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Moody’s Escapes SEC Lawsuit, Now Moves to Shield Itself From Liability

As the major ratings agencies become a focus of more scrutiny from financial regulators, they are seeking to protect themselves from liability when they issue erroneous ratings.

Sept 2: This post has been updated.

Despite allegations that Moody’s Investors Service, one of the three major credit rating agencies, committed fraud when it failed to fix what it knew was an erroneous rating, the Securities and Exchange Commission announced on Tuesday that it wouldn’t sue the rating agency. It instead settled for a scolding, directed at ratings agencies generally.

Historically, rating agencies have argued with some success that the First Amendment protects their ratings, but much of the examination done after the financial meltdown has cast blame on the agencies for caving into pressure from investment banks and compromising standards in order to preserve market share. It has also brought a string of lawsuits from investors and issuers alike.

States and local governments have recently noticed, however, that Moody’s is including in its contracts what’s known as an “indemnification clause,” which helps protect the agency from lawsuits, according to Bloomberg.

The clauses, Bloomberg explained, push liability onto the issuers; in the municipal bond market, lawsuits that hold the issuer responsible for bad ratings could ultimately cost taxpayers.

Moody’s acknowledged the clauses, but said they’re not new.

“These types of indemnification clauses are common in business services agreements,” said Moody’s spokesman Michael Adler told Bloomberg.

And it seems Moody’s hasn’t been alone in seeking some measure of legal protection:

“Fitch has long included indemnification language in some of its general business agreements,” said Daniel Noonan, spokesman for the company in New York. “However, Fitch has not included indemnification language in its issuer agreements.”

S&P has entered into “revised agreements with many issuers over the last several months,” said spokesman Edward Sweeney in New York.

(S&P spokesman Ed Sweeney gave the following statement: ""For the capital markets to function properly, investors should receive from issuers information relevant to the performance of a security. Likewise, S&P's expects issuers to stand behind the accuracy and completeness of the information they provide as part of the rating process.")

As the Center for Public Integrity reported in June, ratings agencies fought hard against language in the Dodd-Frank financial reform bill that would expose them to more liability. From the official summary of the bill (PDF):

Liability: Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.

While this sounds straightforward enough, the effects of the final language are still unclear. The bill essentially requires issuers to get permission from the ratings agencies in order to include their ratings in offering documents for bond sales. If a rating agency agrees, it exposes the agency to liability if the ratings are wrong. Here’s Fitch reacting:

Fitch is not willing to take on such liability without a complete understanding of the ramifications of that liability to Fitch’s business and the means by which Fitch may be able to effectively mitigate the risks associated therewith.

The solution? Moody’s, Fitch, and S&P have all asked for their ratings not to be used in official documentation. (Ratings agencies would argue that ratings are essentially their best predictions of the future, and they shouldn't be held liable if those predictions don't pan out.) There’s a separate SEC rule, however, that requires ratings to be included in the offering documents for asset-backed securities in particular, but that rule has been temporarily suspended until Jan. 24, 2011.

After the rule suspension expires, rating agencies will likely be exposed to more liability for ratings of those securities, but it remains unclear whether that will be true for other bonds. One thing’s for sure — agencies are doing what they can to “mitigate the risks” and minimize the degree to which they can be held responsible for their own mistakes.

Update: Moody's announced it will discontinue the use of indemnification language in its contracts with muni-issuers. This post has also been updated with comment from S&P.

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