The Court of Appeals for the Seventh Circuit recently decided that an investor in securities was not an intended third party beneficiary of the contract between the issuer of those securities and the rating agency that rated them. Therefore, the investor had no right to bring a lawsuit under that contract.
In Quinn v. The McGraw-Hill Companies, Inc., the plaintiff, the majority shareholder of two small banks, purchased collateralized mortgage obligations on behalf of the banks. The banks could purchase CMOs only if they were rated "A" or better. At the time of the investment, the CMOs were rated "A" by Standard & Poor's, and the plaintiff claimed he relied on that rating.
About three years later, the CMOs were downgraded to "CCC" and then defaulted. The plaintiff brought suit against S&P alleging that, as an investor in the CMOs, he was an intended third party beneficiary of the contract between S&P and the issuer and that S&P had breached the contract. He also sued S&P for negligent misrepresentation by assigning the "A" rating in light of other information known to S&P.
The court denied the plaintiff's contract claim on the ground that he was not an intended third party beneficiary and therefore had no right to bring an action against the rating agency. Based on the "intent to benefit" rule followed in many jurisdictions, the court stated that a third party beneficiary may bring a contract claim only if there is express language in the contract declaring an intent to benefit the third party or if the implication of the contract is "so strong as to be practically an express declaration."
In this case, however, despite the plaintiff's claim that the "very existence [of] an independent rating agency is doubtful without investor reliance," the court found that the plaintiff failed to demonstrate that he was an intended beneficiary of the contract between the issuer and the rating agency. Although investors are direct beneficiaries of the rating assigned to a security, the court found that the contract between the rating agency and the issuer is not exclusively for the benefit of the investors and therefore, in the absence of an express intent to benefit investors, an investor could not sue the rating agency.
The court noted that issuers derive certain benefits from receiving a rating that are unrelated to the benefits received by investors in those securities, such as enabling the issuer to set interest rates and determine other marketing strategies. The court analogized this case to that of manufacturers of electrical appliances that submit their products to Underwriters Laboratories for review, yet consumers are not considered third party beneficiaries of such contracts.
The court also dismissed the negligent misrepresentation claim on the ground that the plaintiff had reason to be on notice of the very same discrepancies it accused the rating agency of overlooking in assigning its rating. The court concluded that no reasonable jury could have found that the plaintiff relied on S&P's evaluation of the quality of the bonds and any reliance that might have been placed on the rating was unreasonable. So S&P won on this count, too --though its victory, on the basis that reliance on its rating would have been unreasonable, seems ironic.