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Because Congress has left the courts unarmed, a federal judge said, he wasn’t able to find a rating agency liable for listing a Ponzi scheme in its hedge fund database used by investors.

U.S. District Senior Judge Berle M. Schiller of the Eastern District of Pennsylvania held that Morningstar Inc., which listed Robert Stinson Jr.’s Ponzi scheme in its database for two years with virtually no inspection, couldn’t be required to contribute to investor losses.

Stinson and his various entities were found liable for more than $14 million last year.

The receiver for the estate sought to recover investor losses from Morningstar under the Securities Exchange Act, but that act—Rule 10b-5, specifically—doesn’t allow for it, Schiller said.

“This outcome is necessitated by Congress’s failure to effectively regulate agencies that publish information about investment vehicles,” Schiller said. “Although Rule 10b-5 does not cover Morningstar’s conduct, Congress could take further action to prevent databases such as Morningstar’s from publishing hedge fund data without checking its accuracy.”

“Morningstar’s approach to collecting and publishing data is best described as ‘garbage in, garbage out.’ In the absence of meaningful regulation, this court is powerless to protect investors from such ‘garbage,’” the judge said.

He entered judgment in favor of Morningstar.

The company’s database included about 8,000 hedge funds during the time that Stinson’s fund, called STABL, was there, according to the opinion. In 2009, one of Stinson’s employees filled out the questionnaire and submitted the biography required by Morningstar in order to be listed. All of the information submitted was false, Schiller said. He also noted that Stinson’s employees didn’t know that Stinson was running a Ponzi scheme.

After a single email from a Morningstar data analyst to Stinson’s employee that didn’t indicate the analyst recognized the information was false, STABL was included in Morningstar’s database.

STABL was one of Stinson’s six entities that were part of the Ponzi scheme, which had a total of about 270 investors, according to the opinion. Forty of them testified during a bench trial that was held in January for the case.

The minimum investment in the STABL fund was $5,000.

“To prevail on his claim for contribution, the receiver must establish all the elements of a claim under Rule 10b-5,” Schiller said. “The receiver therefore must establish that Morningstar (1) made a misstatement or an omission of a material fact (2) with scienter (3) in connection with the purchase or the sale of a security (4) upon which investors reasonably relied, and (5) that the misrepresentation proximately caused the injury.”

Since Morningstar didn’t act with scienter and it wasn’t reasonable for the investors to rely on its statements, Morningstar can’t be held liable, the judge found.

He identified eight false statements with regard to the STABL fund published on Morningstar’s website—five that were repeated from Stinson’s false information and three that were calculations done by Morningstar based on Stinson’s information—and he held that Morningstar could be considered the “maker” of all those statements under Rule 10b-5.

The three calculations could clearly be attributed to Morningstar, but the five statements repeated from Stinson were a closer question, Schiller said.

Ultimately, he held that Morningstar could be considered the “maker” of the statements because it published the fund’s data without attribution and it had complete control over how to convey information to investors.

Similarly, Schiller found that Morningstar had failed to disclose two red flags regarding the STABL fund to investors.

However, in order to prevail under Rule 10b-5, “the receiver must prove that Morningstar acted with scienter when it omitted the two risk flags or when it made one of the eight misstatements,” Schiller said. The receiver didn’t meet that bar.

“That Morningstar was generally aware of the risk that self-reported hedge fund data might be inaccurate does not show that Morningstar knew or must have known that the STABL fund’s data were inaccurate. Therefore, the receiver cannot establish scienter based on Morningstar’s acceptance of the STABL fund’s returns data,” Schiller said.

“Morningstar also did not act knowingly or recklessly in failing to disclose the STABL fund’s risk flags on Morningstar.com, or in continuing to publish information about the STABL fund after identifying the risk flags. The risk flags assigned to the STABL fund reflected the absence of certain checks on fraud, but these flags did not alone indicate fraud. Indeed, half of the hedge funds in Morningstar’s database had three or four risk flags. Therefore, the risk flags were not a clear reflection of fraud, and Morningstar’s failure to disclose them did not present an obvious danger of misleading investors,” the judge said.

As to whether the investors reasonably relied on Morningstar’s statements, Schiller said, “Only 15 investors testified that they would not have invested if they had not been aware of Morningstar’s statements. It is a close question whether the remaining 25 investors would have invested in the absence of Morningstar’s statements. However, even if these investors relied on Morningstar within the meaning of Rule 10b-5, their reliance cannot support liability because it was unreasonable.”

The U.S. Court of Appeals for the Third Circuit identified five factors to weigh when considering whether an investor’s reliance was reasonable in its 1976 opinion in Straub v. Vaisman & Co. Only one of those factors—the sophistication of the investor—favored the receiver, Schiller held.

Because he found that Morningstar didn’t act with scienter and the investors didn’t reasonably rely on its statements, Schiller found in favor of the rating agency.

“It was a unique case,” said Gaetan Alfano of Pietragallo Gordon Alfano Bosick & Raspanti, who represented the receiver, Kamian Schwartzman. It might be the first one to pursue a rating agency under Rule 10b-5 on a contribution claim, he said.

Although, as the judge found, Rule 10b-5 doesn’t cover Morningstar, Schwartzman was compelled to bring the case because Stinson had so “thoroughly pilfered” the investors’ retirement funds that there was no other avenue for recovery, Alfano said.

From Morningstar’s perspective, according to its lawyer, Jeffery Dailey of Akin Gump Strauss Hauer & Feld, this was a case where a hedge fund manager submitted false data to an agency that operates consistent with others in the industry.

“The real issue is hedge fund regulation,” Dailey said.

Saranac Hale Spencer can be contacted at 215-557-2449 or sspencer@alm.com. Follow her on Twitter @SSpencerTLI.

(Copies of the 47-page opinion in Schwartzman v. Morningstar, PICS No. 14-1225, are available from The Legal Intelligencer. Please call the Pennsylvania Instant Case Service at 800-276-PICS to order or for information.)