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S&P Has A Perfectly Good Explanation For Rating Deals "Structured By Cows," Which A Lucky Federal Jury Will Get To Hear

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If someone builds structured credit securities out of some dodgy stuff, and someone else rates those securities AAA for no particularly good reason, and someone else sells those securities to you without reading the offering memo, and you buy those securities without any due diligence since you figure that the structurer and rater and broker wouldn't all be messing with you, and it turns out they were, and the stuff blows up, and you end up losing a lot of money on the AAA rated securities, the natural question for you to ask, this being America, is: whose fault was that?

That question is being asked in all the best circles these days, and the answer is probably "everybody's," as it usually is. One place it's being asked and slooooowly answered is in a New York federal court considering the case of the Cheyne Finance SIV, which is special for at least two reasons. First: there is a widespread belief that credit ratings are opinions, and opinions are protected by the First Amendment, and so you can't restrict the creativity and expression of those free spirits and S&P by suing them when their opinions turn out to be, well, wrong. But for (weird!) reasons we've discussed, the judge in this case, Shira Scheindlin, is unimpressed by those arguments, so this is a rare lawsuit against ratings agencies that may actually go to trial.

Second: this SIV may - may - have been the origin of "structured by cows."*

Anyway the case lurched forward incrementally on Friday when the judge denied summary judgment on most of the fraud claims, basically finding that there's enough evidence to ask a jury whether Moody's and S&P gave Cheyne top ratings that, in the words of her ruling, "both misstated the opinions or beliefs held by the Rating Agencies and were false or misleading with respect to the underlying subject matter they address." That evidence unsurprisingly includes the cows thing, as well as a few other choice quotes from rating agency employees who probably should not be allowed near IM or email ever again.**

But Friday's decision was actually a mixed bag, allowing most of the claims against Moody's and S&P to go forward but dismissing a bunch of claims. And the actions that were dismissed make for an interesting list. In particular, Morgan Stanley, which structured the Cheyne SIV and - according to one complainy Morgan Stanley structurer - actually wrote the Moody's rating report on the deal,*** can't be held liable for fraud:

Morgan Stanley now argues that it cannot be liable for fraud because as a matter of law, the ratings — which are the only alleged misstatements — are attributable solely to the Rating Agencies. ... [B]ecause the ratings cannot be attributed to Morgan Stanley, the fraud claim against Morgan Stanley is dismissed.

Morgan Stanley is still in the case for "aiding and abetting" Moody's fraud, which is ... weirdly backwards is it not? Morgan Stanley conceived of this SIV, built it to maximize its ratings, and then sold it to investors and took the bulk of the revenue for it, giving the agencies a relatively small cut. But because it was sold mainly on ratings, and because Moody's and S&P issued those ratings, they are the only ones who may be held liable for fraud.

Also dismissed: the fraud claims of one SEI Investments, which ran some money market funds that bought Cheyne notes. SEI's problem is that it actually thought about its investment decision instead of relying blindly on the ratings:

SEI is suing on investments made by an investment advisor, Columbia Management Advisors (“CMA”). Defendants provide evidence that CMA expressly disagreed with the ratings, and argue that CMA therefore could not have relied on the ratings in deciding to invest in Cheyne on behalf of the SEI Funds. ... CMA testified that: (1) its own analysts did an extensive analysis which did not rely on and was independent of the ratings; and (2) it could consider notes which lacked a “Tier 1” rating. In sum, SEI has provided no evidence that the actual ratings issued by Moody’s and S&P were a substantial factor in CMA’s decision to invest. Accordingly, SEI’s claims are dismissed.

So if you blindly rely on ratings, and things go south, you can (potentially) get damages from the rating agencies. If you do an independent analysis - along with considering the rating - and invest anyway, you're on your own.

It is not particularly easy to parcel out who should be blamed for structured finance deals gone kaput, and it's hard not to be sympathetic to Judge Scheindlin's conclusion that if you are in the business of rating securities you should at least either believe your ratings or get them right. Still isn't it weird to put the primary responsibility to the agencies, and to kick out of the suit anyone - buyer or seller - who gave these securities any independent thought? In a post-crisis world that is trying to move away from reliance on credit ratings agencies, that seems like an oddly backwards results.

Abu Dhabi Commercial Bank v. Morgan Stanley & Co. [SDNY]
Moody’s, S&P Must Face Fraud Claims In Subprime Suit [Bloomberg]

* But that's for a jury to decide. From the opinion, at footnote 148:

Shah, Rahul Dilip (Structured Finance — New York): btw - that deal is ridiculous
Mooney, Shannon: i know right . . . model def does not capture half of the rish
Mooney, Shannon: risk
Shah, Rahul Dilip (Structured Finance — New York): we should not be rating it
Mooney, Shannon: we rate every deal
Mooney, Shannon: it could be structured by cows and we would rate it
Shah, Rahul Dilip (Structured Finance — New York): but there’s a lot of risk associated with it — I personally don’t feel comfy signing off as a committee member.

While the above conversation took place after the Cheyne SIV launched, it is unclear to which deal the analysts are referring. There is an issue of fact as to whether it discusses Cheyne. Even if it refers to the rating of other SIVs, if such evidence is admissible, a jury could infer from it that S&P was in the practice of issuing ratings that it did not believe were accurate.

** So the thing where when you email yourself an attachment from Bloomberg, and the attachment contains a dirty word, and Bloomberg sends you an auto-generated and non-forwardable scolding saying ...

Your email was sent. However, on subsequent inspection it was found that it may have violated one or more compliance policies as detailed below:
The following word(s) or phrase(s) in attachment(s) are inappropriate for business. Please consider revising this word/phrase:


... while super-annoying and presumptuous (how would you know what word(s) or phrase(s) are inappropriate for my business, Bloomberg?), is also useful, because now I knew to search this judicial opinion for "fucking." Footnote 149:

In one striking example, upon receiving pressure from Morgan Stanley to grandfather existing deals, an S&P employee wrote to another S&P employee: “Lord help our fucking scam . . . this has to be the stupidest place I have worked at.”

WHAT OTHER PLACES HAS (S)HE WORKED AT? That seems important to evaluating this statement.

*** "Plaintiffs nonetheless argue that Morgan Stanley authored the rating report based on an e-mail in which a Morgan Stanley employee says 'I attach the Moody’s [NIR] (that we ended up writing).'" Heh! Also: context! Is that, like, "don't worry, boss, this report is good because we wrote it"? Or is it more like "ugh, my life is so hard, not only do I do my own demanding job but I also do every other incompetent's job for them"? Surely the latter, right?