Varga et al v. McGraw Hill Financial, Inc. et al

Filing 41

ORDER AND OPINION re: 22 MOTION to Remand to State Court. filed by Mark Longbottom, Geoffrey Varga. For the reasons herein, the motion is granted and the case is remanded to the Supreme Court of the State of New York. The Clerk of Court is directed to close the Motion at Docket No. 22 and to terminate the case. (Signed by Judge Lorna G. Schofield on 8/4/2014) (kgo)

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
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:
GEOFFREY VARGA, et al.,
:
:
Plaintiffs,
:
:
-against:
:
MCGRAW HILL FINANCIAL, INC., et al.,
:
Defendants. :
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8/4/14

13 Civ. 08743 (LGS)
ORDER AND OPINION

LORNA G. SCHOFIELD, District Judge:
Plaintiffs Geoffrey Varga and Mark Longbottom (“Plaintiffs”), as Joint Official
Liquidators of Bear Stearns High-Grade Structured Credit Strategies (Overseas) Ltd. and Bear
Stearns High-Grade Structured Credit Strategies Enhanced Leverage (Overseas) Ltd. (together,
the “Overseas Funds”) seek to remand this action to state court, asserting that this Court lacks
subject matter jurisdiction because no substantial federal question is implicated by their state law
claim (“Motion”). For the reasons below, the Motion is granted and the case is remanded to the
Supreme Court of the State of New York.
I.

BACKGROUND
Plaintiffs allege that the three foremost credit-rating agencies in the United States engaged

in widespread fraud by misrepresenting the objectivity and accuracy of their ratings. At issue is
whether Plaintiffs’ claim of fraud should be adjudicated in New York state court, where it was
brought, or in federal court, where the case is currently pending as a result of Defendants’
removal pursuant to 28 U.S.C. §§ 1441 and 1446.
Defendants are McGraw Hill Financial, Inc. and its subsidiary, Standard & Poor’s
Financial Services LLC (together, “S&P”); Moody’s Corporation and its subsidiaries, Moody’s
Investors Service, Inc. and Moody’s Investors Service Limited (together, “Moody’s”); and Fitch
Group, Inc., and its subsidiaries, Fitch Ratings, Inc. and Fitch Ratings Limited (together, “Fitch”)

(collectively, the “Rating Agencies” or “Defendants”). Defendants’ business involves evaluating
the creditworthiness of financial products, and each Rating Agency has developed its own rating
scale to accomplish that purpose. S&P and Fitch use a rating scale ranging from “AAA,” which
represents the highest quality, lowest risk security, to “D,” representing the lowest quality,
highest risk security. Moody’s uses a similar scale, with “Aaa” representing the highest quality,
lowest risk security, and “C” representing the lowest quality, highest risk security. The Rating
Agencies are compensated under what is commonly known as the “issuer pays” model. Under
that model, the Rating Agencies charge the issuers of financial products a fee that corresponds to
the complexity and size of the product being rated.
Each of the Defendants has been granted the status of “nationally recognized statistical
rating organization” (“NRSRO”) by the Securities & Exchange Commission. To obtain (and
subsequently maintain) that status, federal law—specifically, the Credit Rating Agency Reform
Act of 2006 (“CRARA”), 15 U.S.C. § 78o-7, et seq., and its implementing regulations—requires
NRSROs to demonstrate that their ratings are objective and that they have implemented “policies
and procedures . . . to address and manage any conflicts of interest . . . .” Id. § 78o-7(h)(1). To
that end, each of the Ratings Agencies has adopted a code of conduct1 that purports to ensure
independence, transparency and objectivity in ratings.
Plaintiffs are the Official Joint Liquidators of the Overseas Funds, currently in liquidation
proceedings before the Grand Court of the Cayman Islands. The Overseas Funds are invested in
“Master Funds,” through which all trading activity takes place. Plaintiffs’ claim in this action is
asserted on behalf of the Overseas Funds and derivatively on behalf of the Master Funds.
1

The S&P Code of Practices and Procedures was initially issued in September 2004 and was
updated with the adoption of “Standard & Poor’s Rating Services Code of Conduct” in October
2005. The “Moody’s Code” was adopted in June 2005 and Fitch’s code was adopted in April
2005.
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The Overseas Funds, through the Master Funds, are invested in structured finance
securities, including residential mortgage-backed securities (“RMBS”) and collateralized debt
obligations (“CDOs”). The Funds are invested only in “high-grade” securities—that is, securities
that were rated between AAA and AA- or the equivalent by Defendants. Plaintiffs assert that the
Funds relied heavily on the ratings assigned by Defendants in selecting their investments, in large
part because the Rating Agencies had access to information about the assets underlying the CDOs
and RMBS that was not accessible to the greater public, and possessed unique tools and expertise
for analyzing that information.
Plaintiffs’ claim in this case centers on their allegation that Defendants misrepresented the
risk and quality of the securities at issue, the currency and accuracy of their models and
Defendants’ own objectivity and independence. Plaintiffs contend that Defendants’ ratings were
motivated primarily by their own financial interests, leading them to manipulate their models and
issue inaccurate ratings in order to capture market share and greater profits under the issuer-pays
model. According to Plaintiffs, the Funds’ reliance on inaccurate ratings led the Funds to invest
in subprime securities that eventually lost all of their value, leading to the collapse of the Funds
and the present liquidation proceedings. Plaintiffs’ complaint asserts one cause of action—
common law fraud under New York law. For relief, Plaintiffs seek both compensatory and
punitive damages.
II.

STANDARD
The removal statute entitles a party to remove from state court “[a]ny civil action . . . of

which the district courts . . . have original jurisdiction.” 28 U.S.C. § 1441. Congress has granted
district courts original jurisdiction over “all civil actions arising under the Constitution, laws, or
treaties of the United States.” 28 U.S.C. § 1331. An action may “arise” under federal law within
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the meaning of § 1331 in one of two ways. First, and in the “vast bulk” of cases, a suit arises
under federal law where federal law creates the cause of action. Gunn v. Minton, 133 S. Ct. 1059,
1064 (2013). Second, and relevant here, a case may arise under federal law, even where no
federal cause of action is asserted, where state law claims “implicate significant federal issues.”
Grable & Sons Metal Prods., Inc. v. Darue Eng’g & Mfg., 545 U.S. 308, 312 (2005). This form
of “‘arising under jurisdiction’” “captures the commonsense notion that a federal court ought to
be able to hear claims recognized under state law that nonetheless turn on substantial questions of
federal law, and thus justify resort to the experience, solicitude, and hope of uniformity that a
federal forum offers on federal issues . . . .” Id.
Whether a substantial federal question is implicated by state law claims is assessed on the
basis of the inquiry articulated by the Supreme Court in Grable, according to which “jurisdiction
over a state law claim will lie if a federal issue is: (1) necessarily raised, (2) actually disputed, (3)
substantial, and (4) capable of resolution in federal court without disrupting the federal-state
balance approved by Congress.” Gunn, 133 S. Ct. at 1065 (summarizing Grable elements). All
four requirements must be satisfied in order for a federal court to have jurisdiction. Id.
The existence of a substantial federal question is “determined by reference to the ‘wellpleaded complaint.’” Merrell Dow Pharm. Inc. v. Thompson, 478 U.S. 804, 808 (1986). Under
the artful pleading doctrine, however, a plaintiff may not “avoid[ ] removal by framing in terms
of state law a complaint the real nature of [which] is federal, regardless of plaintiff’s
characterization, or by omitting to plead necessary federal questions in the complaint.” Marcus v.
AT&T Corp., 138 F.3d 46, 55 (2d Cir. 1998) (second alteration in original) (internal quotation
marks omitted). In addition, a federal defense is not sufficient to confer jurisdiction on a district
court under Grable. Caterpillar, Inc. v. Williams, 482 U.S. 386, 393 (1987); New York v.
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Shinnecock Indian Nation, 686 F.3d 133, 138-40 (2d Cir. 2012).
“[F]ederal courts construe the removal statute narrowly, resolving any doubts against
removability.” Purdue Pharma L.P. v. Kentucky, 704 F.3d 208, 213 (2d Cir. 2013) (quoting
Lupo v. Human Affairs Int’l, Inc., 28 F.3d 269, 274 (2d Cir. 1994)). The burden to establish
federal jurisdiction lies with the removing party. Blockbuster, Inc. v. Galeno, 472 F.3d 53, 57-58
(2d Cir. 2006).
III.

DISCUSSION
The federal courts lack jurisdiction over this action under the standard enunciated in

Grable because a federal issue is not “necessarily raised” by the Complaint’s state law fraud
claim.
To succeed on a claim for fraud under New York law, a plaintiff must establish “[1] a
misrepresentation or a material omission of fact which was false and known to be false by
defendant, [2] made for the purpose of inducing the other party to rely upon it, [3] justifiable
reliance of the other party on the misrepresentation or material omission, and [4] injury.”
Premium Mortg. Corp. v. Equifax, Inc., 583 F.3d 103, 108 (2d Cir. 2009) (alterations in original)
(quoting Lama Holding Co. v. Smith Barney Inc., 88 N.Y.2d 413, 421, 646 N.Y.S.2d 76 (N.Y.
1996)). The Complaint asserts that Defendants misrepresented their objectivity and the accuracy
of their ratings, and that the Funds detrimentally relied upon those misrepresentations when
purchasing securities. No interpretation of federal law is required to assess whether Defendants
did or did not engage in such misrepresentations, or whether Plaintiffs relied on those
misrepresentations and suffered financial loss in doing so.
In contending otherwise, Defendants assert that resolution of Plaintiffs’ claim will require
construction of federal law because CRARA both authorizes the issuer-pays model that allegedly
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incentivized Defendants to make misrepresentations and requires the Rating Agencies to adopt
policies that ensure their objectivity and independence. Therefore, according to Defendants, an
assessment of whether or not the Rating Agencies “did in fact adhere to their assertions of
independence and objectivity” will require an interpretation of CRARA.
This argument is incorrect for three reasons. First, it recasts Plaintiffs’ claim as an
allegation that the Rating Agencies failed to comply with federal law, when in fact Plaintiff’s
claim is a claim of misrepresentation. Plaintiffs chose not to assert claims under federal law, and
the fact that they “could have brought federal . . . claims based on the factual allegations
contained in the complaint is not sufficient to convert the state law claims into federal questions.”
Glazer Capital Mgmt., LP v. Elec. Clearing House, Inc., 672 F. Supp. 2d 371, 377 (S.D.N.Y.
2009) (emphasis in original). Second, because the sole claim is one for misrepresentation,
CRARA is only incidental to that claim; “nothing in CRARA says that the SEC defines the truth
or falsity of statements made about the independence of [a Rating Agency’s] credit rating process
. . . .” Illinois v. McGraw-Hill Cos., Inc., No. 13 Civ. 1725, 2013 WL 1874279, at *4 (N.D. Ill.
May 2, 2013). This statement holds true regardless of whether some of the alleged
misrepresentations were made in federally-mandated documents such as the Agencies’ respective
codes of conduct. Accord Sung v. Wasserstein, 415 F. Supp. 2d 393, 406 (S.D.N.Y. 2006)
(“[T]hat the [allegedly false] statements were made in a federally required document does not
change the inquiry [into] whether, standing alone, they were false or misleading . . . under state
law.”). Third, whether or not Defendants’ conduct was authorized or even required by CRARA
is simply a defense to their allegedly unlawful actions. A defense that arises under federal law
does not confer federal subject matter jurisdiction over a state law claim. Caterpillar, 482 U.S. at
393.
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The case law Defendants rely on for their argument that “federal jurisdiction exists for
disputes regarding compliance with rules required by the federal securities laws” does not compel
a different conclusion. In each of those cases, the plaintiffs asserted state law claims predicated
on violations of federal law or violations of obligations rooted exclusively in federal law. In
D’Alessio v. N.Y. Stock Exch., Inc. 258 F.3d 93 (2d Cir. 2001), for example, the Second Circuit
affirmed the district court’s dismissal of a motion to remand a case that had been removed to
federal court, where the “gravamen” of the plaintiff’s state law tort claims against the New York
Stock Exchange was “that [defendants] conspired to violate the federal securities laws . . . and
failed to perform [their] statutory duty, created under federal law.” Id. at 101. To resolve those
claims “require[d] a court to construe federal securities laws and evaluate the scope of the
NYSE’s duties, as defined under the Exchange Act and the regulations and rules thereto, in
enforcing and monitoring a member’s compliance with those laws.” Id. at 101-02.
The court in In re Facebook, Inc., also relied upon by Defendants, denied a motion to
remand the case to state court. 922 F. Supp. 2d 475 (S.D.N.Y. 2013). In that case, the plaintiff
asserted a state law claim for negligence arising out of NASDAQ’s system failure during the
initial public offering of Facebook. Id. at 481. The court concluded that resolution of the
negligence claim would require an examination of “what duties a national securities exchange
owes to members of the investing public,” and because the answer to that question was found
exclusively in federal law, the court held that a substantial federal question was presented by the
claim. Id. at 483-85; see, e.g., Sparta Surgical Corp. v. Nat’l Ass’n of Sec. Dealers, Inc., 159
F.3d 1209, 1212 (9th Cir. 1998) (holding that while the plaintiffs’ “theories are posited as state
law claims, they are founded on the defendants’ conduct in suspending trading and delisting the
offering, the propriety of which must be exclusively determined by federal law.”) (emphasis
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added).
Here, in contrast, Defendants are subject to obligations—and plaintiffs are the holders of
rights—that exist independently of federal law. As one court in this district reasoned in a case
with similar facts, “[t]he right plaintiffs say they wish to vindicate is the right not to be lied to in a
fashion that causes reliance and results in financial injury, a right possessed by all New York
residents, not the narrower right not to be lied to in connection with a securities transaction
regulated by federal law.” Fin. and Trading, Ltd. v. Rhodia S.A., 04 Civ. 6083, 2004 WL
2754862, at *6 (S.D.N.Y. Nov. 30, 2004); accord In re Standard & Poor’s Rating Agency Litig.,
13 MD 2446, 2014 WL 2481906, at *11 (S.D.N.Y. June 3, 2014); cf. McGraw-Hill Companies,
Inc., 2013 WL 1874279, at *4. Because adjudication of Plaintiffs’ claim does not require
reference to or construction of federal law, Plaintiffs’ case differs fundamentally from the cases
invoked by Defendants.
Each of the four Grable elements must exist in order to establish that federal jurisdiction
exists. Gunn, 133 S. Ct. at 1065. Because the first element is lacking, the remaining three
elements need not be addressed and the case is not properly before this Court.2

2

Similarly, Plaintiffs assert that “remand is appropriate for the additional and separate reason that
Defendants did not timely file their removal petition.” [Motion at 20]. The Court does not reach
this argument in light of the above disposition.
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IV.

CONCLUSION
For the above reasons, the case is remanded to the Supreme Court of the State of New

York. The Clerk of Court is directed to close the Motion at Docket No. 22 and to terminate the
case.

SO ORDERED.
Dated: August 4, 2014
New York, New York

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