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.



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.



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 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.