Ohio Police & Fire Pension Fund v. Standard & Poor's Fin. Servs. LLC

• Decision Date: 03 December 2012
• Docket Number: No. 11–4203.,11–4203.
• Citation: 700 F.3d 829
• Parties: OHIO POLICE & FIRE PENSION FUND; Ohio Public Employees Retirement System; State Teachers Retirement System of Ohio; School Employees Retirement Systems of Ohio; Ohio Public Employees Deferred Compensation Program, Plaintiffs–Appellants, v. STANDARD & POOR'S FINANCIAL SERVICES LLC; The McGraw–Hill Companies, Inc.; Moody's Corp.; Moody's Investors Service, Inc.; Fitch, Inc., Defendants–Appellees.
• Court: U.S. Court of Appeals — Sixth Circuit

700 F.3d 829

OHIO POLICE & FIRE PENSION FUND; Ohio Public Employees Retirement System; State Teachers Retirement System of Ohio; School Employees Retirement Systems of Ohio; Ohio Public Employees Deferred Compensation Program, Plaintiffs–Appellants,

v.STANDARD & POOR'S FINANCIAL SERVICES LLC; The McGraw–Hill Companies, Inc.; Moody's Corp.; Moody's Investors Service, Inc.; Fitch, Inc., Defendants–Appellees.

No. 11–4203.

United States Court of Appeals, Sixth Circuit.

Argued: Oct. 10, 2012.

Decided and Filed: Dec. 3, 2012.

ARGUED:Elizabeth J. Cabraser, Lieff, Cabraser, Heimann & Bernstein, LLP, San Francisco, California, for Appellants. Floyd Abrams, Cahill, Gordon & Reindel LLP, New York, New York, for Appellees. ON BRIEF:Elizabeth J. Cabraser, Lieff, Cabraser, Heimann & Bernstein, LLP, San Francisco, California, Steven E. Fineman, Daniel P. Chiplock, Michael J. Miarmi, Lieff, Cabraser, Heimann & Bernstein, LLP, New York, New York, John P. Gilligan, Matthew L. Fornshell, Columbus, Ohio, for Appellants. Floyd Abrams, Tammy L. Roy, Cahill, Gordon & Reindel LLP, New York, New York, Drew H. Campbell, Bricker & Eckler LLP, Columbus, Ohio, Joshua M. Rubins, Satterlee Stephens Burke & Burke LLP, New York, New York, Martin Flumenbaum, Roberta A. Kaplan, James J. Beha II, Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, New York, Thomas D. Warren, Baker & Hostetler LLP, Cleveland, Ohio, for Appellees. Marion H. Little, Jr., Zeiger, Tigges & Little LLP, Columbus, Ohio, for Amicus Curiae.

Before: GILMAN, GIBBONS, and ROGERS, Circuit Judges.

OPINION

JULIA SMITH GIBBONS, Circuit Judge.

The plaintiffs to this action are five pension funds operated by the State of Ohio for public employees (the “Funds”). The Funds invested hundreds of millions of dollars in 308 mortgage-backed securities (“MBS”) between 2005 and 2008, all of which received a “AAA” or equivalent credit rating from one of the three major credit-rating agencies (the “Agencies”).¹ The value of MBS collapsed during this period, leaving the Funds with estimated losses of $457 million. In an effort to recoup some of these losses, the Funds brought suit against the Agencies under Ohio's “blue sky” laws and a common-law theory of negligent misrepresentation, alleging that the Agencies' ratings were false and misleading and that the Funds' reasonable reliance on those ratings caused their losses. The district court granted the Agencies' motion to dismiss the entire complaint with prejudice. The Funds now appeal that ruling. For the reasons set forth below, we affirm the judgment of the district court.

I.

A.

MBS are “financial products whose value is derived from and collateralized by ( i.e., ‘backed’ by) the revenue stream flowing from” a pool of residential or commercial mortgage loans. Compl. at ¶ 31. An MBS offering is initiated by an “arranger,” “typically an investment bank,” that buys mortgage loans from lenders and transfers those loans to an affiliated “bankruptcy remote trust” that is “immune from any bankruptcy the arranger might suffer and vice versa.” Id. ¶ 32. The trust then offers securities collateralized by this pool of mortgages to investors and uses the funds earned from the sale to cover the costs of acquiring mortgage loans and organizing the offer. Id. ¶ 33. As the owner of the mortgage loans, the trust is entitled to principal and interest payments made by mortgagees. Those payments are passed on to the purchasers of the securities in the form of principal and interest payments. Id.

Arrangers can increase or decrease the risk investors assume when purchasing MBS by altering one of two features of the capital structure of these investments. Id. ¶ 34. First, arrangers can adjust the “overcollateralization” of the securities, which is the amount by which the principal balance of the mortgage pool exceeds the principal balance of the issued securities. Id. ¶ 35. This creates a “buffer” zone before mortgage defaults result in losses for investors. Id. Second, arrangers can change the “excess spread” of the securities, which is the difference between the interest received on the mortgages and the interest paid out to investors. Id. The excess spread can be applied toward delinquent interest payments or used to build up loss reserves. Id. The degree to which securities incorporate these risk-prevention features is known as “credit enhancement.” Arrangers can further apportion risk by issuing multiple classes, or “tranches,” of securities collateralized by the same underlying asset pool. Id. Tranches are prioritized by their level of credit enhancement. Id. Accordingly, investors in the lowest tranche have the lowest up-front costs, but they also bear the lowest level of credit enhancement and would have all losses of payments and interest allocated to them before investors in the next highest tranche could be affected. Id. By contrast, the Funds paid premium prices for “AAA”-rated funds in the highest tranche, which provided the greatest amount of credit enhancement. Id. ¶¶ 3, 38, 100.

B.

It was the role of the Agencies to assess how much risk investors assumed when they purchased MBS. Arrangers typically initiated this process by sending the Agencies data on the sort of mortgages they planned to acquire and securitize, along with their proposed capital structure. Id. ¶ 37. The Agencies used statistical modeling to predict how many of the pooled mortgage loans would enter default, as well as how much of the principal balance of the loan the arranger could expect to recover after a default. Id. Based on these predictions, the Agencies would run “stress tests” in order to determine “how much credit enhancement a given tranche security needed to receive a particular credit rating.” Id. ¶ 38. They would then look at the proposed capital structure to see if it provided an appropriate level of credit enhancement and report their findings to the arranger. Id. ¶ 39. Once the arranger settled on a capital structure and estimated rating for each tranche, the Agency would perform a final review of the estimated cash flow and legal documentation of the proposed MBS offering before providing a final rating. Id. ¶ 40. The Agency would earn its fee if the desired rating issued. Id. ¶¶ 39–40. At any point in this process, the arranger could reject the Agency's proposed rating. Id.

The Funds allege that between 2005 and 2008, this “issuer pays” system compromised the integrity of the credit rating process. Id. ¶ 52. In an effort to attract the significant rating fees paid by MBS arrangers, the Agencies “became intimately involved in the issuance of [MBS]” by assisting arrangers in structuring their securities to achieve certain credit ratings, turning the process into a form of negotiation and placing the Agencies in the position of “rating their own work.” Id. ¶¶ 56, 65, 80. Nonetheless, the Agencies continued to publicize the objectivity, independence, and analytical rigor of their rankings, despite privately acknowledging the “latent conflict of interest” in their business model. Id. ¶¶ 43–51, 66. In addition, the desire to attract business led the Agencies to lower their rating standards. Id. ¶¶ 82–93. They preferred older, more forgiving debt models over more up-to-date ones that might result in the rejection of an arranger's proposed capital structure. Id. ¶ 85. Analysts would also perform “out of model” corrections to achieve a certain rating for a security that computer models did not justify. Id. ¶¶ 92–93. The Funds allege that the Agencies did not properly disclose the weaknesses of the Agencies' ratings, that the Agencies knew investors like the Funds would rely on the accuracy of their ratings in making investment decisions, and that the Agencies' failure to make proper disclosures caused the significant losses the Funds experienced when the MBS market collapsed. Id. ¶¶ 97–101.

The complaint describes these practices at a high level of generality. It draws its allegations from publicly available reports, newspapers, and magazines explaining problems with the Agencies' business model from 2005 to 2008. Although the complaint includes an exhaustive appendix of the 308 MBS the Funds purchased, no fact alleged in the complaint is connected to any particular rating given by an Agency for a security the Funds purchased during the period in question.

C.

The complaint contains three counts: (1) common-law negligent misrepresentation; (2) violation of Ohio Rev.Code § 1707.41; and (3) violation of Ohio Rev.Code § 1707.43. The district court granted a motion to dismiss the entire complaint for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6) and entered judgment with prejudice in favor of the Agencies. At no point in the district court proceedings did the Funds seek to amend their complaint. This timely appeal followed.

II.

A district court's order granting a Rule 12(b)(6) motion receives de novo review on appeal. Courie v. Alcoa Wheel & Forged Prods., 577 F.3d 625, 629 (6th Cir.2009). We must “construe the complaint in the light most favorable to the plaintiff, accept its allegations as true, and draw all reasonable inferences in favor of the plaintiff.” Directv, Inc. v. Treesh, 487 F.3d 471, 476 (6th Cir.2007). Despite this liberal pleading standard, we “may no longer accept conclusory legal allegations that do not include specific facts necessary to establish the cause of action.” New Albany Tractor, Inc. v. Louisville Tractor, Inc., 650 F.3d 1046, 1050 (6th Cir.2011). Rather, the complaint has to “plead[ ] factual content that allows the court to draw the reasonable inference that the defendant[s are] liable for the misconduct alleged.” Ashcroft v. Iqbal, 556 U.S. 662, 678, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009). If the Funds do “not nudge[ ] their claims across the line from conceivable to plausible, their complaint must be dismissed.” Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007)...