WASHINGTON — Moody’s Investors Service is pushing state and local issuers to agree to indemnify and hold it and its officers harmless for any mistakes they might make as a precondition to assigning ratings on municipal bond transactions, market participants said Thursday.

Click here to see text of provision.

The recently added provision to issuer rating applications means that an issuer would have to pay Moody’s legal costs for lawsuits — as well as any judgments against it — that are in any way related to the rating of the issuer’s securities, barring only “fraud or willful misconduct” on the part of Moody’s.

Alarmed market participants said that Moody’s has quietly added the indemnity language in the past few weeks to the fine print of applications that governmental issuers must complete for ratings. The provision comes on the heels of the new financial regulatory reform law that makes it easier for investors to sue rating agencies if they “knowingly or recklessly” fail to investigate the data they rely on to rate a security.

Previously, the rating agencies successfully maintained in court that they were immune from liability for their ratings because they are protected under the First Amendment on free speech.

In seeking to add the new language to the application, which is a legal contract between the issuer and rating agency, Moody’s is “seriously overreaching,” said Roger Davis, a partner at Orrick Herrington & Sutcliffe in San Francisco.

With the provision, any legal claim against Moody’s “could have a cost to the issuer several times the cost of the rating, without the issuer having done anything wrong in the information that is supplied to the rating agency... even if the rating agency itself made a mistake in judgment that was not predicated on information that it got from the issuer,” Davis said. He added that the issuer also would be liable for legal costs even if the claim against the rating agency has no merit.

“It sounds like they’re selling a product and they want their customers to indemnify them for their own failures,” said another bond attorney who did not want to be identified.

“This provision literally says that an issuer that is not at fault could be liable to Moody’s even though Moody’s is negligent,’ said Robert Doty, president of American Governmental Financial Services in Sacramento.

Moody’s spokesman Michael Adler was not immediately available to comment Thursday.

Even as market participants said they were deeply troubled by the new provision, many bond attorneys doubted its enforceability. That is because states can sign indemnifications in only limited circumstances, such as cases in which there is no appropriation.

“In many states, the attorneys general have taken the position that the state can’t sign blanket indemnification agreements,” said Charles Thompson Jr., executive director and general counsel at the International Municipal Lawyers Association. “The same rationale extends down to localities and special entities: they have to have an appropriation to cover the extent of the liability created by a contract.”

Another bond attorney that did not want to be named said Moody’s has agreed to accommodate issuers’ requests that they add language to the provision saying it would only apply to the extent permitted by law.

But Davis said Moody’s is not giving up anything by accommodating that language, since the provision probably would not be enforceable if it is not permitted by law.

Several other lawyers agreed with Davis, saying the Moody’s provision might not be enforceable in many states and localities that prohibit the government from indemnifying itself to third parties in most situations.

“Anybody can sign a contract. Whether it’s enforceable, that’s a different matter,” said a third lawyer who did not want to be named.

Even if Moody’s is backing away somewhat from the provision, its behavior is “bordering on offensive” by even asking for indemnity from the parties paying for a rating, said a fourth attorney who requested anonymity.

Susan Gaffney, director of the Government Finance Officers Association’s federal liaison center here, said: “We are reviewing the contract and planning to talk with the rating agencies in order to gain a better understanding of the issues raised within the document, specifically the indemnity clause, which has caused some concerns with our members. Following this review, we will likely develop an advisory for our members about rating agency contracts.”

Market participants said negligent behavior by Moody’s, for which the agency would be off the hook, may involve obtaining information from an issuer that should result in a Baa rating but instead leads to a Aaa rating. Willful misconduct or fraud — the only types of behavior for which Moody’s would be liable — would require the agency to know the security was triple-B and to intentionally disregard that information in rating it higher.

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