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From Banking and Finance Law Daily, July 17, 2013

Government’s complaint adequately set out criminal fraud case against Standard & Poors

By Richard A. Roth, J.D.

Responding to a request by Standard & Poors that a government enforcement action be dismissed because statements said to be fraudulent were only “puffery,” a United States District Judge has asked whether S&P therefore was claiming that “the company’s credit ratings service added absolutely zero value as a predictor of creditworthiness?” The statements outlined by the government were not puffery or a general statement of corporate aspirations, they were specific assertions the company knew could influence investor behavior, the judge said. The judge also rejected S&P’s attack on the specificity of the government’s complaint and the complaint’s description of who was the victim of the alleged fraud (U.S. v. McGraw-Hill Companies, Inc., July 16, 2013, Carter, U.S. District Judge).

S&P, a subsidiary of McGraw-Hill Companies, Inc., was described in the complaint as one of the three major U.S. credit rating agencies. During the period before the financial crisis, its business included giving ratings for the differing classes—or tranches—of structured debt securities. Ratings were important because investors in lower-rated tranches demanded higher interest rates because financial institutions generally would not invest in low-rated tranches.

The issuers of the securities paid S&P for ratings, which were to be used by investors in making investment decisions. The government asserted this created a conflict of interest. The government also said that S&P was classified by the Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization (NRSRO) based, in part, on S&P’s own code of conduct covering conflicts of interest.

The enforcement action sought civil penalties under the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) for violations of criminal laws against mail fraud, wire fraud, and financial institutions fraud.

Fraud claims. The government’s complaint included detailed claims about the company’s description of its policies and procedures and the company’s violations of those same policies and procedures. Those claims boiled down to allegations that S&P claimed to have taken a number of steps to insulate its rating functions from its business functions, while actually allowing the business functions to exert significant influence over rating decisions.

The result, the government said, was that S&P issued ratings that did not accurately reflect the risks of the rated securities. Among other claims, the government charged that one S&P document called for changes in calculated probabilities of default when doing so was necessary to benefit the business. Another S&P document said that when a calculation did not meet business needs, “we have to change our parameters ex-post to accommodate,” the government alleged.

Puffery. The judge’s skepticism over S&P’s claim that the alleged assertions would have constituted only general, subjective claims—puffery—was made clear from his characterization of the company’s position:

They claim that, out of all the public statements that S&P made to investors, issuers, regulators, and legislators regarding the company’s procedures for providing objective, data-based credit ratings that were unaffected by potential conflicts of interest, not one statement should have been relied upon by investors, issuers, regulators, or legislators who needed to be able to count on objective, data-based credit ratings.

The court did not accept that position.

S&P was said to have used statements about the objectivity of its ratings to convince investors of the company’s trustworthiness, the judge said. The government said the company had made specific claims about its policies and procedures, not general claims that it intended to avoid conflicts of interest. The statements the government alleged were more than “the mere aspirational musings of a corporation setting out vague goals for its future.”

The complaint described statements that would have been made to investors who would have relied on them in making their investment choices and that would have been material to those choices, the judge said. According to the judge, the company’s attorneys had “repeatedly asserted that no reasonable investor would have relied on S&P’s claims of independence and objectivity,” which is what led him to question what value the company thought its service offered.

Specificity of allegations. The Federal Rules of Civil Procedure generally require that fraud must be pled “with particularity,” and S&P asserted that the government had not claimed and could not claim that the company’s ratings were false or that the company knew they were false. The judge rejected that assertion.

FIRREA claims did not need to be pled with particularity, the judge first said. Moreover, the complaint had detailed how the ratings did not represent an objective measure of creditworthiness. Relevant company executives were named in the complaint, and their statements were recounted. That was enough particularity, according to the judge, and adequately outlined both objective falsity and subjective intent.

Deceived person. The fraud claims asserted by the government all required that S&P had acted with the intent to deprive the person who was deceived of money or property. According to the company, this would not have been the case because while investors might have been deceived, the securities issuers paid for the ratings. However, it was not necessary for the money to have flowed to S&P directly from the investors as long as it came to the company indirectly, the judge pointed out.

According to the government, S&P knew that the costs of its securities ratings were passed on to the investors by the issuers. Rating fees were always paid from the proceeds of the sale of the investments, so S&P was paid by the investors indirectly. That satisfied the requirement, the judge said.

The case is No. CV 13-0779 DOC(JCGx).

Attorneys: Floyd Abrams (Cahill Gordon and Reindel LLP) for McGraw-Hill Companies. Anoiel Khorshid, Office of the United States Attorney, Civil Division.

Companies: McGraw-Hill Companies; Standard & Poors Financial Services LLC

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