Tag Archives: California

Round One to California in Suit Against S&P

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California Superior Court Judge Karnow issued a Memorandum Order Overruling Defendants’ Demurrers in California v. The McGraw-Hill Cos. et al., CGC-13-528491 (Aug. 14, 2013 San Francisco County).   California Attorney General Harris alleged “that S&P intentionally inflated its ratings for the investments and that these knowingly false ratings were material to the investment decisions of [California Public Employees’ Retirement System (PERS) and the California State Teachers’ Retirement System (STRS)], in violation of the False Claims Act and other statutes.” (2)

S&P demurred to the False Claims Act causes of action [asked for the causes of action to be dismissed], because, among other reasons,

(l) the complaint does not plead that any ‘claims’ were ever “presented” to the state;

(2) if claims were presented, they did not involve ‘state funds’ . . .. (4)

S&P asserts, among other things, that because it “was not the seller, it did not “present” any claims for payment.” (4) The Court stated, however, that the False Claims Act “imposes liability on any person who ’causes’ a false or fraudulent claim to be presented or ’causes to be made or used a false . . . statement material to a false or fraudulent claim.’ C. 12651(a)(1)-(a}(2).” (4, citation omitted) The Court inferred “from the complaint that S&P ’caused’ PERS and STRS to purchase the securities. This is good enough for present purposes.” (4, citation omitted)

I am a longstanding critic of the rating agencies, but I have to say that I am struck by how broadly courts have interpreted statutes relied upon by the federal government and the states as they pursue alleged wrongdoing by financial institutions involved in financial crisis. In the courts’ defense, they typically rely on the plain language of the statutes, but, boy, do they interpret them broadly.

In this case, giving a rating can “cause” someone to purchase a security — is there any limit on what is a sufficient “cause” to trigger the statute? In DoJ’s case against Bank of America, a financial institution may be liable under FIRREA for a fraud it perpetrates even if the only entity affected by the fraud is — Bank of America! Similar broad interpretations of NY’s Martin Act make it relatively easy for NY government to bring a securities fraud case against a financial institution because our normal intuitions about intent are not relevant under that act.

Pursuing alleged wrongdoers: good.

Pursuing alleged wrongdoers with broad, ambiguous and powerful tools:  worrisome.

Underwater Mortgages Eminent Domain Battle Gears up

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I was quoted in a recent story in www.thestreet.com, Eminent Domain Mortgage Battle Is a Lose-Lose Situation.  It reads in part,

The move by Richmond, Calif., to seize “underwater mortgages” from private investors using its powers of eminent domain has drawn controversy and consternation within the mortgage industry.

The law has mostly been used to seize property for public purposes such as building roads, highways or schools and other critical infrastructure.

Richmond is now testing whether the rule can be applied to seizing underwater mortgages.

Home prices in Richmond, a city with a population of a little more than 100,000 and a significant Hispanic and African-American presence, are still far below peak levels. More than half of its homeowners are underwater — they owe more than their homes are worth.

Richmond Mayor Gayle Mclaughlin said eminent domain is the only way to help borrowers and repair the local economy, as investors of private-label mortgages have been either reluctant or too slow to provide relief to borrowers.

The city, partnering with San Francisco-based Mortgage Resolution Partners (MRP), began sending letters to owners and servicers of 624 underwater mortgages this week.

If the investors do not agree to sell at the negotiated price, the city will seize the property through eminent domain.

The mortgage industry is, predictably, threatening a legal battle.

* * *

“The constitutional challenges for this proposal are weak,” according to David Reiss, law professor at the Brooklyn Law School.

* * *

The bigger source of legal conflict, according to Reiss and other experts, would be on determining what is fair compensation for a mortgage, especially one that is still current.

* * *

“Courts tend to overcompensate properties taken under eminent domain as a general rule,” said Reiss. “The proponents of this rule may be underestimating how these mortgages will be valued.”

* * *

Eminent domain is “theoretically a great idea,” said Reiss. “States certainly have the legal authority to try this experiment. But it is not clear whether the outcome of all this is beneficial.”

California’s S&P Suit

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The California complaint follow on the heels of the DoJ complaint but it hangs its hat on an aggressive theory — that S&P’s ratings violate California’s False Claims Act.  While I do not yet have an opinion about whether that is a stretch, I do note the allegations in the complaint add to the tragicomic ones that we have seen in the other complaints filed against rating agencies.  Here are some of the more quote-worthy ones:

  • S&P executives “suppressed development of new, more accurate rating models that would have produced fewer AAA ratings -and therefore lower profits and market share. As one senior managing director at S&P later confessed, “I knew it was wrong at the time.” (3)
  • “S&P knew that its rating process and criteria had become so degraded that many of its ratings were, in the words of one S&P analyst, little better than a “coin toss.” During those years, its models were “massaged” using “magic numbers” and “guesses,” in the words of other senior S&P executives.” (3)
  • “it rated notes issued by structured investment vehicles (“SIVs”) another type of security central to this case-without obtaining key data about the assets underlying the SIVs. A reporter later asked the responsible executive about this failing: “If you didn’t have the data, and you’re a data-based credit rating agency, why not walk away” from rating these deals? His response was remarkably candid: “The revenue potential was too large.” (4)

This complaint, like the others, highlights the chasm between S&P’s representations of its own conduct and the alleged behavior set forth in the complaint.  Indeed, the complaint states that representations by employees which were authorized by S&P “about its integrity, competence, and the quality of its ratings were knowingly false.” (19)

If the facts in this complaint prove to be true, some of the statements by employees seem hard to explain away:

  • “As explained by Kai Gilkes, an S&P managing director of quantitative analysis at the time, analysts were encouraged to loosen criteria:  The discussion tends to proceed in this sort of way. “Look, I know you’re not comfortable with such and such assumption, but apparently Moody’s are even lower, and if that’s the only thing that is standing between rating this deal and not rating this deal, are we really hung up on that assumption?” (21)
  • “[w]e just lost a huge … RMBS deal to Moody’s due to a huge difference in the required credit support level … [which] was at least.1 0% higher than Moody’s. . . . I had a discussion with the team leads here and we think that the only way to compete is to have a paradigm shift in thinking.” (21)
  • “S&P’s highest management ordered a credit rating estimate even though S&P lacked vital loan data to perform the necessary analysis. This resulted in the “most amazing memo” Mr. Raiter had “ever received in [his] business career.” When Mr. Raiter requested the necessary loan level data, Richard Gugliada, the head of S&P’s CDO group at the time, rejected the request, stating: “Any request for loan level tapes is TOTALLY UNREASONABLE!!! : .. Furthermore, by executive committee mandate, fees are not to get in the way of providing credit estimates…. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.” (22)