Banca Cremi, S.A. v. Alex. Brown & Sons, Incorporated

132 F.3d 1017 (4th Cir. 1997)

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Nature of the Case

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Facts

P, a Mexican bank with $5 Billion in assets, purchased a number of collateralized mortgage obligations (CMOs) through Epley, a broker with D. Three individuals had primary oversight responsibilities for P's unit's operations and investments. Mendez held a degree in economics, and primarily advised D on U.S. dollar-denominated investments. The subdirector, Aguirre, also held a degree in economics. Aguirre served as an economics teacher, a currency investment adviser, and a developer of accounting systems. Aguirre approved all of P's CMO trades. The assistant director, Buentello, held a degree in international relations, had completed postgraduate coursework in international commerce and analysis, and had participated in seminars on derivatives and CMOs while working at P. Epley, sold P from an unsolicited phone call to sell CMOs. Epley discussed CMOs with Buentello and others. P allegedly told Epley that it wished to 'invest in securities that: [(1)] had low risk to capital; [(2)] were highly liquid; [(3)] would be held for short periods (generally 90-180 days); and [(4)] could reasonably be expected to provide a good yield.' Epley provided P with general background materials describing the functioning and risks of CMOs that also described inverse floaters and inverse IOs, calling them each volatile. Epley also wrote a letter to Buentello dated July 22, 1992 (risk letter), outlining four types of risks of inverse floaters: credit risk, coupon risk, price volatility, and liquidity risk. Describing the coupon risk, the risk letter stated that in 'most cases' the index would need to increase by six percent before the yield of the inverse floater became zero. As for price volatility, the risk letter stated that the price had an inverse relationship to interest rates, 'as with all fixed income securities.' As for liquidity risk, the letter claimed that many firms would bid on inverse floaters and that demand 'currently' far exceeded supply. P independently investigated the benefits and risks of CMOs. The Bank discussed the potential investment in CMOs with its counsel and established a fourteen-step review procedure to be followed prior to each CMO purchase. The review procedure was later formalized into a written manual. P's analysis was detailed and fully recognized that if the index rate increased by six percent, the yield of an inverse floater CMO would dwindle to nothing. Director Mendez purchased several lengthy treatises that described mortgage investments and CMOs in extensive detail. These books were made available to P's unit staff. In May 1993 Buentello attended a seminar on derivatives investing. Buentello also attended a seminar at which CMO investing and pricing methods were discussed. P was courted by other brokerage houses for P's CMO business, and each brokerage house provided the Bank with their own internal documents describing the benefits and risks of CMO investing. One article warned of what could occur to CMO investments if interest rates were to rise: 'if interest rates rise . . . what investors thought was a safe, secure medium-term maturity can suddenly be transformed into a highly risky long-term security.' The article suggested that, in these circumstances, a CMO's price would drop ten to twenty percent 'if you can get a bid for it at all.' P purchased its first CMO in August 1992. P purchased a total of twenty-nine CMOs. Epley encouraged P to make additional CMO purchases. Most of these suggested purchases were not pursued by P. Epley also introduced P to CMO expert and finance professor, Frank J. Fabozzi. Fabozzi was made available to the Bank for technical consultation and sent the Bank textbooks he had written which described CMOs and other financial instruments. Epley also provided P with the yield matrix for a CMO before it was purchased. It provided a table that indicated how the CMO's yield and average maturity changed when interest rate and prepayment conditions changed. The CMOs initially earned interest at rates as high as twenty-four percent. P played the CMO market aggressively, trading CMOs frequently to take advantage of short-term market swings. P sold eight CMOs within three weeks of purchasing them, including one trade made within twenty-four hours of P's purchase. P sold a total of twenty-three CMOs, each at a profit, prior to the CMO market downturn in March 1994. The aggregate price of these twenty-three CMOs exceeded $96 million. P's profits exceeded $2 million. P held six CMOs at the time of the market downturn in March 1994. P claims losses on the six CMOs of around $21 million of the original purchase price of around $40 million. P claimed Ds violated § 10(b) and Rule 10b-5 by: (1) making material misstatements and omissions regarding the CMOs sold to P; (2) selling P the CMOs which it knew to be unsuitable investments for P; and (3) failing to disclose fraudulently excessive markups totaling $2 million on the CMO sales. The district court rejected the Bank's suitability claim as a subset of the rejected § 10(b) claim. P appealed.