S&P’s Counterattack on the Government

With the start of the football season, we are sure to hear an analyst trot out the old cliché that the best defense is a good offense. But it certainly applies to the approach McGraw-Hill Companies is taking in defending its Standard & Poor’s unit against the fraud lawsuit filed by the Justice Department. In its defense, the company accuses the government of improperly targeting S&P because it lowered the credit rating on federal debt two years ago.

Putting the government on trial is a tactic used in criminal cases because it can divert a jury’s attention from the defendant’s conduct and taps into a vein of mistrust in how the authorities exercise their power. Judges substantially limit this approach because it can be an unnecessary distraction. So it is questionable how far S&P can get in shifting the focus.

The Justice Department lawsuit claims that S&P engaged in fraud when it gave high ratings to residential mortgage-backed securities and collateralized debt obligations issued before the financial crisis despite knowing that the housing market was deteriorating. The suit also accuses the company of favoring the interests of investment banks with higher than justified ratings so that it could continue to win business from those banks.

The case is brought under the government’s favorite new weapon, the Financial Institution Reform, Recovery and Enforcement Act, which allows for civil penalties for mail and wire fraud violations that affect a financial institution.

S&P sought to dismiss the lawsuit by claiming that its statements about conflicts of interest and the propriety of its ratings constituted what is known as “mere puffery” â€" in other words, they were just like the unreliable statements of a used car salesman. Judge David O. Carter of Federal District Court in California, who is presiding over the case, rejected that argument, saying that this position “is deeply and unavoidably troubling when you take a moment to consider its implications.”

Having lost the preliminary motion to throw out the lawsuit, S&P filed its answer to the government’s complaint last week in which it put forth its own version and offered a first look at its potential defenses. Like most such pleadings, it takes the “kitchen sink” approach, staking out a number of potential positions that may not prove to be useful as the case develops.

The company once again claims that its credit ratings should not have been the basis for any decision to buy a residential mortgage-backed security or collateralized debt obligation. It asserts that “credit ratings are not indicators of investment merit, are not recommendations to buy, sell or hold any security, and should not be relied upon as investment or financial advice.”

Among the 18 defenses offered in its filing is one that argues the case was filed in retaliation for S&P’s downgrade of United States government debt in 2011 from AAA to AA+. The company argues that S&P “was not alone” in failing to “anticipate the full speed, severity, and breadth of the collapse of the housing market and its impact on the economy as whole.” This is a claim of discriminatory prosecution because the one company that poked the government in the eye has been targeted for punishment.

Claims that of being treated unfairly by being singled for punishment usually fall on deaf ears because the government has broad discretion in how it enforces the law. But S&P asserts that lowering its rating of United States debt was an exercise of free speech and that the government lawsuit violates the protection afforded by the First Amendment.

This is a twist on a defense S&P has offered in private lawsuits filed by those who claim to have been misled by its ratings. In some cases, it has successfully defended itself by asserting that the ratings are only opinions protected by the First Amendment and, therefore, it cannot be held liable.

The right to free speech is not a basis to rebut a claim of fraud because the Constitution does not protect false or misleading statements intended to deprive another person of money or property. Instead, S&P is using the First Amendment to argue that the government is trying to punish it for the rating of the federal government’s creditworthiness and that the lawsuit is, therefore, improper.

When the Justice Department filed the case in February 2013, Eric H. Holder Jr., the attorney general, denied that there was any connection between the decision to accuse S&P of violations and the earlier credit downgrade of federal government debt. For conspiracy theorists, the mere denial is enough to show that there is a link between the two.

Unlike a criminal case, in which the discovery rights of defendants are quite limited, this is a civil case. So S&P can try to obtain information from a wide range of government officials to establish its First Amendment retaliation claim.

The roadblock the company will face is a legal doctrine known as the deliberative process privilege, which protects information about how the government reached a policy decision. In a 2001 ruling, the Department of the Interior v. Klamath Water Users Protective Association, the Supreme Court said that “the deliberative process privilege rests on the obvious realization that officials will not communicate candidly among themselves if each remark is a potential item of discovery and front page news.”

But the privilege does not throw up a wall around illegal conduct by government officials. So there may be a basis to seek out information about whether there was a link between the ratings downgrade by S&P and the decision to file the lawsuit.

The question is whether the intent of federal officials in targeting S&P, and not the other credit rating agencies, for the civil penalty lawsuit is even relevant to the civil fraud charges. Just like the sports car driver who claims that other cars on the highway were also speeding but the officer only stopped him, the fact that others who might have violated the law have not been charged is not a justifiable basis to defend a lawsuit.

Taking the depositions of senior government officials is uncommon, but certainly not unknown. A federal judge, for example, authorized Maurice R. Greenberg, the former American International Group chief executive, and his investment company, Starr International, to depose Ben Bernanke, the Federal Reserve chairman, as part of a lawsuit over whether the government’s bailout of A.I.G. violated the Fifth Amendment as an unconstitutional taking.

S&P’s claim of unconstitutional retaliation is sure to lead to a series of motions as the two sides battle over whether â€" and perhaps how much â€" discovery the company can pursue to build its retaliation defense. Putting the government on trial is a means to go on the offense in the case and may increase S&P’s leverage to seek a settlement on more favorable terms.