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Editor’s Note: This is the last of three articles by the Investigative Fund on the credit rating companies.

A decade ago, the nation’s largest credit-rating companies developed a new line of business that boosted their profits and sent them on a hiring spree. They began rating complex investments that featured large packages of bonds sometimes based on subprime mortgages.

Now the raters are reaping the consequences of their embrace of Wall Street’s so-called structured financial products. For one thing, they are facing a flood of about 50 lawsuits — including one filed last month by the state of Ohio — for handing out inflated grades to many such investments that defaulted and cost investors billions of dollars.

But the more ominous development for the raters is that structured finance may have opened a crack in their long-standing shield for warding off investors’ lawsuits — the First Amendment defense.

For years, the companies — Standard & Poor’s, Moody’s and Fitch — have argued that they are analogous to journalists. They say their ratings are independent opinions, protected by the constitutional right to free speech. The defense works: Even when their ratings have turned out to be wrong, as in the collapse of Enron, the companies remain undefeated in court.

Many of those currently suing the credit raters, however, contend that they did not just offer opinions but worked with bankers to help create financial products and then, in effect, graded their own work. The raters “no longer played a passive role but would help the arrangers structure their deals so that they could rate them as highly as possible,” the California Public Employees’ Retirement System, known as Calpers, alleges in a lawsuit. Calpers is the largest state pension fund in the country.

Several former rating company employees confirmed in interviews with the Huffington Post Investigative Fund that rating analysts worked closely with financial institutions as they created structured investments. Research documents produced by the raters and obtained by the Investigative Fund, as well as Securities and Exchange Commission reports, also provide a window into the raters’ role in the structuring process.

The lawsuits against the credit raters further allege that the ratings on these products were only distributed to a select audience. As a result, plaintiffs argue, the credit raters cannot receive First Amendment protection and should be forced to compensate investors who trusted their ratings.

This argument recently gained some traction in federal court.

“It’s one thing to come in after the fact and say, ‘What a beautiful building.’ But it’s another if they first helped build the building.” — Frank Partnoy, former investment banker

In September, a U.S. District Court judge in New York refused to throw out an investor’s lawsuit even in the face of a First Amendment claim. The investor, Washington state’s King County, lost about $100 million on products highly rated by Standard & Poor’s and Moody’s, their lawyers said.

King County’s lawsuit also highlights potential conflicts of interest plaguing the credit-rating business. Since the 1970s, corporations that issue bonds have paid the rating companies for their work. Critics claim this payment arrangement gives the rating companies the incentive to please bond issuers rather than investors.

Structured finance magnified the conflict — and the raters’ bottom line. In its lawsuit, Calpers said that fees for rating structured investments ranged from $300,000 to $1 million per deal — about three times higher than for rating corporate bonds. Consequently, as a 2008 SEC report to Congress pointed out, issuers of structured investments “have the potential to exert greater influence” on a credit rater than a company that issues traditional bonds.

According to the SEC report, the raters generally did not get paid for their work until a structured product was formally offered to investors. And the product often wasn’t offered unless it received a Triple-A rating.

To ensure this top grade was achieved, the rating companies and the bond issuers would be in “constant contact,” Frank Raiter, a former managing director for Standard & Poor’s, said in an interview. The financial institutions “would sit down with a rating analyst and they’d tell you what you need to do to get as many of the senior bonds rated triple-A,” Raiter said.

Occasionally, while profits were soaring, rating officials acknowledged publicly how the system worked. In 2007, Moody’s then-chief operating officer and president Brian Clarkson told a business magazine: “You start with a rating and build a deal around a rating.”

Now under fire, the credit rating companies say their critics are wrong to characterize ordinary discussions about a rating as any kind of collusion.

Floyd Abrams, a renowned First Amendment lawyer who has represented Standard & Poor’s for more than 20 years and has never lost one of their cases, said his clients “don’t structure” financial products.

“But they do engage in an iterative process — a give and take, a discussion with the entities that they’re rating,” Abrams said in an interview.

‘Attractive Returns’

One such discussion began in early 2005 for the structured investment where King County and Calpers put their money.

Cheyne Capital Management Ltd., a London-based hedge fund, assembled an estimated $8 billion portfolio of securities, mostly backed by mortgages, to offer to investors. The product was a so-called structured investment vehicle, or SIV. In the last decade, hedge funds and banks popularized the creation of SIVs—spin-off companies that would raise money from investors and use the proceeds to buy securities with more lucrative returns.

Cheyne turned to S&P and Moody’s to rate its SIV, named Cheyne Finance, so it could start selling slices of the package. To attract big investors, the hedge fund wanted the slice that contained the highest-quality — or “senior” — assets to be rated triple-A, according to King County’s lawsuit.

A Standard & Poor’s research document obtained by the Investigative Fund suggests that — a few months before the Cheyne SIV was available to investors — the rating company helped the hedge fund figure out how to qualify for certain ratings.

The document, labeled “presale” and dated May 17, 2005, assigned a “preliminary” triple-A rating to Cheyne’s senior slice. It also described the steps Cheyne would take to maintain sufficient capital on its books, and in turn, its top rating. Keeping a cushion of capital theoretically protects a company from going bust.

“A variety of different scenarios were analyzed to determine the required level of capital for Cheyne Finance,” the document said. “Standard & Poor’s is comfortable that the minimum capital requirements ensure that under the tested scenarios the senior liabilities will be repaid in full.”

S&P also set forth particular “capital adequacy tests” that Cheyne “is subject to.”

The document does not make clear which party designed those tests. A July 2008 SEC report, which was based on in-depth examinations of several rating companies, described in general how the process worked. If a rating company concluded a structured product had insufficient capital to “support the desired ratings,” this conclusion “would be conveyed” to the issuer, who could then adjust the structure “to get the desired highest rating,” the report said.

In the Cheyne deal, discussion was not limited to the highest-rated slice of the SIV. For the lower-rated parts, Cheyne “will use the methodology described” by Standard & Poor’s, the presale document said.

S&P declined to discuss the document, citing ongoing litigation involving the Cheyne case.

Before Cheyne was even available for purchase, potential investors received the presale document as well as a prospectus advertising the unofficial ratings. The credit raters also had telephone conferences with Cheyne’s issuers “to help draft the language” in the prospectuses, according to the Calpers lawsuit.

The prospectuses made Cheyne’s SIV appear ideal for pension funds and other large groups hoping to protect their nest eggs. In one prospectus, Cheyne was pitched as “ground breaking”; the “First SIV to achieve two public ratings” on its lower-quality slices. Another advertisement, circulated in spring 2005 before the SIV became available, promised “attractive returns.” On a slice rated triple-B by S&P, the document predicted “hypothetical returns” of about 5 percent for the first couple years.

King County was sold on the deal. In 2007, the county invested about $50 million of a $4 billion fund that manages, among other things, school lunch programs. “They wanted the least risky space they could find,” said Patrick Daniels, an attorney for the county. Calpers invested $1.3 billion of its nearly $200 billion fund in three SIVs, including Cheyne.

‘Oasis of Calm’

Within months, the housing market began to implode. Yet the credit raters assured investors that the ripples from the subprime mortgage collapse were not reaching Cheyne and other SIVs.

On July 20, 2007 — 10 days after it downgraded $5.2 billion worth of investments backed by subprime mortgages — Moody’s published a report titled “SIVs: An Oasis of Calm in the Subprime Maelstrom.”

The ”inherent diversity” of SIVs and their focus on highly-rated assets led Moody’s to expect SIV ratings “to remain stable.”

On Aug 15, 2007, S&P issued a similar report that said SIVs were “weathering the current market.”

Two weeks later, Cheyne’s issuers sent S&P and Moody’s a letter saying it was winding down the SIV because it was no longer meeting capital requirements. S&P quickly downgraded Cheyne’s rating.

Moody’s, on the other hand, put it on “review” for a “possible downgrade” but didn’t reduce some ratings to “junk” status until July 2008, Calpers alleged in its lawsuit.

Spokesmen for Moody’s and S&P argue that the reports are examples of their many well-researched publications on market trends and were not meant to encourage anyone to invest in SIVs.

Moody’s and S&P say that, for transparency’s sake, their general methods for grading structured products are publicly available online. But in some structured deals, their specific rating methods were not as transparent as the raters suggest. The July 2008 SEC report said: “Significant aspects of the ratings process were not always disclosed.”

The raters also say that any detailed discussions they hold with issuers are akin to a teacher providing students with grading criteria. Issuers are free to disagree with the raters’ opinions and take their business elsewhere.

Gary Witt, a former managing director for Moody’s, explained that as banks tinkered with their structured products, they would regularly seek feedback from the raters. The raters would evaluate the investments, and if necessary, explain why it didn’t qualify for a high rating.

“Because of the complexity of deals being done, and because the deals are changing a lot over the course of several weeks, a detailed back-and-forth was necessary,” said Witt, now a professor at Temple University.

However, Witt said he believes that SEC should step in to change the relationship. The agency, he said, could prohibit banks or hedge funds from advertising their preliminary ratings in prospectuses.

“The SEC should do away with this,” he said. “Then there wouldn’t be so much pressure to have this detailed back-and-forth.”

A Moody’s spokesman declined to comment for this article. Fitch did not respond to a request for comment.

‘Intimately Involved’

In the most recent lawsuit filed against the raters, Ohio’s Attorney General accused the companies of being “intimately involved in structuring” investments that caused retirement funds for police officers, firefighters and teachers to lose $457 million.

Because the raters’ “fingerprints are all over” the investment documents, “the free speech claim is on much less sturdy grounds,” said Frank Partnoy, a former investment banker and current professor at the University of San Diego Law School.

“It’s one thing to come in after the fact and say, ‘What a beautiful building.’ But it’s another if they first helped build the building,” said Partnoy, who also is an expert consultant for the government, defense attorneys and plaintiffs, including investors who sue the raters.

In the King County case, U.S. District Court Judge Shira Scheindlin threw another potential wrench in the raters’ First Amendment defense. While tossing out almost all of the county’s claims, she said she was rejecting the raters’ request to dismiss the case on free speech grounds because Cheyne Finance’s ratings allegedly “were never widely disseminated” and were offered instead “to a select group of investors.”

A Moody’s spokesman disputes that allegation, noting that Cheyne’s ratings are published on the company’s Web site. But a check of the Web site shows that those ratings are inaccessible without a paid subscription.

Abrams, the Standard & Poor’s attorney, said he doubts Scheindlin’s ruling will be “truly harmful.”

“This case is atypical,” Abrams said, noting how Scheindlin reaffirmed that “under typical circumstances, the First Amendment protects rating agencies.”

But Todd Seaver, an attorney for Calpers, said he was encouraged by Scheindlin’s ruling. He said while it is arguable whether some ratings should be entitled to free-speech protections, when it comes to structured finance, the rating companies “are basically whispering in the ear of a select few people.”

This allegation poses the greatest threat to the raters’ free-speech protections, said Eric Talley, a professor at the University of California-Berkeley law school and a specialist in the credit-rating industry.

“If I got a case in front of me that says the ratings had a small dissemination,” Talley said, “I start to think, ‘Exactly what are the democratic ideals that we need to protect here?’ It doesn’t strike me as a place where we need constitutional protections.”

Maria Zilberman contributed research for this report.

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