Credit rating agencies may find it harder to argue that their opinions deserve free speech protection after a judge rejected efforts by Moody’s Investors Service and Standard & Poor’s to dismiss a fraud lawsuit.
In a case alleging that inflated ratings on risky mortgages led to investment losses, U.S. District Judge Shira Scheindlin Wednesday said ratings on notes sold privately to a group of investors were not “matters of public concern” deserving broad protection under the First Amendment of the U.S. Constitution.
The Manhattan judge said investors may pursue their lawsuit accusing Moody’s, S&P and Morgan Stanley, which marketed the notes, of issuing false and misleading statements about the notes, which were backed by subprime mortgages and other debt.
Scheindlin’s ruling may affect lawsuits by pension funds — including the nation’s largest, the California Public Employees’ Retirement System, or CalPERS — and other investors that want to hold banks and rating agencies responsible for exaggerating the value and safety of debt in order to win fees.
“This is potentially a very significant opinion,” said Jonathan Macey, a professor at Yale Law School.
“It seems they have found a hole in the First Amendment defense, the agencies’ primary line of defense,” he said. “There is a feeling throughout the investment industry that agencies committed an egregious breach, but the issue is how to gain traction under the law. This opinion seems to give hope.”
Rating agencies typically get broad free-speech protection similar to that afforded journalists, and plaintiffs must often show that ratings reflect “actual malice” before they can recover. That protection, of course, is not absolute.
“The First Amendment doesn’t allow anyone to commit fraud,” said George Cohen, a professor at the University of Virginia School of Law.
Sean Egan, managing director of Egan-Jones Ratings Co, an independent agency critical of how rivals are compensated, called Scheindlin’s ruling “a watershed event. This is the first major breach in the First Amendment defense, and makes it substantially easier for other plaintiffs.”
FEES TIED TO RATINGS
The ruling concerned the Cheyne Structured Investment Vehicle, a package of debt that included subprime mortgages.
Scheindlin said Cheyne issued some notes with “triple-A” ratings, the same as the U.S. government, and others that won “the highest credit ratings ever given to capital notes.”
Meanwhile, the rating agencies were paid more than three times their normal rate, and their fees were “contingent upon the receipt of desired ratings,” she said.
Desirable ratings did nothing to save the Cheyne SIV. It went bankrupt in August 2007.
“You can’t yell fire in a crowded theater, but here it seems the agencies were doing the opposite,” Macey said. “There was a fire, but they were saying there was nothing to worry about, and taking money for saying that.”
The case was brought by Abu Dhabi Commercial Bank and King County in Washington state, which includes Seattle. Moody’s Corp owns Moody’s Investors Service, while McGraw-Hill Cos owns S&P.
Floyd Abrams, the best-known First Amendment lawyer, represents S&P. His office referred a call to S&P spokesman Steven Weiss, who declined to discuss the free-speech issue.
Moody’s spokesman Michael Adler said the company hopes the court will revisit its First Amendment ruling “once the true facts are before it.” Morgan Stanley was unavailable for comment.
In her 68-page ruling, Scheindlin said rating agencies are not afforded the broadest free-speech protection when they distribute ratings to “a select group of investors” rather than the public at large.
The judge said an agency’s opinion may be challenged “if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.” It is no defense to hide behind disclaimers that ratings reflect opinion, she added.
Scheindlin did not decide the merits of the case and dismissed several other claims, including all claims against another defendant, Bank of New York Mellon Corp .
Indeed, one beneficiary may be CalPERS, which in July sued Moody’s, S&P and Fimalac SA’s Fitch Ratings for $1 billion over ratings on Cheyne and other SIVs. CalPERS did not immediately return a request for comment.
In May, Sen. Jack Reed, a Rhode Island Democrat, proposed legislation to let investors sue rating agencies that fail to properly review data needed to develop ratings.
The next month, though, the agencies were largely spared in the Obama administration’s proposed financial regulation overhaul, which called for increased disclosure and oversight but would not change the issuer-pays ratings model.
Egan-Jones’s Egan said rating agencies in general deserve the greater free-speech protection afforded to journalists, at least when their activities are not compromised.
“It should be akin to the newspapers, where you don’t know whether your readership is bullish or bearish on a particular company, and you approach matters with clean hands,” he said.
Macey noted that Scheindlin’s opinion was limited to a privately placed note issue, not debt issuance generally.
“The question is whether the commercial obligation extends to publicly available bonds,” he said. “While I think it should, I’m not sure whether the legal precedent if one is set will be extended that far. But given the incentive conflicts endemic to the industry, that would be a natural extension.”
(Reporting by Jonathan Stempel, editing by Gerald E. McCormick)
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