Since I started this column more than three years ago, I’ve shared a number of my opinions and predictions, some of which have turned out to be wrong. So far, however, no one has sued me for those mistakes.
The major credit rating agencies haven’t been so lucky.
The Sixth U.S. Circuit Court of Appeals in Cincinnati recently confirmed, yet again, that rating agencies cannot be held liable for their assessments of the quality of investments. But politicians in search of scapegoats for public investment losses continue to sue rating agencies whose opinions proved to be overly optimistic.
In the latest case, five Ohio pension funds claimed the three major rating agencies – Moody’s Investors Service, Standard & Poor’s and Fitch Ratings – were responsible for the $457 million the funds lost, between early 2005 and mid- 2008, by investing in mortgage debt. The agencies had assigned strong ratings to the securities the funds purchased, and the funds said they relied on those ratings to guide their investment decisions. According to the funds, the fact that the securities turned out to be poor investments was evidence enough that the ratings had been “unfounded and unjustified.”
The case was originally brought in 2009 by then-Ohio Attorney General Richard Cordray, who is now director of the federal Consumer Financial Protection Bureau, courtesy of a controversial recess appointment.
The appeals court upheld an earlier dismissal of the case “with prejudice,” which means that it cannot be brought again. Circuit Judge Julia Smith Gibbons wrote that the funds’ case rested on the “unreasonable” inference that “the agencies did not believe in the correctness of their ratings with respect to any mortgage-backed securities the funds purchased over a three-year period.”
Even though this particular case is now legally dead, it is not the first of its ilk, and it won’t be the last. In May 2011, I wrote about a nearly identical case in New York that yielded the same result. As of 2010, there were 30 separate lawsuits in the works. Meanwhile, in June, the newly created Office of Credit Ratings opened at the Securities and Exchange Commission, with a mandate from the Dodd-Frank financial reform law to conduct annual reviews of the credit rating agencies.
The ratings agencies offer only “predictive opinions,” as the district court judge in the Ohio pension fund case put it. A credit rating is nothing more than the rater’s opinion about the likelihood that a particular borrower will default in a particular transaction. It is not a statement of fact, a guarantee or a promise. An opinion about what will happen in the future may turn out to be incorrect, but absent deliberate falsehood or misrepresentation, it cannot be fraudulent.
Cordray and others intent on attacking the rating agencies have focused on the fact that the agencies are paid by the debt issuers they rate, creating a conflict of interest. I agree that this creates a conflict, but similar conflicts arise in many situations. Companies have their financial statements audited by accountants that they hire. Your tax returns may be examined by a revenue agent, who is supposed to determine the correct tax, but who works a government whose goal is to collect as much as it can. (They don’t call them “revenue agents” for nothing.) You get your car’s emissions checked at a gas station of your own choosing. These hired guns are kept honest, most of the time, by the imperatives of business reputation and legal obligation.
Standard & Poor’s decision last year to stand by its downgrade of U.S. Treasury debt in the face of threatened retaliation deserves notice as evidence of the agency’s commitment to its opinions.
To the extent that rating agencies might be influenced by the source of their income, it still does not make their ratings fraudulent. The agencies do not hide how they are funded. It is up to the ratings’ users to take this inherent potential for bias into account, just as it is up to a newspaper’s readers to check the top of the page to see if they are holding The New York Times or The Wall Street Journal. Investors who believe the conflict of interest is too great are free to disregard the ratings and conduct their own financial analyses.
But despite the fact that the outcome of the Ohio case should have been clear in advance, the rating agencies will still have to pay the costs of defending themselves. When asked about his law firm’s charges in a similar case, Floyd Abrams, an attorney for S&P, told The New York Times he could not comment in order to protect the reporter’s safety. “I’d rather not get into it,” Abrams said. “You’d fall off your chair.”
While Canada, Britain, Germany and several other European countries use a “loser pays” approach to divvying up litigation costs, the U.S. does not. Under our rules, each side of a legal dispute is usually responsible for its own fees, regardless of the merits of the two sides’ cases.
When used by government officials, the “American rule” allows politicians to bludgeon targets, even when they have little hope or expectation of winning. The current system makes it all too easy for prosecutors to seem like political heroes for simply taking on unsympathetic adversaries. A “loser pays” system, on the other hand, would hold those who bring frivolous lawsuits accountable. It would also encourage more defendants to stand up to those lawsuits, as the rating agencies have done thus far.
Under the current system, however, the rating agencies will likely see more lawsuits. They may have AAA chances, but that won’t stop the litigations – or the bills.