WASHINGTON — Market participants are concerned the "Municipal Bond Fairness Act" sponsored by House Financial Services chairman Barney Frank, D-Mass., scheduled to be voted on by the committee today, includes language that is too broad and raises constitutional free speech issues.
If passed by Congress, the legislation would require that credit rating agencies base the ratings of municipal, corporate and other securities on the likelihood of repayment alone, which raises "very serious First Amendment issues," said Floyd Abrams, the constitutional expert who represents Standard & Poor's.
"When the government gets directly involved in the very process by which ratings are issued and the meaning of ratings, significant First Amendment red flags are raised," Abrams, a partner at Cahill Godron & Reindel LLP in New York, said in a brief interview yesterday. "The idea that Congress is being asked to pass legislation, the purpose of which is really to raise the ratings of municipal bonds, is in and of itself a constitutionally impermissible one."
"It involves the government directly in the methodology core of the rating process," he added, "That's the very thing that the credit reporting act did not do," referring to the Credit Reform Act of 2006, which specifically bars the SEC from dictating how nationally recognized statistical rating organizations, or NRSROs, should rate securities.
At a press conference Friday to unveil the legislation, Frank dismissed concerns that the credit rating agency bill would raise First Amendment concerns or that Congress was dictating the ratings NRSROs should make.
"We're not telling you what the rating should be, we're telling you what the criteria should be," he told reporters.
But Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC said that by limiting the ratings criteria, Congress is essentially limiting the ratings, and therefore limiting the rating agencies' freedom of speech.
"If this is okay, maybe Congress could also determine the criteria by which newspapers determine their editorials," he said.
Ciccarone added that the language of the legislation is too broad because it stipulates that ratings should be based solely on repayment, not on timely repayment, which is a better metric, and is the terminology that is currently used to help determine municipal ratings, he said.
Pointing to the crisis in the auction-rate securities market, Ciccarone noted that many ARS investors have seen their
investments become temporarily illiquid until the market stabilizes or the issuer restructures the securities.
"How many people are happy with the fact that they are eventually going to be repaid in most of these situations?" he said. "Not all investors can wait for eventual repayment."
Robert Doty, president of the financial advisory firm American Governmental Financial Services Co. in Sacramento, who supports a switch to a single scale, said the First Amendment concerns over the legislation are "overblown" for a number of reasons, especially because any bill introduced this late into the congressional calendar has essentially no chance of becoming law.
"The value of this is jawboning, and that's fine, there's nothing wrong with jawboning and if it encourages rating agencies to continue down this path, that's good," Doty said.
Stressing that supporters of a unified scale have received "excellent" responses from the credit rating agencies, in terms of their willingness to consider abandoning a dual scale system, Doty said it is still "very unfair" to give a lower-grade municipal credit a lower rating than many corporate bonds when the municipal security has "only a fraction of the risk of default of a triple-A corporate."
Doty added that the free speech arguments are unfounded because the rating agencies are speaking to the securities markets and their ratings are affecting investment choices as well as the prices that issuers get.
"To put a Baa or BBB rating on a municipal bond that has a very low rate of default without distinguishing that rating from an equivalent Baa or triple-B corporate security and not tell people that they're not the same thing, that bothers me," he said. "I don't think you have a First Amendment right to do that. You have to have reasonableness on your side."
But for Abrams, the issue boils down to a simple reality: courts have long held that the opinions of credit rating agencies are protected by the First Amendment, he said.
"If someone wants to say that it would really be clearer to do it a different way, that is something to be decided in and by the marketplace, but it is not something that in my view Congress can decide," he said.