In a April 26, 2010 opinion (here) that could have significant implications for motions to dismiss in the many subprime-related securities actions pending against the rating agencies, Southern District of New York Judge Schira Scheindlin rejected the arguments of Moody’s and S&P that the action investors in the Rhinebridge structured investment vehicle (SIV) should be dismissed because the investors’ losses were caused the global credit crisis rather than those firms’ investment ratings.

Background

The investor plaintiffs had filed a putative class action lawsuit for common law fraud in connection with the collapse of Rhinebridge. The action was brought against IKB Deutsche Industriebank AG and related entities; the rating agency defendants, including Moody’s and S&P; and certain individuals. (If IKB’s name sounds familiar, that is because it was one of the principal buyers in the now infamous Abacus transaction at the heart of the SEC’s action against Goldman Sachs.)

The plaintiffs contend that the defendants fraudulently misrepresented the value of Rhinbridge and its Senior Notes. These misrepresentations took the form of the high credit ratings assigned to the Notes. The Notes’ triple A ratings allegedly conveyed to investors that they were highly credit worthy and exceptionally strong, but also allegedly concealed that Rhinebridge’s portfolio actually consisted of toxic assets that were heavily concentrated in the structured finance and subprime mortgage industries. The Notes were downgraded in October, Rhinebridge entered receivership and the investors lost million of dollars.

S&P and Moody’s moved to dismiss on the grounds that plaintiffs allegations were insufficient to demonstrate loss causation, in that they failed to account for the global liquidity crisis that began in the summer of 2007.

The April 26 Opinion

Judge Scheindlin rejected the defendant rating agencies’ loss causation argument, observing that "to hold that plaintiffs failed to plead loss causation solely because the credit crisis occurred contemporaneously with Rhinebridge’s collapse would place too much weight on one single factor and would permit S&P and Moody’s to blame the asset-backed securities industry when the their alleged conduct plausibly caused at least some portion of plaintiffs’ losses."

She added that "even if the existence of the credit crisis—standing alone – could be enough to defeat a plaintiffs’ pleading of loss causation, it is not apparent that the credit crisis was the sole cause of Rhinebridge’s collapse."

Judge Scheindlin also noted that "S&P and Moody’s may yet prevail at a later stage in this case," adding that "if defendants ultimately prove that plaintiffs’ losses were, in fact, cause entirely by an intervening event, then defendants will prevail either at summary judgment or at trial."

Judge Scheidlin declined to find, as plaintiff had urged, that the rating agencies were "one of the major causes" of the global financial crisis. She observed that:

Blame for the financial crisis can be, and had been, spread globally – from the financial sector’s increasingly complex financial products, to mortgage originators, to the government’s loosened regulatory practices and its failure to respond to the collapse and substantial weakening of multiple financial powerhouses. While the Rating Agencies’ actions may have been a "substantial factor" causing the loss, that is not tantamount to labeling their conduct a "major cause" of the global financial crisis.

Discussion

While numerous subprime and credit crisis-related lawsuits have been filed against the rating agencies have been filed and are slowly working their way through the courts, the fundamental questions of whether and under what circumstances the rating agencies might be held liable to investors are yet to be worked out.

Even before those basic liability issues can be addressed, the threshold pleading issues still have to be sorted out. Judge Scheindlin emphatically did not hold that the rating agencies can be liable. However, her April 26 opinion does represent a strong signal that the rating agencies will not get off the hook merely because there was a larger financial crisis beyond the rating agencies’ actions in connection with the specific transactions.

To put everything under the heading of the credit crisis, Judge Scheindlin held, would be to permit the rating agencies to "blame the asset-backed securities industry when the alleged conduct plausibly caused at least some proportion of plaintiffs’ losses."

So it remains to be seen whether the rating agencies may be held liable. But Judge Scheindlin’s opinion suggests that the rating agencies will not be able to get the cases against them dismissed on the simple theory that the credit crisis and not their rating actions caused investor losses, where plaintiffs have plausibly alleged that the rating agencies cause some proportion of the losses.

This holding potentially removes at least one threshold barrier to the question of ultimate liability, at least for purposes of the pleading stages, and reduces the extent to which the rating agencies may be able to rely on the "coincidence" of the global credit crisis as an out from the cases against them.

For my discussion of Judge Scheindlin’s opinion in a separate subprime lawsuit against the rating agencies in which, on the facts alleged, she held that the rating agencies were not entitled to dismissal on the grounds that their ratings were protected by the First Amendment, refer here.

The WSJ.com Law Blog’s post on Judge Scheindlin’s opinion can be found here. Andrew Longstreth’s April 27, 2010 Am Law Litigation Daily article about the decision can be found here. .

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