Puffery: S&P’s Magical First Amendment Defense

Just when you might havethought the ratings agency business couldn't get any stranger, enter Standard and Poor's defense against the Justice Department's case: They’ve effectively downgraded themselves.

The case, filed and announced in a high-profile presser in early February, alleges S&P fraudulently and knowingly rated low-quality subprime debt at its highest grade, AAA. The presumed motive for this is the issuer-pays model of most corporate and municipal bond issuance: The entity seeking to borrow from the public via bond issuance pays S&P to rate the debt, so S&P (or Moody’s or Fitch) might be motivated to rate debt at artificially lofty levels to win more business from issuers of similar securities. Investors, who presumably seek accurate information, could be disadvantaged by this—it’s a conflict of interest.

The government raises a perfectly valid point. There is potential for conflicts of interest in this structure. But, to me, this doesn’t make the government’s case against S&P open-and-shut. It’s perfectly valid to ponder why there’s a case against only S&P, for one. Moody’s and Fitch had nearly identical ratings on said subprime debt. I'm not suggesting the fact all threehad similar ratingsimpliesaccurate ratings. The interesting part is, as of now, there isn’t a Federal case against Moody’s and/or Fitch—why? The very same issuer-pays model applies to them as well. And the further irony is the issuer pays model exists because Congress created it via legislation in the 1970s. And it seems to me very few people would pay any material attention to the raters if it weren’t for Federal laws, mirrored elsewhere globally, enshrining ratings into regulation, most notably for banks. (Later ratings were adopted by some pensions regarding bonds eligible for investment.) The same laws made it difficult for new entrants to compete with S&P, Moody’s and Fitch because of their special certification as Nationally Recognized Statistical Ratings Organizations (NRSROs). There’s a growing tide to address these factors via legislation, but it’s incomplete at this juncture.

Historically, when challenged, S&P has frequently argued their ratings are independent and objective—the product of in-depth research, unaffected by the money that changes hands between a bond issuer and them as rater. Rather, they argue their opinions are independent and objective. Opinions being a key word, because it effectively invokes the First Amendment. Ratings are, according to this line of logic, constitutionally protected free speech.

There is some sense to this. The argument a rating is a recommendation to investors to take some action seems lacking to me—how can a corporation that doesn’t work with investors directly make recommendations to them? Moreover, investors can benefit from the transparency added when market observers opine on the quality of an investment. Fear of reprisals could reduce that free flow of information, making markets more opaque.

But S&P isn’t making those arguments. Instead, S&P’s defense is the ratings are “puffery.” Yes, puffery—their words exactly—defined by Merriam Webster’s as “exaggerated commendation especially for promotional purposes: hype.”

In several prior cases when S&P has employed a free-speech defense, the ruling judges have agreed by declaring ratings to be puffery—dismissing the suits and freeing S&P from liability. Investors should never have believed it, according to the judges ruling in these cases, because the ratings are that far removed from reality.

A bit outrageous? Perhaps. Then again, here's a quick catalogue of some of the raters’ greatest misses: Enron, a house of cards, was investment-grade rated to nearly the bitter end; the aforementioned AAA-subprime mortgage debt; Lehman Brothers’ high investment-grade rating within days of their demise; downgrading the US based (initially) on a $2 trillion mathematical faux pas (we guess that’s the “statistics” in NRSRO). Just the other day, the same S&P altered its outlook on Venezuelan debt to “Negative” from “Stable.” Which may seem a sensible move until you consider they rated Chavismo Venezuela "Stable." There’s a fundamental logic error there.

But now, it seems S&P is just cutting out the middle man and calling its own work, “puffery.” That might seem bizarre, but to me, it’s the most sensible rating they’ve issued at any time in recent memory. The market long ago downgraded the importance of these agencies. On average, rates tend to fall after a highly rated nation is downgraded. Thatthe ratersmay becatching on now is just the latest example oftheiropinions arriving a bit late.

Neither side is categorically in the right in Feds v. S&P. But on one issue, there should be little to no debate. Take S&P at its word, and take ratings (whatS&P self-defines as “puffery”) with at least agrain of salt.