SEC Staff Report On Credit Rating Agencies: Conflicts

The SEC staff issued a summary report discussing its examinations of three credit rating agencies which were key in the subprime residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDO”) markets from January 2004 to the present. The report raises significant questions about the procedures and conflicts of three key rating agencies in those markets, Fitch Ratings, Ltd, Moody’s Investor Services, Inc. and Standard & Poor’s Ratings Services. Summary of Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, July 2008, (“Report”).

The Report begins with an overview of the regulatory structure and the RMS and CDO markets. The existing regulatory structure stems from The Rating Agency Reform Act of 2006 (“Act”). That Act provided for registration in certain instances and added Section 15E to the Exchange Act. The Act also amended Exchange Act Section 17(a), giving the SEC authority to require reporting and record keeping requirements and examination authority. The 2006 Act however expressly prohibited the SEC from regulating the substance of credit ratings. In June 2007, the SEC adopted certain rules to implement these provisions.

Key findings from the Report include:

? Some rating agencies appeared to struggle with the substantial growth in the RMBS and COD deals. The internal documents from two rating agencies suggest a struggle to handle the work load. For example, one internal e-mail notes in part that an issue had been “poorly addressed – needs to be checked in the next deal … .” Report at 12, n. 7. Another e-mail states in part that “the rating agencies continue to create an ‘even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters. ;o)’.” Id. at n. 8.

? Relevant rating criteria were not always disclosed, although the agencies made claims to the contrary. In some instances there was a lag between the time the firm implemented changes to its criteria and the date at which it published notice of the changes. In some instances, e-mails indicated that the firm used an unpublished model to assess data.

? None of the rating agencies had specific written procedures for rating RMBS and CDOs. In addition, the agencies did not appear to have specific policies and procedures to identify or address errors in their models or methodologies. Likewise, the agencies did not always document significant steps in the process, including the rationale for deviations from their model and for Rating Committee actions and decisions.

? Instances were discovered where the rating agencies failed to follow their internal procedures.

? While rating agencies are required to establish, maintain and enforce policies and procedures reasonably designed to address and manage conflicts of interest, there are, in fact, significant conflicts.

a) In the “issuer pays” model, the arranger or other entity that issues the security also seeks the rating. While each agency has policies and procedures which address this, those policies allow key participants in the rating process to participate in fee discussions. Indeed, the Report found that rating agencies do not appear to prevent consideration of market share and other business considerations.

b) One e-mail quoted in the Report noted: “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision [on assigning separate ratings to principal and interest] and if so, how much?” Id. at 26.

c) Another quoted e-mail notes in part: “[w]e are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals.” Id. at 26.

d) According to the Report, there are conflicts with respect to all asset classes that receive rating but in the “issuer pays” model in rating “structured finance products, particularly RMBS and related-CDOs, [it] may be exacerbated … the arranger is often the primary designer of the deal and as such, has more flexibility to adjust the deal structure to obtain a desired credit rating as compared to arrangers of non-structured asset classes. As well, arrangers that underwrite RMBS and CDO offerings have substantial influence over the choice of rating agencies hired to rate the deals.” Id. at 31.

In the wake of the recent market turmoil, and as the staff conducted the inspections which resulted in the Report, the SEC proposed additional Rules in June 2008. Proposed Rules for Nationally Recognized Statistical Rating Organizations, June 16, 2008. These Proposed Rules are keyed in part to the findings in the Report.

Part XI: Securities Class Actions: Current And Emerging Trends

Another theory of loss causation being utilized by the court’s following Dura is materialization. The court in Glover v. Deluca, 2006 WL 2850448 (W.D. Pa. Sept. 29, 2006) defined the requirements for using this theory, noting that “where the alleged misstatement conceals a condition or event which then occurs and causes the plaintiff’s loss, it is the materialization of the undisclosed condition or event that cause the loss.” To use this theory, the plaintiff must first identify the risk that is concealed. That specific risk must later “materialize” to establish loss causation.

If the concealed risk appears or materializes, loss causation is established. In Teamsters Local 445 v. Bombardier, 2005 WL 218919 (S.D.N.Y. Sept. 6, 2006), the complaint alleged that there were misrepresentations and omissions regarding the integrity of the underwriting standards for securitized interests in a pool of mortgages. Plaintiffs claimed that loss causation was adequately pled because the complaint alleged that the disclosure of any exceedingly high delinquency rate for the mortgage pool caused the price to drop. District Judge Scheindlin held this sufficient, noting that a corrective disclosure was not required where the concealed fact materializes.

Judge Kaplan came to a similar conclusion in In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 510 (S.D.N.Y. 2005). There, plaintiffs alleged sham transactions undertaken to aid Parmalat in concealing its true financial condition. The scheme involved the use of worthless invoices to conceal the fact that Parmalat could not pay its debt. The scheme emerged or materialized because of the increasing delinquency rate for the invoices.

In contrast, where sufficient facts do not materialize to reveal the truth to the markets, loss causation has not adequately been pled. In In re Initial IPO Sec. Litig., 399 F. Supp. 2d 261 (S.D.N.Y. May 6, 2006), the complaint alleged in part that the defendants discounted earnings estimates so that companies could beat the estimates. As a result, the share price became inflated. The scheme materialized, according to the complaint, when the companies failed to meet earnings and the financial statements became available. District Judge Scheindlin, who also wrote the opinion in Bombardier, rejected the claim holding: “The fact that an event – in this case a failure to meet earnings forecasts or a statement foreshadowing such a failure – disabused the market of the belief does not mean that the event disclosed the alleged scheme to the market.” In a subsequent opinion, the court amplified its holding, noting: “Because plaintiffs do not allege that the scheme was ever disclosed, they fail to allege loss causation.”

In contrast, where the truth leaks out and its impact cannot be distinguished from other market events, the theory fails. Thus, in In re Williams Securities Litig., 496 F. Supp. 2d 1195 (N.D. Okla. July 6, 2007), the court held that a plaintiff relying on this theory “must provide proof that the market recognized a relationship between the event disclosed and the fraud.”

Other key loss causation questions concern how much truth must be revealed and the impact of other causes. In In re Retek Sec. Litig., 2005 WL 3059566 (D. Minn. Oct. 21, 2005), the court held that Dura is satisfied at the pleading stage if part of the truth emerges. There, a financial fraud compliant was held sufficient on a motion to dismiss where it alleged four interconnected schemes and the price dropped when a press release revealed one of the schemes. If, however, the complaint is based multiple, separate schemes, one of which is revealed, Dura is only satisfied as to the one. See, e.g., Marsden v. Select Medical Corp., 2007 WL 1725204 (E.D. Pa. June 12, 2007).

Finally, at the pleading stage it is not necessary to establish the sole cause of the loss to satisfy Dura. In In re Daou Systems, Inc., 411 F.3d 1006 (9th Cir. 2005), the complaint alleged a financial fraud in which revenues were overstated. By the third quarter the financial condition of the company was deteriorating. When the quarterly results were announced, the price of the stock dropped. An analyst report suggested that the company was “cooking the books.” The circuit court reversed a district court order dismissing the complaint. The court held that the plaintiff is not required to show that the misrepresentations are the sole cause. Rather, plaintiff is only required to demonstrate that it is “one substantial cause” of the decline. The fact that there are other contributing causes will not bar recovery, according to the court. See also In re Winstar Comm., 2006 WL 473885 (S.D.N.Y. Feb. 27, 2006) (the source of the information need not be the company; what is critical is that the truth emerges); see also In re Acterna Corp., Sec. Litig., 378 F. Supp. 2d 561 (D. Md. 2005) (general declining economic conditions not sufficient).

Next: Conclusions