New Decision Puts Ratings Firms in a Tight Spot


Late in April 2010, Shira A. Scheindlin, a New York federal district court judge, denied a motion to dismiss filed by Moody's Investors Service and Standard & Poor's Financial Services. The suit was filed against them and the other "big" rating firm, Fitch, by several investors as a class action.

The investors claim the three rating firms acted together to conceal or hide the true credit rating of, and so the risk of investing in, Rhinebridge, a structured investment vehicle (SIV). Rhinebridge failed, and the investors lost millions.

Moody's and S&P argued the case should be thrown out because Rhinebridge collapsed because of the credit crisis that began in 2007, and not because of any wrongdoing by Moody's and S&P.

Judge Scheindlin noted that Moody's and S&P might eventually win the case on their argument. But on a motion to dismiss the investors' claims had to be accepted as true. She added it wasn't absolutely clear that the 2007 credit crisis was the only reason for Rhinebridge's failure.

Original Article

For the first time, credit rating agencies may not get the protection of the First Amendment. A New York judge refused to dismiss a lawsuit against Moody's Investors Service Inc. and Standard & Poors. The judge rejected their argument that investors can't sue them over deceptive ratings because their opinions are protected by free speech rights. This decision affects many credit rating agencies and possibly change the entire industry.

What Are Credit Rating Agencies?

A credit rating assigns a score to issuers that sell some type of debt security or bond. Usually the issuers are companies, governments and non-profit organizations that sell a note and traded on the open market. To come up with the score, the credit rating agency considers the issuer's ability to repay the loan and other factors. The credit rating agency then assigns a score, such as AAA or BB. Investors rely on that score when deciding whether the note is a good investment.

Recent Lawsuits against Credit Rating Agencies

Rating agencies frequently get sued by investors who claim their rating was wrong or deceptive. Recently, rating agencies have been accused of issuing misleading opinions about mortgage-backed securities and are being partly blamed for the recent financial crisis.


First Amendment Protection

While these types of lawsuits are common, rating agencies have always succeeded in defending their ratings using the US Constitution. They argue ratings are opinions protected by the First Amendment and the freedom of speech. In the past, courts have agreed and thrown out lawsuits against credit agencies accused of issuing ratings that were too high or too low, unless the investors were able to show that the rating was issued to intentionally defraud investors.

New Decision

However, that's all about to change by the recent decision in Cheyne Finance. In September, Manhattan federal Judge Shira Scheindlin shocked the ratings firms when she rejected the free-speech defense given by Moody's and Standard & Poor's.

The lawsuit claims that the two ratings agencies issued misleading ratings to a $5.86 billion investment that collapsed in 2007. The Judge didn't allow a First Amendment defense, explaining that the protection doesn't apply "where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large."1

In that case, the First Amendment may not apply because the specific securities are rated discreetly for a small group of investors as opposed to a more general rating for the public. The judge said this is what happened with the mortgage-backed securities at issue in the case.

The Legal Issue

It's alleged in Cheyne Finance, that although the debt securities issued were backed in part by risky investments like subprime mortgages, ratings as high as AAA, which is the least risky rating still received. In return for the high rating, the agencies were paid higher-than-normal fees.

This case spotlights the problem with the rating agencies. These firms are paid by the issuers to rate them. As a result, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The lack of independence leads to a lack of objectivity and results in abuses in the credit-rating process.

The Cheyne Finance decision "breaks new ground on the issue of whether the First Amendment applies to ratings of privately offered securities."2 It received widespread media attention and will likely be appealed. It may even make it to the Supreme Court.

This decision, together with the recent Securities and Exchange Commission's more careful scrutiny of credit rating agencies, will likely affect the entire financial industry and hopefully induce more objective standards.


1Nathan Koppel, Judge Rejects Credit Rating Firms' Free-Speech Claims, WSJ Blogs, Sept. 3, 2009, last accessed Sept. 25, 2009.

Questions for Your Attorney

  • What kinds of disclaimers do ratings firms have to supply? How does that affect their liability for decisions based on their ratings?
  • If a consumer holds investments and has limited control over the management of their investments, such as with pension or retirement accounts, who can be held liable for performance and management shortcomings?
  • How should consumers seek to protect themselves when making investments, and what types of information can truly be relied upon?
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