The race to kill the ratings agencies

(Fortune) -- The legal noose is tightening around credit ratings agencies, for practices past and future. Just this week a federal court decision allowed a fraud case against Moody's and Standard & Poor's to move into discovery, dismissing the defendants' claim that their ratings are essentially editorial opinion and hence protected by the First Amendment.

This particular case -- in which plaintiffs charge the deal involved the "shortest-lived Triple A investment fund in the history of corporate finance" -- is just one of roughly a dozen investor lawsuits, making its way through the courts. There are others: California, for example, is asking for $1 billion compensation.

In Congress, the draft financial reform bills could increase liability, unless agencies can show adequate due diligence. Lowering their liability standard to gross negligence -- as Barney Frank's bill currently does -- "could well drive credit agencies out of structured finance," warns John Coffee Jr., a Columbia Law professor and expert in this area. Any new congressional-set liability on agencies' speech could be fought all the way up to the Supreme Court, which is where the industry has promised to go if necessary.

Despite the compelling need for deterrence in the bond ratings system, it's not at all clear that what Congress has in mind will do the trick -- in fact many fear they will compound the mess just when they have an opportunity to fix it.

How the rise of the copy machine led to the fall of the ratings model.

The conflict of interest inherent in the current system is the 'issuer-pays-for-the-ratings' model, coupled with the fact that so much of the business comes from so few clients, leaving the agencies fearful of alienating any of their customers.

Originally ratings were an 'investor-pays' model. It was the rise of the copy machine, of all things, that made sharing prospectuses among investors easier, and threatened the industry's already thin profit margins. After shifting to an issuer-pays model the system held up reasonably well -- until the agencies too fell under the spell of easy-money sub-prime asset backed securities, and all their attendant financial instruments of mass destruction.

How underwriters came to 'own' the ratings agencies

The key difference was that prior to the rise of sub-prime mortgages, no one issuer was larger than 1% of the credit rating agencies' revenue. During the bubble, seven or eight major underwriters came to dominate chunks of agency income -- in the case of Lehman Brothers, up to 15% of the business. In peak years, Moody's (MCO) and S&P rated more than 10,000 RMBS securities each, for which they charged anywhere from $50,000 to more than $1 million. In the years between 2000 and 2007 their operating margins averaged 53%, far outpacing the margins enjoyed by Exxon (17%) and Microsoft (36%), during the same time. It was a trough far richer than the agencies ever imagined. So they gorged. By 2007, S&P derived 48% of its total revenues on this new business line.

The picture of ethical decay was valuably laid out, in the most stunning detail so far, in the testimony and treasure trove of documents (581 pages so far; eventually thousands) presented at the Senate's Permanent Subcommittee on Investigations held last Friday. As a Moody's has described, it was company policy to commit nothing controversial to paper or email. The only exceptions were displays of the firm's singular focus on market share. Emails to managing directors would regularly detail departments' market share and managers were expected to justify and all "missing" deals that were not rated that might have contributed to a slip in market share. The easiest way to maintain or boost market share was to lower credit standards.

Eric Kolchinsky, the MD in charge of rating sub-prime CDOs for Moody's, objected. But pressure to keep up market share continued, even after the ratings agencies began the unprecedented massive write-downs -- reaching $1.9 trillion in about six months up to mid-2008. "Despite the massive manifest errors in the ratings assigned to structured finance securities and the market implosion we were witnessing, it appeared to me that my manager was more concerned about losing a few points of market share than about violating the law," he told the Senate. He was shortly demoted for his qualms; he says it was in retaliation.

This is the fertile ground in which fraud allegedly took place. The investor lawsuits claim the actual fraud occurred in the wildly unreasonable assumptions made in ratings, particularly about default rates and correlations, explains Patrick Daniels, an attorney with Robbins Geller Rudman & Dowd, which is representing the plaintiffs in the so-called Rhinebridge case, the one which Judge Shira Scheindlin allowed to go forward. Daniels argues Moody's and S&P colluded with investment banks by blessing their bonds with inaccurate and undeserving ratings, without which the banks had no chance of selling those securities. This is one of half a dozen other related cases his firm is working up; he won a similar ruling last September from the same judge, who is well respected.

"Where you are seeing progress in this area is in the courts where the judges are far less susceptible, maybe even immune, to the political pressures," says Daniels. "The courts have not been politically anesthetized, the courts have not been put to sleep like the regulators have -- that's just the way it is -- and thank God for judges in the Southern District and elsewhere that see through it."

Coffee favors increased liability exposure for ratings agencies -- Sarbanes Oxley has been harsh on accountants but has dramatically reduced financial report restatements, he notes -- but thinks damages will have to be capped at about $50 million (likely leading to settlements of about $20 million) because the credit agencies are not capitalized to withstand losses of hundreds of millions dollars. That means the aim will be mostly deterrence rather than compensation for investors who lost hundreds of billions dollars. Daniels unsurprisingly called that "political suicide," but then he was part of the team that won a record class-action recovery of $7.5 billion from Enron, which the agencies kept at an investment grade rating until just days before its collapse.