It’s go time on Capitol Hill for financial reform legislation, and the credit rating agencies are breathing a sigh of relief.
On Tuesday evening, the conference committee voted to drop a proposal by Democratic Sen. Al Franken of Minnesota that would have created a government middleman to dole out rating assignments.
The committee also chose the lesser of two evils, in the view of the ratings agencies, by adopting a new liability standard for investors who want to sue. The Senate had proposed a “knowing and reckless” standard on credit rating agency behavior; the committee adopted House language that would require plaintiffs to show that an agency was “grossly negligent.”
Of these two issues, the debate over the Franken amendment has attracted the most press attention. But Center for Public Integrity interviews with several former Moody’s and Standard & Poor’s employees, as well as with plaintiffs lawyers and others familiar with the financial reform package, suggest that the rating agencies are far more concerned with the liability question than with the Franken amendment, which if enacted would have applied only to structured finance products.
“What they really fear is litigation, not legislation,” said Scott McCleskey, a former head of compliance at Moody’s. “They don’t want to see the tissue-thin veneer that that they are just expressing opinions protected by the First Amendment removed.”
“No court has ever found a ratings agency liable for a bad rating,” added David Reiss, a professor at Brooklyn Law School. “They are terrified of losing that protection.”
The industry is dominated by Moody’s Corp., Standard & Poor’s Financial Services, and Fitch Ratings Inc, which collectively spent more than $1 million on financial reform legislation-related lobbyists in the first three months of 2010, according to a Center analysis of lobbying data. The companies have been criticized for contributing to the 2008 financial meltdown by giving glowing ratings to Wall Street debt offerings that later proved to be risky products.
Since 2009, the big three rating agencies spent more than $4 million on lobbying, mostly related to financial reform, according to Senate disclosure reports. Standard and Poor’s led the way. Its parent company, McGraw-Hill Cos., paid $2 million to a group of lobbyists that includes Tony Podesta, one of Washington’s best-known lobbyists, and the firm Nappi & Hoppe, which specializes in financial reform lobbying and is led by Douglas Nappi, a former chief counsel to the Senate Banking Committee. Moody’s, meanwhile, has paid a team from Akin Gump Strauss Hauer & Feld, led by partner Steven Ross, about $1.7 million. Fitch, in comparison, spent a relatively paltry $520,000, with KSCW, Inc. getting the lion’s share.
The ratings agencies either declined comment (Moody’s and S&P) or referred to previous statements opposing any additional liability burden (Fitch).
But this doesn’t mean that we are left to guess their intentions. In March, Cynthia Braddon, a lobbyist for S&P’s parent company, McGraw-Hill, urged Senate Banking Committee members Bob Corker of Tennessee and Judd Gregg of New Hampshire, both Republicans, to oppose a lower liability standard. The letter was denounced as a “cynical attempt by Wall Street lobbyists to kill Wall Street reform before it has a chance to see the light of day” by Democrat Jack Reed, also a member of the committee. Reed authored the provision that would give investors the ability to sue rating firms that “knowingly or recklessly” fail to review key information when developing ratings.
Credit rating agencies rate the creditworthiness of a company or a financial product, such as a bond issue or a structured finance product like the mortgage-backed securities stuffed with rotten mortgages that helped bring down the housing market. Since the 2008 financial collapse, plaintiffs in dozens of private lawsuits, along with the attorneys general of several states, have sued Moody’s, S&P, and Fitch, alleging that the companies conspired with the issuers of high-risk investments to give top ratings to securities loaded with toxic mortgages.
“At minimum, they were aiding and abetting misconduct by issuers,” said Ohio Attorney General Richard Cordray in announcing a $457 million lawsuit on behalf of state employee retirement funds.
First Amendment protection
So far, however, most of the lawsuits have either stalled, or have been tossed out of court, despite whistleblower allegations that the rating agencies were driven by greed to rate any product that a bank put before it, no matter how unsound. One anonymous S&P staffer memorably said, according to text messages unveiled in a House Oversight Committee hearing, that a product “could be structured by cows and we would rate it.”
Rating agencies have successfully fought off liability lawsuits by maintaining they offer forward-looking “opinions” on the credit-worthiness of offerings and thus are protected under the First Amendment. Judges have said that a plaintiff would have to show that an agency did more than make false statements, and did so with “actual malice” in order to pursue a claim. To get around this barrier, some plaintiffs’ lawyers are making the argument that the rating agencies had a hand in creating some of the structured products, such as mortgage-backed securities, and thus shouldn’t be afforded the Constitutional cover.
This protection is almost certain to eventually go away, despite pleas from the rating agencies that doing so would open the floodgates to litigation.
Language in both the Senate and House financial reform bills states that ratings will no longer be considered “forward-looking statements.” The open question going into the conference committee was what kind of behavior on the part of the agencies would be considered egregious enough to allow claims under the anti-fraud provisions of securities laws. The Senate’s version imposed as a threshold question for private litigants whether the agencies were “knowing and reckless.”
This isn’t popular with the ratings agencies. In April, a McGraw-Hill executive said in a statement that the Senate bill “creates a discriminatory pleading standard for credit rating agencies, with many unintended consequences for the market.” Under this standard, a credit rating agency could be sued for failing to predict a bankruptcy, for example, which occurred without fraud, the executive argued.
The conference committee, however, adopted House language that would set a higher bar for those seeking to sue rating agencies. Rep. Barney Frank, the chairman of the House Financial Services Committee and also the chairman of the bicameral conference committee, endorsed House language that would require plaintiffs to show that an agency was “grossly negligent” in its behavior — a higher bar for plaintiffs to clear.
Reiss, the law professor, said gross negligence is the “you know it when you see it” standard. If, for example, Moody’s were to assign an extremely complex rating assignment to a 22-year-old employee fresh out of college, that might be considered grossly negligent, he said.
It is hard to predict how courts would interpret the new liability language in the financial reform bill without a few test cases, said Jonathan Wishnia, a securities lawyer at Lowenstein Sandler. Either way, more litigation is virtually assured, he added.
Joel Laitman, a lawyer at Cohen Milstein, a plaintiff’s firm that is lead counsel in several mortgage-backed securities lawsuits against investment banks and the ratings agencies, said he is eager to see this “protective cloak” abolished. He worries, though, that language imbedded in the House version of the legislation that would put a three-year statute of liability cap on future litigation would mean that the agencies would get a free pass for the years at the height of the subprime boom, when the structured finance boom was at its peak.
“The statute of limitations is problematic for anyone trying to recover for the years 2005 and 2006,” he said. “Everyone who bought mortgage-backed securities under that time frame would be out of luck. That’s frustrating.”
Lobbyists for the credit rating firms also succeeded in derailing Sen. Franken’s plan to create a government clearinghouse that would randomly assign rating agencies to a bank or financial institution. The approach was intended to give credit raters the freedom to issue a poor rating to a new offering without fear of losing business.
Instead, the conference committee members agreed to kill the Franken provision and replace it with a requirement that the Securities and Exchange Commission study the conflict of interest issue for two years. At that point, the SEC can impose a clearinghouse model if it decides that is the best way to address conflicts.
Gary Witt, a former Moody’s managing director who now teaches at Temple University, said that the ratings agencies aren’t too concerned with any of the financial reform bill proposals before Congress, because there is little there that would fundamentally change their business model.
“The current litigation is more important than the current legislation,” Witt said. “There’s nothing in it that the agencies think is all that bad.”