Rating Agencies Must Face Fraud Claims for Toxic SIV Ratings

Rating Agencies Must Face Fraud Claims for Toxic SIV Ratings

In the latest development in the long-running  investor lawsuit  involving the collapsed Cheyne Financial structured investment vehicle, Southern District of New York Judge Shira Scheindlin has held that the rating agency defendants in the case must face the investors' claims for common law fraud under New York law. A copy of Judge Scheindlin's August 17, 2012 opinion can be found here. (Hat tip to The S.D.N.Y Blog.)

As discussed at length here, the plaintiffs invested in certain notes that had been issued by Cheyne Financial, a $5.86 billion structured investment vehicle. The notes were collateralized by certain assets, included residential mortgage backed securities (RMBS). The notes Cheyne issued received the highest possible ratings from the rating agencies. Cheyne collapsed amid the subprime meltdown in 2007. Cheyne was unable to pay the senior debt as it became due and Cheyne is now in bankruptcy. The investors lost substantially all of their investment.

After Cheyne collapsed, the investors filed suit against Morgan Stanley, which had promoted and distributed the notes; Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne; and the rating agencies (including Moody's and S&P and their corporate parents). The plaintiffs asserted thirty-two claims under twelve different legal theories. Essentially, the plaintiffs alleged common law fraud under New York law; common law tort claims alleging misrepresentation; and assertions based on alleged breach of contract.

As discussed here, on May 4, 2012, Judge Scheindlin dismissed plaintiffs' claims for negligence, breach of fiduciary duty and aiding and abetting, but she denied the rating agencies' motions to dismiss with respect to the negligent misrepresentation claims, finding that, based on the plaintiffs' allegations, the ratings qualified as actionable misstatements under New York law. The rating agencies and Morgan Stanley separately moved for summary judgment on the plaintiffs' fraud claims. 

In her August 17, 2012 opinion, Judge Scheindlin denied the rating agencies' motions for summary judgment on the common law fraud. The defendants had argued that the ratings were opinions for which they could not be liable, because they were not disbelieved when made Judge Scheindlin said that "while ratings are not objectively measurable statements of fact, neither are they mere puffery, or unsupportable statements of belief akin to the opinion that one type of cuisine is preferable to another," adding that:

Ratings should best be understood as fact-based opinions. When a rating agency issues a rating, it is not merely a statement of that agency's unsupported belief, but rather a statement that the rating agency has analyzed data, conducted an assessment, and reached a fact-specific conclusion as to creditworthiness. If a rating agency knowingly issues a rating that is either unsupported by reasoned analysis or without a factual foundation, it is stating a fact-based opinion that it does not believe to be true. 

Judge Scheindlin also found, referring to internal rating agency communications and emails (including an instant message involving two S&P analysts, in which one analyst comments that "it could be structured by cows and we would rate it"), that the plaintiffs have "offered sufficient evidence from which a jury could infer that the ratings were both misleading and disbelieved by the Rating Agencies when issued." Judge Scheindlin also found that the plaintiffs had presented sufficient evidence to raise an issue of fact as to whether the defendants acted with the requisite state of mind. Finally, she concluded that the plaintiffs had raised disputed issues of fact whether or not each of the plaintiffs had relied on the alleged misrepresentations.

In an interesting twist, at the end of her opinion, Judge Scheindlin added an "Addendum" in which she "ordered" the plaintiffs "to show cause by August 31, 2012 why their negligent misrepresentation claims against the Rating Agencies should not be dismissed" based on the Second Circuit's August 14, 2012 opinion in Anschutz Corp. v. Merrill Lynch & Co. (here). The Second Circuit affirmed the dismissal of negligent misrepresentation claims against the credit rating agencies, which were accused of issuing misleading and unsupported ratings on auction rate securities that had been issued by Merrill Lynch. The appellate court said New York law requires a showing that the rating agencies had a duty, as a result of a "special relationship," to give Anschutz correct information. The Second Circuit said the claimant had failed to establish such a relationship, so the dismissal of its case against the agencies could not proceed. Alison Frankel has a detailed analysis of the Second Circuit's opinion in an August 15, 2012 post on her On the Case blog, here

An August 18, 2012 Bloomberg article discussing Judge Scheindlin's opinion can be found here.

FDIC's Slow Failed Bank Lawsuit Filing Pace Continues: Almost exactly a month ago, I noted that the FDIC seemed to have broken the apparent lull in failed bank lawsuit filings, when if filed two lawsuits in quick succession. I anticipated that perhaps the two new lawsuits might indicate that the pace of filings would be picking up, particularly given that as the year progresses, the third anniversary of so many bank closures would be approaching (potentially triggering the applicable statute of limitations).

However, it now appears that the assumption that the lawsuits would be picking up may have been premature. Since the two lawsuits were filed in July, the FDIC has filed no new lawsuits, as reflected on the professional liability lawsuits page on the agency's website. Indeed, in the four-month period between April 20, 2012 and August 20, 2012, the agency has filed only three new lawsuits, after filing eleven new lawsuits in the preceding four months. This low number of filings during the last four months as during the equivalent period is all the more surprising given that during the equivalent period three years prior approximately 50 banks closed.

Another reason why it seems reasonable to expect that the FDIC would be filing new lawsuits is that, according to its website, the agency has authorized so many more lawsuits than it has filed - and it has been increasing the number of authorized lawsuits each month. In the latest update to its website on August 14, 2012, the agency indicated that his has now authorized suits involving 73 failed institutions; against 617 individuals for D&O liability (those figures represented an increase from the prior month's numbers of with 68 failed institutions against 576 individuals). So far the agency has filed 32 suits involving 31 failed institutions, involving 268 institutions.

Clearly the difference between the number of suits authorized and the number of suits filed suggests that there are many more cases in the pipeline - and with the increases in the numbers of authorized suits, the logjam in the pipeline seems to be increasing. It is entirely possible that the agency is trying to work out resolutions of at least some of the backlog of cases without filing suit, and in the connection may have entered tolling agreements. But just the same it does seem that we should start to see lawsuits coming in - which we may yet see before the year is out.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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