From First Amendment Absolutism to Financial Meltdown?
posted by Frank Pasquale
In 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a “piggyback,” where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage. While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in “subprime” mortgages taken out by buyers with weak credit.
[T]the real-estate bubble of recent years, like the stock bubble of the late 1990s, both caused and was fed by widespread malfeasance. Rating agencies like Moody’s Investors Service, which get paid a lot of money for rating mortgage-backed securities, seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the ’90s, accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest-quality, AAA assets.
But there’s a big difference between accountants and raters: the latter get first amendment protection for their assessments. Is this a wise extension of the first amendment? It’s a difficult question, but I think the new scandals will lead to increasing calls for regulation, if not liability, of the ratings agencies.
First, it’s unclear if imposing liability on ratings agencies would actually help. The agencies might just “contract around” whatever duty of care judges impose. Or they will simply refuse to rate risky debt. Given the difficulty of applying natural science models of prediction and control to human affairs, perhaps their job is nearly impossible. Commentator Gregory Husisian has also stated that there are several alternatives to rating agencies:
[T]here are several close substitutes for rating agency services, such as in-house technical analysts whose services many securities firms offer to both their clients and their own internal investors. Finally, the ratings firm is unlike the traditional manufacturer, which may have difficulty communicating its product safety information to the marketplace. The performance of rating agencies can be monitored by the simple method of correlating past ratings with actual defaults.
But there’s another reason why liability is suspect: the courts’ characterization of ratings as opinions. As the 10th Circuit said in Jefferson Cty. School District vs. Moody’s, the ratings agencies are often considered members of the media, and
[A]t least in situations … where a media defendant is involved. . . a statement on matters of public concern must be provable as false before there can be liability under state defamation law.
Husisian has called ratings “the world’s shortest editorials,” and courts have characterized a rating of a company’s likelihood of repaying debt as an opinion. Nevertheless, the Supreme Court’s defamation jurisprudence does not provide blanket immunity for opinions; in Milkovich it contemplates at least two exceptions:
[E]xpressions of opinion may often imply an assertion of objective fact:] If a speaker says, “In my opinion, John Jones is a liar,” he implies a knowledge of facts which lead to the conclusion that Jones told an untruth. Even if he states the facts upon which he bases his opinion, if those facts are either incorrect or incomplete, or if his assessment of them is erroneous, the statement may still imply a false assertion of fact. Simply couching such statements in terms of opinion does not dispel these implications; and the statement, “In my opinion Jones is a liar,” can cause as such damage to reputation as the statement, “ Jones is a liar.”
James Grimmelmann puts the matter a bit more succinctly in a recent article:
A statement of opinion may imply an underlying fact (the Court’s example was “In my opinion John Jones is a liar.”); and even a statement of opinion may be false if not honestly held (the Court’s example was “I think Jones lied,” where the speaker thought nothing of the sort.).
So where does this leave us with rating agencies? Francis Bottini wrote a 1993 comment confident that some substantive regulation of the agencies would survive First Amendment scrutiny. He proposed, for example, that
[T]he SEC could pass a rule enabling it to issue a “Writ of Review.” If the Commission believes that a rating agency is unduly delaying changing a rating, it would issue a Writ of Review to the rating agency, suggesting that the rating agency re-evaluate the rating. The rating agency would be free to disregard the writ. However, failure to re-evaluate would raise a presumption of negligence. Complying with the writ would raise a presumption of due care.
Bottini believed such a rule would pass constitutional muster because:
The proposed legislation is narrowly tailored and furthers a significant government interest. Thus, whether the activity of rating agencies is considered commercial speech or regular speech, the legislation proposed here complies with the mandate of the First Amendment that Congress shall make no law abridging the freedom of speech, or of the press.
I don’t know if I am as sanguine as Bottini. As Owen Fiss has chronicled, the Supreme Court over the past three decades has been extremely sympathetic to corporate defendants brandishing free speech challenges to regulation. As Fred Schauer noted in his article on the boundaries of the First Amendment, it’s hard to imagine many of the speech-managing aspects of labor or securities laws (passed in the 1930s) surviving the free speech opportunism that’s become commonplace in today’s courts.
Whatever happens on the ever-enigmatic First Amendment front, the role of ratings agencies will become ever-more controversial as ordinary citizens realize their power. For example, David Reiss has chronicled the raters’ pivotal role in gutting state laws against predatory lending:
A result of the privileged raters’ analysis has been that they have pushed states to standardize their predatory lending laws. This standardization benefits secondary market players because it reduces their risks and tends to increase the size of the RMBS market by reducing transaction costs. However, unlike the standardization that took place in the prime market in the 1970s, this standardization is not implemented with the needs of homeowners in mind.
Reiss concedes that it’s not exactly clear whether deregulation or more intense regulation of ratings agencies would improve the situation. However, he makes a valuable contribution in noting that the public interest needs to be considered in any further discussion here. . . discussion first amendment formalism may render impossible.
What is the public interest? I have one suggestion, based on my research of search engines (another type of “rater” (of relevance)). We might want to suspect any institution that matches “black box” input and unaccountable output. In other words, raters may well plead that whatever goes on inside their shops cannot be transparent because scrutiny would lead to disclosure of their trade secrets. But if their first amendment immunities grow more absolute, they could become entirely unaccountable for their outputs. Though commentators like Schwarcz and Husisian have made strong economic cases against regulating the ratings agencies, anyone concerned about “countervailing power” should suspect an unaccountable oligopoly.