The temptation to cheer the federal government's lawsuit against Standard & Poor's for the AAA- ratings it slapped on securities that promptly blew up is understandable. S&P and other debt raters played a central role in the financial crisis of 2008 and for too long no one has managed to hold them accountable.
But it's also too bad the U.S. Justice Department didn't find a way to take on the legal defense that's at the heart of the ratings business: S&P, Moody's and Fitch rely on the First Amendment to assert that their evaluations of debt securities are the equivalent of opinions, and thus constitutionally protected.
The government's lawsuit accuses S&P of falsely telling investors its ratings were accurate, independent and free of bias. Rather than deal with the First Amendment issue, the Justice Department invoked a law, adopted at the height of the savings and loan crisis in 1989, that targets fraud in cases involving federally insured financial institutions backed by taxpayers.
There are some bizarre chinks in the government's case, starting with the claim that the biggest victims of S&P's depredations were the same banks that misled investors about the toxic securities they were peddling. To believe this line of argument, S&P fooled Citigroup Inc. and Bank of America Corp. about the quality of the very mortgage-backed securities they were creating and peddling to investors.
As Bloomberg View columnist Jonathan Weil has written, pity the government lawyer who appears in court and tries to convince a jury that the biggest, most-sophisticated banks in the country were led astray by S&P. The government might be on sounder ground if it could show that smaller banks bought slices of the securities and did so based on ratings that S&P misstated on purpose.
Even if the government wins, its case will do little to alter two fundamental flaws in the raters' business model. The first of these is the “issuer pays” principle, under which the raters collect their fee not from bond investors but from the issuer of the security they are rating. This creates a conflict of interest. Bond issuers can threaten to take their business elsewhere unless they get the ratings they deem appropriate.
This defect is compounded by a second flaw: the legal standing that regulators have conferred on the companies' ratings. For instance, the amount of capital banks must show on their balance sheets depends in part on the ratings attached to their bond holdings. If it weren't for this requirement, the demand for ratings would diminish. The regulatory system has delegated a crucial function -- attesting to the safety of bonds -- to a third party whose motives, to put it generously, are mixed.
Chipping away at the First Amendment defense is one way to begin putting matters right. Courts have found that the raters are, in essence, journalists who issue independent analysis. This gives the companies some of the strongest protection in U.S. law. Never mind that, unlike journalists, the raters aren't objective by virtue of the fact that they are paid by the very companies -- their sources -- they write about. Direct payment from a source to buy editorial content is barred at credible news organizations.
The First Amendment, the raters and their lawyers have argued, ensures that they can operate independently, deliver reliable opinions and not be cowed by lawsuits over honest mistakes. The First Amendment shield, however, combined with a compensation system that poses an inherent conflict of interest and the obligation on investors to use the ratings in question, creates perverse incentives. The prelude to the financial crisis was replete with examples of raters dishing out grades on securities that turned out to be wrong, often with an eye to winning business from competitors.
The Dodd-Frank Act was supposed to resolve some of these issues, and the Securities and Exchange Commission was charged with drafting rules saying investors no longer had to rely on the raters' opinions. If the aim is to make finance safer in the future, this is a more promising approach than attempting to demonstrate outright fraud after the fact. Yet 2 1/2 years have passed since the law's adoption, and no rules are forthcoming. The delay is dispiriting.
U.S. law recognizes different categories of speech, from news articles published by media outlets to advertisements by companies that want you to buy their products. Raters should fall somewhere in between, perhaps akin to newsletters that are paid by companies to write favorable research reports on their shares, or to auditors retained by companies to express opinions on the accuracy of their financial statements. Federal law requires that newsletters reveal how they are financed. Auditors have to meet stringent standards in their work, and can be liable for third-parties' losses when they fall short. Either raters should be held to similar standards, or investors should no longer be required by the government to use their ratings, or both. The Justice Department's lawsuit advances neither solution.