When Does Reliance Give Rise To A Claim? Caiola and de Kwiatkowski... with thoughts about Eternity

When Does Reliance Give Rise To A Claim? Caiola and de Kwiatkowski... with thoughts about Eternity FEBRUARY 25, 2003 In two recent cases -- Louis S. Caiola v. Citibank, N.A., New York, 295 F.3d 312 (2d Cir. 2002) and Henryk de Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293 (2d Cir. 2002) -- the United States Court of Appeals for the Second Circuit has addressed issues involving the scope of the relationship between a customer and his broker-dealer. Although the facts of the cases differ in significant respects, the opinions speak to a common issue: When is the relationship between a broker-dealer and its customer such that, if the customer relies upon the firm s statements to its detriment, the customer s reliance will support a legal claim against the broker-dealer? This article looks at how the Second Circuit s decisions in these cases, as well as a recent district court decision in a third case -- Eternity Global Master Fund Limited v. Morgan Guaranty Trust Company of New York, 2002 U.S. Dist. LEXIS 20706 (S.D.N.Y. Oct. 29, 2002) -- may affect the obligations of a broker-dealer or other market professional to its customer or counterpart beyond, and notwithstanding, the documentation intended to govern their relationship. The Caiola Decision In Caiola, the district court dismissed allegations of fraud based on, among other things, its finding that Mr. Caiola was not entitled to rely on misrepresentations allegedly made to him by Citibank, because of the no reliance disclaimer included in their written agreement. On appeal,the facts were not in dispute,as the case was decided by the district court on a motion to dismiss the complaint. The relationship between Mr. Caiola and Citibank involved the trading of equity swaps and over-the-counter options. This synthetic trading strategy was intended to allow Mr. Caiola to replicate major positions in Philip Morris shares and exchange-traded options while avoiding many of the risks inherent in large-volume trading. Citibank documented its trading relationship with Mr. Caiola by executing an ISDA Master Agreement and memorialized each trade with a written confirmation ( Confirmation ). The Caiola Disclaimer The ISDA Master Agreement included a provision stating it was the: entire agreement and understanding of the parties with respect to its subject matter and supersed[ed] all oral communication and prior writings with respect thereto. The basic form of Confirmation for each transaction included the standard no reliance disclaimer that neither party was: relying on any advice, statements or recommendations (whether written or oral) of the other party regarding such Transaction, other than written representations expressly made by that STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI 180 MAIDEN LANE, NEW YORK, NY 10038-4982 TEL 212.806.5400 FAX 212.806.6006 WWW.STROOCK.COM

other party in the [ISDA] Agreement and in this Confirmation in respect of such Transaction. 1 Each Confirmation also provided that each party would make its own investment decisions and that neither party was acting as fiduciary or advisor to the other. Citibank s Alleged Misrepresentations Against the backdrop of these contractual provisions, Citibank allegedly made a series of misrepresentations to Mr. Caiola concerning their trading relationship and, specifically, Citibank s hedging strategy. Both Mr. Caiola and Citibank knew that the key to the success of their synthetic trading program was Citibank s utilization of a delta hedging strategy that would allow Citibank to manage its risk through purchases and sales of only a fraction of the share volume represented by its synthetic positions with Mr. Caiola. They also knew that if Citibank chose to hedge its risk by buying and selling large positions in the underlying security, rather than through a delta hedging strategy, such large-scale hedging activity would leave unmistakable footprints in the market, resulting in the kind of market response Mr. Caiola hoped to avoid by trading synthetically. For this reason, Mr. Caiola sought assurances from Citibank that it would continue to delta hedge its positions, and Citibank provided these assurances on numerous occasions. Mr. Caiola relied on these assurances, maintained his account at Citibank, and established sizeable positions based on Citibank s assurances that they would be managed synthetically, with Citibank acting as the delta hedging counterparty. Despite its assurances, and without any notification to Mr. Caiola, Citibank stopped its delta hedging and began executing massive trades in the physical markets that mirrored Mr. Caiola s synthetic transactions thereby converting Caiola s synthetic portfolio into a physical one. 2 Instead of executing synthetic trades as Mr. Caiola s counterparty, Citibank acted as Mr. Caiola s broker, buying and selling exchangetraded stock and options for his account. According to the complaint, Mr. Caiola suffered huge losses as a result of his reliance on the material misstatements made to him by Citibank. The Caiola Disclaimers Were Insufficient to Bar a Fraud Claim The district court dismissed Caiola s complaint on the grounds that Mr. Caiola could not meet the reasonable reliance component of a fraud claim, because the oral misrepresentations allegedly made to him by Citibank directly conflicted with the unambiguous language of the Confirmation. Implicit in the lower court s decision is that the no reliance disclaimers included in the Confirmations insulated Citibank from liability even for (i) intentional misstatements made to Mr. Caiola, and (ii) actions completely inconsistent with its oral assurances to him. In reversing the district court s decision, the Second Circuit cited an earlier Second Circuit case for the proposition that [a] disclaimer is generally enforceable only if it tracks the substance of the alleged misrepresentation.... 3 Applying that precedent, the court of appeals held that [t]he disclaimer provisions contained in the Confirmation fall well short of tracking the particular misrepresentations alleged by Caiola. 4 The Second Circuit rejected Citibank s reliance on Harsco Corporation v. Segui, 91 F.3d 337 (2d Cir. 1996), a case in which the Second Circuit held that specific disclaimers included in a contract precluded a finding of reasonable reliance. The Harsco contract contained a fourteen-page disclaimer of specific representations regarding enumerated categories of information any of which, if fraudulent, could have formed the basis of a fraud action. The plaintiff had agreed to rely on only those representations expressly set forth in the contract. Given the exhaustive nature of those representations, and the plaintiff s disclaimer of reliance on any other representations, the Harsco court held that even the alleged misrepresentations that did not fit within the specific disclaimers could not stand. Once the plaintiff had entered into the contract, it became unreasonable to rely on the allegedly fraudulent representations. 5 2

In contrast, the disclaimers included in the Caiola Confirmations were brief and general. Furthermore, the general no reliance disclaimer included in the Confirmations did not cover the alleged misrepresentations made by Citibank to Mr. Caiola. Mr. Caiola was not arguing that he relied to his detriment upon Citibank s investment advice, but that Citibank had made misrepresentations to him. According to the complaint, Citibank: 1. assured Mr. Caiola that it would delta hedge its own positions as Mr. Caiola s synthetic trading counterparty and that their synthetic trading relationship would remain unchanged; and 2. with knowledge that Mr. Caiola was relying on these assurances, acted in a manner that was completely inconsistent with those assurances. Given the clear causal connection alleged between Citibank s actions and the losses suffered by Mr. Caiola, the Second Circuit was unwilling to allow the general disclaimer language of the Confirmations to shield Citibank from the consequences of alleged fraudulent conduct that was not even alluded to in that disclaimer. The Kwiatkowski Decision In Kwiatkowski, the plaintiff had traded currency futures in his Bear Stearns account during a four-month period in 1992, and a five-month period in 1994-95. In 1992, he earned a $219 million net profit; in 1994-95, he suffered a net loss of $215 million. Mr. de Kwiatkowski brought an action against Bear Stearns in federal district court, arguing that the losses he suffered in 1994 and 1995 resulted from Bear Stearns fail[ure] adequately to warn him of risks, fail[ure] to keep him apprised of certain market forces, and... negligent advice concerning the timing of his trades. 6 Following a jury award of $111.5 million to Mr. de Kwiatkowski, the district court denied Bear Stearns motion for judgment notwithstanding the verdict, finding that Bear Stearns had breached an ongoing duty it owed to Mr. de Kwiatkowski. On appeal, the United States Court of Appeals for the Second Circuit reversed and set aside the jury award. The Kwiatkowski Disclaimer According to the Second Circuit opinion, Mr. de Kwiatkowski was an experienced currency trader whose strategy reflected his belief in the long-term strength of the U.S. dollar. 7 He opened a nondiscretionary margin account with Bear Stearns Private Client Services Group, which provided special services to large private investors. The account opening documents included a number of risk-disclosure statements containing various disclaimers. Significantly, as noted by the Second Circuit, these documents warned Mr. de Kwiatkowski that: commodity futures trading is a highly risky and speculative activity subject to sharp price volatility; and due to the difficulty or impossibility of liquidating positions under certain market conditions, he could sustain substantial losses, even in excess of amounts posted as collateral with respect to margin trading. For these reasons, the Bear Stearns documentation advised Mr. de Kwiatkowski to place at risk only what he could afford to lose and to consider carefully whether such trading was suitable for him. 8 Advice from Bear Stearns and Mr. de Kwiatkowski s Profits and Losses Because of the massive scale of Mr. de Kwiatkowski s trading activities rivaling those of a sovereign government his account was closely monitored by Bear Stearns Executive Committee and senior management. This also gave him access to the top echelon of Bear Stearns advisors, such as the firm s Chief Economist and the head of the Bear Stearns foreign exchange trading operation. Following advice from Bear Stearns in October and December 1994 that the dollar was undervalued, Mr. de Kwiatkowski built up a foreign currency short position with a notional amount of approximately $6.5 billion. He moved half of his currency position to the over-thecounter ( OTC ) market after Bear Stearns advised him that by doing so he could trade with less visibility...and 3

more easily liquidate without impacting the market. 9 Within a short period of time, Mr. de Kwiatkowski s account enjoyed huge unrealized gains, which became almost as huge losses when the dollar began to fall. On December 28, 1994, with his losses totaling $112 million, Mr. de Kwiatkowski informed his broker and the head of Bear Stearns foreign exchange trading operation that he was concerned about the dollar and was thinking of closing his position. 10 On several occasions during this period, he sought and received advice from Bear Stearns, which continued to be bullish on the dollar until February 1995, when it published a report by its futures department downgrading the dollar s outlook to negative and stating that the German mark and the Swiss franc were likely to strengthen. At that time, Mr. de Kwiatkowski held a very significant long position in the dollar and short positions in the German and Swiss currencies. He testified that he never received the report. Mr. de Kwiatkowski followed Bear Stearns advice regarding the timing of liquidations to meet margin calls. In one instance, this enabled him to recoup $50 million, but in another, a recommended delay greatly exacerbated his losses. These losses required him to liquidate a securities account he held at Bear Stearns and make a $2.7 million cash payment to the firm. The District Court Opinion Bear Stearns moved for dismissal of Mr. de Kwiatkowski s negligence claim on the grounds that the duties it owed to a nondiscretionary customer such as Mr. de Kwiatkowski were limited to the faithful execution of the client s instructions, and did not entail ongoing advice. 11 In rejecting Bear Stearns motion, the district court found issues of fact as to whether Kwiatkowski had entrusted matters and Bear Stearns had provided services that exceeded the bounds ordinarily associated with nondiscretionary accounts. 12 The District Court s Finding of Special Circumstances The district court held that the unique nature of Mr. de Kwiatkowski s relationship with Bear Stearns constituted special circumstances that expanded Bear Stearns duty of care as a broker-dealer, even with respect to its nondiscretionary accounts with Mr. de Kwiatkowski. According to the district court: the vast size of Mr. de Kwiatkowski s accounts was both unique and unprecedented Mr. de Kwiatkowski s Bear Stearns broker spoke with him as many as twenty or thirty times daily, continually providing him with the latest market information ; [t]he sheer size, placement and visibility of Kwiatkowski s foreign currency position made it highly exposed and rendered him subject to distinct risks and vulnerabilities ; 13 and the opinions, recommendations and advice Bear Stearns provided Kwiatkowski... occurred on a continuous basis and encompassed matters within the scope of the relationship that, far from mere ancillary routine, embodied the full magnitude of handling Kwiatkowski s accounts, with all the considerable implications that such responsibility entailed. 14 The Second Circuit s Application of the Special Circumstances Test Courts have held that particular circumstances impose a higher duty on a broker only when they render the client dependent for example, a client who is so lacking in sophistication that de facto control of the account is deemed to rest in the broker. 15 Applying that test, the Second Circuit found that Mr. de Kwiatkowski, an extremely wealthy, highly experienced foreign currency trader with a huge appetite for risk perhaps the epitome of a sophisticated investor did not fit the profile. As the Second Circuit observed, Mr. de Kwiatkowski was the very opposite of the naïve and vulnerable client who is protected by special circumstances. 16 Though Mr. de Kwiatkowski s relationship with Bear Stearns was special, the Second Circuit concluded there was no way, absent fraud, which was not alleged, that Bear Stearns could have taken unfair advantage of any incapacity or simplicity on his part. 17 Consequently, it 4

rejected the district court s special circumstances analysis, finding the evidence at trial insufficient to support the legal conclusion that Bear Stearns owed Mr. de Kwiatkowski a duty of reasonable care that entailed the rendering of market advice and the issuance of risk warnings on an ongoing basis, 18 or that Bear Stearns was negligent in performing those services it did provide. 19 No Ongoing Duty of Care The Second Circuit also concluded that Bear Stearns had no ongoing duty of care, the breach of which would give rise to a claim for negligence, because Mr. de Kwiatkowski s account with Bear Stearns was nondiscretionary. The court noted that a negligence claim presupposes an ongoing duty of reasonable care (in this instance, that Bear Stearns had obligations to Mr. de Kwiatkowski between transactions), but that in establishing a nondiscretionary account, the parties ordinarily agree and understand that the broker has narrowly defined duties that begin and end with each transaction. For this reason, Bear Stearns could not be held liable for its failure to provide information or give advice between transactions. 20 Thoughts about Eternity: Unique or Special Expertise The District Court s Decision in Eternity In Eternity Global Master Fund Limited v. Morgan Guaranty Trust Company of New York,a case decided one month after the Second Circuit s reversal in Kwiatkowski, the United States District Court for the Southern District of New York left open the possibility that the duty of a brokerdealer or other market professional to its customer or counterpart may be expanded based on the market professional s unique or special expertise -- without regard to the other party s level of sophistication. In Eternity, the claims of plaintiff Eternity Global Master Fund Limited ( Eternity ) for fraud and negligent misrepresentation were based upon alleged assurances and omissions regarding the liquidity of a secondary market for credit default swaps Eternity had entered into with Morgan Guaranty Trust Company of New York and JPMorgan Chase Bank (collectively, Morgan ). Eternity had entered into these swap transactions to hedge its long position in emerging market bonds it had purchased from Morgan. The district court found that: Morgan s unique or special expertise in swap transactions and emerging market debt... as well as allegations that Morgan was aware of the use to which... information [provided] would be put, was sufficient to withstand a motion to dismiss the negligent misrepresentation cause of action. 21 To make a claim for negligent misrepresentation, Eternity had to allege, among other things, facts supporting the conclusion that, as a result of a special relationship with Eternity, Morgan had a duty to provide Eternity with accurate information. 22 Further, the alleged misrepresentation, according to the district court, must be factual in nature and not promissory or relating to future events that might never come to fruition. 23 Relying on the New York Court of Appeals opinion in Kimmell v. Schaefer, 24 the district court listed the following factors to consider in determining the presence of a special relationship : 1. whether the person making the representation held or appeared to hold unique or special expertise; 2. whether a special relationship of trust or confidence existed between the parties; and 3. whether the speaker was aware of the use to which the information would be put and supplied it for that purpose. 25 Although Eternity did not specifically allege a special relationship of trust with Morgan, the district court sustained the negligent misrepresentation claim based on Eternity s allegations regarding Morgan s unique or special expertise in swap transactions and emerging market debt and the fact that Morgan was aware of the use to which the information [regarding the secondary market] would be put. 26 5

The Impact of Eternity on a Market Professional s Duty to Provide Accurate Information to its Counterpart Though the Eternity decision does not directly contradict the Second Circuit s decision in Kwiatkowski, it could be viewed as creating a duty on the part of a sophisticated market professional to a less sophisticated market professional even in the case of swap counterparties with no more than an arm s-length business relationship. That duty, to use reasonable care to ensure that the information it provides is accurate, would entitle the recipient of such information to rely on its accuracy and would form the basis for a claim should the information turn out to be incorrect. By holding that Eternity had alleged sufficient facts to support the existence of a special relationship between Eternity and Morgan, even in the absence of any allegation of a special relationship of trust, the district court in Eternity may have created such a duty, thereby expanding the scope of liability of institutional market professionals when they provide information to their clients and potential clients in the course of marketing and negotiating principal-to-principal transactions, such as derivatives transactions. Contractual Disclaimers in light of Eternity, Caiola and Kwiatkowski Like Citibank in Caiola, Morgan in Eternity argued that the no reliance contractual disclaimer language included in its ISDA Master Agreement with Eternity precluded Eternity from claiming it relied upon the alleged misstatements. Citing the Second Circuit s earlier decision in Caiola, the district court disagreed, holding that the contractual disclaimer language (commonly used in derivatives documentation) was insufficient to bar Eternity from relying on the alleged statements. However, in Caiola, the Second Circuit reached its conclusion on the basis of intentional, material misstatements, on which the plaintiff reasonably relied to its detriment in other words, allegations that the statements were not merely inaccurate, but fraudulent, and thus did not fall within the scope of the disclaimer. Unlike the allegations of fraud in Caiola, the allegation in Eternity was essentially that Morgan was mistaken when it made predictions about future events. Eternity s allegation that Morgan intentionally misled it by providing certain assurances was belied by Eternity s admission that, initially, Morgan acted in accordance with those assurances. The court held that this admission preclude[d] any argument that Morgan had a pre-conceived intent not to honor its promise. 27 Given the Second Circuit s holding in Caiola, which applies the burdensome Harsco standard to principal-toprincipal derivatives trading, and the Eternity case, which applies the Caiola holding to a negligent misrepresentation claim, it is questionable whether market professionals can rely on the enforceability of any standard contractual disclaimer provision. Under the Harsco and Eternity holdings, such provisions may not be sufficiently specific. In theory, a market professional could place itself within the Harsco holding by listing in a schedule all information, including market views, provided to its customers and then requiring them to disclaim reliance on all information included in the schedule. Such a practice, however, does not seem feasible given the informal way derivatives transactions typically are marketed and negotiated. Another approach would be to craft a disclaimer of reliance on a special relationship, such as the following: Neither party is relying on any unique or special expertise of the other party, or is in any special relationship of trust or confidence with respect to the other party. Neither party owes a duty to the other party to provide it with accurate information, no special relationship exists between the parties that would create such a duty, and any reliance upon information provided by one party to the other is hereby disclaimed. Of course, until the Second Circuit speaks again, no standardized disclaimer or no reliance clause can be viewed as ironclad protection, enforceable in all circumstances. 6

By Melvin A. Brosterman and Sherri Venokur. Melvin A. Brosterman is a partner in the Litigation Practice Group of Stroock & Stroock & Lavan LLP, specializing in securities, derivatives and commodities litigation. Sherri Venokur is a Special Counsel in Stroock's Commodities and Derivatives Practice Group. 1. 295 F.3d at 318. 2. Id. 3. Id. at 330, quoting Grumman Allied Industries, Inc. v. Rohr Industries, Inc., 748 F.2d 729, 735 (2d Cir. 1984). 4. Id. 5. Id. at 345 (emphasis added). 6. 306 F.3d at 1295. 7. Id. at 1298. 8. Id. at 1297. The possibility of suffering losses was more than theoretical to Mr. de Kwiatkowski, who had lost almost $70 million dollars in currency trades prior to opening his account with Bear Stearns. 9.Id. at 1299. 10. Id. 11. Id. at 1301. 12. Kwiatkowski v. Bear Stearns & Co., Inc., 126 F. Supp.2d 672, 684 (S.D.N.Y. 2000). 13. Id. at 702-03. 14.Id. at 708. 15. Kwiatkowski, 306 F.3d at 1308. 16. Id. at 1309. 17. Id. at 1308. 18. Id. at 1302. 19. Id. at 1307. 20. Id. at 1306. The counterparty-to-counterparty relationship between Mr. Caiola and Citibank also did not give rise to any special ongoing duty of care. Thus, like Bear Stearns with regard to Mr. de Kwiatkowski, Citibank would not have had an independent duty to disclose its hedging strategy had Mr. Caiola never raised the issue. Unlike the Kwiatkowski case, where there was no allegation that Bear Stearns made misrepresentations or was negligent in executing a particular trade, Citibank allegedly made material misstatements about its entire trading relationship with Mr. Caiola. Thus, Citibank s lack of a duty to disclose its hedging strategy was no defense because, once it had chosen to discuss its hedging strategy with Mr. Caiola, it had a duty to be both accurate and complete. Caiola v. Citibank, N.A., N.Y., 295 F.3d at 331. 21.The fraud count was dismissed based upon lack of specificity in the complaint. 22. 2002 U.S. Dist. LEXIS 20706 at *17-18. 23. Id. at 18, quoting Hydro Investors, Inc. v.trafalgar Power Inc., 227 F.3d 8, 20-21 (2d Cir. 2000). 24. 89 N.Y.2d 257 (1996). 25. Eternity, 2002 U.S. Dist. LEXIS 20706 at *18-19. 26. Id. at *20. Nonetheless, the court dismissed this cause of action for lack of specificity in the complaint. Id. at *19. 27. Id. at *14. NEW YORK 180 Maiden Lane New York, NY 10038-4982 Tel: 212.806.5400 Fax: 212.806.6006 MIAMI Wachovia Financial Center 200 South Biscayne Boulevard Suite 3160 Miami, FL 33131-2385 Tel: 305.358.9900 Fax: 305.789.9302 LOS ANGELES Floors 16 and 18 2029 Century Park East Los Angeles, CA 90067-3086 Tel: 310.556.5800 Fax: 310.556.5959 www.stroock.com This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan LLP 2003 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Stroock & Stroock & Lavan LLP is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies, and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Legal Publications editor at 212.806.5522.