Justice Department Faces Uphill Battle in Proving S.& P. Fraud

The Justice Department accused Standard & Poor’s of issuing faulty credit ratings on securities tied to mortgages. The 119-page civil complaint is chock-full of e-mails that paint a picture of shoddy practices and greed as S.& P. purportedly watered down its standards to generate more business.

But whether the company’s practices equate to fraud will be difficult to prove.

The government is bringing charges under a provision of the Financial Institutions Reform, Recovery and Enforcement Act, a statute adopted in 1989 during the savings and loan crisis to make it easier to pursue fraud cases in the banking business. The law allows for a penalty of up to $1 million for each violation of the mail, wire and bank faud statutes for conduct “affecting” a federally insured financial institution.

The statute is designed to help the government recoup money it expended bailing out any failed bank. In this case, the government is suing over the failure of Western Federal Corporate Credit Union and other unnamed financial institutions.

The statute was rarely used until recently, when the Justice Department apparently found it useful for cases arising out of the financial crisis. The United States attorney’s office in Manhattan sued Wells Fargo and Bank of America in October for penalties related to their mortgage operations.

The benefit of using the Financial Institutions Reform! , Recovery and Enforcement Act is that one only needs to meet the lower burden of proof in civil cases of a “preponderance of the evidence” while still being able to use the broad mail and wire fraud statutes. This is in contrast to criminal charges, which require that prosecutors prove guilt beyond a reasonable doubt.

The government probably thinks it has some smoking guns. The complaint claims that S.& P. continued to rate subprime mortgage securities highly as the financial crisis began to hit and the securities looked increasingly shaky.

The Justice Department also contends that S.& P. helped fuel the financial crisis. In the first half of 2007, the company rated a number of large mortgage-backed securities, bestowing top grades on the investments. It then quickly downgraded the securities, which defaulted in months.

Then there is the usual array of inappropriate e-mails and text messages. One riffs on the Talking Heads song “Burning Down the House,” creating new lyrics: “Subprime is boi-ling o-ver. Bringing down the house.” Another e-mail from an analyst in response to a question about how his new job was going reads: “Job’s going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we’re all running around to save face … no complaints.”

Despite the colorful e-mails, the Justice Department will face an uphill battle, even with the lower burden of proof.

The first problem is that Justice Department will have to demonstrate that S.& P. acted inappropriately. The government will have to prove that ratings were in fact faulty, and published intentionally so as to deceive investors in the securities. In response, S.& P. could simply argue that the company was just as blinded by the financial crisis as anyone else, and that q! uestionab! le e-mails are simply the work of lower-level employees who were not involved in the decision-making.

In other words, S.& P. lacked the intent necessary to prove fraud.

Even if the Justice Department can prove the agency acted to deceive investors, it still has to deal with something lawyers call reliance. In other words, did investors rely on these ratings to make their decisions

S.& P. did not deal directly with any investors, working only with the issuers and receiving payment for its ratings. In fact, most offering documents for these securities specifically told investors not to rely on the ratings. While that does not preclude finding that the company engaged in a fraudulent scheme, it does make it more difficult to show the link between purportedly shoddy ratings and any direct effect on the investors.

Perhaps more important is that S.& P. was not the only company that rated the securities. Typically, a security was also rated by at least one of the other two major rating agecies, Fitch Ratings and Moody’s Investors Service. They have not been accused of any misconduct by the Justice Department, and S.& P. can point to its competitors’ ratings as proof that it did not intend to mislead investors.

In its complaint, the government asserts that S.& P.’s fraudulent scheme “caused” investors to buy the securities, but the ratings by other firms may well have contributed to that decision. By only suing S.& P., the Justice Department will have to show that the company’s ratings played a major role in the investment decision.

Even if a fraud claim is established, S.& P. is sure to raise an old defense: t! he First ! Amendment’s protection for freedom of the press. The credit rating agencies have fought lawsuits accusing them of negligence and fraudulent misrepresentation by arguing that they are financial journalists whose ratings are only opinions on the future prospects of the securities. Under the Supreme Court’s decision in New York Times Co. v. Sullivan, a plaintiff suing a member of the press would have to prove “actual malice.” It is a difficult standard to meet.

Although S.& P. and the other firms have successfully offered this defense to get cases dismissed, federal courts have been less receptive of late. For example, a Federal District Court judge in New Mexico rejected the argument of the three major credit rating agencies that the First Amendment protected their ratings on a mortgage-backed security, finding that the limitd distribution of the information meant that their statements did not receive the full protection afforded by the Constitution.

In another case in August, Judge Shira A. Scheindlin of Federal District Court in Manhattan also refused to dismiss a case against Moody’s and S.& P. on the basis of the First Amendment’s protections. She wrote that “ratings are actionable if (they) both misstated the opinions or beliefs held by the rating agencies and were false or misleading with respect to the underlying subject matter they address.”

By accusing S.& ! P. of fra! ud, the Justice Department may be able to undermine any First Amendment claim by the company. The protections afforded by the Constitution do not extend to statements made as part of a fraudulent scheme. By charging that the ratings were designed to help the company generate new business, the government may block S.& P. from having the complaint dismissed before trial.

But even if the Justice Department can fight off the First Amendment issue, it must prove that S.& P. ratings were the product of intentional fraud and not just stupidity. It also must show that investors actually cared about the ratings. This could be tough, since the ratings agencies were notorious for getting it wrong. After all, Enron carried a triple-A rating just weeks before its collapse.

While one might think disgust with financial institutions and distaste for ratings agecies will carry the day, the government has had a hard time winning fraud cases in court when juries actually look at the facts. It all means that the Justice Department will have its work cut out for it this time.