Paul Watler's Perspective

It seems that the First Amendment has long been the province of the press as proxy for the public in protecting the marketplace of ideas. But does speech carry the same First Amendment protections when it is made by a commercial heavyweight in the financial marketplace? That question is before the federal courts in actions for fraud by investors attempting to recoup losses from ratings agencies such as Standard & Poor's and Moody's.

Before last year's market meltdown, courts had recognized that ratings agencies enjoy First Amendment protection for their opinions. In 2007, the Sixth Circuit dismissed fraud claims against rating agencies on First Amendment grounds. Closer to home for the Texas business and investment community, the Enron debacle spurred a similar result. In 2005, federal Judge Melinda Harmon of the Southern District of Texas dismissed fraud claims against S&P and Moody's on First Amendment grounds. Judge Harmon found that the investor-plaintiffs had not shown that the ratings agency had issued factual statements – as opposed to mere opinions – that the agencies knew or significantly suspected were false.

Fast forward to the current financial crisis. Investment banks, AIG, Wall Street traders, and regulators have all come under scrutiny for their roles in the staggering financial losses. One group of key players now finding themselves in the cross-hair of the plaintiffs' securities bar is the ratings agencies.

Not surprisingly, the agencies played their First Amendment trump card in seeking dismissal of the fraud actions. But Judge Shira Scheinlein of the Southern District of New York took a much narrower view than earlier decisions. In a suit brought by an Abu Dhabi commercial bank and a Washington State county government over private placement investments in triple-A rated commercial paper, Judge Scheinlein rejected the agencies' First Amendment defenses. The defense was unavailing in the first instance because the ratings at issue were disseminated to a select group of investors rather than the public at large. The court also rejected the contention that the ratings were simply nonactionable opinions. Judge Scheinlein found that the investors had sufficiently pleaded that the agencies did not genuinely believe their assessments, thus the "ratings were not mere opinions but rather actionable misrepresentations."

In the aftermath of the early September ruling by Judge Scheinlein, share prices declined by up to 10% in Moody's and S&P's parent company, McGraw-Hill. One short seller was gleeful that the ratings agencies were getting their come-uppance. Greenlight Capital's David Einhorn told Bloomberg news, "It remind[ed] me of when the courts finally ruled a tobacco victim could sue a cigarette company."

But don't count the ratings agencies out yet. After discovery and a more complete factual development of the case, the New York court's deference to plaintiffs' pleadings may prove transitory. While the investors claimed in their pleadings that the ratings did not receive wide dissemination, discovery may establish otherwise. Similarly, the decision makers for the agencies may be able to convince a judge and jury that their look into the crystal ball was in fact in good faith without any "actual malice."

Thus, while the First Amendment does not protect a person for shouting "fire" in a crowded theater, it may yet prove to extend to declaring "safe investment" in an overheated capital market.

— Paul Watler is a partner at Jackson Walker. He can be reached at pwatler@jw.com.