Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

Those eager to try to hold the credit rating agencies responsible for supposedly enabling the subprime mess will undoubtedly be encouraged by a July 8, 2008 SEC Report identifying rating agency “shortcomings.”

The Report, entitled “Summary Report of Issues Identifies in the Commission Staff’s Examinations of Selected Credit Rating Agencies” (here) reflects the SEC’s efforts to “evaluate whether the three leading rating agencies “adhered to their published methodologies for determining ratings and managing conflict of interest.” According to the Commission’s July 8 press release (here), the SEC was “particularly interested in the rating agencies’ policies and practices in rating mortgage-backed securities and the impartiality of their ratings.”

According to a July 8, 2008 CFO.com article about the Report (here), about 50 Commission staffers reviewed more than 100,000 pages of internal records and more than two million E-mail messages, mostly concerning rating activities related to Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) during the period 2002 through 2006. The SEC’s massive review of electronic communications unearthed exchanges that, while not necessarily incriminating, do not reflect well on the overall integrity of the rating process, to say the least.

The SEC’s Report, which does not cite any particular rating agency by name, concludes that the rating agencies “struggled significantly with the increase in the number and complexity of these securities.”

As evidence that the rating agencies struggled with the transaction volume, the Report cites a number of e-mail communications, including one stating that “our staffing issues, of course, make it difficult to justify our fees.”

As evidence that the rating agencies struggled to keep up with the deal complexity, the Report cites another e-mail communication in which an analyst expressed concern that her firm’s model did not capture “half” of the deal’s risk, but that “it could be structured by cows and we would rate it.”

The Report also examines the “issuer pays” conflicts at length. Under this payment approach, the entity that issues the security pays the rating agency for the rating. The Report found that while each of the rating agencies had policies that prohibited rating analysts from discussing fees with the issuers, “these procedures still allowed key participants in the rating process to participate in the fee discussion process.” The Report also found that the rating agencies “do not appear to have taken steps to prevent considerations of market share and other business interests” that “could influence ratings or ratings criteria.”

Along those lines, the SEC found evidence to suggest that analysts were concerned that specific rating actions might affect business or cost market share. The Report quotes one analyst’s email message as stating “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision and if so how much.”

The Report also found that there are particular aspects of the RMBS and CDO rating process that may exacerbate some of these “issuer pays” conflicts. For example, the Report noted that the deal “arranger” is “often the primary designer of the deal and as such has more flexibility to adjust the deal structure to obtain the desired credit rating as opposed to managers of non-structured asset classes.”

The high concentration of this business among a very small number of “arrangers,” together with the high profit margins associated with the business, potentially could allow or encourage influence on the use, application and revision of credit rating processes.

The SEC said that it found no evidence that these kinds of considerations affected “rating methodology or models.” However, the Report quoted emails inferentially suggesting that analysts at least turned a blind eye to concerns. One email referring to CDOs as a “monster” and went on to observes that “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

The Report noted a number of other deficiencies, including the lack of disclosure about rating processes; insufficient documentation of process and of deviations from models to adjust ratings; and lagging surveillance in updating previously issued ratings.

As a result of September 2007 congressional action, the rating agencies must now register with the SEC as “nationally recognized statistical rating organizations” (NRSRO). In addition, in June 2008, the SEC issued a set of proposed rules that are designed to address many of the kinds of issues identified in the Report, particularly regarding conflicts of interest, documentation and report transparency. Because the SEC has only been regulating the rating agencies since 2007, it is unclear whether or not the SEC has the authority to file enforcement proceedings against the rating agencies in connection with the conduct described in the report, even if the SEC were otherwise so inclined.

Regulatory processes may well be underway to prevent the recurrence of the kinds of “shortcomings” identified in the Report. The Report also notes a variety of other remedial efforts already underway at the rating agencies themselves. But the Report also catalogs a litany of past practices that clearly may have played a role in the events that led up to the collapse of the subprime mortgage market. The ratings shortcomings apparently accompanied (and, it may be argued, enabled) the flood of mortgage securitizations that contributed to the subprime meltdown.

I recently noted (here) that investors and their counsel are starting to try to hold the rating agencies responsible for their investment losses. These claims may well face formidable obstacles (refer here). But, even though the report does not attribute statements or actions to specific rating agencies or to particular transactions, the tenor and content of the SEC’s Report undoubtedly will encourage those who want to try to hold the rating agencies responsible.

Of course, the SEC was able to muster formidable resources and undertake a massive review of electronic communications while passing the cost along to U.S. taxpayers. Those eager to exploit the same communications in separate civil litigation against the rating agencies may be forced to undertake a massive expense just to try to establish whether or not these or similar communications related to the agency or transaction they have targeted.

A July 9, 2008 Wall Street Journal article discussing the Report can be found here. Bloomberg’s July 8, 2008 article about the Report can be found here.

Auditor Liability Cap Alternative: George Washington Law School Professor Larry Cunningham has an interesting post on the Concurring Opinions blog (here) in which he reiterates his proposal for a market-based solution to manage the potentially ruinous liability exposures of auditors. In the post, Professor Cunningham reviews his suggestion that the audit firms “issue bonds in debt markets to provide a backstop against the big judgment,” paying interest commensurate with the risk. I have previously commented on Professor Cunningham’s proposal here.

In his most recent blog post, Professor Cunningham argues persuasively that the auditor liability cat bonds are “a practical, cost-effective solution to the risk that another large auditing firm could disappear.” He also argues that making auditor liability cat bonds a serious point of public debate would reveal the “true stakes” involved in the auditor liability debate.

Special thanks to Professor Cunningham for the link to the blog post.

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About the UnitedHealth Group Class Action Settlement: UnitedHealth Group announced on July 2, 2008 (here) that it reached an agreement to settle its high profile options backdating-related securities class action lawsuit for $895 million. A July 3, 2008 Law.com article discussing the settlement can be found here.

Not only is this settlement the largest options backdating related securities lawsuit settlement to date, it is one of the largest securities settlements ever. The settlement does at least provide some counterweight to the view that some have expressed (refer here) that the options backdating related lawsuits may be settling low compared to historical standards.

This settlement, together with the $750 million Xerox settlement announced in March 2008 (including $80 million from the company’s auditor) and the flood of high profile, high stakes subprime-related litigation, may also undercut the view that has been expressed that overall settlements may begin to decline as the cases from the era of corporate scandals cycle out of the system.

It is probably worth noting that, as reported in the July 3, 2008 Wall Street Journal (here), the UnitedHealth settlement has not yet been completely resolved, as the settlement does not include United ealth’s former CEO William McGuire, nor does it include its former General Counsel, David Lubben.

Although it has not received nearly as much attention, it is also noteworthy that in its July 2 press release UnitedHealth also announced that it had also settled for $17 million the options backdating related ERISA lawsuit pending against the company and certain of its officials. As far as I am aware, this is the roughly half dozen options backdating related ERISA lawsuit to have settled. (To see a complete list of options backdating related ERISA lawsuits, refer here.)

Derivative litigation related to the options backdating woes at UnitedHealth previously resulted in the largest reported derivative settlement, as I discussed in a prior post, here.

I have added the UnitedHealth options backdating securities class action lawsuit settlement and ERISA lawsuit settlement to my table of the options backdating related settlements and dismissals, which can be accessed here.

Credit Rating Lawsuits: As I discussed in a recent post (here), even though the credit rating agencies’ conflicted role has been a central topic in the discussions surrounding the subprime meltdown, the plaintiffs’ lawyers have largely avoided drawing the credit rating agencies into the subprime litigation. However, lawsuits filed just in the past several days suggest that this may be changing, in addition to the lawsuit discussed in my prior post.

Though the plaintiffs’ lawyers had not generally been targeting the credit rating agencies for their rating activities, they have previously filed lawsuits on behalf of the shareholders of Moody’s (refer here) and  of The McGraw Hill Company, parent of Standard & Poor’s (refer here), alleging misrepresentation in their financial disclosures.

As described in a July 1, 2008 press release (here), plaintiffs’ lawyers have now initiated a shareholder securities class action lawsuit against Fimalac, S.A., the corporate parent of Fitch’s rating agency. According to the press release, the complaint (which can be found here) alleges that the defendants failed to disclose with respect to Fitch’s ratings of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO) that:

(i) the information upon which Fitch based its ratings of RMBS and CDOs was misleading and in many cases fraudulent; (ii) to continue to collect fees for its ratings, Fitch was applying lax standards or no standards at all when issuing its RMBS and CDO ratings; and (iii) Fitch was failing to monitor the credit quality of RMBS and CDOs after issuing its initial ratings, as Fitch was obligated to do, and many of these securities had deteriorated badly after Fitch had issued its ratings. Fitch is now under investigation by the New York Attorney General, the Connecticut Attorney General, the Ohio Attorney General and the SEC as a result of its practices of rating billions of dollars of securities without a reasonable basis for doing so and Fimalac’s stock is trading at approximately 50% of its Class Period high.

But the new Fimilac shareholder lawsuit is directed against Fimilac as a reporting company, not directly against the company for Fitch’s rating agency activities. As I noted in my prior post, plaintiffs' lawyers have largely avoided allegations against rating agencies for their rating activities. However, in a lawsuit initiated in New York state court on June 3 , 2008 and removed to federal court on June 23, 2008, plaintiffs have alleged that entities affiliated with Credit Suisse, and the Moody’s, S&P  and the Dominion Bond Rating Service (DRBS) rating agencies misrepresented the values of Mortgage Pass-Through Certificates issued by the Home Equity Mortgage Trusts. (Refer here for background regarding the lawsuit.)

The basis of the claims of liability against the rating agencies in the Home Equity Mortgage Trust lawsuit, as alleged in paragraph 87 of the complaint (here), is that  the rating agencies  “prepared valuations, i.e., assigned ratings to the Certificates, in connection with the Offering, as defined in Section 11 (a)(4) of the Securities Act.” These allegations are similar to the allegations against the credit rating agencies in the HarborView case discussed in my prior post.

Whether or not these cases against the credit rating agencies for their rating activities ultimately go forward remains to be seen. As I have previously discussed (here), the credit rating agencies will contend that their rating activities are protected by the First Amendment.

In addition, it remains to be seen whether the Home Equity Mortgage Trust case will go forward in state or federal court. As discussed at length in my prior post (here), the ’33 Act expressly provides for concurrent state court jurisdiction and also expressly proscribes removal of state court ’33 Act actions to federal court. As discussed here, in at least one case, a federal court has concluded that a ’33 Act claim that has been initiated in state court and removed to federal court must be remanded back to state court.

One More Note About the Fimalac Lawsuit:  Fimilac is a foreign-domiciled company whose shares do not trade on U.S. exchanges. Many of its shareholders obviously are domiciled outside the United States. If these non-U.S. shareholders were to be included in the class, the new class action complaint against Fimilac might present the complicated f-cubed litigant problem (which I discussed most recently here). However, the plaintiffs’ counsel in the Fimilac case purport to represent a class composed solely of U.S. residents, apparently as a way of avoiding the f-cubed litigant problem.

As I discussed in my recent post relating to the new securities class action filed against EADS (refer here), these attempts to plead around the issues involving foreign-domiciled  plaintiffs still test the outer limits of the jurisdictional reach of U.S. securities laws against foreign-domiciled companies whose shares do not trade on U.S. exchanges. The case against Fimilac will be interesting to watch for reasons other than the involvement of a credit rating agency.

And Finally: The news about the dismissal of the lawsuit against Richard Grasso has gained a great deal of press attention. Indeed, the Wall Street Journal, in a July 3, 2008 editorial (here), congratulates Grasso and fellow defendant Kenneth Langone for their success in fighting the lawsuit, which the Journal viewed as an example of the overreaching of former New York AG Eliot Spitzer.  

The Journal’s editorial is perhaps closest to the mark in its observation that “Mr. Grasso is fortunate he had the resources to fight back.” Had Grasso not had the wherewithal to resist, he might never have tasted vindication. Readers of this blog will be particularly interested to know that it was insurance funds – a very large amount of insurance funds – that ultimately allowed Grasso to succeed.

According to Langone, and as reported on Bloomberg (here), in defending themselves against the lawsuit, Grasso, Langone and the NYSE directors “spent more than $70 million fighting the case, all covered by insurance.”

So Grasso is indeed fortunate that he had the resources to fight back, but perhaps contrary to the Journal’s suggestion, and even Grasso’s own prior comments (refer here) it was not his own treasure that financed the fight.

The expenditure of the mind-boggling sum of $70 million in litigating this case is yet another reminder of the extraordinary costs associated with the kind of high stakes litigation in which directors and officers can become involved. As I recently noted (here), the escalating expense associated with this kind of litigation has important implications for limits adequacy assumptions.

While it may be that only extraordinary cases consume these astonishing quantities of money, a company’s D&O program is expected to be able to respond even to catastrophic claims. As seems to be increasingly apparent, the costs associated with just defending a catastrophic claim could exhaust many insurance programs. All of this may suggest the need to reexamine conventional assumptions about limits adequacy.

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As the subprime crisis has unfolded, one of the recurring themes has been the conflicted role of the rating agencies. Last week’s announcement (here) of a negotiated resolution of the New York State regulatory investigation of the rating agencies reflects one aspect of the recurring questions surrounding the rating agencies’ role in the current crisis. These questions are likely to persist in light of the recent revelation (here) that Moody’s continued to assign mortgage-backed securities investment grade ratings despite a whistleblower’s alarm about potential problems with the ratings.

But while the questions about the rating agencies’ role have persisted, and while the agencies own shareholders have sued the rating agencies over the agencies’ own disclosures (about which refer here and here), to date subprime investors have not targeted the rating agencies for their rating activities, to the best of my knowledge.

As discussed in a prior post (here), case law suggests that the rating agencies enjoy First Amendment protection for their rating opinions and activities. And, as also discussed in my prior post, while thoughtful commentators have suggested bases on which these defenses might be overcome with respect to the rating agencies subprime-related investment rating activity, subprime investors have not targeted the rating agencies. Until now.

In a lawsuit filed on May 15, 2008 in New York Supreme Court (New York County), the New Jersey Carpenters’ Vacation Fund has filed a securities class action lawsuit under the ’33 Act on behalf of investors in the three HarborView Mortgage Loan Trusts. In a petition dated June 3, 2008, the defendants removed the case to the United States District Court for the Southern District of New York. A copy of the notice of removal, to which the original complaint is attached, can be found here.

The defendants in the lawsuit include the three HarborView mortgage pass-through certificate trusts; the Royal Bank of Scotland Group (“RBS Group”) and its subsidiary, Greenwich Capital Holdings and related entities, including Greenwich Capital Acceptance (“GCA”) and five individual directors of GCA; and the three rating agencies, Fitch’s Ratings, Moody’s Investor Services, and McGraw Hill, as corporate parent for Standard & Poor’s Rating Services.

The three trusts were issuers of bonds (the mortgage pass-through certificates) created by RBS Greenwich Capital. The offerings were collateralized with loans originated and underwritten by Countrywide Home Loans. The complain alleges that the Registration Statement issued in connection with the offerings failed to disclose “the true impaired and defective quality of the loans collateralizing the Bonds” and that the “loans were not originated pursuant to the underwriting guidelines stated in the Registration Statement.”

The complaint alleges that the rating agency defendants “failed to conduct due diligence and willingly assigned the highest ratings to such impaired instruments since they received substantial fees from the issuer.” The complaint alleges further that the rating agencies “issued the ratings based on an outdated methodology designed in about 2002.” The ratings were alleged to be misleading because the rating agencies “presumed that the loans were of high credit quality issues in compliance with the stated underwriting guidelines, when, in fact, Countrywide had systematically disregarded its stated Underwriting Guidelines.”

The rating agencies later downgraded the mortgage-backed securities. The complaint alleges that the rating agencies “admission that they had not used an appropriate rating methodology …resulted in a substantial decline in the value of the Bonds.” The plaintiff itself claims that its investment in the instruments has declined by 55 percent.

All of the claims asserted in the Complaint are based on the ’33 Act. In Count I of the Complaint, the plaintiff specifically alleges (in paragraph 98) that the rating agencies “served as appraisers” as defined in Section 11(a)(4) of the ’33 Act. The paragraph further alleges that the rating agencies “purportedly reviewed and analyzed each offering and provided the credit rating for each tranche of the HarborView Bonds.” The paragraph further alleges that the service of providing the ratings “was essential to pricing and marketing the Bonds,” and that the ratings were contained in the Prospectus.

As far as I am aware, the plaintiffs’ complaint in the HarborView Mortgage Loan Trust lawsuit represents the first occasion as part of the current subprime litigation wave where subprime investors have sought to hold the rating agencies liable for their ratings. The plaintiff’s allegations will face a number of hurdles, including the jurisdictional issue discussed below.

In addition, the rating agencies will undoubtedly assert a number of substantive defenses, including the First Amendment defense discussed in my prior blog post (here), as well as whether the rating agencies even owed the plaintiff any duties. The rating agencies will particularly dispute the plaintiffs’ attempt to rely on Section 11(a)(4) of the ’33 Act as a basis for the rating agencies’ liability.

The jurisdictional issue pertains to the plaintiff’s initiation of the lawsuit in state court pursuant to the concurrent state court jurisdiction in Section 22 of the ’33 Act. The HarborView case is just the latest of the state court ’33 Act lawsuits arising as part of the current subprime-related litigation wave, as discussed in my prior post (here). In each case, the defendants have sought to remove these cases to federal court, notwithstanding the express prohibition in Section 22 of removal of state court cases to federal court. In at least one of the prior cases, the federal court has remanded the case back to state court in reliance on Section 22’s express removal prohibition (refer here for a discussion of the prior remand case).

It remains to be seen whether or not these cases will go forward in state or federal court. Although it is not altogether clear why the plaintiffs have sought to pursue these cases in state court, the plaintiffs clearly perceive some advantage in doing so. In any event, the success of the plaintiffs’ attempts to hold the rating agencies liable for their investment in subprime-related securities will be interesting to watch. It will also be interesting to see if other investor plaintiffs similarly seek to hold the credit rating agencies liable.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the HarborView removal petition.

Run the Numbers: I have added the HarborView case to my running tally of subprime-related securities class action lawsuits. (My tally can be accessed here). According to my count, the addition of this case, as well as the case filed late last week against Franklin Bank Corp. (about which refer here), the current tally of subprime and credit crisis-related securities class action lawsuits now stands at 88, of which 48 have been filed in 2008.

Speakers’ Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey’s Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon City, Virginia, with my good friend Matt Jacobs of the Jenner & Block law firm.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Samuel Rudman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

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