One thing that looks pretty certain is that lawsuits over crisis-era structured credit products will be around for the rest of our natural lives, burbling around in courts and every now and again surfacing in a Reuters article with a bunch of nine-digit numbers and acronyms of defunct German banks. This is comforting, in a way, but also worrying. How many are there? What are they all about? What is the aggregate amount of liability? Who owes it? It all seems unknowable. Remember how Judge Jed Rakoff rejected that SEC/Citi MBC CDO settlement, and it got appealed, and the appeals court disagreed but it’s still kicking around? Just in the past few days, Rakoff approved a $315mm class action settlement over $16.5bn of Merrill MBS. Did you know that was happening? There’s this thing, with some banks suing the New York insurance regulators over the restructuring of a monoline that insured some structured products, which is like a derivative on a derivative on a derivative on a derivative of the mortgage mess. The supply is endless. Everyone is suing everyone about everything.
Particularly enjoyable, though, are the lawsuits against ratings agencies for rating structured products that are bopping around in federal court in New York. Here’s some news on that front:
U.S. District Judge Shira Scheindlin refused to dismiss claims accusing Moody’s Investors Service and Standard & Poor’s of negligent misrepresentation over their activities regarding the Cheyne and Rhinebridge structured investment vehicles.
Judge Scheindlin’s opinion is here. These cases are pretty simple, as these things go, which is not particularly. Morgan Stanley and IKB structured some SIVs callled Cheyne and Rhinebridge, which sold among other things commercial paper (called “Senior Notes” in the opinion) with P-1/A-1/Aaa/AAA/etc. ratings and used the proceeds to buy what at least in hindsight* looks like a horrific pile of crap, with predictable (in hindsight (?)) results:
The Senior Notes had Top Ratings from their first sale to investors on or about June 27, 2007 to their downgrade to “junk” ratings on October 18 and 19, 2007. Thus, in less than four months, the ratings went from indicating an extremely low probability of default to indicating a near-certain likelihood of default. The Rhinebridge SIV was forced into receivership on or about October 22, 2007, becoming perhaps the shortest-lived “Triple A” investment fund in the history of corporate finance.
True? Anyway, if you were the person who bought these Senior Notes thinking that they were AAA safe assets, and they turned out to be garbage, you might think to yourself “what the heck am I paying Moody’s and S&P for?,” and then you’d notice that you weren’t paying them at all, but in any case something fishy was up. And you might sue them – alongside, IT GOES WITHOUT SAYING, Morgan Stanley and IKB and everyone else around – and hope to one day have your day in court to cross-examine the raters and be all “what type of animals would you say structured this deal?” and “I want the truth!” and stuff. Because … look, maybe the ratings agencies weren’t negligent in rating these things, maybe their models made sense at the time and were falsified by unexpected future events that no reasonable person could have predicted, but … I’m gonna guess that if this goes to trial they will look bad. I mean, they look bad already, no?
So that leaves the agencies with a strong preference for not going to trial, which fortunately for them they have ways to do.** Ways like claiming that the First Amendment protects their freedom of speech to express their opinion, which is … pretty weird, but the law. But in this case, the plaintiffs and the court found a way around that which is … even weirder. From a 2009 (it never ends!) opinion in the same cases:
It is well-established that under typical circumstances, 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. Here, plaintiffs have plainly alleged that the Cheyne SIV’s ratings were never widely disseminated, but were provided instead in connection with a private placement to a select group of investors. Thus, the Rating Agencies’ First Amendment argument is rejected.
The current effort to avoid trial runs along the lines of, sure the rating agencies might have been, say, “careless,” but that doesn’t make them liable under New York law, which requires (from the current opinion):
that (1) the defendant had a duty, as a result of a special relationship, to give correct information; (2) the defendant made a false representation that he or she should have known was incorrect; (3) the information supplied in the representation was known by the defendant to be desired by the plaintiff for a serious purpose; (4) the plaintiff intended to rely and act upon it; and (5) the plaintiff reasonably relied on it to his or her detriment.
There are two main lines of defense here; one is that a rating is just an opinion and not a “false representation,” but as the court says, “under New York negligent misrepresentation law, ‘even statements of opinion are actionable if they are made in bad faith or are not supported by the available evidence.'” The other is that there was no “special relationship” creating a duty not to lie (I know, weird, right?), which requires among other things that the rating agencies know more or less who they’re lying to, as opposed to just lying to the universe. Somewhat surprisingly, the court found that they did:
Because they were members of a select group of qualified investors, plaintiffs were known parties towards whom the Rating Agencies targeted their alleged misrepresentations …. [T]he select group of qualified investors towards which the Rating Agencies targeted their alleged misrepresentation is a “settled and particularized class.” Further, plaintiffs were known parties to the Rating Agencies because — prior to their
purchase of the Senior Notes — plaintiffs directly informed the Ratings Agencies that they rely on credit ratings in making investment decisions.
This … seems a little weird? Basically the point that Judge Scheindlin is making is that the people who bought the SIV notes were qualified institutional buyers under US securities laws, meaning that they were big “sophisticated” investors who could buy private 144A offerings rather than the disseminated-to-the-universe registered deals. If you work in capital markets you get used to thinking that everyone is a QIB – pretty much anyone who buys structured products and corporate debt is, anyway, which is how so many deals can be 144A – so it’s jarring to see a judge call QIBs a “select group.” But I guess they kind of are.
SIV and similar asset-backed deals, and many corporate debt offerings, are done under Rule 144A and limited to QIBs for a number of reasons. A big one is the speed of the process – you don’t need the SEC to review your offering so you can do it pretty much whenever you want, with your timing limited mainly by your ability to get a rating. Another big one, though, is limiting liability: by marketing only to QIBs who are more or less presumed to be “sophisticated,” and by avoiding the stricter liability standards of registered offerings, banks reduce their chances of being held liable if the offered securities go wrong.
But if Judge Scheindlin is right, then QIB-only offerings put rating agencies more at risk of liability. In a registered deal, where anyone could buy the securities, the agencies are protected by the First Amendment – and even if they weren’t, there’d be no identifiable class for them to have a duty not to lie to. In a 144A deal, the universe is limited enough that neither protection applies, and the agencies will be hauled into court and have to defend their ratings practices. Which one suspects will not be pretty.
That seems like a perverse result: sophisticated (heh, whatever), large institutional investors get more legal protections against bad ratings than mom and pop investors do. Maybe that doesn’t matter here – asset-backed securities are sort of forced into 144A for timing reasons, so it’s not like many of them were going to retail – but I wonder if at the margin this will push corporate debt offerings into registered deals, as agencies push banks to take more liability risk so that they can take none. I don’t know. But it does seem problematic to tell rating agencies that, if they want to get away with doing shoddy work that results in misleading ratings, all they have to do is issue those ratings to everybody.
* And quite plausibly in regular sight. From the opinion:
In structuring Rhinebridge, MS and IKB caused the SIV to acquire high-risk toxic assets — unbeknownst to investors, Rhinebridge held over a billion dollars worth of low-quality mortgage-backed securities, more than half of which IKB had transferred from its own balance sheet into the SIV’s portfolio. Morgan Stanley “caused” Rhinebridge to acquire “hundreds of millions of dollars of poor quality, toxic assets” that it knew IKB was trying to “unload.” It “coerced” the Rating Agencies to allow risky Home Equity Loans (“HELs”) to constitute up to seventy-five percent of Liquid Eligible Assets (“LEAs”) in the SIV, where most SIVs limit HELs to fifteen to twenty percent of such assets. It caused Rhinebridge to acquire approximately two-hundred and fifty million dollars in Countrywide securities – a single obligor exposure approximately three times higher than the four percent limit stipulated in the SIV’s operating instructions.
“High-risk toxic assets” doesn’t get me going the way it does for some people, but the “unloading” thing is troubling.
** Incidentally, so do the banks. One way that banks avoid trial is by all the settling. This makes more sense to them because it turns out they made lots of money on these deals and can afford to give some of it back in nine-figure settlements. The Abacus-Citi-whatever settlements are hundreds of millions of dollars against a backdrop of securitization businesses that made a lot more than that over the years; even IKB, in this case, managed to get ex-post-terrible assets off its books via these SIVs so saved itself a lot of losses and was probably pretty pleased about that. The agencies in these deals got paid 10bps-type fees, or $6mm for Cheyne, which is … kind of a lot for a rating, but still not enough to make hundred-million-dollar settlements for cases like this look attractive to them.