Calpers lawsuit tests ratings agency liability in defaults

A lawsuit filed by the California Public Employees' Retirement System (Calpers) against ratings agencies over "wildly inaccurate" ratings of now-defunct structured investment vehicles (SIVs) has the potential to become a landmark case, securities litigators have said.

On July 9, attorneys for Calpers, the largest public pension fund in the US, filed suit at the Superior Court of California against Moody's Investors Service, the McGraw-Hill Companies – parent of Standard & Poor's –and Fitch Ratings over "negligent misrepresentations" the agencies made regarding the creditworthiness of three SIVs in which Calpers had invested $1.3 billion.

The SIVs – Cheyne Finance, Standfield Victoria Funding and Sigma Finance – carried AAA ratings from some or all of the agencies. Despite this, the vehicles collapsed in 2007 and 2008 as liquidity in commercial paper markets evaporated, leading to a loss of more than $1 billion for Calpers.

The lawsuit alleges the agencies applied "unreasonably high" credit ratings to the SIVs, and that the methodology used to rate the vehicles and the assets underlying them was "seriously flawed in conception and incompetently applied".

However, some litigators question whether a $186 billion pension fund can reasonably argue it relied solely on the evaluation of rating agencies, and was unable to conduct any due diligence of its own into the assets underlying the vehicles. Furthermore, they add, if it was concerned at the lack of transparency surrounding the underlying assets, should it have gone ahead with the investment?

"If Calpers alleges it had no other means of evaluating the contents of the SIVs I would expect the rating agencies to ask: who does it think it is kidding? Are we expected to believe it does not have the economic leverage to demand more disclosure about an SIV it is interested in investing in?" commented Carolyn Nussbaum, a partner in the financial services and securities litigation group at law firm Nixon Peabody in Rochester, New York.

Another obstacle Calpers will have to overcome is the clear legal position that no contractual relationship exists between a rating agency and an investor who ultimately buys a rated security. "They make numerous disclaimers to make that clear and the law is pretty consistent that ratings do not constitute due diligence," explained Peter Haveles, a New York-based partner in the financial services litigation department at law firm Kaye Scholer.

In similar litigation in the past, rating agencies have successfully argued they are protected by the First Amendment and, like journalists, are a neutral third party simply publishing their opinion on whether an asset will pay back principle and interest in a timely fashion.

That defence has been challenged in recent years in a number of lawsuits that have sought to argue rating agencies have been actively involved in engineering higher ratings. In addition, litigators remark upon the "patent absurdity" of regarding agency ratings – of fundamental importance to global capital markets – as comparable to the work of journalists.

"This could be a case where the rating agencies' ability to rely on the journalist's privilege will be tested. The plaintiff's allegations about the agencies' involvement in structuring transactions, and their financial interest in getting transactions rated as highly as possible, could deprive the agencies of the protections of the First Amendment in this case," said Jeff Gilbert, a partner in the regulatory litigation group at law firm Reed Smith in Chicago. "I would expect the plaintiff to argue negligent conduct is sufficient to prove the agencies' liability, and that they weren't acting as journalists but interested participants in the investments they were rating."

The financial interest of agencies in the transactions is a major tenet of Calpers' suit, which alleges that "because agencies would not get their full fees unless the issuance of a SIV was completed and the target rating attained, they were highly incentivised to get deals done and the products marketed to investors".

The defendants have denied suggestions they took an active role in structuring deals to secure the highest possible creditworthiness. "While Moody's may comment on the potential credit implications of structural elements of a security, we do not engage in designing, structuring, or marketing securities of any type – that is the role of the underwriter. Our role is simply to offer reasoned, forward-looking opinions on credit risk. Moody's believes it has strong defences to all of the litigations that have been filed against it, and will seek to dismiss the Calpers complaint at the earliest appropriate opportunity," the agency said in a statement.

S&P similarly dismissed the case, saying "the claims asserted by Calpers are without legal and factual merit and we intend to defend against them vigorously". Fitch declined to comment. 

See also: Sell suits 
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