King County Washington v. Merrill Lynch & Co., Inc. et al, No. 2:2010cv01156 - Document 101 (W.D. Wash. 2012)
Court Description: ORDER granting in part and denying in part dfts' 79 Motion to Dismiss First Amended Complaint by Judge Ricardo S Martinez.(RS)
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King County Washington v. Merrill Lynch & Co., Inc. et al Doc. 101 1 2 3 4 5 6 7 UNITED STATES DISTRICT COURT WESTERN DISTRICT OF WASHINGTON AT SEATTLE 8 9 10 KING COUNTY, WASHINGTON, 11 12 13 14 15 16 17 Plaintiff, CASE # 2:10-cv-01156-RSM ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT v. MERRILL LYNCH & CO., INC., a Delaware corporation; MERRILL LYNCH MONEY MARKETS, INC., a Delaware corporation; MERRILL LYNCH, PIERCE, FENNER AND SMITH, INC., a Delaware corporation; and DOES 1-100, Defendants. 18 19 20 I. INTRODUCTION This matter comes before the Court upon Defendants’ (collectively referred to as “Merrill 21 Lynch”) motion to dismiss Plaintiff King County’s First Amended Complaint (“FAC”) under 22 Federal Rule of Civil Procedure 12(b)(6). Dkt. # 79. For the following reasons, Merrill Lynch’s 23 motion is GRANTED IN PART and DENIED IN PART. 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 1 Dockets.Justia.com 1 II. BACKGROUND 2 The Court recounts the facts as alleged by King County, assuming them to be true 3 without expressing belief in their accuracy. 4 A. Merrill Lynch becomes a securities dealer for King County 5 King County is a political subdivision of Washington State. FAC ¶ 15. It is also an 6 institutional investor, controlling a multi-billion dollar investment fund on behalf of itself and 7 over 100 public entities. Id. ¶ 26. King County has adopted investment policies emphasizing 8 prudence. Id. ¶¶ 28-30. 9 The investment policies also govern the hiring of securities dealers. FAC ¶ 32. King 10 County requires applicants seeking to become securities dealers to fill out a “Dealer 11 Questionnaire” that asks various questions about the applicant’s finances, experience, and 12 policies. See Dkt. # 70, Ex. 1 at 1-3. The Dealer Questionnaire also contains a Dealer 13 Certification, which reads: 14 19 I hereby certify that I have personally read the investment policies and objectives of King County and have implemented reasonable procedures and a system of controls designed to preclude imprudent investment activities arising out of transactions conducted between our firm and King County. All sales personnel assigned to your account will be routinely informed of your investment objectives, horizon, outlook, strategies and risk constraints whenever we are so advised. We will notify you immediately by telephone and in writing in the event of a material adverse change in our financial condition. We pledge to exercise due diligence in informing you of all foreseeable risks associated with financial transactions conducted with our firm. I attest to the accuracy of our responses to your questionnaire. 20 Dkt. # 70, Ex. 1 at 5. 21 Merrill Lynch is a global financial services firm. FAC ¶ 16. In 1988, a Merrill Lynch 15 16 17 18 22 account executive named Raymond Thibodeau filled out the Dealer Questionnaire on behalf of 23 Merrill Lynch and signed the Dealer Certification. Dkt. # 70, Ex. 1 at 5. King County approved 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 2 1 Merrill Lynch as a securities dealer in 1990, and Merrill Lynch sold securities to King County 2 until 2011. FAC ¶ 43. 3 B. Merrill Lynch responds to problems in subprime mortgage-backed securities 4 In the mid 2000s, Merrill Lynch was a major player in the field of mortgage 5 securitization. FAC ¶ 67. Merrill Lynch bundled mortgage loans into various securities 6 instruments and traded several billion dollars’ worth of these products annually. Id. ¶¶ 64, 66. It 7 also owned a large amount of these securities. Id. ¶¶ 68-69. At first, Merrill Lynch could limit 8 its exposure to the risk of these securities defaulting. Id. ¶ 69. For various reasons, however, its 9 exposure to the risk of default grew dramatically throughout 2006. Id. 10 By early 2007, the subprime mortgage industry had begun its now-famous decline. FAC 11 ¶ 74. The market collapse started with lenders and quickly spread to mortgage-backed securities 12 of the type Merrill Lynch owned and traded. Id. at 74-76. In the face of this growing problem, 13 Merrill Lynch developed a plan to offload some of its subprime mortgage-backed securities. A 14 March 2007 email chain between several Merrill Lynch officers discusses selling various pieces 15 of Merrill Lynch’s subprime mortgage-backed securities to structured investment vehicles that 16 sold commercial paper to investors. Dkt. # 70, Ex. 8. In turn, Merrill Lynch would market the 17 debt with which the structured investment vehicles funded themselves. Id.; FAC ¶ 81. 18 C. Merrill Lynch sells Mainsail commercial paper to King County 19 This lawsuit concerns three purchases of structured investment vehicle debt known as 20 asset-backed commercial paper. Asset-backed commercial paper is a short-term money market 21 investment. FAC ¶ 95. The safety of such commercial paper depends largely on two factors: 22 (1) the ability of sellers to “roll,” i.e., sell new paper to pay maturing liabilities and (2) the value 23 of the assets securing the paper. Id. ¶ 96. The commercial paper at issue here was subject to 24 certain “triggers” tied to both criteria. Id. ¶ 115. If the commercial paper had too little liquidity ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 3 1 for rolling purposes or suffered major declines in the value of its asset portfolio, it would go into 2 liquidation. Id. 3 The first two purchases at issue in this case were of commercial paper issued by a 4 structured investment vehicle named “Mainsail II.” FAC ¶ 89. Merrill Lynch became a dealer 5 for Mainsail’s commercial paper in April 2007. Id. ¶ 104. The vast majority of the assets in 6 Mainsail’s portfolio consisted of subprime mortgage-backed securities. Id. ¶ 100. 7 When Merrill Lynch became a dealer for Mainsail, it knew that Mainsail had been 8 contaminated by the problems affecting the broader subprime mortgage market. Internal Merrill 9 Lynch analyses of Mainsail revealed that Mainsail’s subprime mortgage-backed securities were 10 particularly prone to losses. FAC ¶ 105. One review of the AA-rated mortgage-backed 11 securities held by Mainsail—equal to about half its asset portfolio—classified most as “awful,” 12 “bad,” or “not horrible.” Id. n.26. 13 Merrill Lynch was not just a dealer for Mainsail. Almost immediately after Merrill 14 Lynch became a Mainsail dealer, Mainsail bought over $100 million of Merrill Lynch’s 15 subprime mortgage-backed securities. FAC ¶ 110. Mainsail paid Merrill Lynch 100 cents on the 16 dollar for these assets despite their questionable value and the fact that similar sales of securities 17 were typically discounted. 1 Id. 18 Throughout mid-2007, Merrill Lynch could see Mainsail’s problems mounting. By the 19 end of June, Merrill Lynch was the only securities broker willing to sell Mainsail commercial 20 paper. FAC ¶ 117. By July, Merrill Lynch knew that Mainsail was close to hitting both its asset 21 value and liquidity triggers. Id. ¶¶ 129, 135. Merrill Lynch knew the liquidity problems were 22 particularly severe. Mainsail had recently lost its only source of loans to address short-term 23 1 Mainsail’s managers apparently agreed to this deal because they were paid for each transaction they conducted. 24 FAC ¶ 81. ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 4 1 liquidity problems, jeopardizing its ability to roll commercial paper. Id. ¶ 129, n.52. The risk of 2 default was so high that Merrill Lynch rejected a request from Mainsail to guarantee funds for 3 short-term liquidity needs. Id. ¶¶ 133-34, n.53. 4 Although Merrill Lynch would not help Mainsail by guaranteeing the money it needed to 5 pay its debts, it did participate in an emergency effort to keep Mainsail afloat. On July 16, 6 Merrill Lynch helped Mainsail sell about $116 million in new debt, which in turn allowed 7 Mainsail to buy new and somewhat better assets. FAC ¶ 136. Merrill Lynch knew, however, 8 that this did not eliminate Mainsail’s liquidity problem. See id. ¶ 140. 9 On the same day as the emergency effort to prop up Mainsail, a Merrill Lynch employee 10 emailed King County’s chief investment officer, describing Mainsail commercial paper as an 11 “offering[] you might like.” Dkt. # 70, Ex. 6. Merrill Lynch never disclosed, however, that 12 Mainsail was staying afloat thanks to Merrill Lynch’s help. Id. ¶ 148. Merrill Lynch also did 13 not disclose that Mainsail still faced a major liquidity problem and that Merrill Lynch had 14 refused to guarantee funds to meet Mainsail’s liquidity needs. Id. Nor did it disclose that 15 Mainsail’s other dealers would no longer sell its commercial paper. Id. 16 King County eventually made two purchases of Mainsail at the end of July. FAC ¶¶ 177- 17 78. In total, King County invested over $53 million in Mainsail commercial paper. Id. Less 18 than a month later, Mainsail collapsed and went into liquidation. Id. ¶ 146. King County lost 19 nearly three quarters of its investment. Id. ¶ 11. 20 D. Merrill Lynch sells Victoria commercial paper to King County 21 The third purchase at issue in this lawsuit was of commercial paper issued by a structured 22 investment vehicle named “Victoria.” FAC ¶ 150. Victoria’s asset portfolio was full of 23 subprime mortgage-backed securities, albeit to a lesser degree than Mainsail’s. Id. ¶¶ 154-55. 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 5 1 Merrill Lynch knew Victoria faced problems similar to those affecting Mainsail. By June 2 2007, Merrill Lynch knew Victoria was having trouble in the rolling process that allowed it to 3 pay maturing debt. FAC ¶ 163. Merrill Lynch knew Victoria was especially exposed to the risk 4 of hitting a liquidity trigger because it had large outstanding obligations relative to its available 5 funds. Id. 6 Merrill Lynch aggressively tried to sell Victoria by offering lower and lower prices, but 7 liquidity problems grew more acute throughout July 2007. FAC ¶ 164. By August 2, Merrill 8 Lynch concluded that lowering the price was not enough and decided to market Victoria 9 commercial paper with a put option. Id. ¶ 165. The put option would allow investors to buy 10 Victoria commercial paper with a maturity date of 270 days but redeem it after 90 or 180 days. 11 Id. This would make investment more attractive because buyers could get their money back if 12 they sensed a risk of default before the maturity date. Id. 13 On August 2, after the put option was authorized but before it was announced, King 14 County paid about $53 million for Victoria commercial paper. FAC ¶¶ 179. Merrill Lynch did 15 not disclose its view of the degree of Victoria’s liquidity problems. Id. ¶ 167. Nor did it disclose 16 that it had decided to market Victoria commercial paper with a put option. Id. 17 Victoria defaulted in mid-January 2008, shortly before King County’s purchase was set 18 to mature. FAC ¶¶ 168-69. King County received some payment through a restructuring option 19 but has still lost over half its investment. Id. ¶ 170. 20 III. DISCUSSION 21 The FAC asserts seven causes of action against Merrill Lynch. One is for breach of 22 contract, and the other six are for violations of the Washington State Securities Act (“WSSA”). 23 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 6 1 FAC ¶¶ 185-239. Merrill Lynch argues, pursuant to Federal Rule of Civil Procedure 12(b)(6), 2 that each cause of action fails to state a claim upon which relief can be granted. See Dkt. # 79. 3 A. Legal standard 4 In evaluating a Rule 12(b)(6) motion, the Court accepts as true all well-pleaded factual 5 allegations and draws all reasonable inferences in the light most favorable to the plaintiff. 6 Adams v. U.S. Forest Serv., 671 F.3d 1138, 1142-43 (9th Cir. 2012). To survive a 12(b)(6) 7 motion, a complaint must allege “sufficient factual matter . . . to ‘state a claim to relief that is 8 plausible on its face.’” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (quoting Bell Atl. Corp. v. 9 Twombly, 550 U.S. 544, 570 (2007)). The Court “may generally consider only allegations 10 contained in the pleadings, exhibits attached to the complaint, and matters properly subject to 11 judicial notice.” Swartz v. KPMG LLP, 476 F.3d 756, 763 (9th Cir. 2007). 12 B. Legal sufficiency of causes of action 13 14 1. Breach of contract King County’s seventh cause of action is for breach of contract and turns on the Dealer 15 Certification signed by its account executive, Raymond Thibodeau, in 1988. King County 16 alleges that Merrill Lynch materially breached its duties under the Dealer Certification by 17 “fail[ing] to implement a system of controls that would preclude King County from investing in 18 imprudent investments such as Mainsail and Victoria’s commercial paper . . . and fail[ing] to 19 disclose to King County all foreseeable risks concerning these investments.” FAC ¶ 238. 20 a. Duty 21 Merrill Lynch argues the breach of contract cause of action lacks an essential element: a 22 duty. Merrill Lynch argues the Dealer Certification expressly applies only to the members of the 23 sales team assigned to King County’s account. Dkt. # 79 at 6-7. Defendant’s position is that a 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 7 1 claim for breach of contract fails because King County has not alleged the sales team members 2 were aware of any undisclosed risks. Id. at 7. 3 This strikes the Court as an implausible spin on the Dealer Certification. As Merrill 4 Lynch sees it, King County made a contract with individual members of a sales team that had no 5 independent corporate existence. These individuals purported to bind the team’s future 6 members, who were not legal successors in interest of the former. And these individuals did all 7 this by having their boss fill out an application for their employer to do business with the other 8 party. 9 Common sense and—more importantly—Washington’s rules of contract interpretation 10 favor King County’s reading. Under Washington law, “[t]he touchstone of contract 11 interpretation is the parties’ intent.” Tanner Elec. Co-op. v. Puget Sound Power & Light Co., 12 128 Wash. 2d 656, 674 (Wash. 1996). Intent is determined by the objective manifestations of the 13 agreement. Hearst Commc’ns, Inc. v. Seattle Times Co., 154 Wash. 2d 493, 503 (Wash. 2005). 14 The inquiry begins and ends with the “ordinary, usual, and popular meaning” of 15 contractual language “unless the entirety of the agreement clearly demonstrates a contrary 16 intent.” Hearst Commc’ns, 154 Wash. 2d at 504. Invoking the plain language rule, Merrill 17 Lynch focuses heavily on the Dealer Certification’s use of the first person and reference to the 18 sales team: 19 20 21 22 23 I hereby certify that I have personally read the investment policies and objectives of King County and have implemented reasonable procedures and a system of controls designed to preclude imprudent investment activities arising out of transactions conducted between our firm and King County. All sales personnel assigned to your account will be routinely informed of your investment objectives, horizon, outlook, strategies and risk constraints whenever we are so advised. We will notify you immediately by telephone and in writing in the event of a material adverse change in our financial condition. We pledge to exercise due diligence in informing you of all foreseeable risks associated with 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 8 1 financial transactions conducted with our firm. I attest to the accuracy of our responses to your questionnaire. 2 Dkt. # 79 at 7 (quoting Dkt. # 70, Ex. 1 at 5) (bold in motion to dismiss). 3 Merrill Lynch’s attempt to conflate the first person with the sales team is too strained to 4 be plausible. See Woo v. Fireman’s Fund Ins. Co., 161 Wash. 2d 43, 76 (Wash. 2007). If “we” 5 and “our” refer to the sales team, the second sentence would require the sales team to be 6 informed of King County’s investment wishes whenever the sales team was so informed. The 7 third sentence would be equally odd: the sales team would have to notify King County of 8 changes in its financial condition rather than Merrill Lynch’s. 9 It is far more plausible to read “we” and “our” as referring to Merrill Lynch as a whole. 10 This is a common convention known as the “editorial we.” See The Chicago Manual of Style 11 ¶ 5.51 (15th ed. 2003). Applied here, it eliminates the implausible features of Merrill Lynch’s 12 reading. 13 One might argue that this reading creates an impermissible redundancy in the fourth 14 sentence, which uses both “we” and “our firm.” Dkt. # 70, Ex. 1 at 5. Contracts are read to 15 avoid redundancies. See Navlet v. Port of Seattle, 164 Wash. 2d 818, 842-43 (Wash. 2008). But 16 with the editorial we, it is standard practice to use both the pronoun and the name of institution it 17 describes interchangeably in the same sentence. Distinguished jurists do so. See, e.g., Diaz v. 18 Brewer, 676 F.3d 823, 828 (9th Cir. 2012) (O’Scannlain, J., dissenting from denial of rehearing 19 on en banc) (“If our court were going to break so dramatically from long-standing practice and 20 tradition—and divide ourselves from the weight of authority on a matter that is so important— 21 we should have done so only after reconsidering this matter en banc.”). So does the national 22 media. See, e.g., Press Release, USA Today, USA Today Celebrates 25 Years As The Nation’s 23 Newspaper (Sept. 14, 2007) (“We are committed to moving forward with the same enthusiasm 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 9 1 and talent that have made this newspaper successful over the last two-and- a-half decades.”) 2 Even prestigious financial services firms talk to their clients this way. See Leveraging Our 3 Strengths, Merrill Lynch 2000 Annual Report, 4 http://www.ml.com/annualmeetingmaterials/annrep00/ar/leveraging.html (last visited June 18, 5 2012) (“By promoting a culture in which . . . ideas and expertise are shared across our firm, we 6 create a more productive and satisfying experience for clients and employees alike.”) 7 This does not dispose entirely of Merrill Lynch’s argument. The first and last sentences 8 of the Dealer Certification both use the first person singular. See Dkt. # 70, Ex. 1 at 5. Merrill 9 Lynch views this as additional proof that Thibodeau spoke only for himself and his sales team. 10 Dkt. # 79 at 7. 11 The Court disagrees. The use of “I” in the Dealer Certification is attached to references 12 to “our firm” and “our answers,” strongly suggesting that Thibodeau spoke in a representative 13 capacity. Dkt. # 70, Ex. 1 at 5. And if there is any doubt, extrinsic evidence cuts in favor of 14 King County’s reading. The Court may turn to extrinsic evidence “to determine the meaning of 15 specific words and terms used.” Hearst Commc’ns, 154 Wash. 2d at 503 (quoting Hollis v. 16 Garwall, 137 Wash. 2d 683, 696 (Wash. 1999)). Valid extrinsic evidence includes “the subject 17 matter and objective of the contract, all the circumstances surrounding the making of the 18 contract, the subsequent acts and conduct of the parties to the contract, and the reasonableness of 19 respective interpretations advocated by the parties.” Tanner-Electric, 128 Wash. 2d at 674 20 (quoting Scott Galvanizing, Inc. v. Nw. EnviroServices, Inc., 120 Wash. 2d 573, 580-81 (Wash. 21 1993)). 22 Here, the most pertinent extrinsic evidence is the Dealer Questionnaire, of which the 23 Dealer Certification is the final part. In the Dealer Questionnaire, Thibodeau explicitly identified 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 10 1 himself as a “representative” of Merrill Lynch. Id. The questions he answered focused heavily 2 on Merrill Lynch’s finances, experience, and policies. See id. at 1-3. He even used the term 3 “we” in response to a question about “your firm.” Id. at 3. In light of basic principles of agency 4 law—which allowed Thibodeau to bind Merrill Lynch to contracts—the use of “I” indicates 5 Thibodeau spoke on behalf of Merrill Lynch. See King v. Riveland, 125 Wash. 2d 500, 507 6 (Wash. 1994); Restatement (Third) of Agency § 6.01 (2006). 7 Merrill Lynch’s remaining arguments for reading the Dealer Certification to apply solely 8 to Thibodeau and his staff are unavailing. First, Merrill Lynch contends that the word “we” must 9 be interpreted in light of its last antecedent. Dkt. # 92 at 3. This grammatical rule, Merrill 10 Lynch claims, makes it arguable that “we” refers to the sales team, and the Court must resolve 11 this ambiguity against the drafter of the Dealer Certification: King County. Id. This argument 12 wrongly assumes that “we” is necessarily ambiguous here. As discussed above, King County’s 13 reading gives that pronoun its only sensible meaning. 14 Second, Merrill Lynch argues that any interpretation of the Dealer Certification other 15 than its own is absurd. Merrill Lynch argues that King County’s construction of the Dealer 16 Certification would require Merrill Lynch to collect the knowledge of tens of thousands of 17 employees working in 130 separate business entities. Dkt. # 79 at 8. Not so. The Dealer 18 Certification required Merrill Lynch to “implement[] reasonable procedures and a system of 19 controls designed to preclude imprudent investment activities” and to “exercise due diligence in 20 informing [King County] of all foreseeable risks associated with financial transactions 21 conducted” with Merrill Lynch. Dkt. #70, Ex. 1 at 5. It would not be absurd for Merrill Lynch 22 to have procedures for moving institutional knowledge about its products to its salespeople and 23 to train its salespeople to advise clients with different levels of tolerance for risk. 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 11 1 b. Breach 2 Merrill Lynch argues that even if the Dealer Certification imposed duties on Merrill 3 Lynch as a whole, King County has not alleged a breach of those duties. Merrill Lynch argues it 4 satisfied its contractual duties by giving King County prospectuses describing the composition of 5 and risks associated with Mainsail and Victoria. Dkt. # 79 at 8. 6 The parties dispute heavily whether the Court may take judicial notice of these 7 prospectuses. See Dkt. # 79, Attachment 3; Dkt. # 90. The Court need not decide that matter. 8 Even if the Court took judicial notice of the prospectuses, it would still find that King County has 9 stated a claim for breach of contract. The prospectuses discussed risks in general, hypothetical 10 terms. See Dkt. # 79 at 9-12. But the Dealer Certification arguably requires more robust 11 warnings. It envisions that Merrill Lynch would actively prevent investments it considered 12 imprudent or at least warn King County when it considered risks likely to come to pass. 13 The Mainsail prospectus would not have alerted King County to the high degree of risk 14 Merrill Lynch perceived with respect to Mainsail commercial paper, especially after the email 15 describing Mainsail commercial paper as a purchase King County “might like.” Dkt. # 70, Ex. 6. 16 Merrill Lynch’s internal review of Mainsail’s asset portfolio was scathing. FAC n.26. By June 17 2007, Merrill Lynch was the only securities broker willing to work with Mainsail. Id. ¶ 117. 18 Merrill Lynch appears to have become a Mainsail dealer as part of a quid pro quo arrangement: 19 Merrill Lynch would help keep Mainsail afloat by selling its commercial paper, and Mainsail 20 would act as a dumping ground for over $100 million in toxic subprime mortgage assets. Id. 21 ¶ 110. Merrill Lynch thus simultaneously made Mainsail weaker and shifted the risk of 22 subprime mortgage losses to investors. Merrill Lynch was so concerned about Mainsail that it 23 refused to assist directly with Mainsail’s liquidity problems, knowing that to do so would expose 24 itself to the risk of default. Id. ¶¶ 133-34, n.53. ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 12 1 Although the circumstances surrounding Victoria are less damning, the Victoria 2 prospectus nonetheless would not have conveyed the likelihood of default that Merrill Lynch 3 perceived. Merrill Lynch knew Victoria was having liquidity problems by June 2007 and that its 4 available liquidity was small relative to its outstanding debt. FAC ¶¶ 163, 166. Merrill Lynch 5 saw Victoria as so unstable that it decided to market a put option, which was clearly a stopgap 6 solution for major liquidity problems. Id. ¶ 165. 7 8 2. Untrue statements or omissions of material fact King County’s remaining causes of action concern alleged violations of Washington’s 9 securities laws. The first, second, and third causes of action arise under WSSA § 21.20.010(2), 10 which makes it “unlawful for any person, in connection with the offer, sale or purchase of any 11 security, directly or indirectly . . . [t]o make any untrue statement of a material fact or to omit to 12 state a material fact necessary in order to make the statements made, in the light of the 13 circumstances under which they are made, not misleading.” Wash. Rev. Code § 21.20.010(2). 14 15 a. Victoria purchase The Court begins with King County’s third cause of action, which concerns the 16 purchase of Victoria. Merrill Lynch argues that the third cause of action fails to state a 17 § 21.20.010(2) claim because the FAC does not allege Merrill Lynch made a statement of fact in 18 connection with Victoria. Dkt. #79 at 13-14. The relevant allegations, Merrill Lynch argues, 19 merely show Merrill Lynch represented compliance with promises made in the 1988 Dealer 20 Certification. Id. at 15. Merrill Lynch argues King County cannot twist past contractual 21 promises into a statement of fact necessary to support a § 21.20.010(2) claim. Id. at 15-16. 22 The Court implicitly rejected this logic when it denied Merrill Lynch’s motion to dismiss 23 King County’s first complaint. The Court ruled that Merrill Lynch’s silence in the face of 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 13 1 promises made in the Dealer Certification could constitute a breach of a duty to disclose and thus 2 support a § 21.20.010(2) claim. Dkt. # 42 at 8. 3 Upon further reflection and additional review of case law, the Court concludes its earlier 4 reasoning was mistaken. It agrees with Merrill Lynch that a § 21.20.010(2) claim cannot be 5 based on a promissory statement and that the third cause of action fails for this reason. 6 Washington courts have not addressed whether a contractual promise is a statement for 7 the purpose of § 21.20.010(2). Federal securities law, however, offers persuasive guidance. The 8 WSSA is to be “so construed as to . . . coordinate [its] interpretation and administration” with 9 federal securities laws. Wash. Rev. Code § 21.20.900. And courts universally agree that 10 “contract breach is not a sufficient predicate for securities fraud” under § 21.20.010(2)’s federal 11 counterpart, SEC Rule 10b-5(b). Reese v. BP Exploration (Alaska) Inc., 643 F.3d 681, 691-92 12 (9th Cir. 2011). This logic flows from the nature of fraud itself. “[A] claim of fraud must rest on 13 an inaccurate assertion as to a matter of past or existing fact.” 26 Williston on Contracts § 69:11 14 (4th ed. 2012). A promise does not contain a false assertion of fact unless it is accompanied by a 15 simultaneous intent not to perform. Id. 16 This reasoning applies equally to § 21.20.010(2). The WSSA’s ban on material 17 misstatements and omissions is worded identically to its Rule 10b-5 counterpart. Compare 18 Wash. Rev. Code § 21.20.010(2) with 17 C.F.R. § 240.10b-5(b). Further, Washington courts 19 recognize that comparable common law fraudulent misrepresentation claims require assertions of 20 fact rather than promises of future performance. See West Coast, Inc. v. Snohomish Cnty., 112 21 Wash. App. 200, 206 (Wash. Ct. App. 2002). 22 Under this widely accepted principle, King County has not stated a § 21.20.010(2) claim 23 regarding the Victoria purchase. Every alleged statement is untrue only when viewed in light of 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 14 1 the promises made in the Dealer Certification. Three of the four alleged statements were 2 representations by “conduct and/or implication” that the Victoria purchase was prudent. See 3 FAC ¶ 205(b)-(d). To the extent these can be characterized as statements, they merely 4 represented that Merrill Lynch had complied with its contractual duties. The other allegation 5 contains independent factual content, but it was true: Victoria had high ratings from credit rating 6 agencies. FAC ¶ 205(a). King County alleges this true statement was misleading because 7 Merrill Lynch represented “by conduct and/or implication” that it had disclosed all information 8 that might call those ratings into question. Id. Thus, as with the other statements, the alleged 9 falsehood exists only through reference to earlier promises. 10 King County argues the above rule does not apply because it “was not deceived by the 11 representations in the contract itself.” Dkt. # 91 at 18. This argument is merely a semantic 12 game. “I have complied with my earlier promises” derives its meaning from earlier promises. 13 King County’s strained effort to treat this as an independent assertion of fact falls apart in its 14 own brief. In order to show the implied assertion of fact exists, King County argues Merrill 15 Lynch’s silence must be viewed in light of promises made in the Dealer Certification. Id. at 19. 16 In other words, King County concedes that it relied on Merrill Lynch’s earlier promise when 17 buying the securities at issue. 18 King County also argues it has shown the necessary assertion of fact because “silence, in 19 the face of a duty to disclose, constitutes a representation of the nonexistence of the matter not 20 disclosed.” Dkt. # 91 at 14. This duty of disclosure still leaves King County in need of a non21 promissory statement. The duty to disclose to which King County refers comes from the Second 22 Restatement of Torts. See Haberman v. Wash. Pub. Power Supply Sys., 109 Wash. 2d 107 23 (1988). Section 551 of the Second Restatement lays out a five-element test for this duty. One 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 15 1 element is that disclosure must be “necessary to prevent [the speaker’s] partial or ambiguous 2 statement of the facts from being misleading.” Restatement (Second) of Torts § 551(2)(b) 3 (1977). Each element in the § 551 test is conjunctive. See id. Thus, this duty to disclose 4 demands that there be an assertion of fact in need of clarification. Every § 551 case King County 5 cites confirms this proposition. See Dkt. # 91 at 21; Haberman, 109 Wash. 2d at 168 (duty to 6 disclose arguably existed following misleading representation); Guarino v. Interactive Objects, 7 Inc., 122 Wash. App. 95, 129-30 (Wash. Ct. App. 2004) (duty to disclose exists to correct 8 misleading representation of fact); Favors v. Matzke, 53 Wash. App. 789, 797-98 (Wash. Ct. 9 App. 1989) (no duty to disclose where representations of fact were complete). 10 King County argues that the Haberman case created a broader duty to disclose that arises 11 whenever a defendant “has knowledge necessary to prevent misrepresentation, or facts basic to 12 the transaction where the plaintiff would reasonably expect disclosure.” Dkt. # 91 at 20 n.63 13 (quoting Haberman, 109 Wash. 2d at 168). This argument mischaracterizes Haberman through 14 selective quotation. In relevant part, Haberman held that common law fraudulent 15 misrepresentation did not require privity or a fiduciary relationship. In line with § 533 of the 16 Second Restatement, Haberman concluded that statements calculated to induce third-party 17 reliance were a basis for a fraudulent misrepresentation claim. See Haberman, 109 Wash. 2d at 18 168; Restatement (Second) of Torts § 533. This confirms rather than contradicts that failure to 19 disclose is fraud only if there was a prior assertion of fact. 20 In the end, King County identifies only one possible representation of fact independent of 21 the Dealer Certification. Specifically, King County seems to argue that the mere act of selling of 22 a security is an implied representation of creditworthiness. See Dkt. # 91 at 14-15. It cites for 23 support a pair of decades-old federal circuit court cases interpreting § 12(2) of the federal 1933 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 16 1 Securities Act: Alton Box Board Co. v. Goldman, Sachs & Co., 560 F.2d 916 (8th Cir. 1977), and 2 Franklin Savings Bank of N.Y. v. Levy, 551 F.2d 521 (2d Cir. 1977). Dkt. # 91 at 14-15. A close 3 examination of these cases shows that neither took the sweeping, implausible position that the 4 mere act of selling a product can be the basis of a fraud claim. In Franklin, the defendant did not 5 dispute that it had made a representation about creditworthiness. See 551 F.2d at 526. Rather, 6 the dispute centered on whether that representation was one of fact or opinion. See id. In Alton, 7 the implied misrepresentation concerned a third-party agency’s rating of a security as 8 creditworthy. But the plaintiff had alleged in his complaint that the agency’s rating was itself 9 based on misrepresentations provided by the defendant broker. See 560 F.2d at 919. This 10 allegation was consistent with a tort claim for a misleading statement made with the expectation 11 of third-party reliance. See Restatement (Second) of Torts § 533. 12 Further, even if King County’s reading of Alton and Franklin is correct, the Court would 13 not adopt it. Both cases concerned § 12(2) of the 1933 Securities Act. Rule 10b-5, by contrast, 14 is an implementation of the 1934 Securities Exchange Act. Rule 10b-5 requires intent to 15 defraud. See Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Section 12(2) is broader: it 16 applies to negligent omissions, and Franklin explicitly disclaimed any applicability to Rule 10b17 5 on that ground. See Franklin, 551 F.2d at 526. King County points to several Washington 18 cases adopting features of § 12(2) doctrine for the WSSA. See Dkt. # 91 at 14 n.43. But it 19 would go too far to read a pair of decades-old § 12(2) cases as equating sales with statements for 20 the purpose of a fraud claim. To do so would give § 21.20.010(2) a meaning completely at odds 21 with its federal counterpart. See Matrixx Initiatives, Inc. v. Siracusano, --- U.S. ---, 131 S. Ct. 22 1309, 1321 (2011) (“Rule 10b–5(b) do[es] not create an affirmative duty to disclose any and all 23 material information.”) 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 17 1 b. Mainsail purchases 2 King County’s first and second causes of action apply to Mainsail. They allege the same 3 statements found insufficient with respect to Victoria plus one more. The additional allegation is 4 that Merrill Lynch recommended Mainsail commercial paper as an offering King County “might 5 like.” FAC ¶¶ 187(a), 196(a). The additional allegation is insufficient for the same reason as the 6 others: it is meaningful only with respect to the promises made in the Dealer Certification. King 7 County alleges the email was misleading because “by implication [it] represented that Mainsail 8 commercial paper fit King County’s conservative, risk-averse investment objectives and 9 guidelines.” FAC ¶¶ 187(a), 196(a). Thus, by its terms, the alleged representation is of 10 compliance with earlier promises. King County even concedes this: it argues the email must be 11 “viewed in the context of the long-standing relationship between the parties and the Dealer 12 Certification’s role as a ‘standing request for disclosures of material risks.’” Dkt. # 91 at 15 13 (quoting FAC ¶ 32). 14 15 3. Act, practice, or course of business operating as a fraud or deceit King County’s fourth and fifth causes of action arise under WSSA § 21.20.010(3). 16 Section 21.20.010(3) makes it unlawful “in connection with the offer, sale or purchase of any 17 security . . . [t]o engage in any act, practice, or course of business which operates or would 18 operate as a fraud or deceit upon any person.” Wash. Rev. Code § 21.20.010(3). The fourth 19 cause of action alleges Merrill Lynch engaged in deceitful practices by selling Mainsail and 20 Victoria commercial paper despite knowing of the risks associated with similar products and 21 while trying to limit its own exposure to such risks. FAC ¶ 215. The fifth cause of action 22 centers on Merrill Lynch’s using Mainsail as a dumping ground for toxic subprime assets and 23 selling it by touting its misleadingly high credit ratings. Id. ¶ 222. 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 18 1 a. Victoria purchase 2 Merrill Lynch argues that to the extent the fourth cause of action applies to Victoria, it 3 does not meet Federal Rule of Civil Procedure 9(b)’s requirement that a complaint alleging fraud 4 “state with particularity the circumstances constituting fraud.” Fed. R. Civ. P. 9(b); Dkt. # 79 at 5 23. As King County notes, the Court has already rejected the same argument. Dkt. # 91 at 23. 6 Earlier, the Court ruled that WSSA claims are not fraud claims for the purposes of Rule 9(b) 7 because the WSSA does not require proof of scienter, which is a traditional element of fraud 8 claims. Dkt. # 42 at 3-4; Kittilson v. Ford, 93 Wash. 2d 223 (Wash. 1980). The Court now concludes it was mistaken. Under Ninth Circuit precedent, Rule 9(b) 9 10 requires particularity where fraud is not an essential element of a claim but the challenged claim 11 “sound[s] in fraud.” Vess v. Ciba-Geigy Corp. USA, 317 F.3d 1097, 1103 (9th Cir. 2003). This 12 rule applies to state law causes of action that encompass fraudulent and non-fraudulent conduct. 13 See id. 14 Although not conceding that the Court was mistaken earlier, King County argues that the 15 particularity requirement does not apply because its allegations regarding Victoria do not sound 16 in fraud. Dkt. # 91 at 23. The Court finds this “nominal effort[]” to disclaim fraud as the basis 17 of the fourth cause of action unconvincing. See In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1405 18 n.2 (9th Cir. 1996). The fourth cause of action alleges that 22 Merrill engaged in deceitful acts and practices in connection with [its] offer and sale of . . . Victoria . . . . By mid-July 2007, Merrill was well aware of the serious risks surrounding virtually all structured finance products, including but not limited to those with any significant exposure to the residential mortgage market. Merrill was doing all it could internally to reduce its own exposure to these risks. Yet at the same time it continued to market and sell products exposed to these risks to unsuspecting parties like King County. 23 FAC ¶ 215. 19 20 21 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 19 1 King County also alleges that it would not have bought Victoria but for these deceitful 2 practices. FAC ¶ 216. Taken together, these allegations present a claim that “sound[s] in fraud.” 3 Vess, 317 F.3d at 1103. “Fraud can be averred . . . by alleging facts that necessarily constitute 4 fraud (even if the word ‘fraud’ is not used).” Id. at 1105. The alleged facts show all of the 5 textbook elements of fraud. See 5A Charles Alan Wright & Arthur R. Miller, Federal Practice 6 and Procedure § 1297 (3d ed. 2004) (“all or almost all jurisdictions” view fraud as requiring 7 falsehood or misleading omission, scienter, victim’s belief in accuracy of representations, intent 8 to deceive, and detrimental reliance). 9 The question, therefore, is whether the allegations concerning Victoria are particular 10 enough to support a § 21.20.010(3) claim. They are not. Averments of fraud must describe 11 circumstances “specific enough to give defendants notice of the particular misconduct . . . so that 12 they can defend against the charge and not just deny that they have done anything wrong.” Vess, 13 317 F.3d at 1106 (citation and internal quotation marks omitted). The factual allegations show 14 Merrill Lynch sold Victoria with the knowledge it was a bad product. But the FAC does not 15 allege specific conduct tending to show a deceitful scheme. Quite the contrary. Merrill Lynch 16 signaled to investors that Victoria was not a good product by cutting its price aggressively. FAC 17 ¶ 164. This behavior merely indicates Merrill Lynch followed the law of supply and demand. 18 b. Mainsail purchases 19 King County’s fifth cause of action and the remainder of the fourth cause of action allege 20 Merrill Lynch sold Mainsail despite knowing its risks and while using Mainsail to offload toxic 2 21 assets on to investors like King County. FAC ¶¶ 215, 222. Merrill Lynch argues these claims 22 fail because the Mainsail prospectuses adequately described all material risks. Dkt. # 79 at 24. 23 2 The Court notes that with the Victoria claim dismissed, these causes of action seem virtually identical. Merrill 24 Lynch does not argue they are redundant, and the Court expresses no opinion on that question. ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 20 1 As noted above, the parties dispute whether the prospectuses are subject to judicial 2 notice. See Dkt. # 79, Attachment 3; Dkt. # 90. And as before, the Court need not address the 3 question because the prospectuses would not resolve the issue. The prospectuses discussed 4 Mainsail’s risks in generic, hypothetical terms. See Dkt. # 79 at 9-12. King County alleges not 5 only that Merrill Lynch sold Mainsail while expecting it to collapse but that it used Mainsail as a 6 vehicle to dump toxic subprime assets on investors. FAC ¶¶ 110, 117, 129, 133-34; nn. 26, 53. 7 8 4. Control person liability King County’s sixth cause of action is the last WSSA claim and the easiest to address. It 9 alleges control person liability under WSSA § 21.20.430(3). King County alleges several of the 10 entities making up Merrill Lynch controlled other entities directly responsible for the alleged 11 WSSA violations. As a result, the entities are jointly and severally liable pursuant to 12 § 21.20.430(3). FAC ¶¶ 228-32. 13 Merrill Lynch challenges this cause of action solely on the ground that there is no 14 underlying WSSA violation. Dkt. # 79 at 24. This argument fails. As discussed above, King 15 County’s § 21.20.010(3) causes of action survive in whole or in part. 16 17 IV. CONCLUSION Having reviewed the FAC, the exhibits attached thereto, Defendants’ request for judicial 18 notice, and the relevant briefs, the Court hereby ORDERS: 19 20 21 22 23 (1) Defendants’ motion to dismiss the FAC (Dkt. # 79) is: a. GRANTED with respect to Plaintiff’s first, second, and third causes of action; b. GRANTED with respect to Plaintiff’s fourth cause of action to the extent it concerns the purchase of Victoria and DENIED to the extent it concerns the purchase of Mainsail; 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 21 1 c. DENIED with respect to Plaintiff’s fifth cause of action 2 d. DENIED with respect to Plaintiff’s sixth cause of action; and 3 e. DENIED with respect to Plaintiff’s seventh cause of action. 4 (2) The parties’ requests for oral argument are DENIED as moot. (3) The Clerk is directed to forward a copy of this Order to all counsel of record. 5 6 7 8 9 10 Dated this 25 day of June 2012 A RICARDO S. MARTINEZ UNITED STATES DISTRICT JUDGE 11 12 13 14 15 16 17 18 19 20 21 22 23 24 ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS’ MOTION TO DISMISS FIRST AMENDED COMPLAINT - 22
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