Standard & Poor’s effort to have the U.S. Justice Department’s fraud lawsuit over credit ratings on mortgage-backed securities thrown out was tentatively rejected by a federal judge.
U.S. District Judge David Carter issued a tentative decision at a hearing yesterday in Santa Ana, California. He rejected the argument by S&P that public statements about its ratings, which it described as objective and free of conflicts of interest, were mere “puffery” or “couched in aspirational terms” that couldn’t be the basis of a fraud claim.
“S&P stands accused of fashioning a unified public image of trustworthiness backed by specific statements designed to induce consumers to rely on the objectivity of its ratings,” Carter said in the tentative ruling. “S&P’s statements were not a ‘general, subjective claim’ about the avoidance of conflicts of interest, but rather a promise.”
The judge said at the hearing that he would issue a final ruling by July 15. The government will get an opportunity to file an amended complaint if he changes his mind and grants S&P’s request to dismiss the case, Carter said.
“I want to go back and really look at this again,” Carter said.
The U.S., accusing the company of being more concerned about getting continuing business from investment banks that paid it to rate securities than the accuracy of the ratings, seeks as much as $5 billion in civil penalties.
Yesterday’s court hearing was the first over the Justice Department’s claims that S&P defrauded investors with assurances that its ratings were independent, objective and free of conflicts of interest. S&P argued that reasonable investors wouldn’t have relied on its “puffery” about credit ratings.
S&P’s generic statements about its business aspirations weren’t material to the banks buying securities and didn’t meaningfully change the mix of information available to investors, John Keker, a lawyer for the McGraw Hill Financial Inc. (MHFI) unit, said in court yesterday.
“They’re seeking to blame the entire financial crisis on Standard & Poor’s,” Keker said. “Those generic statements don’t make a scheme to defraud. For a scheme to defraud, there has to be a specific intent to harm the victim, in this case the investor.”
The Justice Department didn’t adequately support its allegations that the company defrauded federally insured financial institutions by knowingly understating the credit risks of securities linked to residential mortgages, Keker said.
“I think the tentative misreads or mis-cites the complaint in many places,” Keker said of Carter’s tentative decision. “This opinion is very close to the arguments in the government’s opposition.”
S&P asked in its request to dismiss the case that Carter take into account that the U.S. is pressing fraud claims “despite the fact that other rating agencies issued ratings identical to those of S&P on the same securities at issue, and despite the fact that its views were consistent with those of virtually every other market participant,” according to an April 22 filing.
“Where’s Moody’s?” Carter asked Assistant U.S. Attorney George Cardona, who represented the Justice Department at the hearing.
Cardona said the government had developed evidence against S&P in this case without indicating whether the U.S. had investigated Moody’s Investors Service as well. Keker said the only difference between S&P and Moody’s was that S&P had downgraded the U.S. credit rating.
Cardona told the judge that S&P’s “puffing” about its ratings being independent and objective was material because the ratings were important in reassuring investors about the credit quality of the securities they bought from investment banks.
The ratings weren’t independent and objective because S&P let issuers influence its models and criteria, Cardona said.
Cardona and Keker declined to comment after the hearing on the tentative ruling.
The U.S. sued New York-based S&P on Feb. 4, alleging its credit ratings for residential mortgage-backed securities and collateralized-debt obligations that included those securities, contrary to what the company told investors, were based on a desire to win business from issuers of the securities more than on the credit risk of the investments.
A surge in defaults of high-risk mortgages packaged in securities that had helped fuel the U.S. housing boom until 2007 led to the country’s longest recession since 1933. S&P rated $2.8 trillion in residential mortgage-backed securities from September 2004 through October 2007 and $1.2 trillion worth of CDOs, according the government’s complaint.
In evaluating S&P’s request to dismiss the case, the judge will assume that everything the government said in its complaint is true. If the judge finds the government’s allegations lack the legally required specificity, he may give the Justice Department an opportunity to address the deficiencies in a revised complaint.
The lawsuit was brought by U.S. Attorney Andre Birotte Jr. in Los Angeles under the 1989 Financial Institutions Reform, Recovery and Enforcement Act, a law passed after the savings and loan crisis to allow the government to seek civil penalties for losses of federally insured financial institutions caused by fraud.
In its 119-page complaint, the Justice Department cited meetings, messages and memos to support its claims.
S&P argued in its April 22 filing that it’s “ironic” that the government seeks penalties for losses by the same banks, Bank of America Corp. and Citigroup Inc. (C), that were creating and selling the CDOs.
“The complaint charges S&P with intending to defraud these financial institutions about the likely performance of their own products,” the company said.
Banks create collateralized debt obligations by bundling bonds or loans into securities of varying risk and return. They pay ratings firms for the grades, which investors may use to meet regulatory requirements.
The case is U.S. v. McGraw-Hill Cos., 13-cv-00779, U.S. District Court, Central District of California (Santa Ana).
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