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HuffPost Investigative Fund

Under Attack, Credit Raters Turn to the First Amendment

Ben Protess and Lagan Sebert

Standard and Poor’s New York headquarters (Lagan Sebert)

For two decades, the nation's top credit rating agencies have
managed to fend off a crackdown from Washington by relying on a
surprising ally - the First Amendment.

Despite their key role in the most recent economic calamity, the
three big bond raters-Standard & Poor's, Moody's and Fitch-seem
poised to do it again. With help from two of the most storied
constitutional lawyers in the country, the raters have successfully
argued that when they make a mistake -- say, awarding the top triple-A
grade to a multibillion-dollar bundle of bonds that later default --
they cannot be sued or held accountable.

That's because ratings are opinions, the agencies claim, protected by the constitutional right to free speech.

A Huffington Post Investigative Fund examination of court filings,
congressional testimony and Securities and Exchange Commission
documents illustrates how the companies have repeatedly invoked that
right to free speech to dodge government regulation and court action.
The raters have never lost a courtroom battle to a disgruntled
investor, not even in the Enron scandal. Enron enjoyed high grades on
its bonds just four days before it filed for bankruptcy in 2001.

Critics of the rating companies argue that they are misusing the
Bill of Rights to protect a flawed but highly profitable business.

Frank Partnoy, who used to design investment products while working
for Morgan Stanley, said that given the success of the First Amendment
defense, it is not surprising the companies have published
"unreasonably high" ratings. "Rating agencies have had a free go at it
under a cloak of the First Amendment," said Partnoy, now a professor at
the University of San Diego Law School.

But Floyd Abrams, the renowned First Amendment lawyer who has
represented Standard and Poor's for more than 20 years, said the rating
companies are entitled to the same free-speech protections afforded to

"It's an opinion," Abrams said. He acknowledged: "It may not be a
great opinion if, when you look back on it, you say, ‘you gave it
triple-A, how could you do this?'"

To be sure, there have been some small cracks in the credit raters'
defenses given the magnitude of the current financial crisis. Last
month, a federal judge in New York declined to dismiss an investor's
lawsuit even in the face of a First Amendment claim.

And on Wednesday, the House Financial Services Committee approved
the latest bill designed to rein in the agencies. But after hearing
testimony last month from the raters' lawyers and executives, the
committee backed off a plan to make the companies collectively liable
for mistakes in each others' ratings.

Partnoy said he expects lawmakers to water down most attempts at tightening regulation of the business.

"I've watched the rating agencies be recklessly wrong, over and over
again, and I've seen them get nothing more than a slap on the wrist,"
said Partnoy, who is also an expert consultant for the government,
defense attorneys and plaintiffs, including investors who sue the
raters. "Anytime you can hold up the Constitution, it's going to get
people's attention."

'The Safest Possible Place'

Credit raters are entrenched in the U.S. financial system.

When banks, corporations or city governments want to raise money,
they issue debt in the form of bonds for investors to purchase. The
rating companies judge the quality of the bonds. Ratings can range from
the highly-coveted triple-A to the "junk" bond status of C or lower.

For several decades, until the early 1970s, the big three raters
charged investors for ratings. Then the rating companies started
charging the banks and companies that issue the bonds. That payment
arrangement, critics argue, creates an inherent conflict of interest,
where the agencies serve the issuers rather than the investors who rely
on the ratings.

King County in Washington state relied on ratings and lost between
$70 and $100 million from a several-billion dollar fund that manages,
among other things, school lunch programs, according to the county's
lawyers. Along with the Abu Dhabi Commercial Bank, the county filed a
lawsuit against S&P and Moody's alleging that they used "flawed"
assumptions to issue "false and misleading" ratings.

Some of the investments King County made were rated triple-A, its
suit alleges, leading the county to believe it was making conservative

"They were trying to be good fiduciaries and put their money in the
safest possible place," said Patrick Daniels, an attorney for the

Despite the top rating, the investment was actually quite risky. The
county had bought into structured investment vehicles, which are
complex bundles of bonds backed by assets such as mortgages, credit
cards and car loans. When the mortgages defaulted, so went the bonds,
and ultimately the county's money.

Another lawsuit brought by the California Public Employees'
Retirement System alleges that the fees for rating structured products
ranged from $300,000 to $1 million per deal.

Indeed, the rating companies saw their profits peak in 2006 and 2007
while structured products were flourishing. Now that bubble has burst,
and the raters' profits have returned to 2005 levels. But even in a
down year like 2008, S&P and Moody's generated more than $1.7
billion in revenue. Moody's last year had net income of $457 million
while Standard and Poor's saw operating profits of more than $1
billion, although that total includes earnings from the S&P index.

Fitch is not a publicly traded company so its profits are unknown.
Fitch and Moody's officials declined requests for an interview.


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A federal judge in New York last month threw out most of King
County's claims but refused to dismiss the suit altogether. In a rare
defeat for the agencies' First Amendment defense, Judge Shira
Scheindlin said in a preliminary ruling that because the county alleged
the ratings were not widely published, the companies weren't entitled
to free-speech protections.

‘Part of the Culture'

Some former Moody's employees believe the rating companies are wrong to claim free-speech protections.

"To my eye, the problem with the First Amendment defense is it seems
to shield them from any accountability," said Jerome Fons, a former
managing director for credit quality at Moody's.

Eric Kolchinsky, a former Moody's managing director turned critic of
the company, said that the First Amendment defense enabled some Moody's
analysts to adopt a laissez faire attitude toward the quality of
ratings. "Some people almost didn't even care because they feel it's
just an opinion," said Kolchinsky, who is also a lawyer. "It's part of
the culture there."

Kolchinsky added, however, that he believes the raters' First Amendment protections should not be lifted entirely.

Egan-Jones Rating Co. is a smaller competitor of the big three that
sells its ratings to investors instead of bond issuers to avoid a
conflict of interest. Sean Egan, the company's managing director,
believes that rating companies should be entitled to some free-speech
protections because "it's legitimate to make mistakes." But when bond
issuers pay for ratings, Egan said, "there's a clear bias" and the
"potential liability should increase."

Floyd Abrams is joined in his defense of the companies by Laurence
Tribe, a longtime Harvard Law professor who was hired by Moody's in
June. He was a law-school mentor to then-student Barack Obama and later
became an adviser to Obama's presidential campaign.

In an interview with the Investigative Fund, Abrams said that credit
ratings are educated opinions about the quality of bonds, not
guarantees that the bonds will or will not default."Is it an opinion
based upon a level of expert knowledge and analysis? I hope so," Abrams
said. "That certainly is what rating agencies try to be and try to do."

The First Amendment protects other opinions, such as newspaper editorials, so why not credit ratings, he argues.

Abrams noted that there are some limitations to the First Amendment
defense. It cannot shield the raters from fraud, he said. And even with
free-speech protections, Abrams said the agencies still face some
accountability for their ratings.

"We've got lots of lawsuits." About forty to be more exact, he said.

‘Believe It When I See It'

Investors are also looking to Congress and the SEC to hold the rating companies accountable.

But nearly every time the SEC has broached the idea of rating agency
reform, the companies have filed comments with the commission invoking
the First Amendment, records show. In the face of these claims, the SEC
has often either abandoned or modified some of its attempts at
regulation. The rating companies said they have tightened internal
controls in response to criticism and remain open to some government

More recently, the commission enacted some rating agency regulations
to increase competition among the agencies and require them to disclose
their conflicts of interest. The commission also approved rules this
month that will require agencies to disclose a history of their
ratings. It's now discussing a plan to expose the rating companies to
greater liability in certain situations.

But Congress has prevented the SEC from changing the rating
companies' methodologies. Abrams and agency executives have flocked to
Capital Hill in recent years to remind lawmakers that those
methodologies are protected by the First Amendment, congressional
testimony shows.

Rep. Paul Kanjorski (D-Pa.), a member of the House Financial
Services Committee, proposed a draft bill last month that would have
required the companies to share liability when one violates securities
laws. The committee approved a modified proposal Wednesday, by a 49-14
vote, without such a provision. The bill would instead make it easier
for investors to sue the companies if they fail to follow their own
rating methods, a feature sure to attract opposition from the companies
as it hits the House floor and the Senate.

Partnoy, the law professor, said he doubts Congress will allow much to change.

"I'll believe it when I see it," he said. "The agencies are on their
own, against common sense and public opinion, and yet they continue to

Maria Zilberman and Rachel Leven contributed research for this report.

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