Ratings Agencies May be Held Liable for Fraud for Misleading Ratings
In a recent decision, the United States District Court for the Southern District of New York, in Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc., et al1 denied a motion to dismiss fraud claims brought by certain noteholders against Moody's and Standard & Poors ("Rating Agencies"), in connection with the defendants' ratings of certain mortgage and asset backed securities. Departing from the general rule, the Court rejected the Ratings Agencies assertion that liability based upon their ratings is prohibited under the First Amendment right to free speech.
In Abu Dhabi Commercial, the Ratings Agencies were hired by Morgan Stanley, the arranger and placement agent for the notes (the "Placement Agent"), to rate notes in connection with the issuance of three categories of notes under a structured investment vehicle. These ratings were included with the knowledge and approval of the Ratings Agencies in information memoranda and other documents distributed to specific potential investors, but not disseminated to the general public.
The Ratings Agencies worked directly with Placement Agent to structure the notes in a manner to ensure that they received the highest ratings. As a part of that structure, the Ratings Agencies were responsible for ensuring certain minimum and maximum percentage requirements of rated assets backing the notes were met. These percentage requirements, however, were not met, resulting in riskier notes than the ratings suggested. In particular, the structured investment vehicle failed meet its guaranteed minimum percentages "AAA" and "AA" collateral assets and exceeded its maximum percentage of residential mortgage backed security investments.
Subsequently, the issuer, not being able to service its debt, filed for bankruptcy. As a result, the notes produced little to no recovery for the noteholders.
The Abu Dhabi Commercial Court denied the portion of the Ratings Agencies motion to dismiss the noteholders' fraud claims finding, among other things, that these ratings were not protected speech under the First Amendment. In reaching this result, the Court held:
the First Amendment protects rating agencies, subject to an 'actual malice' exception, from liability arising out of their issuance of ratings and reports because their ratings are considered matters of public concern. However, 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 not afforded the same protection.2
Here, the lack of wide spread dissemination of the ratings was pivotal in the Court's finding that the First Amendment protections were in applicable.
In short, this decision steps away from the traditional treatment of ratings as protected First Amendment speech and opens a new avenue for noteholders to seek redress for claims such as fraud. As many similar securities offerings are so targeted, this case may have wide reaching repercussions.
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1 08-7508 (S.D.N.Y. September 2, 2009)
2Id. at page 33.
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