Refining Underwriter Liability: Second Circuit Affirms Dismissal of Rating Agencies' Liability in Mortgage-Backed Securities Litigation

Refining Underwriter Liability: Second Circuit Affirms Dismissal of Rating Agencies' Liability in Mortgage-Backed Securities Litigation

Introduction

The appellate case, In re LEHMAN BROTHERS MORTGAGE-BACKED SECURITIES LITIGATION, adjudicated by the United States Court of Appeals for the Second Circuit on May 11, 2011, addresses significant questions regarding the liability of credit rating agencies under the Securities Act of 1933. The plaintiffs, comprising state treasurers, retirement systems, and other similarly situated entities, sought to hold major rating agencies — Moody's Investors Service, S&P, and Fitch — liable as underwriters and control persons for alleged misstatements and omissions in the registration statements of mortgage-backed securities (MBS).

Summary of the Judgment

The Second Circuit unanimously affirmed the district court's dismissal of the plaintiffs' class-action complaints against the rating agencies. The core argument centered on whether these agencies qualified as "underwriters" or "control persons" under §§ 11 and 15 of the Securities Act of 1933. The court held that the rating agencies did not meet the statutory definitions necessary for such liability. Consequently, the plaintiffs' claims were dismissed with the judgment being affirmed.

Analysis

Precedents Cited

The court extensively reviewed prior case law to interpret the definitions within the Securities Act. Notably:

  • SEC v. Kern, 425 F.3d 143 (2d Cir. 2005): This case clarified that the term "underwriter" pertains to those directly involved in distributing securities, not merely facilitating their creation.
  • HERMAN MacLEAN v. HUDDLESTON, 459 U.S. 375 (1983): Emphasized the limited scope of strict liability under § 11, confined to enumerated parties.
  • PINTER v. DAHL, 486 U.S. 622 (1988): Distinguished between § 11's participant liability and broader fraud claims under other securities laws.

The court rejected plaintiffs' attempts to broaden the definitions based on these precedents, maintaining that "underwriter" must align with the statutory language focusing on distribution-related activities.

Legal Reasoning

The court undertook a meticulous statutory interpretation, emphasizing the plain language of §§ 11 and 15. It concluded that to be considered an underwriter, a party must be directly involved in the distribution of securities, such as purchasing securities with the intent to resell or actively selling securities on behalf of the issuer. The rating agencies, while influential in structuring and rating the MBS, did not participate in these distributional activities.

Regarding § 15, which imposes joint liability on control persons, the court determined that plaintiffs failed to demonstrate that the rating agencies had the requisite control over the primary violators. Merely providing advice or feedback does not equate to having the power to direct management or policies of the issuers.

Additionally, the court addressed plaintiffs' demand for leave to amend their complaints, ruling that such requests were either implicit or lacked substantive new information to overcome the existing deficiencies in their claims.

Impact

This judgment reinforces the boundaries of liability for credit rating agencies under the Securities Act. By clarifying that rating agencies do not qualify as underwriters or control persons absent direct participation in the distribution of securities, the court limits the scope of potential litigation against these entities for their role in the financial crisis. This decision underscores the importance of adhering to statutory definitions and the challenges plaintiffs face in expanding liability beyond prescribed categories.

Future cases involving rating agencies will likely reference this judgment to delineate the extent of their legal responsibilities, particularly concerning their involvement in the structuring versus the distribution of financial products.

Complex Concepts Simplified

Underwriters: Entities or individuals directly involved in distributing securities to the public, such as purchasing securities to resell or actively selling them on behalf of the issuer.

Control Persons: Parties that have the power to direct or influence the management and policies of another entity, making them jointly liable for securities violations under § 15.

Mortgage-Backed Securities (MBS): Financial instruments backed by pools of mortgages, where investors receive payments derived from the underlying mortgage payments.

Section 11 of the Securities Act: Provides strict liability to certain parties for misstatements or omissions in the registration statements of securities.

Section 15 of the Securities Act: Extends liability to individuals or entities that control any party already liable under § 11.

Conclusion

The Second Circuit's affirmation in In re LEHMAN BROTHERS MORTGAGE-BACKED SECURITIES LITIGATION serves as a pivotal reference point in securities litigation, particularly concerning the liability of rating agencies. By upholding the district court's dismissal of claims against the rating agencies, the court emphasized adherence to the specific statutory roles outlined in the Securities Act of 1933. This decision delineates the legal boundaries, ensuring that liability under the Act remains confined to clearly defined participants in the distribution of securities, thereby providing clarity and predictability in the regulatory landscape.

Case Details

Year: 2011
Court: United States Court of Appeals, Second Circuit.

Judge(s)

Reena Raggi

Attorney(S)

Joel P. Laitman, Cohen Milstein Sellers Toll PLLC, New York, N.Y. (Michael B. Eisenkraft, Daniel B. Rehns, Kenneth M. Rehns, Cohen Milstein Sellers Toll PLLC, New York, NY; Steven J. Toll, Joshua S. Devore, Matthew B. Kaplan, S. Douglas Bunch, Cohen Milstein Sellers Toll PLLC, Washington, D.C., on the brief), for Lead Plaintiff-Appellant Locals 302 612 of the International Union of Operating Engineers — Employers Construction Industry Retirement Trust and Plaintiffs-Appellants New Jersey Carpenters Health Fund and Boilermakers-Blacksmith National Pension Trust. Joseph J. Tabacco, Jr., Berman DeValerio, San Francisco, CA (Patrick T. Egan, Berman DeValerio, Boston, MA, on the brief), for Plaintiffs-Appellants Wyoming State Treasurer and Wyoming Retirement System. Lester L. Levy, Wolf Popper LLP, New York, NY, for Lead Plaintiff-Appellant Vaszurele Limited. Floyd Abrams (S. Penny Windle (admission pending), Adam Zurofsky, Tammy L. Roy, on the brief), Cahill Gordon Reindel LLP, New York, NY, for Defendant-Appellee The McGraw Hill Companies, Inc. James J. Coster (Joshua M. Rubins, Glenn C. Edwards, on the brief), Satterlee Stephens Burke Burke LLP, New York, NY, for Defendant-Appellee Moody's Investors Service, Inc. Andrew J. Ehrlich (Martin Flumenbaum, on the brief), Paul, Weiss, Rifkind, Wharton Garrison LLP, New York, NY, for Defendant-Appellee Fitch, Inc.

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