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Second Circuit Declines to Impose Securities Act Liability Against Rating Agencies

May.16.2011

The United States Court of Appeals for the Second Circuit recently affirmed rulings that credit rating agencies (such as Standard & Poor's, Fitch and Moody's) cannot be held liable for misrepresentations made in registration statements filed with the Securities Exchange Commission either as "underwriters" within the meaning of Section 11 or as "control persons" under Section 15 of the Securities Act of 1933.  The Court left open the possibility, however, that rating agencies might be adjudged liable under Section 11 for "expert" liability as a result of changes in the law pursuant to the recent Dodd-Frank Act.

The opinion is In re Lehman-Brothers Mortgage-Backed Securities Litigation, Nos. 10-0712-cv; 10-0898-cv; and 10-1288-cv (2d. Cir. May 11, 2011).  It concerned three separate cases in which the plaintiffs were purchasers of mortgage pass-through certificates that were registered with the Securities and Exchange Commission.  The purchasers alleged that the rating agencies, whose role it is to evaluate the credit risk of these certificates, also assisted in the structuring and securitization process.  For example, the purchasers pointed to loan data analyses and modeling that the rating agencies coordinated with and communicated about to investment banks in determining the composition of loan pools, certificate structures and credit enhancements necessary to achieve desirable credit ratings.

The purchasers attributed the significant losses they incurred on these mortgage pass-through certificates to the rating agencies’ downgrading the credit ratings on those securities during the mortgage crisis of 2008.  They sought to hold the rating agencies strictly liable under Sections 11 and 15 of the Securities Act.  Strict liability means that a Section 11 plaintiff has to show only a material misstatement or omission in the registration statement and is not required to demonstrate fraudulent intent, reliance and other factors necessary for a securities fraud claim under Section 10(b) of the Securities and Exchange Act of 1934.

Based on textual analysis of Sections 11 and 15 of the Securities Act, the Second Circuit declined to impose strict liability on the rating agencies.  The Court reasoned that, to qualify as an "underwriter" for purposes of Section 11 liability, a party must participate in the underwriting, offering, sale or purchase of securities, and that the purchasers' allegations that the rating agencies "facilitated" the offering of securities to the public did not suffice to impose liability on the rating agencies as "underwriters."  The Court acknowledged the possibility that, as a result of the Dodd-Frank Act, there may be a basis in the future for asserting claims against the rating agencies as "experts" under Section 11.  The Court also ruled that the rating agencies did not qualify as "control persons" of the issuers or depositors of the securities for purposes of Section 15 liability, because the rating agencies did not have the power to direct the management or policies of the issuers or depositors of the securities. 

A fuller description of the Second Circuit's reasoning follows below.

I. Section 11 Underwriter Liability

While Section 11 of the Securities Act imposes strict liability for material misstatements or omissions made in registration statements filed with the Securities and Exchange Commission, it does so only for the enumerated persons listed in Section 11(a) of the Act.  These include:  (1) signatories to the registration statement; (2) directors or partners of the issuer at the time of filing; (3) those consenting to be named in the registration statement as a director or partner; (4) accountants or other experts consenting to be named as preparing or certifying part of the registration statement; and (5) underwriters of the securities at issue.

The purchasers asserted that the involvement of the rating agencies in the structuring and securitization process of the mortgage pass-through certificates at issue made them "underwriters" within the meaning of the Securities Act and that, as a consequence, strict liability should be imposed upon the rating agencies pursuant to Section 11(a)(5).  The Second Circuit affirmed a Southern District of New York ruling rejecting this argument by focusing on the text and legislative history of the Securities Act.

Specifically, the Court analyzed the Securities Act's definition of the term "underwriter."  That term is defined as:

any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.

In essence, the purchasers argued that the rating agencies' involvement met this definition because they helped structure certificates so as to achieve desired credit ratings, which was a necessary factor for distribution of the securities within the market.

The Court reasoned, however, that the Securities Act "does not reach . . . as underwriters persons who provide services that facilitate a securities offering, but who do not themselves participate in the statutorily specified distribution-related activities."  It identified the critical component of the "underwriter" definition as "activity related to the actual distribution of securities."  The Court, therefore, concluded that "to qualify as an underwriter . . . a person must participate, directly or indirectly in purchasing securities from an issuer with a view to distribution, in offering or selling securities for an issuer in connection with a distribution, or in the underwriting of such an offering."

In short, the Second Circuit held that the underwriter definition does not extend to "persons not themselves participating in such purchases, offers or sales, but whose actions may facilitate the participation of others in such undertakings."

II. Section 11 Expert Liability

Although rating agency participation in the structuring and securitization of the mortgage pass-through certificates does not meet the requirements of "underwriter" liability under Section 11(a)(5) of the Securities Act, the Second Circuit noted that recent legislative changes might mean that rating agency involvement could be subject to the requirements of "expert" liability pursuant to Section 11(a)(4).  As the Court explained:  "The rating issued by a Rating Agency speaks merely to the Agency's opinion of the creditworthiness of a particular security.  In other words, it is the sort of expert opinion classically evaluated under the ‘expert' provision of § 11." 

This "expert" liability under Section 11 is conditioned upon the naming and consent requirements of Section 11(a)(4).  That is, the expert is only subject to liability when the expert "has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement . . ."  In the cases reviewed by the Second Circuit, the purchasers did not allege “expert liability” or that the rating agencies provided any such consent, which would be necessary for Section 11(a)(4) liability in any event.

Moreover, until the recent passage of the Dodd-Frank Act, the Securities and Exchange Commission had specifically excluded rating agencies from Section 11(a)(4) "expert" liability.  In 1981, the Commission promulgated Rule 436(g), providing that credit ratings are not to be considered part of the registration statement "prepared or certified by a person within the meanings of sections 7 and 11 of the Act."  At the time, the Securities and Exchange Commission identified the purpose of Rule 436(g) as "exclude[ing] any [rating agency] whose security rating is disclosed in a registration statement from civil liability under Section 11."  Rule 436(g) remained in effect when the purchasers filed suit against the rating agencies, which, as the Second Circuit commented, was the likely reason the purchasers sought to establish liability of the rating agencies as "underwriters" or "control persons" and not as "experts."

The Second Circuit noted that in Section 939G of the Dodd-Frank Act, Congress changed course, providing that "Rule 436(g) . . . shall have no force or effect ."  Thus, as of July 2010, when Dodd-Frank went into effect, a rating agency that met the naming and consent requirements of Section 11(a)(4) could be subject to "expert" liability.  It should be noted, however, that there is legislation pending in Congress attempting to repeal Section 939G of the Dodd-Frank Act. The Securities and Exchange Commission has issued a no-action letter, stating that it will not currently bring enforcement actions against issuers that do not disclose their credit ratings in prospectuses, which would allow the issuance without a rating.  See http://www.sec.gov/divisions/corpfin/cf-noaction/2010/ford072210-1120.htm.

III. Section 15 Control Person Liability

Finally, the Second Circuit addressed the purchasers' allegations of "control person" liability on the rating agencies under Section 15 of the Securities Act.  That section imposes liability upon "[e]very person who, by or through stock ownership, agency, or otherwise . . . controls any person liable under Section 11."  Since the purchasers had sufficiently pled Section 11 liability against the issuers or depositors of the mortgage pass-through certificates, the question was whether the purchasers of the certificates had established a factual basis supporting a conclusion that the rating agencies controlled the alleged primary violators.

The Second Circuit had not previously addressed the standard governing control person liability under Section 15 of the Securities Act.  It, therefore, adopted in its decision the standard it has used in analyzing claims under Section 20 of the Securities and Exchange Act, which imposes control person liability for Section 10(b) violators and is largely comparable to Section 15 of the Securities Act.  That standard provides that control is "the power to direct or cause the direction of the management and policies of [the primary violators], whether through the ownership of voting securities, by contract or otherwise."  The Court determined that the rating agencies did not qualify as "controlling persons" of the issuers or depositors of the securities because, at most, they provided advice and strategic direction on how to structure the securities, which is not enough to show a power to direct the primary violators' management and policies.

Because the purchasers failed to demonstrate sufficient control of the issuers and depositors by the rating agencies, the Second Circuit did not need to address whether the additional requirements necessary for control person liability under Section 20 of the Securities and Exchange Act also apply to Section 15 of the Securities Act.  Specifically, Section 20 liability requires as well that the "controlling person was in some meaningful sense a culpable participant in the fraud perpetrated by the controlled person."  Whether "culpable participation" is also required for Section 15 control person liability under the Securities Act has been left for another day.

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Daniel D. Edelman
Partner – New York
Phone: +1 212.895.4309
Email: dedelman@crowell.com