CalPERS’ Suit Against Ratings Agencies Survives

On September 10, the California Supreme Court declined to review the latest ruling allowing the lawsuit to proceed. The lawsuit, filed in 2009, focuses on a form of debt called structured investment vehicles (SIVs), complex packages of securities made up of a variety of assets, including subprime mortgages. CalPERS invested $1.3 billion in them in 2006, only to see their value collapse in 2007 and 2008. 

In its suit, CalPERS alleges that in giving these packages of securities the agencies’ highest credit rating, the three top ratings agencies—Moody’s Investors Service, Standard & Poor’s (S&P) and Fitch Ratings—”made negligent misrepresentation” to the pension fund. The AAA ratings given by the agencies “proved to be wildly inaccurate and unreasonably high,” according to the suit, which also said that the methods used by the rating agencies to assess these packages of securities “were seriously flawed in conception and incompetently applied.”

In 2010, a trial court moved the case forward, finding that dismissal would be improper because CalPERS successfully demonstrated a probability of prevailing on the merits of its claim of negligent misrepresentation.

Moody’s Investors Service and Standard & Poor’s appealed the court’s decision, arguing, for one thing, that their ratings are opinions protected under the U.S. Constitutional right to free speech. However, according to the opinion of the Court of Appeal of the State of California, 1st Appellate District, CalPERS, citing a previous appellate court ruling, noted: “Under certain circumstances, expressions of professional opinion are treated as representations of fact. When a statement, although in the form of an opinion, is ‘not a casual expression of belief’ but ‘a deliberate affirmation of the matters stated,’ it may be regarded as a positive assertion of fact. Moreover, when a party possesses or holds itself out as possessing superior knowledge or special information or expertise regarding the subject matter and a plaintiff is so situated that it may reasonably rely on such supposed knowledge, information or expertise, the defendant’s representation may be treated as one of material fact.”

The court agreed with CalPERS that the rating agencies published the ratings from a position of superior knowledge, information and expertise regarding the SIVs’ composition, underlying structure and function that was not generally available in the market. “More specifically, we conclude this evidence reflects not only that the agencies employed superior knowledge and special information and expertise to assign ratings to the SIVs, they employed their special knowledge, information and expertise to participate in, and exert control over, the very construction of the SIVs.  As such, we agree with CalPERS a prima facie case has been made that the ratings are actionable as ‘professional opinions’ or ‘deliberate affirmations of fact’ regarding the nature and quality of the SIV product,” the court said in its opinion.

The court based its decision on certain declarations in the evidence, including that of the former Standard & Poor’s Director in the Structured Finance Rating Group involved in rating the SIVs: “Standard & Poor’s (in conjunction with the other rating agency(s) participating in the deal) sets the requirements for portfolio composition, capitalization, capital sufficiency, and the management of market and liquidity risk associated with the asset portfolio.[¶] With regard to [SIVs,] Standard & Poor’s actively influenced the structure and amount of the debt issued.”  Further, “[i]f the [S&P] criteria was not applied as directed by [S&P], then the issuer could  not achieve its desired rating of AAA/A-1+, which in practice meant the SIV would not be rated at all.”  

The former Moody’s Senior Credit Officer described the overall SIV industry as existing in a “shroud of secrecy.” Noting that “the typical CP and MTN program documents for a SIV discuss only in general broad strokes the potential asset composition of the SIV’s portfolio,” he explained that, “[i]n fact, actual portfolio composition is a highly held secret for SIV’s, and even within Moody’s such information is only shared on an as-needed basis.” He also attested that, “[w]hile Moody’s analysts would not build or personally review the SIV’s capital model, they would request the manager to run various permitted portfolio compositions and stress scenarios until Moody’s judged that the model showed reliable results within the specifications Moody’s required.”  

Further, while the operational requirements of the SIVs were set forth in legal documents to which the rating agencies were not party, the agencies nonetheless “required that the actual parties to such documents not adopt any substantive or material amendments without obtaining a prior written confirmation from each of them that such proposed amendment or change would not cause them to downgrade or withdraw any of its ratings by altering the structure of the SIV that the agencies had approved.” 

The appellate court also found some declarations sufficed to prove on first impression a case the ratings agencies lacked a reasonable basis for believing the accuracy or truthfulness of their ratings, and that the agencies supplied their ratings with knowledge of the existence of a well-defined type of transaction which the ratings were intended to influence. 

The appellate court’s opinion is here.