Illinois Tells Standard & Poor’s to Pay the Piper | Courthouse News Service
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Illinois Tells Standard & Poor’s to Pay the Piper

CHICAGO (CN) - The Illinois attorney general claims Standard & Poor's defrauded investors by systematically misrepresenting the credit analysis of structured finance securities.

"This lawsuit seeks redress for S&P's unfair, deceptive, and illegal business practice of systematically misrepresenting that its credit analysis of structured finance securities was objective, independent and not influenced by either S&P's or its clients' financial interests. These representations were untrue," Attorney General Lisa Madigan says in the 47-page complaint in Cook County Chancery Court.

The state sued Standard & Poor's Financial Services and its corporate parent, The McGraw-Hill Cos.

A structured security is an investment strategy based on derivatives, which packages stocks, commodities, options, debt issuance and/or foreign currency, among other financial products. Based on its research, Standard & Poor (S&P) rates the risk of such investments.

"S&P represents that its analysis of structured finance securities is independent and objective and the result of the highest quality credit analytics that are available to S&P," Madigan says. "Indeed, S&P's reputation for independence, objectivity and integrity is emphasized by S&P to the users of its ratings at nearly every turn."

Citing S&P's own Code of Professional Conduct, the complaint states: "'(I)t is a central tenet of [S&P] that its ratings decision not be influenced by the fact that S&P receives fees from issuers'. ... The S&P Code also assures consumers, shareholder, investors and regulators that S&P 'endeavors to conduct the rating and surveillance processes in a manner that is transparent and credible and that also maintains the integrity and independence of such processes in order to avoid any compromise by conflicts of interest, abuse of confidential information, or other undue influences.'" (Brackets in complaint.)

However, Madigan says: "(B)y at least 2001, S&P's desire to increase revenue and market share by rating as many structured finance deals as possible led S&P to ignore the increasing risks of structured finance securities to cater to the preferences of large investment banks and other repeat issuers of structured finance securities that dominated S&P's revenue base."

The complaint continues: "Although S&P's analysis was designed to satisfy the demands of repeat issuers, S&P represented that its analysis and rating of structured finance securities was independent, objective and, as stated in its Code of Conduct, 'not ... affected by the existence of, or potential for, a business relationship between [S&P] and the issuer ... or any other party, or the non-existence of any such relationship.' This representation by S&P was false.

"Since S&P allowed its compensation structure, desire for profits and fear of losing investment bank clients to taint the integrity of its supposedly independent credit analysis, S&P misrepresented the true nature of its services by advertising itself as objective and independent." (Brackets in complaint.)

Madigan specifically targets S&P's risk assessment of residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs), the sources of the subprime mortgage crisis of 2008.


"In order to obtain market share, S&P relaxed its rating criteria so issuers of structured finance securities could achieve higher ratings with less credit enhancement," the complaint states. "S&P relaxed its criteria in a number of ways, including but not limited to: 1) using outdated models to rate RMBS and CDOs; 2) feeding bad or outdated data into its statistical modeling software; and 3) making ill-conceived assumptions about the risks involved in structured finance transactions, including underestimating the correlation risk of mortgage assets in a structured finance security."

Internal S&P emails show that employees did not make independent evaluations, but were influenced by business considerations, Madigan says: "An internal email dated May 24, 2004 encapsulates the way S&P generally approached changes to its rating methodology: 'We just lost a huge Mizuho [Bank] RMBS deal to Moody's due to a huge difference in the required credit support level ... What we found from the arranger was that our support level was at least 10 percent higher than Moody's ... the only way to compete is to have a paradigm shift in thinking.'"

In another example cited in the complaint, a senior employee responsible for performing a credit estimate on a CDO asked for loan data to run through S&P's model. He was chastised by the co-head of S&P's CDO group, who said in an email, "Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. Nevertheless we MUST produce a credit estimate. ... It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so. Please provide the credit estimates requested!"

The CDO received an AAA rating, the company's highest grade.

Madigan says: "S&P disregarded the safeguards that its internal policies were designed to ensure and the recommendation of one of its most senior managers, because it wanted to meet the demands of one of its best customers and it did not want to forego revenue that otherwise would be captured by one of its competitors." The complaint quotes a former managing director of S&P, who testified before Congress that "profits were running the show."

Madigan claims that "S&P continued to provide AAA ratings for RMBS and CDOs, despite clear evidence both internally and externally that the underlying assets were defaulting at an alarming rate."

She says, "S&P continued to issue investment grade ratings for RMBS and CDOs up until days before it began massive downgrades of these same securities."

A 662-page reportfrom the Financial Crisis Inquiry Commission to supports Madigan's allegations, calling S&P and the other two major credit-rating agencies, Moody's and Fitch, "key enablers of the financial meltdown."

The report states: "the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms."

Madigan said in a statement that "publicly, S&P took every opportunity to proclaim their analyses and ratings as independent, objective and free from its desire for revenue. Yet privately, S&P abandoned its principles and instead used every trick possible to give deals high ratings in order to retain clients and generate revenue. The mortgage-backed securities that helped our market soar - and ultimately crash - could not have been purchased by most investors without S&P's seal of approval."

Illinois seeks disgorgement of profits from S&P's unfair practices, and damages for fraud and deceptive trade.

The complaint is signed by Deborah Hagan, chief of Illinois' Consumer Protection Division.

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