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Bond Rating Powers Increasingly Facing Challenges

News analysis: They are rarely sued, but O.C. move focuses attention on investors and agencies who are questioning the process.


SANTA ANA — Orange County's unusual step Tuesday of suing Standard & Poor's Corp. comes as investors and agencies are increasingly challenging the power wielded by the major Wall Street bond rating firms.

The ramifications could spread throughout the $1.3-trillion municipal bond market as cities, counties and other government agencies scrutinize the firms responsible for ratings that help direct investment decisions.

"This Orange County suit will ultimately call into question the value of bond ratings and even rating agencies," said Dean Misczynski, who has written several municipal bond laws in California. "Maybe it serves a purpose to have a court examine this question."

In one of the most high-profile suits ever filed against a rating agency, Orange County accused Standard & Poor's of negligence and breach of contract.

Orange County claims that if S&P had disclosed risks in the county's investment pool, county officials would have avoided the sale of more than $500 million of notes in the two years before the bankruptcy. That would have cut the county's losses from roughly $1.8 billion to $1.3 billion, according to the lawsuit.

Officials at Standard & Poor's said they could not comment on specific claims in the suit, but the rating agency has maintained that it was misled with financial information from the county and its officials.

However, municipal bond specialist say the real issue in the suit is the great power enjoyed by the nation's rating agencies. These agencies bestow ratings that are similar to an individual's credit rating.

The difference between a good and bad bond rating is important because a bad rating can mean millions more in higher borrowing costs.

As a result, government agencies and corporations court the rating agencies with elaborate proposals and statistics to try to garner higher ratings.

In recent years, as the financial markets have become more complex, the role of rating agencies has come under increasing fire.

In 1975, rating agencies were criticized by the Securities and Exchange Commission for failing to make "diligent inquiry" into the extent of New York City's financial crisis.

And more than a decade ago, rating agencies were chastised for ignoring the difficulties at the Washington Public Power Supply System before the utility defaulted on $2.25 billion of bonds.

In 1992, California Insurance Commissioner John Garamendi filed suit in Los Angeles against S&P and others for fraud and breach of fiduciary duty in the collapse of Executive Life Insurance Co. S&P and Moody's Investors Service Inc., another major credit rating agency, had given the insurer high rating marks.

A judge later dismissed the rating agencies from the suit and they paid nothing, according to Christopher Maisel, a Los Angeles lawyer involved in the liquidation of Executive Life.

"The unresolved legal question, at least in California, is does any creditor have the right to rely upon ratings by a rating agency, and if they do, can a rating agency be liable?" Maisel said.


Rating agencies typically argue that their ratings are opinions and therefore protected by the 1st Amendment. As a result, they are rarely sued successfully.

In fact, of the many bondholder suits filed in the wake of Orange County's bankruptcy, reportedly none were filed against a rating agency.

"There's not a history of successful litigation against credit rating agencies," said Richard Lehmann, who heads the Bond Investors Assn., a nonprofit group.

"I hope these lawyers are working on a contingency basis for Orange County; otherwise the county is going to be paying them a lot of money and won't get squat back," he said.

While other agencies, such as Moody's, also rated Orange County's bonds, S&P rated the bulk of deals affected by Orange County's bankruptcy, giving stellar ratings to bonds sold in the months before the county filed bankruptcy.

Although not yet embroiled in the Orange County suit, Moody's has its own woes. It is being scrutinized by the U.S. Justice Department's antitrust division for unsolicited ratings. Such ratings are given by Moody's even when a government agency doesn't ask or pay for them.

A Colorado school district recently sued Moody's in federal court in Denver over an unsolicited credit report that the school district said cost taxpayers about $800,000 in interest on a 1993 bond deal.

When asked why Orange County did not sue Moody's on Tuesday, the county's attorney, Bruce Bennett, said: "We don't comment on suits that have not yet been filed."'


Still, several municipal bond specialists said that S&P actually did a more thorough job of rating bonds sold by agencies in Orange County in the months before the bankruptcy, "so maybe there's a sense they screwed up more," one official said.

Bond rating experts said Orange County's move to sue its rating agency could send a chill through the rating process.

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