In re Lehman Bros. Mortgage-Backed Securities Litigation: Second Circuit Rejects Plaintiffs’ Underwriter and Control Person Theories of Liability Against Rating Agencies

On May 11, 2011, the Second Circuit affirmed the district court’s dismissal of three class action complaints that sought to hold rating agencies liable for misstatements or omissions in securities offering documents.  The plaintiffs had alleged that the rating agencies were liable as “underwriters” or “control persons” under Sections 11 and 15 of the Securities Act of 1933.  The Second Circuit rejected the plaintiffs’ underwriter theory of liability, explaining that “[t]he plain language of the statute limits liability to persons who participate in the purchase, offer, or sale of securities for distribution.”  The Second Circuit also rejected the plaintiffs’ control person theory of liability based on the plaintiffs’ failure to plead facts suggesting that the rating agencies provided anything more than advice and “strategic direction”—as opposed to direction over management policies—in the underlying transactions.

Background

The plaintiffs filed three class actions arising from the purchase of $155 billion worth of mortgage pass-through certificates between 2005 and 2007.  The certificates were sponsored, deposited, and underwritten by various financial entities.  The plaintiffs alleged that, in the securitization process, the defendant rating agencies (Standard & Poors, Moody’s, and Fitch) were not passive evaluators of credit risk; rather, they actively participated in the structuring and securitization process by providing modeling tools and advice about the composition of loan pools, the certificates’ structures, and the combination of credit enhancements and loans needed to achieve specific ratings.  The rating agencies’ models were allegedly outdated and flawed, and, as a result, the AAA or investment-grade ratings assigned to the certificates allegedly did not accurately represent their risk.
Based on the rating agencies’ alleged conduct, the plaintiffs alleged that the rating agencies were “underwriters” and thus strictly liable under Section 11(a)(5) for material misstatements or omissions in the certificates’ registration statements.  The plaintiffs also alleged that the rating agencies were liable under Section 15 as control persons of the depositors or issuers.  

The district court granted the rating agencies’ motion to dismiss, ruling that the rating agencies could not be liable under Section 11 because they did not satisfy the statutory definition of “underwriter.”  The district court also found that the rating agencies were not liable as “control persons” because the rating agencies did not direct the actions of the issuers or sellers.

An “Underwriter” Under Section 11 Must be Involved in Distributional Activities

The Second Circuit rejected the notion that the rating agencies were underwriters under Section 11 because they had structured the certificates to meet a desired rating, a necessary step in the distribution of the securities to the market.  The Second Circuit explained that “[t]he plain language of the statute limits liability to persons who participate in the purchase, offer, or sale of securities for distribution.  While such participation may be indirect, the statute does not reach those who provide services that facilitate a securities offering, but who do not themselves participate in the statutorily specified distribution-related activities.”

The Second Circuit also drew upon prior cases, the law in other circuits, and legislative history to support its view that merely taking steps that facilitate the sale of a registered security does not render the entity an underwriter under Section 11.  Rather, a successful plaintiff must allege that the rating agencies “‘participated in the relevant’ undertaking:  that of purchasing securities from the issuer with a view towards distribution, or selling or offering securities for the issuer in connection with a distribution.”  Such an approach “avoids the implausible result of transforming every lawyer, accountant, and other professional whose work is theoretically ‘necessary’ to bringing a security to market into an ‘underwriter’ subject to strict liability under § 11, a dramatic outcome that Congress provided no sign of intending.”

The Second Circuit pointed out that its decision regarding underwriter liability under Section 11 does not immunize rating agencies from liability for fraudulent securities offerings.  Plaintiffs may still bring securities fraud claims against the rating agencies under Section 10(b) of the ’34 Act, though Section 10(b) claims, unlike Section 11 claims, require proof of scienter, reliance, and loss causation.  Yet, the Second Circuit stated, “[i]t is precisely because § 11 gives rise to liability more readily” that it is applied “more narrowly.”

Control Person Liability Under Section 15 Requires the Same Elements as Section 20

The Second Circuit began its analysis of the plaintiffs’ Section 15 claim by adopting the governing definition of “control” for Section 20 set forth in SEC v. First Jersey Sec., Inc., 101 F.3d 1450 (2d Cir. 1996).  Thus, for both Section 15 and Section 20 claims, “control” is defined as “the power to direct or cause the direction of the management and policies of [the primary violators], whether through the ownership of voting securities, by contract, or otherwise.”

The plaintiffs alleged that the rating agencies “actively collaborated” with the depositors by providing “direct input,” “advisory opinions,” and “guidance” on how to structure the securities, and that the rating agencies influenced the banks by providing advice to achieve specific ratings.  The Second Circuit concluded that these allegations, at most, “suggest that the Rating Agencies provided advice and ‘strategic direction’” regarding obtaining specific ratings, but that “[s]uch purported involvement in transaction-level decisions falls far short of showing a power to direct the primary violators’ ‘management policies.’”  In other words, “providing advice that the banks chose to follow does not suggest control.”