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DOJ Lawsuit Against S&P and McGraw Hill

Philip R. Stein

Last week, the Department of Justice (DOJ) filed a civil suit in the Central District of California against Standard & Poor’s Financial Services (S&P) and its parent company McGraw-Hill. The suit alleges that S&P engaged in a scheme to defraud investors in Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations(CDOs).

As noted in the DOJ’s press release, the lawsuit alleged that investors, many of them financially insured institutions, lost billions of dollars on CDOs for which S&P issued inflated ratings that misrepresented the securities’ true risk.

The Complaint also alleges that S&P falsely represented that its ratings were objective, independent and uninfluenced by S&P’s relationships with investments banks, when actually, S&P’s desire for increased revenue and market share led it to favor the interests of these banks over investors.

The Complaint: Exhaustive and Methodical Inquiry

The Complaint is over 100 pages, and goes into great detail as to the greed and brazenness of S&P in its attempt to manipulate the market and bolster the ratings of products it knew were not worthy of the favorable ratings it was giving. It alleges that S&P knew that its investment ratings were critically important, and that many financial institutions relied on them to assess the worthiness of their investments.

Those investments were made in extraordinary volumes: from September 2004 through October 2007, S&P issued credit ratings on over $2.8 trillion worth of RMBS and nearly $1.2 trillion worth of CDOs. The Complaint asserts that S&P knew its fees for making the ratings, ranging from $150,000 to $750,000, were passed on to the investors who purchased CDO tranches. Thus, it allegedly had incentive to help generate wide pools of investors so that S&P’s fees could be paid. Unsurprisingly, McGraw Hill’s annual reports reflected significant profits in these years.

Alleged Scheme

S&P’s scheme to defraud, as alleged in the Complaint, was tied to its repeated representation that its ratings were objective and uninfluenced by any conflict of interest, when in actuality, there was a significant conflict, as S&P well understood. The Complaint exhaustively lists many policies of S&P that were in place to ensure that it was conflict free. Likewise, the Complaint catalogues the many public representations it made asserting that it was.

Nevertheless, the DOJ contends that S&P’s “desire for increased revenue and market share in the RMBS and CDO ratings markets, and its resulting desire to maintain and enhance its relationship with issues that drove its rating business improperly influenced S&P to downplay and disregard the true extent of the credit risks posed by RMBS and CDO tranches in order to favor issuers in its rating of those tranches.”

The DOJ has put together, through this pleading, what is clearly an exhaustive and methodical inquiry into S&P’s practices.

We look forward to seeing the underlying support for its allegations, and are interested to see how aggressive S&P will be in defending itself against these detailed and specific allegations.


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