By orders dated September 1, 2009 and October 15, 2009, the U.S. District Court for the Southern District of New York granted in part, and denied in part, the defendants motion to dismiss in Abu Dhabi Commercial Bank et al v. Morgan Stanley et al, which names as defendants Moody’s Corporation (“Moody’s”) and McGraw Hill Companies (“McGraw Hill”) (collectively, the “Rating Agencies”). Also named as defendants are Morgan Stanley (the arranger and placement agent for the notes) and Bank of New York (the principal paying agent). The October 15, 2009 ruling confirmed that only the fraud cause of action survived the motion to dismiss as against the Ratings Agencies. A copy of the September 1, 2009 and October 15, 2009 rulings can be found here.
The plaintiffs, on behalf of a class of purchasers of capital notes backed by subprime mortgages issued by the Cheyne Special Investment Vehicle (“SIV”), alleged causes of action for breach of fiduciary duty, breach of contract, breach of the covenant of good faith and fair dealing, unjust enrichment, tortious interference, and common law fraud against S&P (owned by McGraw Hill) and Moody’s for their failure to analyze and to undertake a reasonable investigation of the collateral assets that backed the notes prior to issuing a credit rating. Specifically, the amended complaint, filed on March 31, 2009, attacked the Rating Agencies’ relationship with Morgan Stanley (the placement agent for the notes), alleging that the Rating Agencies worked directly with Morgan Stanley to structure the notes in such a way that they would qualify for the highest ratings. According to the plaintiffs, even after providing the initial ratings on the notes, the Ratings Agencies monitored the performance of the Cheyne SIV’s portfolio and provided instructions as to the types of assets the Cheyne SIV should acquire in order to maintain its high credit rating. In exchange for these services, the Rating Agencies received a fee at the “launch” of the SIV and also shared an annual remuneration based on the Cheyne SIV’s value. The plaintiffs alleged that the tying of performance of the Cheyne SIV to the fees paid to the Rating Agencies created an impermissible conflict of interest. The complaint targeted this conflict of interest as a basis for the common law fraud claims against the Rating Agencies.
The court also rejected the Rating Agencies’ contention that the First Amendment entitles them to immunity. Specifically, the court reasoned that the ratings assigned to the notes were not a matter of “public concern” and therefore could not be held to the heightened “actual malice” standard because the ratings were disseminated to a select group of investors in connection with a private placement. Further, the court rejected the Rating Agencies’ argument that the ratings assigned to the Cheyne SIV notes are non-actionable opinions. Here, the court found that the complaint sufficiently pled that the ratings were actionable misrepresentations rather than mere opinions because “the Rating Agencies did not genuinely or reasonably believe that the ratings they assigned to the [notes] were accurate and had a basis in fact.”
Having established that the ratings constituted potentially actionable misrepresentations, the court addressed the remaining elements of common law fraud. With respect to the knowledge element, the court found that the complaint adequately alleged that the Rating Agencies knew that even though the high ratings assigned to the notes made the notes appear as safe as corporate bonds, the SIV portfolio that backed the notes consisted of high risk mortgage-backed securities. In order to further support its conclusion that the Ratings Agencies had knowledge of the falsity of the ratings, the court pointed to the above-referenced conflict of interest that arose where the Rating Agencies assigned rating to an entity in which they have a financial stake.
With respect to the “scienter” requirement, the court concluded that the complaint alleged sufficient facts to support a plausible inference that the Ratings Agencies had motive and opportunity to issue false ratings. Again, the court cited the conflict of interest and the fact that the Rating Agencies had an incentive to assign high ratings not only to collect higher fees as value of the Cheyne SIV increased but also because Morgan Stanley, as the underwriter of the notes, would not have engaged the services of the Ratings Agencies unless the offerings were highly rated. Finally, the court found that the complaint adequately alleged reliance because the public had come to rely on the accuracy and independence of the Rating Agencies.
Finally, the court dismissed, with prejudice, the tort causes of action for breach of fiduciary, negligence, negligent misrepresentation, unjust enrichment and aiding and abetting on the ground that each cause of action was pre-empted by New York’s Martin Act, which grants the New York State Attorney General exclusive power to regulate the sale of securities in the state of New York. In support of its conclusion, the court found that a majority of the conduct underlying each of the tort-based causes of action occurred in New York.
Additionally, the court granted the Rating Agencies’ motion to dismiss with respect to the contract claims because the the complaint inadequately pled the existence of a contract between the plaintiffs and the Rating Agencies based on the offering documents.
Finally, the court dismissed the third party beneficiary claims, with prejudice, holding that the complaint failed to establish that the plaintiffs were an intended beneficiary of a contract between the Ratings Agencies and Morgan Stanley.
