By now you will have heard that the U.S. Department of
Justice has filed a securities class action lawsuit against S&P and its
corporate parent, McGraw-Hill, about the rating agency's ratings of
collateralized debt obligations as the subprime meltdown unfolded. A copy
of the DoJ's complaint, filed on February 4, 2013 in the Central District of
California, can be found here.
The complaint has attracted widespread media attention,
as well it should, since it represents that government's first action against a
rating agency in connection with the subprime meltdown and the credit crisis
But there are a number of interesting features to this action, beyond just the
fact that the DoJ has filed a lawsuit against a rating agency.
First, there's the fact that the lawsuit was filed in the
Central District of California, rather than in New York, where S&P is
located. To the extent that the complaint supplies an answer for the choice of
venue question, it appears that the DoJ chose the C.D. Cal. because that is
where the failed Western Federal Corporate Credit Union was located. As is
alleged in the complaint, the failed credit union was apparently an investor in
a number of the specific CDOs mentioned in the complaint. Many of these
investments resulted in a total loss to the credit union. More broadly, the DoJ
alleges that the S&P engaged in a scheme to "defraud investors." The
specific investors mentioned by name in the complaint area all federally
insured depositary institutions.
The second interesting thing about the complaint is that
thought it was filed by the Department of Justice, it has been filed as a civil
action, presumably because the DoJ feels stands a better chance of success with
the lower standard of proof applicable in a civil case. But though the case was
filed as a civil action, the claims asserted are a little unexpected (at least
to me). The DoJ asserts substantive claims for wire fraud, mail fraud, and two
counts of financial institution fraud under the Financial
Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA").
In its February 4, 2013 press release about the
then-anticipated law suit, S&P characterizes the DoJ's use of FIRREA
as a "questionable legal strategy" intended as an attempt to "end run" the
"well-established legal precedent " on which the defendants hope to rely. Presumably,
the reference to the established precedent refers to case law finding that that
rating agency's opinions represent opinion protected under the first amendment.
I suspect a different explanation for the DoJ's reliance
on FIRREA. The fact is, many of the events described in the complaint took
place many years ago, in some instances six years ago or more. The DoJ is
rightly worried about possible statute of limitations concerns. That's where
FIRREA comes in. FIRREA has a ten-year statute of limitations for a violation
of, or a conspiracy to violate, the mail or wire fraud statutes, if the offense
affects a financial institution (about which refer here).
The defendants undoubtedly will try to raise a host of defenses, but the DoJ
doesn't want statute of limitations issues to cut the action short.
Third, the complaint names as defendants only S&P and
its corporate parent. None of the other rating agencies are named - a point
that gripes S&P. In its February 5,
2013 press release, issued after the complaint was filed, S&P notes
that "every CDO cited by the DoJ also independently received the same rating
from another rating agency." It may simply be that S&P is up first and the
other rating agencies' turn is coming. However, another possibility may be that
the DoJ had more to work with against S&P, particularly from the apparent
treasure trove of emails that are liberally quoted in the complaint.
The complaint paints a very detailed picture of the
dynamic inside S&P as it became increasingly apparent in early 2007 that
residential mortgages originated in 2006 were failing quickly, particularly
with respect to subprime and Alt-A mortgages. It is clear that S&P felt
under a great deal of pressure not to move any more quickly than its
competitors for fear of losing business. The warning signs appeared to
accumulate as 2007 unfolded while at the same time the issuers who sought out
S&P's ratings were scrambling to complete offerings, to get mortgage backed
securities out of their warehouse. The emails and other internal communications
(at least as portrayed in DoJ's complaint) seem to show a sequence of events
where alarm bells were sounding louder yet deals continued to get pushed
through.
As things deteriorated, a gallows humor seems to have set
in, provoking a number of emails in which S&P staffers apparently
acknowledged the growing problems. As quoted in detail in this February 5, 2013
Business Insider column (here),
the emails show an apparent perception on the part of at least some S&P
staff that the firm was compromising its rating standards under pressure from
issuers. The emails include the now-infamous email in which one staffer quipped
that a transaction could be "structure by cows" and the firm would still rate
it. Another email exchange between an analyst and an investment banker outside
the firm about how the MBS world is "crashing" and the firm is running around
to "save face."
Another analyst sent an email with a spoof version of
Talking Heads' classic hit, "Burning Down the House," including lyrics that
"huge delinquencies" in the 2006 vintage were "bringing down the
house." The complaint alleges that shortly after this first email, the
same analyst sent an email with a video of the analyst singing the first verse
of the spoof for an audience of laughing S&P staffers. (More about the
surprise appearance from the Talking Heads in the DoJ's complaint here.)
Whatever may be the reasons why the DoJ decided to
proceed under FIRREA and to sue only S&P, the agency will still have to
contend with the argument that the rating agency's ratings are
inactionable opinion or are protected by the First Amendment - arguments that
the Sixth Circuit appeared to validate in its December
2012 opinion dismissing actions that the Ohio Attorney General filed
against the rating agencies on behalf of Ohio state employee pension funds.
Time will tell how the DoJ attempts to address these
arguments, but it appears from the agency's complaint that the agency will be
attempting to argue that S&P is not entitled to rely on these defenses
because the ratings did not represent the rating agency's opinions. The
complaint alleges that the rating agency "falsely represented" that the ratings
"reflected S&P's true opinion" regarding the credit risks the complex
securities represented to investors. The DoJ may be poised to argue that
the alleged misrepresentations on which its claims are based are not the
opinions themselves but rather the rating firm's statements about its process
and the integrity of its process.
One final question is why is the government acting now,
years after the crash and years after the events described in the complaint?
Several media reports suggested that the DoJ acted only after attempts to work
out a negotiated settlement failed. One of the S&P's lawyers tried to suggest
on CNBC that the government investigation intensified after the rating firm
downgraded the U.S.'s debt. What ever the reason that the complaint is only
being filed now, if nothing else the complaint does show that we are continuing
to live with the fallout from the credit crisis and the issues from the crisis
are going to be litigated for some time to come.
Alison Frankel has a good summary of the complaint and
its allegations in her February 5, 2013 post on her On the Case blog (here).
Special thanks to the several readers who sent me a copy
of the DoJ's complaint.
And Finally: With
a hat tip to the Business Insider article linked above, here is the original
video version of "Burning Down the House"
Read
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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