Moody's Investors Service and Standard & Poor's are to face fraud allegations that they assigned inflated ratings to notes sold to investors, a federal court judge in the United States has ruled.
A case brought by investors including Abu Dhabi Commercial Bank (ADCB) in 2008 alleged negligent representation and breach of fiduciary duty on the part of Morgan Stanley, which originally structured the deal.
Among other plaintiffs is Washington state's King County, which encompasses the city of Seattle.
A US federal judge in New York, Shira Scheindlin, dismissed the fraud claims made against Morgan Stanley but left the door open for fraud cases to be brought against ratings agencies that gave the deal an "investment grade" credit rating.
"Even if Morgan Stanley had actual knowledge that the ratings were false, it could only be liable for aiding and abetting fraud … because the ratings cannot be attributed to Morgan Stanley, the fraud claim against Morgan Stanley is dismissed," the judge said.
Motions to dismiss the case entirely, which had been filed by the two ratings agencies, were also thrown out.
Moody's and S&P both assigned the investment vehicle, Cheyne Finance, their highest credit ratings in the years preceding its liquidation in 2007.
An analyst from Moody's said at the time the Aaa rating on Cheyne meant it "should survive the equivalent of the US Great Depression".
Cheyne Finance, a so-called structured investment vehicle or SIV, was designed to profit from borrowing short-term through issuing commercial paper and investing in long-term securities, many of them backed by residential mortgages.
The implosion of a number of SIVs when the US mortgage market started to malfunction in 2007 contributed to a wide-scale liquidity crisis across the financial services sector, culminating in multiple bank bailouts and an unprecedented injection of funds by the US Federal Reserve.
Instant messenger dialogue provided as evidence in the case revealed credit analysts at S&P had misgivings about signing off on the risks involved in the deal before it was launched.
"That deal is ridiculous … we should not be rating it," said one analyst. "We rate every deal," replied another. "It could be structured by cows and we would rate it."
Cheyne Finance collapsed in 2007. That year, ADCB set aside Dh493.5m (US$134.3m) in provisions.
"We're pleased that the court, after examining the evidence, has recognised the value of our fraud claims against Morgan Stanley and the rating agencies," Daniel Drosman, a lawyer with the firm Robbins Geller Rudman & Dowd who represents the investors, told Bloomberg News.
ADCB also previously filed suits against Credit Suisse and S&P in New York over other investments in credit-default swaps, which the Abu Dhabi bank believes were missold.
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