(CN) - Though it never disclosed its substantial exposure to the subprime housing market ahead of that bubble's burst in 2008, Morgan Stanley is not liable, the 2nd Circuit ruled Monday.
Shareholders had sought relief with regard to two multibillion dollars trades by Morgan Stanley in 2006 of residential mortgage-backed securities.
In its $2 billion deal, Morgan Stanley bid short on credit default swaps (CDs) and collateralized debt obligations (CDOs) backed by subprime residential mortgage-backed securities - essentially betting that the housing market was overvalued and due for a decline.
It also placed $13.5 billion in a long position selling similar CDs, which were backed by higher-rated, lower-risk residential mortgage-backed securities.
"In essence, the company was betting that defaults in the subprime mortgage markets would be significant enough to impair the value of the higher-risk CDO tranches referenced by the Short Position, but not significant enough to impair the value of the lower-risk CDO tranches referenced by the Long Position," according to the judgment.
The firm failed to anticipate the magnitude of the housing market's coming collapse, and lost billions on its long trade in the 2008 financial crisis.
Shareholders claimed that the financial services misrepresented and omitted information regarding its exposure to credit risk in the U.S. housing market.
U.S. District Judge Deborah Batts dismissed the action, however, and the 2nd Circuit in Manhattan affirmed Monday.
At issue is whether Morgan Stanley's alleged failures were "consciously reckless" or intended to mislead investors, according to the judgment.
"Plaintiffs make allegations about developments in the subprime market, internal concern about capital calls and write-downs on the Long Position, and the creation of a task force to investigate selling off some of Morgan Stanley's subprime positions," Judge Debra Ann Livingston wrote for the three-judge panel. "But these facts do not 'approximat[e] actual intent' to mislead investors by failing to make Item 303 disclosures."
While Morgan Stanley's failure to make disclosures may have been negligent, it was not fraudulent, the court ruled.
"We find no basis to infer anything more than 'a heightened form of negligence' (if that)," Livingston said, "especially after taking into account that Morgan Stanley was also profiting from the declining market through its Short Position." (Emphasis in original.)
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