For more than two years, a team of federal prosecutors had their eyes trained on the largest credit rating agency in the world: Standard & Poor’s Financial Services LLC.

The U.S. Justice Department dedicated nearly two dozen attorneys in Washington and Los Angeles to the fraud investigation, reviewing millions of pages of documents, serving hundreds of subpoenas and interviewing more than 150 witnesses. The internal DOJ code name: "Alchemy," a nod to a medieval practice that included trying to turn common metals into those more noble.

But that moniker wasn’t the only throwback. When it came time to bring charges against S&P over allegations that the company duped investors with "gold" ratings of "lead" securities, DOJ lawyers turned to a rarely used provision of a law enacted in 1989 in the aftermath of the savings and loan crisis.

The Financial Institutions Reform, Recovery and Enforcement Act will get a new life in one of the highest-profile cases to come out of the financial meltdown of 2008. The federal government is seeking more than $5 billion in damages from S&P and its parent, The McGraw-Hill Cos. Inc., in a suit that alleges the company inflated mortgage-bond ratings and misrepresented the true risks of certain securities. Up until now, credit-rating agencies appeared impregnable.

"It’s sort of like buying sausage from your favorite butcher, and he assures you the sausage was made fresh that morning and is safe," Tony West, the DOJ acting associate attorney general, told reporters on February 5. "What he doesn’t tell you is that it was made with meat he knows is rotten and plans to throw out later that night."

Sixteen states, including Connecticut, Delaware and California, in addition to the District of Columbia, are pursuing civil actions against S&P. Kamala Harris, the California attorney general, said in a statement that "when the housing bubble burst, S&P’s house of cards collapsed and California paid the price — in billions."

Cahill Gordon & Reindel litigation partner Floyd Abrams, a lead attorney for the rating agency, didn’t return messages seeking comment. S&P said in a statement after DOJ announced the suit that "claims that we deliberately kept ratings high when we knew they should be lower are simply not true." The company said DOJ "cherry-picked" emails that "are contradicted by other evidence and do not reflect our culture, integrity or how we do business."

The financial institutions reform law gives prosecutors broader reach than traditional securities law statutes and the ability to seek civil damages — on behalf of federally insured financial institutions — for alleged criminal acts, including mail, wire and bank fraud, all of which are alleged in the complaint against S&P. The provisions come with a lower burden than reasonable doubt: preponderance of the evidence.

Jeffrey Manns, who teaches banking and securities law at George Washington University Law School, said the statute’s "broad-based language hasn’t been tested in the courts in any substantial way." That ambiguity, Manns said, potentially gives the government "substantial leverage in dusting off this old provision."


Between 2004 and 2007, S&P, DOJ officials said, issued ratings on trillions of dollars’ worth of financial products — including residential mortgage-backed securities and collateralized debt obligations. Central to the complaint against S&P, filed in U.S. District Court for the Central District of California, is the contention that the credit-rating agency promised its ratings would be "objective and independent," DOJ said.

"But the evidence we have uncovered tells a different story," West said last week at a news conference at Main Justice, where top DOJ officials and state attorneys general teamed up to announce the case. The suit alleges S&P "knowingly disregarded the true extent of the credit risks" even as analysts knew those risks for mortgage-backed securities were increasing.

The burden for the government in the case, the first federal enforcement action against a rating agency following the financial crisis, is proving that S&P acted knowingly to deceive investors. S&P said in its statement that the ratings were based on "subprime mortgage data available to the rest of the market" — including the U.S. government. The company added that "20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals."

The First Amendment can protect rating agencies in limited circumstances, Cahill’s Abrams told a House of Represent­atives committee in testimony in 2009. That defense, however, isn’t expected in the federal action DOJ brought.

"I don’t have any magic First Amend­ment wand in my pocket," Abrams said in an interview with Bloomberg News last week. "The government is alleging that S&P didn’t believe what it said; the First Amendment doesn’t protect against that."

Abrams denied there was any intent to defraud. "People at S&P cared a lot and fought a lot with each other and tried their best to come out with the right answers about what would happen in the future," he said. "That is no basis for bringing a lawsuit."

One central issue in the case, for prosecutors, centers on showing that S&P’s alleged rating fraud "affected" federally insured financial institutions. The law doesn’t define the term, however.

"As cases are litigated, the courts will define more clearly the reach and limits of the statute in response to the government’s expansive application of the law," BuckleySandler partner Andrew Schilling, who leads the New York office’s government-enforcement practice, wrote in an article last year in Bloomberg BNA’s Banking Report.

Several lawyers who practice in securities law said they expect S&P to settle the allegations rather than risk sinking considerable resources into a trial. Last week, Attorney General Eric Holder Jr., asked about the possibility of a settlement, said the government is "always open to conversations."

"There are obviously going to be questions of proof," Holder said. "But we would not have brought this case unless we felt we had a case that we could bring and that we would win, and that’s what I expect to have happen."

Zachary Rosenbaum, who leads the capital-markets litigation group at Low­enstein Sandler, said one potentially divisive point in any deal between S&P and the government is whether the rating agency is required to admit guilt. "They may be under pressure, political pressure, both S&P and DOJ, to require an admission of wrongdoing," Rosenbaum said. "I would not be surprised if that’s a heavily negotiated issue, and one that would be difficult for DOJ to back off from."

Ronald Rubin, a Hunton & Williams securities partner in Washington and a former enforcement attorney with the U.S. Securities and Exchange Commis­sion, noted that prosecutors have not had much success in assigning blame for the financial crisis. "The public really wants to hear a financial company admit they were wrong," he said.

Mike Scarcella can be contacted at