities.

"In so concluding, however, the District Court misapplied the standard on a motion to dismiss," Straub said.

At the motion to dismiss stage, plaintiff need only allege sufficient facts to "raise a reasonable inference that Magnetar's overall involvement caused an ascertainable portion of its loss." It need not prove that Magnetar's involvement was the exclusive cause of its losses, the court concluded.

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