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Business Law Today

Credit Rating Agencies in the Spotlight
A New Casualty of the Mortgage Meltdown
By Larry P. Ellsworth and Keith V. Porapaiboon
As the financial system digests the losses related to the current financial crisis, credit-rating agencies, once a relatively anonymous group, have come under increasing scrutiny for their role in the crisis. This scrutiny has led to additional litigation and both congressional and regulatory oversight.

Major banks and other investors have lost hundreds of billions of dollars because of their misplaced belief in the value of residential mortgage-backed securities, including subprime securities. These losses have set off a ripple of related securities lawsuits. The initial wave of such lawsuits was mainly run-of-the-mill securities fraud cases alleging that the mortgage lenders, investment banks, and companies purchasing subprime securities failed to disclose material information about their portfolio of subprime securities.

The Rating Agencies
The credit rating agencies, which were generally paid by the issuers, produced ratings for many of these subprime securities. To produce their ratings, the agencies would look at different aspects of each individual mortgage making up the security--including the principal amount, geographic location, and credit history of the borrower--and then use that information to make predictions about the likelihood of default on the loan. There are 10 credit rating agencies designated as Nationally Recognized Statistical Rating Organizations by the SEC: Moody's Investors Service (Moody's); Standard & Poor's (S&P); Fitch Ratings Ltd. (Fitch); A. M. Best Company; Dominion Bond Rating Service, Ltd.; Japan Credit Rating Agency, Ltd.; R&I, Inc.; Egan-Jones Ratings Company; LACE Financial; and Realpoint, LLC.

Cases Against the Rating Agencies
As the crisis moves forward, the related litigation has begun to expand to include a broader range of types of claims. One such expansion is that courts are now seeing cases alleging that credit rating agencies gave inflated triple-A ratings to many of the subprime securities that did not accurately represent the risks associated with such securities. The three major U.S. credit rating agencies—Fitch, Moody's, and S&P—saw their revenues double, from $3 billion in 2002 to $6 billion in 2007, as the real estate bubble expanded. Because of those gains, they now face the brunt of the early lawsuits in this area.

One of the earliest such lawsuits was filed on May 14, 2008, by the New Jersey Carpenters Vacation Fund against a number of participants associated with the HarborView Mortgage Loan Trusts, including the agencies who rated the securities, Fitch, Moody's, and S&P. The complaint alleges that the rating agencies "failed to conduct due diligence and willingly assigned the highest ratings to . . . impaired instruments since they received substantial fees from the issuers," and that the ratings for different tranches of bonds issued by Harbor View were inflated because of an outdated rating methodology. The suit alleges an improperly cozy relationship between the agencies, and it describes a process known as "ratings shopping," by which an issuer unhappy with the rating it received at one agency would simply move on to another agency to see if it could get a better rating. Such practices, the suit alleges, led to inflated ratings, which eventually led to a substantial decline in the value of the bonds when their true value became known. The actions of the rating agencies allegedly violated section 11 of the Securities Act of 1933.The case, originally filed in New York Supreme Court, has been removed to federal court in Manhattan. The district court denied a motion to remand the case back to state court, but also ruled that it was "a matter of first impression" and suitable for an immediate appeal, which the plaintiff has taken. In separate cases, New Jersey Carpenters Health Fund makes similar allegations against various rating agencies with respect to other mortgage-backed securities.

Shareholders of the rating agencies themselves also have begun bringing securities class actions. Teamsters Local 292 Pension Trust Fund filed a securities class action suit against Moody's on September 26, 2007. The plaintiff alleges that, as the downturn in the housing market caused rising delinquencies of subprime mortgages, Moody's failed to disclose that it assigned "excessively high" ratings to securities backed by risky subprime mortgages. When those securities were later downgraded, the suit alleges, Moody's stock price fell. Plaintiffs seek redress under sections 10(b) and 20(a) of the Securities Exchange Act of 1934.

Similarly, Indiana Laborers Pension Fund filed a class action suit against the parent company of Fitch Ratings on July 1, 2008, in the Southern District of New York. The suit alleges that the company applied "lax standards or no standards" in its ratings of mortgage-backed securities. These high ratings led to more business, which boosted earnings at Fitch and artificially inflated its stock. The plaintiff alleges that this activity violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934.

A plaintiff also has brought a derivative suit against officers and directors of Moody's in a suit filed in the Southern District of New York on October 30, 2008. The complaint alleges that Moody's awarded falsely high ratings to mortgage-backed securities in order to win business, and that these actions constituted a breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, and violations of section 10(b) of the Securities Exchange Act of 1934.

Inquiries by State Attorneys General
Attorneys general in several states also have begun looking into the credit rating agencies' role in the foreclosure crisis. Ohio, one of the states hardest hit by the crisis, began an investigation in 2007, although no court action has yet been filed. The attorney general there has indicated that he believes that the agencies and the issuers were too close and that the agencies did not properly vet data provided by securities issuers.

In New York, all three major agencies reached an agreement with the attorney general in June 2008. Under that agreement, credit rating agencies will charge fees for various analytical tasks, not just rating, under which they will be entitled to be paid even if they are not ultimately hired to rate the deal. The agencies will disclose information about all securitizations submitted for their review. Credit rating agencies also will have to begin reviewing individual mortgage lenders and the lenders' mortgage origination processes. The agreement also requires the agencies to develop criteria for the due diligence information that is collected by investment banks on the mortgages underlying mortgage-backed securities. The credit rating agencies, on an annual basis, also must identify and rectify any practices that could compromise the independence of their ratings of mortgage-backed securities. Finally, credit rating agencies must require a series of representations and warranties from investment banks and other parties about the loans underlying mortgage-backed securities.

Richard Blumenthal, attorney general of Connecticut, took direct action against the credit rating agencies by filing suits on July 30, 2008, accusing the agencies of "deceptive and unfair practices" by systematically giving lower credit ratings to bonds issued by public entities as compared to corporate debt with similar default rates. The suits allege that the credit rating agencies violated the Connecticut Unfair Trade Practices Act by intentionally misrepresenting and omitting material facts that caused Connecticut public bond issuers to purchase bonds at higher interest rates or purchase bond insurance to cover issuance.

Potential Defenses Abound
While the rating agencies face the threat of mounting litigation at the hands of private and governmental plaintiffs, adverse judicial decisions against the rating agencies are far from certain. In fact, the rating agencies possess a number of substantial legal defenses due to their unique treatment under the U.S. constitutional and regulatory system. These defenses surely are to be tested in the time ahead.

Possible Preemption
One notable barrier to government and private litigation may be federal preemption. A preemption defense may come into play where a state government or private plaintiff challenges the methods by which credit rating agencies operate or determine their credit ratings for securities. The Credit Rating Agency Reform Act of 2006 (CRARA) established SEC regulation of the credit rating agencies. Pub. L. No. 109-291, 120 Stat. 1327 (2006). It provides that "neither the [SEC] nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedure and methodologies by which any nationally recognized statistical rating organization determines credit ratings." Connecticut's case can be read as trying to use the Connecticut Unfair Trade Practices Act to "regulate the substance of credit ratings." Connecticut is trying to get rating agencies to upgrade the ratings they give public bonds, an apparent attack on the substance of credit ratings and the methodology used to set ratings. Another thrust of the Connecticut complaint is that the rating agencies had a conflict of interest in that they naturally favored their corporate bond issuer and bond insurer clients over public bond issuers. This also may be preempted by CRARA, which specifically gives the SEC exclusive authority to enforce the provision's procedures regarding the prevention of conflicts of interest.

In an apparent attempt to avoid these defenses, Connecticut's complaint implies that the actions of the rating agencies were so egregious as to amount to fraud and deceit, for which the CRARA creates a narrow exception allowing state actions to proceed. By attempting to fashion a fraud action to thread the preemption needle, Connecticut and other states may face another barrier. As the Connecticut actions allege, the ratings methodologies that allegedly created an improper bias against state and municipal securities vis-^-vis their corporate counterparts were well-known. It will be difficult for the state governments to allege, much less prove, critical elements of deception or reliance where the alleged bias was known at the time that the ratings were purchased.

First Amendment Defenses
Attempts by public and private parties alike to influence the ratings of credit rating agencies face another big hurdle, the First Amendment. Previous litigation brought against credit rating agencies has run headlong into the agencies' argument that they are members of the press and that their ratings are protected under the heightened "actual malice" standard of New York Times v. Sullivan, 276 U.S. 254 (1964). A number of courts have ruled in favor of the rating agencies on this issue. Courts have held that rating agencies' opinions are protected by the First Amendment in a variety of contexts. For example, in Jefferson County School District No. R-1 v. Moody's Investors Services, Inc., 175 F.3d 848 (10th Cir. 1999), the court held that the First Amendment barred claims for intentional interference with contractual relations, intentional interference with prospective contractual relations, and publication of an injurious falsehood. Similarly, in County of Orange v. McGraw Hill Cos., Inc., 245 B.R. 151 (C.D. Cal. 1999), the court held that the First Amendment barred claims for negligence and breach of contract. And in one of the numerous actions in In re Enron Corp. Securities, Derivative & "ERISA" Litigation, 511 F. Supp. 2d 742 (S.D. Tex. 2005), the Connecticut Resources Recovery Authority (CRRA) sued to recover approximately $200 million of public funds it lost in a transaction with Enron (notably, the case was brought on behalf of the CRRA by Richard Blumenthal, then and current Connecticut attorney general). CRRA sued S&P, Moody's, and Fitch, alleging that they were liable for negligent misrepresentation and violations of CUTPA for failing to exercise reasonable care or competence in obtaining and communicating accurate information about Enron's creditworthiness. The court ultimately dismissed the negligent misrepresentation claims against the rating agencies because the complaint did not properly allege actual malice.

Such cases demonstrate that the rating agencies have a strong First Amendment defense, but that if a plaintiff can demonstrate actual malice, there may be an opening for plaintiffs. Moreover, while stating that it was not reaching the merits of the First Amendment defense, in a subpoena enforcement action, the Second Circuit in In re Fitch, 330 F.3d 104 (2d Cir. 2003) (the circuit in which the Harbor View case is being litigated), highlighted two factors it considered important in determining whether a rating agency should be designated as a member of the press. First, it asked whether the agency only "reported on" specific transactions for which it had been hired, as opposed to covering an array of securities and transactions as a more traditional press outlet would. Second, the court examined the agency's role in the transaction, to determine whether "[the agency's communications] reveal a level of involvement with the client's transactions that is not typical of the relationship between a journalist and the activities upon which the journalist reports." In any event, the recent complaints filed by both plaintiffs' attorneys and the Connecticut attorney general are peppered with allegations seemingly meant to demonstrate actual malice. Further, while this defense has been tested in several cases brought by private plaintiffs, no cases have explored the extent to which First Amendment protections will prevent federal or state regulators from rule making in this area.

Other Defenses
Even without the special defenses discussed above, properly pleading a fraud case against a rating agency may not be easy. Ratings are judgment calls based on incomplete information that the markets often dictate be made quickly. Each credit rating agency may be able to claim that it was generally following the normal industry practice in making its determinations. Moreover, greed and speculation may be the real culprits in what is now a deep worldwide recession. Accordingly, it may be very difficult to prove (or sufficiently allege) facts showing scienter or loss causation involving individual credit rating decisions.

New Regulations
Not only do credit rating agencies find themselves besieged in courts, they also now face increasing scrutiny from lawmakers and regulators. During an October 22, 2008, hearing before the House Committee on Oversight and Government Reform, some congressmen accused the CEOs of Fitch, Moody's, and S&P of failing to warn the public of the problems they knew were coming. Representative Henry Waxman, the chair of the committee, stated, "The story of the credit rating agencies is a story of colossal failure." The committee clearly signaled an intention to enact legislation to rectify the perceived problems.

Even earlier, the SEC in July 2008 concluded a 10-month examination of the three major credit agencies by issuing a report finding serious weaknesses in rating practices. The examination found that the agencies struggled to handle the huge uptick in the number and complexity of subprime residential mortgage-backed securities and collateralized debt obligations since 2002. SEC Chairman Christopher Cox noted that the investigation "uncovered serious shortcomings at these firms, including a lack of disclosure to investors and the public, a lack of policies and procedures to manage the rating process, and insufficient attention to conflicts of interest."

In a recent rule-making action, the SEC sought to remedy some of these problems. Under the new rules, promulgated in December 2008, rating agencies will have to
  • disclose statistics about rating transitions (i.e., upgrades and downgrades) and defaults for each asset class the firm rates;
  • disclose how much verification performed on assets underlying a structured finance transaction is relied on in determining credit ratings;
  • reveal how assessments of the quality of originators of structured finance transactions play a part in the determination of credit ratings;
  • provide more detailed information on the surveillance process, including whether different models or criteria are used for ratings surveillance than for determining initial ratings;
  • disclose a random sample of 10 percent of issuer-paid credit ratings six months after they are issued;
  • avoid conflicts of interest by not rating debt they helped structure, barring individuals who help negotiate fees from participating in the rating process, and barring individual analysts from accepting some types of gifts;
  • keep records of any complaints lodged against individual analysts;
  • make and retain records of all rating actions related to a current rating, and record when a rating for structured finance debt differs from the rating implied by a quantitative model; and
  • provide the SEC with an annual report of the number of credit rating actions that occurred during the fiscal year for each class of security for which the agency is registered.
Although these new rules are significant, the SEC has signaled that it is not done. Still on the table is a proposal to require disclosure of ratings history information for 100 percent of issuer-paid ratings. The SEC also voted to re-propose amendments that would have prohibited firms from rating structured debt unless the information used for the rating was made available to other rating agencies. The SEC believes that such a rule would enhance competition by providing an opportunity for rating agencies to evaluate issuer-paid ratings made by other agencies.

In these trying economic times, credit rating agencies are in the spotlight more than ever before. They are under pressure from litigation filed by shareholders, state attorneys general, and others, and are under investigation by the SEC's Enforcement Division. New SEC regulations have been enacted, more are proposed, and Congress is considering action. Of necessity, the credit agencies must perform in that spotlight by improving their own procedures while defending prior practices created under circumstances very different than those they face today.

To follow up on the cases discussed in this article, please view the following:

Litigation by the New Jersey Carpenters Vacation Fund against participants associated with the Harbor View Mortgage Loan Trusts:
  • Notice of Removal, Exhibit A, New Jersey Carpenters Vacation Fund v. HarborView Mortgage Loan Trust 2006-4, No. 1:08-cv-05093-HB (S.D.N.Y. May 14, 2008).

New Jersey Carpenters Health Fund makes similar allegations against various rating agencies with respect to other mortgage-backed securities:
  • Notice of Removal, Exhibit B, New Jersey Carpenters Health Fund v. NovaStar Mortgage Funding Trust, Series 2006-3, No. 1:08-cv-05310-DAB (June 10, 2008).
  • Notice of Removal, Exhibit B, New Jersey Carpenters Health Fund v. Home Equity Mortgage Trust, No. 1:08-cv-05653-DAB (June 23, 2008).
  • See also Tsereteli v. Residential Asset Securitization Trust 2006-08, No. 08-cv-10637 (S.D.N.Y. Dec. 8, 2008) (removed case alleges that Moody's ratings were not consistent with IndyMac Bank's business and financial condition).

Teamsters Local 292 Pension Trust Fund filed a securities class action suit against Moody's:
  • Complaint, In re Moody's Corp. Sec. Litig., No. 1:07-cv-8375-SWK (S.D.N.Y. Sept. 26, 2007).

Indiana Laborers Pension Fund filed a class action suit against the parent company of Fitch Ratings:
  • Complaint, Indiana Laborers Pension Fund v. Fimalac S.A., No. 1:08-cv-05994-SAS (S.D.N.Y. July 1, 2008).

Derivative suit against officers and directors of Moody's:
  • Complaint, Louisiana Municipal Police Employees Retirement System v. McDaniel, No. 1:08-cv-09323-SWK (S.D.N.Y. Oct. 30, 2008) (defendants have filed a notice of a related case attempting to consolidate this action into a similar case, In re Moody's Corp. Sec. Litig., No. 1:07-cv-8375-SWK (S.D.N.Y. Sept. 26, 2007)).

Richard Blumenthal, attorney general of Connecticut, took direct action against the credit rating agencies:
  • See, e.g., Notice of Removal, Exhibit A, Connecticut v. McGraw Hill Co., Inc., No. 3:08-cv-01316-AWT (D. Conn. Aug. 29, 2008).

Ellsworth is a partner and Porapaiboon is an associate in the Washington, D.C., and Chicago offices, respectively, of Jenner & Block LLP. Their e-mail addresses are lellsworth@jenner.com and kporapaiboon@jenner.com.

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