The Justice Department's February 4, 2013 lawsuit against credit rating agency Standard & Poor's Ratings Services ("S&P"), a subsidiary of McGraw-Hill Co., puts an exclamation point on the latest era in civil fraud enforcement. Following close on the heels of several high profile complaints in the Southern District of New York in 2012 in so-called "mortgage fraud" cases, the United States has now fully embraced the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA")—a 23 year-old statute whose civil penalty provisions had atrophied from nonuse. The Justice Department appears committed to dusting off this powerful weapon and using it either in tandem with the civil False Claims Act ("FCA") or, as in the case of S&P, as the sole basis for extracting huge damages and penalties from companies whose allegedly fraudulent conduct affects federally insured financial institutions.
The lawsuit against S&P arises out of a criminal investigation by the Financial Fraud Enforcement Task Force, but it alleges civil causes of action under FIRREA, a statute enacted to strengthen the federal deposit insurance system and to protect financial institutions from fraud. FIRREA's civil penalty provisions authorize the United States to bring civil suits based on violations of fourteen specific criminal offenses, primarily from Title 18—including bank, mail, and wire fraud. The government has the burden of proving—under the preponderance of the evidence standard—the right to recover substantial penalties based on violations of these so-called "predicate offenses." 12 U.S.C. § 1833a(f). In addition, a civil cause of action under FIRREA can be brought up to 10 years after the cause of action accrues. 12 U.S.C. § 1833a(h).
The complaint alleges that S&P engaged in a scheme to defraud investors in connection with Residential Mortgage-Backed Securities ("RMBS") and Collateralized Debt Obligations ("CDOs") ahead of the 2007-08 financial crisis. The Attorney General's public announcement of the lawsuit stated that twelve states would be bringing separate suits against S&P under state unfair competition laws. And, the next day, California filed suit against S&P under its own False Claims Act, seeking treble damages and penalties based on the same underlying conduct.
The FIRREA Claims
The Allegations. The U.S. complaint—which is being handled by Main Justice attorneys from the Civil Division's Consumer Protection Branch—centers on S&P's representations that its credit ratings of RMBS and CDOs were (a) "objective, independent, uninfluenced by any conflicts of interest that might compromise [its] analytic judgment," and (b) reflective of its current opinion regarding the credit risks that rated RMBS and CDOs posed to investors. See Complaint at 2, United States v. McGraw-Hill Cos., No. 13-00779 (C.D. Cal. Feb. 4, 2013). According to the complaint, S&P charged fees for its RMBS and CDO ratings, which ultimately were passed through to the RMBS and CDO investors/purchasers. The complaint alleges that S&P disregarded the risks posed by RMBS and CDOs in its ratings models, that it was motivated by a desire for increased revenue and market share in the ratings market, and that it knew that its representations regarding the independence, objectivity, and accuracy of its ratings were materially false.
The claims cover the period 2004-2007. The complaint alleges that as the subprime mortgage market deteriorated, S&P "limited, adjusted, and delayed updates to the ratings criteria and analytical models S&P used to assess the credit risks" posed by RMBS and CDOs. For instance, the complaint cites an S&P CDO analyst's April 2007 statement that loosening correlation assumptions "resulted in a loophole in S&P's rating model big enough to drive a Mack truck through." Complaint at 56. Whether these allegations accurately portray S&P's conduct at the time, or are simply post hoc attempts to unfairly lay blame on S&P for losses suffered due to the financial crisis, remains to be seen.
FIRREA. The complaint cites bank fraud (18 U.S.C. § 1344), mail fraud (18 U.S.C. § 1341), and wire fraud (18 U.S.C. § 1343) as the predicate offenses allegedly forming the basis for S&P's liability under FIRREA. Under FIRREA, S&P can be liable for bank fraud under 18 U.S.C. § 1344 as long as the government can prove that S&P's conduct satisfies the elements of Section 1344, namely (1) defrauding a financial institution, or (2) obtaining money from a financial institution by false pretenses. There seems to be a substantial question as to whether the "ratings" misrepresentation conduct alleged here was specifically intended to defraud any financial institution. Certainly, by any standard, the conduct alleged in the complaint is not a traditional bank fraud scheme. Under FIRREA, mail and wire fraud offenses are only actionable if they "affect[ ] a federally insured financial institution." 12 U.S.C. § 1833a(c)(2). Here, too, there will be a substantial question as to whether the mail and wire fraud conduct alleged in the complaint affected a federally insured financial institution within the meaning of FIRREA. Indeed, the reach of FIRREA in civil cases has yet to be established by the courts, although the issue is teed up for decision in several mortgage fraud cases pending in the Southern District of New York and certainly will be litigated in the S&P case.
Interestingly, the complaint does not allege that any false statements or claims were made by S&P to the United States government. As a result, the FIRREA claims do not include any alleged violation of 18 U.S.C. § 1001 as a predicate offense. Moreover, the United States did not bring any claims under the False Claims Act, which it could have tried to do if claims for payment had been made to the United States. California, however, did not see any such impediment to proceeding against S&P under the California FCA, alleging in its separate suit that S&P's conduct defrauded state pension fund investors.
Penalties. Section 1833a(b) of FIRREA provides for a civil penalty of $1 million per violation or $5 million for a continuing violation. However, these penalty limits can be exceeded if "any person" derives pecuniary gain from the violation or if a person other than the violator suffers a pecuniary loss. 12 U.S.C. § 1833a(b)(3)(A). If the gain or loss exceeds the penalty amounts, damages can be awarded in the amount of the gain or loss. In the S&P complaint, the United States contends that financial institutions suffered $5 billion in losses.
California's False Claims Act Allegations
California took a different approach from the federal government in its complaint. See Complaint, People v. McGraw-Hill Cos., (Cal. Super. Ct. Feb. 5, 2013). While Attorney General Holder stated that other states planned to join the federal government's attack on S&P's rating practices by suing under state unfair competition laws, California's suit is unique in alleging violations of the California False Claims Act ("CFCA"). California was the first state to enact a state false claims act with qui tam provisions, and it has enacted amendments mirroring the recent amendments to the federal law. California's complaint mimics many of the government's FIRREA claims, in terms of the underlying conduct, but California seeks treble damages—more than $3 billion—based on the theory that "when the state makes a purchase based on a false statement, the defendant is responsible for the amount lost times three." See Press Release, Cal. Dep't of Justice, Attorney Gen. Kamala D. Harris Sues Standard & Poor's for Inflated Ratings that Caused Investors to Lose Billions (Feb. 5, 2013).
The California complaint focuses on the claim that the California Public Employees Retirement System ("PERS") and California State Teachers Retirement System ("STRS") purchased securities in reliance on S&P's ratings, and alleges that S&P knowingly misrepresented its integrity, independence, and expertise in ratings of those securities purchased by these state entities. However, potential "false claims act" weaknesses in California's CFCA case abound. For instance, the complaint lists a number of assurances made by S&P to the SEC and Congress, as well as references to Nationally Recognized Statistical Rating Organization ("NRSRO") standards, but it lacks evidence of false statements fraudulently assuring the state government that its methodology met specific statutory, regulatory, or contractual requirements. Instead, the complaint states that S&P's ratings were "highly material" to purchases by PERS and STRS, that they relied on them, and that the ratings "were one of the foundations on which [the structured finance] market was built." Rather than simply alleging its reliance on the ratings, however, the State must show that S&P's ratings were knowingly and materially false. As in the federal litigation, the focus will be on whether S&P's methodology was materially flawed, on what S&P knew about it, and when it knew it.
The State must also show that the ratings caused the alleged loss. While the complaint attaches an appendix showing losses suffered by PERS and STRS on securities rated by S&P, asserts that PERS and STRS relied on these ratings, and states that defendants' conduct was "a substantial factor in causing the false claims to be presented," other contributing conduct or causes will surely be raised for consideration on the requirement of causation. In a statement issued the day the complaints were filed, S&P alluded to this factor, observing that "20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals." In the securities context, the Supreme Court has found that, in addition to a material misrepresentation or omission, scienter, a connection with the purchase or sale of a security, reliance, and economic loss, the basic elements of a private damages action under the securities laws included loss causation, which requires showing that the misrepresentation "proximately cause[d] the relevant economic loss." Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 342 (2005). This common law requirement for a private damages action under the securities laws is also relevant in this context, where the loss is based on the state's ownership of securities.
Moreover, under Allison Engine Co. v. United States ex rel. Sanders, 553 U.S. 662 (2008)—which applies to conduct prior to the enactment of the recent CFCA amendments—S&P's false statements must be made "to get" a false claim paid by the government. This requires a particular level and type of intent—namely that S&P intended the false statement to cause the State of California to pay the false claim. Here, S&P's interest in maintaining its market share may not suffice to show intent to present a false claim to state entities. See, e.g.,United States ex rel. Gudur v. Deloitte & Touche, No. 07-20414, 2008 WL 3244000 (5th Cir. Aug. 7, 2008) (ruling that evidence of a regulatory violation coupled with Deloitte's profit motive was insufficient to create a fact issue as to knowledge and intent). Finally, California's statement that, for purposes of tolling the running of the state's statute of limitations under its tolling agreement and the CFCA's three-year "knowledge" exception, it only discovered the cause of action against S&P on June 15, 2008, is suspect.
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