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This Election Day, Remember Your Constitutional Right To Carelessly Misrate Structured Credit Products

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Have you finished reading Judge Jayne Jagot's 43,000-page opinion in the Australian CPDO case yet? Good, because we've got to move on to other things.1 Like: what does it all mean?

One obvious thing that it could mean is "nothing," or at least not very much. The case involved $30 million of damages, and there seems to be an Australian class action coming that might involve more damages, but it seems unlikely that CPDOs are going to track S&P across the globe to haunt its bovine dreams. Euromoney points out some of the many barriers to suing, though it adds:

In the case of CPDOs, however, of which around $5 billion were issued, there might be impetus for investors to follow the Australian councils’ lead. The firm that funded their litigation, IMF Australia, is believed to be examining the viability of further claims in Europe (CPDOs were largely arranged by European banks and sold in Europe).

Here in America, though, S&P seems safer. Here's the FT:

Floyd Abrams, an attorney for S&P, says: “It is highly unlikely that this Australian court opinion will have any significant impact elsewhere. The case does not involve mortgage-backed securities. And the ruling does not recognise – as courts in the US and elsewhere generally have – that ratings are opinions which are not actionable unless disbelieved by those that issued them.”

They also point out that the statute of limitations will protect most crisis-era ratings at this point. And here's John Carney:

The ratings agencies are shielded by the First Amendment because what they do is offer opinions about the quality of debt, companies, and other financial products. Except in some limited cases, the "end-users" of these opinions — investors — don't have any explicit right to rely on them that would give rise to agency liability.

So: not always! The ratings agencies tend to get off pretty easy on U.S. lawsuits on First-Amendment and that's-just-like-your-opinion-man grounds, but sometimes they don't. It depends on who they're rating things to, and how sloppily they do the rating. In particular the Cheyne SIV case still kicking around in federal court in New York rejected both of those defenses; from a 2009 opinion:

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.

I also reject the argument that the Rating Agencies' ratings in this case are nonactionable opinions. "[A]n opinion may still be actionable if the speaker does not genuinely and reasonably believe it or if it is without basis in fact." For the reasons discussed below, plaintiffs have sufficiently pled that the Rating Agencies did not genuinely or reasonably believe that the ratings they assigned to the Rated Notes were accurate and had a basis in fact.

So there is a path forward to suing ratings agencies for terrible ratings, as long as the terribly rated products were only marketed to a "select group" of buyers, where "select" sort of sounds like "elite" but probably means more like the opposite. "Congratulations, you are part of a select group of investors who have been offered the opportunity to buy this timeshare!" etc.

The CPDO product was marketed pretty widely, but its US marketing was limited to qualified institutional buyers under Rule 144A - which a court could read (as the New York court did) as "a private placement to a select group of investors." And did S&P reasonably believe its rating and have a basis in fact for it? Umm not according to the Australian judge's 114,000-page opinion; Felix Salmon's synopsis hits the highlights of devastating unreasonableness and basislessness-in-fact. Basically any number you could input into the model, they used a crazy-wrong number.

In short it's actually pretty easy to imagine a U.S. court ruling exactly the same way as the Australian one did here. That doesn't mean that one will - the statute of limitations has likely run for most CPDOs, and anyway if they were mostly sold in Europe then they won't be mostly sued-over here. (One credit derivatives guy told me that he's unaware of any being sold here and that "among our clients in the US there was no way anybody was going to fall for that." Go America!) But, y'know, the next deal. S&P will have to be more careful in the next deal. In theory.

When I first wrote about that New York case, I was kind of weirded out by the fact that "qualified institutional buyers" - sophisticated investors - got more legal rights against the rating agencies than public investors do. You market a deal to everyone, the rating is a First-Amendment-protected opinion; you market it only to sophisticated investors, and the agency may have a duty to them. That seems a little less creepy after spending some time with CPDOs: with a modest step-up in investor sophistication you get a vast increase in product befuddlement. Which makes sense: selling CPDOs to anyone seems disreputable, but selling it to individual retirees is worse; there's some thin veneer of respectability to saying "we sold this to QIB hedge funds and not middle-class retirees," so some of the creepiest things were built for supposedly-sophisticated audiences.

It does make sense to hold S&P more to account for rating creepy bespoke things than for expressing its opinion on the credit quality of Microsoft or Bank of America or the United States. Everybody's got a view on the latter issues, and nobody should really rely on ratings agencies to do their corporate credit homework. But on creepy custom things you perhaps have more of an excue for relying on the rating; S&P's structured-credit expertise, if it had, y'know, existed, could have been useful to potential CPDO investors.

Incidentally: the new law that lets you advertise your hedge fund on Dealbreaker also lets you market other private placements of securities broadly: you can only sell to qualified institutional buyers, but you can, like, send the termsheet to anyone you want. This means that if you want to market a newfangled CPDO now, and you manage to get a AAA rating, you can just blast out the marketing documents - and the rating - to everyone. This may or may not be helpful to your marketing efforts - but it would seem to throw a blanket of First Amendment protection over the rating. Which, if it's as bad as the last set of CPDO ratings, would be well advised.

Australian CPDO court ruling unlikely to inflict wider damage on rating industry [Euromoney]
Copycat litigation threat for rating agencies [FT]
A New Idea of How to Fix the Ratings Agencies [CNBC]

1. Unless of course: you'd like to move backwards to more CPDO lore. Here is a Federal Reserve paper on CPDOs that treats them as an actual economic activity rather than a ratings arb, though you can tell they're a little uncomfortable: "These arguments lend plausibility to the CPDO as a trading strategy. Many hedge funds and asset managers are active in the CDS markets, and it would not be surprising if some of these institutions were pursuing a strategy along these lines. What is less obvious is the rationale for structuring CPDO liabilities as debt rather than as equity." Here is FT Alphaville's wonderful million-part series on CPDOs, in which they catch Moody's doing an even worse job of rating them.


Today In Swiss Banks With Creepy But Defensible Structured Products

I don't really understand it but the TVIX thing is creepy fun. If you haven't followed it, Credit Suisse issued this exchange-traded note called TVIX that was a 2x levered bet on the VIX. They suspended new issuance about a month ago due to position limits, and people were just so damn excited to own the thing that its price crept up to 189% of its fair value, where "fair value" is a reasonably easily measurable thing based on the formula in the TVIX prospectus. Then last week Credit Suisse announced that they would be creating more units, and the price plummeted to and then through fair value, which is what you'd expect to happen. Except that it started plummeting a few hours before that announcement, which is Suspicious. So of course people are sad and so there's a Bloomberg Brief with sort of sad-funny quotes like: “When it started to fall, I bought more because I couldn’t believe how low it was going. I didn’t realize I was playing with a hand grenade.” – Michael Gamble [heh! - ed.], 67, who doubled down on his TVIX investment before the price collapsed. Investors “all think: ‘Oh, I’ll just buy these things, I’ll be hedged against volatility and everything will be wonderful.’ And now they’ve seen the market goes down and their volatility protection goes down too, and they’re going ‘Hmm, what happened here?’ These people are going to have to pay a really expensive lesson.” – Larry McMillan, who manages $30 million as president of McMillan Analysis Corp. So, yes, Larry, they are going to pay a really expensive lesson. But what is it? Stephen Lubben has a little thing in DealBook today where he frets: