Hoping that the nation's credit rating agencies will someday be exposed to expert-advice liability is like rooting for the Washington Generals against the Harlem Globetrotters: The Globetrotters invariably win, and the Generals aren't just overmatched--they're part of the show.
To be fair, the handful of Nationally Recognized Statistical Rating Organizations (NRSROs) have escaped liability for misstatements in securities registrations for decades, thanks to court rulings that their ratings are opinions protected by the First Amendment. Congress didn't give the SEC authority to oversee the NRSROs until 2006, and even then it barred the agency from regulating "the substance of the credit ratings or the procedures and methodologies."
But the Crash of '08--and the role the NRSROs played in both structuring and rating risky securities--prompted increased scrutiny. As the Financial Crisis Inquiry Report
, released in February, noted: "Issuers needed [the credit rating agencies (CRAs)] to approve the structure of their deals; banks needed their ratings to determine the amount of capital to hold; repo markets needed their ratings to determine loan terms; some investors could buy only securities with a triple-A rating; and the rating agencies' judgment was baked into collateral agreements and other financial contracts."
The problem for investors was endemic conflicts of interest, since all the major NRSROs function on an issuer-pays business model. According to the report, "If an issuer didn't like a Moody's rating on a particular deal, it might get a better rating from another ratings agency. The agencies were compensated only for rated deals--in effect, only for the deals for which their ratings were accepted by the issuer."
The Dodd-Frank Act of 2010 (Pub. L. No. 111-203) promised to change that model by imposing the threat of liability. Its section 939G effectively repealed SEC rule 436(g) of the Securities Act of 1933, which had been promulgated to provide that an NRSRO rating was not
an expert-certified part of the registration statement. Under Dodd-Frank, a rating can't be disclosed in such a statement unless the CRA consents to be named as an expert--which exposes it to liability if it knowingly or recklessly fails to conduct a reasonable investigation of a debt offering, or fails to verify data supplied by customers.
That's when the Globetrotters made the Washington Generals look foolish. In July, Fitch Ratings, Standard & Poor's Ratings Services, and Moody's Investor Service simply refused to give the required consent to Ford Motor Company's financing arm, or to any company like it. Ford immediately asked the SEC not to recommend enforcement action against it. To the strains of "Sweet Georgia Brown," the Washington Generals then tossed up two air-balls: a no-action letter indicating that the agency would not recommend enforcement, followed by a second letter in November putting that policy in effect indefinitely.
Those antics set the tone for developments in a lawsuit CalPERS had filed against the credit rating agencies in 2009, alleging negligent misrepresentation during its purchase of notes issued by three structured investment vehicles (SIVs) that had been rated triple-A before they collapsed. Last year San Francisco Superior Court Judge Richard A. Kramer overruled in part a demurrer and permitted the lawsuit to proceed. "The right to free speech allows us to give our opinions on things of public concern," Kramer wrote. "The issuance of these SIV ratings is not, however, an issue of public concern. Rather, it is an economic activity designed for a limited target for the purpose of making money." (California Pub. Employees' Ret. Sys. v. Moody's Corp.
, No. 09-490241 (S.F. Super. Ct. order filed June 1, 2010).)
But the Globetrotters had another trick play. In October the CRAs filed a special motion to strike CalPERS's cause of action under California's anti-SLAPP statute, enacted in 1992 to counter so-called strategic lawsuits against public participation. (Cal. Code Civ. Proc. § 425.16.) Under the statute, intended to protect the First Amendment rights of private citizens, discovery is automatically stayed so that courts can quickly dismiss lawsuits filed primarily to chill the exercise of protected activity. But in 1997, the Legislature amended the statute to provide that it be broadly construed. "The anti-SLAPP statute is like taffy these days," says Joseph Tabacco, a partner in the San Francisco office of Berman DeValerio who represents CalPERS.
Defendants who move to strike must satisfy a two-pronged test, first showing that an action "arises out of" protected activity. Last December, Judge Kramer found that the CRAs had met the first test. "My rulings on the demurrers early on have absolutely nothing to do with this hearing," he said. "[H]ere, the ongoing activity of the defendants of making public and other future predictions as to the economic performance of investment vehicles is the activity. Is that public? Tentative ruling is, yes."
Tabacco then sought to import discovery that had been produced in a New York federal case alleging fraud by the defendants in the rating of the same SIV notes (Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc.
, 651 F. Supp. 2d 155 (S.D.N.Y. 2009)). In that case, U.S. District Judge Shira A. Scheindlin rejected the defendants' First Amendment arguments for immunity, distinguishing broadly disseminated ratings from those provided to a select group of investors, such as pension funds.
But Judge Scheindlin had issued a protective order covering discovery. So at a hearing in late March, Tabacco argued that under special anti-SLAPP rules, Kramer should grant relief from the discovery stay by permitting him limited access to deposition transcripts in Abu Dhabi
The CRAs wouldn't play. "The plaintiffs haven't given you any basis to conclude that named individuals would help them fill gaps in the evidentiary record," responded Floyd Abrams of New York's Cahill Gordon & Reindel. "They are trying to build a case."
Kramer denied Tabacco's motion. The burden under the anti-SLAPP statute now shifts to CalPERS, which has the onerous task of demonstrating the likelihood it will succeed on the merits based on whatever evidence it has managed to acquire.
Even if CalPERS wins the motion, the defendants have an immediate right of appeal, and they may still move for summary judgment. And under the statute, prevailing defendants are guaranteed attorneys fees; plaintiffs collect legal fees only if the anti-SLAPP motion is deemed frivolous or filed solely for delay.
Two-and-a-half years after the crash, then, neither the SEC nor the trial courts have established expert-advice liability for CRAs. Talk about tossing up air-balls.
"The recent SEC no-action letters were discouraging for our clients," Tabacco says. "Why investors would put up with built-in conflicts of interest at the rating agencies is beyond my pay grade."