The Ratings Agencies, Part II: Fiduciary Duty

Originally Posted at BullionBullsCanada.com.

In Part I, I noted how the “Big Three” ratings agencies (Fitch, Moody’s, S&P) were the world’s premier “experts” in analyzing and rating financial products for investors. I pointed out the lucrative fees which they were paid for their expert opinions – along with the complete reliance of investors on those opinions, especially in the realm of complex financial “derivatives”.

I then explained how our legal system dealt with such scenarios: through the imposition of a “fiduciary duty”. This duty could be imposed on those selling these financial products and/or on any expert warranting/assuring the general public as to the “safety” and “quality” of such financial products (i.e. the ratings agencies).

Before the law imposes a “fiduciary duty” on any party(s) to these transactions, however, there is one more element to this legal “test”. We have already established that the ratings agencies are “experts” – unequivocally the world’s most highly-esteemed experts in rating any/all financial products. We have already established that in many circumstances (i.e. the sale of derivatives) that investors were totally reliant upon the expertise of these ratings agencies. The final requirement necessary to impose a legal duty in this scenario is that it must have been “reasonable” for investors to rely upon the expertise of the ratings agencies.

Once again, this is another issue which becomes crystal-clear when we view the world of complex financial derivatives. Understand that there are only three legitimate approaches which governments can take regarding the marketing of extremely complex financial products:

1) They can simply ban any/all such products as being “too dangerous” to investors, specifically due to their “complexity” and/or lack of transparency.

2) They can restrict the sale of such products to “sophisticated investors” only. In other words, anyone seeking to purchase derivatives would be required to sign a waiver, attesting to their own expertise in buying/assessing such products – thus releasing the bankers and/or their agents from any responsibility/liability. Essentially these investors would be their own “fiduciaries”.

3) They can impose a fiduciary duty on the vendors of these products and/or any entity whose representations toward those products would constitute “an inducement to purchase” these financial products (i.e. the ratings agencies).

There are no other possibilities when it comes to operating (and regulating) markets in a responsible manner. The failure to adhere to one of the three approaches above would be nothing less than a “green light” to any/all forms of market fraud.

In hindsight, simply banning all derivatives would have been the correct choice. These scam-products have already caused $trillions in losses for investors, nearly destroyed the entire, global financial system, pushed half of Europe’s economies to the brink of bankruptcy, and with the $1.5 quadrillion derivatives “bubble” teetering ominously, quite obviously the worst is still ahead. The U.S. government refused to do this, however.

It would have also been quite reasonable to only market these products to “investors” (i.e. gamblers) willing to sign a waiver of liability – caveat emptor. The U.S. government also refused to do this.

Given the absolute refusal of the U.S. government to do anything to protect investors from the huge risks inherent in these financial products, and given the complete inability for ordinary investors to understand what they were buying, I’ll ask the question again: was it “reasonable” for investors to rely upon the expertise of the ratings agencies, in assuring investors again and again and again that these financial products were “AAA”?

The obvious answer to that question is “yes”.

Understand that even once we conclude that the ratings agencies are “fiduciaries” and that (under the circumstances)  it would be “reasonable” to impose a fiduciary duty upon them that in no way does this make these ratings agencies automatically liable for any/all losses suffered by investors. Our legal system recognizes that “mistakes” are made. Even the world’s most esteemed and successful investors merely hope to “get it right” on most of their investment decisions. Imposing a fiduciary duty on the ratings agencies still allows them the fallibility inherent in all of us.

Where the fiduciary duty carries considerable legal weight is with respect to the conduct of any/all fiduciaries. This imposes the positive duty to act “in good faith”, along with the negative duty to avoid any/all actions (i.e. ratings) which could be considered either “negligent” or “reckless”.

With respect to recklessness and negligence, this requirement is self-explanatory: fiduciaries are not expected to be “perfect”, but they are required to exhibit some minimal standard of competence. However, many readers may not be entirely clear what is implied by the requirement of “good faith”.

This represents a collection of duties on the part of the fiduciary which would generally be considered synonymous with “honesty”. For example, we now see the U.S. government blatantly punishing Standard & Poors for having the audacity to “downgrade” the credit of the hopelessly insolvent U.S. government. First it immediately launched a “legal probe” of S&P’s ratings activities during Wall Street’s housing sector fraud-spree. It then pressured S&P to force its CEO to “fall on his sword”. Obviously, not only was this “revenge” against S&P, but it was a clear “warning shot across the bow” of the other two ratings agencies.

The message is clear: any ratings agency which dares to offer its honest opinion on the creditworthiness of the United States (or lack thereof) will be immediately “attacked” by the U.S. government, not to mention having its reputation sullied by the legions of “hacks” employed in the U.S. propaganda machine.

Legally, it is now an “open question” as to whether it will ever again be possible for these ratings agencies to assess the creditworthiness of the U.S. in good faith. While we may feel sympathy for someone forced to offer their “impartial assessment” of something while a gun is pointed at their head, this doesn’t change the fact that such an assessment would not be “honest” – and thus failing the test of good faith.

Clearly, there are many more bases for challenging the “good faith” of the ratings agencies. The most obvious grounds is the apparent “conflict of interest” inherent in receiving lucrative fees from Wall Street in return for assigning the ratings agencies’ highest rating to their financial products. With respect to the saturation-level of fraud in many of the “products” assessed by these ratings agencies, one could also argue that their “failure to detect” this rampant fraud was either indicative of negligence and/or a lack of good faith (i.e. “willful blindness”).

In defending themselves, the ratings agencies have already claimed (and will continue to claim) that their “disclaimer of liability” absolves them of any responsibility. We can see an example of such a disclaimer on the report S&P published concurrent with its “downgrade” of the U.S.’s credit rating:

“Credit-related analyses, including ratings…are statements of opinion…The Content should not be relied on…when making investment and other business decisions…S&P does not act as a fiduciary or an investment advisor…”

Those who want to read the disclaimer for themselves will have to scroll right to the very bottom of the final page, and any reader with poor vision may need to use a magnifying glass to read the small print. There are a lot of other “weasel words” added to the disclaimer, but the intent is clear: to unequivocally inform investors that the opinions of S&P (and the other ratings agencies) are “worthless”.

Note that I am using the word “worthless” here in an absolute literal sense: if these ratings cannot be trusted by investors in doing their buying and selling then they are clearly lacking in any value whatsoever. Indeed, it could be argued that they are worse than worthless: since they created the illusion of safety and/or quality with respect to $trillions in Wall Street fraud-products.

Despite the fact that the ratings agencies do everything possible to hide their “disclaimers” (short of using “invisible ink”), and despite the apparent intent to deceive investors; apologists for the ratings agencies will insist that the language of the disclaimer is all that is necessary to absolve them of any “fiduciary duty” and/or legal responsibility to investors.

The law in this area is not nearly so simple.

First of all, courts will quite often simply ignore the language which companies use in these disclaimers. The example often used in teaching this concept to law students are the disclaimers on ski-lift tickets. These disclaimers not only absolve the “operators” of any responsibility with regard to any unreasonable expectations on the part of skiers, but typically attempt to go much, much farther. The disclaimer will also state the operator isn’t liable for injuries/damages even in the case of “its own gross negligence”.

Judges simply erase such language from these disclaimers on “public policy” grounds. Specifically, if someone plummets to their death because a ski resort failed to fence-off a dangerous cliff from its patrons, our legal system concludes that “justice” is not being served by allowing such a disclaimer to be strictly/literally interpreted. Thus, given the $trillions in losses suffered by investors as the consequence of massive Wall Street fraud, it would not be surprising to see our courts simply erase much/most/all of what is written in the disclaimers of these ratings agencies.

As I mentioned in Part I, there is a further “issue” regarding the location/visibility of these disclaimers. Again we have an obvious example for purposes of comparison: the legal disclaimers which appear on the packages of cigarettes. Here, our courts ruled that due to the extremely hazardous nature of this product that the “disclaimer” must be so large/visible that no one could fail to see it. Quite obviously, many of the products assessed by these ratings agencies have also proven to be “extremely hazardous” to consumers.

Are the disclaimers of the ratings agencies visible enough? Let’s look at what is implied by the actions of the U.S. government.  When the United States of America lashed-out at S&P over its downgrade, that response seems to imply either one of two interpretations. Either the U.S. government itself is oblivious to S&P’s disclaimer; or, it believes that most other actors in our debt markets are oblivious to it. In thousands of commentaries subsequently written about S&P’s downgrade, I’m not aware of a single one who concluded the downgrade was meaningless because of S&P’s liability disclaimer.

Clearly, with S&P claiming that its rating is merely some worthless, ornamental decoration which is tacked-on to various financial products, there should be no possible reason for the rabid theatrics of the U.S. government which followed. It is only in a marketplace where the vast majority of participants are ignorant about these disclaimers that the reaction of the U.S. government is rational/reasonable.

We are left with the following scenario. We have every participant in our markets, up to and including the “world’s only superpower” deeming these ratings agencies to be the premier “experts” in valuing any/every financial product (despite the denials of the ratings agencies, via their tiny disclaimer). We have the U.S. government permitting Wall Street to sell $trillions in extremely complicated financial products. We have the ratings agencies assessing many/most of these financial products as “AAA”: the safest, highest-quality investment products on the market. We have investors utterly reliant upon these ratings. And we have the ratings agencies accepting large payments for those ratings – from the same Wall Street banks selling those products.

Subsequently, we have discovered that many of these financial products (which received “AAA” ratings) are saturated with fraud and/or nearly worthless. We have the Wall Street fraud-factories being fined again and again and again for overtly fraudulent acts. And we have the ratings agencies claiming that irrespective of any (potential) negligence or lack of “good faith” on their part that they bear no responsibility for the $trillions of losses suffered by investors – because they “are not fiduciaries”.

You be the judge.