Federal Judge Rules Credit Rating Agencies Had No First Amendment Protection in Rating Asset-Backed Securities

In a case that goes to the heart of the conflict of interest issue and credit ratings agencies, and with reform legislation being considered in the EU and the U.S. Congress, a federal judge ruled that institutional investors in a structured investment vehicle containing mortgage-backed securities sufficiently alleged an actionable misstatement against the credit rating agencies and the investment bank that placed the rated notes. Important to the investors’ reasonable reliance on the alleged misleading ratings, noted that court, was the fact that, in 1975, the SEC created a special status to distinguish the most credible and reliable rating agencies, identifying them as nationally recognized statistical rating organizations (NRSROs) to help ensure the integrity of the ratings process. The structured investment vehicle collapsed amid the credit crisis and the awareness of the actual quality of the subprime mortgages that secured the notes. (Abu Dhabi Commercial Bank, et al. v. Morgan Stanley & Co., et al., SD NY, Sept 2, 2009, 08 Civ 7508)

Rejecting a First Amendment defense, the court ruled that ratings issued to securities in a private placement to a select group of investors, and never widely disseminated, did not afford the rating agencies First Amendment protection. The court also rejected the defense that the ratings were non-actionable opinions. The investors alleged actionable misrepresentations, said Judge Scheindlin, because they alleged that the rating agencies did not genuinely or reasonably believe that the ratings they assigned to the asset-backed securities were accurate and had a basis in fact. Similarly, disclaimers in the information memorandum that the credit rating was an opinion and not a guarantee or a recommendation to buy were unavailing and insufficient to protect the agencies from liability for promulgating alleged misleading ratings.

Although a rating agency’s role as an unbiased reporter of information typically requires it to remain independent of the issuers whose notes it rates, said the court, the rating agencies here played a more integral role in the structuring and issuing of the rated asset-backed securities. The agencies worked directly with the investment bank to structure the securities in such a way that they could qualify for the highest ratings. Also, the rating agencies received fees in excess of their normal fees for rating the securities, noted the court, fees that increased in tandem with the growth of the structured investment vehicle. Unknown to investors, the compensation of the rating agencies was contingent on the receipt of high ratings for the notes.

The court also plausibly inferred that both the rating agencies and the investment bank knew that they were disseminating alleged false and misleading ratings because they knew that the rating process was flawed by conflicts of interest, knew that the portfolio was not a safe investment, and knew that the rating agencies could not issue an objective rating because of the effect it would have on their compensation.

The rating agencies were compensated, not by investors, but by the structured investment vehicle and the investment bank at a fee substantially larger than their normal fee, noted the court, and a fee directly tied to the success of the investment vehicle. This structure created a conflict of interest that compromised the objectivity of the ratings. The rating agencies sought the business, said the court, and knew that the business would have gone elsewhere if they refused to assign the structured notes the desired high rating.

The court also rejected the defense that the investors unreasonably relied on the alleged false ratings. While conceding that the investors were sophisticated, the court found that the market at large, including sophisticated investors, have come to rely on the independence of rating agencies because of their NRSRO status and, as here, their access to non-public information that even sophisticated investors cannot obtain. Thus, the court concluded that the investors stated their reasonable reliance on the alleged false ratings.

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