California Fights Back Against S&P – False Claims Act Suit Against Credit Rating Giant

Kamala Harris image from wikipedia.com

One day after the United States government accused Wall Street’s biggest credit rating agency, Standard & Poor’s Financial Services LLC, of ratings inflation on mortgage-backed securities, the California Attorney General filed an additional suit claiming the credit ratings company violated the state’s False Claims Act (FCA). California joins twelve other states and the District of Columbia in following the Justice Department’s lead. California, however, is the only state to allege violations of its False Claims Act. The FCA, typically a law used by company whistleblowers, is now seeing its scope of practice stretched into new areas according to some experts.

California Attorney General Kamala Harris asserts that between the years of 2004 and 2007, S&P corrupted its own supposedly objective ratings process in order to gain favor from large banking institutions, which allegedly paid S&P billions of dollars in return. By using what Harris calls “magic numbers” and “guesses” to inflate ratings, S&P ultimately cost California public pension funds an estimated $1 billion.

The state is seeking $4 billion in damages from S&P after the ratings drained pension funds. Under the FCA, California can ask for triple damages and penalties from S&P.

“Those who lost homes in California were first-grade teachers, firefighters … we talk about the impact of S&P’s conduct, it’s profound,” Attorney General Harris said in Washington after a news conference announcing the federal and state suits. “They pretended to be an independent agency and we believe the evidence is clear it was quite the contrary.”

The California suit is the first of its kind in using the FCA to go after a violator. In 2011, Attorney General Harris created a mortgage fraud strike force with the specific mission to pursue investigations related to the recent housing crisis. She openly stated she would use every power at her disposal under the FCA to pursue securities cases.

Under the California law, the state can recover for fraud against the state’s pension funds. In particular, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System both invested massive amounts of money into mortgage-backed securities that were highly rated by S&P during better financial years.

In previous cases, S&P has asserted a First Amendment defense, arguing that they have a right to openly and freely state their opinions about financial products. However, their standard argument may not hold up against these new allegations if the federal or state investigators can prove the ratings agency knowingly gave incorrect evaluations, according to Kurt Egert, a Chapman University Law professor.

“I am not sure that defense will hold if California or the feds can prove that they knowingly did not provide effective ratings,” said Eggert. “If the feds and the states can show that the ratings agencies knowingly diverged from their system in order to make money, the 1st Amendment defense might crumble.”

The California suit specifically alleges that S&P misrepresented to state pension funds that their ratings were not influenced by economic interests, but were based solely on objective analysis. Instead, the company allegedly lowered its standards to make more money and then suppressed all efforts to develop models that were more accurate, effectively violating the False Claims Act.