Jury Verdict Targets Banks' Over-Reliance on Credit Ratings
By CHRISTIAN SIEBOTT and DAVID HARRISON
|Thursday, July 29, 2010
Last month, a jury in Minnesota reached a verdict that should cause banks to shudder and investors to cheer. The jury found, among other things, that Wells Fargo breached its fiduciary duty to its clients when it invested in mortgage-backed securities (MBSs) and purchased notes issued by structured-investment vehicles (SIVs) on their behalf. Notably, these were securities that had received an AAA rating or the equivalent from ratings agencies. Thus, this verdict is an indictment of those banks that failed to conduct their own proper due diligence on their clients' behalf before investing in securities backed by fragile assets. It stands for the proposition that ratings from the rating agencies are not enough.
To understand why this verdict is so significant, and why it may be a precursor to new litigation and a sign of a fundamental change in the role of ratings agencies, some brief background on the failure of the credit ratings and the flawed system upon which they are based is instructive.
The Failure of the Credit-Rating Agencies
Between 2007 and 2008, as the housing market began to crumble, the market revealed that the ratings handed out for many structured-debt products had been grossly inflated. Mass downgrading ensued. With respect to mortgage-backed securities alone, during this time period, the agencies downgraded the credit ratings on nearly $1.9 trillion worth of securities. This unprecedented measure signaled the agencies' prior failure to accurately rate these securities, and put the ratings in the forefront of several financial- crisis investigations by regulators.
As federal regulators began to unravel how these inaccurate ratings contributed to the financial crisis, two fundamental flaws in the structure upon which ratings were based became evident: (1) Just a handful of credit agencies had market power gifted to them by regulatory bodies such as the Securities and Exchange Commission, which promulgated rules that depend substantively on the ratings; and (2) The agencies adopted an issuer- pays model, dismantling impartiality and removing accountability for the accuracy of their ratings. Professor Frank Partnoy, the George E. Barrett Professor of Law and Finance and the director of the Center on Corporate and Securities Law at the University of San Diego, has cogently argued in his extensive work on the ratings malfunction that these defects played a significant role in the agencies' inability to properly forecast the credit risk of structured-debt products.
Three credit-ratings agencies first began to acquire market power in the mid-70's. Moody's, Standard & Poor's, and Fitch became the first (and until recently, the only) rating agencies to be designated Nationally Recognized Statistical Ratings Organizations (NRSROs) by the SEC. Around the same time, the SEC began adopting rules that conditioned regulatory treatment on a favorable rating by the NRSROs.
The SEC has passed dozens of NRSRO ratings based rules since then. For example, Rule 2a-7 under the Investment Company Act of 1940 limits money-market funds to investing only in "eligible securities" -- those which receive a rating from the NRSROs in one of the two highest short-term rating categories. Such ratings-dependent regulations have had the effect of sanctioning investor dependence on the ratings. Even the SEC itself has recognized this phenomenon, in recent proposals to eliminate such rules.
To investors, an AAA rating became a regulator stamp of approval, and to issuers of structured debt products, it became a regulatory license. Regulations with NRSRO ratings components created a system by which strong ratings offered issuers a golden ticket into the financial markets. Thus, the ratings business became enormously profitable, particularly for the NRSROs, whose ratings were so highly regarded by investors and so sought after by issuers.
The introduction of such federal regulations coincided --perhaps not by chance -- with a rating agency shift to an issuer-pays model. Under this new system, the sellers of the financial product -- that is, the issuers, rather than the investors -- paid the agencies to evaluate the securities to be issued. According to a study of the credit-rating agencies that was conducted by the SEC, "The conflict of interest inherent in this model is that rating agencies have an interest in generating business from the firms that seek the rating, which could conflict with providing ratings of integrity."
Furthermore, in many cases, an agency would receive a second, larger fee when it delivered an investment-grade rating to an issuer. As the agency's client, the issuer can decide not to seek the rating if the rating will not qualify the issuer for regulatory acceptance. Thus, the credit-ratings agencies' profits were largely dependent on the issuance of a specific rating. And, it was incumbent upon the profit-driven agencies then, to deliver such a rating.
Another contributing factor, in addition to this deterioration of the market -- with market forces militating against unbiased ratings -- was the loss of agency accountability. Traditionally, credit-ratings agencies were paid by investors, and functioned under a reputation-capital-based model that essentially regulated itself. According to this model, the profits of an agency that is issuing assessments of financial products are based substantially on that particular agency's reputation for accuracy. Thus, it would be in a credit-rating agency's best interest, under this system, to develop ratings models that consistently delivered accurate ratings.
In an issuer-pays system, however, the premium for accurate information is substantially diminished. Again, it is not the investor who is paying the agencies for information with regard to a particular product, but the issuer, who needs a particular rating in order to be granted access to the market. The credit agencies get paid provided that they deliver an investment-grade rating to the issuer. Therefore, any risk to the credit- rating agencies of losing fees due to the issuance of inaccurate information is all but entirely removed.
The massive downgrading of ratings which occurred between 2007 and 2008 reflects the materialization of these conflicts: This flawed system substantially contributed to the issuance of inaccurate ratings. While little can be said about this breakdown that hasn't been said already, the Minnesota verdict has led to new questions regarding credit-rating reliance. Specifically, what level of due diligence must be conducted prior to making investments on behalf of clients? And, what did the banks know -- or what should they have known -- about the credit-rating-agency system, prior to relying on the ratings? Litigation that is being brought by investors, such as those in Minnesota, should iron out the answers to these questions.
The Minnesota Verdict and its Impact
In the Second Judicial District Court in Minnesota, the jury awarded four non-profit, institutional investors $30 million, $14.1 million of which went toward the breach-of-fiduciary-duty claims. The jury found, among other things, that the investment decisions made by the bank on the plaintiffs' behalf relied too heavily on the credit ratings. The court held, as a matter of law, that Wells Fargo had a fiduciary duty to its clients. The jury found that Wells Fargo had breached that duty with respect to all four plaintiffs.
Wells Fargo had invested in a securities-lending program that it marketed to its clients as being conservative and safe. The bank's conclusion that these investments were safe was undoubtedly based largely on an AAA rating given to these securities by credit-rating agencies, not a proper independent investigation. For example, Wells Fargo invested in the SIVs despite the SIVs' refusal to disclose anything about the underlying assets. Intuitively, such investments carry significant risk. But, because the SIVs were highly rated by the agencies, Wells Fargo nevertheless proceeded with the investment.
While the Minnesota verdict may seem relatively small compared to the plaintiffs' overall investment in the Wells Fargo securities lending program ($407), the securities-lending market alone had $1 trillion in investments. Moreover, investors incurred billions in losses from MBS and SIV investments following the collapse of the housing market. Under these conditions, the potential for a significant rise in litigation brought by investors seeking recourse against the banks cannot be overstated.
Banks should be alarmed. As outlined above, regulations guided by NRSRO ratings and the issuer-pays model have been around for over thirty years. Leaders and scholars in the industry have been exposing the pitfalls of this system for years. The fact that the credit ratings are unreliable -- due to, among other things, centralized power and a conflict of interest -- is, and was at the time, well-known.
Recently, at a hearing before the Financial Crisis Inquiry Commission (FCIC), Warren Buffett, and Raymond McDaniel, Chairman and CEO of Moody's, testified. Despite being CEO of Moody's single biggest investor, Buffett testified that Berkshire Hathaway did not rely on the credit ratings, but rather did its own independent research to make investments. Furthermore, in his opening remarks, McDaniel stated, "Institutional investors (who are the primary purchasers of structured products) have their own obligations to their clients and therefore must perform their own analysis when purchasing, selling or holding a security." Accordingly, banks would have been well- advised to avoid relying on the credit ratings to any meaningful extent.
In addition, attempts to defend breach-of-fiduciary-duty claims by asserting ignorance of the fragility of the assets will fall short. As the Minnesota court held, in the case described above, banks holding and investing a client's money are fiduciaries. A fiduciary duty fundamentally means that the bank must act in a client's best interest at all times; and such a duty includes, in this context, the obligation to perform a reasonable inquiry into the appropriateness and soundness of the client's investments. Thus, banks that relied on the ratings face an uphill battle defending claims similar to those brought by the Minnesota plaintiffs.
On the other hand, for investors who lost billions as a result of these bad investments, the Minnesota verdict provides a silver lining. Holding banks responsible for failing to conduct an investigation prior to making investment decisions for clients not only offers investors an opportunity to be compensated for losses, but it also properly aligns incentives: It puts the onus back on the banks to live up to the obligations inherent in their assuming a fiduciary role in the management of their clients' investments. And, it incentivizes the credit-rating agencies to earn back the trust of both banks and investors by reshaping their model to ensure the issuance of accurate ratings.
The Minnesota jury did not specifically delineate in its verdict the ways in which it found that Wells Fargo failed its clients as a fiduciary. However, the banks' unreasonable reliance on the credit ratings was crucial to the plaintiffs' case. Based on the evidence, Wells Fargo did in fact conduct some research and made inquiries prior to making the investments. Yet it still breached its fiduciary duty, according to the jury. Thus, it should be concluded that the jury found that more than just a superficial inquiry was required.
Going forward, courts and juries will be asked to make a factual inquiry into the individual circumstances surrounding the due diligence that was conducted by each bank. For banks, the Minnesota verdict should be a warning that blind reliance on the credit ratings -- or the conduct of what was merely a token, ineffective investigation -- will likely subject them to liability.
Christian Siebott is a partner in the New York law firm of Bernstein Liebhard LLP, and David Harrison is an associate at the firm. They concentrate their practices in complex and class action litigation.