The opinion of the court was delivered by: Hochberg, District Judge
Plaintiffs Dow Corning Corp. and Hemlock Semiconductor Corp. bring this lawsuit alleging that they were induced to invest in auction rate securities by defendants' material misrepresentations and omissions concerning the market, in violation of Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 promulgated thereunder, and the Michigan Uniform Securities Act. They also assert state common law claims for fraud, negligent misrepresentation, and breach of fiduciary duty. Plaintiffs are corporate citizens of Michigan. Defendants are BB&T Corp. and Scott & Stringfellow, LLC. BB&T is a citizen of North Carolina. Scott & Stringfellow is a wholly owned subsidiary of BB&T. Defendants move to dismiss the amended complaint pursuant to Federal Rule of Civil Procedure 12(b)(6).
II. SUMMARY OF THE ALLEGATIONS
The following is a summary of the allegations in the amended complaint, which the Court must accept as true for the purposes of this motion. Also summarized below are matters of public record and undisputedly authentic documents upon which plaintiffs' claims are based, which the Court may consider when evaluating a motion to dismiss.
A. Auction Rate Securities
Plaintiffs Dow Corning and Hemlock Semiconductor are corporations that invested their cash and current assets in auction rate securities ("ARS"). Defendant BB&T is one of the nation's leading financial services firms. Defendant Scott & Stringfellow, a wholly owned subsidiary of BB&T, is a registered broker-dealer. Most of defendants' alleged contacts with plaintiffs relevant to this action were through the broker Mr. Jeff Boyd, an employee of Scott & Stringfellow, who operated out of its New Jersey and Florida offices. Defendants have provided investment and cash management services to plaintiffs since at least 2002.
ARS are long-term bonds whose interest rates are periodically reset through a bidding process known as a Dutch auction. They are based on the debt obligations of pools of loans, such as student loans, residential mortgages, or municipal bonds. Dutch auctions for ARS typically occur every 7, 14, 28, or 35 days. At a Dutch auction, bids with successively higher interest rates are accepted until an interest rate is reached at which the number of "buy" orders matches the number of "sell" orders, at which point the auction is concluded and the ARS are sold. That interest rate is called the "clearing rate." However, if there are not enough bids at auction to buy all the ARS, the auction "fails," and the holders of the ARS must await the next auction in order to sell them. ARS are typically only sold at auction; there is no established secondary market for them. In the event of auction failure, each ARS pays interest at a rate established in its prospectus, unless the issuer redeems it.
Plaintiffs allege that defendants were underwriters in the ARS market and served as the managing broker-dealer for many ARS auctions. When acting as the sole manager, defendants allegedly would be the only firm that could submit bids at an auction, both for their own clients and for other broker-dealers. Plaintiffs contend that, in that capacity, defendants had inside knowledge about the auctions and the market for ARS. For example, plaintiffs allege that defendants knew but did not disclose to plaintiffs information about the identities of bidders, the number of bids, the rates at which bids were made, or the dollar amounts of bids made at ARS auctions.
Prior to an auction, broker-dealers would survey investor interest and give guidance to investors, called "price talk," which included a range of rates within which they believed the auction would clear. Price talk allegedly enabled broker-dealers to influence the clearing rate at auctions they managed, because they could consider whether investors were placing bids above the price talk. In turn, that would influence whether the broker-dealer would submit a support bid to ensure that the auction cleared, and at what rate. Defendants allegedly did not disclose to plaintiffs that they would submit support bids to ensure that auctions would clear or clear at a certain rate; plaintiffs claim they believed that the ARS auctions were clearing at all times due to the ordinary market forces of supply and demand.
ARS are subject to maximum rate restrictions -- i.e., an absolute cap on the interest or dividend that a security will pay. That means that the potential payment obligations of the issuer are decreased if the maximum rate is low. Setting low maximum rates therefore makes it easier for an ARS issuer to obtain a high-quality, investment-grade AAA rating from a ratings agency on its ARS. Plaintiffs allege that these low maximum rates were not adequately disclosed. Another effect of a low maximum rate is that, in the event of auction failure, the issuer is less likely to redeem the ARS. Plaintiffs invested in ARS with low maximum rates. Partly as a result, many of plaintiffs' ARS have not been redeemed by the issuers.
Plaintiffs allege that one of their principal investment objectives is liquidity. Defendants allegedly marketed ARS to plaintiffs as highly rated, highly liquid, and secure investments that were equivalent to cash. They allegedly represented that ARS auctions rarely failed. Plaintiffs allege that defendants were aware of their investment objectives and knew that plaintiffs purchased ARS due to their purported safety and liquidity.
Mr. Boyd, a broker with Scott & Stringfellow, had a long-standing relationship with plaintiffs. Throughout 2007 and until February 13, 2008, Mr. Boyd submitted bids on plaintiffs' behalf to purchase ARS at auction. According to the amended complaint, Mr. Boyd knew that he was expected to monitor the market and keep plaintiffs apprised of the safety and liquidity of ARS, which involved an assessment of the true supply and demand in the ARS market.
Plaintiffs claim that Mr. Boyd had discretionary authority to make trades in ARS and would inform plaintiffs on a daily basis as to what trades he had made on their behalf. Plaintiffs also allege that some of the time they purchased ARS based on defendants' recommendations.*fn1 Plaintiffs further allege that, beginning some time prior to 2005 and continuing until February 13, 2008, defendants sold ARS to plaintiffs, presumably at auction. Although each issuance of ARS is described in a prospectus, Mr. Boyd allegedly did not provide plaintiffs with the prospectuses associated with his purchases of ARS on plaintiffs' behalf.
The risk of auction failures increased dramatically from Fall 2007 until February 13, 2008, when the ARS market is alleged to have collapsed. Consequently, plaintiffs allege, defendants increased their support bids substantially during this period. As their support bids increased, so also did defendants' portfolio of ARS. This in turn allegedly increased defendants' need to unload their own ARS on other market participants, including plaintiffs. Nevertheless, defendants allegedly continued to create a false impression of supply, demand, and liquidity in the ARS market by making undisclosed support bids, and Mr. Boyd continued to advise plaintiffs to buy ARS while the market deteriorated. Plaintiffs also allege that defendants were motivated to prevent auction failure and to conceal the true state of supply and demand in the ARS market by their desire to generate underwriting fees, auction management fees, and commissions and to maintain favorable business relationships with ARS market participants, including issuers and investors.
Defendants allegedly knew or should have known from Fall 2007 through February 13, 2008 that ARS were no longer safe, highly liquid investments. That is, plaintiffs claim, because the defendants knew that bids submitted by brokers, rather than investors, were keeping ARS auctions from failing. Plaintiffs allege that defendants nevertheless misrepresented the risk that auctions would fail and continued to market ARS to plaintiffs as before. In support, they specify eleven communications from Mr. Boyd during this period concerning the state of the ARS market:
1. On November 7, 2007, Mr. Boyd forwarded Ms. Heather Szafranski, a securities trader at Dow Corning, a news story reporting that Fitch, a ratings agency, might downgrade FGIC, one of the so-called monoline insurance companies. He allegedly wrote,
Heather, we have one bond FIGC [sic] insured and will be selling that on the 7th. If you would like me to review the other portfolio's [sic] I will be happy to do so. JB We don't use FIGC [sic] for any of our bonds. (Am. Compl. ¶ 35.)
2. On November 20, 2007, in response to a question from Mr. Jan Hjalber, the Treasurer of Dow Corning, concerning a recent increase in interest rates in the "muni market," Mr. Boyd allegedly replied,
Jan, Very Good to hear from you! Rates are very good for us! I have looked at this 5 different ways. Trying to make sure there are no surprises. Have been on several conference calls and the same outcome. The basis [sic] answer is 2 fold. . For us the first one is the amount of tax free buyers is dwarfed by people who can only buy taxable (institutionally-size) and the actual $$market arena is being spooked into treasuries as evidenced by the huge inversion of 2yr notes (3.15%) and funds (4.25%) would love to cover this with you further and provide whatever supporting materials you need. (Am. Compl. ¶ 63.)
3. On December 17, 2007, Mr. Boyd emailed Ms. Szafranski, forwarding a news story reporting that Moody's, a ratings agency, had reaffirmed high ratings for two of the monoline insurance companies. He allegedly wrote,
Good news for Ambac and MBIA. Ratings for the two ins. providers we hold were affirmed AAA. Ambac especially and MBIA affirmed with neg outlook but still AAA. If you want to discuss this please let me know. Also pls pass this info on to Jan [Hjalber]. (Am. Compl. ¶ 64.)
4. On January 8, 2008, Mr. Boyd allegedly told Dow Corning's risk controller, Mr. Mark Looker, that plaintiffs' ARS holdings were "very safe" and emphasized to Mr. Looker and Ms. Szafranski that the student loan-backed ARS were much safer than those that were insured by the monoline insurance companies. (Am. Compl. ¶ 56.)
5. On January 24, 2008, in response to a question from Mr. Hjalber about student loan-backed ARS, Mr. Boyd allegedly wrote,
basically the way it works is each state originates the loans and the Dept. of Education guarantees the loans through different programs. You could call it a subsidy. The purpose is obviously to promote the US college programs. Yes, the states are responsible to manage each individual program and the D.O.E. has established guidelines for maintaining the guarantee. The D.O.E. is *Not* a sponsored agency like Freddy Mac or Fannie Mae. The Guarantee the D.O.E. provides comes with the full faith and credit of the United States. The equivalent of U.S. Treasury bonds. (Am. Compl. ¶ 66.) (emphasis in original)
6. On January 29, 2008, Mr. Boyd forwarded to Mr. Looker a news story reporting that certain monoline insurers, Ambac and MBIA, were being downgraded by Fitch. (Am. Compl. ¶ 67.)
7. On January 30, 2008, Mr. Boyd forwarded to Mr. Looker two news stories reporting that Fitch had reaffirmed a AAA rating for a different monoline insurer, Dexia. He allegedly wrote, "Mark, some good insurance news for a change." (Am. Compl. ¶ 68.)
8. On February 1, 2008, in response to an email from Mr. Hjalber expressing concerns about the ARS market and asking whether there had been auction failures in the "muni market where we invest," Mr. Boyd allegedly replied,
Good morning Sir, I was waiting for this one. : ) BMY [Bristol Meyers Squibb] bo[ough]t subprime backed auction product (chasing yield) our space is not that product and as you point out what exposure we could have theoretically we have addressed. And continue to do so. I will say even the FGIC and XL (already downgraded) issues are clearing no problem. Issuers are raising caps to accommodate the downgrades so things seem to be taking all this into account. I hope the shareholders don't have anything similar to BMY investments. I can only help them with your blessing. : ) Was planning on covering this on the 25th but with all the news let me know if you want me to update reporting. By the way ...