The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Credit rating agencies have proven a popular target for investors in the wake of the subprime meltdown. However, they have often had an automatic defence in the significant body of case law that suggests their ratings opinions are protected by the US constitution's First Amendment - freedom of speech.

That is until last year however, when two significant events laid the foundations for the wall of liability that many loss-struck investors would like to see the rating agencies backed up against.

In September, US Federal Judge Shira Scheindlin set a precedent by rejecting the arguments of the "big three" credit rating agencies - Standard & Poor's (S&P), Moody's and Fitch - that their rating opinions were entitled to immunity under the First Amendment. It is a decision that subsequent securities class action lawsuits will almost certainly seek to rely on.

In addition, on 11 December last year, the US House of Representatives approved The Wall Street Report and Consumer Protection Act of 2009, which attempts for the first time to clarify the pleading standard applicable to private securities actions that have been rated by a nationally recognised agency.

IQ caught up with Kevin LaCroix, partner at US law firm OakBridge Insurance Services, to analyse the backlash that the rating agencies face and why the outcome may be different this time.

First amendment
Specialist directors' and officers' litigator LaCroix explains that the principle of the rating agencies' first amendment defence originated from litigation in the early 1990s in Orange County, California.

LaCroix explains: "The county defaulted on its municipal bond debt and many of the investors who lost out sued the county, the underwriters and the rating agencies, which provided the investment grade ratings to Orange County's bonds.

"The rating agencies were able to have themselves dismissed out of that litigation by arguing that their rating opinions were a form of speech that is protected by the first amendment under the US constitution and as such, it could not be the basis of liability."

And there are other similar precedents under US case law for protecting commercial speech. "The courts have pretty uniformly upheld that defence and the rating agencies had consistent success relying on that argument up until September," he adds.

The success of the "big three's" defence against the securities class action litigation - including a current lawsuit brought by five Ohio pension funds - will depend on whether the plaintiffs are able to argue that the circumstances are different, and on whatever the rating agencies' rights might be in relation to their historical practices.

Integral to the deal
Judge Scheindlin's case is important because it is the first where the First Amendment defence has not been allowed, and it highlights the difference between an agency simply rating an end product and it being integral to the structure of a transaction.

The world of high finance has come a long way since the 1990s and structured transactions such as the disputed Cheyne structured investment vehicle (SIV) in the Scheindlin case are very complex. Assets are pooled and securities are issued out of the pools, while ratings are delivered on the securities that are collateralised by the underlying assets.

"The rating agencies' role in those transactions is now more than merely providing an opinion"

LaCroix argues that, even though the wording is narrow, the Scheindlin case is an example that plaintiffs can point to where the constitutional defence was not enforced. An attorney can argue that the rights the rating agencies may have when they are providing neutral, objective services should not apply to structured products, because they are providing opinions for hire.

"Not only were they being paid to provide opinions but they were counselling the issuers on how to structure the transactions," continues La Croix.

"The rating agencies' role in those transactions is now more than merely providing an opinion - if the issuers want the highest rating, they have to structure the transactions in the way that the rating agencies advise. This distinction is going to be the battleground."

Lucrative fees
Five Ohio pension funds are suing S&P, Moody's and Fitch, accusing them of "wreaking havoc" on US financial markets and, according to LaCroix, they will undoubtedly seek to rely on Judge Scheindlin's opinion.

The pension funds maintain that the big three agencies provided "unjustified and inflated ratings of mortgage-backed securities in exchange for lucrative fees from securities issuers".

The 20 November filing claims the rating agencies negligently misrepresented the risk of a variety of asset-backed securities, all of which were rated AAA or equivalent in July 2008.

The complaint asserts that "when the housing and credit markets collapsed, the flaws in the defendants' AAA ratings gradually became clear".

The value of the pension funds' investments "dropped precipitously" and the filing alleges that this led to the loss of over $457mn.

"These purportedly safe investments became obvious for what they were - high risk securities that both the issuers and the rating agencies knew to be little more than a house of cards," it states.

The action echoes a growing list of similar filings against the rating agencies. It alleges that the asset-backed securities issuers did not just pay the defendants for rating the financial instruments, but also for helping to structure them, before downgrading and withdrawing their ratings suddenly in 2008 as the markets imploded.

Conflict of interest
Inevitably, critics point to the conflict of the agencies receiving payment from the firms selling the securities. Not only was a rating essential to legitimise the security, they became surrogate pricing tools for the banks, which were parcelling up and selling on the securities into the debt markets.

In this respect, Judge Scheindlin's opinion is also important as it draws attention to the inherent conflict of interest present in the current rating agency model.

"The only way I would think of that the model could be conflict free is if the rating agencies made their money not by collecting fees from those whose instruments and securities are rated, but rather from those who rely on the ratings," LaCroix asserts.

"There really isn't a precedent for that model. Fitch, S&P and Moody's continue to dominate the market, even after everything that has happened. Anybody that would try to come in and be independent by charging fees to people who rely on the ratings would have to convince the insurance companies and pension funds and other institutional investors to pay for the ratings."

LaCroix comments that such a model could come into force at some point in the future.

Pleading standard
Meanwhile, The Wall Street Report and Consumer Protection Act of 2009 continues to work its way through the US legislative system. The sprawling 1279-page document contains a proposal (Section 6003) that clarifies the pleading standard applicable to rating agencies.

Section 6003 says it "shall be sufficient for purposes of pleading any required state of mind for purposes of such action that the complaint shall state with particularity facts giving rise to a strong inference that the nationally recognised statistical rating organisation knowingly or recklessly violated the securities laws".

The section also specifies that a nationally recognised rating agency's credit rating opinions "shall not be deemed forward looking statements".

Of course, just because the House version of the bill has passed it doesn't mean it will become law. The legislative process will rumble on to the Senate, which has until November to decide on a final version.

However, LaCroix thinks that the bill is significant because it implies that there are circumstances in which liability is appropriate - which is a first for the rating agencies.

"My impression is that the people that drafted the bill wanted to clarify the liability standards - that there needs to be further statutory language," he continues. "There currently isn't any statutory provision addressing the issue of rating agency liability specifically."

"Not only were the rating agencies being paid to provide opinions but they were counselling the issuers on how to structure the transactions"

Nevertheless, under the US legal hierarchy, constitutional principles will always trump statutory provisions, so there is not necessarily anything in the proposed statute that would be inconsistent with the idea of the rating agencies retaining their constitutional defence.

But the movement towards clarifying rating agencies' liability is gaining momentum with each law suit filed, and it stands to reason that some of the mud being slung at the big three might well stick eventually.

Scheindlin on Cheyne
In her 2 September 2009 opinion, Scheindlin rejected Standard & Poor's (S&P), Moody's and Fitch's argument that their rating opinions were entitled to immunity under the First Amendment.

Scheindlin denied the three rating agencies' motion to dismiss a lawsuit brought by investors in the $5.86bn Cheyne structured investment vehicle (SIV).

The plaintiffs Abu Dhabi Commercial Bank et al invested in the Cheyne SIV, which collapsed amid the subprime meltdown in 2007, with investors losing substantially all of their investment.

The notes Cheyne issued received the highest possible ratings from the rating agencies. However, according to Judge Scheindlin, the rating agencies played a more integral role than merely providing ratings. Instead, they were involved in structuring and issuing the notes. For example, the agencies helped to determine how much equity was required at each level of the SIV and were paid approximately $6mn for their work.

And, unknown to the rating agencies, the compensation was contingent upon the receipt of the desired ratings for the Cheyne SIV's Rated Notes, Scheindlin comments.
The suit was filed against Morgan Stanley, which had promoted and distributed the notes. The Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne and the rating agencies or their corporate parents.

It alleges common law fraud, misrepresentation and breach of contract.

Judge Scheindlin said: "Where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is not afforded the same protection."

The case continues in the Southern District of New York.