As the financial crisis unfolded in 2007 and 2008, and many investment-grade mortgage-backed securities -- even those with top AAA ratings -- turned out to be junk, popular anger understandably flared against ratings agencies Moody's (MCO), Standard & Poor's (MHP) and Fitch. And much of that anger has been channeled into lawsuits against the agencies for their role in th global credit meltdown.
No less than former Federal Reserve Chairman Alan Greenspan recently testified before Congress's Financial Crisis Inquiry Commission that the AAA ratings on mortgage-backed securities were "grossly inflated," and "inaccurately high." And he suggested that market participants, voraciously hungry for "securitized subprime mortgages" but overwhelmed by the complexity of these securities, relied heavily on the ratings agencies to sort out the risks for investors. "We have a fundamental problem that the credit-rating agencies gave triple-A valuations. . . which in retrospect were nonsense. . . . If instead of giving AAA designations to these securities, they received BBB instead, many in the U.S. and Europe would not have bought them." (Note, however, that in his testimony, Greenspan does not doubt the agencies' sincere belief in their ratings at the time they were issued.)
Similarly certain that the ratings agencies share the blame for crisis, the Securities and Exchange Commission has proposed and adopted new rules to prevent them from reprising their role in the future.
Inflated Ratings for Juicy Fees: A Slam-Dunk Legal Case?
As the SEC's investigation, three congressional hearings and lots of investigative journalism have revealed, the underlying story (one vigorously contested by the rating agencies) appears to be that the ratings agencies catered to the big banks that were flipping so many ludicrously underwritten residential and commercial mortgages into securities. That is, the agencies allegedly gave the securities inflated ratings in order to secure the inflated fees such securities commanded.
When plaintiffs who bought gold-rated junk can tell a story like that -- ratings agencies pocketed big profits from selling rosy ratings that duped innocent investors into throwing away their money -- you'd think it would be easy to win lawsuits against the ratings agencies.
And so far, at least, you'd be wrong. The ratings agencies are currently undefeated in lawsuits that accuse them of making "material misstatements" in the documents used to sell the securities -- such misstatements being the core of federal securities fraud claims. The agencies' success has led one commentator to call the group "untouchable."
Needed: A Change of Legal Strategy
Did the most recent congressional hearing last Friday, the one that revealed hundreds of pages of juicy emails and involved damning testimony from ex-employees, including one who thinks Moody's committed securities fraud, add anything to the story that will make the ratings agencies more vulnerable?
No, and yes.
But first, why do the ratings agencies keep winning? The problem isn't the pattern of facts in these cases; it's the plaintiffs' choice of law. To win a federal securities fraud claim, plaintiffs have to fit the ratings agencies into one of the categories of people who can be held responsible for misstatements in the securities' selling documents. And so far, plaintiffs' can't do that, and nothing that came out at Friday's hearing will help plaintiffs do that.
However, that doesn't mean plaintiffs are out of luck. Other types of suits, using the same basic story but pressing claims under other laws, are moving forward. And that's where Friday's hearing may help the plaintiffs. One of the defenses the ratings agencies hope to rely on in other types of cases is the First Amendment. The argument is this: Ratings are opinions about current and future events of public concern, like newspaper editorials, and thus protected speech. Protected, that is, unless the ratings agencies didn't really believe what they were saying when they said it.
That wouldn't be protected speech -- that would be fraud. And the written and oral testimony of the witnesses on Friday suggests that it may be possible to prove that the agencies didn't really believe in the ratings they were giving. Indeed, one of the ex-employees specifically charges that about a 2009 deal.
Moreover, one opinion discussed below suggests that if plaintiffs can show that the ratings agencies didn't believe the ratings at the time they were issued, then the ratings themselves could be material misstatements supporting a securities fraud claim.
The Fatal Flaw in the Cases So Far
Under federal securities laws, purchasers can sue the people responsible for the securities' sales documents. However, the law is very specific about who is considered responsible. Unless you fit into one of the magic definitions -- which include the underwriters, sellers, experts and control persons -- you can't be sued.
So far, plaintiffs have tried and failed to define the agencies as underwriters, sellers and control persons. Generally, they've avoided suing the agencies as "experts," which sure seems like it describes them: ". . .any person whose profession gives authority to a statement made by him, who has. . . prepared or certified any report or valuation which is used in connection" with the security selling document. But SEC regulations specifically exempt the agencies from that definition (at (g) in the linked document).
The ratings agencies have gotten three federal securities lawsuits against them dismissed for good. The first to rule was Judge Lewis A. Kaplan, when he dismissed the ratings agencies from a suit involving mortgage securities issued by Lehman Brothers Holdings' affiliates and subsidiaries. In his Feb. 1 opinion, Judge Kaplan rejected plaintiffs' efforts to cast the ratings agencies as underwriters, noting that their alleged roles -- which included helping to decide what mortgages to buy and securitize and at what price, and how many classes of securities to issue with what levels of credit enhancement -- didn't include purchasing securities from the issuer to resell them to investors.
When Judge Harold Baer Jr. assessed the same issue in a March 26 opinion, he concluded: "I agree with Judge Kaplan." Judge Jed Rakoff recently dismissed the ratings agencies from a similar suit, but he hasn't yet issued an opinion explaining his April 1 order. However, it will likely contain similar reasoning.
Who's a "Seller"?
Judge Kaplan also took on the claim that the ratings agencies were "sellers" because they had such a substantial role in drafting the selling documents. Kaplan compared this transaction to the sale of a house, casting the ratings agencies as architects or builders who design or construct a house for the homeowner who later goes on to sell the house. Only the homeowner is actually involved in the sale, reasoned Kaplan. Judge Baer's case didn't involve a seller allegation, nor did Judge Rakoff's.
Finally, both Judge Kaplan and Judge Bear, but not Judge Rakoff, faced the claim that the ratings agencies were "control persons," in that they directed the activities of others who made actionable false statements. Both judges also dismissed this claim. Judge Kaplan found that the ratings agencies had influence but not control, and Judge Baer asserted that because the agencies didn't have primary liability (they weren't underwriters), they couldn't have control liability.
A couple of weeks after he dismissed the ratings agencies from the suit, Judge Kaplan issued another opinion that may affect litigation, even though it involved only claims against individual defendants. In that dismissal, Judge Kaplan held that failing to disclose the conflict of interest inherent in having the issuers pay the ratings agencies for their ratings wasn't actionable since the information already in the public domain, and there's no duty to disclose what is already known.
But the evidence uncovered at last Friday's hearing might enable plaintiffs to persuade other judges to disagree. The apparent depth of ratings agency subservience to the investment banks goes far beyond what was previously in the public domain.
Judge Kaplan also decided that the ratings agencies' role in structuring the transactions wasn't material as a matter of law, so that the failure to disclose their structuring role couldn't result in liability. While this conclusion isn't likely affected by last Friday's hearing, as The D & O Diary notes, it's not obvious that other judges will agree with Judge Kaplan. Lastly, Kaplan decided that the ratings themselves were opinions that could not be characterized as misstatements unless plaintiffs could show that the ratings agencies -- as opposed to a handful of individuals at the agencies -- did not believe the opinions at the time the ratings were issued. As noted earlier, last Friday's hearing gives plaintiffs a lot more ammunition on this point.
Not easily discouraged, Cohen Milstein Sellers & Tolls, the plaintiffs' firm on the losing side of Kaplan's and Baer's opinions, has again gone after the ratings agencies under the federal securities laws. This time, Cohen Milstein filed suit in New Jersey District Court, and it doesn't allege that the ratings agencies were underwriters. Instead, it focuses again on trying to make them fit the "control persons" definition, including even more detail about the ratings agencies' involvement. We'll see if the New Jersey judge finds Cohen Milstein or his Southern District colleagues more persuasive.
When Abu Dhabi Commercial Bank and King County of Washington State decided to sue under similar circumstances -- they bought highly rated securities only to discover they were junk and made the same basic allegations against the agencies -- they avoided the problems discussed above by bypassing the federal securities laws. Instead they sued under New York common law. One of their claims, for fraud, has survived a motion to dismiss.
To allow the fraud claim to go forward, Southern District of New York Judge Shira Scheindlin didn't have to consider the definitions of underwriter, seller or control person. Instead she had to decide if plaintiffs had provided enough specific details to support claims that the ratings were material misstatements that the ratings agencies knew were false; that the ratings agencies had the motive and opportunity to deceive; and that the plaintiffs reasonably relied on the deceptive ratings.
Assuming everything the plaintiffs claimed was true (which is how motions to dismiss are assessed), Judge Scheindlin held that the plaintiffs had successfully alleged all four elements of fraud. (Judge Scheindlin's take on the ratings agencies' conflict of interest and the agencies' role in structuring the transaction was very different from Judge Kaplan's, although her ruling preceded his and so didn't consider it.) Plaintiffs in this case must have watched last Friday's hearing's with glee.
The First Amendment Doesn't Always Protect the Agencies
Judge Scheindlin also addressed the rating agencies' claim that their ratings were opinions about the future, akin to newspaper editorials, and thus protected by the First Amendment. She rejected that argument, pointing out that the securities in the cases before her were private placements, and the ratings were intended for those investors alone. Thus, the ratings weren't "matters of public concern" and, therefore, not protected under the First Amendment.
It's not clear what impact this ruling will have. For one thing, the First Amendment is no defense against fraud, so the ruling is superfluous. Second, it's application is inherently limited because it covers only cases with private securities, and many of the securities in the other lawsuits are publicly traded. Third, although some argue that the First Amendment doesn't protect the ratings agencies, at least one First Amendment scholar claims Judge Scheindlin's ruling on this issue is not persuasive, and other judges may not follow it.
Whatever the impact, the holding has some odd implications. Sophisticated investors -- the only folks allowed to purchase private securities -- could be entitled to more protection from the ratings agencies than the unsophisticated public at large. Nonetheless, at least one commentator thinks the decision has positive impacts for all investors.
Agencies May Be Liable Under State Statutes
A second kind of case that is, again, substantially similar to the securities law losers above but not subject to the same flaws is the Connecticut Unfair Trade Practices Act suit against the ratings agencies brought by Connecticut Attorney General Richard Blumenthal. That law prohibits false and deceptive advertising, which Blumenthal alleges the agencies repeatedly engaged in with their public representations of their ratings and how the ratings were determined. That case is so new -- it was filed on March 10, 2010 -- that no judge has yet assessed its claims. Nonetheless, the complaints against S&P and against Moody's make compelling reading.
And in Ohio, Attorney General Richard Cordray filed suit against the ratings agencies in November, 2009, alleging a common law negligent misrepresentation claim and claims under Ohio's securities laws, but no federal securities law claims. Although federal securities law preempts much of state securities law, states are still allowed to bring fraud actions under their own securities laws. That suit is facing a motion to dismiss, and since the AG's reply brief was filed a couple of weeks ago, a decision should follow relatively soon. Southern District of Ohio Judge James L. Graham's opinion could be tremendously important for the future of state-law-based suits because it will address key issues that cross state lines.
Judge Graham will decide if the First Amendment protects the agencies from suit; whether the federal Credit Rating Reform Act of 2006 preempts state securities law claims against the agencies, and if not, whether they're "sellers" under Ohio securities law; and whether the negligent misrepresentation claim based on Ohio law is nonetheless preempted by New York's Martin Act, and if not, whether it is sufficiently pled.
On the ratings-agencies-as-"sellers" issue, the defendants cite, among other things, Judge Kaplan's decision under federal law that they are not sellers. However, the Ohio AG notes that Ohio's law is significantly different than the federal statute, in that anyone "who receives the profits accruing from [selling securities]" is liable as a seller, not merely the people who actually transfer title, like the homeowner in Judge Kaplan's analysis.
And Then There Are Shareholder Suits
Lastly, a third type of suit that could force the ratings agencies to pay up is based on the federal securities laws, but is brought by the agencies' shareholders, rather than purchasers of gold-rated junk. As a result, plaintiffs don't have an underwriter/seller/control person conundrum. Instead, plaintiffs have to show that the ratings agencies knowingly made material misstatements that artificially inflated their stock price, and that when the truth came out, the stock suffered.
An example of this type of case that has already survived a motion to dismiss is In Re Moody's Corporation Securities Litigation. That suit is currently in the discovery phase and is still many months from trial. In allowing the suit to proceed, Southern District of New York Judge Shirley Wohl Kram held that if the plaintiffs' allegations were assumed to be true and that Moody's had made two kinds of material misstatements with sufficient knowledge of their falsity: One, that it was independent of the banks creating and selling the securities and wasn't compromised by conflicts of interest; and two, that its ratings methodologies evaluated the quality and performance of the mortgages underlying the securities.
Judge Kram specifically rejected plaintiffs' claims that the ratings themselves were actionable misstatements. With the evidence uncovered at last Friday's hearing, perhaps the judge in the next such suit will disagree.
Indeed, the ratings agencies' shouldn't take too much solace from their current legal winning streak because those favorable decisions have all been for just one type of suit. The tide could very well turn against the agencies as plaintiffs, both private and attorneys general, pursue other lines of attack.
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