Objective Ratings? I Said That?


Standard & Poor’s weighed in with its initial response to the U.S. Justice Department’s lawsuit that its ratings on structured debt defrauded investors.  Its 26-page motion to dismiss the Government’s case states that S&P’s claims to objectivity, independence, integrity and unbiased ratings were corporate puffery, that its codes of conduct and other standards of conduct were merely aspirational, and that representations made to the U.S. Securities Commission and the International Organization of Securities Commissions and testimony made to the U.S. House of Representatives and U.S. Senate were general and vague and therefore should be disregarded.  S&P’s scorched earth defense reflects the importance of the case, but at what price victory?


As we noted previously, the Government’s case rests on two allegations: 1) that S&P systematically delayed updating models and criteria which would have negatively impacted S&P’s market share; and 2) that S&P rated and affirmed existing ratings on CDOs even when it knew the RMBS assets contained in the CDOs were impaired.

S&P’s motion to dismiss attempts to short circuit the allegations by claiming that no fraud occurred.  First, S&P says that none of its representations cited in the Government’s complaint are fraudulent.  Second, it argues that the CDO ratings in the second leg of the Government’s complaint were in fact S&P’s true credit opinions and that internal concern about the validity of the ratings simply reflected “a robust internal debate.”  Finally,  S&P argues that the Government fails to establish that S&P possessed an intent to defraud investors.  Let’s examine each of these arguments in more detail.

S&P’s Representations Should be Ignored

The Government’s complaint contains ten pages of various representations by S&P that its ratings were objective, independent and uninfluenced by any conflicts of interest.  S&P’s response is that the representations are vague, generalized statements that are not actionable as fraud.  Specifically, S&P offers three defenses.  First, statements such as “S&P is highly valued by investors…for its analytical independence” are corporate puffery and not a sufficient basis for allegations of fraud.  Second, S&P’s various codes of conduct, which were made public on S&P’s website and are extensively quoted in the complaint, “fail to state a claim for fraud because they are ‘couched in aspirational terms,’ not representations regarding current activity.”    Directives to employees on how to rate securities are “commands for how business should be conducted…not actionable representations of objective facts.”

Finally, all other representations, including Congressional testimony, should be ignored as general and vague.  “Although these statements describe how S&P conducted its business activities, the statements are altogether too general and vague to constitute the basis for a fraud claim.”  Here is one of the statements cited in the Government’s complaint, taken from an S&P publication “The Fundamentals of Structured Finance Ratings” published August 23, 2007.  What do you think, is it too general and vague?

[S&P] is paid by the issuers we rate…Clearly, since there is a choice of rating agencies, the potential exists for a conflict of interest.  In theory, one way to increase revenue would be for us to weaken our criteria to ensure that we are selected as the agency to rate a transaction or to ensure that a transaction would not have been economically viable can take place.  This would, of course, violate our internal rules…[W]e do not engage in such behavior.

The S&P response highlights its recent victory in the dismissal of a class action suit which was upheld in the Second Circuit Court of Appeals based on similar arguments.  However, the suit in question, Boca Raton Firefighters and Police Pension Fund v. Bahash, differed from the Government’s case in that it did not depend on the accuracy of the credit ratings themselves, but on whether McGraw-Hill maniputated its stock.  Most importantly, the statements dismissed by the courts were primarily statements taken from McGraw-Hill annual reports and earnings calls.

In contrast, the Government’s suit cites a much broader set of sources.  It draws on a Code of Practices and Procedures dated September 2004, a Code of Conduct published in October 2005 and updated in June 2007, a November 2005 Analytic Firewalls Policy, a February 2006 “Report on Implementation of S&P’s Rating Services Code of Conduct”,  its application to the SEC for NRSRO status, three separate sets of Congressional testimony, an OpEd article in the Wall Street Journal, public statements made to institutional investors at conferences and various S&P articles and publications.

CDO Ratings Were S&P’s True Opinions

The Government’s complaint argues that S&P knew that the default risk of RMBS was accelerating at an alarming rate, that this would result in RMBS downgrades and in downgrades of CDOs, but continued to rate CDOs for as long as possible to collect the high CDO ratings fees.   S&P argues that the Government’s complaint doesn’t establish that its CDO ratings were wrong or that S&P disbelieved them.  It quotes an earlier court decision that ratings are non-actionable unless those “who published credit ratings actually knew the credit ratings were false or did not believe the credit ratings were true at the time that each credit rating was issued.”

Here the argument gets circular.  The Government doesn’t rate bonds, so how does it know what the right rating was?  The CDO ratings relied on the ratings of the RMBS, and since the RMBS ratings didn’t change, S&P was not obligated to change its CDO ratings.  Even if the Government is correct that the RMBS securities should have been downgraded, the existing CDO ratings still might have been ok.   Ratings are opinions, and they were S&P’s opinions, even if wrong.  Internal dissent is immaterial: “Any internal disagreements within S&P are evidence of the robust debate that does and should take place in any large and diverse workplace — not evidence the entity was engaged in a scheme to defraud.”

It seems that the Government’s complaint presents evidence that the CDO ratings would have changed if the RMBS ratings had changed.  It contains references to S&P’s criteria manuals and excerpts from memos indicating that downgrades of RMBS would impact CDO ratings.  An example taken from a memo to the head of S&P’s structured ratings group: “If the number of downgrades taken on ‘BBB’ and ‘BB’ rated tranches of RMBS transactions increases during 2007, we expect a significant increase in negative rating activity affecting tranches issued by mezzanine SF CDOs of ABS.”

However, despite rising internal tensions documented in the complaint, S&P held off on deciding to downgrade RMBS until June 28, 2007, a decision apparently made by the head of S&P’s structured ratings group.  Since the ratings on RMBS were unchanged, there was no reason for S&P to change the ratings on its CDOs.

The gap between S&P’s position (we were doing things based on our process to the best of our ability) and the Government’s position (S&P knew it would have to downgrade RMBS and consequently CDOs but put it off as long as possible) will require the court to wade into the arcane world of credit ratings, something that courts have shown very little appetite to do, up until now.  But then again, previous litigants did not have access to the inner workings of credit ratings.

No Intent to Defraud Investors

S&P’s third argument for dismissing the Government’s case is that the Government fails to establish intent to defraud.  In a fraud case, the plaintiff has to allege a “scheme to deprive another of money or property by means of false or fraudulent pretenses, representations, or promises.”  In fact, the Government’s complaint cites evidence that S&P knew that CDO ratings fees were not actually paid by the issuers but by investors as part of the costs of the CDO transaction.  The complaint quotes from a speech given by the head of S&P’s structured ratings group to institutional investors: “…investors ultimately do pay since all deal fees including ratings fees are netted out of the total deal proceeds.”

However, S&P argues that this contradicts the main thrust of the Government’s case, namely that ratings are conflicted by the issuer-pay model: “Because this conclusory allegation is inconsistent with the rest of the Complaint, the Court is permitted to disregard it.”

Will the Government’s Case Be Dismissed?

S&P has a strong legal team and a formidable track record in defending itself against litigation.   S&P’s motion is full of citations to cases it has won in the past, and it draws on those cases as precedents for its arguments.  The tone of the document is confident, with a touch of swagger: “With much fanfare, a parade of senior officials congratulated one another for their efforts — the hundreds of subpoenas they had served, the thousands of hours their team had devoted to the case, the millions of documents they had read.  Notwithstanding all the back-slapping, the Government’s Complaint fails to state a claim.”

Yet this is different animal than S&P has faced in the past.  Not so much the fact that the suit is brought by the Government, but more that it draws on mountains of confidential, internal material that no other litigants have previously had access to.  We are not lawyers, and certainly not trial lawyers, but it seems to us that while S&P makes a vigorous defense, the Government’s case is sufficiently broad and detailed to survive S&P’s motion to dismiss.  Take that with a grain of salt.

The Government, however, is expecting that the case will not be dismissed.  Prosecutors have been contacting potential witnesses to inform them that they may be called to testify in Santa Ana, California in the summer of 2015.

A trial date of 2015 might be optimistic.  The Boca Raton Firefighters case was originally filed in August 2008, dismissed in March of 2012 and upheld on appeal in January 2013.  You can be sure that S&P’s legal team will be fighting vigorously each step along the way, drawing out the case as long as possible.  Time is ultimately on S&P’s side.  All the back-slappers who brought the case will probably be in private practice by the time the case is finally resolved.


McGraw-Hill stock has mostly recovered from its swoon after the Government’s case was filed.  From a high of $58 it fell to $42 and is now back to $52.  Shareholders are betting that S&P will ultimately prevail, or that a negative resolution will be so far in the future as to be highly discounted.

The more near-term concern is collateral damage from the Government’s suit and S&P’s scorched earth defense.  How should the SEC or IOSCO take S&P’s statements that its Codes of Conduct are merely aspirational and not objective fact?  How should legislators take S&P’s dismissal of its testimony as vague and general?  Or for that matter, how should investors take S&P’s claims to objectivity as corporate puffery?  S&P runs the risk of winning the battle while losing the war.









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