A Strict Liability Regime for Rating Agencies

• Author: Alessio M. Pacces,Alessandro Romano
• DOI: http://doi.org/10.1111/ablj.12054
• Published date: 01 December 2015
• Date: 01 December 2015

A Strict Liability Regime for Rating

Agencies

Alessio M. Pacces* and Alessandro Romano**

INTRODUCTION

The behavior of Credit Rating Agencies (CRAs) has received careful

scrutiny in the past decade, particularly in the aftermath of the global

financial crisis. This is with good reason. According to the law and eco-

nomics literature, ratings are valuable for the society because they

reduce asymmetric information in finance.

1

In this perspective, the

function of CRAs is to provide investors with certifications of the quality

*Professor of Law & Finance at Erasmus School of Law, Erasmus University Rotterdam,

and Research Associate at the European Corporate Governance Institute (ECGI).

**Visiting Researcher at Yale Law School and PhD candidate at Erasmus School of Law,

Erasmus University Rotterdam, and at LUISS-Guido Carli School of Law in Rome.

A previous version of this article was published as ECGI research paper in law and a short sum-

mary of it was posted on the Harvard Law School Forum on Corporate Governance and Finan-

cial Regulation. Part of the research included in this article was carried out at the Study Center

Gerzensee of the Swiss National Bank, whose hospitality is gratefully acknowledged. This article

benefitedfrom the feedbackof participantsin the 2014 European Summer Symposiumon Eco-

nomic Theory (ESSET) in Gerzensee, the 2014 MaCCI Law and Economics Conference on

Financial Regulation and Competition in Mannheim, the 2013 Meeting of the Canadian Associ-

ationinLawandEconomicsinToronto,the15thJointSeminaroftheEuropeanAssociationof

Law and Economics and the Geneva Association in Girona, the 4th Annual Conference of the

Spanish Association of Law and Economics in Grana da, and the 11th Annual Meeting of the

German Association of Law and Economics in Bolzano. We thank Gaia Barone, Patrick Bolton,

Jeff Gordon, Alice Guerra, Martin Hellwig, Todd Henderson, Claire Hill, Giovanni Immordino,

Yair Listokin, Vyacheslav Mikhed, Marcello Puca, Pietro Reichlin, Roberta Romano, Ulrich

Schroeter, Alan Schwartz, Bob Scott, Angela Troisi, and Roland Vaubel for valuable comments

on previous versions of this work. The usual disclaimers apply.

1

See, e.g., Lawrence J. White, Markets: The Credit Rating Agencies,24J.ECON.PERSPECTIVES 211,

212–13 (2010)(“The purpose of credit rating agencies is tohelp pierce the fog of asymmetric

information by offering judgments—they prefer the word ‘opinions’—about the credit quality

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C2015 The Authors

American Business Law Journal V

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673

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Volume 52, Issue 4, 673–720, Winter 2015

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of financial assets, which is a form of gatekeeping.

2

CRAs are perform-

ing this beneficial role in financial markets so long as the ratings they

produce are above a certain accuracy threshold, which for simplicity we

assume to be exogenously determined by the existing forecasting tech-

nology. Ratings are informative, thus valuable, because such technology

is not available to the public. The problem of asymmetric information

applies to financial regulators too, which explains why financial regula-

tion is reliant on ratings for a number of purposes.

3

Conversely, when

they are systematically higher than warranted, ratings may fuel asset

bubbles and eventually lead to financial crises. Given the pivotal role

played by CRAs in financial markets, it is of vital importance to develop

a framework that provides CRAs with optimal incentives to issue accu-

rate ratings. In this article, we attempt exactly this task.

Unsurprisingly, on both sides of the Atlantic, the regulatory reaction

to the global financial crisis also focused on rating agencies.

4

Legislators

have tried simultaneously to police the CRAs’ conflicts of interest

through regulation and to make them more accountable for their mis-

takes, overcoming the traditional insensitivity of CRAs to the threat of

of bonds that are issued by corporations, U.S. state and local governments, ‘sovereign’ gov-

ernment issuers of bonds abroad, and (most recently) mortgage securitizers.”).

2

See Reinier H. Kraakman, Gatekeepers: the Anatomy of a Third-Party Enforcement Strategy,2J.

L. ECON.&ORG. 53, 54 (1986); Gregory Husisian, What Standard of Care Should Apply to the

World’s Shortest Editorials? An Analysis of Bond Rating Agency Liability,75C

ORNELL L. REV.

411, 421 (1990) (arguing that rating agencies add value because they analyze issues less

expensively than the average investor); Susan M. Phillips & Alan N. Rechtschaffen, Interna-

tional Banking Activities: The Role of the Federal Reserve Bank in Domestic Capital Markets,21

FORDHAM INT’LL.J. 1754, 1762–63 (1998) (“Finally, credit rating agencies enhance the capi-

tal markets infrastructure by distilling a great deal of information into a single credit rating

for a security. That rating reflects the informed judgment of the agency regarding the issu-

er’s ability to meet the terms of the obligation. Such information is frequently critical to

potential investors and could not be acquired otherwise, except at substantial cost.”).

3

See John C. Coffee, Jr., Ratings Reforms: The Good, The Bad and the Ugly,1HARV.BUS.L.

REV. 231, 261 (2011) (“Some believe that the basic error made by regulators was to grant

ratings agencies a de facto regulatory role. In truth, this decision, which dates back to the

1930s in the United States, was the product of the inability of financial regulators to define

excessive risk themselves.”).

4

For an overall comparative analysis of the regulatory approaches towards CRAs in the

European Union and in the United States, see generally ALINE DARBELLAY,REGULATING

CREDIT RATING AGENCIES (2013).

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liability.

5

In this vein, different from the past, some recent attempts to

impose liability on rating agencies have been successful. Australian

courts found Standard & Poor’s liable for misleading investors on struc-

tured finance products rated triple-A.

6

And in the United States,

Standard & Poor’s ultimately settled for payment of $1.5 million in the

lawsuit brought against them by the U.S. Department of Justice and a

few other states.

7

Only time will tell whether these outcomes can be generalized.

Undoubtedly, however, CRAs face today an increased liability threat

and more regulatory constraints on their operation.

8

The desirability

5

Before the Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010, Pub.

L. No. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act], CRAs were largely

immune to liability in the United States. See Frank Partnoy, How and Why Credit Rating

Agencies Are Not Like Other Gatekeepers,in FINANCIAL GATEKEEPERS:CAN THEY PROTECT INVEST-

ORS? 61 (Yasuyuki Fuchita & Robert E. Litan eds., 2006). See also JOHN C. COFFEE,JR.,

GATEKEEPERS:THE PROFESSIONS AND CORPORATE GOVERNANCE 302 (2006) (emphasizing that

CRAs had enjoyed de facto immunity to liability). CRAs were immune to legal liability for

various reasons. For one, some U.S. courts placed ratings under the umbrella of the first

amendment. See Jefferson Cty. Sch. Dist. No. R-1 v. Moody’s Investor’s Serv., Inc., 175

F.3d 848, 852–56 (10th Cir. 1999); In re Enron Corp. Sec. Derivative & ERISA Litig. 511

F. Supp. 2d 742, 819–27 (S.D. Tex. 2005) (analyzing case law addressing first amendment

protection). For arguments against these decisions, see Caleb Deats, Note, Talk That Isn’t

Cheap: Does The First Amendment Protect Credit Rating Agencies’ Faulty Methodologies From Regu-

lation?, 110 COLUM.L.REV. 1818, 1818 (2010). Along similar lines, it was practically impos-

sible to sue CRAs for fraud under Securities and Exchange Commission (SEC) Rule 10b-5

until the pleading standard—particularly regarding the showing of scienter—was lowered

by section 933 of the Dodd-Frank Act. See Coffee, supra note 3, at 267–68. Finally, SEC

Rule 436(g) exempted CRAs from liability as experts under section 11 of the Securities Act

of 1933. Adoption of Integrated Disclosure System, 47 Fed. Reg. 11,380, 11,391 (Mar. 18,

1982). Rule 436(g) was abolished by section 939G of the Dodd-Frank Act, supra.

6

ABN AMRO Bank NV v Bathurst Regional Council [2014] FCAFC 65 (Austl.) (confirming

the decision by the court of first instance to hold Standard & Poor’s liable for negligently

deceiving investors through inflated ratings).

7

See Aruna Viswanatha & Karen Freifeld, S&P reaches $1.5 Billion Deal With U.S., States over

Crisis-era Ratings, REUTERS (Feb. 3, 2015, 1:46 PM), http://www.reuters.com/article/2015/02/

03/us-s-p-settlement-idUSKBN0L71C120150203. Interestingly, the Department of Justice

decided to bring suit against S&P’s based on the private cause of action of a long-standing

statute, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIR-

REA), Pub. L. No. 101-73, 103 Stat. 183 (1989). Under FIRREA, the plaintiff needs to

establish its claim under a preponderance of evidence standard avoiding the more

demanding requirements of criminal law enforcement.

8

For example, among other things, the Dodd-Frank Act creates the “Office of Credit Rat-

ing” to monitor and control CRAs behavior. Dodd-Frank Act, supra note 5, § 939C. Also,

2015 / Strict Liability for Rating Agencies 675