By Tom Wicker
The tide of opinion has turned against the ‘big three’ credit rating agencies. Downgraded governments worldwide have been protesting ever more loudly about being held to ransom by organisations they blame for aggravating the financial crisis. But all of this huffing and puffing has largely amounted to a lot of hot air.
For this reason, the Department of Justice’s (DOJ) decision in February to prosecute Standard & Poor’s (S&P) for allegedly defrauding investors out of $5bn in mortgage-related securities between 2004 and 2007 is a landmark action. So what has emboldened the US government to bare its fangs?
The DOJ’s civil court suit alleges that S&P deliberately ignored internal warnings about the housing market, issuing inflated ratings to make itself and its parent company, McGraw-Hill, a profit, while falsely claiming commercial objectivity.
Cynics might argue that it’s no coincidence that the US government has singled out the agency responsible for its bruising AAA downgrade two years ago. But whatever the reason, such a claim would have been difficult to bring in previous years due to the First Amendment.
Ratings issued by S&P, Moody’s and Fitch Ratings had long been considered constitutionally protected opinions. But in a summary judgement ruling in a fraud case last August – which included Moody’s and S&P as defendants – Judge Shira Scheindlin of the Southern District of New York cast doubt over this. She argued:‘When a rating agency issues a rating, it is not merely a statement of that agency's unsupported belief, but rather a statement that the rating agency has analyzed data, conducted an assessment, and reached a fact-based conclusion as to creditworthiness.’
‘The US government has to show both that S&P knowingly committed fraud and that this fraud affects a federally insured financial institution’
Associate Professor of Law, George Washington University
Bill Carmody, a leading trial lawyer responsible for Susman Godfrey's New York office, believes this paved the way to the DOJ’s action. ‘Once judges start to carve out pure opinions that are constitutionally protected into something less, it’s a way under existing legal precedent to put credit issuers in a potentially precarious position.’
The DOJ’s suit against S&P is novel for its use of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) as a stick with which to beat the agency. Other sovereign states such as the UK (recently downgraded from its AAA status by Moody’s) lack such a statute ‘already on the shelf,’ says Jeffrey Manns, Associate Professor of Law at George Washington University.
‘The key from the standpoint of the S&P suit is that the government is leveraging the Act’s ambiguity. It recognises that there is not much in the way of precedent or for guidance to defendants as to the scope of FIRREA.’
Enacted in response to the 1980s banking crisis, FIRREA was dusted off by the US government in 2009 as a tool to ‘encourage’ banks into settling claims. Advantageously, a civil (as opposed to criminal) claim doesn’t need evidence beyond all reasonable doubt to be filed. And the Act enables the DOJ to subpoena S&P for documentation.
A win for the DOJ would set a major precedent in other cases in courts all around the country. ‘But the hard part will be to find a smoking gun,’ Manns explains. ‘The government has lots of evidence of underlings running amok. But that’s not the same as showing what happened at the corporate policy level.’
‘Once judges start to carve out pure opinions that are constitutionally protected into something less, it’s a way under existing legal precedent to put credit issuers in a potentially precarious position’
Susman Godfrey, New York
Put simply, colourful emails between employees may be embarrassing but – in and of themselves – don’t equal a slam-dunk guilty verdict. The US government’s burden is, as Manns says, ‘that it has to show both that S&P knowingly committed fraud and that this fraud affects a federally insured financial institution.’
The DOJ is also facing a scenario aptly compared by Manns to ‘the pot calling the kettle black.’ In part, the central concern of the suit is that the rating agencies failed to anticipate the nature and scope of the financial crisis. But neither did the US government or any number of international monetary funds.
Philip Wood, Special Global Counsel at Allen & Overy and a leading expert in cross-border financial law, argues that scapegoating the rating agencies is, at best, disingenuous. ‘Maybe people have short memories, but in April 2007 the IMF released a statement to say that conditions were benign! That was three months before the market froze.’
Wood can’t comment specifically on the DOJ’s suit. In general, though, he sees going after the rating agencies as ‘a vindictive attack on the messenger.’ But irrespective of the ethics, a win for the US government against S&P could have mixed consequences for financial markets.
Overly conservative ratings issued by agencies fearful of being targeted ‘could turn out to be almost as bad as being reckless,’ Manns suggests. The ‘chilling effect’ of this on the debt markets currently lubricating the global economy might actually impede future growth.
Manns goes on to suggest that knocking S&P out of the picture entirely, through bankruptcy, could have the ironic consequence of turning an oligarchy of rating agencies into a monopoly – simply tightening a noose that governments claim is already chafing at their necks.
In a global economy, the checks-and-balances benefits of objective, trans-national credit ratings are obvious. A win for the DOJ against S&P might be politically cathartic, but it isn’t a long-term solution to the wider problems of corporate accountability underlying the suit.
FIRREA is, as Manns has argued elsewhere, a ‘blunt and inadequate tool to deal with systematic conflicts of interest.’ Ultimately, comprehensive regulatory reform via statutes such as the Dodd-Frank Act is the way forward. But whether the US government is willing to stop taking pot shots and truly tackle Wall Street is another story.
Tom Wicker is a freelance writer and editor. He can be contacted at email@example.com