Article: November 2013 Securities Litigation Update

Rating Agency S&P’s “Puffery” Defense Rejected in U.S.’s Landmark Fraud Case Under FIRREA. Credit-rating agencies have successfully asserted several defenses to private investors’ fraud claims, including a First Amendment defense and the defense that credit ratings, as “opinions” rather than statements of fact, can be actionable only where the rating agency did not “genuinely believe” the rating was warranted. See, e.g., Abu Dhabi Comm. Bank v. Morgan Stanley, 2009 WL 2828018, *18 (S.D.N.Y. Sept. 2, 2009). More recently, however, in an action brought by the United States against ratings agency S&P under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), the court drew the line at S&P’s defense that its public pronouncements about its independence, objectivity and conflict controls were “mere puffery.” United States of America v. McGraw-Hill Companies, Inc. and Standard & Poor’s Fin. Serv. LLC, Case No. 13cv779 (C.D. Cal.).

In that case, the government sued S&P, alleging two fraudulent schemes under the mail, wire, and financial institution fraud statutes. First, the government alleges S&P defrauded investors by proclaiming on its website that its ratings were independent, objective, and uninfluenced by conflicts of interest, when S&P knew that it had altered CDO ratings models, and refrained from collateral downgrades, to preserve market share. Id. at 7-9. Second, the government alleges that S&P defrauded investors when it issued ratings for more than 700 CDOs between March and October 2007 that did not reflect its “true credit opinions.” Id. at 13-16.

“Deeply troubl[ed]” by the puffery argument mounted against the government’s first theory of fraud, the court disagreed with S&P that its public representations of independence and objectivity, as well as specific policies and procedures published on S&P’s website, were merely “aspirational” in nature. Rather, “they appear designed to induce reliance on current [conflict of interest] policies and practices.” Id. at 9.

Against the government’s second theory of fraud—false ratings on more than 700 CDOs issued between March and October 2007—S&P argued that the government neither pled the ratings’ objective falsity nor that S&P subjectively disbelieved them. Id. at 13. The court rejected this argument as well, holding that it was sufficient for the government to plead S&P’s knowledge that CDOs were backed by deteriorating RMBS collateral and that this should have affected S&P’s ratings, but that S&P failed to adjust those ratings when S&P issued them on the CDOs. Id. at 14. More fundamentally, the court held, by pleading that business considerations infected S&P’s ratings process overall, the government stated a claim that “none of S&P’s credit ratings represented the thing that they were supposed to represent, which was an objective assessment of creditworthiness.” Id. at 14 (emphasis in original).

Lastly, the court rejected S&P’s argument that the government’s case should be dismissed because the allegedly deceived parties—CDO investors—were not the parties from whom S&P schemed to obtain money; S&P’s fees were paid directly by issuers of CDOs, who the government claims remained undeceived by S&P’s schemes. Id. at 17. The court reasoned that S&P knew issuers routinely passed the costs of rating agency fees on to CDO investors, and thus these investors were in fact the persons who (indirectly) paid S&P. Id. at 18.

It remains to be seen whether the California district court’s approach, issued in a case involving the government as plaintiff under FIRREA, will have an impact in cases brought by private investors.