By Jerry Carter.  An investor is sometimes faced with a situation in which he or she holds an illiquid investments that is nominally performing even though the investment’s risk profile has increased due to factors that were misrepresented or inadequately disclosed at the time of sale.  The United States Court of Appeals for the Second Circuit addressed such a situation in NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., 693 F.3d 145 (2nd Cir. Sept. 6, 2012).  In a decision that is likely to have a significant impact, the Court of Appeals held that an investor was not required “to plead an out-of-pocket loss in order to allege a cognizable diminution in the value of an illiquid security” under Section 11 of the 1933 Securities Act.

The investor purchased mortgaged-backed certificates underwritten by Goldman Sachs & Co.  The certificates are securities backed by pools of residential real estate loans.  The investor alleged that the truth about the certificates’ risk came to light in mid-2008.  Rating agencies put negative watch labels on the certificates and downgraded previously-assigned ratings.  The delinquency rates on the underlying mortgages skyrocketed.  The certificates were no longer marketable at prices anywhere near the prices paid by the investor.  The investor further alleged that the certificate holders would likely receive less absolute cash flow in the future and receive it, if at all, on an untimely basis.

The defendants contended that the investor suffered no loss because the investor had not yet suffered any missed payment.  The Second Circuit rejected “the proposition that a fixed income investor must miss an interest payment before his securities can be said to have declined in ‘value.’”  The “revelation that borrowers on loans backing the Certificates were less creditworthy than the Offering Documents represented affected the Certificates’ ‘value’ immediately, because it increased the Certificates’ credit risk profile.”  Moreover, the Court of Appeals held that the absence of an actual market price for a security at the time of suit does not defeat an investor’s plausible claim of injury from misleading statements contained in that security’s offering documents.  “The value of a security is not unascertainable simply because it trades in an illiquid market and therefore has no ‘actual market price.’”