Rating Agencies and the First Amendment


Rating agencies have long argued that their ratings of securities are constitutionally protected opinions. Many people have pinned some of the responsibility for the financial markets meltdown on the rating agencies. It sure looks like they gave a fair number of these securities a high rating when they were actually toxic.

Abu Dhabi Commercial Bank and King County, Washington decided to bring a class action because of their losses in a structured investment vehicle. They included the arranger, placement agent, the rating agencies, the administrator and others involved in the structuring of the securities issued by the structured investment vehicle. The plaintiffs included a full slate of claims against these parties.

The first decision in the law suit was a ruling on a motion to dismiss that was issued last week. U.S. District Judge Shira Scheindlin ruled in this opinion that the investors in the structured investment vehicle containing mortgage-backed securities sufficiently alleged an actionable misstatement against the credit rating agencies and the investment bank that placed the rated notes.

Under typical circumstances, the First Amendment protects ratings agencies, unless there was actual malice. (See Compuware Corp. v. Moody’s Inv. Servs., Inc.., 499 F.3d 520 (6th Cir. 2007) [pdf.]) But are the ratings of securities that were distributed to a limited number of investors deserving of the same free-speech protection as more general ratings of corporate bonds that were widely disseminated? Judge Scheindlin said no and rejected the rating agencies’ First Amendment argument.

Judge Scheindlin also rejected the argument that the ratings are merely non-actionable opinions. “[A]n opinion may still be actionable if the speaker does not genuinely and reasonable believe it or if it is without basis in fact.”  Judge Scheindlin also found that the disclaimers in the offering materials are insufficient to protect the rating agencies from liability for promulgating misleading ratings.

This decision is only an early step in the litigation and has not imposed liability on the rating agencies. The plaintiffs will still need to prove the facts that they alleged in the initial pleadings.

But the ruling does open a door that was previously thought closed. The stock prices of McGraw-Hill, which owns Standard & Poor’s, fell 10%, and Moody’s Corp., parent of Moody’s Investors Service, fell 7.1% in New York Stock Exchange composite trading on Thursday.

Other plaintiffs are likely to use this decision to persuade other judges to open rating agencies up to potential liability. I’m sure that plaintiffs’ lawyers involved in subprime lawsuits are amending their complaints this morning.