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

In a ruling that may have potential significance for the many claims that have been filed against the rating agencies in the subprime litigation wave, on February 17, 2010, Southern District of New York Judge Lewis Kaplan dismissed all but one of the claims that had been filed against the individual defendants in the Lehman Brothers Mortgage-Backed Securities Litigation. A copy of Judge Kaplan’s February 17 order can be found here.

Background

Plaintiffs had purchased the mortgage back securities that Lehman Brothers issued in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the offering documents had failed to disclose that the rating agencies, which were paid for providing their ratings, had conflicts of interest and had been involved in helping to structure the securities. The plaintiffs also allege that the offering documents failed to disclose that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The individual defendants in the case are the officers and directors of the Structured Asset Securities Corporation, which issued the registration statements and acted as depositor in the securitization process. The individual defendants moved to dismiss.

As noted in prior posts, Judge Kaplan has previously dismissed plaintiffs’ claims against the rating agencies themselves (refer here), rejecting plaintiffs’ arguments that the rating agencies were "underwriters" under the ’33 Act. Judge Kaplan also previously dismissed the separate ERISA class action claims (refer here, scroll down). In his February 17 decision, Judge Kaplan separately ruled on the individual defendants’ motion to dismiss.

The February 17 Decision

Judge Kaplan held that the plaintiffs’ allegations that the offering documents failed to disclose the rating agencies’ conflict of interest were insufficient to state a claim, for two reasons.

First, Judge Kaplan held that the Securities Act does not require disclosures of "that which is publicly known," and "the risk that the rating agencies operated under a conflict of interest because they were paid by the issuers had been known publicly for years."

Judge Kaplan then went on to hold that "the rating agencies’ role in structuring the certificates is not material as a matter of law." His conclusion is based on the following analysis:

If the fee arrangement undermined an investor’s confidence in the rating agencies’ independence, a disclosure that a rating agency was involved in structuring the Certificates prior to rating them would have added nothing important to the "total mix" of information. If, on the other hand, an investor trusted the ratings agencies to give an honest opinion notwithstanding the fact that they were paid by the issuer, the fact that they were involved in structuring the Certificates, assuming that they were, likewise would have been unimportant. In consequence, these claims are insufficient.

With respect to the plaintiffs’ allegations that the offering documents contained misrepresentations about the amount and form of credit enhancement, Judge Kaplan held that the statement about the credit enhancement was a "statement of opinion," which could be actionable only if the complaint alleged that the rating agencies did not actually hold that opinion.

Judge Kaplan found that "at best" the complaint’s allegations "support an inference that some employees believed the rating agencies could have used methods that better would have informed their opinions," which he held to be insufficient to state a claim.

But Judge Kaplan did hold that the complaint’s allegations that the loan originators "systematically failed to follow the underwriting guidelines" were "sufficient at this stage to support a reasonable inference that the offering documents’ description of the underwriting guidelines was materially misleading."

Accordingly, Judge Kaplan granted the individual defendants’ motion to dismiss all of the claims against them except plaintiffs’ Section 11 claims about the loan originators’ supposed departures from underwriting standards.

Discussion

Even though Judge Kaplan’s February 17 opinion was issued in connection with claims asserted against the individual defendants and not in connection with claims asserted against the rating agencies themselves, the opinion nevertheless potentially could be of great significance in other subprime mortgage-related cases in which claims have been raised against the rating agencies.

In particular, Judge Kaplan’s holding that the offering documents’ omissions about the rating agencies’ alleged conflicts of interest and role in structuring the securities were not legally actionable may be of particular significance.

In many of the other cases in which claims have been asserted against the rating agencies, the claimants have, like the plaintiffs in the Lehman case, alleged that the rating agencies had undisclosed conflicts of interest and were involved in structuring the investments at issue. The rating agencies will undoubtedly find Judge Kaplan’s holding that the alleged omission of this information is not legally actionable to be helpful.

Judge Kaplan did not reach the question whether or not the rating agencies’ ratings are protected by the First Amendment, which is another defense on which the rating agencies will attempt to rely. But if the alleged omissions about the rating agencies are not actionable in the first place, there may never be a need to reach the First Amendment issues.

Judge Kaplan conclusion that the disclosures concerning the securities’ credit enhancements represented opinion rather than statements of fact is also instructive, even without getting into the First Amendment issues. As his February 17 decision states, statements of opinion are actionable only if the allegations show that the opinions were not actually as disclosed. Again, Judge Kaplan’s rulings are instructive and potentially significant as they suggest ways in which the claims against the rating agencies may be considered without even getting into the First Amendment issues.

Finally, Judge Kaplan’s holding that the rating agencies’ alleged conflicts of interest and involvement in the securitization transaction are immaterial does raise interesting questions about claimants’ ability to overcome the rating agencies’ First Amendment defenses. The plaintiffs have argued that the rating agencies were not entitled to rely on the First Amendment defense in the context of these kinds of structured investments because of the conflicts of interest and involvement in the transaction. Perhaps Judge Kaplan’s rulings are unrelated to these issues, but it does seem incongruous that considerations that are immaterial would be sufficient to overcome a constitutional defense.

Of course, it is entirely possible that other courts may not be persuaded by Judge Kaplan’s analysis. It is not intuitively obvious that, because it was public knowledge that rating agencies had conflicts, the rating agencies’ involvement in the transactions is legally immaterial. Indeed, the jump between the public knowledge of the conflict of interest and the immateriality of the rating agencies’ involvement in the transactions is frankly unsatisfying. Other courts might well be unwilling to make that analytic jump.

I have in any event added Judge Kaplan’s February 17 opinion to my table of subprime-related lawsuit motion to dismiss rulings, which can be accessed here. Because a portion of the claims against the individual defendants survived the dismissal motion, I have listed the ruling in the table of dismissal motion denials.

Special thanks to a loyal reader for sending a copy of Judge Kaplan's February 17 opinion.

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Rating agencies are not susceptible to ’33 Act liability as "underwriters," even if they helped structure the mortgage backed securities at issue, according to February 1, 2010 ruling (here) by Southern District of New York Judge Lewis Kaplan in which he dismissed Moody’s and McGraw-Hill (S&P’s parent) from the Lehman Brothers Mortgage-Backed Securities Litigation.

Plaintiffs had purchased the mortgage back securities that Lehman Brothers had issued in two offerings in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the rating agencies determined the composition of the loans in the mortgage pool that the instruments securitized. The plaintiffs also allege that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The plaintiffs premised their securities liability claims against the rating agencies based on their argument that the rating agencies were "underwriters" within the meaning of Section 11 of the ’33 Act. The plaintiffs based their theory that the rating agencies were "underwriters" within the meaning of Section 11 on the argument that the "underwriter" liability extends to those "who engaged in steps necessary for the distribution."
 

Judge Kaplan found this argument "unpersuasive," noting that

The Rating Agencies’ alleged activities may well have had a good deal to do with the composition and characteristics of the pools of mortgage loans and the credit enhancements of the Certificates that ultimately were sold. But there is nothing in the complaint to suggest that they participated in the relevant "undertaking" – that of purchasing the securities here at issue, the Certificates – "from the issuer with a view to their resale." The Section 11 claim is insufficient in law.

Judge Kaplan also rejected plaintiffs’ arguments that the rating agencies had "seller" liability under Section 12(a)(2) or control person liability under Section 15.

The rating agencies dismissal from this subprime-related securities class action lawsuit is not as significant as it would have been if it had based on the rating agencies’ claims that their ratings opinions are proteced by the First Amendment. Though Judge Scheindlin rejected that argument on narrow grounds in the Cheyne Financial case (refer here), the First Amendment defense undoubtedly will play a crucial role in many of the subprime-related securities cases that have been filed against the rating agencies, and the litigants in the many cases that have been filed against the rating agencies will have to await a later date to get a clearer sense of how those arguments will fare in these cases.

But though Judge Kaplan did not reach the first amendment issue, his ruling nevertheless is significant. As the subprime litigation wave unfolded, there were a number of complaints filed against the rating agencies asserting ’33 Act claims against them in which the plaintiffs in those cases had argued that the rating agencies were susceptible to "underwriter" liability under Section 11. Judge Kaplan’s rejection of that theory undoubtedly will be influential in those other cases where the plaintiffs have attempted to assert Section 11 "underwriter" liability against the rating agencies.

I have in any event added Judge Kaplan’s ruling to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

SEC Issues Climate Change Interpretive Guidance: The SEC decided recently to issue interpretive guidance on climate change disclosure. The SEC has now issued the interpretive guidance, which can be found here. I think this is a significant development, and not just because the SEC has now formally put climate change disclosure on the list of things to do for reporting companies.

It is clearly a topic worthy of much longer treatment than I am able to give it while I am in New York attending the PLUS D&O Symposium, but the danger is that the disclosure requirement establishes the predicate for a plaintiff to later claim that a public company failed to meet its climate change-related disclosure obligations. In my view, the SEC’s issuance of the interpretive guidance brings us that much closer to the day when we may start to see D&O claims arising out of misrepresentations or omissions concerning climate change related disclosures.

The End of the World: In response to my recent statement that I was tired and could use a nap, one of my much younger colleagues replied "O.K, first we take zee nap, ZEN WE DEESTROY ZEE WORLD!" She undoubtedly saw from the puzzled look on my face that I didn’t have a clue what she was talking about, so she immediately sat down and showed me this YouTube video, which she described as "the original viral Internet video." Readers should be forewarned that  the video uses vulgar language and contains humor that some may find crude or offensive. It is also seriously funny. Viewer discretion is, however, strongly advised.

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On November 20, 2009, Ohio Attorney General Richard Cordray announced (here) the filing of a lawsuit in the Southern District of Ohio on behalf of five Ohio pension funds against Standard & Poor’s, Moody’s and Fitch. According to his press release, the complaint, which can be found here, charges the rating agencies with "wreaking havoc on U.S. financial markets by providing unjustified and inflated ratings of mortgage-backed securities in exchanged for lucrative fees from securities issuers."

During the period January 1, 2005 through July 8, 2008, the plaintiff pension funds purchased a variety of asset-backed securities all of which had "false and misleading" ratings of AAA or equivalent. The complaint alleges that while the ratings purportedly were objective and independent, "in truth, the Rating Agencies subverted those principles and negligently provided unjustified and inflated ratings in exchange for the lucrative fees the ABS issuers paid the Defendants for not only rating the securities but also for helping to structure them."

The complaint makes liberal use of the rating agencies’ internal communications that the SEC disclosed following its own investigation of the firms, and also quote extensively from the SEC’s investigation report (about which refer here).

The complaint asserts that "when the housing and credit markets collapsed, the flaws in the Defendants’ AAA ratings gradually became clear." The value of the pension funds’ investments "dropped precipitously" which, the complaint alleges, caused the funds to lose over $457 million, as "these purportedly safe investments became obvious for what they were – high risk securities that both the issuers and the Rating Agencies knew to be little more than a house of cards." The complaint asserts claims for relief under the Ohio Securities Act and for negligent misrepresentation.

The Ohio action follow the similar action that Calpers filed in July 2009 against the rating agencies, as discussed here.

As I have previously discussed on this blog, the rating agencies have proven to be a popular target for investors angry about losses they sustained on mortgage-backed securities and other investments following the subprime meltdown. But as I have also previously noted, these investor actions could face significant hurdles, particularly with respect to the rating agencies’ constitutional defenses. Significant case law supports the rating agencies’ position that their ratings opinions are protected by the first amendment.

In attempting to overcome these arguments, the Ohio funds will undoubtedly seek to rely on Judge Shira Scheindlin’s September 2009 opinion in the Cheyne Financial case, in which she rejected the rating agencies’ argument that their rating opinions were entitled to immunity under the First Amendment.

But as I noted in my prior post discussing Judge Scheindlin’s opinion, the extent to which these plaintiffs will be able to rely on her opinion may be limited. First, as a district court opinion, it will be of at most persuasive but not precedential value. Moreover, Judge Scheindlin’s conclusions were made in the context of an action made under New York’s fraud laws, which may or may not be relevant to an action under Ohio’s laws.

In addition, Judge Scheindlin’s ruling in the case was limited by its own terms. In disallowing the first amendment defense, she said "where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is note afforded the same protection." To the extent the ratings the Ohio funds’ allege to be misleading were not made to a select group of investors, as was the case with respect to the investments involved in the Cheyne Financial case, Judge Scheindlin’s ruling arguably may not be relevant.

But despite the obstacles, Cordray appears enthusiastic about the case. In fact, he seems to have decided in general that he can extract significant political value by pursing securities litigation. On November 20, 2009, he wrote on his blog, Speak Out Ohio, that "my office is aggressively pursuing Wall Street corporations and executives that harm investors here in Ohio and around the world." (Yes, the Ohio Attorney General has a blog. Doesn’t everybody?) Among other things, he also references in his blog post the recent $400 million settlement in the Marsh contingent commission securities class action lawsuit, in which his office participated.

Just to underscore how enthusiastic he is about pursing securities class action litigation, Cordray also separately published on November 20, 2009 a detailed report of the securities class action lawsuits his offices has pursued or is pursuing.

The political value that Cordray thinks he can gain by initiating securities litigation may be discerned from the tenor and tone of some of his remarks in his blog. For example, with respect to the rating agency lawsuit, he says that:

This case goes to the heart of what’s wrong with Wall Street today. Ohio workers—including our families, friends and neighbors – work hard to create wealth in our economy. Then Wall Street corporations and executives manipulate that wealth, for their benefit, and they do so with total disregard for our life’s work and the importance of our retirement savings. Ordinary people throughout Ohio are hurt by this kind of misconduct. And we won’t stand for it.

If you are wondering whether Cordray’s litigation endeavors are producing their intended results (that is, by generating favorable publicity for Cordray, who clearly has higher political aspirations), you will be interested to know that the filing of the rating agency lawsuit made the front page of the business section of Saturday’s Cleveland Plain Dealer. Since the only thing in Cleveland worse than the Cleveland Browns is the Cleveland economy, the paper’s business section is actually widely read, for same morbid reasons that people gawk at traffic accidents.

Ben Hallman of the Am Law Litigation Daily has an interesting November 20, 2009 profile of Cordray and of the ratings agency case here. Among other things, Hallman notes that Cordray is a former five-time undefeated Jeopardy! champ. Hallman also (correctly, in my view) notes that Cordray is "making a strong bid to be the Midwest’s answer to Andrew Cuomo."

On the Other Hand, Securities Litigation Could Also a Scam Worse Than Bernie Madoff’s: While Cordray is convinced that he is helping to protect the little guy by pursuing securities suits against Wall Street, Lawrence W. Schonbrun, the executive director of Class Action Litigation Watch, asserts that securities class action litigation is "a financial rip-off worse than Bernie Madoff."

In a November 21, 2009 editorial in The Buffalo News (here), Schonbrun takes on the plaintiffs’ securities class action bar, asserting that class action securities litigation is "skimming hundreds of millions of dollars from investors in U.S. corporations." Using Judge Rakoff’s rejection of the SEC’s settlement of the BofA/Merrill Lynch bonus action as a starting point, Schonbrun argues that:

In a typical year, more than 200 securities class action lawsuits are filed against American companies, with an average settlement of more than $100 million each; that adds up to a staggering $20 billion a year! Over nearly 40 years, that means that the system has drained upward of $800 billion of shareholder wealth, not just from people who directly trade securities but from all Americans who own mutual funds, or have pension funds or other types of investments. Kind of dwarfs Madoff’s $65 billion, doesn’t it?

Schonbrun is rather obviously playing fast and lose with the numbers, since there has never yet been even one year when class action lawsuits settlements average $100 million, and there certainly have not be 40 years’ worth of average settlements of $100 million.

But his rant does raise an interesting question, which is -- who is actually helped and who is actually hurt by the class action lawsuits? It is true that when class action settlements are funded in whole or in part by defendant corporations, it is shareholders that are hurt. As Schonbrun points out, among the most significant shareholders are the very kinds of pension funds on whose behalf Cordray is busy filing lawsuits. Schonbrun’s intemperate screed didn’t quite get there, but there is a very interesting question about whether the kinds of lawsuits Cordray is busy congratulating himself for filing (at least to the extent they are filed against publicly traded companies, as opposed to the rating agencies) actually benefit the pension funds over the long haul.

So here’s my idea: Let’s have a public debate between Cordray and Schonbrun. Call it "Class Action Smackdown" or something like that. To enhance the entertainment value, the rules of engagement could specify (drawing on Cordray’s Jeopardy! experience) all of the contestants’ statements would have to be expressed in the form of a question. That could be quite a spectacle.

And Speaking of Class Action Litigation: Meanwhile, back at the Southern District of New York courthouse, the Vivendi securities class action lawsuit trial is now in its sixth week. The trial disappeared from the radar screen for a while, but it was back in the news again this week, as former Vivendi CEO Jean-Marie Messier took the stand.

According to news reports, he told the jury that he might have made mistakes but her never misled shareholders. The AP newswire story quotes him as saying "Some of my management decisions turned out wrong, but fraud? No. Never. Never. Never." According to the AmLaw Litigation Daily account of his testimony, Messier also called the allegations in the case "blatant lies, infamous lies." Messier’s testimony reportedly will continue for several days.

And Speaking of Liability Exposures: I have been involved with D&O claims, one way or another, for well over 25 years. After such a long period observing the havoc of lawsuits against directors and officers, I never ceased to be amazed by corporate officials who are convinced they don’t need management liability insurance. To me, that attitude as foolhardy and dangerous as that of the soldier who is convinced he doesn’t need a helmet because he is sure that he is never going to get hit.

One product I have been particularly surprised that corporate officials often must be convinced they need is Fiduciary Liability Insurance. This insurance, which is quite inexpensive given the extent of the protection it affords, is designed to protect plan fiduciaries against claims by employee plan participants or beneficiaries that the fiduciaries breached their duties.

On November 19, 2009, CFO.com had a particularly good article entitled "Fiduciary Liabilities: Are you Covered?" (here) which describes Fiduciary Liability Insurance and explains why it is an indispensible part of every company’s insurance program. I commend the article for anyone involved in advising companies about their management liability insurance.

And Finally: So which country do you think has the most English speakers, India or China? You might might be tempted to say India. But you would be wrong. Correct answer? China. I guess if you start with a billion people, having the most of anything is a lot simpler.

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Among the causes many cite for the subprime meltdown is the willingness of the rating agencies to assign investment grade rating to securities backed by subprime mortgages. For that reason, in many of the lawsuits filed as part of the subprime litigation wave, plaintiffs have named rating agencies as defendants, seeking to hold them responsible for their investment losses. However, as discussed here, whether the rating agencies could actually be held liable is unclear, because in the past courts have found the rating agencies’ rating opinions to be protected by the First Amendment.

However, in a September 2, 2009 opinion (here) in a lawsuit relating to investment notes issued by Cheyne Financial, Southern District of New York Judge Shira Scheindlin denied the rating agencies’ motions to dismiss. Most significantly, Judge Scheindlin rejected the rating agencies’ argument that their rating opinions were entitled to immunity under the First Amendment, and she also rejected their argument that their rating represented non-actionable opinion.

Background

Plaintiffs claims in the lawsuit related to their investment in certain notes that had been issued by Cheyne Financial, a $5.86 billion structured investment vehicle. The notes were collateralized by certain assets, included residential mortgage backed securities (RMBS). Cheyne collapsed amid the subprime meltdown in 2007. Cheyne was unable to pay the senior debt as it became due and Cheyne is now in bankruptcy. The investors lost substantially all of their investment.

The notes Cheyne issued received the highest possible ratings from the rating agencies. However, according to Judge Scheindlin’s factual recitation in her September 2 opinion, that rating agencies played a "more integral role" than merely providing ratings. The rating agencies were involved in "structuring and issuing" the notes. For example, the rating agencies "helped to determine how much equity was required at each level of the SIV."

For their efforts, the rating agencies were paid approximately $6 million, an amount the court noted was "three times their normal fees." Moreover, the rating agencies fees increased "in tandem with the Cheyne SIV’s growth." As Judge Scheindlin put it, "unbeknownst to investors, the Rating Agencies’ compensation was contingent upon the receipt of the desired ratings for the Cheyne SIV’s Rated Notes."

After Cheyne collapsed, the investors filed suit against Morgan Stanley, which had promoted and distributed the notes; Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne; and the rating agencies (including Moody’s and S&P and their corporate parents). The plaintiffs asserted thirty-two claims under twelve different legal theories. Essentially, the plaintiffs alleged common law fraud under New York law; common law tort claims alleging misrepresentation; and assertions based on alleged breach of contract. The defendants moved to dismiss.

Judge Scheindlin’s Opinion

The rating agencies moved to dismiss the plaintiffs’ fraud allegations, arguing that their ratings were protected by the First Amendment and represented non-actionable opinion.

Judge Scheindlin rejected the rating agencies’ attempt to rely on the First Amendment, noting that "where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is note afforded the same protection." Judge Scheindlin held that here, because the Cheyne note ratings were provided only to "a select group of investors" as part of a private placement, the First Amendment defense is inapplicable.

Judge Scheindlin further rejected the rating agencies’ argument that their ratings were in any event non-actionable opinion, holding that the "plaintiffs have sufficiently pled that the Rating Agencies did not genuinely or reasonably believe that the ratings they assigned to the Rated Notes were accurate and had a basis in fact."

In finding that the plaintiffs had adequately alleged that the rating agencies did not reasonably believe the rating had a basis in fact, Judge Scheindlin among other things noted that the complaint alleged that the ratings "appeared to investors to equate the Rated Notes to other investments" such as investment grade bonds, though the notes "in reality and unbeknownst to investors, differed materially"; that, contrary to representations, the SIV’s portfolio consisted of more that 55% of RMBS, which "made the SIV a risky investment and certainly not deserving of high ratings."

The complaint further alleges that the rating agencies were subject to numerous conflicts of interest. Thus, even the rating agencies allegedly were aware that "the process used to derive ratings was deeply flawed and unreliable," but they nonetheless issued the ratings because they were compensated by a fee "substantially larger than normally received" and their fee was "directly connected to the success of the Cheyne SIV." These conflicts "compromised the objectivity of the ratings."

Judge Scheindlin further found that the plaintiffs had adequately pled scienter, based on the complaint’s allegations of motive and opportunity. She noted that the complaint alleged that the rating agencies knew Morgan Stanley would have "taken its business elsewhere" if the notes did not receive the desired rating, and in exchange for their "unreasonably high ratings" the rating agencies received "fees in excess of three times their normal fees."

With respect to motive and opportunity, the complaint further alleged that the rating agencies’ "remuneration was dependent on the successful sale of the Rated Notes," and that "they could sell successfully only if they were highly rated."

Judge Scheindlin also rejected the rating agencies’ argument that as sophisticated investors, the plaintiffs’ could not show actionable reliance on the ratings.

Finally, with respect to the plaintiffs’ other claims, Judge Scheindlin found that New York’s Martin Act precluded the plaintiffs’ common law tort claims, and that the plaintiffs’ had not alleged sufficient facts to support plaintiffs’ claims sounding in contract. She allowed the plaintiffs’ leave to amend their contract claims, but the dismissal with respect to the plaintiffs’ tort law claims was with prejudice.

Discussion

Judge Scheidlin’s rulings in the Cheyne Financial case are potentially of great significance in the many other lawsuits that have been filed against the rating agencies as part of the subprime litigation wave. In those many other cases, the rating agencies will also attempt to rely on the same threshold defenses on which they sought to rely in the Cheyne Financial case. The claimants in those other cases will cite Judge Scheindlin’s opinion in attempting to argue that the defenses should not be available to the rating agencies.

Several aspects of Judge Scheindlin’s opinion could be particularly helpful to other claimants. In particular, the significance she attached to the involved role of the rating agencies in structuring the investments they later rated could be particularly helpful, as claimants have asserted these same kinds of allegations in many of the other cases against the rating agencies. The same is also true with respect to her findings that the rating agencies’ compensation arrangement put them in a conflict of interest.

But while Judge Scheindlin’s opinion undoubtedly will be helpful to other claimants, the Cheyne Financial decision is far from conclusive of the issues surrounding the protections the rating agencies may be able to rely upon in connection with their ratings. Thus, even in the Southern District of New York, the opinion is at most of persuasive not precedential value. Though Judge Scheindlin is a highly respected Judge, other court nevertheless may decline to follow her analysis, particularly if the factual allegations are distinguishable.

A further way that Judge Scheindlin’s opinion could be of limited value is that her rulings were made under New York law with respect to allegations of common law fraud. Many of the other lawsuits that have been filed against the rating agencies allege violations of the federal securities laws, which other courts could view as being a critical distinction – although it does seem that shouldn’t make any particular difference with respect to the First Amendment issue.

Another consideration could further limit the impact of Judge Scheindlin’s rulings is that her analysis of the First Amendment issue may not persuade other courts. Indeed, a September 4, 2009 Wall Street Journal article (here) discussing the opinion quotes First Amendment scholar Martin Redish as saying that "the fact that [a rating] was just to a select audience should not disqualify it from First Amendment protection."

Even if other courts agree that the First Amendment protection does not apply to ratings that have only been disseminated to a small group, many of the claims that have asserted against the rating agencies in other cases do not involve the same kind of restricted offering involved in the Cheyne case. Many of the ratings that are now being challenged were issued in connection with public offerings, for securities that subsequently traded on the public securities exchanges. For ratings on those kinds of securities that were issued as part of those kinds of offerings, Judge Scheindlin’s analysis of the First Amendment issue, based on the fact that ratings of the Cheyne notes were not widely distributed, simply would not be applicable.

That does not necessarily mean that in those cases the rating agencies would be able to rely on the First Amendment defense, but it does mean that Judge Scheindlin’s First Amendment analysis would appear to be unavailing. Because so many of the cases in which the rating agencies have been named as defendants involve public securities offerings, Judge Scheindlin’s opinion could well have little impact at least on the First Amendment issue itself in many other cases against the rating agencies.

Nevertheless, as the Journal article puts it, Judge Scheindlin’s opinion is "one of the first to interpret the extent to which the [rating agencies] can expect First Amendment protection for their ratings of certain securities." The Journal quotes attorney David Grais as saying that Judge Scheindlin’s opinion "breaks new ground." Andrew Longstreath’s September 4, 2009 Law.com article about the opinion (here) quote Patrick Daniels of the Coughlin Stoia firm as saying "This is what we needed." Investors apparently believe that her ruling is a "landmark decision"

So, even though the Cheyne Financial decision is by no mean dispositive of the issue, it is nevertheless a highly significant development that could have a very significant impact in the many other subprime-related cases that have been filed against the rating agencies.

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As I have previously noted (here), one of the significant procedural developments in the subprime securities litigation wave has been the plaintiffs’ apparent interest in pursuing ’33 Act subprime-related lawsuits in state court. Section 22(a) of the ’33 Act expressly provides that the federal court’s jurisdiction for ’33 Act lawsuits is "concurrent with State and Territorial courts," which presents an immediate forum selection issue for any prospective ’33 Act plaintiff.

A recent ’33 Act lawsuit filing suggests that the forum selection issue involves not only electing between federal and state courts, but also deciding in which state to file, if a state court forum is to be preferred. The case also suggests that the forum selection may also entail forum shopping.

The Lawsuit

On December 2, 2008, the Public Employees’ Retirement System of Mississippi filed a ’33 Act class action complaint in Orange County (California) Superior Court against Morgan Stanley and several Morgan Stanley affiliates, several individuals associated with the Morgan Stanley affiliates and fourteen issuing trusts that sold certain mortgage pass-through certificates. The complaint also names as defendants McGraw Hill Companies, the corporate parent of S&P, and Moody’s. A copy of the complaint can be found here.

The complaint alleges that the offering documents associated with the securities "misstated and omitted material information regarding the quality of the loans underlying the Certificates," and failed to disclose" that the loan originators had "systematically ignored their stated and pre-established underwriting and appraisal standards." The complaint also alleges that Morgan Stanley entities "overpaid for underlying mortgages without regard to the quality of the loans for the sole purpose of increasing its position in the mortgage lending and securitization industry."

The complaint further alleges that the rating agency defendants "directly participated in structuring the securitization transaction" and that the rating agencies’ ratings "did not represent the true risk of the Certificates."

The complaint asserts claims under Sections 11, 12 and 15 of the ’33 Act and seeks relief on behalf of the class of investors who purchased securities pursuant to or traceable to the March 16, 2006 Registration Statement and accompanying prospectus.

Jurisdiction and Venue

The plaintiff is a Mississippi public employee pension fund. Morgan Stanley has its headquarters in midtown Manhattan. The complaint does not allege that any of the other defendants are domiciled in California. Apparently none of the parties are from California. So what exactly is this case doing in California?

As to why it is in state court rather than federal court, the state court has concurrent jurisdiction as I noted at the outset. But the mere availability of a state court forum does not explain why a state court was chosen in preference to a federal court. In my earlier posts (here), I have speculated that the plaintiffs are hoping to make an end run around the PSLRA’s procedural requirements, although no one has ever confirmed that.

But even if the preference of state court over federal court can be explained, why a state court in California?

The complaint itself purports to allege a variety of California connections: a "substantial portion of the wrongs complained of" are alleged to have occurred in Orange County. The defendants are alleged to have "availed themselves of the benefits of conducting business" in Orange County. Moreover, the complaint alleges that "a great percentage of the underlying mortgages pooled in the Certificates…were securitized by properties located in California."

All of these supposed connections to California are superficially plausible. But the fact is that all the parties are from outside California. The transaction that is at the heart of the lawsuit took place outside California. The supposedly misleading documents were created outside California.

I have my own theory why the case has been filed in California. That is, the plaintiffs really want the case to be in state rather than federal court. They anticipate that the defendants will seek to remove the case to federal court. The case law on which the plaintiffs would seek to rely in trying to have the case remanded back to state court is more favorable in California and less favorable in New York.

Specifically, as discussed here, in New York, in the HarborView mortgage case (about which refer here), the plaintiffs’ motion to remand the subprime-related securities case to state court was denied. However, in the Luther v Countrywide case, a subprime-related Section 11 lawsuit originally filed in California state court but removed by the defendants to federal court, the motion to remand the case to state court was granted, and the remand was specifically affirmed by the Ninth Circuit. For a detailed discussion of the Luther case including the Ninth Circuit’s opinion, refer here.

So did the plaintiffs choose a California state court because of the Ninth Circuit’s opinion in the Luther v. Countrywide case -- that is, because the chances of being able to proceed in state court in California was perceived to be greater than the chances of being able to proceed in state court in New York? If I am right, the plaintiffs selected the forum in order to increase the likelihood of a state court venue. Call it forum shopping to the second power.

Anyone who questions my theory should know that the complaint in the Morgan Stanley case explicitly references the Luther case, complete with case citation to the Ninth Circuit opinion. .

Of course, it may also be fairly observed that Orange County is ground zero for the mortgage meltdown, and as result the plaintiffs may expect a more sympathetic court and jury in that forum . This possible explanation is not inconsistent with my theory. Call it fourm shopping to the third power.

In any event, as I have previously noted, it appears likely that in connection with the subprime litigation wave, a significant amount of high stakes class action securities litigation will be going forward in state court. The plaintiffs’ lawyers ’33 Act forum selection preference is now well-established. Now we must wait and see what it all portends.

Rating Agency Defendants

The Morgan Stanley case is not the first subprime securities lawsuit naming the rating agencies as co-defendants. Indeed, the HarborView case referenced above also named rating agencies as defendants. However, in the HarborView case, the complaint alleged that the rating agency defendants were liable under Section 11 as "appraisers" as defined in Section 11(a)(4) of the ’33 Act. (Refer here for a detailed discussion of the allegations in the HarborView complaint.)

The Morgan Stanley complaint takes a different approach. Because it alleges that the rating agencies were directly involved in the creation of the securitized assets, the Morgan Stanley complaint alleges that the rating agencies are liable under Section 11(a)(5) as "underwriters" of the mortgage pass-through certificates. (The text of Section 11 can be found here.)

It will be interesting to see in any event whether these various liability lawsuits against the rating agencies succeed under any theory. As I have previously noted here, the rating agencies may have constitutional defenses protecting their rating activities. It remains to be seen whether the rating agencies involvement in the securitization process transformed them into "underwriters" sufficiently to subject them to Section 11 underwriter liability.

Run the Numbers

In any event, I have added the Morgan Stanley Pass-Through Certificates lawsuit to my running tally of subprime related securities litigation, which can be accessed here. With the addition of the new Morgan Stanley case, the current tally of subprime and credit crisis-related securities lawsuits now stands at 133, of which 93 have been filed in 2008.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for a copy of Morgan Stanley mortgage pass-through certificates lawsuit complaint.

Subprime Loans, Predatory Lending?: One of the recurring allegations on behalf of subprime borrowers is that the subprime loans in which the borrowers became ensnared represented "predatory lending." A November 20, 2008 article by three NERA Economic Consulting economists – Denise Neumann Martin, Faten Sabry and Stephanie Plancich – reviews "the definition of predatory lending and describe the recent litigation history. The authors then examine alleged discriminatory lending in detail, reviewing key economic theory and evidence, as well as relevant statistical techniques."

The paper also reviews predatory lending allegations and takes a look at recent predatory lending lawsuit filings. The article categorizes the lawsuits according to the specific allegations, and also examines predatory lending lawsuit settlements.

The report contends that proper statistical analysis is required to establish whether or not discriminatory or other improper lending activity has taken place. The report states that:

A proper assessment of alleged predatory lending, then, must control for characteristics including but not limited to the credit history, employment status, income level, and education of the borrower, as well as the borrower’s preference for risk (or discount rate). The competitiveness of the market in which the loan was arranged and other relevant macroeconomic factors may also need to be considered. Such analysis is essential to distinguish behavior that is predatory from that which is explainable by these other factors and would not be evidence of discrimination.

The paper, entitled "The Use of Economic Analysis in Predatory Lending Cases: Application to Subprime Loans," can be found here.

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