Monday, September 15, 2014

Shareholders Have Right to Open McGraw-Hill’s Books to Investigate Ratings Violations

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

Shareholders of The McGraw-Hill Companies, Inc. (McGraw-Hill) have the right under state law to inspect the company’s books for evidence of possible violations in the ratings for mortgage-backed securities, a New York appellate court has held. Reversing the decision below, the court granted the petitioners’ request for the purpose of investigating claims that Standard & Poor's Financial Services LLC (S&P), a McGraw-Hill subsidiary, issued inflated credit ratings on the securities in order to garner business from the issuers (Retirement Plan for Gen. Empls of the City of N. Miami Beach v. McGraw-Hill Cos., September 11, 2014, per curiam).

Optimistic credit ratings. The petitioners allege that McGraw-Hill’s management directed S&P as a credit rating agency to undertake a strategy of fraudulently issuing positive ratings on residential mortgage-backed securities and other complex financial products. As the complex mortgage-backed securities industry grew, McGraw-Hill allegedly directed S&P to further provide optimistic credit ratings in an effort to attract more business from the issuers and gain more revenue from the other services that S&P provided.

Books and records request. In November 2011, one of the petitioners made a written demand upon McGraw-Hill under the New York Business Corporation Law (BCL) and the common law to inspect books and records relating to the board of directors' oversight and management of S&P and the board's independence. Among other things, the demand sought records concerning policies and procedures regarding the board's oversight of S&P's policies and procedures for issuing credit ratings for mortgage-related securities; and policies and procedures for addressing and managing conflicts of interest, particularly those arising out of the "issuer pays" model for issuing credit ratings.

The parties then engaged in a series of discussions to determine whether they could compromise on the scope of the demand, but McGraw-Hill refused to produce any documents not specifically required under BCL Sec. 624, namely, a record of shareholders, shareholder meeting minutes, and profit and loss statements. When the discussions ultimately proved unfruitful, the petitioners went to court. The Supreme Court denied the petition, finding that the petitioners should have first made a demand upon McGraw-Hill and then, once McGraw-Hill rejected the demand, should have commenced a shareholders' derivative action rather than filing a petition under BCL Sec. 624.

Proper purposes. On appeal, the appellate court reversed, noting that New York law provides shareholders with both statutory and common law rights to inspect a corporation's books and records so long as the shareholders seek the inspection in good faith and for a valid purpose. The shareholders had a proper purpose because they sought to investigate alleged mismanagement and breaches of fiduciary duty by McGraw-Hill’s board in failing to oversee purported wrongdoing by S&P. This alleged wrongdoing, according to the petitioners, exposed McGraw-Hill to substantial potential liability in multiple civil actions and investigations.

Rejecting McGraw-Hill’s contentions, the court reasoned that investigating alleged misconduct by management and obtaining information that may aid legitimate litigation are, in fact, proper purposes for a request under BCL Sec. 624, even if the inspection ultimately establishes that the board had engaged in no wrongdoing. Moreover, because the common law right of inspection is broader than the statutory right, the petitioners were entitled to inspect books and records beyond the specific materials delineated in the statute. Accordingly, the appellate court reversed and remanded the matter for a hearing to determine which records were relevant and necessary for the petitioners' purposes.

The case is No. 12438 650349/13.