S&P raises puffery defense at U.S. case’s first court test

Reassuring Investors

Cardona told the judge that S&P’s “puffing” about its ratings being independent and objective was material because the ratings were important in reassuring investors about the credit quality of the securities they bought from investment banks.

The ratings weren’t independent and objective because S&P let issuers influence its models and criteria, Cardona.

The U.S. sued New York-based S&P on Feb. 4, alleging its credit ratings for residential mortgage-backed securities and collateralized-debt obligations that included those securities, contrary to what the company told investors, were based on a desire to win business from issuers of the securities more than on the credit risk of the investments.

Longest Recession

A surge in defaults of high-risk mortgages packaged in securities that had helped fuel the U.S. housing boom until 2007 led to the country’s longest recession since 1933. S&P rated $2.8 trillion in residential mortgage-backed securities from September 2004 through October 2007 and $1.2 trillion worth of CDOs, according the government’s complaint.

In evaluating S&P’s request to dismiss the case, the judge will assume that everything the government said in its complaint is true. If the judge finds the government’s allegations lack the legally required specificity, he may give the Justice Department an opportunity to address the deficiencies in a revised complaint.

The lawsuit was brought by U.S. Attorney Andre Birotte Jr. in Los Angeles under the 1989 Financial Institutions Reform, Recovery and Enforcement Act, a law passed after the savings and loan crisis to allow the government to seek civil penalties for losses of federally insured financial institutions caused by fraud.

In its 119-page complaint, the Justice Department cited meetings, messages and memos to support its claims.

‘Ironic’ Goal

S&P argued in its April 22 filing that it’s “ironic” that the government seeks penalties for losses by the same banks, Bank of America Corp. and Citigroup Inc., that were creating and selling the CDOs.

“The complaint charges S&P with intending to defraud these financial institutions about the likely performance of their own products,” the company said.

Banks create collateralized debt obligations by bundling bonds or loans into securities of varying risk and return. They pay ratings firms for the grades, which investors may use to meet regulatory requirements.

The case is U.S. v. McGraw-Hill Cos., 13-cv-00779, U.S. District Court, Central District of California (Santa Ana).

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