Morgan Stanley won dismissal of a government pension fund lawsuit accusing it of defrauding investors in $1.2 billion of risky mortgage debt that it expected to fail.

U.S. District Judge Barbara Jones in Manhattan said the Virgin Islands fund did not allege sufficient facts to conclude that Morgan Stanley made an actionable misrepresentation or material omission in selling triple-A rated notes tied to a 2007 collateralized debt obligation known as Libertas.

In its December 2009 complaint, the fund accused Morgan Stanley of collaborating with Moody's Investors Service and Standard & Poor's on credit ratings for the notes, which were backed by subprime mortgages. It also said the bank shorted the notes in a successful bet that they would lose value.

Jason Davis, a lawyer for the Virgin Islands fund, did not immediately return a call seeking comment. Morgan Stanley also did not immediately return a call.

Several banks have faced allegations that they helped package risky debt for investors, only to then bet against it or allow a client to do so.

In July 2010, Goldman Sachs Group Inc agreed to pay $550 million to settle such charges by the U.S. Securities and Exchange Commission over the Abacus 2007-AC1 CDO, an accord that won approval from Jones.

And in June 2011, JPMorgan Chase & Co reached a $153.6 million settlement with the SEC over the Squared CDO 2007-1.

TITANIC

According to the Virgin Islands fund complaint, the Libertas CDO had been backed by assets from subprime lenders New Century Financial Corp, which went bankrupt, and Option One Mortgage Corp, then owned by H&R Block Inc .

The fund also said Morgan Stanley should have given investors more than a generic warning in the CDO's offering materials that rising delinquencies may cause losses.

It likened this to the Titanic's captain telling passengers that his ship may sink because others had, while concealing that the ship had struck an iceberg and was taking on water.

But Jones said the fund made only a conclusory allegation that Morgan Stanley collaborated with the rating agencies to generate false ratings. She also said the offering materials were prepared by the issuers and were not a statement by Morgan Stanley promoting false ratings.

Moody's is a unit of Moody's Corp and S&P is a unit of McGraw-Hill Cos . Neither was a defendant.

The case is Employees' Retirement System of the Government of the Virgin Islands v. Morgan Stanley et al, U.S. District Court, Southern District of New York, No. 09-10532.

(Reporting by Jonathan Stempel in New York; Editing by Ted Kerr and John Wallace)

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