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Grika v. McGraw

Supreme Court, New York County

December 21, 2016

L.A. GRIKA, Derivatively on Behalf of Nominal, Defendant MCGRAW HILL FINANCIAL, INC., Plaintiff,
v.
Harold McGraw III, DOUGLAS L. PETERSON, DEVEN SHARMA, ANDREA BRYAN, KATHLEEN A. CORBET, BARBARA DUKA, THOMAS GILLIS, VICKIE A. TILLMAN, JOANNE ROSE, DAVID TESHER and PATRICE JORDAN, Defendants, and MCGRAW HILL FINANCIAL, INC., Nominal Defendant.

          Plaintiffs are represented by Benjamin Y Kaufman Firm Name: Wolf Haldenstein Adler Freeman & Herz LLP

          Defendants are represented by FLOYD ABRAMS Firm Name: CAHILL GORDON & REINDEL LLP

          HON. JEFFREY K. OING, J.S.C.

         In this shareholder derivative action, nominal defendant McGraw Hill Financial, Inc. ("McGraw Hill" or the "Company") [1] moves, pursuant to CPLR 3211(a)(1), (3), (5) and (7) and Business Corporation Law ("BCL") § 626(c), to dismiss the amended complaint (mtn seq. no. 001).

         The individual defendants separately seek pre-answer dismissal of the amended complaint pursuant to CPLR 3013, 3016(b), 3211(a)(1), (3) and (7) (mtn seq. no. 002).

         Both motions are consolidated for disposition.

         FACTUAL ALLEGATIONS

         This shareholder derivative action asserts claims on behalf of McGraw Hill against certain of its employees, officers and directors to recover for losses McGraw Hill incurred as a result of allegedly improper conduct perpetrated by its Standard & Poor's Ratings Services business ("S & P").

         S & P is a credit rating agency relied upon by investors to issue fair and accurate assessments of credit risks. The alleged improper conduct relates to S & P's credit ratings for residential and commercial mortgage-backed securities ("RMBS" and "CMBS"), and second-order structured finance securities known as collateralized debt obligations ("CDOs") between 2004 and 2007. The amended complaint also alleges misconduct that occurred between 2010 and 2014 with respect to the rating of conduit/ fusion commercial mortgage-backed securities ("CF CMBS") and the use of improper loss assumptions in its ongoing surveillance of RMBS ratings (Am. Cmplt., ¶¶ 107-152).

         The amended complaint alleges that rather than follow its own internal and publicly-stated guidelines and commitment to issuing credit ratings based on analytically rigorous methodology S & P, with the knowledge and/or tacit approval of the Company's board of directors (the "Board"), ignored those guidelines and provided investment grade credit ratings for mortgage-backed securities which were not deserving upon the investment merits of those securities. These actions were allegedly taken to avoid large investment banks and others involved in the issuance of structured-finance taking their deals to S & P's competitors, Moody's and Fitch, to get higher or at least investment grade credit ratings. At the start of the 2007-2010 financial crisis, S & P was forced to withdraw investment grade ratings from many thousands of mortgage-backed securities.

         The Company has been forced to pay millions of dollars to settle charges by federal and state regulatory agencies, as well as lawsuits by investors, in connection with this alleged wrongdoing, and McGraw Hill still faces additional untold liability in ongoing and potential lawsuits.

         On August 18, 2008, another shareholder of McGraw Hill, Teamsters Local 456 Pension Fund ("Teamsters"), made a demand on the Board claiming that the Company's current and former directors and officers had breached their fiduciary duties by not preventing S & P from issuing false credit ratings for CDOs in the period leading up to July 2008 (Burnovski Affirm., Ex. F).

         On October 3, 2008, the Board rejected the Teamsters' demand advising that the Company's officers and directors are entitled to indemnification against claims based on their actions as officers and directors (Id., Ex. G). To avoid full indemnification, the Company would have to establish bad faith, intentional misconduct, a knowing violation of the law, or actions taken for personal financial profit (citing BCL § 402 [b]), and no such facts were alleged in the Teamsters' demand or known to the Board that would support any such claim against any officer or director. A second reason was that the Company's interests would not be served by asserting claims against its own personnel while it was the subject of at least nine lawsuits relating to its issuance of ratings between 2006 and 2008, and government investigations by Connecticut, Massachusetts, and the United States Securities and Exchange Commission ("SEC").

         Following the Board's rejection of the Teamsters' demand, a shareholder derivative action was filed on January 8, 2009 in the Southern District of New York entitled Teamsters Allied Benefit Funds v McGraw, No. 09 Civ. 140 (PGG) (the "Federal Action"), asserting federal securities law claims and state law claims against Harold McGraw III, Harold McGraw, Jr., and the Board members for breach of fiduciary duty, gross mismanagement, corporate waste, and unjust enrichment arising from inflated ratings of RMBS and CDO deals that were backed by risky sub-prime home loans.

         In March 2010, the District Court dismissed the complaint, holding that the Teamsters' demand did not place the Board on adequate notice of the Teamsters' federal claims and that the Teamsters' complaint failed to plead that a proper demand would be futile (Teamsters Allied Benefit Funds v McGraw, 2010 WL 882883, at *4-6, 2010 U.S. Dist LEXIS 23052 [SD NY Mar. 11, 2010]). The District Court also held, in the alternative:

Even if Plaintiff's demand were adequate to support the federal securities law violations alleged in the Complaint, dismissal would still be required, because Plaintiff has failed to allege facts demonstrating that the Board's rejection of its demand was not made in good faith by disinterested directors.

(Id., at *6). The District Court further held that the Teamsters' complaint pleaded no facts regarding whether the directors who considered the demand were disinterested or did not employ sufficient investigative procedures, alleging only that the Board rejected the demand on October 3, 2008 and refused to pursue legal action against any director or officer (Id., at *7).

         With respect to the state law claims, the District Court declined to exercise supplemental jurisdiction. Although the Teamsters was given leave to amend the complaint (id., at *12), it did not do so. As such, the District Court directed the clerk to close the case on March 23, 2010.

         In the meantime, on July 9, 2009, the California Public Employees Retirement System ("CalPERS") commenced an action in California state court against Moody's, S & P and Fitch alleging that the methods used by the rating agencies to grant AAA ratings to structured investment vehicles ("SIV") were seriously flawed (the "CalPERS Action").

         On March 10, 2010, the State of Connecticut sued McGraw Hill and S & P alleging that they had violated the Connecticut Unfair Trade Practices Act in connection with their ratings of securities backed by sub-prime loans, the first of twenty such lawsuits brought by various state attorneys general and the District of Columbia.

         On February 4, 2013, the United States Department of Justice ("DOJ") filed suit against the Company and S & P in California federal court, asserting claims pursuant to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 based on alleged fraud, misrepresentations and concealment of material facts in connection with S & P's credit ratings of RMBS and CDO securities between 2004 and 2007 (the "DOJ Action"). As stated, supra, nineteen other states, including the District of Columbia, filed lawsuits against McGraw Hill and S & P between 2011 and 2013 (Kaufman Affirm., Ex. A at 1-3), and these cases, together with the Connecticut action, were eventually consolidated with the DOJ Action.

         On February 22, 2013, plaintiff herein, through his counsel, sent a letter to the Board demanding that it assert claims against its own employees responsible for the conduct underlying the DOJ's claims (the "2013 Demand") (Am. Cmplt., ¶ 174 & Ex. A). The 2013 Demand asserted that unnamed current and former officers and directors of the company "devised, participated in, executed or condoned a scheme whereby the Company issued false and inflated ratings that were relied upon by investors in determining the credit-worthiness" of RMBS and CDO securities from September 2004 through at least October 2007 (Id., Ex. A at 1-2). As a result of the scheme, the Company had become the subject of numerous state and federal investigations and civil lawsuits. The 2013 Demand asserted that the Company should not have to bear the enormous financial burdens caused by the actions of the officers and directors who appear to have breached their fiduciary duties and otherwise acted improperly and failed to discharge their oversight responsibilities. Plaintiff demanded that the Board take remedial action, including commencing "legal action for breach of fiduciary duty, fraud or other appropriate claims against the persons responsible for the perpetration of the wrongdoing described [therein] and/or failure to detect and prevent it for the purpose of recovering monetary damages for the benefit of the Company" (Am. Cmplt., Ex. A at 9). Plaintiff also demanded that the Board review and overhaul the Company's internal controls and obtain tolling agreements from any potential defendants.

         By letter dated May 2, 2013, Floyd Abrams, Esq., a partner at the law firm of Cahill Gordon & Reindel LLP, responded to the 2013 Demand (the "Abrams Letter") (Burnovski Affirm., Ex. C). Abrams advised that the Board had considered the 2013 Demand at its May 1, 2013 meeting, and determined that pursuit of the remedies outlined in the 2013 Demand was not in the best interests of the Company based on the same two reasons that the Board rejected the Teamsters' demand. As an additional basis in rejecting the 2013 Demand, the Board took the position that it identified only wrongs to investors in RMBS and CDO securities, not any wrong done to the Company.

         Plaintiff contends that he was not happy with the Board's rejection of his demand, but that due to the pendency of the DOJ Action and other litigation, he took no further action until the settlements of these lawsuits were announced publicly (Am. Cmplt., ¶ 181).

         On January 21, 2015, the SEC issued three consent orders against S & P relating to its violations of federal securities laws and regulations: (i) in 2012 concerning its criteria for rating CF CMBS and related research (File No. 3-16346); (ii) S & P's failure to maintain and enforce internal controls regarding changes made to loss assumptions used in surveilling certain RMBS between 2012 and 2014 (File No 3-16347); and (iii) the publication of eight CF CMBS pre-sale reports between February and July 2011 which failed to describe a changed methodology for calculating the Debt Service Coverage Ratio ("DSCR") of the securities (File No. 3-16348) (Kaufman Affirm., Exs. 2 - 4). As part of its offer to settle these charges, S & P agreed to pay civil penalties of $58 million as well as to take a one year "time out" from rating any new U.S. CF CMBS transactions until January 21, 2016. Also on January 21, 2015, the SEC issued a separate order instituting administrative, and cease and desist proceedings against defendant Barbara Duka, relating to her role in the 2011 CF CMBS ratings (File No. 3-16349) (Id., Ex. 5). S & P also agreed to pay $19 million to settle parallel actions by the states of New York and Massachusetts (Am. Cmplt., ¶ 165).

         In January of 2015, S & P settled the CalPERS Action for $125 million (Am. Cmplt., ¶ 156). On February 2, 2015, the Company settled the DOJ Action, thus settling not only with the United States, acting through the DOJ, but with the states of Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Idaho, Illinois, Indiana, Iowa, Maine, Mississippi, Missouri, New Jersey, North Carolina, Pennsylvania, South Carolina, Tennessee, Washington and the District of Columbia, through their respective state attorneys general. The settlement provides for the payment of $1.375 billion in connection with alleged wrongdoing relating to inflated securities ratings.

         On February 6, 2015, plaintiff sent a second demand letter to the Board (the "2015 Demand") (Am. Cmplt., ¶ 174 & Ex. B). The 2015 Demand reiterated plaintiff's claims in his 2013 Demand and demanded further action against the following individuals: Harold McGraw, III, Douglas L. Peterson, Deven Sharma, Mark Adelson, Gary T. Carrington, Barbara Duka, Peter Eastham, Francis Parisi, Joanne Rose, Vickie A. Tillman, and Ian Thompson.

         Plaintiff also demanded that action be taken against the senior executives and officers of the following S & P departments, groups and/or committees: (i) Structured Finance; (ii) RMBS Group; (iii) CMBS Group; (iv) CDO Group; (v) Structured Finance Criteria Committee; (vi) Compliance Department; (vii) Model Quality Review Group; (viii) Quality Group; (ix) Criteria Group; and (x) RMBS Surveillance Group.

         In addition to pursuing damages for breach of fiduciary duty, waste and unjust enrichment, plaintiff demanded that the Company commence suit to "claw back" bonuses, deferred compensation and other payments made to these individuals. The 2015 Demand claimed that the Board had failed to investigate the claims underlying the 2013 Demand or to give any serious consideration as to whether those claims should be pursued in 2013 or at some subsequent date. The 2015 Demand also stated that the Board acted improperly and in its own self-interest by seeking and obtaining the dismissal of the Federal Action, "where many of the same claims had been made" (Am. Cmplt., Ex. B at 2). In addition, the 2015 Demand argued that the Company's settlements with the DOJ and state attorneys general, CalPERS, and the SEC eliminated two of the reasons proffered in the Abrams Letter for rejecting the 2013 Demand, because these settlements brought to a close the most significant litigation facing the Company, and the payments of $1.375 billion, $125 million and $58 million, respectively, represents very real damage to the Company, not just to investors who relied on the corrupted ratings.

         Plaintiff further pointed out that the Company's officers were not exculpated from liability by its certificate of incorporation or pursuant to BCL § 402(b), and that its directors are not entitled to absolute immunity because the members of the Board knew about the illegal and improper conduct as early as 2007 and failed to make good faith efforts to remedy such conduct.

         On May 4, 2015, Lucy Fato, Esq., then General Counsel of McGraw Hill, responded on behalf of the Board to plaintiff's 2015 Demand (Burnovski Affirm., Ex. E). Fato explained that, while certain claims had been settled, the Company and S & P continued to defend other actions related to ratings issued during the time period identified in plaintiff's letters and that pursuing litigation against its own directors, officers and employees would disrupt and impair the defense of those litigations. Fato also explained that the Company's officers were entitled to indemnification under the Company's by-laws.

         Plaintiff filed this lawsuit on January 28, 2016. The amended complaint asserts four causes of action [2] -- breach of fiduciary duty, contribution and indemnification, aiding and abetting breaches of fiduciary duty, and unjust enrichment. The relief sought is monetary damages against the individual defendants as well as disgorgement of benefits and other compensation. The amended complaint also seeks mandatory injunctive relief directing McGraw Hills's present directors to take all necessary action to reform and improve corporate governance and internal procedures of the Company to prevent a repeat of the damaging events described therein.

         The individual defendants are: Harold McGraw III ("McGraw"), who is the Chairman of the Board and was the President and Chief Executive Officer ("CEO") of McGraw Hill from 1998 until November 2013; Douglas L. Peterson ("Peterson"), a director since July 2013 and who succeeded McGraw as President and CEO, and who was also the President of S & P between September 2011 and November 2013 [3]; Deven Sharma ("Sharma"), who was the President of S & P from September 2007 until September 2011 and Chairman of the Board of S & P from 2010 to 2011; Andrea Bryan ("Bryan"), who was the Managing Director of S & P's Synthetic CDO Group; Kathleen A. Corbet ("Corbet"), the President of S & P between April 2004 and August 2007; Barbara Duka ("Duka"), the Managing Director of S & P's CMBS Group; Thomas Gillis ("Gillis"), the head of the Research and Criteria Group within S & P's Structured Finance Department; Vickie A. Tillman ("Tillman"), an Executive Vice President and Global Business Head of S & P between 1999 and 2009; Joanne Rose ("Rose"), who was the Executive Managing Director of Global Structured Finance Ratings between 1999 and January 2008, and then the Executive Managing Director for Risk Quality & Policy at S & P between January 2008 and January 2012; David Tesher ("Tesher"), the Managing Director of S & P's Cash CDO Group; and Patrice Jordan ("Jordan"), the Managing Director of S & P's Global CDO Group. No dates of employment are alleged for defendants Bryan, Duka, Gillis, Tesher and Jordan; plaintiff alleges only that each of these defendants were employed "at relevant times" (Am. Cmplt., ¶¶ 15, 17, 18, 21, 22).

         DISCUSSION

         I. McGraw Hill's Motion to Dismiss for Lack of Standing

         The Company argues that plaintiff lacks standing to bring this action for three reasons: 1) plaintiff's claims relating to alleged misconduct between 2010 and 2014 were not properly presented to the Board for consideration, and, as such, the relevant demands are inadequate; 2) the amended complaint fails to plead any facts in support of its conclusory assertion that the Board wrongfully refused plaintiff's demands; and 3) the Federal Action determined that the Board did not wrongfully decide not to pursue legal claims against ...


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