The rating agencies have been among the targets in many of the lawsuits filed as part of the subprime-related litigation wave. By and large, the rating agencies have been successful in knocking out these cases in the early stages, particularly the lawsuits seeking to hold them liable as "underwriters" under the federal securities laws.


At the same time, there is a small but growing number of cases in which the rating agencies’ preliminary motions have been unsuccessful, and there is a definite sense in which these decisions are building on each other, particularly with respect to the issues surrounding the First Amendment defenses on which the rating agencies are seeking to rely.


The latest example of a case where the rating agencies’ preliminary motion on First Amendment grounds have been unsuccessful is the negligence suit that Calpers filed in California state court against the three principal rating agencies.



In July 2009, Calpers sued the three main rating agencies in California state court. Calpers alleged that it had invested about $1.3 billion in instruments issued by three structured investment vehicles (SIV). The investments carried the rating agencies highest ratings, which ratings Calpers alleged were "wildly inaccurate." Calpers claims to have lost over $1 billion on the investments.


Calpers alleged that it would not have invested in the securities if the securities had not carried the highest investment ratings. Calpers alleged that the rating agencies "did not have a reasonable basis" for giving the SIVs the highest investment ratings.


The ratings were flawed, Calpers alleged, because they failed to account for "foreseeable scenarios" and failed to account for the SIVs’ critical risk – that is, that the were highly concentrated in certain types of residential mortgages and residential mortgage backed securities. Calpers also alleged that the rating agencies used "inadequate mathematical and statistical models" and "employed increasingly lax standards" while giving the SIVs the highest ratings, in order to be able to continue to secure business providing ratings for structured financial products.


The rating agencies demurred to Calpers’ complaint, asserting that the allegations were legally insufficient. In early May 2010, California (San Francisco County) Superior Court Judge Richard Kramer announced from the bench that he would be overruling the rating agency defendants’ demurrer to Calpers’ negligence claims, but that he was sustaining the demurrers with leave to amend as to Calpers’ allegations of negligent interference with prospective economic advantage. Judge Kramer indicated at the hearing that the reasons for his reasons would appear in a forthcoming opinion.


The May 24 Opinion

In an opinion dated May 24, 2010 and filed on June 1, 2010 (and which can be found here), Judge Kramer set out the reasons for his rulings on the rating agency defendants’ demurrers.


The most noteworthy aspect of Judge Kramer’s opinion is his statement of the bases on which he rejected the defendants’ argument that they could not be held liable for their ratings opinions because the opinions are protected under the First Amendment. Judge Kaplan said (citing and relying on Judge Shira Sheindlin’s opinion in the Cheyne Financial case, about which refer here):


The court rejects Defendants’ arguments that the First Amendment to the United States Constitution preempts Plaintiff’s claims. The right to free speech allows us to give our opinions to things of public concern. 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. That is not something that should be afforded First Amenment protection and the Defendants are not akin to members of the financial press.


Judge Kaplan also rejected the rating agency defendants’ arguments that the plaintiff’s claims are precluded by New York’s Martin Act or by the Credit Rating Agency Defense Act. However, he did find that plaintiff’s claim of negligent interference with prospective economic advantage was legally insufficient, although he allowed plaintiff leave to attempt to replead the claim.



There have only been a handful of preliminary motion rulings so far that have been unfavorable to the rating agencies. But Judge Kaplan’s opinion in the Calpers case demonstrates that each of these rulings, even though seemingly limited, creates an opportunity for later plaintiffs to try to exploit the rulings in other cases.


For example, Judge Kaplan expressly relied on Judge Sheindlin’s September 2009 opinion in the Cheyne Financial case. Judge Sheindlin’s rejection of the rating agencies’ First Amendment defense in that case was by its own terms narrow; she said only that credit rating that is not directed to the public at large, but that is "provided instead to a select group of investors," is not entitled to First Amendment protection.


Though Judge Kaplan expressly quoted this narrowing language, his opinion arguable is not as narrow. To be sure, he emphasized that the SIV itself was designed for a "limited target. But he also said that the rating agencies are not the equivalent of the "financial press," and he indicated that the opinions were not entitled to protection where the opinions are not of "public concern." This analysis may or may not be sufficient to bar the First Amendment defense in a public-at-large kind of claim, but it nonetheless does seen to constrain the availability of the defense in a wide variety of circumstances – and a wider variety of circumstances than would the standard in Judge Sheindlin’s case.


Whether plaintiffs in other cases will be able to build further on Judge Kaplan’s opinion remains to be seen. It particularly remains to be seen whether Judge Kaplan’s analysis will prove useful in a public-at-large case, as opposed to a "select group of investors" kind of case.


Nevertheless the plaintiffs in these cases have shown themselves capable of building on openings in the defense. However, even the plaintiffs that have already survived preliminary motions are all still a very long way from any actual recovery. But surviving the motions to live for another day is the name of the game for plaintiffs in these kinds of cases. The small but growing number of rulings favorable to the plaintiffs seem to offer some reason to suspect that a number of these cases against the rating agencies may yet go forward.


Special thank to Henry Turner of the Turner Law Offices for providing me with a copy of Judge Kaplan’s opinion in the Calpers case.