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Roundtable-Class Action

Game Over -- Is Credit Rating Free Speech?

Credit-rating agencies find that courts and state AGs have become more skeptical of the First Amendment defense.

By the end of last year, the major credit-rating agencies were in the eye of the storm created by the nation's financial crisis. Roughly 20 class actions had been filed in state and federal courts based on allegations ranging from inaccurate ratings to negligence and fraud. Congress debated opening the agencies to more liability, the Securities and Exchange Commission sought to toughen oversight, and several state attorneys general launched investigations.

Much of the litigation is based on huge investor losses in structured investment vehicles (SIVs) that were worth an estimated $400 billion at their peak in June 2007. These instruments, typically composed of highly rated debt contracts and asset-backed securities, were often constructed by the same rating agencies that graded the assets.

But lawsuits against the credit raters face a formidable roadblock in the First Amendment. Over the years, these agencies have successfully asserted they are simply publishers of opinion, insulated from liability under the "actual malice" standard of New York Times Co. v. Sullivan (376 U.S. 254 (1964)).

In 1999, for instance, Orange County's $2 billion negligence claim against McGraw-Hill?parent company of Standard & Poor's?for overly optimistic bond ratings ran directly into a First Amendment defense. The court applied the actual malice standard and dismissed a portion of the county's claim. A school district in Colorado lost a battle that same year with Moody's Investors Services on similar grounds. And in 2005 a federal court in Texas rejected the state of Connecticut's $200 million claim that rating agencies were too slow to downgrade Enron bonds.

However, last September U.S. District Judge Shira A. Scheindlin in New York put a chink in the rating agencies' armor, keeping alive various claims against Moody's and S&P (Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc., 2009 WL 2828018 (S.D.N.Y., filed Sept. 2, 2009)). "Where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is not afforded [actual malice exception] protection," Scheindlin wrote. The judge also held that the plaintiffs had sufficiently pled that "the Rating Agencies' ratings were not mere opinions but rather actionable misrepresentations." (2009 WL 2828018 at *9.)

McGraw-Hill spokesman Frank Briamonte responded that the company was pleased that Scheindlin had dismissed most of the claims and also recognized that the First Amendment applies to the rating agencies. "We are confident that when the court considers more than the plaintiffs' baseless allegations, it will be apparent that the facts do not support the fraud claim, and we will prevail," he said.

A second suit before Scheindlin, filed by Washington state's King County, names the three major rating agencies and IKB Deutsche Industriebank AG. It alleges that an IKB-sponsored debt investment known as Rhinebridge was just a scheme to move losses off its own balance sheet and dump them onto investors (King County, Washington v. IKB Deutsche Industriebank AG, 2009 Civ. 8387 (S.D.N.Y., filed Oct. 2, 2009)).

Other suits alleging fraud, negligent misrepresentation, and conflicts of interest have been filed against the credit agencies by the Teamsters union, carpenters and laborers unions in Indiana, the Louisiana police retirement fund, the California Public Employees' Retirement System (CalPERS), and the state of Connecticut.

Much has changed in the business of rating debt instruments in the decades since the Sullivan decision. For instance, in the 1970s the agencies changed their business model from charging fees to subscribers for ratings and analysis to charging issuers for ratings on their own debt products. But according to Joseph J. Tabacco Jr., a partner in San Francisco's Berman DeValerio Pease Tabacco Burt & Pucillo, there is a critical difference between publishing an editorial in a newspaper and "being paid to participate in building a complex financial product and then touting that product as a safe investment." Tabacco is representing CalPERS in a recent suit that alleges fraud behind $1 billion in losses invested in three SIVs that were highly rated by Moody's, S&P, and Fitch (California Public Employees Retirement System v. Moody's Corp., No. 09-490241 (S.F. Super. Ct., filed Jul. 9, 2009)).

By 2000 the rating agencies had also become deeply involved in structuring the SIVs that hold mortgage-backed securities and collateralized debt obligations. According to the CalPERS complaint, the agencies charged $300,000 to $1 million for structuring an SIV. The complaint also asserts that Moody's was generating $715 million?41 percent of its annual revenue?from structured finance by 2005, and that S&P's revenue from structured finance grew by 800 percent from 2002 to 2006.

Nevertheless, S&P President Deven Sharma told a House Financial Services subcommittee last year, "Our ratings in the mortgage-backed securities area were not venal. These were honest views expressed based on the best information available, dealing with complex instruments." Also, Moody's Chief Credit Officer Richard Cantor testified, "Like other market participants ... we did not fully anticipate the magnitude and speed of the deterioration in mortgage quality or the suddenness of the transition to restrictive lending."

CalPERS witnessed that speed of deterioration firsthand. In the summer of 2007 Moody's and S&P reported that one of the SIVs in the complaint, Cheyne Finance, was doing fine despite the exposure of half its portfolio to subprime mortgages and home equity loans. But just two weeks after its report, S&P downgraded it's rating on Cheyne by six notches. Moody's didn't react until September 5, 2007?the day Cheyne was forced into receivership.

The rating agencies' participation in structuring debt?and the potential for conflicts of interest in an issuer-paid fee system?finally sparked congressional scrutiny last fall. Critics argued that the agencies had become handmaidens of Wall Street, inflating debt ratings to garner hefty fees. In hearings before the House Financial Services Subcommittee on Capital Markets, Chairman Paul E. Kanjorski (D-Penn.), suggested that the agencies be made collectively liable for inaccuracies published by any one of them. Kanjorski sponsored HR 3890, the Accountability and Transparency in Rating Agencies Act.

But in a show of defiance, S&P used famed First Amendment lawyer Floyd Abrams, a partner in New York's Cahill Gordon & Reindel, to defend against several lawsuits and to respond in congressional hearings. In September, Abrams told the House Committee on Oversight and Government Reform, "In general there has been an overreliance on ratings only. ... [Since] the bad events of the last few years, my client has been trying to get out the story of what ratings are and what they're not. They're essentially an assessment of creditworthiness in the future?not of market value, not of volatility, not of liquidity."

S&P's Sharma contends that the agencies have reformed since the onset of the debt crisis. S&P, he says, has improved its analyst training and created risk assessment oversight committees, as well as an ombudsman's office to address potential conflicts. "At S&P, we understand there must be a clear separation between analysts who analyze securities and employees who negotiate issuer fees," Sharma stated in a July advertisement.

In late October the House Financial Services Committee approved HR 3890, albeit without Kanjorski's joint-liability provision. The measure aims to make it easier for investors to sue if the agencies don't follow their own rating methodologies?which cannot be challenged by the SEC under provisions of the Credit Rating Agency Reform Act of 2006.

Meanwhile, California Attorney General Jerry Brown launched his own investigation of potential rating-agency abuses under state law. Brown is focused on the ratings of so-called toxic assets, and on how the agencies "got it so wrong," says Evan Westrup, Brown's spokesman.

But Brown and Connecticut Attorney General Richard Blumenthal?who filed a state action against the credit-rating agencies in June 2008?face yet another legal roadblock: The Credit Rating Agency Reform Act includes a preemption provision that could block regulatory enforcement by the states.

Pamela A. MacLean, a freelance writer based in the Bay Area, has reported on state and federal courts for 25 years.

Kari Santos

Daily Journal Staff Writer

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