Fradulent, or Just Wrong
This writer does not normally comment on legal issues, but this one is just too interesting, and raises too many questions, to leave alone.
On Monday, in the Central District of California, the US Justice Department (together with 16 states that have joined the action) filed a civil lawsuit against Standard & Poor's (a rating agency, owned by McGraw-Hill), alleging that, from September 2004 through October 2007, S&P "knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors" in certain securities. Prior to the filing, settlement talks between S&P and the Justice Department had broken down, principally because the government had insisted that S&P admit wrongdoing, pleading guilty to at least one count of fraud.
The securities were collateralized debt obligations, known as C.D.O's, complicated instruments composed of bundled mortgage-backed securities, which in turn were made up of individual home loans (hence the term "derivative" commonly used to describe such instruments). The filing, seeking $5 billion in penalties (about 5 times S&P's 2011 profit) to cover the losses to investors (particularly institutions like state pension funds and federally-insured financial firms) was done in the California district that was home to the now defunct Western Federal Corporate Credit Union. It collapsed (along with many others throughout the United States) during the financial crisis in 2008, as a result of losses on mortgage-backed securities rated by S&P.
S&P says it will vigorously defend itself against "these unwarranted claims". Its lead lawyer, Floyd Abrams, is best known as an expert in defending First Amendment (freedom of religion and speech) rights. But he is apparently intending to launch a much simpler approach in court (if the case ever reaches that point), saying on CNBC this morning that, put bluntly, "the ratings that were issued were believed by the people who issued them. And that's what the government has got to disprove". That S&P's opinions turned out to be wrong (even spectacularly, though hardly uniquely, so) is not fraud. The issue is did S&P say one thing, but believe another? Did S&P intend to mislead, for the sake of protecting its clients and its profitability?
Despite now possessing reams of internal S&P emails, and interviewing more than 150 people at S&P, the Justice Department would seem to have an uphill battle in proving fraud. Proving fraud is always tough. Watch for the suit to drag on for months or years, and become political, particularly as Republicans accuse the Obama administration, through its Justice Department, of re-fueling the Wall Street versus Main Street debate.