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FORUM (FORUM & FOCUS) - Jul. 27, 2009

Ratings (Fool's) Gold

By Mark Labaton

Credit rating agencies, which bear significant responsibility for the financial collapse of 2008, hope to avoid liability by using the First Amendment as their shield — a defense the courts should reject.

In recent years, these agencies provided guidance and ratings instrumental in putting trillions of dollars of mortgaged-backed securities — often referred to as collateralized debt obligations — on the market. They played the same role in assembling structured investment vehicles. Much like collateralized debt obligations, structured investment vehicles are a mixture of assets packaged together and rated.

These obligations typically were securitized loans segregated into tranches, packaged into bonds, and given ratings. Each rating was a stamp of approval, made to assure purchasers the investments were sound.

Without the ratings, these securities could not have been sold; and, without them, banks would not have made millions of poorly underwritten loans. But when the housing bubble burst, investors learned high ratings vastly overstated these securities' value.

As they have done in the past, the rating agencies will rely on the First Amendment to dodge accountability. These agencies, Moody's, Standard & Poor's and Finch, contend that the First Amendment protects them from liability because — like The Wall Street Journal and other publications — they employ journalists and "editorial" writers, who enjoy special First Amendment protections. But their faith in the First Amendment will be tested.

Besides rating collateralized debt obligations and structured investment vehicles, the rating agencies also helped segregate these securities into tranches, determined the capital parameters and cushions for each tranche, and otherwise helped design the capital structure to market them. The collateralized debt obligations and structured investment vehicles could not have been sold without these agencies, which were paid lucrative fees of up to $1 million to help package each deal on top of premium fees to rate them.

When they rate municipal and corporate bonds, these agencies do not help design or market anything. Instead, they only evaluate each offering's value, and synthesize this information into a rating. Then, somewhat like a publisher, they sell their ratings to subscribers, many of whom are investors.

With collateralized debt obligations and structured investment vehicles, however, the agencies acted more like underwriters (who structure and market offerings) than like publishers, according to a paper for the Hudson Institute by Joseph R. Mason, a Louisiana State University finance professor, and Joshua Rosner, an institutional investor adviser. The difference is critical. Publishers can rely on qualified, though powerful, First Amendment defenses. Underwriters cannot rely on these defenses; rating agencies should not be allowed to do so either.

Frank Partnoy, a professor at University of San Diego Law School, agrees that the rating agencies did not act like publishers in structuring the collateralized debt obligations and structured investment vehicles. In a white paper for the Council of Institutional Investors, he explains that by helping assemble these instruments, the rating agencies opened up lucrative markets.

Depending on the situation, these agencies compare themselves to both publishers and financial services companies. To justify their executives' compensation, they compare themselves to financial service companies, whose executives earn far more than publishing executives. Similarly, outside of litigation, rating agencies (and issuers) acknowledge the substantial assistance they provide. Yet, when sued, these agencies contend they are publishers.

Recent cases against the rating agencies are in the early stages, though it seems clear that they will rely on precedents that they function like publishers. Some of these cases are factually different from recent collateralized debt obligations and structured investment vehicles cases because they were brought by entities allegedly harmed by low ratings. In other cases, including one brought after the collapse of Enron Corporation, the agencies played a greater participatory role.

Parties suing publishers are sometimes required to demonstrate that the publisher acted with "actual malice." This barrier, set by the Supreme Court in New York Times v. Sullivan, must be overcome in defamation lawsuits brought by public officials against news organizations.

New York Times v. Sullivan protects these organizations from defamation lawsuits when they publish information negligently or even recklessly. The rationale is that limiting these officials' redress for reputational injuries is preferable to restricting open discourse of public issues -political speech essential to democratic government. But this limitation should not apply to non-defamation lawsuits or lawsuits that do not involve editorial-type opinions; it should limit actions brought by collateralized debt obligations or structured investment vehicles investors. Buying either rating was no different than paying for an expert opinion and having that expert help structure a transaction, which are not protected by the First Amendment.

By using flawed rating models, the rating agencies transformed pools of junk mortgages (or other assets) into securities supposedly worth far more than the sum of their parts. In reality, these securities were overvalued. The rating agencies' desire to please their clients was so strong that, in the words of one rating executive, the securities could have been "structured by cows" and they still would have received high ratings.

Inevitably, the rating agencies had to downgrade half their collateralized debt obligations ratings often because they failed to account for a drop in housing prices and for high-risk, poorly underwritten, loans. And, they downgraded many structured investment vehicles ratings as well.

Now that they are under fire, kinks have appeared in the rating agencies' armor. For example, this month Calpers, the nation's largest pension fund, sued the three major credit agencies in San Francisco Superior Court in connection with $1 billion in losses allegedly caused by "wildly inaccurate" ratings for structured investment vehicles investments it owned.

Moreover, a district court judge in New York recently held that conflicts of interest in how it was paid subjected Moody's to liability to its investors. And, Sen. Jack Reed, D-R.I., has introduced legislation that would hold the rating agencies accountable for intentional and reckless conduct.

Rating agencies oppose this legislation on the ground that the courts are already equipped to ferret out claims against them. At the same time, however, they intend to mount First Amendment defenses to short- circuit any ferreting.

Courts should reject these defenses as the 2nd Circuit did a few years ago when a bank suing its broker subpoenaed records from Fitch. Fitch tried to resist the subpoena by arguing it was a "news-gathering" organization protected by the First Amendment and New York's press shield law. But the 2nd Circuit rejected that argument because Fitch: was paid by the company whose securities it rated, and played "a fairly active role ... in commenting on proposed transactions and offering suggestions about how to model" them "to reach desired ratings," demonstrating "a level of involvement with the client's transactions that is not typical of the relationship between a journalist and the activities upon which the journalist reports." This reasoning should also apply to rating agencies that worked closely with, and were paid, by issuers.

Moreover, as an Oklahoma state appellate court held, purchased ratings are commercial transactions, not opinions. This distinction makes sense: A columnist cannot be sued for expressing an opinion, but a rating agency should be liable for its conduct. (The conduct here was not even commercial speech, a form of expression entitled to some deference, but less than political speech.)

Rating agencies should be held accountable for expert services that they provided to issuers. Although these agencies contend their ratings are "editorials," editorial writers are not paid by those whom they write about. As Eric Dash of The New York Times accurately analogized, having a customer buy a rating is like having Hollywood studios pay "movie critics to review their would-be blockbusters."

The First Amendment should not block lawsuits brought by collateralized debt obligations and structured investment vehicles investors against rating agencies. Without this barrier, these investors might stand a fighting chance of recovering a portion of their losses.

Mark Labaton is a partner at Kreindler & Kreindler, where he litigates securities, corporate governance and whistle-blower cases. He can be reached at mlabaton@kreindler.com.