Insider's Game

Selected writings by David Fiderer

S&P’s Utterly Bogus 1st Amendment Defense

First published in OpEdNews on April 15, 2013


In seeking to prevent the South Carolina Attorney General from filing a lawsuit, Standard & Poor’s attorneys, Cahill Gordon & Reindel, asserted one of the most fatuous legal arguments of the 21st century. “Credit ratings are fully protected by the First Amendment,” they claimed.


Here’s how Cahill Gordon partner Floyd Abrams put it to The New York Times:


It shouldn’t change the legal dynamics that rating agencies are more important, or play a greater role, or are looked to by this or that element of the marketplace…The major similarity here is that both the newspaper and S.& P. are offering opinions on matters that people can and do disagree about.


Really? A credit rating is just like an opinion published in a newspaper? Mr. Abrams should Google the words “Henry Blodget.”


Journalistic Opinions Versus Professional Opinions


Blodget wrote lots and lots of opinions about different companies. Most of those opinions were published by media outlets, and some of them were published by Merrill Lynch, where he worked as a securities analyst during the bubble.


The SEC went after Blodget for committing securities fraud because he assigned  inflated ratings, i.e. “buy” ratings, to companies like InfoSpace, Inc., 24/7 Media, Inc., and, Inc. when he was an analyst at Merrill.


Blodget never had the audacity to claim that his ratings and opinions for Merrill were merely a “journalistic” effort, for obvious reasons. Every lawyer who ever bought malpractice insurance understands the difference between a journalistic opinion and a professional opinion.  Merrill’s and Blodget’s work product were regulated by the SEC, the NASD and the NYSE. When he was a securities analyst Blodget wrote professional opinions, which are governed by certain minimal standards of care.


Of course professionals can have different opinions, which is why a patient may seek out a different physician for a second opinion on his diagnosis. But a doctor can still lose his license if he expresses his “opinion” that Oxycontin is appropriate for mild headaches because it is not addictive.


Blodget settled with the SEC, by giving up $4 million and agreeing to a permanent ban from the securities industry.


Guess who else is licensed and regulated by the SEC? S&P and the other rating agencies. The triple-A ratings assigned by S&P and Moody’s to various CDO investments were probably more disreputable that Blodget’s “buy” ratings for certain startups.


Yes, the First Amendment does protect the free expression of opinion, which is why newspapers are not regulated and journalists are not licensed. And this is why the Federal Drug Administration never went after John Tierney for touting the unfettered use of Oxycontin.


Journalistic Opinions Versus Legally Sanctioned Opinions


The rating agencies do not publish individual opinions, like those of a security analyst at Merrill. They publish opinions set by ratings committees; a rating is the work product of an institutionalized vetting process, just like the FDA process for approving over-the-counter sale of a new drug, or the process for licensing a new attorney.


These vetting processes never guarantee an outcome–a drug may have harmful side effects for some people, and a licensed physician may demonstrate gross incompetence–but people can be held liable for compromising the integrity of that vetting process.


And whether they like it or not, the government has treated the rating agencies as de facto regulators for 75 years. Beginning in 1936 the Fed and the FDIC announced that banks were prohibited from holding “speculative securities,” which were those without a rating of triple-B or higher. In 1951, the National Association of Insurance Commissioners imposed higher capital reserve requirements for lower-rated bonds. In 1975, the SEC mandated that broker/dealers should apply higher capital haircuts on bonds rated below triple-B. In 1989, in the midst of the savings and loan crisis and the collapse of the junk bond market, Congress passed a new law prohibiting S&Ls from investing in bonds rated below triple-B.  In 1991, a new rule by the SEC limited the amount of lower-rated paper that could be held by money market funds.


This stuff is all very obvious to anyone from the financial world, who would know that ratings determine the price and availability of credit.


A Credit Rating Cannot Be Separated From a Structured Finance Deal


S&P’s First Amendment defense, as it pertains to ratings for structured finance deals, relies on a warped definition of the word, “opinion.” An opinion is something entirely separate from the object of that opinion.


That’s the way it is for ratings assigned to any company or entity other than a structured finance transaction. Microsoft, Spain, Enron and Stockton, California all existed in some form or other prior to the point when they received credit ratings.  The rating agencies played no role in the “creation” of any of these entities.


But structured finance transactions are creatures of the law. They have no existence before they close, and they cannot close until all conditions precedent have been attained. And invariably, one of those conditions is that certain specific ratings from certain rating agencies will be assigned to specific tranches of the deal.


Rating agency standards are legally embedded within every structured finance deal, the way a father’s DNA is embedded in a newborn child. It’s absurd to argue otherwise. Which is why any court decision pertaining to a credit rating for a non-structured finance deal would be totally irrelevant to the cases before a number of State and Federal Courts.


What About Those Court “Precedents”?


In its effort to prevent the filing of a lawsuit in South Carolina, S&P cites two Federal Court decisions, Jefferson County School District v. Moody’s, and Compuware v. Moody’s. Neither case addressed the issues pertaining to the recently filed lawsuits pertaining to mortgage securities and CDOs.


In Jefferson County, Moody’s was sued for defamation, based on the rating agency’s announcement of a “Negative Outlook” for certain bonds. The Tenth Circuit ruled that the phrase “Negative Outlook” was too vague to constitute an actionable claim of defamation.


By way of contrast, a triple-A rating assigned to a bond is not vague at all. It is a clear cut statement that the risk of loss within a three or four-year period is submicroscopic. The rating agencies specifically quantify the risk of default and loss according to credit ratings, and they use those numbers to quantify the risk of loss on bond portfolios, like CDOs.


At first blush, Compuware seems more relevant.  Compuware sued Moody’s after the rating agency downgraded the firm, which had no funded debt, from Baa2 to Ba1. Compuware accused Moody’s of making defamatory statements, whereas Moody’s said it was making a subjective evaluation about the firm’s longterm business prospects. That was good enough for the Sixth Circuit, which wrote:


A Moody’s credit rating is a predictive opinion, dependent on a subjective and discretionary weighing of complex factors.  We find no basis upon which we could conclude that the credit rating itself communicates any provably false factual connotation.  Even if we could draw any fact-based inferences from this rating, such inferences could not be proven false because of the inherently subjective nature of Moody’s ratings calculation.


Yes, predictions are hard, especially about the future. It’s one thing to draw inferences regarding the future of a high tech firm, quite another to draw inferences from a mountain of statistics pertaining to mortgage defaults.


S&P is licensed as Nationally Recognized Statistical Rating Organization. It cannot simply ignore history and statistics–any more than a doctor can ignore history and statistics about the effects of smoking–when it assigns credit ratings.


Yet that’s exactly what the rating agencies did when they assigned triple-A ratings to mortgage bonds and CDOs. They simply disregarded the statistics concerning real estate cycles, hyper-leveraged transactions, default correlations and the incidence of mortgage fraud. Again, triple-A ratings on mezzanine CDOs were no less reckless than Henry Blodget’s “buy” ratings.


Which is why the case against the rating agencies is a slam dunk.