Suddenly, the Ratings Agencies Don't Look Untouchable

RON GRASSI will admit that when he decided to sue the three major rating agencies in early 2009, he was too enraged to think about his odds. A retired family law specialist who lives in California, he filed his suit in a low boil a few months after $40,000 in Lehman Brothers corporate bonds he owned all but vanished when the investment bank collapsed.

Government Regulation
Government Regulation

At first, he was furious at the bank. But then he decided the true villains were the rating agencies that had stamped those now-worthless bonds with high grades.

“My friends were complaining and moaning about what had happened on Wall Street, but nobody was doing anything about it,” says Mr. Grassi, 69. “By sheer coincidence, there’s a state court a few blocks from where I live in Tahoe City, and one day I walked down there, filled out a two-page form and sued.”

Since then, he has forced the defendants — Standard & Poor’s, Moody’s and Fitch — to spend a small fortune on legal fees. At one hearing, the companies sent no less than nine lawyers. Unfortunately for Mr. Grassi, little else about his lawsuit has gone as planned. Currently he’s appealing a judge’s decision in March to dismiss his case.

His solo legal assault is unique, but his results, it turns out, are not. There are roughly 30 lawsuits aimed at the rating agencies, and though many of the battles, including Mr. Grassi’s, are still unfolding, this much is clear: in the realm of private litigation, so far, the rating agencies are winning. Of the 15 motions to dismiss already acted on by judges, the rating agencies have prevailed 12 times, according to the Standard & Poor’s legal team, which keeps a running tally. In addition, five cases have been dropped.

“We’re making good progress in the courts and believe the remaining claims are without merit,” says Ted Smyth, an executive vice president at McGraw-Hill, which owns S.& P. Michael Adler, a Moody’s spokesman, says that “in many cases these suits have been found to be without merit, and we will continue to vigorously defend against these suits as appropriate.” Fitch declined to comment.

It’s an impressive run of victories, of a piece with the industry’s nearly perfect litigation record over the years. But it is just about the only good news the rating agencies can point to these days.

The streak of dismissals notwithstanding, several major lawsuits against the rating agencies have survived the pretrial phase and might — emphasis on might — end with huge jury verdicts or expensive settlements. In addition, a newly emboldened Congress is on the verge of overhauling financial regulation and could rewrite the rules of the industry.

For S.& P., Moody’s and Fitch, this is a war on two fronts. And while fought in vastly different realms — in courts and in Washington — the fights have this in common: either could wind up costing the rating agencies vast sums of money.

“I’m not seeing any signals that hedge funds are pouring in to short these stocks, like we saw with Lehman and Bear Stearns,” says Adam Savett of RiskMetrics, a corporate advisory firm. “But if the ratings agencies lose some of these battles, and especially if we see a big jury verdict, there will be blood in the water, and the sharks are going to swim.”

The threat from Washington is relatively new. For months, it looked as though S.& P., Moody’s and Fitch would escape the regulatory overhaul relatively unscathed.

But on Thursday the Senate passed a bill that included two notable ratings-related amendments. The first, by Senator George LeMieux, Republican of Florida, would strip from federal laws a requirement that a variety of institutional buyers — including banks, insurers and money market funds — buy only products stamped with a high grade by a rating agency. The idea is to encourage bond buyers to conduct their own research, or think creatively about outsourcing that job, instead of reflexively relying on S.& P., Moody’s and Fitch. The big three rating agencies, the amendment’s supporters hope, would no longer be the default raters for Wall Street.

Then there’s the amendment from Senator Al Franken, Democrat of Minnesota, which is an attempt to upend the conflict of interest that has been at the heart of the rating agencies for some 30 years. Currently, bond issuers pay for grades to their products, giving rating agencies a financial incentive to provide high grades. Senator Franken’s amendment calls for the creation of a Credit Rating Agency Board, essentially a committee that would pair issuers with rating agencies.

The goal is to break the direct link between issuers and raters and theoretically reduce the financial incentives that led to so many wildly inflated grades. It’s an idea that is even more revolutionary than it sounds, because the committee could turn the handful of smaller and newer rating agencies — which have barely registered in terms of market share — into players.

If the amendment works as planned, the three-way oligopoly that has long dominated the ratings business could be doomed.

As Congress appears to have roused itself to action, so too has the Securities and Exchange Commission. Moody’s recently disclosed that the commission had warned that it might sue the company. At issue are a number of former Moody’s executives who allowed some European derivatives to keep their high ratings even after it became clear that the grades were the result of a computer glitch. The particulars of the suit, however, aren’t as important as the signal that it has sent.

“This along with the Goldman Sachs lawsuit is a clear indication that the S.E.C. wants us to believe that it’s getting tougher,” says Lawrence White, a professor of economics at New York University. “The S.E.C. wants the world to know that the cop is back on the beat.”

IT’S too early to say what Washington’s legislative and regulatory actions portend for the rating agencies, but already they have altered the sense, prevalent as recently as three months ago, that these companies are in a business so complicated, and operating in an economy so fragile, that it is best to leave them undisturbed.

Perhaps legislators have been emboldened to fiddle with our nation’s troubled financial machinery because the economy is stronger, making any tinkering less threatening to the entire contraption. Maybe it is part of a populist anger over Wall Street bonuses and the banks’ exceptionally strong earnings reports. Whatever the cause, the atmospherics have changed.

A similar shift might be happening in the courts, though if Ron Grassi’s lawsuit is any indication, beating the rating agencies legally is still a very difficult maneuver.

The origins of his case can be traced to 2004, when he and his wife, Sally, were looking for very safe investments for their retirement years. A broker explained that the high ratings awarded by the three agencies — A+ from S.& P., A1 from Moody’s, AA-1 from Fitch — were proof the Lehman bonds were all but risk-free. They expected that by 2023, they would have their $40,000 in principal back, plus $90,000.

Two months after Lehman’s collapse in September 2008, Mr. Grassi called Lehman’s bankruptcy committee. A representative there said he could expect pennies on the dollar.

“Then I started thinking that the real culprit here isn’t Lehman,” says Mr. Grassi. “The only reason I bought those bonds is because the ratings agencies said the bonds were investment grade. But at the time, Lehman was loaded with all of these incredibly risky mortgage-backed securities. No one who actually studied Lehman’s books could possibly have described the company’s bonds as investment grade.”

After he filed his suit, he converted the guest room in his three-bedroom home into what he calls the “war room.” A set of bunk beds was soon piled high with documents and books about the financial crisis. When his case was moved to federal court — because he was suing out-of-state defendants — he bought an introductory guide to federal civil procedure.

At a hearing in July, he squared off against a crowded bench of opposing lawyers, including Floyd Abrams, a renowned First Amendment attorney and S.& P.’s lead counsel in these cases. (“We talked about our favorite New York delis,” says Mr. Grassi.)

One of Mr. Abrams’s arguments, as he put it in a recent phone interview, is that “it can’t be the case that any of the millions of people who purchased a particular bond can bring a lawsuit against a rating agency or an auditor, saying it turned out to be wrong.”

In March, Judge Dale A. Drozd in Sacramento seemed to agree with that reasoning when he granted the rating agencies’ motion to dismiss the case. Essentially, the judge contended that since Mr. Grassi never had contact with a rating agency representative before buying the bonds, the companies didn’t owe him a “duty” — a legal obligation that could form the basis of a negligence claim.

The issue of duty is just one of a batch of defenses that have long given the rating agencies a kind of legal force field that has yet to be breached. Several judges have rejected the idea that the rating agencies worked so closely with the investment banks that they were essentially co-underwriters. And a 77-year-old regulation exempts rating agencies from the definition of “experts” who can be sued.

“It’s important to understand,” says Joel Laitman of the law firm Cohen Milstein Sellers & Toll, which has seen two of its five lawsuits against the agencies dismissed, “they’re winning because this is not a level playing field.”

As for the apparent conflict of interest built into the rating agencies’ business model — judges have ruled that it has been around so long and is so widely known that it isn’t a cause of action. And, of course, the rating agencies have long and successfully argued that their grades are just opinions about the future and therefore entitled to robust First Amendment protections, like those afforded journalists.

The success of these and other defenses has kept a number of potential litigants on the sidelines, say experts, and that includes state attorneys general. After attorneys general in Ohio and Connecticut sued the rating agencies, it looked for a moment as though the companies would face a collective assault similar to the one that forced cigarette makers into a global, multibillion-dollar settlement in 1998. But since March, when Connecticut filed, no other attorney general has jumped in.

“I don’t have a good explanation,” says Ohio’s attorney general, Richard Cordray. “I fully expected more states to join by now.”

But the rating agencies have lost several skirmishes in court that could prefigure disaster for them. Two judges have rejected their First Amendment defense. In one case involving a $5.86 billion structured investment vehicle sold by Cheyne Capital, a federal judge in Manhattan, Shira Scheindlin, ruled that the First Amendment wasn’t a defense because rating agencies had, in this instance, “disseminated their ratings to a select group of investors rather than to the public at large,” as part of a private placement.

The First Amendment might also fail in “public at large” cases if judges find that the rating agencies didn’t actually believe the grades they were selling. As legal scholars put it, there is no free speech protection when it comes to matters of fraud.

Ultimately, it’s hard to predict where these lawsuits are going because the past might be a less-than-useful indicator about what will happen to these cases in the future. During the years of subprime mortgage mania, the rating agencies conducted themselves in ways they never had before — awarding investment grades to bonds that even analysts in the company thought were risky, allegedly trampling their own internal safeguards to manage the issuer-pays conflict of interest, and so on. The legal arguments offered by the rating agencies are time-tested, but the facts are new.

“If these cases were to gather momentum and create an industry-challenging level of damages, it could well change the behavior of the ratings agencies,” says Kevin LaCroix, a lawyer with OakBridge Insurance Services who has closely followed the litigation. Once again, the precedent here is the cigarette companies, which agreed to a wide range of restrictions and new regulations after the master settlement.

“But we’re nowhere near that point yet,” notes Mr. LaCroix.

What is happening with the rating agency lawsuits is what happens every time an industry is attacked through the courts en masse — the plaintiffs lawyers learn from each ruling, including the dismissals, then fine-tune their arguments and refile.

That is exactly what Mr. Grassi is doing as he attempts to restart his lawsuit with an amended complaint. He admits that if someone came to him now with a case like his, he’d talk the client out of suing. The odds are too long; the costs are too high.

Then again, he is representing himself, so his expenses are far less than $1,000. And even if this exercise proves futile, he’s having a great time “poking back” at Wall Street, as he puts it.

“When you’re retired,” he says, “you’ve got time to do dumb things.”

And, he happily notes, any time he files a motion he sends copies to 17 different lawyers at the three rating agencies. Given that there have been more than 90 pleadings so far, and given that many of these lawyers bill at well over $500 an hour, he assumes that his case has already cost the company far more than he could ever hope to recover.

Mr. Abrams, the lawyer for S.& P., declined to get specific about the billings from his law firm:

“I’d rather not get into it. You’d fall off your chair.”