S&P Legal Defense—No Reasonable Investor Would Take Us Seriously

Standard & Poor’s, facing up to $5 billion in civil damages on charges of knowingly understating the credit risks of mortgage backed securities, is offering a novel defense—no reasonable investor would have taken S&P’s claims about its own objectivity seriously.

It’s a multi-pronged case, but one key issue is how we should understand the legal status of S&P’s claims to offer independent, objective credit ratings that are free of conflicts of interest. The Department of Justice’s view is that those are meaningful claims, and that evidence suggests they are false claims. Rather than offering independent objective ratings, the government charges, S&P offered softball ratings to banks in order to gain their business. S&P counters that there’s no liability here. Its ratings are protected free speech and claims about objectivity are “puffery” rather than meaningful financial statements upon which a reasonable investor would rely.

The law is the law, but this line of defense simply underscores that these agencies deserve to die.

As a theoretical matter, the business model in which the issuer of a security pays a ratings agency to evaluate it can make sense. As the security issuer, you don’t just want a good rating you want a credible rating. Which means that to obtain business over the long-term, a rater needs a reputation as a credible source. That need to maintain a credible brand should give raters a financial incentive to avoid giving positive ratings to bad products even if they’re being offered money to do that. But this entire logic rests on the theory that claims to objectivity and independence aren’t puffery—that they’re actually at the core of the ratings agencies’ business model. So close to the core, in fact, that developing a reputation for violating the norms of objectivity would be devastating to their reputation and their standing.

If talk of objectivity is just marketing hype, then the ratings are worthless. It’s just a form of paid public relations for security issuers and nobody should take the ratings seriously for a minute.