Should We Take the Department of Justice’s Suit Against Standard & Poor’s Seriously?

I know cynicism-hardened Naked Capitalism readers will expect the answer to the question in the headline to be “no”. But based on a summary of the filing at Bloomberg (and having conferred with lawyers on this beat), the answer looks more like “possibly yes”.

The reason to be skeptical of lawsuits against ratings agencies is that despite the monstrous damage done by crap ratings, suits against ratings agencies by aggrieved investors have gone all of nowhere. It isn’t a matter of evidence; there is overwhelming evidence that the agencies did a crappy job on structured credit ratings and that lots of investors really, truly relied on them. The issue is coming up with a legal theory.

So far, the ratings agencies have proven to be pretty much impervious to litigation. They’ve been able to rely on two lines of defense. The first, as absurd as it may seem, is First Amendment, to say that their ratings are simply journalistic opinions. There has only been some limited qualification of that position. For instance, judge Shira Scheindlin denied a rating agency motion to dismiss, on the ground that the ratings were of relevance to such a small group of investors so as not to qualify for First Amendment protection. But this ruling was narrow . The court distinguished private placement ratings from public ratings, with private ratings having less First Amendment protection. Mortgage backed securities ratings were public and so this line of argument would not apply to them. CDOs were typically 144A offerings. CDOs were almost always listed on the Irish Stock Exchange, so it would be hard to argue that the ratings were not public.

In addition, the unfavorable rulings were on asset backed commercial paper, where the issuer had much more interaction with the rating agencies. The courts courts took the view that the agencies did more than just provide an opinion – they had been involved in structuring the deals and were therefore entitled to less First Amendment protection. It’s harder to make that case for typical CDOs, since the rating approach for them typically model driven and formulaic.

The other line of defense is that the legislation authorizing the rating agencies as nationally recognized statistical ratings organizations give them significant protections if they stay within the relatively limited restrictions of those rules. In the past, the Federal government has tried overcoming these considerable obstacles by using other legal theories. For instance, the Department of Justice launched an antitrust suit against Moody’s in the 1990s.

So the reason the Department of Justice civil suit might be the real deal is that it is using a new legal theory and is focusing on a comparatively small number of specific transactions. As Bloomberg states:

The U.S. Justice Department filed a complaint yesterday in federal court in Los Angeles, accusing McGraw-Hill and S&P of mail fraud, wire fraud and financial institutions fraud. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the U.S. seeks civil penalties of as much as $1.1 million for each violation. McGraw-Hill’s shares tumbled the most in 25 years yesterday when it said it expected the lawsuit, the first federal case against a ratings company for grades related to the credit crisis.
S&P issued credit ratings on more than $2.8 trillion of residential mortgage-backed securities and about $1.2 trillion of collateralized-debt obligations from September 2004 through October 2007, according to the complaint. S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them, the U.S. said.

“It’s a new use of this statute,” Claire Hill, a law professor at the University of Minnesota who has written about the ratings firms, said in a phone interview from Minneapolis. “This is not a line to my knowledge that has been taken before.”

Despite the sweeping language, the case focuses on approximately 40 CDOs issued during the toxic phase of the bubble. The New York Times reports that S&P earned about $13 million rating these deals. The New York Times explains why the use of FIRREA puts a comparatively small number of transactions in the crosshairs:

The government is taking a novel approach by accusing S.& P. of defrauding a federally insured institution and therefore injuring the taxpayer.

Among others, the compliant includes the demise of Wescorp, a federally insured credit union in Los Angeles that went bankrupt after investing in mortgage securities rated by S.& P. Wescorp is included as one example of the contended fraud, and as a way to bring the case in California. The suit was filed in Federal District Court for the Central District of California.

The linchpins are that first, that the DoJ is using FIRREA. Second, the government is accusing Standard and Poor’s of conflict of interest (favoring banks and increased market share) and disregarding risks and failing to adhere to their stated approach to ratings. The key phrase: S&P falsely represented to investors that its ratings were objective, independent and uninfluenced by any conflicts of interest.

The Times reports that the suit was filed because settlement negotiations fell apart:

Settlement talks between S.& P. and the Justice Department broke down in the last two weeks after prosecutors sought a penalty in excess of $1 billion and insisted that the company admit wrongdoing, several people with knowledge of the talks said. That amount would wipe out the profits of McGraw-Hill for an entire year. S.& P. had proposed a settlement of around $100 million, the people said.

S.& P. also sought a deal that would allow it to neither admit nor deny guilt; the government pressed for an admission of guilt to at least one count of fraud, said the people. S.& P. told prosecutors it could not admit guilt without exposing itself to liability in a multitude of civil cases.

As indicated, the reason this suit might fly is that the causes of action rely on different statues than previously invoked, and the focus is on S&P’s misrepresentation of its own process: that it presented it as objective and unbiased, when it had significant conflicts of interests and its employees believed it was concerned only about profit, and that it may also have failed to adhere to its own procedures.
While getting a ratings agency scalp is small potatoes compared to getting the executives at one of the many financial institutions that helped bring about the crisis, I’ll take my victories where I can get them. Winning a case against a public company that is really keen not to lose (tons of private litigation would follow) would break a long losing streak in the DoJ and SEC on the finance front. Although the agencies have been craven, they apparently really were demoralized after losing their misguided suit against Bear Stearns hedge fund managers, and they’ve been gun shy. That does not mean they would not have lost in a fight against the Treasury if they had wanted to go after any targets, but let’s not kid ourselves: these fights never occurred. Breuer in a significant role was also a big part of the problem, but people who know something about the DoJ say the agency’s learned timidity was an even bigger impediment. They really lost their mojo after the Bear Stearns fiasco. You could have imagined a less cowardly DoJ filing suits against safe and obvious targets like WaMu.

Let’s hope that the DoJ’s prosecutorial efforts live up to the caliber of their filing. Too often the Feds have proven to be great draftsmen but lousy prosecutors. We’ll see if they can up their game.

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