From Tolin v. AMBAC Fin. Group, 2009 U.S. Dist. LEXIS 119986 (S.D.N.Y. Dec. 23, 2009):

This action raises what appears to be a question of first impression in this Circuit: does the Second Circuit's decision in Ontario Pub. Serv. Employees Union Pension Trust Fund v. Nortel Networks Corp., 369 F.3d 27 (2d Cir. 2004) (hereinafter "Nortel") bar the purchasers of a derivative securities product from bringing a 10(b)(5) action against the issuer of the securities that were bundled by a second issuer to create the derivative?

I conclude that it does not, at least not on the facts of this case. ***

Beginning in at least 2005, Ambac guaranteed billions of dollars of private asset-backed structured financial instruments supported by collateral, including (1) residential mortgage backed securities ("RMBS"), which are collateralized by the underlying mortgages, and (2) collateralized debt obligations ("CDOs"), which are supported by large bundles of securitized RMBS rather than by the mortgages directly. Ambac directly insured the RMBS, and it issued credit default swaps ("CDS") to guarantee CDOs that were backed by bundles of RMBS. ***

According to the complaint, Ambac played a key role in the explosion of the RMBS and CDO markets, by providing direct insurance for RMBS and by providing protection for CDOs that were collateralized by bundles of RMBS via the use of credit default swaps. Ambac also allegedly insured increasing amounts of RMBS backed by secondary lien second mortgage loans, often home equity lines of credit. Such loans are, of course, riskier than first lien loans, because repayment is directly related to the borrower's ability to pay down the underlying first mortgage. And Ambac did not need to allocate as much capital to support credit default swaps, which made them at once riskier and more profitable for the company. ***

Plaintiffs allege that Ambac ''effectively sold its AAA credit rating to enhance the credit rating of bonds and asset backed securities." ***

Plaintiffs are investors who purchased a derivative product known as Structured Repackaged Asset-Backed Trust Securities, Callable Class A Certificates, Series 2007-1, STRATS(SM) Trust for Ambac Financial Group Inc. Securities, Series 2001-1 (hereinafter "STRATS"). ***

Plaintiffs and other STRATS owners have, by virtue of their investment, a beneficial interest in a trust that is funded with a single asset: securities issued by Ambac, known as Ambac February 2007 Directly-Issued Subordinated Capital Securities ("DISCS")***.The STRATS themselves, however, were not issued by Ambac; rather, they were packaged and issued by a subsidiary of Wachovia Bank, known as Synthetic Fixed-Income Securities, Inc. ("SFIS") (emphasis added)***.

In this case, while the DISCS are the underlying financial assets that immediately back the STRATS, the real underlying assets were the residential mortgages themselves, which had been securitized via RMBS, and perhaps securitized again into CDOs, which were guaranteed by Ambac, which securitized its own guarantees by creating the DISCS and selling them off to the public through the medium of SIFS.

[Footnote 1] For some months, a collection of cartoons entitled "The Subprime Primer" [available at http://www.businesspundit.com/sub-prime/] has circulated on the internet and been distributed to students of business and finance. It describes (using language that cannot be quoted in a judicial opinion) the various steps in asset-backed securitization involving mortgages, from the taking out of a mortgage by a homebuyer who cannot afford it through the various levels of securitization of the ensuing risk and on to the ultimate default — i.e., the process summarized here. It is highly instructive.

The complaint alleges — and it is obvious enough — that ABS securities and ABS issuers differ significantly from garden-variety corporate securities and their issuers when it comes to making the disclosures required under the federal securities laws. The issuer of the ABS (in this case, SFIS) generally has no business or management to describe — it is a so-called Special Purpose Vehicle ("SPV"), and its business consists of taking pools of assets that were assembled by someone else (many of which are themselves ABS, like RMBS and CDOs), and securitizing (or resecuritizing) those pools. Plaintiffs allege that ABS investors value securities by examining the characteristics and quality of the underlying asset pool and the timing and certainty of cash flows from the underlying asset pool. Plaintiffs further allege that the Securities and Exchange Commission ("SEC") has recognized the unique nature of ABS products, to the point of providing a separate regulatory framework to govern them. Of particular importance to this case are SEC regulations that allow the issuer of an asset-backed security to make the disclosures required by the securities laws by referring to the filings of the issuer of the security that backs the ABS. 17 C.F.R. § 210 et seq. This rule recognizes the fact that an ABS issuer would find it difficult to obtain and analyze some other party's financial information, and so sends the investor back to the underlying issuer's financial statements for information pertinent to the investment decision. ***

In the Prospectus and Registration Statement for STRATS here at issue, SFIS refers to Ambac's public filings with respect to the DISCS, and informed investors that they should "obtain and evaluate the same information concerning the Underlying Issuer as they would obtain and evaluate if they were investing directly in the DISCS or in other debt securities issued by the Underlying Issuer." ***

So plaintiffs and other members of the putative class purchased STRATS, an ABS backed solely by Ambac-issued debt securities (the DISCS), which were in turn backed by pools of collateralized debt obligations on mortgage-backed securities, or by mortgage-backed securities themselves, all of which were insured or guaranteed by Ambac, purportedly in accordance with its highly-touted historic underwriting standards. ***

It is undisputed that the securities purchased by the plaintiffs were issued by SFIS, not by Ambac. The question posed by defendants' motion is whether plaintiffs have standing to sue Ambac for making material misrepresentations about its earnings, underwriting criteria and business prospects.

Defendants say not. Indeed, defendants say that the Second Circuit's decision in Nortel, which binds this Court, resolves the question in their favor.

Plaintiffs say not so.

I agree with plaintiffs.

To understand why, it is necessary to discuss Nortel, 369 F.3d 27 (2d Cir. 2004), in some detail. ***

[Following an extensive discussion of Nortel:]

The primary purpose of the securities laws is to provide protection to investors. See e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195(1976). The development and evolution of new and complex financial instruments, such as ABS and RMBS and CDOs, created new challenges for investors who are trying to make informed decisions. While scholars and commentators have called for a variety of new laws to deal with this development — with some even going so far as to suggest making subprime mortgages themselves subject to the federal securities laws, and others suggesting a revision of Blue Chip Stamps' "purchaser or sale" requirement — we need not consider these and other interesting suggestions for expanding existing law, because in our case we are dealing with instruments that are admittedly securities, and that are already subject to federal law. The issue for this Court is whether it makes sense, as a policy matter, to allow purchasers of a derivative security to bring suit under Section 10(b) and Rule 10-b(5) against the firm whose assets have been securitized by a shell corporation, on the theory that persons who purchased those securities were defrauded about their value, not by some statement about the issuer, but by inaccurate descriptions of the securitized assets that were made by the owner of those assets.

[Footnote 2] See Richard E. Mendales, Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown, and How to Fix It, 2009 U. Ill. L. Rev. 1359, 1407 (2009); Jonathan Macey et al., Helping Law Catch Up to Markets: Applying Broker-Dealer Law to Subprime Mortgages, 34 J. Corp. L. 789, 813 (2009). Professor Mendales proposes modification of the securities laws to cover mortgages and other debt instruments that will be securitized. *** Macey et al. argue instead that the current antifraud provisions of the securities laws are sufficient, but should be applied more broadly. They argue, inter alia, that because the securitization process turns subprime mortgages into traded securities, the mortgage origination itself falls under the securities laws as a transaction in connection with the purchase or sale of a security. *** Therefore, they argue subprime borrowers should be entitled to the protections of the antifraud provisions of the securities laws with respect to their mortgages.

[Footnote 3] See Doug Winnard, Know When to Hold 'Em, Know When to Fold 'Em: The Collapse of the Auction Rate Securities Market and the Problem of Standing for Securities Holders Under Rule 10b-5, 104 Nw. U. L. Rev. (forthcoming 2010), available at http://ssrn.com/abstract=1392046. Winnard argues that investors in auction-rate securities (a financing instrument created in the mid-1980s, whose market collapse in early 2008 was an early casualty of the financial crisis) should be allowed to bring "holder" claims under 10b-5; claims which have been disallowed since Blue Chip Stamps. . . . Further, Winner argues that "developments in both securities markets and securities law require the Court to -examine the standing requirements for injured securities holders." . . .

The question answers itself. SPVs like SFIS have been described as "essentially robot firms" that are "thinly capitalized" and "have no employees, make no substantive economic decisions, have no physical location, and cannot go bankrupt." Gary Gorton and Nicholas S. Souleles, Special Purpose Vehicles and Securitization, in The Risks of Financial Institutions 550 (Mark Carey & Rene Stulz eds., 2007). By design, the SPV that issues the securities does not function as a separate, independent entity except on paper. Its purpose it to serve as a pass-through vehicle for money going to corporations like Ambac and securities (and the risk they represent) going to investors like plaintiffs. Plaintiffs could never recover anything from the SPV, so limiting the right to sue for misrepresentations in connection with the purchase of a derivative to the shell corporation that is technically the "issuer" means that the investing public has no recourse, while underlying issuers like Ambac — which benefited by passing off its risk to the investing public, while being handsomely paid for doing so — are insulated from their own alleged frauds.

It is true that allowing plaintiffs to sue Ambac expands the class of persons who can sue that company. However, I agree with Judge Schwarzer in Zelman v. JDS Uniphase Corp., 376 F. Supp. 2d 956 (M.D. Cal. 2005) that this expansion will not lead willy-nilly to a world in which any investor can sue any corporation on any cock-and-bull theory that the corporation's public statements have affected some wholly unrelated security. . . . Nortel is still good law in this Circuit, so where the relationship between Corporation A's disclosures and Corporation B's stock price is too remote, Corporation B's shareholders cannot sue Corporation A under the antifraud provisions of the '34 Act. In this case, however, the relationship between Ambac's disclosures and the STRATS is anything but remote, as the SEC regulations make clear. Therefore, this Court is perfectly comfortable in concluding that plaintiffs have standing to sue Ambac if material misstatements made by that company illegally inflated the price of the STRATS that issued "for benefit of Ambac."