Standard & Poor’s downgraded Greece’s sovereign debt rating by three notches on Monday, reflecting its view that it would be next to impossible to imagine a scenario where the country could restructure its debt.
The move has once again highlighted the powerful position that credit rating agencies (CRAs) hold in the world of finance, despite being roundly criticised for their role in the global financial crisis.
Despite moves to bring stronger regulation on the CRA industry in the US and other jurisdictions around the world, the likes of S&P, Moody’s and Fitch continue to assess debt with little threat of litigation.
The sudden downgrade of Greece’s debt is reminiscent of the unprecedented downgrades of AAA-rated securities during the GFC, when rating agencies infuriated investors worldwide by issuing multiple downgrades to 30% of subprime-based securities in a matter of days.
Of course, many investors will also recall that the rating agencies rated Enron’s debt as “investment grade” just days before it filed the largest claim for bankruptcy protection in history.
I have written previously about the problems associated with the flawed rating methodology that the agencies used to calculate risks.
Finance academic and author Frank Partnoy has demonstrated that the rating process before the sub-prime meltdown was largely a mathematical game in which quantitative analysts, who understood all the intricacies of the models, could manipulate the risks and “tweak” the inputs and assumptions to produce ratings that appear to add value, although in reality they did not.
To illustrate this point, one only needs to mention how the rating agencies devised a statistical “house appreciation rate” in their models to calculate risks, because they were so confident that house prices would always only appreciate.
So how is it that, despite the overwhelming evidence of professional incompetence, the rating agencies continue to shape the destinies of investors and even entire nations post GFC?
One explanation is the practice of “regulatory reliance” on the ratings in many spheres of public finances and commercial life, as well as an absence of realistic alternatives.
This tension should be of interest to a handful of local councils and other investors who are currently engaged in a class action in the Federal Court against the local arm of collapsed investment bank Lehman Brothers.
The investors lost hundreds of millions of dollars investing in AAA-rated financial products of dubious value.
But can CRAs be held legally liable for the broader outcomes of the ratings they give to these kinds of financial products?
There are many legal and procedural obstacles that investors will encounter if they decided to sue the agencies to recover any losses sustained as a result of reliance placed on the ratings.
For a great majority of investors, it will be almost impossible to argue their case in court because of the inherent legal limitations on proof.
For example, to prove an action for a breach of contract, it would be necessary for an investor to demonstrate that there was in fact a contact between the investor and the rating agency (which is rarely, if ever, the case).
In rare situations, the investor may be able to argue that it was the intended “third party beneficiary,” under an existing agreement between an investment bank and the rating agency. The investor would then have to demonstrate in court that they were expressly identified in the contract (if they ever managed to get a copy of it).
In theory, investors might have a better chance to argue their case under the law of tort, which imposes various standards of proper behaviour on actors in the public domain.
Here the practical problem lies in the requirement to prove an intent by a rating agency to harm the investors, because ratings are typically provided to the public “at large”. There is, at least in theory, no requirement for anyone to act upon the rating.
Investors will also have to demonstrate that the ratings were published with the knowledge that they were false, or with a reckless disregard as to whether they were false or not.
In theory this may sound like a reasonable argument, but in practice the requirements of privity, intent and access to documents held by the agencies and banks will be insurmountable obstacles for a vast majority of litigants.
Another example of the difficulties that investors are facing is the so-called “freedom of speech” defence in the US, which allows rating agencies to claim that their ratings are constitutionally protected journalistic opinions, or, as one commentator put it, “the world’s shortest editorials.”
The defence dates back to the time when agencies were paid by investors, rather than the investment banks whose financial products ratings agencies now jointly structure and rate.
This seems to be a crucial issue, because there are legal precedents in the US which suggest that the freedom of speech defence will be less effective if that speech was “motivated by the desire for profit.”
This will particularly be the case where the agencies have played an active role in the process of structuring of financial products, and where those ratings were designed for a small group of investors in a private offering. Many “toxic CDO” ratings issued during the GFC would arguably fall under this category.
All this suggests that a tort-based claim will be more likely to succeed where the rating is used for the specific purposes of a targeted or private product offering, rather than dissemination to the general investing public “at large”.
As one US court put it, such transactions “reveal a level of involvement with the client’s transactions that it is not typical of the relationship between a journalist and the activities upon which the journalist reports.”
Some interesting and rather fancy legal arguments have been advanced in the US recently, including the proposal to impose “consumer protection standards” on credit rating agencies or to prosecute them for securities legislation fraud.
I would like to mention another one, which is still untested in the courts. Namely, there are many conceptual similarities between rating agencies and auditors, because they both tend to verify financial information for interested parties and make other transactions possible.
If the regulators and courts were willing to treat credit rating agencies as “auditors” of financial information, then they should be able to impose on them some of the standards of liability that are imposed on auditors in relation to third parties?
There are established legal principles which govern auditors’ liability to third parties, such as where a financial report was prepared with the knowledge that it would be passed on to a third party to rely upon, and the third party suffered loss as a result of placing reliance on the audited information for investing purposes.
This proposal may not be particularly helpful to investors “at large,” however, it might be useful to those investors who were invited to participate in targeted offerings where the financial product was co-structured by a credit rating agency that also rated the product.