First Amendment protections challenged

Subsequent to the 2007 crisis, the premise of the constitutional protection hereto afforded CRAs and their ratings has increasingly begun to be tested in the courts while also being more acutely questioned in academic literature. It has been argued that U.S.

courts have applied the matters-of-public-concern test established in Dun & Bradstreet (1985) to determine whether the market-place-of-ideas theory was being upheld and whether a CRA (or other party) merited First Amendment protection.⁴⁰⁴ An alternative recommendation by Heggen⁴⁰⁵ calls for the setting aside of the actual malice standard by the courts and instead advocates for focussing on a functional analysis to determine the extent of the active role played by CRAs, particularly in the process of designing and

401 See, Pub. L. No. 109-291, 120 Stat. 1327.

402 See Section 3.2. above

403 Stephen Foley, Rating agencies clash over standards, FINANCIAL TIMES, Nov. 6, 2012, at 25 (“They are actually acting like competitors”; Jules Kroll, noting Moody’s has twice been critical of S&P ratings within a month, and Fitch has criticised AAA ratings awarded by the Big Two to the CMBS ‘North Star’).

404 See, Jonathan W. Heggen, Not Always the World's Shortest Editorial: Why Credit Rating Agency Speech Is Sometimes Professional Speech, 96IOWA L.REV., 1745, 1763 (2011) (“... [T]he market-place-of-ideas theory is the free-speech theory that courts believe is relevant to CRAs”).

405 Id., Heggen, 2011, at 1759 (2011).

constructing structured products. Other commentators have suggested that CRA claims for First Amendment protection should instead be measured against a “press test”⁴⁰⁶ standard. Additionally, In re Fitch, 330 F.3d 104 (2d Cir. 2003)⁴⁰⁷ – discussed below – the Second Circuit court introduced an assessment formula that takes into consideration the issuers’ remuneration for the purpose of determining the extent of CRA liability.

▪ In re Fitch, 330 F.3d 104 (2d Cir. 2003)

Background: The plaintiff was the American Savings Bank, FSB (hereinafter, ASB), a federally-chartered savings bank based in Hawaii and regulated by the Office of Thrift Supervision (hereinafter, OTS). OTS regulations prohibited savings banks like ASB from buying and holding non-liquid and non-investment grade rated securities.⁴⁰⁸ The defendant, UBS PaineWebber, Inc. (hereinafter, PaineWebber) had been one of ASB's long-serving brokers. In 1999, PaineWebber created “principal protected” securities for ASB that were based on equity in a “Collateralized Loan Obligation” (i.e. “CLO”)⁴⁰⁹ structure, specifically designed to be in compliance with OTS requirements. The structure was meant to allow ASB to earn an equity-like rate of return while complying with the statutory requirement of not actually holding any equity.

406 e.g. Larry P. Ellsworth & Keith V Parapaiboom, Credit Rating Agencies in the Spotlight: A New Casualty of the Mortgage Meltdown, 18BUS.L.TODAY (4) 1, 3 (2009) (stating the two-factor press test requisites:

scope of reporting and role in transaction); and Alec Klein, Credit Raters speak against oversight, WASH. POST, June 29, 2005, at A08 (CRAs are “members of the financial press”).

407 In re Fitch, Inc. 330 F.3d 104 (2d. Cir. 2003) (per curiam), (In Re Fitch, American Savings Bank, Fsb, v.

UBS PaineWebber).

408 See, 12 C.F.R. § 560.40 (2002).

409 A Collateralized Loan Obligation is created by aggregating large numbers of commercial debt obligations (i.e. CDOs), dividing the rights to the repayment stream into many sub-divisions referred to as “tranches”, and selling those tranches as tradable securities.

Between 1999 and 2000 ASB invested $83 million into several CLO products, after which the OTS informed them that the CLOs were in violation of the regulations as they were considered non-investment grade and that ASB should therefore dispose of them.

When PaineWebber refused to accept the return of Trust Certificates from ASB, the latter sued. ASB had received a private letter rating of the swap agreements from Moody’s as to the likelihood of getting its principal repaid. The CLOs had been rated by both Moody’s and Fitch.

The lawsuit against Fitch arose from ASB’s failure to get satisfactory compliance from Fitch concerning a subpoena requiring disclosure of the extent of their communication with PaineWebber regarding:

“(i) whether Fitch would rate the Trust Certificates; (ii) whether this type of security could ever be rated investment grade;⁴¹⁰ (iii) the methodology of the modelling used to perform the ratings; and (iv) what changes to the deal's structure would be required to achieve the desired rating”.⁴¹¹

Argumentation: Fitch’s defence primarily relied on the principle of “journalistic privilege” established in O'Neill v.Oakgrove Construction, Inc. (1988)⁴¹² in which the court determined that information obtained by the press, such as the identity of confidential sources, is generally not subject to subpoena. New York state law codified

410 See, JOHN C.COFFEE JR.,in GATEKEEPERS:THE PROFESSIONS AND CORPORATE GOVERNANCE 303, Oxford University Press, 2006 (2006) (“[F]or over a century institutional investors have been found by courts to have satisfied their due diligence obligation as fiduciaries when they relied on investment grade ratings from the ratings agencies.”). See also, Caleb M. Deats, ‘Talk that Isn't Cheap’, 110COLUM.L.REV. 1818, 1858, (2010).

411 In re Fitch, Inc. 330 F.3d 104, n.181 (2d. Cir. 2003) (per curiam).

412 O'Neill v. Oak Grove Const., 71 N.Y.2d 521, 526-27, 528 N.Y.S.2d 1, 523 N.E.2d 277 (1988).

this in its Shield Law⁴¹³ which provides journalists⁴¹⁴ who refuse to comply with a non-party subpoena with protection from being held in contempt of court in instances where the subpoena aims to discover information provided to the journalist in confidence.⁴¹⁵ Additionally, the law also prohibits discovery of unpublished non-confidential information. A party seeking the subpoena is required to make a “clear and specific declaration showing that the [information] sought: (i) is highly material and relevant; (ii) is critical or necessary to the maintenance of a party's claim, defence or proof of an issue material thereto; and (iii) is not obtainable from any alternative source”.⁴¹⁶

In their defence, Fitch highlighted two earlier district court decisions involving S&P; In re Pan Am Corp., 161 B.R. 577 (1993)⁴¹⁷ and In re Scott Paper Co. Sec.

Litig., 145 F.R.D. 366 (1992),⁴¹⁸ in which S&P was recognized by the courts as meriting journalistic privileges and protections. In both cases the courts accepted the argument that because S&P rated almost all public debt, whether issued by clients or not, their actions were similar to those of regular journalists who would cover all stories and transactions considered newsworthy and as such merited journalistic protection.

413 Shield Law, N.Y. Civ. Rights Law § 79-h (McKinney 2002).

414 The Shield Law defines professional journalist as “one who, for gain or livelihood, is engaged in gathering, preparing, collecting, writing, editing, filming, taping or photographing of news intended for a newspaper, magazine, news agency, ... or other professional medium or agency which has as one of its regular functions the processing and researching of news intended for dissemination to the public”, at § 79-h(a)(6).

415 Shield Law, § 79-h (b).

416 Shield Law, § 79-h (c).

417 In re Pan Am Corp., 161 B.R. 577, 580-82 (S.D.N.Y.1993).

418 In re Scott Paper Co. Sec. Litig., 145 F.R.D. 366, 369-70 (E.D.Pa. 1992).

Decision: In ruling against Fitch, the Appeal Court highlighted two objections to its defence. Firstly, the court concurred with the S.D.N.Y. District Court’s decision in re Pam Am in finding that S&P had been considered a journalist in part because it rated “virtually all public debt financing and preferred stock issues whether they were done by S&P clients or not”.⁴¹⁹ However, as the court could not find evidence supporting Fitch's claim that it had regularly analysed or published ratings for transactions for which it was not paid to rate,⁴²⁰ it ruled that S&P’s defence was not applicable to Fitch’s position and this in turn

“weigh[ed] against treating Fitch like a journalist”.⁴²¹ In reaching its decision, the court also relied on an earlier testimony to a state court by a Managing Director for Asset-Backed Securities at Fitch who stated the following:⁴²²

A: “It is not our [Fitch's] regular practice to rate transactions ... that we are not paid [for] by the underlying issuer initially. There are transactions that we have commenced on that we have not been paid to rate …”

419 In re Pan Am Corp., 161 B.R., 577, 583 (S.D.N.Y.1993) (“We believe, however, that Fitch’s information-disseminating activity does not seem to be based on a judgement about creditworthiness, but rather on client needs”)(emphasis added).

420 In re Fitch, Inc. 330 F.3d 104, 110 (2d. Cir. 2003), (per curiam). See also, Phillippe Jorion, Zhu Liu, Zhu & Charles Shi, Informational effects of Regulation FD: Evidence from Rating Agencies, 76J.FIN. ECON. (2) 309, 316-20 (2005 (noting that CRA ratings rely on both public and non-public information, although the explanations given for a rating only refer to public information).

421 In re Fitch, 330 F.3d 104, 110 (2d Cir. 2003). See also, American Savings Bank, FSB v. UBS Paine Webber, Inc., 2002 U.S. Dist. LEXIS 24012, 2-3 (S.D.N.Y. Dec. 16, 2002) (”… [T]he journalist privilege is a qualified one. Fitch is not primarily engaged in newsgathering generally, nor was it doing so when procuring information sought by the subpoenas. The Court finds that Fitch is not entitled to the protections offered by the journalist privilege”).

422 In re Fitch, 330 F.3d 104, 110 (2d Cir. 2003) (court citing the testimony of Kevin Duignan, Managing Director of Fitch's Asset-Backed Securities testimony), in Koch Reply Aff’d at Ex. L (Duignan Dep. at 49:13-17, 51:3-11).

Q: So, is it a fair statement then that the underlying transactions you are rating without a fee are still part of a larger transaction for which Fitch is getting paid a fee by somebody?

A: Yes.

Q: Any other instances that you're aware of where Fitch rates a transaction without being paid a fee by somebody?

A: On a transaction level basis, I can't recall any.”

The aforementioned testimony excluded Fitch from claiming that, unlike S&P, their decision to provide ratings was contingent on a corresponding claim for payment in return of the service. Hence, Fitch could not be considered as being on a par with journalists.

Secondly, construing correspondence showing Fitch officials commenting on proposed transactions and offering suggestions about how to model the transactions in order to reach a desired rating, the court ruled that Fitch’s role had been inconsistent with traditional journalism as it had exceeded the bounds of an acceptable relationship between a journalist and the activities upon which the journalist typically reports. Moreover, the court found that the plaintiff’s claim regarding Fitch’s allegedly active role in the transaction’s structuring process to have been “extremely credible.”

The two-factor “press test” relied upon by the Appeal Court in deciding this case hinged on two determinants: (i) whether the CRA only “reported on” specific transactions for which it had been hired (as opposed to covering a broad array of significant and relevant securities and transactions as a more traditional journalist/press outlet would);

and (ii) whether the court examined the agency’s role in the transaction, to determine whether there is evidence of a level of involvement with the client’s transactions that is atypical of the regular relationship between a journalist and the activities upon which the journalist reports. Other subsequent decisions⁴²³ have drawn on the Appeal Court’s

423 See e.g., King County v. IKB Deutsche Industriebank AG, No. 09 Civ. 8387 (SAS) (S.D.N.Y. 2012); and In re Fitch, 330 F.3d 104, 106, n.18 (2d Cir. 2003) (citing Securities and Exchange Commission, Report on

reluctance In re Fitch to extend media protection to CRAs in instances where they were hired and paid a fee in exchange for either providing a solicited rating or where CRAs have been shown to have actively participated in the structuring of the transactions.⁴²⁴