S&P Settles Market Crisis Actions With DOJ, States

The Department of Justice, in conjunction with 19 states and the District of Columbia, resolved market crisis era suits in a $1.375 billion settlement. The DOJ suit named as defendants rating agency Standard & Poor’s Financial Services LLC and its parent McGraw-Hill Companies, Inc. The case focused on ratings given to traunches of residential mortgage backed securities or RMBS and collateralized debt obligations or CDS. It centered on a period beginning in 2004 and continuing through the unraveling of the U.S. economy as the securities S&P once rated AAA turned to junk. U.S. v. McGraw-Hill Companies, Inc., Case No. CV 13-00779 (C.D. Cal. Filed Feb. 4, 2013).

The DOJ complaint was based on the Financial Institutions Reform, Recover, and Enforcement Act of 1989 or FIRREA, an S&L era statute designed to protect federally insured institutions. Alleging wire fraud, mail fraud and financial institution fraud, the suit was central on the interests of a number of federally insured institutions ranging from Citibank and Bank of America to the Easter Financial Florida Credit Union, which purchased the RMBS and CDOs based on the lofty ratings given the securities by S&P, one of the nation’s premier rating agencies.

The scheme alleged was straight forward. The complaint detailed an on-going scheme to defraud purchasers of securities by S&P in a series of transactions over years. It involved repeated representations that the firm’s credit ratings of RMBS and CDO traunches were objective, independent, uninfluenced by any conflicts that might compromise S&P’s analytic judgment. In making these assertions the firm knew that its prominent reputation and ratings were critical to the sale of the securities. It knew that the ratings assigned by the firm were relied on by the financial institutions and others who purchased the securities the complaint claimed. It also knew that the assertions were false, the DOJ asserted.

The motive for the scheme was equally straight forward: The firm acted in the interests of the securities sellers who retained it and to maintain and grow its market share and profits, according to the complaint. This is evidenced by the fact that:

· Weakened standards: Beginning in September 2004, and continuing through the period, the firm “limited, adjusted, and delayed updates to the ratings criteria and analytical models . . .” used in formulating its ratings which had the effect of weakening the standards heading into the market crisis.

· Revised criteria to minimize downgrades: In 2006 analysts in RMBS at the firm began noticing rising delinquencies in the mortgages underlying non-prime RMBS that S&P had rated. To deal with the problem new criteria were developed to test their assumptions after which those assumptions with lead to the desired results – fewer downgrades – were selected.

· Ignored increasing risk: Beginning in March 2007 the firm disregarded “the true extent of the credit risks associated with those non-prime RMBS tranches in issuing and/or confirming ratings for CDOs with exposure to those non-prime RMBS tranches . . .” knowing that the ratings did not reflect the actual credit risk of the securities.

· Disregarded announced policies: As the markets continued to deteriorate during the summer of 2007, the firm disregarded policies it announced to reassure the public that the ratings accounted for market conditions. In selected instances S&P worked with issuers on an issue by issue basis to achieve the desired rating.

The complaint demanded civil money penalties in an unspecified amount and other relief. A number of states joined the DOJ in its suit.

S& P vigorously litigated the action. At one point it claimed that the suit was the result of the agency downgrading the credit rating of the United States.

Under the terms of the settlement S&P acknowledged conduct associated with its ratings of RMBS and DCOs during 2004 to 2007 in an agreed statement of facts. The firm also agreed to formally retract its allegation that the U.S. filed the lawsuit in retaliation for the decision regarding the credit rating of the United States. In addition, Standard & Poor’s agreed to comply with the consumer protection statutes of each of the settling states and the District of Columbia and to respond in good faith to any requests for information or material concerning possible violations of those laws.

Under the terms of the settlement half of the sum paid, or $687.5 million, is a penalty that will be paid to the U.S. It is the largest penalty of its type ever paid by a ratings agency. The remaining half of the settlement will be divided among the 19 states and the District of Columbia.

Last month Standard & Poor’s settled three similar, but much more limited, actions with the SEC. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan., 21, 2015); In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015); and In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16346 (Jan. 21, 2015). A related action is being set for hearing. In the Matter of Barbara Duka, Adm. Proc. File No. 3-16349 (Jan. 21, 2015). The three cases are discussed here.