US regulators, including the Department of Justice and the SEC, are reported to be undertaking civil (apparently not criminal) investigations into the rating agencies’ practices in rating mortgage-backed securities in the run-up to the financial crisis. The WSJ reports here, but behind the subscriber wall; the Washington Post reports:
The probe is the latest of dozens of government investigations and investor lawsuits targeting Moody’s and S&P, a unit of McGraw-Hill Cos., all based in New York, over the top grades they assigned to bonds backed by subprime mortgages. Even as the Financial Crisis Inquiry Commission called them “key enablers of the financial meltdown,” the raters avoided legal liability, according to Benchmark Co.’s Edward Atorino.
“People have been poking around Moody’s and McGraw-Hill forever,” Atorino, a New York-based analyst, said in a telephone interview. “They haven’t found the smoking gun yet.”
The Justice Department has been contacting analysts to discuss mortgage-bond ratings since 2009, the former employees said. In May, Senator Carl Levin, the Michigan Democrat who chairs the Permanent Subcommittee on Investigations, referred the results of a probe into mortgage bonds, credit ratings and the financial crisis to the agency.
Most observers would agree that the rating agencies were key enablers of the financial crisis, as the FCIC said; from a legal liability standpoint, the question is why. The most detailed accounts by financial journalists such as Michael Lewis or Roger Lowenstein point mostly to complexity – the inability of the rating agencies to understand the complex financial instruments they were being paid to rate, with the result being that they relied upon what the issuers themselves said about the risk and risk modeling. The financial journalists mostly emphasize not understanding complexity and, in the absence of any independent modeling themselves, acceptance of the banks’ risk models, even over the conflict of interest created by who pays whom for ratings. If that’s the case, then it is hard to see how fraud and related claims get going.
The WP article observes that the agencies have won in court, on the grounds that they are expressing opinions, nothing more – which is to say, however implausible the opinions might have been in retrospect (all those triple-A ratings?), that’s not fraud and in any case, the sophisticated market players are in the best position to judge and protect themselves:
Terry McGraw, the chief executive officer of S&P’s parent company, said on a July 28 conference call with analysts that 30 lawsuits against the rater have been dismissed or dropped and that he’s seeing “those dark clouds go away.” Judges have ruled that the ratings are opinions, protected by the right to free speech, according to Sean Egan, president of Egan-Jones Ratings Co.
To date, the freedom of speech defense has worked,” Egan said in a telephone interview. “If there’s evidence that a ratings firm intentionally issued an inflated rating and the effect was to defraud somebody then I think it would be a completely different matter.”
This is roughly to say that the rating agencies have no duty of care toward anyone in how they reach their ratings; incompetence in reaching their conclusions is not culpable unless there is something more at issue. I’m not sure that is 100% watertight as a legal matter, even in the US.
However, the US is not the only jurisdiction that matters here, of course, particularly as European sovereign debt comes under rating agency scrutiny. The EU has different standards on commercial speech, duties on free expression in the market place, and at either the EU or national level (or even local level, to judge by the recent moves by a local Italian prosecutor against the agencies), calls for scrutiny have begun that are outside of US legal standards. European jurisdictions might conclude that there are legal obligations to use “generally accepted” and reviewable (by courts or regulators) methods of determining ratings in order to prevent disorders in the markets leading to unjustified losses.
I don’t think this is completely off the table even in a US setting, actually. Supposing, to take the silly hypo, that S&P decided, quite consistent with its announced and contractually accepted mechanisms for revising its ratings, that it would now draw ratings out of a hat? Is this really beyond regulatory or judicial review? In the real world, moves by the rating agencies – as provided in their policies and contract terms – to alter their standards going forward, presumably to improve them, have raised important questions as to the ratings done under earlier standards. Is it really true, even under the US’s much stronger opinion protections, that none of this is reviewable to determine whether there was a rational method behind it? In the US, perhaps not – and quite so, in my view, given the problems of the regulator of such standards being the US government, which is also subject to the rating agencies – but I doubt European courts and regulators feel the same way.
Finally, however, there is an area in which it seems to me there is genuine room for litigation that would have a far greater chance of being entertained in court – whether US courts or abroad. That is the question of terms that have legal meaning – often separate legal meanings in different regulatory circumstances – such as “default.” The rating agencies have their own definitions, but as the arguments over the US downgrade brought to the surface, what are the events of default and what a default legally means, have genuine issues attached to them. There has been litigation, and likely much more litigation, over how to interpret contract provisions in financial contracts – credit default swaps, for example – such as events of default. There is lots of contract doctrine, case law, a lot of legal authority, for how to interpret such clauses. But the idea that such terms are beyond litigation as a matter of their “meaning” just because they are part of the “opinion” of a rating agency, whether in US courts or courts abroad, seems to me a bridge too far, at least if one is trying to predict tomorrow’s court behavior today.
Update (brought up from the comments):
I’ve deliberately been vague on US case law, as I’m trying to emphasize that theories of liability, or at least the imposition of some kind of regulation, on the rating agencies, are more likely to come from non-US jurisdictions. Also, with apologies for the vagueness above, I’m trying to emphasize that the theories of liability in non-US jurisdictions particularly need not be based around fraud, but instead around failures to take due care in the methods used for rating, both in their design and in their application, and that a rater offering its ratings in public had a duty to use reasonable care in expressing its opinions to and in the market place.
I am not endorsing this by any means — far from it — but I do think it would be the most likely theory of liability in non-US jurisdictions. That and fights over the meanings of terms such as “default,” on a theory that even if defined privately in contracts, the contracts have a public market implication — whatever that might mean in a particular jurisdiction — that gives the regulator or the courts the ability to insist that it be the, or at least “a,” standard legal definition of the same.
Finally, I have no special inside insight into the work of the rating agencies. This is a reflection on having gone back over what a selection of a dozen of the better books on the financial crisis said about how the rating agencies did what they did. Overall, they say the rating agencies and their staff did not understand the financial instruments at issue. Take that for what you will. Probably Michael Lewis is the most scathing.