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.