The opinion of the court was delivered by: Paul G. Gardephe, U.S.D.J.
This is a shareholder derivative action brought by Plaintiff Teamsters Allied Benefit Funds on behalf of Nominal Defendant The McGraw-Hill Companies and against the directors and several officers of McGraw-Hill. Plaintiff alleges violations of the Securities Exchange Act and breach of fiduciary duty arising from the financial losses and other harm suffered by the Company as a result of its allegedly inflated ratings of mortgage-backed securities and other securitized products.
Plaintiff filed suit against Defendants McGraw III, Ross, Lorimer, Taurel, Rust, Jr., Bischoff, McGraw, Daft, Schmoke, Aspe, Ochoa-Brillembourg and Rake (collectively, the "Director Defendants"), as well as Defendants Bahash, Stafford, Korakis and Vittor (collectively, the "Officer Defendants") on January 8, 2009.*fn1 The Director and Officer Defendants have moved to dismiss under Fed. R. Civ. P. 8, 9(b), 12(b)(6) and 23.1 and the Private Securities Litigation Reform Act of 1995 ("PSLRA"). (Dkt. No. 13) The Nominal Defendant joins this motion. (Dkt. No. 9)
For the reasons set forth below, the motion to dismiss will be GRANTED as to all defendants.
Nominal Defendant The McGraw-Hill Companies, Inc. is a New York corporation. (Cmplt. ¶ 14) The allegations in the Complaint concern the activities of the Financial Services Division of McGraw-Hill, which operates Standard & Poor's Ratings Services ("S&P"). (Cmplt. ¶¶ 2, 14)
According to the Complaint, S&P "provides credit ratings, research, and analysis covering fixed-income securities, other debt instruments and the entities that issue such instruments in the global capital markets." (Cmplt. ¶¶ 2, 46) Among the instruments to which S&P assigns ratings are mortgage-backed securities, including those backed by "risky 'subprime' home loans," and those packaged as collateralized debt obligations, or "CDO's." (Cmplt. ¶ 47) Plaintiff alleges that S&P assigned inflated credit ratings to these instruments in order to obtain the fees paid by issuers, thus misleading investors, damaging the Company's reputation for integrity, and exposing the Company to regulatory investigation. (Cmplt. ¶¶ 3-6, 8-9, 78(g))
The Complaint goes on to allege that the Officer and Director Defendants "were aware of material problems with the performance of the subprime mortgage loans that were the foundation for the securitizations which the Company rated," but maintained high ratings of these securities in order to ensure the continued flow of "lucrative financial returns," in the form of fees paid to the Company by issuers. (Cmplt. ¶ 78(d)) The Officer and Director Defendants ignored "red flag[s]" about the potential poor performance of these products and "caused the Company to be perpetually late and/or inadequate in conducting its surveillance" of mortgage-backed securities transactions. (Cmplt. ¶ 78) The ultimate downgrading of these highly rated securities led the Company to suffer "massive revenue decreases" and "devastated" its "credibility and integrity in the marketplace." (Cmplt. ¶ 78(f), (g))
The Complaint further alleges that the Officer and Director Defendants -- with knowledge that S&P's ratings were inflated and that the Company had become dependent on the profits generated by issuing those ratings -- made a variety of false and misleading statements about McGraw-Hill's financial performance between July 25, 2006 and March 11, 2008. (Cmplt. ¶¶ 49-80) The alleged false and misleading statements were made in press releases and conference calls announcing earnings results (Cmplt. ¶¶ 49-52, 55-56, 58, 61, 64, 67, 72), and in submissions to the Securities and Exchange Commission (Cmplt. ¶¶ 53, 57, 60, 62, 65, 69, 76). Plaintiff also alleges that false and misleading statements were made with regard to the Company's 2007 decision to increase its dividend and to implement a stock repurchase program (Cmplt. ¶ 59), as well as in January 2008 announcements regarding the Company's condition. (Cmplt. ¶¶ 71, 73). The Complaint also alleges that Defendants failed to disclose that the Connecticut Attorney General had issued a subpoena "to McGraw-Hill as part of an antitrust investigation into the commercial debt ratings industry." (Cmplt. ¶ 68)
Plaintiff was an owner of McGraw-Hill common stock throughout the relevant time period and remains an owner of that stock today. (Cmplt. ¶ 81) On August 18, 2008, Plaintiff made a formal demand on the McGraw-Hill Board of Directors "seeking to remedy any legal violations committed by the Company's current and former officers and directors" between July 25, 2006 and July 2008. (Cmplt. ¶ 82, Ex. A)
In the demand letter, Plaintiff made the following allegations: Throughout the Relevant Period, it appears that McGraw-Hill's Officers and Directors caused the Company to issue improper ratings in connection with collateralized debt obligations ("CDOs"). In particular, the Company's Officers and Directors condoned a practice where employees would issue ratings which were relied upon by investors in determining the creditworthiness of various financial instruments. McGraw-Hill Officers and Directors facilitated an environment lacking in internal controls with insufficient staff to properly evaluate mortgage securities.
The Company's Officers and Directors also permitted and/or encouraged employees to issue false ratings on securities in order to satisfy Wall Street expectations, and artificially adjust commercial-mortgage rating criteria in response to Wall Street pressure. (Cmplt. Ex. A.) Plaintiff further claimed that Defendants' misconduct had "significantly damaged the credibility of McGraw-Hill," and led to investigations by the New York Attorney General and the SEC. Id.
With respect to the Company's internal controls, press releases and public filings, Plaintiff charged that the directors had breached their fiduciary duty to the Company "by failing to properly supervise and monitor the adequacy of McGraw-Hills' internal controls, permitting the omissions to remain undisclosed, and allowing misleading statements and filings to be issued and disseminated." Id.
Plaintiff demanded that the Board "investigate and bring forward all appropriate legal action," "require the Officers and Directors to account to McGraw-Hill for all damages sustained or to be sustained by the Company by reason of the wrongs and misconduct complained of herein," and require that the Officers and Directors found to have breached their fiduciary duties return all payment made to them during the period of the breach, and pay interest "on the amount of damages sustained by the Company as a result of their culpable conduct." Id.
On October 3, 2008, the Board responded to Plaintiff's demand letter. (Cmplt. ¶ 85, Ex. C) The Board noted that it had "undertaken a review of the matters that are described in general terms in your letter to determine its course of conduct at this time with respect to your assertions. Following that review, the Board has determined not to pursue legal action against any Officer or Director at this time. . . ." (Cmplt. Ex. C)
The Board set forth several reasons for its decision not to pursue legal action, including the following:
Pursuant to Section 402(b) of Business Corporation Law of the State of New York, the liability of the Company's Directors to the Company or its stockholders for damages for breach of duty as a Director is eliminated to the fullest extent permitted by law. Under New York law, accordingly, any legal claims against a Director would have to establish bad faith, intentional misconduct, knowing violation of law, or actions for personal financial profit in order to state a claim (see, e.g., Business Corporation Law § 402(b)). There are no facts or even assertions in your letter that could support any such claim against any Officer or Director and the Directors are aware of none.
The Company's By-Laws also provide that the Company shall indemnify any person who is made party to a litigation because he or she was or is an Officer or Director of the Company, to the full extent permitted by law. Given the nature of your assertions as set forth above, there could be no basis for the Company to recover any amount from any Officer or Director that would not be fully repaid by the Company to the Officer or Director plus counsel fees. The Company thus could have no expectation of a net recovery against any Officer or Director.
In addition, the Company is presently defending nine actions relating to its issuance of ratings during the time period indicated in your letter. The Company is also responding to ongoing investigations by the Connecticut and Massachusetts State Attorneys General, has participated in a detailed examination by the Securities and Exchange Commission (and is subject to continuing oversight by the SEC) and recently resolved by agreement an investigation by the New York Attorney General.
Given that context, the Board has concluded that proceeding in the manner your letter indicates, while these actions and investigations remain pending, would be harmful to the interests of the Company in its defense of those litigations: it would be disruptive to the defense of those matters; and it could be harmful to the Company's interest in preserving all applicable privileges and protections.
The Board has also taken note that your letter parrots -- in the vaguest possible terms -- criticism that has been made in the media and other public sources concerning ratings activity during the relevant time period. The Board has determined that such media and public criticism -- which would only be exacerbated and prolonged by the course of conduct you propose -- is harmful to the interests of the Company and that the Company's interest in protecting its reputation further mitigates against pursuing at this time the course of conduct your letter advocates. (Cmplt. Ex. C) The ...