READERS: This is a very important decision  against both corporate fraud as a form of free speech and against the fraudulent forms of securitization. As a decision it is likely to go to the US Supreme Court on an appeal. As it stands it is unlikely to be overturned, which means that Clients who lost based upon fraudulent ratings will be able to collect damages. This will put most of the current big five banks out of business.

By Joseph A. Giannone

NEW YORK (Reuters) - A court setback for Moody's Corp and Standard & Poor's parent McGraw-Hill Cos this week could potentially prove "devastating" for the two credit rating agencies, said David Einhorn, a hedge fund manager who announced a short position against Moody's in May.

In an order issued Wednesday, U.S. District Judge Shira Scheindlin in Manhattan said ratings on notes sold privately to a select group of investors were not matters of public concern deserving broad protection under the U.S. Constitution.

Plaintiffs led by Abu Dhabi Commercial Bank as a result now may pursue fraud claims accusing Moody's, S&P and underwriter Morgan Stanley of making false statements about notes backed by subprime mortgages and other debt.

"It's an important case. I think it's a game-changing decision," Einhorn said in an interview Friday.

Einhorn told Reuters he thinks the ruling will stand as a milestone. A lawsuit challenging S&P and Moody's may for the first time move past the pretrial phase and be heard in court. If Abu Dhabi prevails, more investors could follow suit.

"Simply losing one case like this, were it to stand up, could have a devastating effect," he said.

Moody's Corp, he said, had $300 million of cash and $900 million of debt.

The situation, he said, is reminiscent of the personal injury claims against Big Tobacco or the wave of litigation that hobbled manufacturers connected to asbestos.

Officials from Moody's and McGraw-Hill both observed that the judge dismissed all but one of 11 claims, and said that they expect the remaining claim will be defeated.

Shares of the two companies fell Thursday as investors worried the ruling may make it harder to argue their ratings deserve free speech protection. Moody's fell 10 percent Thursday but was flat Friday. McGraw-Hill rose 2 percent.

Officials from the two companies played down the ruling.

"The court recognized that the First Amendment generally protects ratings. The First Amendment does not, however, protect against properly asserted fraud claims, and the court's opinion simply concluded that plaintiffs had said enough to allow this one claim to proceed at this time," said McGraw-Hill spokesman Steven Weiss.

"Ten of the 11 claims were dismissed by the court on grounds completely unrelated to the First Amendment," said Moody's spokesman Michael Adler. "The court also said the First Amendment does apply except under narrow exceptions. We believe the facts will show it does apply to this case."

Some analysts also played down the ruling.

"The decision has little implication for the eventual outcome of the case or the ability of the rating agencies to rely on freedom of speech defense in ongoing litigation," Piper Jaffray's Peter Appert said in a note Thursday. He reiterated "overweight" ratings on Moody's and McGraw-Hill stocks.

Credit ratings from a select group authorized by the U.S. government play a crucial role in the capital markets by rating the strength of companies and municipalities. Moody's and S&P came under fire after highly rated Enron in 2001 collapsed.

The agencies are under the gun again for granting perfect AAA ratings to debt vehicles built on risky mortgages and other debt. Critics like Einhorn say agencies published conflicted opinions swayed by the lucrative fees paid by Wall Street.

Einhorn last year warned that investment bank Lehman Brothers had too little capital taking on too much risk several months before Lehman collapsed last September. In May this year Einhorn announced he was shorting Moody's, arguing the agency's brand had been ruined by conflicted advice.

A legal defeat for the agencies, he said Friday, might spur U.S. authorities to address the industry's conflicts and end their oligopoly status.

"That would be a very good thing for people who are hoping for real financial reform," Einhorn said. "It could prompt Washington to decide to truly get rid of this issuer-pays model, or just rid of the special status altogether."

(Additional reporting by Jonathan Stempel; Editing by Lisa Von Ahn and Steve Orlofsky)

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