How the DOJ bought more time to go after Wall Street
FORTUNE — The use of an obscure law in the case against Standard & Poor’s gives the government a sharp tool that could impose years of litigious misery across Wall Street. The move not only gives the Justice Department more time to go after almost anyone it suspects of committing banking fraud, but it also lowers the burden of proof necessary for it to win in the courts. If the government is successful in its case against S&P, it could expand its targets beyond just the banks to other ancillary parts of the financial machine, including the accountants and attorneys that helped structure all those toxic deals.
The U.S. government this week sued S&P, the oldest and largest of the three main credit ratings agencies, for fanning the flames of the financial crisis. While the suit, which was filed in a California court, was solely directed at S&P, investors believe that it will not end with them. Indeed shares of Moody’s (MCO), the only other major publicly traded ratings agency, have tumbled 18% this week, mirroring the 21% drop in S&P’s parent company, McGraw-Hill (MHP).
Investors were clearly caught off guard by the Justice Department’s complaint. Why? Well, quite simply, so much time had passed since the government began its investigation of the ratings agencies (the SEC launched its first investigation in 2007) that it was generally believed that the government wasn’t going to bring charges against them. While it is true that the agencies had been sued by a couple of states and a few private parties, the commonly held view on the Street and in Washington was that no smoking gun had ever been found and that the government had simply moved on.
So did the government finally find its smoking gun? It doesn’t seem so. In fact, the complaint was like a blast from the past – there was very little in it that was new or interesting. Then why is the DOJ going after S&P now? Last year the government announced it had basically thrown in the towel in trying to achieve criminal prosecutions in connection with the financial crisis. Proving something beyond a reasonable doubt was apparently really hard for them. Instead, they would focus on what Attorney General Eric Holder said were “other tools available to us – such as civil sanctions – to seek justice.” What that basically meant was that the government was going to make Wall Street pay for its role in the financial crisis and that the gloves were finally coming off.
The government first established a special working group inside the Financial Fraud Enforcement Task Force that would focus solely on crimes committed in relation to the sale of residential mortgage-backed securities (RMBS). It then broke the glass and pulled out its special emergency weapon: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).
The act allows the Justice Department to bring civil proceedings against individuals or institutions who committed banking crimes against the government or a federally insured entity, e.g. a bank. Being a civil proceeding, as opposed to a criminal one, the burden of proof that the government must meet to win its case is much easier to achieve. It no longer has to prove its case beyond a reasonable doubt; it only needs prove guilt by a preponderance of the evidence, meaning that more than 50% of the evidence points to fraud. The act also gives the government more time to bring an action by doubling the statute of limitations needed to file a case from five to ten years. That’s important because many of the shenanigans that led to the mortgage meltdown occurred more than five years ago, from 2003 to 2007.
The government has avoided using this weapon in the past because it is somewhat controversial. The DOJ is supposed to use its powers to put people in handcuffs, not to slap them on the wrist and reach for their wallets – that’s the job of regulators like the SEC.
So far the DOJ has used FIRREA mostly against the mortgage units of the big banks. Last February the DOJ brought a case against CitiMortgages for falsifying compliance certifications to HUD at the height of the crisis. The bank settled the same day, agreeing to pay $158.3 million in restitution. It has since gone after Wells Fargo, which is fighting the charges. If the government continues to win these early cases, then it could possibly expand its target list to include basically any financial services institution that bought or sold RMBS in the last decade. That would include not only the banks and mortgage lenders, but would also extend to parties they directly traded with, most notably hedge funds and mutual funds.
The government is not playing around. Before it brought its civil action against S&P it reportedly offered it a deal: a $1 billion fine and an admission of guilt. S&P didn’t take it. Attorney General Holder said on Tuesday that they have enough evidence to charge S&P with $5 billion in fraud – ouch. A $1 billion fine would be nearly double the largest penalty paid so far as a result of the financial crisis. A $5 billion fine is unfathomable. FIRREA makes reaping those sorts of payouts possible.
While it might seem dumb to fight the government, if S&P admitted guilt — something the government rarely asks for in civil proceedings — would be just as devastating, as it would open the firm up to further civil law suits from other parties. That would pretty much include anyone who bought or sold RMBSs. If the $1 billion fine wouldn’t sink the ship, admitting guilt surely would.
That seems like a hefty fine given that S&P was only indirectly involved here. The company didn’t create the toxic products that caused banks to fail; it just rated their credit quality. It was essentially offering advice – bad advice, but advice nonetheless. S&P has argued in the past that ratings should be considered free speech, therefore shielding them from criminal prosecution. Some don’t see it that way.
“What S&P did was fraud – plain and simple,” Ted Kaufman, the former Senator from Delaware, tells Fortune. Kaufman was a vocal critic of the government’s slow response in bringing criminal charges against Wall Street and remains active in pushing for financial reform. “I don’t know what S&P’s motivation was when it was assigning those bogus ratings, and frankly, I don’t care. What we should be asking is: ‘what was the result of their behavior?’ Well, the result was that they nearly destroyed the financial system and created a target rich environment for fraud.”
If the government successfully pounds the rating agencies it may then start to expand its search to the Wall Street’s closest handmaidens, most notably the large law and accounting firms. Both have largely avoided the ire of the government as they focused on those who were directly responsible for the crisis, like the banks and their trading desks. But those days may be coming to an end. Like S&P, they were indirect parties to the financial crisis – they didn’t buy or sell those bad loans but many of them made them happen. Law firms wrote up the offering documents while the tax firms audited the books.
“Section 11 of the Securities Act does provide some basis for attorneys and accountants and others to be liable for fraud, typically in the issuance of securities,” Robert K. Jackson, a professor of corporate law at Columbia University Law School, told Fortune. “Accountants, for example, were famously held liable under section 11 in the WorldCom case in 2002.”
Trying a civil-case under FIERRA would be a walk in the park compared to filing a full-blown fraud case under section 11 given the lower burden of proof necessary to win. The government can subpoena anyone it wants and grill them for pretty much as long as it wants before any charges have been filed. Individuals subpoenaed by the government under FIERRA can’t even claim the Fifth Amendment to avoid the government’s grilling as self-incrimination is not applicable in civil cases.
The government seems to have finally decided to just go for the money. While Attorney General Holder says that his office will continue to pursue criminal action where it deems it necessary. It seems pretty clear, at least for now, that you won’t be seeing Lloyd Blankfein, the chief executive of Goldman Sachs, being led off dramatically in handcuffs. While it might not be as satisfying to some who are crying for blood, the huge fines that the government can now levy using FIRREA for some on the Street may end up being a far harsher punishment compared to a couple years playing tennis at Leavenworth.