California has filed suit against Wall Street's biggest credit rating agency, Standard & Poor's, charging the firm with violating the state's False Claims Act by using "magic numbers" and "guesses" to inflate ratings that ultimately cost California public pension funds an estimated $1 billion.
The action was filed Tuesday in San Francisco Superior Court and came a day after federal prosecutors filed suit against the bond-rating agency, alleging that S&P gave top marks to troubled mortgage-backed securities that later failed, helping to trigger the financial crisis.
California will seek $4 billion in damages after S&P's ratings cost state pension funds what it estimates are about $1 billion in losses. The state can seek triple damages, along with penalties, under the False Claims Act.
"Those who lost homes in California were first-grade teachers, firefighters ... we talk about the impact of S&P's conduct, it's profound," Atty. Gen. Kamala Harris told the Times in Washington after a news conference there 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 barrage of state and federal actions signal an aggressive new push against one of the mortgage crisis' key actors. The California action is the first use of its False Claims Act by Harris to pursue a major player in the mortgage meltdown. Harris in 2011 created a mortgage fraud strike force to pursue investigations related to the housing crisis and said she would use her powers under the act to pursue securities cases.
Under the state law, which makes it a crime to defraud the state, damages of up to three times the amount of the claim can be awarded if the victim was an institutional investor, such as one of the state's pension funds. In particular, the California Public Employees' Retirement System and the California State Teachers' Retirement System invested heavily in mortgage-backed securities and other financial instruments rated by S&P during the boom years.
S&P, which is a unit of publisher McGraw Hill, on Tuesday denounced the state and federal actions.
"The `U.S. Department of Justice~ and some states have filed meritless civil lawsuits against S&P," the company said in a statement. "We will vigorously defend S&P against these unwarranted claims. S&P has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information."
The California suit alleges that investors relied on S&P to rate securities because these big investors had access to only general descriptions of the mortgages and other investments backing these securities. Institutional investors relied on S&P because they were required to purchase investments that got a "AAA" rating, meaning they were highly sound and bore little risk.
While S&P has tried in other cases to argue that it was protected under the 1st Amendment to state an opinion about certain financial products, that argument may not hold up if federal or state investigators are able to prove that the ratings agency knowingly gave improper evaluations, said Kurt Eggert, 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," Eggert said. "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 alleges that, from 2004 to 2007, S&P misrepresented to the state pension funds that its ratings were not influenced by economic interests and were based solely on objective analysis. Instead, the company lowered its standards to make money, the suit alleges, and suppressed efforts to develop more accurate models.