CMMF, LLC,
Plaintiff,
against
J.P. Morgan Investment Management, Inc.,
Defendant.
|
601924/09
for Plaintiff - Quinn Emanuel Urquhart & Sullivan, LLP
for Defendant - Paul, Weiss, Rifkind, Wharton & Garrison LLP
Melvin L. Schweitzer, J.
This is the court's decision following a three-week bench trial. The complaint alleges
two causes of action, one for breach of contract and one for negligence, both relating to
the plaintiff's investment of its funds with the defendant, which managed those funds in a
discretionary account under the rubric of "Enhanced Cash." The plaintiff seeks to recover
more than $100 million it lost due to the defendant's alleged mismanagement of the funds
during the earlier stages of the housing crisis of 2007.
Background
CMMF, LLC (CMMF), a
privately owned master feeder fund created by Access Industries Group (Access), an
industrial holdings company owned by Leonid Blavatnik (Mr. Blavatnik), a wealthy
investor. The feeder fund was created for the benefit of Mr. Blavatnik and his family as a
vehicle through which other Access-affiliated funds could invest their assets.
J.P. Morgan Investment Management, Inc. (JPMIM), is a registered
investment advisor in New York which is wholly-owned by JPMorgan Chase (JP
Morgan), a global financial services firm.
Prior to 2006, Mr. Blavatnik was a long-time client of JP Morgan and its
private bank. In early 2006, in recognition that Access had substantial sums on deposit at
JP Morgan that were only partially insured and not diversified, Access decided to
consolidate certain funds and invest them in a diversified, cash separate account with a
professional money manager. Access interviewed several alternative money managers,
but settled on JPMIM.
JPMIM presented CMMF with two possible strategies to achieve its goals:
Enhanced Cash (EC) and Liquidity. The Liquidity Strategy was the more conservative
and was designed to preserve principal while providing same-day liquidity. Eligible
investment securities did not [*2]include
Mortgage-Backed Securities (MBS). (Ufferfilge Aff. ¶ 26.) EC was designed to
provide higher returns with some preservation of principal and no daily liquidity. It used
longer-duration securities than a money-market fund, including MBS and Asset-Backed
Securities (ABS). (Id. at ¶¶ 26, 28.)
Access Chief Executive Officer Lincoln Benet (Mr. Benet) met with JPMIM
Client Portfolio Manager Ted Ufferfilge (Mr. Ufferfilge) to negotiate JPMIM's proposed
EC guidelines, which set the maximum allowed sector allocations for CMMF's Enhanced
Cash Account (the Account). During the meeting, Mr. Benet revised the proposed
guidelines. The new investment guidelines for the CMMF account (the Guidelines)
reduced the maximum ABS allocation proposed by JPMIM from 60% to 40% and the
maximum JPMIM-proposed MBS allocation from 40% to 20%. According to Mr. Benet,
he "left the meeting with the understanding . . . that (a) mortgage securities were carved
out of the Asset Backed Securities bucket and (b) all securities collateralized by
mortgages would fall within the Mortgage Securities sector." (Benet Aff. p. 6.) Based on
this understanding of the Investment Guidelines, CMMF alleges that JPMIM
misclassified securities collateralized by pools of subprime loans, known as ABS-home
equity loans (ABS-HELs), as ABS. It argues that these securities are in fact MBS and
their inclusion results in MBS exceeding the 20% cap.
On May 19, 2006, the parties entered into an Investment Management
Agreement (IMA) creating the Account, appointing JPMIM as its investment advisor
with "full investment authority, subject to the Investment Guidelines" and incorporating
the revised, negotiated Guidelines. (Ex. 244.)
The Guidelines stated the Account's objective was: "to provide a high level
of current income consistent with low volatility of principal . . . with some preservation
of principal." (Ex. 244, p. 1.) The benchmark for returns on CMMF's portfolio was set at
a relatively conservative three-month LIBOR.
Under the IMA, JPMIM was required to provide CMMF with regular
statements, no less frequently than monthly, detailing positions and activity of the
Account. JPMIM provided CMMF with daily, monthly and "ad hoc" statements. The
daily statements showed portfolio market value as well as unrealized gains and losses.
(Ufferfilge Aff. ¶63; see e.g. Ex. 378.) The monthly statements provided
more detailed information for each security held, and disclosed the percentages of the
Account invested in each asset class, including ABS or MBS. (Ufferfilge Aff. ¶ 65;
see e.g. Ex. 379.) In addition, Ufferfilge, very occasionally, would provide "ad
hoc" statements that organized the securities by their asset class, and showed a detailed
breakdown of each security's characteristics.
CMMF received only three ad hoc statements in the entire course of its EC
relationship with JPMIM, the first arriving approximately one month after the opening of
the Account. The June 22, 2006 statement identified "ABS-Home Equity Loans"
securities as included under the "Asset Backed Securities" category. (Ex. 282 at
-956-57.) It also showed that ABS-Home Equity Loans comprised 8.29% of the
portfolio, with all ABS comprising 10.96%, while "Mortgage (Prepayment Sensitive)"
securities comprised .19% of the portfolio. (Id. at 962.) The next such "ad hoc"
statement was sent July 5, 2006. This statement showed ABS-Home Equity Loans as still
classified under ABS and comprising 13.87% of the portfolio, while all ABS comprised
17.72 %. Mortgage securities comprised only 2.7% of the portfolio. (Ex. 52 at 203.) The
final "ad hoc" statement was sent to CMMF August 20, 2007. Once again ABS-HELs
were classified as ABS and the report showed that 21.58% of the portfolio was in [*3]ABS, of which 17.31% was ABS-HELs, and 23.19% in
Mortgage securities. (Ex. 219 at 590.)
The IMA also contained the following release from liability applicable to
JPMIM:
Investment Advisor shall cause to be rendered to Client, no less frequently
than monthly, statements setting forth the property in the Account and transactions
therein and advices of changes as they are made in the Account in accordance with
Investment Advisor's normal procedures. Client agrees to review promptly all statements
and advices. . . . Except with respect to any act or transaction of Investment Advisor as to
which Client shall object in writing to Investment Advisor within period of twelve (12)
months from the date of receipt of any statement from Investment Advisor . . . or any
affiliate thereof (collectively, the "JPMC Entities and Persons") shall upon the
expiration of such period be released and discharged from any liability and accountability
to Client and any of its agents or representatives as respects the propriety of acts,
omissions, and transactions to the extent shown in such statement.
(Ex. 244 ¶ 7) (emphasis added).
According to JPMIM's witnesses, the process for selecting and monitoring
securities was a two-pronged one, and JPMIM states that it followed this process when it
purchased Alt-A non-agency CMOs (a type of MBS) and ABS-HELs for the Account.
There was a "top down" or "macro" process in which JPMIM's Fixed Income team
reviewed and discussed economic forecasts for an upcoming quarter and then used those
forecasts to develop "model portfolios" — JPMIM's best recommendations for
how to invest an EC account over that upcoming quarter. The second prong, in turn, was
a "bottom up" process — in which portfolio managers then applied the model
allocations to each individual account in light of that account's customized guidelines.
This "bottom up" process of selecting individual securities for a portfolio involved due
diligence on each security and risk monitoring and compliance processes.
None of the Portfolio Managers (PMs), Client Portfolio Managers (CPMs)
or sector specialists who worked on the Account could remember the specific decisions
made or analyses conducted prior to making investments for the CMMF Account more
than six years after the fact. They all described the same investment process and testified
that they believed it was followed in making decisions for the Account.
Portfolio construction began with PMs, who manage accounts on a
day-to-day basis, consulting with CPMs to understand a client's objectives and
customized guidelines that reflect client preferences about level of risk, exposure to
various fixed income sectors, and level of liquidity. The PMs then would consider the
broad investment guidance provided through JPMIM's quarterly Macro Process. The
Macro Process consisted of meetings in which senior investors, PMs, and sector
specialists developed forecasts for the US economy. After the Macro Process concluded,
the Short Term Portfolio Construction Team met to construct representative portfolios
for short-term accounts and funds. According to JPMIM, up through the summer of
2007, the recommendation for the Enhanced Cash Strategy always included significant
allocations to ABS-HELs. (Martucci Aff. ¶21.) The PMs then decided how to
apply the guidance coming out of the Macro Process and portfolio construction process
to each individual account. (Id.)
Once PMs made broad allocation decisions, they worked with ABS and
MBS sector analysts to select specific securities to be purchased. PMs discussed
securities with the sector teams to make sure they were appropriate for individual
accounts. It was not the practice to document these communications and research. PMs
and sector analysts sat close to each other [*4]and simply
spoke to each other or looked at each other's computer screens. Once PMs decided on
which securities to purchase, they entered each specific security into the Compliance
Master System to ensure that each security complied with an account's customized
guidelines. Finally, PMs continued to monitor the portfolios on a daily basis to ensure
continued compliance with applicable guidelines.
The ABS and MBS sector teams specialized in making recommendations
with respect to their respective types of securities. They were also responsible for
pre-purchase due diligence and ongoing monitoring, as well as making recommendations
to the PMs for the purchase and sale of specific securities. (Ufferfilge Aff. ¶ 18.)
For example, as part of the pre-purchase due diligence process, ABS Team
members looked at the originators, servicers, and the underlying loan pool (loan-to-value
ratio, FICO scores, documentation, occupancy, etc.). (Noh Aff. ¶¶ 29-34.)
They reviewed historical loss and prepayment data for every vintage, the year the
underlying loans were issued, going back a minimum of five years. (Id. at ¶
36.) They also reviewed historical market data. This information was then used to create
different scenarios based on assumptions about delinquencies, loss and prepayment.
(Id. at ¶ 37.) Using a software called Intex, they would analyze the structure
of each security and perform cash-flow analysis based on these different scenarios.
(Id.) They also used Intex to run stress tests to determine how great the losses on
underlying loans would need to be for a given tranche to suffer principal losses.
(Id. at ¶ 38.) ABS team members analyzed subordination of tranches,
excess spread and overcollateralization and reviewed other forms of credit support.
Finally, the primary person running the analysis would discuss his views with at least one
other ABS Team member before ultimately making a recommendation to a PM.
Following a purchase, sector teams would continue to monitor each security. (Id.
at ¶¶ 39-40.)
According to David Martucci, one of the PMs on the Account, when the
Account was funded, JPMIM believed AAA-rated ABS-HELs and non-agency CMOs
were well suited for the Account's objectives — to create a diversified portfolio
that outperformed three-month LIBOR and offered protection against loss — as
these securities offered a relatively high level of return in exchange for a low level of
risk. (Martucci Aff. ¶¶ 42,44.) Mr. Martucci explained that although a
number of EC clients did not permit the purchase of any ABS and/or MBS, "whenever
[JPMIM]; had the discretion to do so, [it]; sought to include AAA-rated ABS-HELs and
non-agency CMOs in accounts that fit within [its]; general Enhanced Cash
strategy."[FN1]
(Martucci Aff. ¶ 43.)
Sometime in February 2007, CMMF became dissatisfied with the returns in
the Account. In a February 2, 2007 email, Access Senior VP of Finance Richard Storey
wrote to Mr. Ufferfilge: "we are not doing much better than Libor after deducting our
[sic]; fee our expectation was that we would yield more than we are." (Ex. 380.) After
discussing the matter with Mr. Ufferfilge, Mr. Storey informed Mr. Benet that JPMIM
advised against increasing risk: "Ufferfilge does not recommend going any longer in the
portfolio or changing the risk profile at this time as it will have no benefit [for]; us and
recommends we let the strategy play out." [*5](Ex.
381.)
In early 2007, as the market began to experience volatility, sector teams
believed that the volatility in lower-rated securities was a temporary event and remained
confident that high quality securities at the top of the capital structure would be protected
from a weaker housing market. (Martucci Aff. ¶ 47.) Additional AAA-rated
ABS-HELs were purchased for CMMF's account from May to July 2007. (Id. at
¶ 48.) Once again, none of the team members on the Account recall making these
purchases, but they do recall that at the time the PM team continued to look favorably on
these securities, which continued to trade at or near par.[FN2]
(Id.)
Prices began to deviate from par mid-July 2007. (Id. at ¶ 49.)
JPMIM continued to believe in the intrinsic value of the AAA-rated securities. It
attributed the price drops to the growing liquidity crisis, rather than to a change in
underlying credit risk. (Id.) By August 2007, when liquidity became largely
unavailable, JPMIM still viewed this as a short-term liquidity-driven market development
and continued recommending to clients who could tolerate the price volatility to hold
securities that had strong credit protections. (Martucci Aff. ¶ 50.)
The ABS-HELS and non-agency CMOs in the Account (the Challenged
Securities)[FN3]
were specifically designed to protect investors against loss of underlying collateral.
(Ufferfilge Aff. ¶¶ 45-46.) The Account held only senior or super-senior
tranches of CMOs, backed by pools of residential mortgage loans to the more
creditworthy Alt-A and prime borrower. Each CMO received the highest available rating,
AAA or equivalent. (Id. ¶ 49.) Senior tranches would not suffer any loss
until defaults reached levels that wiped out the investors in the more junior tranches.
(Id. ¶ 48.) The CMOs in the Account were also predominantly not
agency-backed. (Id. ¶ 50.) If they had been agency-backed, then
government agencies would have guaranteed the repayment of principal in the event of
default. According to Mr. Ufferfilge, the benefit of having these in the portfolio rather
than agency CMOs, was that it reduced risk from interest rate fluctuations and
prepayment and provided more attractive yield. (Id.) The Account's ABS-HELs,
primarily collateralized by first-lien home equity loans to subprime borrowers, offered
similar protections. Subordination for these securities generally offered even greater
protections than CMOs because of the lesser creditworthiness of the underlying
borrowers. These securities also offered excess spread protection, by which investors
were paid a lower rate of interest than that charged to borrowers and the difference was
retained to provide investors with additional protection. (Id. ¶¶
52-53.)
In August 2007, CMMF became concerned about unrealized losses in its
Account. From that point, Mr. Storey was in constant contact with Mr. Ufferfilge about
possible mitigation [*6]strategies. In an August 14, 2007
email, Mr. Ufferfilge advised that selling AAA-rated ABS-HELs was an option if
CMMF wanted to mitigate potential for future decline, but advised against it because the
markets were illiquid and price execution poor. (Ex. 317 at 193.) Mr. Ufferfilge added:
"[o];ur research team still is extremely confident that the AAA Home Equity
asset-backed securities are money good, meaning that over time you will get the entire
amount of your principal back." (Id.) In response to the August 14, 2007 email,
Mr. Benet wrote: "I understand your point on the AAA's for Home Equity, but anything
you can do to get out of those you think are even slightly cuspy' could be great. It could
get even worse before it turns around. . . ." (Ex. 227.) CMMF contends that despite this
request, JPMIM took no affirmative steps to make meaningful adjustments to CMMF's
portfolio.
Around this time, Mr. Storey also began to seek input from Nancy
Zimmerman, one of Access's outside advisors and founder of the multi-billion hedge
fund Bracebridge Capital. (Uffferfilge Aff. ¶ 10; Storey Trial Tr. 1254:4-10.) In
late August 2007, Mr. Ufferfilge had a conference call with Ms. Zimmerman and Mr.
Storey, in which he conveyed JPMIM's view that the intrinsic value of the securities was
greater than what was available on the market, and thus selling was inadvisable.
(Uffferfilge Aff. ¶ 98.) According to Mr. Ufferfilge, Ms. Zimmerman
recommended a swap in which certain ABS-HELs in the Account, issued by "MABS,"
were to be sold and proceeds reinvested in shorter maturity ABS-HELs. (Uffferfilge Aff.
¶ 100.)
To satisfy CMMF's requests, Mr. Ufferfilge contacted Kyongsoo Noh, one
of the Sector Specialists on the ABS Team, who identified bonds that might be sold to
reduce ABS-HELs allocations. (Ufferfilge Aff. ¶ 101.) On August 30, 2007, Mr.
Ufferfilge informed Mr. Storey that JPMIM would sell five bonds, including three
MABS, "to swap out of into something of higher credit quality." (Ex. 391.) The sale of
one of the MABs realized an approximately $400,000 loss. (Ufferfilge Aff. ¶ 104;
Ex. 393.) Upon being informed of this loss in early September, Mr. Storey responded: "I
thought you were going to let us know what you would exit, what you would buy and the
loss to be realized before anything was sold?" (Ex. 629 at 579.)
Here, the parties differ as to the significance of this exchange and several
subsequent ones. According to Mr. Ufferfilge, Mr. Storey called a few days later and
made it clear that CMMF was unwilling to take realized losses on security sales going
forward and JPMIM was not authorized to make any investment decision without prior
CMMF approval.[FN4]
(Ufferfilge Aff. ¶ 106.) Mr. Storey insists that he never gave such instructions, but
simply wanted to be informed before an action was taken. (Storey Aff. p. 10.)
JPMIM continued to advise CMMF against selling. In a September 20, 2007
email, Mr. Ufferfilge wrote: "It is going to take several months before we can make a
better determination as to how the subprime market will fare. We still feel AAA home
equity ABS will be good money, but need to have strong stomach to wait it out. Market
is trading better of late, but more time needed to see what happens to delinquency/default
rates." (Ex. 1014 at 207.)
On October 12, 2007, Mr. Ufferfilge sought permission from CMMF to sell
two MABS securities that JPMIM felt were at risk of a downgrade. These were the same
securities from the [*7]list of securities recommended for
sale in September 2007. JPMIM expected to sell at 97.5 and 96, which would have
resulted in realized losses of approximately $120,000 and $175,0000 respectively. (Ex.
397 at 512.) JPMIM recommended the sale because:
1. The likelihood of a downgrade to below AAA for the above two securities
has grown.
2. While we still feel these securities will pay 100 percent of principal over
time, given CMMF's potential need for funds (in short order), selling now may be a
better exit point should a downgrade occur.
(Id.) Mr. Benet responded: "OK to sell if they are close to [Mr.
Ufferfilge's]; marks. Not OK if he is selling way below the marks — but then I'd
like to understand why we have our marks where they are, which is a bigger question."
(Id. at 510.) Ultimately, JPMIM could not get the price they had hoped for and
the securities were not sold. (Id.; Ufferfilge Aff. ¶ 116.)
According to Mr. Storey, this is not evidence of CMMF's unwillingness to
sell if it would have resulted in realized losses. Mr. Storey states he never told JPM
anything of the sort and does not recall being advised to sell the MABs at whatever price
was then available to avoid future losses. (Storey Aff. pp. 12, 17-18.) Likewise, Mr.
Benet explained that, rather than prohibiting sales, he merely wanted an explanation for
why JPMIM was unable to obtain the prices it initially quoted. Mr. Storey also points to
an October 30, 2007 email, which demonstrated a willingness to take losses: "But we
also need to discuss YOUR JUDGEMENT on whether there are things we can start to
get out of without a material impact, those securities where we should take our losses
now as they will get worse and those we shouldn't wait' on." (Ex. 260.)
As the market continued to suffer, JPMIM continued to advise CMMF to
hold onto its securities. In October 2007, Mr. Ufferfilge reinforced this recommendation
by forwarding a JPMIM presentation on market conditions. It observed that in September
"ABS home equity stopped deteriorating and actually has bounced off its lows . . . buyers
have returned to the market" (Ex. 58 at 454). The presentation went on to note that the
trend in mortgage delinquencies was "troubling" but that it was JPMIM's opinion the risk
of principal loss was remote: "We believe AAA and AA sub prime paper is money-good,
but it may take a long time to find out." (Ex. 58 at 464.) In a November 26, 2007 email
Mr. Ufferflige wrote: "All CMO's and ABS securities in the CMMF, LLC portfolio
remain AAA rated and not on watch . . . The portfolio will throw off approx $8-10mm a
month in paydowns (principal and interest on the CMO and ABS) and will pick up as the
underlying mortgages age, especially the CMOs (Prime and Alt A mortgages)." (Ex.
260.)
On November 30, 2007, CMMF decided to withdraw all available liquid funds from
the Account, approximately $298 million. (Ex. 1728.) CMMF made the cash withdrawal
on December 6, 2007. According to JPMIM, the removal of the cash/near-cash portion
of the account increased the account allocations, on a percentage basis, e.g. ABS-HELs
percentage allocation increased from 18% to 26%, though no new purchases were made.
(Ufferfilge Aff. ¶ 141.) JPMIM contends that at this point, sector allocation became
less reflective of the investment strategy and became more concentrated in certain
"underperforming" sectors. According to JPMIM, it could not rebalance the account
because the prices for the securities were not reflective of their likelihood to mature.
(Ufferfilge Aff. ¶¶ 142, 144, 164.) CMMF was made aware that the account
was concentrated in corporate bonds, ABS and BMS. (Ex. 395 at 522.)
[*8]Another source of tension in the
CMMF-JPMIM relationship was a seeming miscommunication about the nature of the
CMOs held in the Account. According to CMMF, it was under the impression that the
majority of the CMOs were agency-backed. According to Mr. Storey, in the summer of
2007, "Mr. Ufferfilge began to tell us that securities in the account were agency-backed,
and over-collateralized and had no real credit risk." (Storey Aff. p. 7.) According the Mr.
Ufferfilge, he had spoken in error in a December email, stating that the CMOs were
agency backed. (Ex. 254 at 366.) However, he insists that based on many prior
communications, he had no doubts that CMMF understood that the Account held
non-agency CMOs. (Ufferfilge Aff. ¶ 149.) Moreover, he corrected the
misstatement a few days later, writing to CMMF: "The majority of the CMO's owned by
CMMF are non-agency." (Ex. 403 at 524.) CMMF insists that similar misstatements were
made much earlier. In a December 17, 2007 email, Mr. Benet wrote to Mr. Ufferfilge: "I
thought I recollected that when we discussed the cmos' in cmmf in summer that you said
the underlying mtgs in our cmo's were gtd by the agencies-so we did not have default risk
there?" Ex. 403 at 525.)
CMMF terminated the IMA on May 5, 2008. The initial investment in May
2006 was $775 million and over the two-ear period that JPMIM managed the Account,
the portfolio ranged from $680 million to $2.1 billion. Before the Account closed in May
2008, the portfolio earned $4 million. JPMIM's fee was based on a fixed percentage of
the value of the assets held in CMMF's portfolio. In total, JPMIM earned over a million
dollars in fees in return for its management of the CMMF portfolio.
CMMF's suit for breach of contract and negligence alleges, first, that JPMIM
misclassified ABS-HELs, securities collateralized by pools of subprime loans, as ABS. It
argues that these securities are in fact MBS and their inclusion in that category exceeds
the 20% MBS cap. Second, CMMF alleges that JPMIM acted negligently and in breach
of its fiduciary duties in managing CMMF's account by, among other things: (a)
purchasing mortgage securities for CMMF's account after January 1, 2007, at prices that
it knew or should have known exceeded their true value and at a time it knew or should
have known that the securities did not represent appropriate investments for CMMF; and
(b) continuing to hold the mortgage securities in CMMF's account after June 30, 2007,
when JPMIM knew or should have known that they were overvalued and that such
securities did not represent appropriate investments for CMMF. Discussion
Breach of
Contract
CMMF contends that JPMIM breached the IMA by exceeding the 20% cap
on Mortgage Securities. It argues that JPMIM misclassified ABS-Home Equity Loans as
ABS. CMMF claims that the proper inclusion of these securities in the Mortgage
Securities category exceeds the 20% cap set by the negotiated IMA's Guidelines.
CMMF argues that although the Guidelines did not define "Asset-backed
Securities," it is commonly understood to include securities backed by various assets,
such as credit card receivables, auto and student loans. Mortgages are assets, and in a
broad sense, securities backed by mortgages are ABS. But the negotiated Guidelines
created a separate category for "Mortgage Securities," indicating that "Mortgage
Securities" would not be treated as "Asset-backed Securities" under the Guidelines.
CMMF urges that the express language of the negotiated Guidelines should govern. It
contends that to allow ABS-HELs to be classified as ABS instead of Mortgage Securities
would render the negotiated 20% cap on mortgage-related [*9]securities meaningless, allowing JPMIM to invest in
mortgage-related securities up to an additional 40%.
CMMF points to the negotiation of the Guidelines, which it maintains
confirm the plain and unambiguous language of the IMA. CMMF claims that at no time
during negotiations did Mr. Ufferfilge or any other JPMIM employee advise CMMF that
ABS-HELs would not be considered Mortgage Securities. CMMF points to Mr. Benet's
contemporaneous emails and trial testimony as establishing that the parties' discussions
were to the effect that ABS would be "carved out" and treated as a "separate bucket"
from Mortgage Securities and that all securities backed by mortgages would count as
"Mortgage Securities" for purposes of assessing the Account's compliance with the
Guidelines.[FN5]
JPMIM counters that universal industry practice must be considered in
construing the Guidelines. JPMIM contends that investment managers classified
ABS-HELs and MBS separately because, at the time, ABS-HELs were considered to
present risks distinct from MBS and were treated differently to facilitate diversification
and reduce portfolio risks.
According to JPMIM the investment industry referred to securities backed
by subprime mortgages as ABS-HELs and classified them as ABS — not MBS or
"Mortgage Securities." To support this position, JPMIM points to the Lehman Brothers
and Merrill Lynch indices and a number of respected mutual funds. JPMIM argues the
classification of securities backed by subprime mortgages as ABS made sense from a
portfolio management perspective. Throughout the trial, one JPMIM witness after
another testified that securities backed by subprime mortgages posed a risk distinct from
securities collateralized by loans made to higher quality Alt-A or prime borrowers, which
were classified as MBS. Because Alt-A and prime borrowers had a greater ability to
prepay their mortgages through refinancing, disrupting the cash flow of the securities as
interest rates fell, these securities were viewed as having an interest-rate risk. The
performance of ABS-HELs was driven predominantly by the perception of credit risk.
Subprime borrowers were less likely to prepay, given their credit characteristics and
because the terms of their mortgages often offered a lower initial "teaser rate" or included
prepayment penalties that reduced their likelihood of refinancing. (Noh Aff.
¶¶ 9-11; Venkatakrishnana Aff. ¶¶ 13-16; Stancher Aff.
¶¶ 16-17.) Because of this distinction, the investment industry classified
ABS-HELs and CMOs differently, facilitating portfolio risk diversification. (Richard
Trial Tr. 2073:11-21; Martucci Aff. ¶ 42; Donohue Aff. ¶¶ 95-96.)
JPMIM argues that CMMF expressly released JPMIM from all liability for
losses and "claims of any kind or nature" under the IMA "except to the extent such
Losses are judicially determined to be proximately caused by the negligence or willful
misconduct of [JPMIM];." (Ex. 244 ¶ 14(b).) Because its classification of
ABS-HELs is consistent with industry practice, [*10]and
is well grounded in the principles of portfolio management, JPMIM argues that it did not
act negligently or willfully and so it cannot be held liable for breach of contract.
JPMIM points to Section 7 of the IMA, which bars any claim based on any
act or transaction by JPMIM that is reflected in statements delivered to CMMF unless
CMMF objects in writing within 12 months from the date of receipt of any statement.
JPMIM points to the June 22 and July 5, 2006 statements, sent to CMMF just months
after the Account was opened. These statements identified every ABS-HEL and labeled
each "ABS-Home Equity Loans." These securities were listed under the "Asset Backed
Securities" category rather than the separate "Mortgage (Prepayment Sensitive)"
category. (Exs. 282 at 956-57; 52 at 197-98.) These statements also showed the
percentage of the Account allocated to each category, and again ABS-HELs were
included as a part of the "Asset Backed Securities" category. (Exs. 282 at 962; 52 at
203.) CMMF never objected to the classification despite being aware of this supposed
misclassification. Mr. Benet specifically reviewed the June 2006 statement. In an email
to Ms. Zimmerman, he wrote: "we always had home eq's . . . Attached is the email with
the portfolio you, me and Rich reviewed with Ted on the June 22 conference call in 2006
for example that had Home Eqs from the beginning." (Ex. 386 at 060.) For these reasons,
JPMIM contends that CMMF's breach of contract claim must fail. Indeed, JPMIM's
violation of the 20% cap brought the total amount of mortgage securities to an amount
over 40%, more than doubling the negotiated limitation.
The court finds that JPMIM breached the IMA's Guidelines by exceeding the
20% cap on Mortgage Securities.
Where a contract is clear, extrinsic evidence is not to be considered.
Missionary Sisters of the Sacred Heart, Ill v NY State Div. of Hous. & Cmty.
Renewal 283 AD2d 284, 288 (1st Dept 2001). The IMA's Guidelines had two
distinct categories: "Asset-backed securities" and "Mortgage Securities." Broadly
speaking, ABS-HELs are securities backed by assets, i.e. subprime mortgages.
Technically, any mortgage-backed security would then be an ABS. The Guidelines
provided a separate and distinct category of "Mortgage Securities." In order that the term
"Mortgage Securities" may have meaning, rather than be swallowed by the
all-encompassing "Asset-backed securities," the court finds that ABS-HELs should have
been classified as Mortgage Securities under the negotiated Guidelines. See
Missionary Sisters, 283 AD2d at 288 ("[W];hen interpreting a writing, the court
should adopt an interpretation which gives meaning to every provision of a
contract."(internal quotations omitted)); see also Aguirre v City of New York,
214 AD2d 692, 695 (1st Dept 1995) ("Where there is an inconsistency between a specific
provision and a general provision of a contract, the specific provision controls.").
JPMIM's reliance on industry practice in unavailing. "[T];rade usage is not
admissible to influence the construction of a contract unless it appears to be so well
settled, so uniformly acted upon, and so long continued as to raise a fair presumption that
it was known to both contracting parties and they contracted in reference
thereto." Reuters Ltd. v Dow Jones, 231 AD2d 337, 343-44 (1st Dept 1997)
(emphasis added)); AG Capital
v State St., 10 AD3d 293, 295 (1st Dept 2004) (where contract is plain it is
improper to consider industry practice). Not only was the ostensible "industry practice" to
which JPMIM repeatedly refers unknown to CMMF, JPMIM itself frequently defined
securities backed by subprime mortgages as "mortgage securities" and not as
asset-backed securities — and did so in some of its most important documents
used with regulators (SEC), clients (pitchbooks to potential clients and articles
distributed widely to [*11]clients), shareholders (10K
Annual Report) and internally (JPM Macro Package, an important JPMIM document that
was to affect how portfolios were managed).
Whether JPMIM had its own understanding that the "Asset-backed
securities" category included some types of mortgage backed securities is of no moment.
There is no evidence that this was ever communicated to CMMF during the negotiations.
Neither Mr. Ufferfilge nor any other JPMIM witness claims to have advised CMMF
when negotiating the Guidelines that JPMIM construed them so that securities backed by
subprime mortgages would not be deemed mortgage securities. An
uncommunicated understanding is of no effect in contract negotiations. "[O];nly
objective manifestations of intent" are relevant. See Faulkner v Nat'l Geo., 452 F
Supp 2d 369, 377-78 (SDNY 2006); see also Trinidad v King, 1998 WL 823653
(SDNY 1998) (where parties have conflicting understandings of a term, the contract is
given "the meaning of the party who is unaware of the ambiguity if the other party knows
or has reason to know of the ambiguity" (citing John D. Calamari & Joseph M.
Perillo, The Law of Contracts sec 3-11, at 169 (3d ed., 1987) and REST. 2d
CONTRACTS sec. 201 (2)). JPMIM thus cannot invoke an industry practice to alter the
plain language of the Guidelines. As the court observed at trial, "a mortgage by any other
name is still a mortgage."
The uncontradicted testimony of JPMIM's own expert, John Richard, is that
there is no industry standard by which to interpret the investment guidelines of an IMA.
As the terms at issue here were drafted by JPMIM, to the extent JPMIM argues that its
own understanding created an ambiguity in the IMA, that ambiguity must be construed
against JPMIM. Chatterjee Fund Mgmt. v Dimensional Media Assocs., 260
AD2d 159 (1st Dept 1999) (ambiguities construed against the drafter).
The court is left with two legal arguments presented by JPMIM in defense of
its conduct and its consequences. First, JPMIM argues that unless CMMF can prove
negligence or willful misconduct in violating the IMA guidelines, the IMA provides
there can be no liability. JPMIM points to its good faith in following industry practice
and in the categorization of certain of the mortgage backed securities as asset-backed.
But as CMMF correctly points out, what could be more intentional than a conscious
breach of the Guidelines in light of CMMF's explicit negotiation to reduce the percentage
of permitted mortgage investments from the original 40% proposed by JPMIM to 20% in
order to reduce CMMF's exposure to this sector. So when JPMIM used the
"asset-backed" bucket to house some of the mortgage-backed assets, it intentionally
increased CMMF's aggregate portfolio of mortgage backed securities from the "up to
20%" which Mr. Benet had sought and obtained in negotiations to an entirely unintended
"up to 60%" of the portfolio.
The second argument presented by JPMIM is that CMMF, having gotten
statements in 2006 showing how JPMIM was classifying ABS-HELS as ABS, waived its
right to object to this classification because the IMA requires that any such objection to
be lodged with JPMIM in writing within one year of receipt of the statements. However,
a cap violation was not shown on these statements. Simply put, there was nothing to
object to. It is a meritless point to say that somehow this failure to object to a
non-objectionable position could somehow be construed to constitute a failure to object
to an objectionable position that had not yet occurred. It makes no sense. Ambac Assur. UK Ltd. v J.P.
Morgan Inv. Mgmt. Inc., 88 AD3d 1 (1st Dept 2011) (applying virtually an
identical provision, the court found that the action was not barred where the "cornerstone
of the plaintiff's allegations [was]; not a fact which would be evident in the statements.").
At the time the June and July 2006 ad hoc statements were delivered, JPMIM had [*12]not breached the 20% cap. That the statements showed the
purchase of ABS-HELS is irrelevant, since the Guidelines did not prohibit their
purchase. CMMF was not charged with reviewing the statements to ensure compliance
by JPMIM with proper characterization of securities when there was no cap violation.
Compliance was JPMIM's task.
The court also relies on the clearly established principle of New York law
that a waiver must be knowing, clear and unequivocal. Fundamental Portfolio Advisors,
Inc. v Tocqueville Asset Management, L.P., 7 NY3d 96 (2006). It cannot be
implied through an opaque set of circumstances and its consequences imposed on an
unsuspecting contracting party. Were the court to find for JPMIM, it would be doing just
that. There are no surprise waivers in New York.
By the time the third such ad hoc report was issued in August 2007, the
violations existed. CMMF objected to the over-concentration in the mortgage sector, and
gave JPMIM a draft complaint within a year, thereby satisfying any duty to object under
the IMA.
Negligence and Breach of Fiduciary Duty
With respect to its negligence and breach of fiduciary duty claim, CMMF
contends that JPMIM failed to exercise due care in selecting the Challenged Securities
for the Account. First, CMMF argues that JPMIM saturated CMMF's portfolio with the
riskiest and most illiquid mortgage securities — subprime and Alt-A loans
— at a time when a number of alternate, safer options were available to meet the
Account's benchmark. Second, CMMF argues that JPMIM negligently purchased such
securities for the Account and continued to hold previously purchased securities at times
when it knew or should have known the securities were significantly overpriced and far
too risky for a client with CMMF's stated investment objectives. Finally, CMMF argues
that JPMIM failed to conduct proper due diligence when selecting the Challenged
Securities.
Availability of Alternate Investments
CMMF contends that in December 2007, CMMF was locked into a set of
subprime residential real estate investments that it should not have been exposed to and
never needed to achieve its three-month LIBOR benchmark and its other conservative
objectives. CMMF argues that its portfolio value plummeted, while comparable funds
with investment objectives and benchmarks similar to CMMF, but which were invested
in substantially lower concentrations of mortgage securities, performed positively
between May 2006 and April 2008. CMMF argues that this needless exposure to
unnecessary risk, in view of the Accounts conservative objectives, requires a verdict for
CMMF.
CMMF contends that JPMIM's own damages expert, Professor Kenneth
Lehn (Professor Lehn), establishes that there was no need for JPMIM to invest in
non-agency mortgage securities during the period from May 2006 through June 30, 2007.
Professor Lehn's statement demonstrates that the three-month LIBOR benchmark could
have been achieved by investing in "Cash, Short Term & Other" and that such
investments were providing better monthly returns than the subprime and Alt-A
securities in CMMF's account. (Lehn Aff. ¶ 23.) According to CMMF, this is not
merely hindsight. These returns were available to JPMIM in real time, had anyone taken
the time to do the necessary comparisons.
CMMF points out that to achieve returns consistent with the Account's
benchmark, JPMIM had numerous low-risk investment options at its disposal. U.S.
treasury bills, unsubordinated U.S. agency master notes and bonds, and U.S. corporate
bonds were all listed as permissible investment under the Guidelines. JPMIM was
permitted to invest up to 100% of the [*13]portfolio in
US treasury bills, up to 50% in U.S. agencies, and up to 50% in corporate bonds. JPMIM
could also have invested in agency collateralized mortgage obligations (CMOs), a
sub-category of mortgage securities, which were far safer than other types of mortgage
securities due to the government's guarantee of repayment in the event of defaults on the
underlying mortgage collateralizations. Instead, JPMIM invested heavily in subprime and
Alt-A mortgage securities.
CMMF also points to the fact that the "lion's share" of EC accounts was not
invested in subprime or other mortgage securities. (Ex. 267 at 752.) In response to
JPMIM's contention that many of the other EC accounts prohibited investment in such
securities, CMMF argues that this simply proves that JPMIM knew that it was not
necessary to invest in risky securities in order to achieve an EC account's conservative
benchmark.
As further evidence of JPMIM's negligent mismanagement of the Account,
CMMF submitted a comparative analysis conducted by Dr. James McClave (Dr.
McClave). After comparing the Account with 63 other EC accounts managed by the
JPMIM's Fixed Income Team., Dr. McClave concluded that the Account "performed so
poorly that it is a statistically significant outlier for each metric" and "so poorly that it is
not part of the same population as the other accounts." (McClave Aff., pp 9-10.)
According to CMMF, JPMIM's own analyses are consistent with Dr.
McClave's conclusions. An October 2007 JPMIM analysis shows that CMMF held
$32,375,878.87 of non-agency CMO floaters that were to be sold because of "poor
underwriting" and "underperformance concerns." (Ex. 263.) A few months later, in
February 2008, JPMIM created a list of the "worst" CMO floaters. Of the eight bonds
listed, CMMF held four, none of which were ever sold for the Account. (Ex. 334.) In
April 2008, JPMIM created a list of non-agency mortgage securities "expected to
underperform the general market" due to "potential ratings downgrades and collateral
underperformance." (Ex.237 at 316.) The list ranked all of the bonds from most risky to
least risky." (Id. at 325.) CMMF held about $89,000,000 of the bonds identified
as likely to underperform the market— the greatest exposure of all accounts.
Nonetheless, the court is not persuaded that JPMIM acted negligently by not
choosing less risky investments for the Account. That other investments performed better
is irrelevant. The question is whether JPMIM exercised reasonable judgment, not
whether another investment would have performed better. JPMIM correctly points out
that a prudent manager does not sell one type of security because another performed
better last month. Rather than haphazardly trading into securities or sectors that happen
to have the best performance during the prior month, investment managers construct
diversified portfolios designed to spread risk and achieve targeted returns over an
investment cycle. JPMIM has demonstrated that the Challenged Securities were included
in the Account because, given their credit enhancement features, they "offered attractive
risk-adjusted returns in the market place for investment strategies like CMMF." (Richard
Aff. ¶ 93.) Moreover, CMMF expressly rejected a strategy that was more heavily
concentrated in cash and other short term investments, i.e. the Liquidity Strategy.
Instead, it chose the more aggressive EC strategy.
Although the EC accounts "were part of product intended to be managed
consistently," clients were able to customize the guidelines. (Jonsson Trial Tr. 783:9-16.)
CMMF took advantage of this option to reduce its overall exposure to mortgage
securities. Other investors may have chosen to eliminate it entirely. The statistical
comparison of CMMF's account with the performance of others does not account for this
variable. The comparison is not meaningful.
[*14]JPMIM's Knowledge Regarding the
Challenged Securities
JP Morgan Recognized Risk
According to CMMF, while JPMIM's parent company, JP Morgan,
recognized the unfolding crisis and substantially exited the subprime residential real
estate market, JPMIM took no affirmative steps to account for the crises. Instead, JPMIM
consistently advised CMMF to hold its positions and added an additional $100 million in
mortgage securities to CMMF's account between May and July of 2007. Although
CMMF makes much of JP Morgan's reducing its exposure to subprime mortgages long
before June 30, 2007, it fails to demonstrate how that relates to the Challenged Securities
in the Account.
According to CMMF, JP Morgan saw the writing on the wall before June
30, 2007.
CMMF points to an October 2006 "urgent" call JP Morgan CEO Jamie
Dimon made to William King, global co-head of the securitized trading for a division of
JP Morgan's Investment Bank (the IB) — J.P. Morgan Securities, Inc. (JPMSI).
According to press reports, during the conversation, Mr. Dimon allegedly told Mr. King,
"I really want you to watch out for subprime. We need to sell a lot of our positions. I've
seen it before this could go up in smoke." (CMMF Post-trial Brief p.15.) During
depositions, the two participants to the conversation vehemently denied that any such
exchange took place. Mr. Dimon said that he informed Mr. King that "delinquencies and
charge-offs were going up more than you would have expected . . . And that he should be
very thoughtful on the managing of the subprime mortgage positions." (Dimon Dep.
105:7-13.) Mr. Dimon denied that he instructed Mr. King to sell the subprime positions:
"If I ordered him to do that, he would have done that . . . we didn't." (Dimon Dep 105:
14-17; 108:4.) Likewise, Mr. King's recollection mirrors Mr. Dimon's version: "I recall
him being alarmed by the sharp increase in delinquencies and him wanting to review the
positions, the hedges that I had on for positions we had." (King Dep. 110:19-22.) When
asked if Mr. King walked away from the conversation with a general impression that he
should reduce the subprime mortgages, Mr. King responded: "I didn't walk away with
that. What I walked away was him wanting to review [the IB's]; positions." (King Dep.
147:20-22.) According to Mr. King, after the review, the IB "didn't materially change any
of the risk positions that [it]; had on at that time." (Id. at 153:20-22.)
CMMF points to statements Mr. Dimon made in JP Morgan's Annual
Reports. It points to the 2008 Annual Report, in which Mr. Dimon says: "[JP Morgan ];
substantially cut back on subprime early in the crisis. While subprime mortgages cost us
nearly $1 billion in 2008, we avoided far worse results because we had significantly
reduced our exposures in 2006. This was true both in the mortgage business and in the
Investment Bank." (Ex. 456 p. 11.) CMMF also points to Mr. Dimon's deposition, during
which he explained that JP Morgan began its substantial cut-back on subprime in 2006
because by then JPMorgan had already "started to see delinquencies and charge-offs go
up." (Dimon Dep. pp. 14-15.)
These statements are primarily related to the mortgage origination business,
rather than proprietary and agency securities that are the subject of the present action.
When asked what actions were taken in the mortgage business and the IB "to
significantly reduce subprime exposure starting in 2006," Mr. Dimon responded:
The originations that took place in '07 we sold because we thought it was
better execution. Unfortunately, we still had a lot of subprime and stayed on the balance
sheet. If we were as smart as you think we are, we would have sold that too. Then the
Investment Bank they used to underwrite subprime mortgages, and I think they just
became more careful in the kind of [*15]subprime
mortgages they were underwriting or warehousing.
(Dimon Dep. 16:21-17:12.) Although JP Morgan took steps to reduce its
exposure to subprime early on, it did so primarily in its mortgage origination
business — a very different matter from the AAA-rated securities at issue here,
with their various built-in protections against delinquencies.
CMMF then draws attention to a January 2007 Citigroup Financial
Conference Power Point presentation given by Mr. Dimon and a transcript of his
comments. Referring to the "recent credit performance," Mr. Dimon said, "only in
sub-prime mortgages, a little in sub-prime auto, but not in card, not really in auto, not
really in others, only in sub-prime mortgages do you really see something taking place
here, which looks like a recession." (Ex. 461 at 723.) Then, discussing JPMorgan's
subprime exposure, Mr. Dimon said:
You're going to see all of our consumer loans; at the end of the third quarter,
$23 billion with subprime; at the end of the fourth quarter, $20 billion was subprime. We
sold all of our production during the course of the year, subprime mortgages, which we
think shows pretty good discipline, because that does hurt income a little bit.
(Id. at 725.) The bullet point on an accompanying chart reads
"Mortgages is the majority of sub-prime portfolio, but exposure is being reduced. Sold
most of 2006 sub-prime vintage production. 4Q06 sub-prime mortgage portfolio of
$13.2B includes $4.5B of loans classified as held-for-sale; expected to be sold in 1Q07."
(Id.) Once again, Mr. Dimon's comments were directed to the mortgage
origination business.
CMMF argues that by the end of 2007, due to the protective measures JP
Morgan had taken earlier in the year, JP Morgan's exposure to subprime was a fraction of
its peers — a mere $421 million — compared to CMMF's subprime
exposure at the time of more than $200 million. (CMMF Post-trial Brief p. 16.) An IB
Business Update from early 2008 confirmed that throughout 2007, JPMorgan
deliberately unloaded subprime to protect itself:
"Here's a chart we're thrilled to be at the bottom of. This is how we
compared to our competitors on writedowns in the third and fourth quarters of 2007. It
includes mortgage related, structured credit and leveraged lending related marks. It hurts
to writedown $2.9bn in any market, but compared to everyone else, we're feeling pretty
good about that. This isn't by accident . . . We made a choice to limit and manage our
exposure to subprime."
(Ex. 1024 at -295.) Once again, there is no question that JP Morgan took
steps to reduce its exposure to subprime. These reductions did not extend to the
Challenged Securities.
Another piece of evidence CMMF relies on is JP Morgan's Market
Committee Meeting Weekly Risk Report. According to CMMF's expert witness Ezra
Zask (Mr. Zask), the Chief Investment Office (the CIO), which invested the bank's own
excess cash portfolio, had disposed of billions of dollars of CMOs. (Zask Aff. pp.
23-24.) This seemingly pertinent piece of evidence does not help CMMF's case. During
Mr. Zask's cross-examination, it became apparent that he arrived at this conclusion by
comparing Weekly Risk Reports from November 20, 2006 and February 23, 2007. He
then deduced from the change in the CMOs that $2.7 billion of CMOs were sold or
expired. (Zask Trial Tr. 1490:10-11499:8.) However, Mr. Zask was unable to explain
why he chose these specific reports for his analysis. (Zask Trial Tr. 1499:18-1502:14.) It
became apparent that he had no explanation to offer when he was presented with a [*16]Weekly Risk Report from October 26, 2007. The report
showed the CIO had approximately $3.6 billion in CMOs. It had actually increased
exposure from November 2006, when it had only $2.7 billion. (Zask Trial Tr.
1502:18-1504:19.) Notably, the October 2007 report demonstrates that the CIO had
increased its CMO exposure nearly four months after the date Mr. Zask chose as the
deadline by which the Challenged Securities should have been sold if the Account had
been managed prudently.
Challenged Securities' Prospectus Disclosures
CMMF argues the information found in the prospectuses should have alerted
JPMIM to the imprudence of investing in the Challenged Securities. Between May and
July 2007, JPMIM added over $100 million of additional subprime securities to the
Account. The prospectuses for a number of these securities warned that there may be
limited liquidity and that a resale market may not develop. Likewise, the prospectuses
warned that the underlying loans may experience higher rates of delinquency, foreclosure
and loss than conforming mortgages. The prospectus for the Option One security
received particular attention during trial. It warned that a resale market may not develop
and in the event that one does, "it may not provide certificate holders with liquidity of
investment." (Ex. 1866AAAA at 138.)
The court does not find these disclosures compelling. Standard risk
disclosures often contain extensive — but unqualified—risk disclosures. If
CMMF's theory were valid, investment managers would face liability whenever, in
hindsight, a disclosed risk, however unlikely, came to fruition.
Warning from MBS Team to Sell CMOs
CMMF also points to the testimony of Fred Loh (Mr. Loh), who was the
co-head of the MBS Team at the time. The MBS Team was the sector team responsible
for recommendations regarding CMOs. Mr. Loh testified that in early 2007, his team
recommended that due to outsized risk JPMIM should sell Alt-A negative amortizing
CMOs. (Loh Dep. 57:8-58:17, 137:21-139:6, 60:7-60:25.) CMMF contends that JPMIM
failed to follow this recommendation and these CMOs are responsible for a substantial
portion of CMMF's damages.
Not following the recommendation may have been the wise choice. First,
Mr. Loh had nothing to do with the Account. He was responsible for analysis of
agency-backed mortgage securities — a class of securities unrelated to the
non-agency CMOs at issue here. (Bernstein Aff. ¶ 37(b).) Mr. Loh specifically and
repeatedly disavowed any knowledge of the credit characteristics of non-agency CMOs.
(Loh Dep. 126:22-127:3; 137:10-20.) He testified that the primary reason for his
recommendation to sell non-agency CMOs was so that the proceeds could be used
towards an investment that he was championing. (Loh Dep. 58:18-59:16, 61:2-61:23,
67:15-68:14.) Notably, Mr. Loh was fired because the public mortgage group suffered
from "bad decisions" and "bad behavior." (Bernstein Aff. ¶ 37(b).)
Published Research and Internal Analysis
CMMF argues that JPMIM's purchases were imprudent because JP Morgan's
published research and internal analyses recognized the subprime market was entering a
"severe correction" and "blowout." In February 2007, a JPMSI US Fixed Income
Strategy analyst reported: "We believe we are in the early stage of a severe correction in
sub-prime mortgage credit . . . despite significant re-pricing of subprime market in the
past six weeks, we believe that risks are still sharply skewed to the downside." (Ex. 1026
at 787.) The report continued:
We have been underweighing the Home Equity sector since early
2006, based on deteriorating housing and weak fundamentals for subprime mortgage
credit. In short, the combination of flat [*17]or negative
house price appreciation, together with egregious loan underwriting in 2006 (which
continues, in our view) has created exceptionally poor conditions for the sector . . . We
believe that we are still in the early stages of a severe correction in sub-prime mortgage
credit . . . risks are still sharply skewed to the downside.
(Ex. 1026 at -787) (emphasis added). In March 2007, The Board of
Directors Risk Policy Committee received a presentation on consumer mortgage risk.
The presentation spoke of "[s];ignificant market turmoil . . . in the housing market with
default rates rising (particularly in sub-prime), sub-prime lenders failing, and mortgage
backed bonds exhibiting stress" and anticipated a "[c];ontinued downward trend . . . in
sub-prime mortgage lending for the foreseeable future." (Ex. 462 at 517.) The response
to this downturn included "[c];ontinuing to strategically manage limited exposure to
sub-prime real estate. Asset sales; Credit policy tightening; and Default management
intensity." (Id.) An April 2007 JPMSI analyst report observed: "The subprime
mortgage market is now beginning the second stage of its correction: the credit crunch. A
prolonged second stage will likely be accompanied by significant rating agency
downgrade activity." (Ex. 508 at -765.)
None of the reports and analyses relied on by CMMF demonstrate that the
reasonable conclusion was that the Challenged Securities were an imprudent investment.
None of these documents predict a significant risk to AAA-rated securities or suggest
reducing exposure to those investments. The February report maintained a "neutral"
recommendation on highly rated ABS-HELs. (Ex. 1026 at -787.) The March presentation
focused on lending. Although it noted that "mortgage backed bonds exhibiting stress," it
is not clear how this observation should have influenced JPMIM's decision-making with
respect to the Challenged Securities. The April report was primarily focused on
BBB-rated ABS-HELs. There was no mention of highly rated tranches like the ones in
the Account. (Ex. 508 at -765-66.)
The reports add nothing new. They contain a negative assessment of
subprime mortgage securities. JPMIM was not oblivious to market conditions. The
evidence has shown that JPMIM was aware of a downturn in mortgage securities, but it
believed the Challenged Securities had adequate protections and could withstand the
stressful market conditions. (Venkatakrishnan Aff. ¶¶ 38-50; Stancher Aff.
¶¶ 88-91.) JPMIM took proactive steps to reduce risk by purchasing more
conservative ABS-HELs. (Noh Trial Tr. 1910:5-19.) JPMIM also increased its
monitoring and analysis of the Challenged Securities and concluded that CMMF should
continue to hold highly-rated ABS-HELs rather than sell them at depressed market
prices. (Stancher Aff. ¶¶ 99-105.) There is no evidence that JPMIM ignored
events that counseled divestment of mortgage securities. The question is whether the
decision to buy and hold AAA-rated mortgage securities was negligent in light of the
information available to JPMIM at the time. These documents do not shed any light on
the matter.
JPMIM's Senior Executives' Early Knowledge of Crisis
CMMF also contends that before June 30, 2007, JPMIM senior executives
with ultimate responsibility for accounts knew the subprime market was entering a "full
blown crisis." CMMF points to communications between Seth Bernstein (Mr. Bernstein),
who was JPMIM's Head of Global Fixed Income responsible for CMMF's account, Paul
Bateman (Mr. Bateman), who was Vice Chair of JP Morgan Asset Management
(JPMAM) and Mr. Bernstein's superior, and Jes Staley (Mr. Staley), who was the Head
of Asset and Wealth Management and Mr. Bateman's superior. CMMF points to an email
from Mr. Bateman to Messrs. Staley and Bernstein in [*18]August 2007 describing how they had foreseen the
subprime crisis: "This problem is of our own making even allowing for the extreme
conditions in the markets today; we have been saying for the last eighteen months that
something like this would happen." (Ex. 420 at 392.) In September 2007, Mr. Bernstein
also wrote a letter to some Fixed Income clients discussing the "summer's trauma." In it,
he discussed how "[b];y late-June/early-July this growing unease with the credit quality
of subprime borrowers in the US had grown into a full blown crisis of confidence for all
mortgage securities." (Ex. 426 at 915.) CMMF also relies on a letter to clients written in
December 2007 by C.S. Venkatakrishnan (Mr. Venkatakrishnan), the Managing Director
and Head of the Fixed Income Group in New York. The letter, entitled The Best of
Times The Worst of Times, described how "[s];ince last year [2006];" JPMIM had
been "concerned with sub-prime lending and had trimmed [its]; exposure to about 4% in
portfolios [with]; AAA-rated and AA-rated bonds, primarily the former, of a variety of
vintages." (Ex. 439 at -562.)
Although it is plain that JPMIM personnel foresaw a general, long-predicted
dislocation in the credit markets, this does not demonstrate that JPMIM foresaw the
actual crisis or that anyone recognized the outsized risk in the markets for CMMF's
highly protected securities. With respect to Mr. Bateman's August 2007 e-mail, Mr.
Bernstein whole heartedly disagreed with the assessment that the crisis was foreseen. In
his deposition, Mr. Bernstein explained
[W];e knew that there was too much liquidity in the system. What we didn't
agree on was where was the bubble . . . there were debates on where the bubble found
itself. . . . The debate in the asset committee was in what asset classes, equities, real
estate, fixed income, was the manifesting itself? . . . There wasn't a consensus that it was
in fixed income markets or in respect to mortgage-related or real estate securities.
(Bernstein Dep. 276:12-17; 277:16-24; 280:14-17.)
Mr. Bernstein's description of the debate within JPMAM is consistent with
the statement of JPMIM's expert, Professor F. Allen Ferrel (Professor Ferrel). According
to Professor Ferrel, there was no consensus among the academia about the existence of a
housing bubble prior to the crisis. Those that argued for it, did so years before the market
peaked and so lost credibility. (Ferrel Aff. ¶ 68.) Mr. Bernstein's assessment of
JPMIM's views heading into the crisis is not merely an attempt to explain away
admissions made six years earlier. During his exchange with Mr. Bateman in August
2007, Mr. Bernstein expressed genuine surprise at the unfolding events: "I've never in 23
years seen the markets as skittish. To have Aaa' and Aa' short-dated paper treated as
toxic is really unprecedented." (Ex. 420 at 392.)
Mr. Bernstein's comments in his September 2007 letter to investors are
couched in language that makes it clear that his insights are the product of hindsight. As
he speaks of "full blown crisis of confidence for all mortgage securities" by "late
June/early-July" he is also speaking "with the benefit of hindsight." (Ex. 426 at -915-16.)
As he states that "despite the well-publicized weakness in the subprime market earlier
this year [JPMIM]; continued to believe that [it was]; well insulated from the anticipated
jump in defaults and chose to maintain [its]; positions," he also admits that "[w];ith the
benefit of hindsight, that proved to be the wrong assumption." (Id.) Notably, the
letter echoes JPMIM's recommendations to CMMF: "I believe the passage of time will
demonstrate that our decision to hold these securities to be wise." (Id.)
Mr. Venkatakrishnan's The Best of Times The Worst of Times letter
to clients also does little to advance CMMF's negligence case. While the letter references
subprime lending and [*19]reduction in exposure to
AAA-and AA-rated subprime securities, the court is not persuaded that this is evidence
that JPMIM foresaw the risks of subprime securities as early as 2006. CMMF makes
much of the fact that the paragraph discussing how JPMIM's concern with sub-prime
lending led it to trim its exposure starts with the phrase "[s];ince last year," meaning
2006. (Ex. 439 at -562.) After examining the letter, the court finds the conclusion urged
by CMMF is a stretch. Not only is the letter written in very general terms, without
reference to a specific strategy or fund, but it clearly includes portfolios with entirely
different investment guidelines and goals from that of CMMF — portfolios
investing in securities prohibited by CMMF's guidelines. (Ex. 439 at -562,-564.)
JPMIM's "Damning Admissions"
CMMF contends that JPMIM's own witnesses confirmed that it was a
mistake to buy and hold- non-agency mortgage securities for accounts like CMMF' and
these admissions confirm that this mistake was a result of negligence.
One of the most frequently cited communications at trial was Mr. Bernstein's
August 2007 memo to Messrs. Staley and Bateman, among others, regarding "The
Summer of 07: Lessons and Actions for Global Fixed Income & Currency." In it,
Mr. Bernstein was highly critical of the New York/London team's performance. He
identified a "fundamental lack of investment talent" and "lousy management and risk
taking" as reasons for "woeful performance" of certain EC funds. He noted that the ABS
Team had not foreseen that the crisis would undermine confidence in AA- and
AAA-rated ABS-HELs and had failed to reduce exposure earlier in the year: "The
positions that ultimately undermined our investment performance were measured and the
risks visible to anyone caring to spend the time to look at the reports generated." (Ex. 314
at 554.)
Mr. Bernstein also sent out a questionnaire to everyone attending a
mandatory September 2007 meeting to discuss investment performance across the New
York/London engine. The questionnaire sought input on what went wrong and what
could be improved. Mr. Venkatakrishnan responded:
Lack of macro and sector team insight into the severity and pervasiveness of
the sub-prime problem and technical forces behind spread widening . . . Poor portfolio
oversight of the mortgage positions with lack of appreciation of the correlated risk across
sectors and of risk in enhanced cash strategies. In the enhanced cash space we did not
question our premise that AAA' and AA' rated bonds would be immune to problems.
Also, the portfolio managers have delegated portfolio monitoring to junior people and
are involved in too much day-to-day investment activity: . . . Martucci and Sherman in
buying corporate floaters. The US short term portfolio managers are too junior.
(Ex. 427 at 466.) Mr. Noh was also among those who responded. He wrote:
"we look at our holdings overall, but not on an acct by acct basis, and some accts became
too heavily allocated to 06 [vintages]; and certain servicers/originators." (Ex. 296 at
233.)
CMMF also points to the Private Bank (PB), arguing that through its
interactions with the Fixed Income group, it reached similar conclusions to those of the
internal review at JPMIM. In an October 2007 presentation entitled "PB review of
JPMAM NY Taxable Fixed Income," Michael Cembalest (Mr. Cembalest), Chief
Investment Officer of JP Morgan's Private Bank, wrote that "there was evidence that
subprime was deteriorating, and time to protect fund investors from the damage" but
JPMIM "failed to reduce the extent of subprime exposure at [*20]points in time when it would have been prudent to do so."
(Ex. 301 at -538.) Mr. Cembalest went on: "We do not consider the aggregate investment
judgment, risk management and market experience on the team to be sufficient to
manage risk-oriented investment products for PB clients." (Ex. 544 at 433.) As a result,
the PB put the "NY Taxable Fixed Income (NY-TFI) engine . . . on probation across all
Bond Fund, RV and Enhanced Income products." (Id.)
In response to Mr. Cembalest's presentation, Mr. Bernstein prepared and
circulated the "New York/London Presentation for the Investment Committee Meeting
on Tuesday, October 16, 2007." (Ex. 431.) He explained that JPMIM had not expected
traditionally safe AAA-rated ABS-HELs to be affected by the disruptions in the housing
market, but maintained the belief that these securities would timely pay all interest and
principal. The presentation also acknowledged that "[t];he summer highlight[ed]; the
engine's limited pool of talented, experienced investors and [JPMIM's]; need to continue
upgrading talent, particularly in two Sector Teams and in the New York broad markets
Portfolio Management role. We need additional senior talent." (Ex. 431 at 807.) Mr.
Bernstein's presentation also contained a slide entitled "Root Cause Analysis-Enhanced
Yield Funds." It identified the root causes for the strategy's "underperformance,"
including: "[s];ecurities selection short-comings in ABS, specifically HELs,"
disproportionate "[e];xposure to HELs" and the "decision to hold after February [being];
incorrect given product design." (Ex. 431 at 832.)
These "admissions" do seem "damning" when read one after another with
little, if any, context. However, having examined these documents closely, and having
read the statements and depositions as well as heard the testimony of the individuals who
made these statements, the court finds they do little to further CMMF's case.
Although Mr. Bernstein's memo on "The Summer of '07: Lessons and
Actions for Global Fixed Income & Currency" and the responses to his
questionnaire contain many critical statements, none establish negligence. As Mr.
Bernstein explained in his affidavit, most of the memo related to parts of the Fixed
Income business that had no connection to CMMF's account. (Bernstein Aff. ¶ 37.)
Indeed, even portions of the memo that addressed the "New York/London team's
performance," encompassed strategies entirely unrelated to the Short Term business that
managed CMMF's account — including broad markets and Relative Value (RV)
funds, both of which are long-term products. (Ex. 314 at 552-54; Bernstein Aff. ¶
41.)
Mr. Bernstein's harshest criticism fails to establish negligence. In the
discussion of the Quantitative Risk Group, he stated "the positions that ultimately
undermined our investment performance were measured and the risks visible to anyone
caring to spend the time to look . . . No one . . . seems to have made the effort." (Ex. 314
at 554.) Yet the evidence presented at trial does not support this assessment. In fact,
JPMIM's expert John Richard (Mr. Richard) testified that after conducting an
independent review — examining the information available at the time and
resisting the urge to provide analysis hindsight — he did not conclude that people
were not looking at the documents they were supposed to be looking at. (Richard Trial
Tr. 2057:13-2059:12.) In addition, evidence regarding this statement showed that it
concerned the performance of agency MBS in RV funds, which are distinct from the EC
Strategy of the Account. (Oswald Trial Tr. 1302:18-1303:25.) Notably, even in this
highly censorious memo, Mr. Bernstein still believed that: "clients who redeemed shares .
. . did so prematurely" because AAA-rated ABS-HELs were "money-good." (Ex. 314 at
552.)
Mr. Bernstein's presentation entitled "New York/London Presentation for the
Investment Committee Meeting on Tuesday, October 16, 2007" included a slide that
contained some very [*21]concisely phrased bullet points
identifying "root causes" for underperformance. (Ex. 431 at 832.) These are hindsight
statements about the obvious: that decision with respect to subprime securities proved to
be incorrect. The court does not find this slide to be an admission of negligence.
Although various "admissions" question whether there were enough talented
investment professionals in New York, this does not demonstrate negligent staffing of
the Account. As Mr. Bernstein explained, he did not believe there was a lack of talented
investment professionals in the lead-up to the crisis. His concern was regarding the need
for additional personnel after the crisis. (Bernstein Aff. ¶ 37(c); Ex. 12 at 349.) The
post-September 2007 reorganization of the Fixed Income business reflects his continued
confidence in his team. Mr. Venkatakrishnan was promoted to CIO of the NY Fixed
Income Strategies, replacing Mr. Pecoraro. Mr. Pecoraro was made head of sector teams
dealing with securities backed by mortgages and other liquid investments like US
Treasuries. Mr. Donohue continued as CIO for the London engine and Short Term
business. Mr. Loh was fired for his poor judgment in the area of agency MBS. None of
the PMs for the Short Term business or members of the ABS Team were disciplined or
demoted. (Bernstein Aff. ¶ 4; Venkatakrishnan Aff. ¶¶ 60-62.)
An additional concern about staffing was the location of Mr. Donohue and
delegation of too much responsibility to junior PMs. In his memo, Mr. Bernstein
questioned "whether John's absence from New York left him deaf to the rumblings in the
sub-prime marketplace." (Ex. 12 at 347.) He also concluded that "it seems clear that John
delegated too much to the PM team in New York in the management of the Short-Term
Bond Strategies." (Ex. 12 at 347.) This criticism was echoed by Mr. Venkatakrishnan
who thought "portfolio managers [had]; delegated portfolio monitoring to junior people."
(Ex. 427 at 466.) Mr. Cembalest also questioned the team's "investment judgment, risk
management and market experience." (Ex. 544 at 433.)
Testimony established that the junior PMs were in regular contact with their
superiors. Jon Jonsson (Mr. Jonsson) was head of the portfolio management team for the
EC funds and reported to Mr. Donohue. Mr. Jonsson testified that he had worked with
the PMs assigned to CMMF's account, Jarred Sherman and David Martucci, on a
day-to-day basis from 2001-2005, when he joined Mr. Donohue in London. Having
worked closely with both men, he was comfortable with the delegation of responsibility.
Indeed, throughout the trial, CMMF attempted to call into question whether the PMs on
the Account had sufficient experience, but there was never any evidence demonstrating
anything of the sort. Although higher ups questioned whether they had been permitted
too much discretion, their immediate supervisor was satisfied with their experience and
work.
In his statement, Mr. Bernstein explained that after writing the memo he had
spoken to Mr. Donohue, who explained that he was in regular contact with NY personnel
and was well aware of US market developments. Mr. Bernstein agreed his location in
London had not been an issue. (Bernstein Aff. ¶ 37(d).) Mr. Venkatakrishnan also
admitted that despite writing that the US Short Term PMs were too junior, he "could not
identify then, and cannot identify today, anything that a more senior PM would have
done differently with respect to our ability to foresee the impact of the crisis on highly
rated ABS-HELs or CMOs." (Venkatakrishnan Aff. ¶ 58.)
Mr. Bernstein's questionnaire led to a number of problems being identified
and improvements suggested to the investment process. (See e.g. Exs. 296, 297,
427.) Because there was room for improvement does not establish negligence with
respect to the management of CMMF's account. Mr. Noh commented that the ABS Team
looked at holdings overall rather [*22]than on an account
by account basis and that this led to over-allocation to 2006 vintages. (Ex. 296 at -233.)
Although the Account did have a high concentration of 2006 vintage securities,
testimony revealed that this had nothing to do with the due diligence process. Because
the Account was funded in 2006, there was an insufficient amount of earlier vintage
securities on the secondary market to fund the portfolio. (Noh Trial Tr. 1837:6-20;
1860:9-21.) JPMIM conducted analyses on the 2006 and 2007 vintages and thought
those were appropriate credit risks at the time it purchased them for the Account. (Noh
Trial Tr. 1861:12-15.) This testimony was corroborated by Mr. Richard, who explained
that earlier vintages were generally not available in the market because they were
typically purchased in the new issuance market by buy-and-hold accounts and did not see
the light of day again. (Richard Trial Tr. 2087:10-2088:3.)
PB's decision to place JPMIM on probation in September 2007 was the
decision of a single client. It does not prove that the investment product was managed
inappropriately. Mr. Cembalest's statements only demonstrate that he came to differ with
JPMIM's views rather than that JPMIM was negligent.
As CMMF has demonstrated, over and over again, JPMIM was not deaf to
the rumblings of the subprime market. Although Mr. Cembalest ultimately disagreed
with JPMIM's assessment of risk, finding its research unconvincing, he generally found
JPMIM's work was thorough. After meeting with various members of the JPMIM Fixed
Income team in August 2007, Mr. Cembalest wrote: "Just spent 2 hours with stancher,
oswald, Sherman, ufferfilge and another guy. C plus. And a sell on the rest of the
enhanced income." (Ex. 533.) During deposition, he explained the grade was for
convincing, not thoroughness. (Cembalest Dep. 241:9 -243:3.) During deposition, when
asked about whether he was able to verify JPMIM's assertion that it had applied superior
underwriting standards, Mr. Cembalest responded: "I wasn't able to verify it. It didn't
mean it didn't exist, but I was not able to verify it in the week that I imposed on [the PB];
to make that decision." (Cembalest Dep. 192:13-21.)
Differences of opinion aside, there are a number of other difficulties with
using the PB's relationship with JPMIM as evidence of JPMIM's negligence in managing
the Account. The PB did not act to withdraw funds until August and September 2007,
which is inconsistent with CMMF's view that the Challenged Securities should have
been liquidated no later than June 30, 2007. Most importantly, PB had different
circumstances than CMMF's. PB had a commingled fund with JPMIM and its
withdrawal of funds was strongly influenced by concern about the prisoner's dilemma.
(Bernstein Aff. ¶¶ 44-45.) Mr. Cembalest was pushing hard to get the PB to
make the decision because of the risk that other investors might flee before them.
(Cembalest Dep. 190:17-23.)
Due Diligence for the Account
CMMF also argues that JPMIM failed to do proper due diligence for the
Account. CMMF contends that had JPMIM acted reasonably and with due care, there
would be substantial evidence of the analyses it performed to determine whether or not to
buy and hold the Challenged Securities. Yet after dozens of hours of depositions, and the
production of hundreds of thousands of pages of documents and hundreds of pages of
witness statements, JPMIM was unable to point to a single document showing that any
such analysis was done before June 30, 2007 and not a single witness was able to recall
doing any analysis to support the decision to invest CMMF in the Challenged Securities.
CMMF argues that although witnesses were sure [*23]that the investment process was followed, there was no
evidence that the due diligence process exhorted at trial was ever applied to the securities
held by CMMF. CMMF points to Mr. Bernstein's deposition, during which he
unequivocally testified that he would expect pre-purchase due diligence to be
documented. (Bernstein Dep. 84:18-85:9.) CMMF also argues that there is no evidence
with respect to what was done by the MBS Team to justify the purchase and retention of
the non-agency CMOs held for CMMF. None of the members of the MBS Team
testified, leaving a gap in the record.
CMMF also argues the process was flawed or outright ignored. The ABS
Team did not conduct security-level analyses on a portfolio level, instead analyzing the
holdings on an aggregate basis across portfolios. This, CMMF contends, led to certain
accounts becoming over concentrated in certain originators or, as in the case of CMMF,
certain vintages. CMMF argues PMs who constructed CMMF's portfolio outright
ignored the process, because the Macro Packages recommended reducing subprime
exposure. (Exs. 207, 208, 485, 230.)
CMMF contends that part of the reason for JPMIM's failures is the lack of
written policies and procedures. Nick Gibson, a JPM compliance officer, wrote on March
2007: "There are no documented procedures detailing the lines of responsibility and
segregation of duties between strategists, PM's and traders . . . . In addition there are no
procedures for . . . the monitoring and oversight undertaken by Management." (Ex. 342
at 600.) CMMF's maintains that under these conditions, it is no wonder that CMMF's
account fell through the cracks and no JPMIM witness can recall being assigned specific
responsibility for performing due diligence for the Account.
Despite the overwhelming lack of documentary evidence, the court is
persuaded that the necessary due diligence took place. The absence of documentation
does not establish JPMIM's negligence. The unchallenged evidence was that investment
managers typically do not conduct written analyses of diligence or investment decisions.
CMMF's characterization of Mr. Bernstein's testimony on the matter as "unequivocal" is
misleading. During deposition, Mr. Bernstein could not specify the kind of
documentation he would expect his group to create in order to document analyses or due
diligence and admitted that in ongoing due diligence, he would not necessarily expect
any documentation. (Bernstein Dep. 86:16-90:14.) Even CMMF's independent advisor,
Ms. Zimmerman, admitted that she does not keep written records of security trades or
processes involved in investment decisions. (Zimmerman Dep. 81:20-82:20.) Although
individuals could not remember actually engaging in due diligence with respect to the
Account six years after the fact, they consistently testified that they did not doubt they
followed the process and the court finds this testimony credible.
CMMF offered no evidence that JPMIM's process diverged in any respect
from the relevant and accepted industry practices. Mr. Zask, CMMF's expert offering
testimony on JPMIM's decision-making, acknowledged that he did not compare JPMIM's
practices or decisions to those of other investment managers. By contrast, JPMIM's
expert, Mr. Richard, reviewed JPMIM's process and offered the only expert opinion in
the record comparing JPMIM's process with the industry practices:
JPMIM's process for selecting and monitoring the securities acquired for the
CMMF portfolio was consistent with industry standards and practices. JPMIM followed
a detailed investment process that properly evaluated market conditions from a macro
level, conducted due diligence on individual securities, and established risk monitoring
and compliance processes consistent with industry standards.
(Richard Aff. ¶ 15(c).) The testimony of numerous fact witnesses
confirmed the adequacy of JPMIM's process. The court is simply not swayed by the lack
of testimony with respect to the MBS Team. There was testimony with respect to the due
diligence process generally, and the court was not presented with any reason to draw a
negative inference against JPMIM.
While the process was not without flaws, CMMF has failed to demonstrate
how this impacted the Account. As discussed earlier, the overconcentration in 2006
vintages is not related to the review process. The allocation in CMMF's portfolio tracked
those set forth in the "model portfolio," indicating that the Account was being
appropriately managed in accordance with JPMIM's process. (Jonsson Trial Tr.
829:2-832:20.) For example, during the second quarter of 2007 — when CMMF
claims JPMIM should have been divesting the Challenged Securities — the
"model portfolio" had allocation to ABS of 19.2% and an allocation to CMOs of 20.7%.
(Ex. 1615.23.) CMMF's Account Statement portfolio had a 17.2% allocation to ABS and
a 21.3% allocation to CMOs. (Ex. 1625.66-67.) By August 2007, CMMF's Account had
increased the allocation to ABS to 21.28%. (Ex. 1686.11.) The last non-agency MBS had
been purchased in April 2007, so allocations were not increased at this time. When asked
why JPMIM continued to purchase ABS-HELs for certain EC accounts after March 30,
2007,[FN6]
Mr. Martucci explained that the securities still offered attractive returns relative to all
other sectors, and based on credit analysis and ideal portfolio construction "we wanted to
reach a certain target level in this asset class . . . around 20 to 22 percent and we were
looking to bring all of our accounts up to that level so accounts that weren't at the 22
percent target, we looked to add more through the July of 2007 date." (Martucci Trial Tr.
2010:16-26.)
Of the Macro Packages cited by CMMF to demonstrate that JPMIM did not
follow the recommendation to reduce subprime exposure, the earliest is from October
2007. By that time, the conditions which prompted JPMIM to purchase the securities
earlier that year had changed drastically. The only thing CMMF has to complain of with
respect to the recommendations in these Macro Packages is that it may not have been
advised to sell its positions. Mr. Ufferfilge could not recall whether or not he had
communicated this information to CMMF and the evidence has shown that JPMIM
repeatedly advised CMMF to hold its positions. (Ufferfilge Trial Tr. 271:13-21.) This is
not enough to base a finding of negligence.
The Macro Packages were intended as a broad, thematic recommendation. It
was up to the PMs to translate these into separate accounts, as guidelines and client
guidance permitted. (Donohue Trial Tr. 1802:2-21; Stancher Aff. ¶ 113.) The
Macro Package for the first quarter of 2008 makes this clear: "General recommendations:
Overall: Continue to reduce risk in accounts given potential for economic/mortgage
market continued softness and the apparent reluctance of some clients to experience
volatility. Need to work with individual CPMs /PMs to develop strategies and
specific recommendations." (Ex. 208 at 605-06) (emphasis added). JPMIM's
recommendation to hold the Challenged Securities rather than sell them at deeply
discounted prices — when CMMF did not require immediate liquidity and had
demonstrated a reluctance to take losses — was not unreasonable.
The court finds that JPMIM was not negligent and did not breach its
fiduciary duty in its management of the Account. To establish a cause of action for
negligence, plaintiff must prove [*24]that there existed a
duty of care, which the defendant breached thereby proximately causing plaintiff's injury.
See Friedman v Anderson,
23 AD3d 163, 165 (1st Dept 2005). A cause of action for breach of fiduciary duty
requires a showing that a fiduciary duty existed between the parties, which the defendant
breached thereby proximately causing plaintiff's injury. See People v H & R
Block, Inc., 16 Misc 3d 1124[A], * 7 (NY Sup Ct Supreme 2007). Because JPMIM
had complete discretion to manage CMMF's investment account, it owed CMMF a
fiduciary duty to act with care and loyalty. See Assured Guar. (UK) Ltd. v J.P. Morgan Inv. Mgt. Inc., 80
AD3d 293, 306 (1st Dept 2010); Bullmore v Ernst & Young Cayman Is., 45 AD3d 461,
463 (1st Dept 2007) ("Professionals such as investment advisors, who owe fiduciary
duties to their clients, may be subject to tort liability for failure to exercise reasonable
care. . . ." (quotation omitted)); Brooks v Key Trust Co. Natl. Assn., 26 AD3d 628, 630 (3d
Dept 2006) (financial advisor with discretionary authority to act owes a fiduciary duty).
This fact is not in dispute. The issue is whether JPMIM breached these duties by
imprudently purchasing and retaining the Challenged Securities.[FN7]
The court in In re Janes — although addressing a fiduciary's duties under
the prudent investor standard as codified by the EPTL — was presented with a
similar question and its reasoning is instructive. It observed:
No precise formula exists for determining whether the prudent person
standard has been violated in a particular situation; rather, the determination depends on
an examination of the facts and circumstances of each case . . . . In undertaking this
inquiry, the court should engage in "a balanced and perceptive analysis of [the
fiduciary's]; consideration and action in light of the history of each individual investment,
viewed at the time of its action or its omission to act ". . . . And, while a court should not
view each act or omission aided or enlightened by hindsight . . . a court may,
nevertheless, examine the fiduciary's conduct over the entire course of the
investment in determining whether it has acted prudently. . . . Generally, whether a
fiduciary has acted prudently is a factual determination to be made by the trial court.
90 NY2d 41, 50 (1997) (citations omitted).
The evidence has established that JPMIM purchased the Challenged
Securities as part of an investment plan that was created to achieve CMMF's objectives.
At the time they were purchased, these securities were deemed relatively safe and
desirable due to their credit protections and returns. Subsequent developments caused the
securities to become illiquid and JPMIM advised CMMF to wait out the storm rather
than sell at deeply discounted prices. The court finds that JPMIM acted reasonably in
light of the information that was available to it at the time. JPMIM did not fail to timely
reduce exposure to the Challenged Securities due to inattention or inaction. It made an
error of judgment, that is all, and this alone is not sufficient to establish a breach of
duties owed to CMMF as its investment advisor. See In re HSBC Bank USA,
N.A., 98 AD3d 300, 309 (4th Dept 2012) (" [I];t is not sufficient that hindsight
might suggest that another course would have been more beneficial; nor does a mere
error of investment judgment mandate a surcharge.'" (quoting In re Bank of NY,
35 NY2d 512, 519 (1974)); In re Janes, 223 AD2d 20, 26 (4th Dept 1996),
affd 90 NY2d 41 (1997) ("Investment decisions typically present a choice among
myriad alternatives, some more or less prudent, and some imprudent, and the mere
availability of other prudent courses of action that a fiduciary could have pursued does
not support a finding that the fiduciary acted imprudently in choosing one such
course.").
Damages
The court is presented with two issues before it can resolve the question of
damages with respect to the breach of contract cause of action.[FN8]
First, it must determine whether CMMF had ratified JPMIM's actions in August or
December 2007, thereby creating an earlier cutoff date for damages. Second, the court
must decide on the appropriate formula for calculating damages.
JPMIM proposes two dates as possible cutoff dates for the calculation of damages.
Instead of May 6, 2008, when the Account was closed, JPMIM argues the court should
use August 31, 2007 or December 31, 2007. JPMIM points out that New York courts
have long recognized that ratification occurs when "the beneficiary's subsequent conduct
supports the . . . reasonable conclusion that he, by his assent thereto or acquiescence
therein, has accepted and adopted the fiduciary's actions." In re Levy, 69 AD3d
630, 632 (2d Dept 2010). JPMIM argues that the information it sent to CMMF in August
and December 2007 made it clear that the Account contained well over 20% of securities
collateralized by mortgages. CMMF's subsequent silence on the matter, JPMIM argues,
amounts to ratification.
JPMIM relies on the final ad hoc statement sent to CMMF on August 20,
2007. The statement showed 17.31% of the Account was invested in ABS-HELs and an
additional 23.19% in MBS. (Ex. 219 at -590.) A total of 40.5% were at that point
invested in mortgage-related securities. Mr. Benet and Ms. Zimmerman reviewed this
statement together. (Ex. 386.) In an August 20, 2007 email, Ms. Zimmer questioned
whether the portfolio was supposed to contain home equities. (Id. at 061.) In
response, Mr. Benet sent her the June 2006 statement, saying "we always had home eq's."
(Id. at -060.) Thus, JPMIM argues, there can be no doubt that CMMF knew that
more than 40% of the Account was in mortgage related securities by August 2007.
JPMIM also relies on a December 2007 email to CMMF that showed that "Home Equity
Receivables" and "Mortgage-Backed Securities" together exceeded 20%. (Ex. 374 at
008.) CMMF did not challenge the allocations. (Benet Trial Tr. 1045:2-4; Storey Trial
Tr. 1184:25-1185:25.) JPMIM argues that under these circumstances, CMMF accepted
JPMIM's classification practices and cannot recover losses that it suffered thereafter.
See Tripi v Prudential Secs., 303 F Supp 2d 349, 354-55 (SDNY 2003)
(speculating that arbitrator's reduction in damages may have been due to a finding of
ratification where customer failed to review regular account statements.)
The court is not persuaded that CMMF's failure to object to the breach upon
receipt of the statements amounts to ratification. CMMF objected within a reasonable
time — the contracted for 12-month period it had to object from the receipt of any
statement — by bringing this suit.[FN9]
The reasoning and law referenced above with respect to waiver are applicable here.
There are no surprises with respect to matters relating to waiver under New York law,
whether they be styled as ratification or any other theory. The court will use May 6, 2008
as the cutoff for damages.
The court turns to the formula to be used in the calculation. Mr. Zask and JPMIM's
damages expert, Mr. Lehn, differ slightly in the application of this formula. In calculating
the damages attributable solely to the violation of the Guidelines' 20% sector cap on
MBS, Mr. Zask looked at the last mortgage securities purchased in July 2007 (the
Breaching Securities) by purchase settlement date in reverse chronological order. Using
this method, he identified $297.6 worth of mortgage securities (based on their July 2007
market value) which should not have been purchased because they exceeded the 20%
cap. He then calculated the capital losses on these securities by subtracting from the
initial purchase price the sum of (1) the value of the [*25]securities that matured during this period and (2) the value
of the securities as reflected in JPMIM's statement as of May 5, 2008. He calculated the
damages to be $54.3 million.[FN10]
(Zask Aff. pp. 34-35.)
Mr. Lehn also looked at the breaching mortgage securities in reverse
chronological order. The formula he applied differs from Mr. Zask's. He reasoned that if
JPMIM had not invested in the Breaching Securities, it would have invested the funds in
an alternative investment that would have been exposed to the potential of gains and
losses. (Lehn Aff. p. 10.) Mr. Lehn reflected this risk by accounting for alternative losses
or gains as part of his damages formula. This was accomplished by looking at the
performance of the non-real estate related securities held in the Account during the entire
period of JPMIM's management. This analysis led him to conclude that the non-real
estate securities held in the Account had returns that varied significantly from the
three-month LIBOR rate, including periods during which the returns were negative.
(Id. at p. 11.) Mr. Lehn assumed that the "Account would have held
proportionally more of the securities that were actually held in the Account if it had not
held the [Breaching Securities];. To the extent that holding more of a particular class of
securities would have led to a violation of the sector allocation limits in the Guidelines
(e.g., corporate notes), [Mr. Lehn]; allocate[d]; any excess above the allocation
limit proportionately among the other classes of [non-Breaching Securities];." (Id.
at p. 12.) The formula can be summarized as follows:
(amount paid at purchase) — (amount received if sold/security's value
at damages cutoff) — (income received on the security) + (estimated lost earnings
if had been invested in alternative ways) + (prejudgment interest).
In this way, Mr. Lehn arrived at $37.1 million of lost principal and
$5,393,005 in lost earnings, a total of approximately $42.5 million in damages, before
prejudgment interest. (Lehn Aff. p. 17.)
CMMF argues that JPMIM's approach is inconsistent with In re Janes, 90
NY2d 41 (1997). In Janes the court was faced with whether the Surrogate's Court
had correctly calculated damages against a trustee who failed to timely sell securities,
which subsequently dropped in value. The damages were calculated by "determin[ing];
the value of the [securities]; on the date [they]; should have been sold, and subtract[ing];
from that figure the proceeds from the sale of the [securities], or if [securities are]; still
retained by the [plaintiff], the value of the [securities]; at the time of the accounting."
In re Janes, 90 NY2d at 55. The court in Janes also observed that
"[d];ividends and other income attributable to the retained assets should offset any
interest awarded." Id. at 55. CMMF argues that because it has not sought
discretionary interest on the losses (during the period starting at the purchase of
Breaching Securities to the closing of the Account), JPMIM's formula inappropriately
deducts the income CMMF received while it owned the Breaching Securities. See
Janes, 90 NY2d at 55; see also In re Garvin, 256 NY 518, 521 (1931);
Williams v JPMorgan, 199 F Supp 2d 189, 194 (SDNY 2002).
The court finds CMMF's reliance on Janes to be misplaced. The court in
Janes, and [*26]other cases CMMF cites,
addressed a breach of fiduciary duty where "a fiduciary's imprudence consists solely of
negligent retention of assets it should have sold." Janes, 90 NY2d at 55. In such
circumstances "the measure of damages is the value of the lost capital." Id. The
court is faced with a breach of contract based on a fiduciary's improper purchase of
securities.
CMMF is not arguing that the securities should have been sold before they
lost their value. Rather, CMMF argues that the Breaching Securities should never have
been purchased in the first place. In light of this, it is disingenuous to simultaneously
argue for the retention of gains resulting from the purchases. In a contract case, damages
serve to " put [the plaintiff]; in as good a position as he would have occupied had the
contract been kept.' " Menzel v List, 24 NY2d 91, 97 (1969) (quoting 11
Williston, Contracts [3d ed.], § 1395A, p. 484); see also 36 NY Jur. 2d
Damages § 9 ("The fundamental principle of damages . . . is fair and just
compensation, commensurate with the loss or injury sustained from the wrongful act
complained of."). As the Court of Appeals explained:
It is axiomatic that . . . the law awards damages for breach of contract to
compensate for injury caused by the breach — injury which was foreseeable, i.e.,
reasonably within the contemplation of the parties, at the time the contract was entered
into. . . But it is equally fundamental that the injured party should not recover more
from the breach than he would have gained had the contract been fully
performed.
Freund v Washington Sq. Press, 34 NY2d 379, 382 (1974)
(emphasis added). To allow for a simple lost capital calculation advocated by CMMF
— to allow an award of $54.3 million rather than the $42.5 million in damages
calculated by Mr. Lehn — would result in an $11.8 million gain to CMMF over
what it would have earned had JPMIM performed the contract based on Mr. Lehn's
calculations.
This leads to the question of whether Mr. Lehn's calculations are the proper
measure of CMMF's lost earnings. "The law does not require that [damages]; be
determined with mathematical precision. It requires only that damages be capable of
measurement based upon known reliable factors without undue speculation." Ashland
Mgt. v Janien, 82 NY2d 395, 403 (1993); see Wathne Imports, Ltd. v PRL USA, Inc., 101 AD3d 83,
88 (1st Dept 2012) (noting that a number of federal cases explained that where lost
profits are at issue, expert testimony based on unrealistic assumptions should be excluded
as speculative, but observing that "a degree of uncertainty is to be expected in assessing
lost profits."). The court finds that Mr. Lehn's calculations are not speculative as they are
based on the actual performance of the Account during the relevant period as well as the
allocations provided in the Guidelines. The court, therefore, finds that CMMF suffered
$42.5 in damages, before prejudgment interest, as a result of JPMIM's breach of
contract.
CMMF next argues that breach of contract damages should be adjusted by
10%, before prejudgment interest, to account for the overstated IDC marks in JPMIM's
statements. CMMF argues that IDC pricing, which was the basis of the prices reflected in
JPMIM's statements, was inflated such that CMMF could not have sold the securities at
those prices. To support this position, CMMF points to a holding report created by Mr.
Ufferfilge for the Account, which he then sent to Mr. Bernstein. (Ex. 259.) The report
showed broker indicated pricing for the Account's securities, IDC pricing for the same
and the differential as of March 20, 2008. (Id.) Notably, the report also showed
the difference in IDC pricing from March 19, 2008 and March 20, 2008. In that one day,
IDC recorded a price drop for the Account's securities, [*27]although not enough to catch up with broker pricing. This
is in line with testimony that IDC pricing lagged behind broker pricing. Based on this
information, CMMF calculated that the prices were inflated by 10.32%. (CMMF's
Closing Statement Slides p. 66.)
Although there has been sufficient evidence to demonstrate that, as a general
matter, IDC pricing lagged behind what could be obtained in the markets, CMMF's use
of a single report from more than a month before the Account was closed to obtain the
10% figure is too speculative. Moreover, the evidence showed that when a number of the
Challenged Securities were sold by Ms. Zimmerman, who took over managing CMMF's
portfolio, just weeks after the account was closed, those transactions were executed at or
above the IDC prices reported on CMMF's statements. (Richard Trial Tr.
2135:5-2136:8.) Therefore, CMMF's request for a 10% adjustment is denied.
Finally, the court must determine the appropriate prejudgment interest to be
applied to the damages. "Interest shall be recovered upon a sum awarded because of a
breach of performance of a contract . . . interest and the rate and date from which it shall
be computed shall be in the court's discretion." CPLR § 5001; see In re
Saxton, 274 AD2d 110, 121 (3d Dept 2000) (the trial court " possess[es];
considerable discretion regarding the imposition of interest, its rate, and the method of
compounding, if any.").
CMMF urges the court to apply the 9% statutory rate. See CPLR
§ 5004. However, the cumulative return from receiving a 9% annual rate from May
6, 2008 through the present does not reflect available market rates of interest. (Lehn Aff.
pp. 13-15.) The court adopts what it deems to be a more appropriate 5% annual rate as
the prejudgment interest rate to be applied to the damages from May 6, 2008 through the
date of this decision. The 9% mandatory statutory rate will run on the whole of the
judgment, including prejudgment interest awarded, until the judgment is entered and
from entry until satisfaction of the judgment. See Siegel, NY Prac. § 412
(5th ed.).
ORDERED that plaintiff is to submit judgment in accordance with this Decision and
Order.
Dated:August 21, 2013
ENTER:
/s/Melvin L. Schweitzer
J.S.C.
Footnotes
Footnote 1:Mr. Martucci explained
that investors may have chosen to avoid ABS and MBS due to an aversion to structured
products and their decision should not be taken as a general preference against exposure
to the housing market. (Martucci Aff. ¶ 45.)
Footnote 2:In particular, Mr.
Martucci remembers one Enhanced Cash client, who had to liquidate due to a corporate
restructuring, and sold all AAA-rated ABS-HELs and non-agency CMOs virtually at par
around June/July 2007. (Id. at ¶ 48.)
Footnote 3:The Challenged
Securities also include a handful of corporate bonds (e.g. Bear Stearns,
Countywide) that were also subject to the risks of the subprime mortgage market.
Because the trial dealt almost exclusively with ABS-HELs and non-agency CMOs
— whereas the corporate bonds are primarily relevant in the computation of
damages — the court will not dwell on these corporate bonds in the Background
and Discussions portions of its opinion.
Footnote 4:Mr. Ufferfilge reiterated
this policy to Messrs. Bernstein and Donohue in a March 2008 memo describing dealings
with CMMF: "We are not to sell anything without getting permission, this guideline has
been in place since Nov. 2007." (Ex. 259 at 323.)
Footnote 5:Indicative of the
discussions are two internal emails which Mr. Benet sent in preparation for the
Guidelines negotiations with JPMIM. The first email was sent on March 30, 2006 in
which Mr. Benet flagged some of the questions he wanted to discuss with JPMIM.
Included in his queries was: "are the MBS included in the ABS bucket?" (Ex. 106.) In
another internal email, sent April 5, 2006, Mr. Benet directed another Access employee
to pass on certain question and discussion topics to JPMIM in advance of their meeting,
including: "MBS and ABS exposure max." (Ex. 108.)
Footnote 6:Ex. 483 shows that Mr.
Martucci ceased purchasing ABS-HELs for one EC account as early as March 30, 2007.
Footnote 7:The First Department,
CMMF argues, has held that CMMF's evidence is more than enough to establish
negligence. It cites a string of inapposite cases, all generally holding that broad
allegations of negligence/breach of fiduciary duty are sufficient to survive a motion to
dismiss. See Ambac Assur. UK
Ltd. v J.P. Morgan Inv. Mgt., Inc., 88 AD3d 1, 5-6 (1st Dept 2011) (finding
plaintiff sufficiently alleged gross negligence based on Mr. Dimon's statement in early
October 2006 that subprime securities could go up in smoke, despite JPMIM's argument
that the statement did not concern the type of securities at issue); Assured Guar. (UK) Ltd. v J.P.
Morgan Inv. Mgt., Inc., 80 AD3d 293, 305 (1st Dept 2010) (denying JPMIM's
motion to dismiss gross negligence claim based on allegations that JPMIM invested in
needlessly risky subprime securities while reducing its own exposure and favoring one
client over another); Sergeants Benv. Ass'n v Renck, 2004 WL 5278824, No.
601735/03 (Sup Ct NY Co Mar. 31, 2004) (holding plaintiffs stated claim for breach of
fiduciary duty by alleging that, in view of plaintiff's conservative objectives,
discretionary investment manager exposed plaintiff's assets to undue risk), affd in rel.
part, 19 AD3d 107 (1st Dept 2005). CMMF overlooks that in all of these cases, the
First Department was deciding a pre-trial motion to dismiss. See Ambac, 88
AD3d at 6-7 (finding that "at this stage of the pleadings the motion court should have
accepted the plaintiff's allegations as true, given the plaintiff the benefit of every possible
inference . . . We are not required to determine at this stage if . . . there was a distinction
for investment purposes between the Dimon-referenced CDOs . . . and the securities in
the subject accounts."); Assured 80 AD3d at 305 ("[W];hen deciding whether to
grant a motion to dismiss . . . a court must take the allegations asserted within a plaintiff's
complaint as true and accord plaintiff the benefit of every possible inference") (internal
citations omitted); Sergeants 2004 WL 5278824 at *2 ("On a motion to dismiss . .
. if the plaintiff is entitled to recovery upon any reasonable view of the facts, the
complaint is legally sufficient.") Here, the court cannot accept CMMF's allegations as
true and give it the benefit of every possible inference. CMMF has the burden to prove a
breach of duty occurred.
Footnote 8:As previously noted, the
parties only touched in passing on the issue of the corporate notes purchased for the
Account. CMMF argues the JPMIM was negligent with respect to these securities as it
was with respect to ABS-HELs and non-agency CMOS. It argues that JPMIM undertook
to reduce the exposure to these notes in other accounts, but not in CMMF's. (Ex. 575 at
050-52.) The court has considered CMMF's arguments and finds them unconvincing for
the same reasons that led it to conclude JPMIM did not act negligently or in breach of its
fiduciary duties with respect to the Challenged Securities. As such, the court will not
include the corporate notes in the Damages portion of its opinion.
Footnote 9:Notably, the plaintiff in
Levy waited over 25 years to raise his objection and the account statements
ignored in Tripi became binding if not objected to within 10 days. See
Levy, 69 AD3d at 632; Tripi, 303 F Supp 2d at n 9.
Footnote 10:Mr. Zask calculated
the interest earned by CMMF on these securities was $17.1 million, compared to the
$15.6 million the Account would have earned on a conservative investment yielding
three-month LIBOR. (Zask Aff. p. 35.) Although Mr. Zask provided these estimates, he
did not include them in his damages calculations.