Sept. 3 (Bloomberg) -- A U.S. judge refused to dismiss a lawsuit against Moody’s Investors Service Inc. and Standard & Poor’s, rejecting arguments that investors can’t sue over deceptive ratings of private-placement notes because those opinions are protected by free-speech rights.

The ruling may affect Fitch Group Inc. and other credit raters that have made similar arguments after investors lost money following their advice on subprime and other asset-backed investments.

U.S. District Judge Shira Scheindlin in New York rejected the ratings firms’ arguments yesterday, forcing them and Morgan Stanley, which was also sued, to respond to fraud charges in a class-action by investors claiming the raters hid the risks of securities linked to subprime mortgages.

“It’s the first major ruling upholding fraud allegations against an arranger and the rating agencies on the instruments that are at the heart of the financial crisis,” said lawyer Patrick Daniels of Coughlin Stoia Geller Rudman Robbins LLP, the San Diego-based securities litigation firm that represented investors in the case.

“In previous cases,” Daniels said, “the ratings companies would hide behind First Amendment protection, saying they were merely reporting their opinion.”

McGraw-Hill Cos., which owns S&P, fell $3.30, or 10 percent, to $29.01 in New York Stock Exchange composite trading. Moody’s Corp., the parent of Moody’s Investors Services, fell $1.84, or 7.1 percent, to $24.26. The opinion was posted on the judge’s docket after U.S. markets closed yesterday.

Private Distribution

Scheindlin said in her ruling that the First Amendment of the U.S. Constitution doesn’t provide a defense because the rating firms’ comments were distributed privately to a select group of investors and not to the general public.

Without ruling on the merits of the lawsuit, the judge also said opinions by the ratings companies may be the basis for a lawsuit “if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.”

There are enough facts alleged against the two ratings companies and Morgan Stanley, the sixth-biggest U.S. bank by assets, for the lawsuit to go forward with evidence gathering needed for a trial, she said.

According to Daniels, Scheindlin rejected the First Amendment claim because the rating firms’ opinions are an essential component of private-placement transactions in which securities are sold directly to institutional or private investors without a public offering.

Limited Protection

Jonathan Macey, a professor at Yale Law School, said today in an interview that the ruling makes clear that the First Amendment isn’t a defense to allegations of fraud by ratings services. He said the narrowly written decision refutes the claim that ratings companies have absolute First Amendment protection.

“Frankly, a lot of judges are intimidated by First Amendment arguments,” he said. Scheindlin “is not running scared,” he said.

Alan Palmiter, a law professor at Wake Forest University in Winston-Salem, North Carolina, said the opinion is consistent with other rulings that have given some First Amendment “protection to broadly disseminated ratings but not to ratings meant for particular investors.”

‘Instruments of Fraud’

Citing allegations in the complaint that the ratings companies helped create, package and market so-called structured investment vehicles, or SIVs, “it would be surprising” if a judge would allow the firms to be “instruments of fraud and then hide behind a veil of merely offering a public opinion, Palmiter said in an e-mail.

The case concerns notes issued by Cheyne Finance Plc, an SIV that collapsed in 2007. It received the “highest credit ratings ever given to capital notes,” according to Scheindlin’s ruling. SIVs issued short-term debt to fund purchases of higher- yielding long-term notes and failed when credit dried up amid the financial crisis.

The rating companies worked directly with Morgan Stanley to structure the notes, and their own compensation was based on the notes receiving the desired ratings, according to the order. The ratings companies were paid more than three times their normal fees, the judge said.

The value of the notes collapsed during the worst economic slump in decades, making repayment of the debt impossible as it came due, according to the ruling. The notes were liquidated at discounted prices, leaving investors with a fraction of their investment or with notes that were worthless, according to the opinion. The investors sued based on fraud, negligence and contract claims to recover their losses.

Bank’s Role

Morgan Stanley, as the arranger and placement agent for the notes, distributed documents to investors that included Moody’s and S&P’s ratings, according to the ruling.

“I just hope that this action is the start of a trend toward rationalizing the rating agencies’ role,” said Attilio di Mattia, a money manager at Aurelius Capital in Vienna who’s writing a book about credit-rating companies.

The lawsuit was filed by Abu Dhabi Commercial Bank, based in the United Arab Emirates, and Washington’s King County, which includes Seattle. The plaintiffs, seeking class-action status, filed the complaint on behalf of themselves and other investors.

Scheindlin yesterday dismissed all claims against Bank of New York Mellon Corp.

10 Claims Dismissed

Edward Sweeney, a spokesman for S&P in New York, said the company is pleased that Scheindlin dismissed 10 of the 11 claims in the suit.

“We are confident that we will prevail on the remaining claim,” Sweeney said.

Jennifer Sala, a Morgan Stanley spokeswoman, declined to comment.

“We are pleased that the court dismissed all but one of the claims against Moody’s,” said Michael Adler, a spokesman for Moody’s in New York. “We are confident that the remaining claim will be dismissed once the court has been presented with facts, not just plaintiff allegations.”

In May, U.S. Senator Jack Reed, a Rhode Island Democrat, proposed legislation that would allow investors to sue credit- rating companies when firms fail to scrutinize data on mortgages, credit-card debt and other loans that make up asset- backed securities.

Proposed Legislation

Under that proposal, companies could avoid litigation by demonstrating they examined the underlying assets or by obtaining assessments from independent firms.

In July, the California Public Employees’ Retirement System, the largest U.S. public pension fund, sued Moody’s, S&P and Fitch in state court in San Francisco for $1 billion in losses over “wildly inaccurate” risk assessments. The companies face a similar lawsuit, filed in federal court in Sacramento, California, over bond ratings.

The case is Abu Dhabi Commercial Bank and King County, Washington v. Morgan Stanley, 08-7508, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporters on this story: Joel Rosenblatt in San Francisco at jrosenblatt@bloomberg.net; David Glovin in New York federal court at dglovin@bloomberg.net.

Last Updated: September 3, 2009 16:22 EDT