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King County, Washington v. IKB Deutsche Industriebank AG

May 4, 2012




Institutional investors King County, Washington ("King County") and Iowa Student Loan Liquidity Corporation ("ISL") bring this action to recover losses stemming from the October, 2007 collapse of Rhinebridge, a structured investment vehicle ("SIV"). Plaintiffs' First Amended Complaint included claims of common law fraud and aiding and abetting fraud against two individuals - who have since been dismissed from the action - and eight corporate entities: Deutsche Industriebank AG and IKB Credit Asset Management, GmbH (together, "IKB"); The McGraw Hill Companies, Inc. d/b/a Standard & Poor's Rating Services ("S&P"); Moody's Investors Service, Inc. and Moody's Investors Service Ltd. (together, "Moody's"); Fitch, Inc. ("Fitch," and, with S&P and Moody's, the "Rating Agencies"); Morgan Stanley & Co. Incorporated and Morgan Stanley & Co. International Limited (together, "Morgan Stanley," or "MS").*fn1

At the time the plaintiffs filed their First Amended Complaint, it was settled in the Second Circuit that New York's Martin Act preempted common law tort claims in the securities context. On December 20, 2011, the New York Court of Appeals ruled that the Martin Act does not preempt common law claims in the securities context,*fn2 and on December 27, 2011, I granted plaintiffs leave to amend their complaint to state causes of action for negligence, negligent misrepresentation, and breach of fiduciary duty, as well as aiding and abetting with respect to those claims.*fn3 King County and ISL filed the Second Amended Complaint ("SAC") on January 10, 2012, and defendants now move to dismiss plaintiffs' claims of negligence, negligent misrepresentation, breach of fiduciary duty and aiding and abetting. For the reasons stated below, defendants' motions are granted in part and denied in part.


A. Credit Ratings and Rhinebridge

Structured investment vehicles are special purpose entities that borrow money by issuing short- and medium-term debt, and then use that money to buy longer-term securities including mortgage bonds and other asset-backed securities.*fn5

SIVs are often likened to "conduits" because they raise short-term funds and channel those funds into longer-term assets, and the SIV business model resembles that of a bank in that its goal is to earn a spread between its borrowing interest rate and its lending interest rate.*fn6 Like banks, SIVs have both assets and liabilities.*fn7

As an SIV, Rhinebridge could only operate, raise funds, and invest those funds through its agents, such as the defendants.*fn8 At the direction of the defendants - who controlled Rhinebridge's capital structure and credit ratings - the SIV borrowed money from investors by issuing debt securities of varying maturities and payment priority, including: (1) short term commercial paper (the "Senior Notes") with maturities of up to 364 days; and (2) several tranches of Capital Notes that were junior to the Senior Notes and would mature in several years.*fn9 Rhinebridge used the proceeds from the sale of these debt securities to acquire various income-producing assets.*fn10 Rhinebridge's securities were not offered or sold to the public but only to a select group of buyers in private placements.*fn11

The notes that SIV investors purchase typically receive very high or "investment grade" ratings from Rating Agencies.*fn12 Rating Agencies - such as defendants Moody's, S&P, and Fitch - use public, and sometimes non-public, information regarding the assets of issuers to evaluate and rate debt offerings; the ratings are intended to convey information about the creditworthiness of the issuer's debt to potential creditors and investors.*fn13

The role allegedly played by Moody's, S&P, and Fitch in creating, operating and rating Rhinebridge represents a deviation from the historical role of Rating Agencies. Prior to 1975, rating agencies used publicly available information about corporations - such as Securities and Exchange Commission ("SEC") filings - to generate unsolicited "opinions" on the creditworthiness of corporations, which they then charged investors to view.*fn14 Over time, the market came to trust rating agencies for their integrity and unbiased approach to evaluating bonds.*fn15 In 1975, the SEC created a special status to distinguish the most credible and reliable rating agencies, identifying them as "nationally recognized statistical rating organizations" or "NRSROs" to help ensure the integrity of the ratings process.*fn16

According to the SEC, the "single most important criterion" to granting NRSRO status is that "the rating organization is recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings" and that part of awarding the NRSRO label to the company hinges on "the rating organization's independence from the companies it rates."*fn17

A credit rating is important to both issuers and investors. The Second Circuit has recognized that:

[Issuers] have their securities rated for two reasons. First, once the security or debt has received a favorable rating, that rating makes it easier to sell the security to investors, who rely upon [the rating agency's] analysis and evaluation. The second reason is that a favorable rating carries with it a regulatory benefit as well. Fitch, along with its direct competitors Amici Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's ("S&P"), has been designated by the Securities and Exchange Commission ("SEC") as a "nationally recognized statistical rating organization" ("NRSRO") whose endorsement of a given security has regulatory significance, as many regulated institutional investors are limited in what types of securities they may invest based on the securities' NRSRO rating.*fn18

A credit rating provides essential information to potential investors in an SIV because an SIV's success depends on the credit quality of the assets acquired by the SIV.*fn19 Indeed, credit quality is of such paramount importance that SIVs such as Rhinebridge are only supposed to invest in assets of the highest credit quality.*fn20

An SIV's assets typically include some combination of "investment grade" rated asset-backed securities ("ABS"), residential mortgage backed securities ("RMBS"), and collateralized debt obligations ("CDOs") - this was true of Rhinebridge and its Rated Notes which were invested, in part, in RMBS securities.*fn21 Even though Rhinebridge held over a billion dollars worth of low-quality, mortgage-backed securities, the Senior Notes it issued were "top rated*fn22 -

Moody's rated the Senior Notes "Prime-1" and "AAA," Fitch rated the Senior Notes "F1[]" and "AAA," and S&P rated the Senior Notes "A-1" and "AAA" (collectively, "Top Ratings").*fn23 These ratings are the same as those usually assigned by the Rating Agencies to bonds backed by the full faith and credit of the United States Government, such as Treasury Bills.*fn24 Top Ratings are terms of art in the investment industry, and when assigned to a financial product such as the Senior Notes, they convey to investors that the product has been evaluated by an objective and independent third-party and is found to be "nearly risk free," "safe, secure and reliable," and possessing both a "very low probability of default" and "a high likelihood of recovery in the event of default."*fn25 Starting on or about June 27, 2007, the Top Ratings assigned to the Senior Notes were communicated to investors; all defendants knew that investors such as the plaintiffs would view and rely upon the ratings when deciding whether or not to invest in Rhinebridge.*fn26

According to the U.S. Commercial Paper Private Placement Memorandum, the Senior Notes could not be offered to the public at large; they could only be offered and sold to Qualified Institutional Buyers, as defined in Rule 144A under the Securities Act of 1933, that are also Qualified Purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940 ("QIBs").*fn27

King County and ISL are QIBs, and - as qualified investors often do - have minimum ratings requirements for their investments.*fn28 The defendants knew this, and accordingly, the Rhinebridge U.S. Commercial Paper Placement Agency Agreement ("PAA") specified that the Senior Notes would not be issued unless they received Top Ratings.*fn29 The Senior Notes did receive Top Ratings when they were first sold to investors on or about June 27, 2007.*fn30

B. The Role of IKB and Morgan Stanley

IKB and MS were responsible for: (1) overseeing Rhinebridge's portfolio; (2) facilitating the purchase of portfolio assets; (3) conducting capital, market sensitivity and liquidity tests to monitor Rhinebridge's assets; and (4) monitoring the Senior Notes to determine whether they were supported by sufficient equity and junior notes.*fn31 Throughout the negotiation, ramp-up and launch periods, MS and IKB circulated and received drafts of virtually all of the documents concerning Rhinebridge, and set deadlines by which deal documents were to be completed and distributed to investors.*fn32 Morgan Stanley operated as a Co-Arranger and placement agent for Rhinebridge, and - through marketing materials - provided potential investors with the allegedly misleading ratings, accompanying definitions of the ratings, and statements regarding the Senior Notes' safety and stability.*fn33

In structuring Rhinebridge, MS and IKB caused the SIV to acquire high-risk toxic assets - unbeknownst to investors, Rhinebridge held over a billion dollars worth of low-quality mortgage-backed securities, more than half of which IKB had transferred from its own balance sheet into the SIV's portfolio.*fn34 Morgan Stanley "caused"*fn35 Rhinebridge to acquire "hundreds of millions of dollars of poor quality, toxic assets" that it knew IKB was trying to "unload[]."*fn36 It "coerced"*fn37 the Rating Agencies to allow risky Home Equity Loans ("HELs") to constitute up to seventy-five percent of Liquid Eligible Assets ("LEAs")*fn38 in the SIV, where most SIVs limit HELs to fifteen to twenty percent of such assets.*fn39 It caused Rhinebridge to acquire approximately two-hundred and fifty million dollars in Countrywide securities -- a single obligor exposure approximately three times higher than the four percent limit stipulated in the SIV's operating instructions.*fn40 It knew Rhinebridge had breached its "Major Capital Loss Test"*fn41 ("Capital Test") before Rhinebridge was launched on June 27, 2007, and that its Top Ratings were false.*fn42

By virtue of their roles in creating, structuring, managing and monitoring the SIV, MS and IKB had access to confidential information regarding Rhinebridge.*fn43 Because Morgan Stanley structured and underwrote several of the SIV's underlying assets, it had intimate knowledge regarding the quality of its securitizations.*fn44 And because it had unsuccessfully attempted to sell its low-quality mortgage-backed securities on the open market, IKB had unique information regarding the demand and liquidity of those assets - assets IKB was "thrilled" that it could sell to Rhinebridge.*fn45

C. The Rating Agencies' Collaboration with MS and IKB

The Rating Agencies collaborated with IKB and MS to draft key selling documents, determine which assets the SIV could hold and what structural protections to put in place, and investigate and recommend securities for the SIV's portfolio.*fn46 The Rating Agencies had a significant ongoing role in the operation of Rhinebridge, which included (among other rights and responsibilities) the right to veto changes in management and the right to review and potentially veto any changes in how Rhinebridge obtained funding, modified its operating instructions, or changed its investment guidelines.*fn47 Regardless of their historical roles, the Rating Agencies did not merely provide ratings; rather, they were deeply entrenched in the creation and operation of Rhinebridge.*fn48

The Rating Agencies were compensated for their involvement with Rhinebridge, and had significant economic incentives to provide falsely high ratings.*fn49 Each of the three Rating Agencies gave the Senior Notes the "Top Ratings" without which Rhinebridge could not have existed.*fn50 Yet these ratings were false or misleading, in part because all three Rating Agencies used information that was stale and inaccurate, and models that were outdated.*fn51

Moreover, the Rating Agencies knew that their ratings were false or misleading*fn52 because they: (1) had access to confidential information about the assets held by Rhinebridge; (2) had knowledge unavailable to the public regarding the assumptions and methodologies used in rating the SIV; and (3) knew that, although the goal of an SIV is to acquire high-quality assets making it worthy of a "Top Rating," the Rhinebridge SIV included low-quality toxic mortgage-backed assets.*fn53

D. Defendants' Targeting of QIBs

The defendants knew that the Senior Notes could only be offered to QIBs and QPs,*fn54 and indeed, according to the PPM, any offer or sale of Rhinebridge-issued Senior Notes to a party other than a QP or a QIB would "BE DEEMED NULL AND VOID AB INITIO AND OF NO EFFECT."*fn55 Not only were defendants aware that many qualified investors could only invest in SIVs that received "Top Ratings," but prior to their Senior Note purchases, the plaintiffs directly informed the Rating Agencies they relied on credit ratings to make investment decisions.*fn56 Knowing that qualified investors, including the plaintiffs, were relying on the Senior Notes' ratings to decide whether or not to invest in Rhinebridge, the defendants worked closely to ensure that the Senior Notes received "Top Ratings"*fn57 - according to the PAA, receipt of the "Top Ratings" was a "condition precedent" to issuing the Senior Notes.*fn58

The Rating Agencies knew or should have known the identity of the potential Senior Notes investors,*fn59 and Morgan Stanley and IKB did know the identities of the Senior Notes investors prior to those investors' purchases of the Senior Notes.*fn60

E. The Collapse of the Rhinebridge SIV

The Senior Notes had Top Ratings from their first sale to investors on or about June 27, 2007 to their downgrade to "junk" ratings on October 18 and 19, 2007.*fn61 Thus, in less than four months, the ratings went from indicating an extremely low probability of default to indicating a near-certain likelihood of default.*fn62 The Rhinebridge SIV was forced into receivership on or about October 22, 2007, becoming perhaps the shortest-lived "Triple A" investment fund in the history of corporate finance.*fn63


A. Rule 12(b)(6) Motion to Dismiss

In deciding a motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6), the court "accept[s] all factual allegations in the complaint as true, and draw[s] all reasonable inferences in the plaintiff's favor."*fn64 The court evaluates the sufficiency of the complaint under the "two-pronged approach" suggested by the Supreme Court in Ashcroft v. Iqbal.*fn65 First, a court "'can choose to begin by identifying pleadings that, because they are no more than conclusions, are not entitled to the assumption of truth.'"*fn66 "Threadbare recitals of the elements of a cause of action, supported by mere conclusory statements, do not suffice" to withstand a motion to dismiss.*fn67 Second, "[w]hen there are well-pleaded factual allegations, a court should assume their veracity and then determine whether they plausibly give rise to an entitlement for relief."*fn68 To survive a Rule 12(b)(6) motion to dismiss, the allegations in the complaint must meet a standard of "plausibility."*fn69 A claim is facially plausible "when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged."*fn70 Plausibility "is not akin to a probability requirement;" rather, plausibility requires "more than a sheer possibility that a defendant has acted unlawfully."*fn71

"In considering a motion to dismiss for failure to state a claim pursuant to Rule 12(b)(6), a district court may consider the facts alleged in the complaint, documents attached to the complaint as exhibits, and documents incorporated by reference in the complaint."*fn72 However, the court may also consider a document that is not incorporated by reference, "where the complaint 'relies heavily upon its terms and effect,' thereby rendering the document 'integral' to the complaint."*fn73

B. Rule 8 Pleading Requirement

"Federal Rule of Civil Procedure 8(a)(2) requires . . . 'a short and plain statement of the claim showing that the pleader is entitled to relief.'"*fn74 To survive a Rule 12(b)(6) motion to dismiss, the allegations in the complaint ...

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