Tag Archives: S&P

Reiss on Booming Structured Finance Litigation

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Law360 interviewed me about the boom in structured finance litigation arising from the Financial Crisis (here, behind a paywall):

banks will not be able to let their guard down anytime soon, thanks to the U.S. Department of Justice’s rediscovery of a statute developed in response to the late 1980s savings and loan crisis and the increasing ability of plaintiffs attorneys to expand claims first brought in mortgage cases to other consumer finance products, according to Brooklyn Law School professor David Reiss.

“I would still be worrying if I were the [general counsel] of a large financial institution about the cases that might still be filed,” Reiss said.

Most of the fraud claims available under federal securities law have a statute of limitations that expires after five years. Because most of the securities that failed did so in 2007 and 2008, 2013 looked like the end of the line for many of the government’s claims.

That was until the DOJ sued Standard & Poor’s Financial Services LLC in February, claiming it was rife with conflicts of interest and that it ignored evidence that mortgage-backed securities were stuffed with subprime mortgages that were likely to fail. In bringing its suit, the DOJ dusted off the 1989 Financial Institutions Reform, Recovery and Enforcement Act, a federal response to the savings and loan crisis of the late 1980s that allows the government to bring claims against defendants that adversely affect federally insured financial institutions.

Using that statute was a game-changer, Reiss said.

Among a host of other measures provided in the law, FIRREA extended the statute of limitations on those claims from five to 10 years, giving prosecutors more time to bring claims. It also gave the government the chance to bring civil versions of mail, wire and other fraud claims that normally would be brought in a criminal context, meaning the government will now only have to prove its allegations to a jury by a preponderance of evidence, rather than beyond a reasonable doubt.

“If courts favor DOJ’s expansive reading of FIRREA, all bets are off as to how much financial institutions may still be on the hook for suits arising from the financial crisis brought by the government,” Reiss said.

Prosecutors are also looking to bring more cases as pressure from lawmakers mounts.

After Attorney General Eric Holder admitted Wednesday that some banks were “too big to jail,” the spotlight has been turned anew on whether regulators have been tough enough on banks. Critics say that prosecutors and bank regulators have been too timid in their pursuit of crimes allegedly committed by banks.

That could also push the DOJ and the other regulators to find new theories to bring cases, Reiss said.

“It does seem that there is a bit more of a populist bent to prosecutions now that we are past the worst of the crisis,” he said.

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)

 

More on DoJ’s S&P Complaint

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I highlighted some of the juicy bits of the complaint a few days ago.  There has been a lot of discussion of the suit and related issues.  Here is my two cents’ worth.

  • FIRREA, an untested enforcement statute, has gone from zero to hero in sixty seconds.  The federal government has had very little experience using the enforcement provisions of FIRREA but commentators have now identified it as a powerful tool to hold financial companies accountable for their misdeeds in the early 2000s.  Time will tell if courts agree that this expansive interpretation will hold up.
  • It is probably no coincidence that the federal government brought the S&P case in California, which is in the 9th Circuit.  Or rather, I should say, it is probably no coincidence that the government did NOT bring it in the 2nd Circuit.  The 2nd Circuit has ruled in favor of the rating agencies even since the events of the financial crisis had become well known, continuing the trend of treating rating agencies as editorialists, albeit terse ones.  Even though Judge Scheindlin (SDNY) has issued a series of rulings against rating agencies, the 2nd Circuit will ultimately rule on any appeals from the cases she hears.  While the 9th Circuit is more of a wild card than other Circuits, there is no doubt that it will go its own way on rating agency liability.
  • It is hard to say whether the federal government is primarily seeking to reform the rating agency industry by bringing this lawsuit (I would assume that similar suits are in the works for Moody’s and Fitch) or whether it is merely seeking to hold it accountable for its alleged bad acts.
  • It is interesting to see how the states are piling on, with lawsuits and investigations in a number of states, including NY.  The rating agencies’ potential liability from all of these suits combined is quite significant — indeed, going-out-of-business significant.
  • And it is scary to realize that for all of the documented flaws in the rating agency industry, no one has come up with a model for the industry that is clearly superior to what we have now.  There is a lot of work to be done.