US government sues S&P in US$5 bil. fraud lawsuit

The lawsuit is the first by the U.S. government against a ratings agency, and if successful in its use of a little-used law with a lower burden of proof, the Justice Department could use the strategy in other cases.

The United States said S&P misled investors by stating that its ratings on mortgage products were objective and not influenced by conflicts of interest.

Instead, the DOJ contends, S&P inflated ratings and understated risks as the housing bubble started to burst, driven by a desire to gain more business from the investment banks that issued mortgage securities.

“Put simply, this alleged conduct is egregious — and it goes to the very heart of the recent financial crisis,” said Attorney General Eric Holder at a news conference in Washington on Tuesday announcing the charges. Sixteen states and the District of Columbia are also suing S&P.

Shares of S&P parent McGraw-Hill Companies Inc have fallen 23 percent in the last two days, wiping out more than US$3.7 billion of market value. The company had said on Monday it was expecting the lawsuit.

A source close to S&P said the firm expects a years-long battle with the government over the lawsuit. Settlement talks recently collapsed, the source said, after the government sought a penalty of over US$1 billion and admissions of wrongdoing, which would exposed the firm to outside liability.

A settlement could still happen, however. S&P is likely to file a motion to dismiss the case, and any court rulings on the preliminary legal battles could pave the way for another round of negotiations.

A deal could be in the best interest of both sides. It would allow S&P to avoid a costly, drawn-out courtroom battle.

Also, the government may not want to gamble on a jury trial, even though the case was brought in California, one of the states hardest hit by the housing crisis.

The Justice Department does have some advantages. For one, while the federal case still requires the government to prove intentional fraud, it only needs to prove that based on the preponderance of the evidence, rather than the higher threshold for criminal cases of beyond a reasonable doubt.

The government also steered away from attacking individual ratings, which have largely been shielded under free speech protections, and instead focused on proving false just one statement S&P made — that its ratings were objective.

But legal experts said the Justice Department is using a relatively untested interpretation of FIRREA, a federal civil fraud statute passed after the 1980s savings-and-loan scandals, which makes predicting the success of the suit difficult.

While the law has appeared in only a few dozen cases, its low burden of proof, broad investigative powers and long statute of limitations encouraged the Justice Department to dust it off for potential cases, especially after criminal inquiries failed to yield major prosecutions.

It covers fraud affecting federally insured financial institutions but has generally been used when the government was the target of fraud. The Justice Department contends FIRREA applies because S&P's alleged fraud caused a federally insured California credit union to suffer losses.

“It's rare but not unprecedented for the Justice Department to bring a civil fraud suit where the government itself is not the victim of the fraud,” said Andrew Schilling, a partner at the law firm BuckleySandler who led the civil division in the U.S. Attorney's office in Manhattan and help build prior cases under FIRREA.

The 2007-2009 financial crisis was due in large part to massive losses triggered by risky mortgage loans packaged and sold to investors, often with top ratings from credit raters.

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