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In re Moody's Corporation Securities Litigation

February 18, 2009

IN RE MOODY'S CORPORATION SECURITIES LITIGATION


The opinion of the court was delivered by: Shirley Wohl Kram, U.S.D.J.

OPINION AND ORDER

I. BACKGROUND

In this putative class action, the Teamsters Local 282 Pension Trust Fund, Charles W. McCurley, Jr., and Lewis Wetstein (collectively, "Plaintiffs") bring securities fraud claims against the Moody's Corporation ("Moody's" or the "Company"), Moody's Chief Executive Officer ("CEO") Raymond W. McDaniel Jr., Moody's Chief Operating Officer ("COO") Brian M. Clarkson, and Michael Kanef, Group Managing Director of Moody's U.S. Asset Finance group (collectively, "Defendants") on behalf of all other persons and entities who acquired securities issued by Moody's from February 3, 2006 to October 24, 2007 (the "Class Period"). Pending before the court is Defendants' motion to dismiss brought pursuant to Federal Rules of Civil Procedure 12(b)(6), and 9(b), and the Private Securities Litigation Reform Act of 1995 ("PSLRA"). For the following reasons, the motion to dismiss is granted in part and denied in part.

A. Procedural History

On July 19, 2007, Nach v. Huber, the first of several putative class actions alleging securities fraud against Moody's, was filed in the U.S. District Court for the Northern District of Illinois. 08 Cv. 1536 (SWK). This action was transferred to the Southern District of New York; the Court consolidated it with all related securities cases pending in this District, and appointed Plaintiffs to represent the putative class. In re Moody's Corp Sec. Litig., 07 Cv. 8375 (SWK), Dkt. No. 7.

Plaintiffs' Consolidated Amended Complaint (the "AC") alleges that Moody's made material misrepresentations and omissions in public statements respecting: (1) Moody's business, business conduct, and independence; (2) the meaning of Moody's credit ratings; (3) the method of Moody's credit ratings; and (4) the manner in which Moody's had generated financial results and growth. See 07 Cv. 8375 (SWK), Dkt. No. 9. It also alleges control liability for defendants McDaniel, Clarkson, and Kanef (collectively, "Individual Defendants") under § 20(a) of the Securities Exchange Act of 1934 ("Exchange Act"). Defendants then filed the motions to dismiss that are the subject of this Opinion.

B. FACTUAL ALLEGATIONS*fn1

1. Credit Ratings and the Structured Finance Market

Credit markets are a financial market where securities and debt instruments are bought and sold. For credit markets to operate, buyers and sellers must be able to evaluate the credit-worthiness, or expected loss, of a given security or debt instrument. For over one hundred years, Moody's has evaluated, rated, and provided credit ratings for securities and debt instruments. (AC ¶¶ 10, 12.) During the class period, it was one of a handful of United States based Nationally Recognized Statistical Rating Organizations ("NRSRO's"). (AC ¶ 11.)

The credit markets rely on credit ratings organizations such as Moody's and other NRSRO's to evaluate and rate the countless securities and debt instruments traded in global capital markets. In addition, the credit rating given to a particular security impacts its rate of interest (the higher the credit rating, the lower rate of interest the issuer has to pay to whomever buys its debt). During the class period, Moody's controlled approximately 40% of the credit rating market; the other 60% was divided largely between two competitors: Standard and Poor's ("S&P") and Fitch Ratings. Historically, Moody's evaluated and rated debt issued by corporations. Corporations would pay Moody's a fee proportionate to the size of the its issuance for a credit rating. (AC ¶ 12.) Although Moody's used to collect revenue from the investors who relied upon its ratings, in recent years, it has been paid by the entities issuing the debt. (AC ¶ 12.)

More recently, the bulk of Moody's revenue has come from rating structured finance products such as residential mortgage-backed securities ("RMBS"), collateralized debt obligations ("CDOs"), and structured investment vehicles ("SIVs"). (See AC ¶ 291.) Structured finance products are also known as asset-backed securities ("ABS") because they are based or collateralized on a pool of assets. (AC ¶ 26.) Any asset can form the basis for a structured finance security; the largest class of these securities is backed by residential mortgages. In 2006, approximately $1.9 trillion of mortgages were securitized into RMBS. (AC ¶ 27.) In addition, collections of ABS's can themselves serve as the basis for second-order structured finance securities, such as CDOs. (AC ¶ 30.) CDO issuance reached $314 billion in 2006. (AC ¶¶ 29-30.) Finally, SIVs borrow funds in the short term while investing in securities such as RMBS and CDOs. (AC ¶ 31.) Four hundred billion dollars worth of SIV related securities were issued in 2007. (AC ¶ 31.) By 2006, Moody's grossed $1.635 billion from its ratings business; structured finance accounted for 54.2% of this revenue. (AC ¶ 290 n. 76.) Indeed, structured finance revenue accounted for 43.5% of Moody's total revenue for that year. (AC ¶ 290 n. 76.)

Conflicts of interest arise because the institutions paying Moody's for an evaluation are the very ones benefiting from a positive rating.*fn2 Therefore, although Moody's ostensibly trades in risk analysis and evaluation, in reality, Moody's trades on its reputation for honesty, integrity, and independence. (See AC ¶¶ 32-36.) They are a leader in the market because issuers and purchasers of securities alike trust that Moody's rates debt instruments accurately and impartially. (See AC ¶¶ 32-36.) Consequently, Moody's business model rests on its reputation for independence and integrity.

During the class period, several unique features of the structured finance market intensified the conflicts of interest inherent in the ratings of corporate bonds. First, structured finance generated the bulk of the Company's revenue and growth. (See AC ¶ 289.) During the class period, it accounted for 29.3% of the Company's growth and 54.2% of its ratings revenue. (AC ¶ 291.) The fees were three times higher than the fees for rating corporate bonds of a similar size, (AC ¶ 292), and came from a smaller set of repeat issuers. (AC ¶ 17.) The process of issuing structured finance ratings also involved the bifurcation of rating and payment. Generally, issuers pay Moody's for the rating of corporate debt after Moody's conducts its evaluation and delivers its rating. In the structured finance market, however, issuers pay a nominal amount for a pre-evaluation of the ratings, and make a full payment only if they choose to publish the pre-evaluation rating provided by Moody's. (AC ¶ 306.)

Plaintiffs allege that Moody's made a host of false and misleading statements in order to artificially inflate their stock price. These statements can be grouped into four broad categories.*fn3

2. Plaintiffs Allegations of Wrongdoing

i. First Category: Misrepresentations Regarding Moody's Independence, the Integrity of Its Ratings, and Its Handling of Conflicts of Interest

Plaintiffs first allege that Moody's made false statements regarding its independence from interested entities, particularly issuers of securities and investment banks. This category includes statements that Moody's made regarding its handling of conflicts of interest as well as statements concerning the integrity of Moody's ratings. Moody's attempted to preserve its independence and ratings integrity in two distinct ways. First, Moody's did so by assertion.

a. Moody's Asserts Its Independence

Moody's 2005 and 2006 Annual Reports ("2005 Report" and "2006 Report") repeatedly refer to its reputation for independence and integrity. (See generally AC ¶¶ 71, 83.) The 2005 Report cites "the market's trust in and reliance upon Moody's" as one of the two "raw materials" supporting Moody's business, and asserts that Moody's is committed to "reinforcing . . . a sense of trust in the accuracy, independence, and reliability of Moody's products and services." (AC ¶ 71.) The 2005 Report further characterizes the Company's "operating, financial, and regulatory strategies" as "strategies of trust." (AC ¶ 71.) In closing, the 2005 Report emphasizes that Moody's remains committed to "upholding the independence and integrity" of the business. (AC ¶ 71.) Moody's 2006 Report reiterated the 2005 Report's message and added that Moody's must "embrace the demand for trust," and "apply [its] opinions consistently, fairly, and objectively." (AC ¶ 83.) Likewise, the Forms 10-K filed by Moody's in 2005 and 2006 contain assertions that Moody's provides "independent credit opinions," and that these "independent credit ratings" help investors analyze credit risks with fixed income securities. (AC ¶¶ 73, 80.)

b. Moody's Code of Conduct

Moody's also promulgated a Code of Conduct (the "Code") to address the potential for conflicts of interest and protect the integrity of the ratings process. (AC ¶ 68.) The Code details, inter alia, Moody's plan to protect the quality and integrity of the ratings process, manage conflicts of interests, and adopt internal procedures to identify and address conflicts of interests. (See AC ¶ 68.)

Moody's Code specifies that Moody's "maintains independence in its relationships with Issuers and other interested entities." (AC ¶ 68.) It also states that "Credit Ratings will reflect consideration of all information known," and that Moody's will "take steps to avoid issuing credit analyses, ratings or reports" that "are otherwise misleading as to the general creditworthiness of an Issuer or obligation." (AC ¶ 68.) In the Code, Moody's also commits to rating issuances using only "factors relevant to the credit assessment." (AC ¶ 68.)

Plaintiffs allege that, despite the assurances enumerated in the Code, Moody's independence had been "systematically compromised" resulting in "debased" rating methodologies that did not reflect objective credit realities. (AC ¶ 55.) They allege that Moody's did not address or manage its conflicts of interests and that the Company failed to consider "information in plain view." (AC ¶ 55.)

ii. Second Category: Misrepresentations Regarding the Meaning of Moody's Ratings

The AC also alleges that the Company misrepresented the applicability of Moody's Global Rating Scale to structured finance products. Moody's uses the Global Ratings Scale to express its credit rating evaluations. (AC ¶¶ 20, 22.) The ratings run from Aaa, representing obligations with the highest quality and minimal risk, to C, the lowest rated class of bonds, associated with the highest risk of losing one's investment. (AC ¶ 20.) The Company issued a reference guide entitled "Moody's Rating Symbols and Definitions" (the "Ratings Guide") to explain the Global Rating Scale. (See AC ¶ 93.) The Ratings Guide explains that "structured finance ratings are engineered to replicate the expected loss content of Moody's Global Scale." (AC ¶ 93.) It goes on to state that the Company's structured finance ratings "use the same symbol system and are intended to convey comparable information with respect to the relative risk of expected credit loss." (AC ¶ 94.) Plaintiffs allege that, in reality, a structured finance Aaa rating is not comparable to a corporate finance Aaa rating, and allege that the methodology used to evaluate structured finance transactions improperly inflated credit ratings assigned to structured finance securities. (AC ¶ 99.)

iii. Third Category: Misrepresentations Concerning Moody's Structured Finance Revenue

The third category of alleged misstatements includes statements implying that Moody's structured finance revenue was derived from legitimate business practices. Throughout the class period, Moody's promulgated multiple statements suggesting that structured finance operations were critical to Moody's growth and success. (AC ¶ 285.) Plaintiffs allege that these statements were false and misleading because Moody's had debased its models and lowered its standards to award high ratings to structured finance securities. (See AC ¶¶ 138-60; AC ¶ 145 (alleging that "substantial increase in issuance [of subprime loans] . . . is the result of the loosening of mortgage underwriting standards that has occurred over the past few years").)

iv. Fourth Category: Misrepresentations Regarding Rating Methodologies

The fourth and final category consists of statements concerning Moody's rating methodologies, particularly with respect to RMBS, CDOs, and SIVs. Plaintiffs allege that, as early as 2003, Moody's knew that it was "important" to examine the quality of originator practices and that one way to assess the quality of individual loan originators was to "monitor the past performance of its loans." (AC ¶ 111.) At that time, Moody's asserted that it relied on "quantitative means as well as qualitative reviews to assess originator and servicer quality." (AC ¶ 111.)

In 2007, Moody's reiterated this commitment, asserting that its models incorporated salient loan attributes as well as "qualitative elements" of originators in the subprime market into its "analysis of loan performance." (AC ¶ 112.) At the time, Moody's unequivocally stated that its evaluation of the "overall quality of origination . . . as well as originator[']s historical performance is applied to assess the pool loss estimates." (AC ¶ 112.)

Plaintiffs allege that, despite these statements, Moody's misrepresented that it was "keeping a close eye" on origination standards. (AC ¶ 114.) They also allege that Moody's purported evaluations of originator practices and standards were "a sham, wholly devoid of substance." (AC ¶ 115.)

C. LEGAL CLAIMS

Count I alleges that Defendants made materially misleading statements and omissions throughout the Class Period in violation of § 10(b) of the Exchange Act and Rule 10b-5.

Count II alleges that the Individual Defendants controlled primary violators of the securities laws in violation of § 20(a) of the Exchange Act.

II. LEGAL STANDARDS

A. Standard of Review for a 12(b)(6) Claim

Under Federal Rule of Civil Procedure 12(b)(6), the touchstone for adequate pleading is plausibility. Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007); see also ATSI Commc'ns v. Shaar Fund Ltd., 493 F.3d 87, 98 & n.2 (applying Twombly to securities fraud complaint). Thus, materials properly before the court must provide grounds for more than mere speculation or suspicion that a plaintiff is entitled to the requested relief. See Twombly, 550 U.S. 556-57 (citations omitted). Instead, a plaintiff must "nudge[] [his] claims across the line from conceivable to plausible." Id. at 1974.

In ruling upon a motion to dismiss an action for securities fraud, courts must accept the complaint's allegations as true, Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2509 (2007), and draw all reasonable inferences in the plaintiff's favor, Caiola v. Citibank, N.A., 295 F.3d 312, 321 (2d Cir. 2002). The court only "assess[es] the legal feasibility of the complaint," it does not "assay the weight of the evidence which might be offered in support thereof." Levitt v. Bear Stearns & Co., 340 F.3d 94, 101 (2d Cir. 2003) (citations omitted).

In addition to the complaint, courts "may consider any written instrument attached to the complaint, statements or documents incorporated into the complaint by reference, legally required public disclosure documents filed with the SEC, and documents possessed by or known to the plaintiff and upon which it relied in bringing the suit." ATSI Commc'ns, 493 F.3d at 98. Courts may also consider matters subject to judicial notice. Tellabs, 127 S.Ct. at 2509 (citation omitted).

B. Hume Declaration

The Court will also take judicial notice of the documents submitted by the Plaintiffs in opposition to the motion to dismiss that were not filed with the original complaint. Generally, the Court only considers facts "stated on face of complaint, and documents appended to complaint or incorporated in complaint by reference and to matters of which judicial notice may be taken." Allen v. WestPoint-Pepperell, Inc., 945 F.2d 40, 44 (2d Cir. 1991) (citing Kramer v. Time Warner Inc., 937 F.2d 767, 773 (2d Cir. 1991); Fed. R. Civ. P. 12(b)(6). When a plaintiff files documents outside the pleadings, the Court may exclude the additional material and decide the motion on the complaint alone or it may convert the motion to one for summary judgment under Rule 56 and afford all parties the opportunity to present supporting material. See Fed. R. Civ. P. 12(b); Fonte v. Bd. of Managers of Continental Towers Condominium, 848 F.2d 24, 25 (2d Cir. 1988) (citations omitted); Chambers v. Time Warner, Inc., 282 F.3d 147, 152 (2d Cir. 2002). The court can, however, consider public records without converting the motion to one for summary judgment. Johnson & Johnson v. Am. Nat. Red Cross, 528 F. Supp. 2d 462, 463 n. 1 (S.D.N.Y. 2008); see also Long Island Lighting Co. v. Transamerica Delaval, Inc., 646 F. Supp. 1442, 1446 n. 3 (S.D.N.Y. 1986); Watterson, 987 F.2d at 3 ("[C]courts have made narrow exceptions . . . for public records.").

The document in question is the Declaration of Daniel Hume ("Hume Decl."), filed with the Plaintiffs' Opp'n. These documents are transcripts of Congressional hearing testimony conducted on October 22, 2008, after the AC was filed. As such, they are public records, which courts in this District have found to be subject to judicial notice. Johnson & Johnson v. American Nat. Red Cross, 528 F. Supp. 2d 462, 463 n. 1 (S.D.N.Y. 2008) (finding that Congressional hearing testimony is a public record subject to judicial notice); See Long Island Lighting Co. v. Transamerica Delaval, Inc., 646 F. Supp. 1442, 1446 (S.D.N.Y. 1986) (considering published decisions of state commissions when ruling upon motion to dismiss).

C. Pleading under Rules 8, 9(b), and PSLRA

In general, only a "short and plain statement" of the plaintiff's claim for relief is necessary. Fed. R. Civ. P 8. Claims of securities fraud, however, are subject to the heightened pleading standards set forth in Rule 9(b), requiring a plaintiff to state their claim "with particularity." Fed. R. Civ. P. 9(b). In order to satisfy Rule 9(b), a securities fraud complaint premised upon material misstatements "must (1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent." ATSI Commc'ns, 493 F.3d at 99 (citing Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir. 2000)).

Private securities fraud actions must also pass muster under the PSLRA. See 15 U.S.C. § 78u-4(b)(3)(A); ATSI Commc'ns, 493 F.3d at 99. In an action for money damages requiring proof of scienter, the PSLRA prescribes that "the complaint shall . . . state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). An inference is "strong" under the PSLRA only if "a reasonable person would deem [it] ...


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