Hole poked in rating agencies' lawsuit shield

(breakingviews.com) -- Credit rating agencies have long relied on the right of free speech as protection against litigation, especially in the U.S. A hole has just been poked in this shield.

Judge Shira Scheindlin of the Southern District of New York has has cast doubt on the defense by allowing a lawsuit over a structured finance deal to go ahead. If the case succeeds, the agencies may face a flood of suits they actually have to fight.

Plaintiffs Abu Dhabi Commercial Bank and Washington's King County claim that Standard & Poor's and Moody's committed fraud because they neglected to mention the risks associated with highly rated structured securities issued by Cheyne Finance. Abu Dhabi claims it lost its entire investment.

The rating agencies, on the other hand, say they merely offered an opinion on creditworthiness -- one protected from legal challenge by U.S. free speech rights. While this defense has generally worked for them up to now, it has always appeared to have several weak links -- especially for structured finance deals as opposed to more traditional corporate or sovereign ratings.

First, the agencies are paid by issuers, not investors -- this gives the appearance of commercial speech, which is not protected to the same degree as non-commercial speech. Second, the rating agencies participated in a "dialogue," as they put it, with banks when structured securities were created. Banks would tweak and re-submit these vehicles until they received the desired rating. The agencies claim this was never direct advisory work, but it is arguably a form of participation rather than observation and comment. Third, while traditional ratings are usually made available to the general public, ratings on structured securities are often not so widely circulated.

Scheindlin latched onto this third point, saying that because the ratings were disseminated only to a select group of investors in a private placement rather than to the general public, she wouldn't dismiss the case on free speech grounds as the rating firms had wanted.

Having the case proceed doesn't mean the plaintiffs will succeed in proving fraud. And there is always scope for multiple appeals. But if the rating agencies' free speech defense is undermined and more cases proceed, they will face the uncertain task of having to justify their ratings in courtrooms.

Even if they were rarely to lose a case, the U.S. habit of settling litigation could become costly. Investors don't appear to be waiting to find out. Shares in Moody's and McGraw Hill, the owner of Standard & Poor's, were down 7% and 10% respectively in Thursday trading.