April 22 (Bloomberg) -- McGraw-Hill Cos.’s Standard & Poor’s unit is set to take its first stab at fending off the U.S. Justice Department’s allegations that the company’s mortgage-backed securities ratings were fraudulent.
The largest U.S. rating company by revenue faces a deadline today to file its response in federal court in Santa Ana, California. Justice Department officials said when the complaint was filed in February that S&P could face more than $5 billion in civil penalties based on losses by federally insured financial institutions that relied on S&P’s ratings.
“They won’t get the entire complaint dismissed at this stage,” John Hueston, a former federal prosecutor now at Irell & Manella LLP in Los Angeles, said in a phone interview. “At best, a part of it might get dismissed.”
S&P can’t support its request to dismiss the case by supplying evidence to contradict the allegations, Hueston said. It can only argue that the Justice Department will never be able to prove its civil fraud claims even if all the facts alleged in the complaint are true, the lawyer said.
S&P may argue that the government hasn’t been specific enough in its fraud allegations as required by law, Hueston said. Even if U.S. District Judge David Carter were to agree with S&P, the judge most likely would allow the government to file a new complaint to address such failings, he said.
The U.S. brought its claims under the 1989 Financial Institutions Reform, Recovery, and Enforcement Act, which allows it to seek civil penalties for fraud affecting federally insured financial institutions.
The U.S. said in its Feb. 4 complaint that S&P knowingly and intentionally defrauded investors in residential mortgage-backed securities and collateralized-debt obligations that included those securities for which the company provided credit ratings.
McGraw-Hill shares fell the most in 25 years following the government’s lawsuit. They had surged 51 percent through the beginning of February from September 2011 when it bent to pressure from Jana Partners LLC and the Ontario Teachers’ Pension Plan with a proposal to spin off the deteriorating education business.
The Justice Department probe, code-named “Alchemy,” began in November 2009. The suit marked the culmination of a “massive, multiyear investigation” by a team of almost two dozen lawyers, Stuart Delery, principal deputy assistant attorney general, said in February.
Conflicts of Interest
The Justice Department alleged that S&P lied about its ratings being free of conflicts of interest because it downplayed or disregarded credit risks to win more business from investment banks and other issuers of the securities that paid the company to provide the ratings and that sought the highest possible ratings.
In its 119-page complaint, the government cited meetings, messages and memos that it said show S&P analysts assigned investment-grade ratings to securities based more on a desire to win business than to be accurate.
The Justice Department cited e-mails from S&P employees discussing the need to modify ratings criteria to win business after the company’s grades were more conservative than competitors.
“Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact on future deals,” one analyst said in a May 2004 e-mail cited in the lawsuit. “There’s no way we can get back on this one but we need to address this now in preparation for future deals.”
‘Structured by Cows’
In March 2007, an analyst wrote mock lyrics about the weakening of the housing market to the tune of “Burning Down the House” by the rock group Talking Heads. The government said the analyst later sent a video of himself singing and dancing the first verse “before an audience of laughing S&P co-workers.”
In e-mails cited in the complaint, two S&P analysts joked in April 2007 about the company’s willingness to rate deals. Discussing the company’s model for collateralized debt obligations, one messaged that a deal was “ridiculous” and that S&P “should not be rating it,” according to the complaint.
“We rate every deal,” the other replied, according to the government. “It could be structured by cows and we would rate it.”
S&P said in a statement in February, “The e-mail excerpts cherry-picked by DOJ have been taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business.”
S&P in its motion to dismiss will try to get out the message that e-mails of individual employees cited in the government’s complaint aren’t evidence of fraud, said Joe Akrotirianakis, a formal federal prosecutor now with Hobart Linzer LLP in Los Angeles. Instead, the company will portray the messages as evidence of vigorous internal debate, he said.
“They have two audiences,” Akrotirianakis said in a phone interview. “One is Judge Carter, the other is the rest of the public who are looking to see what they are going to say about their business practices.”
S&P probably won’t be successful in dismissing the lawsuit because the standard for throwing out a complaint is high, said Neil Kaufman, chairman of the corporate department at Abrams Fensterman. The company will eventually reach a settlement with the government, the lawyer predicted.
“I doubt this case is going to trial,” Kaufman said. “I think the government is looking for a scapegoat.”
The collapse in value of securities that packaged home loans from the riskiest borrowers led to a credit seizure starting in 2007 that sent the world’s largest economy into its longest recession since 1933 as defaults soared and home values plummeted.
S&P said in a Feb. 5 statement that the Justice Department’s lawsuit is without merit.
“There was robust internal debate within S&P about how a rapidly deteriorating housing market might affect the CDOs, and we applied the collective judgment of our committee-based system in good faith,” S&P said.
S&P is also contending with 18 lawsuits from state attorneys general and the District of Columbia over ratings. The company has moved 17 of the cases to federal court and is seeking to consolidate them, arguing the cases are based on the same allegations and that it’s more efficient to consider them together for pretrial proceedings.
While its request to consolidate the cases is pending, the ratings service has succeeded in halting at least three of the lawsuits -- in Pennsylvania, Iowa and Colorado. State attorneys general have been fighting the effort to postpone the cases and want to move them back to state court. A hearing on S&P’s request to consolidate cases is scheduled for May 30 in Louisville, Kentucky, before a federal panel.
In December, S&P defeated a lawsuit by a Florida pension fund based on claims that it misled investors that were similar to the U.S. complaint.
The Boca Raton Firefighters and Police Pension Fund alleged in a complaint in New York federal court that S&P deliberately lowered and sacrificed ratings criteria to avoid losing market share, putting short-term financial results ahead of the company’s reputation.
The fund accused S&P of touting ratings models as “state of the art” while deliberately not updating them because it knew doing so would require lowering ratings and would cause the company to lose market share, according to the filing.
The U.S. Court of Appeals in Manhattan in December upheld dismissal of the lawsuit. The court said statements about the integrity and objectivity of S&P’s credit ratings can’t be the basis of the complaint because they are merely “puffery,” or statements that are too general to cause a reasonable investor to rely on them, according to the decision.
“In short, no reasonable purchaser of McGraw-Hill common stock would view statements such as these as meaningfully altering the mix of available information about the company,” the appeals court said.
McGraw-Hill completed the sale of its education and publishing unit to Apollo Global Management LLC for $2.4 billion in cash last month. The remaining company, to be renamed McGraw Hill Financial Inc., is using part of the $1.9 billion it will receive after tax to pay down short-term debt and repurchase shares, with the rest possibly paying for “selective tuck-in acquisitions,” according to a statement.
S&P will be at the center of the new company, accounting for about half its revenue, according to data compiled by Bloomberg.
The company was founded in 1888 by James H. McGraw, the great-grandfather of current Chief Executive Officer Harold “Terry” McGraw III, when he acquired The American Journal of Railway Appliances, according to the company’s website. He later merged his book-publishing department with John A. Hill’s, creating the McGraw-Hill Book Co.
After McGraw-Hill announced the breakup, Terry McGraw said he was putting aside concerns about abandoning the business’s roots in publishing to serve “shareholders, employees and customers.”
The case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Santa Ana).
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