By now you will have heard that the U.S. Department of Justice has filed a securities class action lawsuit against S&P and its corporate parent, McGraw-Hill, about the rating agency’s  ratings of collateralized debt obligations as the subprime meltdown unfolded. A copy of the DoJ’s complaint, filed on February 4, 2013 in the Central District of California, can be found here.


The complaint has attracted widespread media attention, as well it should, since it represents that government’s first action against a rating agency in connection with the subprime meltdown and the credit crisis But there are a number of interesting features to this action, beyond just the fact that the DoJ has filed a lawsuit against a rating agency.


First, there’s the fact that the lawsuit was filed in the Central District of California, rather than in New York, where S&P is located. To the extent that the complaint supplies an answer for the choice of venue question, it appears that the DoJ chose the C.D. Cal. because that is where the failed Western Federal Corporate Credit Union was located. As is alleged in the complaint, the failed credit union was apparently an investor in a number of the specific CDOs mentioned in the complaint. Many of these investments resulted in a total loss to the credit union. More broadly, the DoJ alleges that the S&P engaged in a scheme to “defraud investors.” The specific investors mentioned by name in the complaint area all federally insured depositary institutions.


The second interesting thing about the complaint is that thought it was filed by the Department of Justice, it has been filed as a civil action, presumably because the DoJ feels stands a better chance of success with the lower standard of proof applicable in a civil case. But though the case was filed as a civil action, the claims asserted are a little unexpected (at least to me). The DoJ asserts substantive claims for wire fraud, mail fraud, and two counts of financial institution fraud under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”).


In its February 4, 2013 press release about the then-anticipated law suit, S&P characterizes  the DoJ’s use of FIRREA as a “questionable legal strategy” intended as an attempt to “end run” the “well-established legal precedent “ on which the defendants hope to rely. Presumably, the reference to the established precedent refers to case law finding that that rating agency’s opinions represent opinion protected under the first amendment.


I suspect a different explanation for the DoJ’s reliance on FIRREA. The fact is, many of the events described in the complaint took place many years ago, in some instances six years ago or more. The DoJ is rightly worried about possible statute of limitations concerns. That’s where FIRREA comes in. FIRREA has a ten-year statute of limitations for a violation of, or a conspiracy to violate, the mail or wire fraud statutes, if the offense affects a financial institution (about which refer here). The defendants undoubtedly will try to raise a host of defenses, but the DoJ doesn’t want statute of limitations issues to cut the action short.


Third, the complaint names as defendants only S&P and its corporate parent. None of the other rating agencies are named – a point that gripes S&P. In its February 5, 2013 press release, issued after the complaint was filed, S&P notes that “every CDO cited by the DoJ also independently received the same rating from another rating agency.” It may simply be that S&P is up first and the other rating agencies’ turn is coming. However, another possibility may be that the DoJ had more to work with against S&P, particularly from the apparent treasure trove of emails that are liberally quoted in the complaint.


The complaint paints a very detailed picture of the dynamic inside S&P as it became increasingly apparent in early 2007 that residential mortgages originated in 2006 were failing quickly, particularly with respect to subprime and Alt-A mortgages. It is clear that S&P felt under a great deal of pressure not to move any more quickly than its competitors for fear of losing business. The warning signs appeared to accumulate as 2007 unfolded while at the same time the issuers who sought out S&P’s ratings were scrambling to complete offering s, to get mortgage backed securities out of their warehouse. The emails and other internal communications (at least as portrayed in DoJ’s complaint) seem to show a sequence of events where alarm bells were sounding louder yet deals continued to get pushed through.


As things deteriorated, a gallows humor seems to have set in, provoking a number of emails in which S&P staffers apparently acknowledged the growing problems. As quoted in detail in this February 5, 2013 Business Insider column (here), the emails show an apparent perception on the part of at least some S&P staff that the firm was compromising its rating standards under pressure from issuers. The emails include the now-infamous email in which one staffer quipped that a transaction could be “structure by cows” and the firm would still rate it. Another email exchange between an analyst and an investment banker outside the firm about how the MBS world is “crashing” and the firm is running around to “save face.”


Another analyst sent an email with a spoof version of Talking Heads’ classic hit, “Burning Down the House,” including lyrics that “huge delinquencies” in the 2006 vintage were “bringing down the house.” The complaint alleges that shortly after this first email, the same analyst sent an email with a video of the analyst singing the first verse of the spoof for an audience of laughing S&P staffers. (More about the surprise appearance from the Talking Heads in the DoJ’s complaint here.)


Whatever may be the reasons why the DoJ decided to proceed under FIRREA and to sue only S&P, the agency will still have to contend with the argument that the rating agency’s ratings are inactionable opinion or are protected by the First Amendment – arguments that the Sixth Circuit appeared to validate in its December 2012 opinion dismissing actions that the Ohio Attorney General filed against the rating agencies on behalf of Ohio state employee pension funds.


Time will tell how the DoJ attempts to address these arguments, but it appears from the agency’s complaint that the agency will be attempting to argue that S&P is not entitled to rely on these defenses because the ratings did not represent the rating agency’s opinions. The complaint alleges that the rating agency “falsely represented” that the ratings “reflected S&P’s true opinion” regarding the credit risks the complex securities represented to investors.  The DoJ may be poised to argue that the alleged misrepresentations on which its claims are based are not the opinions themselves but rather the rating firm’s statements about its process and the integrity of its process.


One final question is why is the government acting now, years after the crash and years after the events described in the complaint? Several media reports suggested that the DoJ acted only after attempts to work out a negotiated settlement failed. One of the S&P’s lawyers tried to suggest on CNBC that the government investigation intensified after the rating firm downgraded the U.S.’s debt. What ever the reason that the complaint is only being filed now, if nothing else the complaint does show that we are continuing to live with the fallout from the credit crisis and the issues from the crisis are going to be litigated for some time to come.


Alison Frankel has a good summary of the complaint and its allegations in her February 5, 2013 post on her On the Case blog (here).


Special thanks to the several readers who sent me a copy of the DoJ’s complaint.


And Finally: With a hat tip to the Business Insider article linked above, here is the original video version of “Burning Down the House”