Sept. 11 (Bloomberg) -- A UBS AG employee referred to asset-backed securities sold by the Swiss bank as “vomit” in an internal e-mail in 2007, according to a fraud lawsuit brought by hedge fund Pursuit Partners LLC.

A Connecticut judge cited the e-mail in ruling that UBS must post a $35.6 million bond because Pursuit has enough evidence to pursue a claim that the bank failed to disclose that its collateralized debt obligations faced rating downgrades.

“OK still have this vomit?” a UBS employee wrote in September 2007 to a director, referring to a CDO with an investment-grade rating, according to the ruling. Another UBS e- mail referred to selling “crap” to Pursuit.

“Pursuit has established probable cause to sustain the validity of a claim that the UBS defendants were in possession of material nonpublic information regarding imminent ratings downgrades on the notes it sold to the plaintiffs, information UBS withheld from the plaintiffs,” Superior Court Judge John Blawie wrote in a Sept. 8 opinion in Stamford, Connecticut.

The judge allowed the lawsuit to proceed without ruling on the merits of the case by Stamford-based Pursuit. Zurich-based UBS, the largest Swiss bank, sold Pursuit $40.5 million worth of CDOs between July and October 2007, just as the market for such securities was declining, according to court papers.

A worldwide credit crisis, sparked by defaults on debt tied to subprime mortgages, resulted in more than $1.6 trillion in writedowns and losses since the start of 2007.

Moody’s Review

UBS employees pitched the securities to Pursuit while they were in contact with the credit-rating company Moody’s Investors Services Inc., which was reviewing its “investment grade” ratings on the CDOs, according to court papers.

After meetings with Moody’s, UBS employees became aware that the CDOs would “soon turn into financial toxic waste,” Blawie wrote.

Pursuit, which claims it lost $35.6 million, can pursue claims that UBS hid material non-public information that the debt instruments would lose their investment-grade rating, and that the loss of the rating would render their investments “worthless,” the judge wrote.

UBS spokeswoman Karina Byrne said the bank expected to prevail in the litigation and that no UBS employee had information that Moody’s was considering downgrading the securities before Pursuit bought them.

‘Sophisticated Investor’

“Pursuit Partners is a sophisticated investor whose own evidence demonstrated that Pursuit was fully aware that it was purchasing troubled securities at deep discounts in the summer of 2007,” Byrne said in a statement. “Pursuit insisted on discounts that averaged 70 percent; one investment was purchased as a 96 percent discount.”

Pursuit itself referred to the investments in unflattering terms, according to Byrne.

“In e-mail correspondence with their UBS client relationship manager, a Pursuit principal described the collateral underlying some of these securities as ‘sh--,’” Byrne wrote. “Any suggestion that Pursuit was unaware of the risks it was assuming in purchasing these investments is unsupported by Pursuit’s own e-mails and evidence.”

Moody’s, which also is a defendant, wasn’t required to post a bond. Moody’s is a unit of New York-based Moody’s Corp. Moody’s spokesman Michael Adler didn’t immediately return calls before business hours seeking comment.

On Sept. 2 a federal judge in New York allowed a class action, or group, case against Moody’s, Standard & Poor’s and Morgan Stanley to proceed. The lawsuit claims the credit rating companies hid the risks of securities linked to subprime mortgages.

The case is Pursuit Partners, LLC v. UBS AG, 08-cv-4013452, Connecticut Superior Court (Stamford).

To contact the reporters on this story: Carlyn Kolker in New York at ckolker@bloomberg.net; David Voreacos in Newark, New Jersey, at dvoreacos@bloomberg.net.

Last Updated: September 11, 2009 14:42 EDT