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No Due Diligence? No Fraud by Omission Recovery

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By Robyn Hagan Cain on June 20, 2012 4:09 PM

Maybe $50 million isn't a lot of money to a bank.

Before the mortgage meltdown of 2007 and 2008, Republic Bank & Trust Company purchased over $50 million of residential-mortgage-backed securities from Bear Stearns.

Anyone who knows anything about the mortgage industry can easily spot three red flags in that paragraph, so it's no surprise that Republic's investment turned out to be a bad decision. Republic lost millions on the deal, and Republic and Bear Stearns found themselves litigating responsibility for that bad decision before the Sixth Circuit Court of Appeals.

Republic sued in 2009, alleging that Bear Stearns and one of its employees fraudulently induced it to buy, and then to retain, the securities. It claimed that a series of misrepresentations and omissions, both oral and in the written offering documents, were actionable under common-law theories of fraud and negligent misrepresentation, and under the Blue Sky Law, Kentucky's securities statute.

The district court disagreed, and dismissed the case with prejudice. Wednesday, the Sixth Circuit Court of Appeals affirmed dismissal, noting that Republic failed to perform due diligence on the deal, reports The Associated Press.

According to the Sixth Circuit Judge Danny Boggs, Republic has itself to blame. In his opinion for the court, Judge Boggs wrote, "Republic would have understood that the loans underlying the certificates carried a high risk of default, had it read the prospectus supplements."

Because Republic never read the disclosures, its fraud by omission claims failed. Judge Boggs cited multiple Bear Stearns prospectus supplements in the opinion, which "amply warned" about the increased risk of default on the underlying loans. "Had it read the disclosures, [Republic] would have known that the trusts contained loans issued to borrowers with questionable credit histories," Boggs wrote.

May $50 million isn't a lot of money to a bank, but it's enough to warrant due diligence. And if a bank doesn't take time to read up on a $50 million deal, the Sixth Circuit Court of Appeals won't entertain its fraud by omission claim.

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