In Re Lehman Bros. Mortgage-Backed Securities Litigation

650 F.3d 167 (2nd Cir. 2011)

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Nature of the Case

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Facts

Ps tried to hold the ratings agencies as underwriters or control persons for misstatements or omissions in securities offering documents in violation of §§ 11 and 15 of the Securities Act of 1933 ('1933 Act'). See 15 U.S.C. §§ 77k(a)(5), 77o (a). From 2005 to 2007, Ps purchased approximately $155 billion worth of mortgage pass-through certificates registered with the SEC entitling them to distributions from underlying pools of mortgages. Each tranche in a loan pool that is sold is denominated by a credit rating issued by one or more Rating Agencies. Eventually, the depositor of the tranche sells the certificates to underwriters, who then offer them to investors. Many of the certificates received AAA ratings, the 'safest' tranche supposedly least likely to default. Investment-grade ratings were crucial to the certificates' sale because many institutional investors must purchase investment-grade securities. Moreover, some senior certificates' sales were conditioned on the receipt of AAA ratings. Ps allege that the Rating Agencies, which ordinarily serve as passive evaluators of credit risk, exceeded their traditional roles by actively aiding in the structuring and securitization process. Ps contend that the issuing banks engaged particular Rating Agencies through a 'ratings shopping' process, whereby the Rating Agencies reviewed loan-level data for a mortgage pool and provided preliminary ratings. The banks put their business up for bid by playing the agencies off one another and choosing the agency offering the highest percentage of AAA certificates with the least amount of credit enhancements. The Rating Agencies engaged in an 'iterative process' with the banks, providing 'feedback' on which combinations of loans and credit enhancements would generate particular ratings. Issuers adjusted the certificates' structures until they achieved desired ratings. Ps submit that the Rating Agencies helped determine the composition of loan pools, the certificates' structures, and the amount and kinds of credit enhancement for particular tranches. The Rating Agencies allegedly provided their modeling tools to the banks' traders to help them pre-determine the combinations of credit enhancements and loans needed to achieve specific ratings. The banks in turn used those credit ratings to sell the products. Just by pure coincidence, the Rating Agencies, purportedly failed to update their models to reflect accurately the higher risks of certain underlying loans, such as subprime, interest-only, and negative amortization mortgages. The certificates' AAA or investment-grade ratings did not accurately represent their risk. During the 2008 mortgage crisis, the Rating Agencies downgraded Ps' AAA or investment-grade certificates, causing their values to decline. Ps proceeded to sue various entities involved in their offerings. Ps allege that the Rating Agencies that rated their certificates are 'underwriters' as defined in 15 U.S.C. § 77b(a)(11) and, therefore, are strictly liable pursuant to § 11(a)(5) for misstatements and omissions in the certificates' offering documents. See 15 U.S.C. § 77k(a)(5). They alleged that the Rating Agencies were liable under §15 as control persons of the depositors or issuers. The Rating Agencies moved to dismiss all claims. The district court ruled that the Rating Agencies could not be liable under §11 because they did not fall within the statutory definition of 'underwriter' when they participated in creating the securities but not in purchasing them for resale. The district court also dismissed the control person claim because the Rating Agencies' power to influence or persuade the primary violators did not constitute the requisite 'practical ability to direct the actions of people who issue or sell securities.' The motions were granted and Ps appealed.