Morgan Stanley successfully pushed Standard & Poor’s and Moody’s Investors Service Inc. to give unwarranted investment-grade ratings in 2006 to $23 billion worth of notes backed by subprime mortgages, investors claimed in a lawsuit, citing documents unsealed in federal court.
According to the plaintiffs, the documents reveal that what the ratings companies describe as independent judgments were actually unsupported by evidence and written in collaboration with the bank that was packaging the securities. Morgan Stanley and the ratings companies deny the allegations.
Executives at the ratings companies failed to warn investors about the risks associated with subprime-backed notes that were issued by a unit of London-based hedge fund Cheyne Capital Management Ltd., the investors claimed. Moody’s and S&P sought to reap financial rewards from doing business with Morgan Stanley, the sixth-largest U.S. bank by assets, they alleged, citing court filings unsealed yesterday in Manhattan.
“All of us were under instructions to rate everything that we could bring in the door, and they were measuring market share on a monthly basis,” Frank Raiter, a former analyst of residential-mortgage bonds at S&P, said in a deposition, according to the documents. “I wasn’t real confident we were doing a very good job at it.”
U.S. District Judge Shira Scheindlin last month dismissed some claims against the defendants, while allowing the investors to proceed on a claim of negligent misrepresentation. In 2009, she rejected an argument that the ratings were protected speech under the U.S. Constitution.
The unsealing of the internal documents from Moody’s and Standard & Poor’s came in one of the largest ratings lawsuits to emerge from the 2008 financial crisis. The lawsuit was filed in 2008 by Abu Dhabi Commercial Bank, based in the United Arab Emirates, and Washington’s King County, which includes Seattle.
The case focuses on notes issued by Cheyne Finance Plc, a so-called structured-investment vehicle that collapsed in 2007. SIVs issued short-term debt to fund purchases of higher-yielding long-term notes and failed when credit dried up amid the financial crisis, sparked by investments in mortgage-backed securities.
The Cheyne SIV declared bankruptcy in August 2007 when borrowers defaulted on the mortgages that secured the notes, according to the 2009 ruling. Holders of the notes that were initially rated AAA got back little of their investment and some other securities turned out to be worthless, the judge said.
As Morgan Stanley bankers were designing the Cheyne notes, they asked Moody’s to use the same volatility assumptions for subprime-backed mortgage securities as for those that had prime home loans as collateral, the investors allege in yesterday’s filing. The ratings company agreed, the investors claim.
“We in fact built everything,” Dorothee Fuhrmann, an executive for New York-based Morgan Stanley, said according to the documents, allegedly referring to the risk-analysis methods applied to the Cheyne ratings.
The investors are using e-mails “chosen from thousands of pages of documents” out of context to support a “baseless” case, Ed Sweeney, a spokesman for S&P, said in a statement.
Mary Claire Delaney, a spokeswoman for Morgan Stanley, said that the investors’ allegations are “without merit.”
“Our rating opinions in this case were, as always, fully independent,” Michael Adler, a spokesman for New York-based Moody’s, said in a phone interview.
Before the crisis, Moody’s Investors Service, a unit of Moody’s Corp., had given AAA ratings to 42,625 mortgage-backed securities, the same seal of approval U.S. Treasury bonds get. Of those rated in 2006, 83 percent were downgraded within four years, according to the Financial Crisis Inquiry Commission.
The credit-rating companies have successfully defended themselves from investor lawsuits since the financial crisis by arguing that ratings are opinions, protected by the right to free speech, and that any mistakes were inadvertent. Terry McGraw, the chief executive officer of S&P’s parent company, McGraw-Hill Cos., said last year on a conference call with analysts that 30 lawsuits against S&P have been dismissed or dropped and that he’s seeing “those dark clouds go away.”
“They’ve made an argument that effectively they’re just journalists,” David Reiss, a professor at Brooklyn Law School who has studied credit ratings, said in a phone interview. Other judges have accepted this argument for decades, he said.
Scheindlin in 2009 rejected the free-speech defense in the Abu Dhabi case, saying the rating companies’ comments were distributed privately to a select group of investors, and not to the general public.
Morgan Stanley successfully pressured New York-based S&P to raise its rating on some of the Cheyne securities, according to the plaintiffs. After Lapo Guadagnuolo, an S&P employee, told Morgan Stanley that some of the securities would get BBB ratings instead of the desired A grade, a banker e-mailed his boss and said the ratings were “very inappropriate.” S&P then agreed to give the higher rating, according to the court filing.
Morgan Stanley earned fees totaling as much as $30 million when the Cheyne notes were issued, according to the documents. The ratings companies earned about $6 million initially, according to the 2009 ruling.
“Because MS was responsible for the SIV from cradle to grave, MS is liable for the fraudulent ratings and for its omission of material facts from the Cheyne SIV documents it created and distributed,” the investors said in the filing.
While the analysts who devised S&P ratings were supposed to be insulated from the pressure to win business, some appeared to take market share into consideration, according to the plaintiffs. Perry Inglis, the head of the S&P group that rated the Cheyne securities, wrote in an e-mail that it would be a “good idea” to figure out how to change its methodology to be more “competitive,” according to the court filing.
“I’m a bit unclear if it is a big change or a ‘wee itty bitty no-one’s going to notice’ change!” Inglis is quoted as saying in an e-mail.
Scheindlin, the Manhattan federal judge, ordered the documents unsealed because the plaintiffs are using them to oppose motions presented by Moody’s and Standard & Poor’s for summary judgment to dismiss the case. Many of the other cases against the ratings companies were dismissed before the investors could review internal documents, according to Sylvain Raynes, a principal at R&R Consulting in New York and a former analyst at Moody’s.
“Now the pendulum has shifted,” Raynes said in a phone interview. “That’s why things will be different this time.”
Scheindlin has previously rejected Moody’s, S&P’s and Morgan Stanley’s bid to have the suit thrown out on the grounds that the economic downturn, not the defendants’ misconduct, was to blame for investors’ losses on the notes. The judge said the securities received the “highest credit ratings ever given to capital notes,” according to court filings.
In December, after a procedural ruling in New York state court, Scheindlin also allowed the plaintiffs to reinstate their claim that the ratings companies are guilty of negligent misrepresentation. This would require the plaintiffs to show only that Moody’s and Standard & Poor’s should have known that the ratings were wrong, as opposed to proving they knowingly and fraudulently disregarded facts at their disposal.
“The case has the potential to be a landmark moment for rating agency accountability, which has been sorely missing in the wake of the financial crisis,” Jeffrey Manns, a professor of law at George Washington University who specializes in securities regulation, said in an e-mail.
Plaintiffs in the case are represented by Robbins Geller Rudman & Dowd LLP, a San Diego-based law firm that settled shareholder claims stemming from the 2001 collapse of Enron Corp. for $7.2 billion.
The case is Abu Dhabi Commercial Bank v. Morgan Stanley, 08-7508, U.S. District Court, Southern District of New York (Manhattan).