Are credit rating agencies about to get re-rated?

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According to New York Times columnist, Thomas Friedman, 'There are two superpowers in the world today; there's the United States and there's Moody's Bond Rating Service'. However, CNBC-TV18's Jaya Taurani reports that credit rating agencies may soon lose this status with the massive liability facing them as a result of their alleged complicity, or at the very least negligence, in this century's worst financial crisis.

Credit agencies are paid by the issuers of securities, not by the buyers of securities, which creates a potential conflict of interest in favor of issuing strong securities ratings. This problem was illustrated in the sub-prime market crisis Barack Obama Election Campaign.

Henry Waxman, Chairman - House Oversight and Government Reform Committee said, "The story of the credit rating agencies is a story of colossal failure." 

Richard Blumenthal, Connecticut Attorney General said, "It's time to shatter the 'Old Boys Club' of rating agencies" 
The business of ratings is about to change!

What do rating agencies such as Moody's and Standard & Poor's have in common with newspapers like the New York Times and the Wall Street Journal?  They are all legally members of the press under the first amendment of the US constitution. Thus, ratings issued by credit rating agencies afford protection under the freedom of press defense.

Jeffrey Gilbert, Partner, Reed Smith said"Anybody who was suing a rating agency had to prove among other things actual malice which effectively meant that the rating agencies had intentionally published a falsehood. That's a very high standard to meet in courts in this country. There have been a number of decisions in corporate bond ratings, corporate security ratings, where rating agencies have issued their ratings more publicly, published them more publicly and they've gotten the first amendment protection for that; a protection that is now being tested."

In September 2009, Abu Dhabi Commercial Bank sued S&P and Moody's for issuing the highest ever credit rating to notes issued by a Cheyne Finance Structured Investment Vehicle; notes that collapsed in 2007.

Last month, the federal court in New York hearing the case, lifted the constitutional protection for ratings which are not made public.

Here are a few expert views:

Jeffrey Gilbert:

"I think that the decision in the Abu Dhabi case is consistent with other decisions that have allowed investor suits against rating agencies in privately placed transactions where there are more limited distribution of the rating agencies ratings to go forward. I think the reason you seeing a lot of publicity about this now is that there's a lot of publicity about rating agencies generally - so these cases are getting more press than they otherwise would."

Jonathan Macey, Prof of Corporate Law, Corporate Finance & Securities Law, Yale University:

"Its easy for credit rating agencies to avoid the consequences of this opinion simply by declining to make direct private communications with investors and simply making a general representation/publication of their ratings and then they get the old first amendment protection - so even to the extent that there is anything new to this opinion - it is very easy as a legal matter for the credit rating agencies to side-step the results of the case.

Private suits aside, rating agencies now face the threat of mounting public litigation."
In July 2009, the California Public Employees' Retirement System or Calpers, backed by the state's Attorney General sued Moody's, S&P and Fitch for 1 billion dollars in losses over "wildly inaccurate risk assessments".

Soon after in September this year, New York Attorney general, the famous Andrew Cuomo issued subpoenas to these rating agencies to determine whether they recklessly gave 'stellar ratings to shaky assets'.  

Experts argue these cases have a higher possibility of success than private litigation.

Jonathan Macey: 

"The states are actually clients of the credit rating agencies because states and municipalities have debt issues that they want to have rated - so the credit rating agencies really do want to make peace with the state attorney generals maybe more than they do with the private plaintiffs. And finally the major goal for the credit rating agencies is to make sure that no significant legislation is passed in congress that regulates their activities and the states attorney generals have more clout, more political ability to influence that legislation - so there is some effort that's going to be made by the credit rating agencies to appease and assuage the concerns of the states attorney generals. Not only do credit rating agencies find themselves besieged in court, they now face increasing scrutiny from lawmakers and regulators."

Jeffrey Gilbert:

There are some proposals in Congress for example, that would do away - at least as I read it - with this first amendment protection and would subject rating agencies to the same type of liability standards as underwriters, issuers, accountants and so forth - that could have a major effect on the way the rating agencies do business - its simply too early to tell right now how all of this is going to play out. But I think a combination of the private litigation and congressional regulation along with how the SEC promulgates regulations under that legislation potentially could have a large effect on how the rating agencies do business."

This month the U.S House Financial Services Committee is expected to take up the credit ratings agency bill - part of the Obama administration's plan to reform financial regulation. There has been criticism of many crucial aspects of that bill being watered down. Will the new rules call for an annual SEC review of credit rating agencies? Will they block banks from shopping for the best rating? Will they mandate rating agencies to make more disclosures. Whether in Congress or in Court, the business of ratings is set to change.