California AG’s false claims case vs S&P: secret route to issuers?

By Alison Frankel
February 11, 2013

If you’ve been keeping track of the Justice Department’s civil suits against banks accused of marketing deeply flawed mortgage-backed securities and collateralized debt obligations, you know there are two laws at the heart of the feds’ cases: the Financial Institutions Reform, Recovery and Enforcement Act and the False Claims Act. (Shout-outs to my Reuters colleagues Aruna Viswanatha and Nate Raymond, who noted Justice’s creative application of these two laws long before most reporters knew FIRREA from an unfortunate stomach complaint.) The FCA, which offers the prospect of triple damages, has provided the federal government with a particularly big stick to use against banks. As of last November, federal prosecutors had already cited the FCA in more than half a dozen civil fraud suits against such mortgage lenders as BofA, Citigroup, Deutsche Bank and Flagstar, obtaining more than $1.6 billion in settlements, mostly based on alleged defrauding of a federal home insurance program.

The Justice Department, in other words, isn’t shy about asserting the FCA in mortgage cases, even when its interpretation of a “claim” stretches the classic whistle-blower definition of a government contract or request for payment under a government program. Manhattan U.S. Attorney Preet Bharara, for instance, brought claims under both the FCA and FIRREA when he sued Bank of America in November for supposedly deceiving Fannie Mae and Freddie Mac about deficient underwriting of mortgages peddled by Countrywide.

So it was notable that last week, when the Justice Department sued Standard & Poor’s for knowingly promulgating false ratings of deficient securities, it brought claims under only FIRREA, not the FCA. More than a dozen states that rode sidecar with Justice sued under state trade practices or unfair competition laws rather than under state versions of the federal False Claims Act. Only one state, California, also sued S&P for violating its state false claims law.

California’s false claims theory is that if it hadn’t been for S&P’s ratings, the state’s behemoth teachers and public employees pension funds would not have purchased mortgage-based securities that turned out to be dogs. Similar arguments about allegedly misleading ratings from all kinds of investors, including state pension funds, have mostly been squelched by the rating agencies’ First Amendment defenses. But California’s suit isn’t based on the ratings themselves, so it doesn’t matter whether they’re protected opinions. Instead, the AG’s new suit alleges that S&P knowingly provided misleading ratings to issuers for the purpose of influencing sales of high-rated securities to state pension funds.

That theory, of course, depends on a key question: Is the purchase price of a mortgage-backed note or a CDO a “claim” as defined by state and federal false claims laws? Andrew Schilling of BuckleySandler, who oversaw FCA cases against financial institutions as head of the civil division of the Manhattan U.S. Attorney’s office until 2012, told me that California’s suit marks “a novel and aggressive use of the False Claims Act,” since S&P is a step removed from the sale of the securities. His old office’s assertion of the federal FCA in the case it filed against BofA in November claims a more direct connection between the bank’s alleged conduct and the purchase of securities by Fannie Mae and Freddie Mac, but BofA defense lawyer Brendan Sullivan of Williams & Connolly has already signaled plans to argue that the False Claims Act doesn’t apply.

Whistle-blower lawyer Mark Labaton of Motley Rice said that if the AG’s case is not settled quickly, it could end up testing California’s definition of a claim under the state False Claims Act, which is modeled on the federal law but hasn’t been interpreted as widely. Just asserting the state FCA claim, which carries treble damages just like its federal counterpart, could enhance the California AG’s leverage over S&P, Labaton said.

But leverage over S&P may not be the state AG’s only motive. The unseen target of California’s suit, according to whistle-blower lawyer Eric Havian of Phillips & Cohen, could be MBS and CDO issuers.

Discovery in the state’s case against S&P, Havian said, will likely turn up evidence of what banks knew about the ratings S&P supplied. “If issuers knew the ratings were false and they sold securities to state pension funds, they would absolutely be liable,” he said. “That’s an easy FCA case.” Havian told me he wouldn’t be surprised if the AG’s strategy were to obtain discovery through the suit against S&P, see what emerges and then go after banks that were aware of S&P’s supposed ratings manipulation. “This is like the first little unraveling of a sweater,” he said. There’s still time for California to pursue issuers under the false claims act: According to Havian, the state has to bring a suit within three years of the date it knew or should have known about the false claims and within 10 years of the false claim itself. As long as the state case against S&P moves quickly, potential suits against issuers won’t be time-barred.

Michael Troncoso, who is senior counsel to the California AG, told me the state false claims law covers securities rated by S&P. “The FCA is broad enough to reach any claim for money services or property involving the state funds,” he said, adding that his office has an obligation as the enforcer of state laws to bring FCA claims when such claims apply to losses of state funds. California specifically announced a policy in 2011 of using its 25-year-old false claims law to go after mortgage fraud perpetrators.

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