With all the hand-wringing over the role of Wall Street banks in the financial crisis, one group of key players in the mess has been keeping â?? and undoubtedly enjoying â?? a relatively low profile: the rating agencies.
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Remember Moodyâ??s and Standard & Poorâ??s, and all those triple-A ratings they assigned to subprime debt?
For the last two years, a series of lawsuits brought on behalf of investors against the rating agencies have been floating around the court system. The agencies have been trying to use a First Amendment defense, claiming that their reports, in which they assign various grades to securities to signal their riskiness to investors, should be granted the same free-speech protections as a newspaper editorial.
The biggest problem with that defense, of course, was that Moodyâ??s and S.& P., a unit of McGraw Hill, were being paid directly by the banks underwriting the securities, making the entire process seem, well, somewhat less than armâ??s length. Remember the whole business in the 1990s when banks were collecting fees on initial public offerings and other banking work in exchange for positive reports from their analysts? You get the idea.
So some intrepid investors recently took a different tack to go after the rating agencies. They get points for effort, even though they lost the case, which was decided two weeks ago but received little attention. Their case is a pointed lesson in how difficult it will be for investors trying to hold the ratings agencies accountable.
The investors in the case, which centered on $100 billion of mortgage-backed securities issued by Lehman Brothers, decided to sue the rating agencies on the basis that their involvement in the creation of the securities was so critical that they should be considered underwriters themselves under Section 11 of the Securities Act of 1933. (Of course, going after Moodyâ??s and S.& P. would seem easier than suing Lehman; it is harder to collect from Lehman, a bankrupt entity.)
The investorsâ?? argument was similar to one made by David J. Graisand Kostas D. Katsiris of the law firm Grais & Ellsworth, in 2007. They wrote a persuasive paper that suggested â??the rating agencies are not journalists gathering information and reporting to the public, but rather participants in the transactions that they rate.â?
So the plaintiffs argued that the rating agencies, rather than Lehman, as listed in the offering documents â??largely determined the composition of the securitized pool of loans, the amount and form of the certificatesâ?? levels of credit enhancement before the certificates were created and the ratings agencies were â??engagedâ?? to rate the securities.â?
That statement was not far off the mark. The role of the rating agencies, as documented in several of these cases, shows that the firms were intimately involved in the creation of these securities, from start to finish. They didnâ??t simply put their Good Housekeeping Seal of Approval on them in the form of triple A-ratings. They played a big role in putting them together.
The judge in the case, Lewis Kaplan, didnâ??t necessarily disagree with the investorsâ?? premise, writing in his decision that the role of the ratings agencies was â??no different than those of an architect or a builder in designing and constructing a house.â?
But in deciding to dismiss the case â?? and this is the crucial part â?? he ruled that, ultimately, the ratings agencies were not the owners of the house that was being resold to investors.
â??While it doubtless is true that the architect or builder had a lot to do with the characteristics of the house â?? no doubt characteristics that made it an attractive and salable product â?? they cannot properly be said to have participated in any legally relevant sense in its resale down the line,â? Judge Kaplan wrote.
The judge seemed to acknowledge that he might very well have found the rating agencies guilty. â??The collapse of the mortgage-backed securities market has been a national disaster. Many actors, quite likely including the rating agencies, contributed to the catastrophe,â? he wrote.
But that broader context could not be addressed in this case, he wrote, adding that the â??task before this court is a narrow one.â?
Some lawyers were outraged by the decision, saying that Judge Kaplan didnâ??t follow through with his analogy that ratings agencies were like architects: a homeowner can sue an architect for a design flaw if the house comes crashing down.
â??Judge Kaplanâ??s rejection of that theory undoubtedly will be influential in those other cases where the plaintiffs have attempted to assert Section 11 â??underwriterâ?? liability against the rating agencies,â? Kevin M. LaCroix, a lawyer and partner at OakBridge Insurance Services, wrote on his influential blog, The D&O Diary.
So pick your analogy. Are the ratings agencies like architects, or like a publishing company? Or perhaps something else? No doubt angry investors will keep looking for the one that will make them pay.
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