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From Securities Regulation Daily, May 28, 2014

CalPERS suit over inflated ratings survives constitutional challenge

By Anne Sherry, J.D.

CalPERS’ allegations that Moody’s and S&P negligently misrepresented their ratings of three structured investment vehicles (SIVs) established a prima facie case sufficient to defeat California’s anti-SLAPP statute. The rating agencies had filed a special motion to strike the lawsuit as chilling their constitutional rights to free speech (California Public Employees’ Retirement System v. Moody’s Investors Service, Inc., May 23, 2014, Jenkins, M.).

Allegations. CalPERS alleged that it relied on the agencies’ AAA ratings of the SIVs, which were negligent misrepresentations. At the time, the agencies (including Fitch, which did not join in the appeal) justified their ratings based on the purported high quality of the assets purchased by the SIVs (whose make-up was kept confidential) and on the internal structural mechanisms designed to ensure minimum capital levels. But CalPERS maintained that the rating agencies lacked reasonable grounds for such high ratings, alleging specifically that they used flawed and incomplete methodologies that failed to adequately capture market risk.

Anti-SLAPP statute. California’s anti-SLAPP statute provides that a cause of action arising from an act in furtherance of the defendant’s right of petition or free speech under the U.S. or California Constitution in connection with a public issue shall be subject to a special motion to strike, unless the court determines that the plaintiff has established a probability of success on the merits. The trial court found that the negligent misrepresentation claim fell within the scope of the anti-SLAPP statute, but denied the defendants’ special motion to strike after finding that CalPERS had succeeded in proving a probability of success on the merits.

Public issue. The court rejected CalPERS’ contention that its negligent misrepresentation claim was not based in significant part on the rating agencies’ speech-related activity. Although CalPERS challenged the publication of SIV ratings in otherwise private offering materials, the complaint itself also made clear that the negligent misrepresentation claim arose from allegations that inflated ratings were “communicated to Plaintiff via the offering materials of the [SIVs], the Rating Agencies’ respective websites, through financial reporting services and directly to CalPERS’ authorized agent.” The communications themselves may have been private, but the ratings “concerned an ongoing discussion regarding the financial well-being of a significant investment opportunity that was of interest to a definable portion of the public,” thus satisfying the public issue/issue of public interest requirement of the anti-SLAPP statute.

Prima facie case. The second prong of the anti-SLAPP statute is whether CalPERS established a probability of success on the merits. To state a claim for negligent misrepresentation, a plaintiff must show a misrepresentation of a material fact, without reasonable ground for believing it to be true, with intent to induce reliance on the misrepresented fact, justifiable reliance, and resulting damage. While the ratings could be seen as opinions about a future event, the court agreed with CalPERS that the rating agencies published the ratings from a position of superior knowledge, information, and expertise, and moreover, they employed these privileges to participate in and exert control over the construction of the SIVs. This established a prima facie argument that the ratings were actionable as “professional opinions” or “deliberate affirmations of fact.” At this stage of the proceedings, the court affirmed the trial court’s finding that CalPERS had made a prima facie case.

First Amendment and preemption. As affirmative defenses, the rating agencies invoked the First Amendment right to freedom of speech and claimed that the Credit Rating Agency Reform Act of 2006 (CRARA) preempted the negligent misrepresentation claim. After considering the agencies’ contention that CalPERS would have to show “actual malice” to defeat the First Amendment claim, the court concluded that this standard did not apply and that public dissemination of the SIV ratings did not alone shield the agencies from liability. The anti-SLAPP provisions do not apply in every case in which a defendant may raise a First Amendment defense, but should be limited to lawsuits “brought primarily to chill the valid exercise” of constitutional rights in connection with a public issue. Turning to the CRARA, the court did not find the requisite “clear and manifest” Congressional purpose to preempt state common law actions for negligent misrepresentation against rating agencies. Nothing in the Act’s language gave such an indication, and tort claims for fraud or deceit are traditionally handled by the states.

The case is No. A134912.

Companies: California Public Employees’ Retirement System; Moody’s Investors Service, Inc.; Moody’s Corporation; The McGraw-Hill Companies, Inc.; Fitch, Inc.; Fitch Group, Inc.; Fitch Ratings Ltd.

MainStory: TopStory CreditRatingAgencies FederalPreemption CaliforniaNews

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