In early 2007, as signs of distress began appearing in securities backed by residential mortgages, executives at Standard & Poor's began advising analysts responsible for rating mortgage bonds that they should put the phrase "privileged and confidential" on emails to one another.
Analysts working for the McGraw Hill Cos division also were discouraged from doodling on notepads and official documents during meetings to discuss pending deals and existing ratings, several former S&P employees said.
That was not the first time S&P had tried to caution employees about paper trails. In 2005, a full two years before the housing market began to melt down, several top S&P managers attended an off-site meeting at hotel in Old Saybrook, Connecticut, to discuss ways to increase the fees it collected from Wall Street banks for rating mortgage bonds. A former S&P executive said that after the meeting, employees were instructed to discard any notes they had taken from the meeting.
As it turns out, S&P employees didn't fully heed such warnings. The U.S. government's civil fraud lawsuit against S&P relies heavily on emails in which employees voiced doubts about the integrity of the agency's ratings.
But S&P may still come out on top. Legal and business experts, and even some critics of the role of the rating agencies in vouching for bonds during the financial crisis, aren't impressed with the prosecution's handiwork. Most legal experts interviewed said they expect S&P to prevail at trial, if there isn't a settlement before then for considerably less than the $5 billion the government is seeking in the lawsuit.
While a few lawyers said the government's case is a strong one, a dozen securities lawyers interviewed by Reuters saw significant weaknesses in the fraud claim.
The lawsuit suffers from many of the same problems that have plagued dozens of other unsuccessful cases against the rating agencies in recent years.
It will be hard for prosecutors to argue that S&P alone was privy to a unique window into the shaky state of the U.S. housing market in early 2007, which the Wall Street banks churning out the securities, or even the U.S. Federal Reserve, didn't have. Other lawyers point out that S&P's ratings on residential mortgage bonds in early 2007 weren't much different from those of Moody's Investors Service, a rival rating agency the government hasn't sued.
"It is a crappy case. It's a hammer to get a settlement and all of the settlements we have seen so far have been a mere slap on the wrist," said Janet Tavakoli, a derivatives and structured finance consultant who has written a number of books about complex securities. She said the case "re-enforces the narrative that bank officers have put forward, which is they couldn't have known about how bad the subprime crisis would be."
A spokesman for the Department of Justice did not respond to requests for comment to discuss the lawsuit, which does not name any individuals as defendants. U.S. Attorney General Eric Holder said in statement announcing the lawsuit's filing, "this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis."
Legal experts said the U.S. government's case appears to suffer specifically from a lack of available witnesses to make a compelling argument that S&P intentionally defrauded banks and two federal credit unions by slapping investment grade ratings on dozens of mortgage bond deals that quickly went bust.
They also anticipate S&P arguing that the two credit unions cast as victims by prosecutors were sophisticated investors who were criticized by a federal government overseer for failing to appreciate the risk of buying bonds backed mostly by subprime mortgages. A similar argument could be raised against Citigroup Inc and Bank of America Corp, which prosecutors argue lost money because of mortgage bond deals that S&P rated for those institutions.
One defense S&P can raise is to say that its ratings were based in large part on information about mortgage loan data provided by the Wall Street banks backing these bonds, said Joseph Mason, a business professor at Louisiana State University.
"The banks signed off that this was good data," Mason said, citing a number of lawsuits that say just that.
To be fair, the 119-page civil complaint filed by the Justice Department on Feb. 4 cites emails that appear to show that some analysts charged with monitoring the performance of mortgage securities were seeing evidence of a rapidly deteriorating housing market.
The complaint also provides detail about the desire of S&P officials to continue rating mortgage bond deals, especially CDOs, which had emerged as one of the rating agency's most lucrative products ever.
The government contends S&P compromised its work to chase after the rich fees for rating these deals - up to $150,000 for every subprime mortgage bond and $500,000 for the typical CDO, a security cobbled together from a wide array of mortgage bonds.
"I've been litigating financing and bank related financing cases for years, and this seems like one of the strongest," said Richard Greenfield of Greenfield & Goodman, who was part of a suit against Moody's with a settlement last year that included governance reforms and a $4.95 million payment by the credit rating agency.
S&P has said "hindsight is no basis to take legal action against the good-faith opinions of professionals." The firm, which has until next month to file its first formal response to the lawsuit, said it intends to fight the government's claim.
Problem of Finding Witnesses
A federal prosecutor who is not involved with the S&P case but has been party to a number of securities fraud prosecutions said cases that rest mainly on emails are "just not successful."
The best way for U.S. prosecutors to use emails effectively is to bring forward witnesses who can explain how they reflected a deliberate intent to deceive the investing public.
But many of the emails were written by current S&P employees, who legal experts say will have a strong incentive to provide the most innocent explanation for their communications if asked to testify.
A Reuters review of the complaint found that at least a quarter of the 40 or so people referred to in the Justice Department complaint are still employed by S&P.
For instance, there is Shannon Mooney, still an analyst in S&P's structured finance division. The author of one of the more colorful instant messages cited in the complaint, Mooney wrote in 2007 the agency would rate deals "structured by cows."
S&P has said messages such as these are examples of prosecutors cherry-picking unflattering comments. The agency said Mooney's comment wasn't even discussing the rating of residential mortgage-backed securities or CDOs.
Mooney declined to comment.
Another current S&P employee who would appear to be a potentially strong witness for the prosecution is Ernestine Warner, who in 2007 was the head of residential mortgage bond surveillance for S&P and frequently voiced concern about the faltering housing market and its impact on mortgage bonds the agency had rated.
Identified in the lawsuit as Executive F, she wrote in an email to a colleague in 2007: "Wow, these deals are in huge trouble." In another email, she complained that S&P's bond surveillance was "really falling behind."
But former colleagues said Warner, now a senior director in S&P's investor relations division, is reluctant to testify. She declined to comment.
Some potentially favorable witnesses to the prosecution's side appear out of reach. Several former employees who were critical of S&P's procedures during the waning days of the housing boom told Reuters they have no desire to testify.
The government also may be hard-pressed to force witnesses to appear in court in California where the case was filed. In a civil case, federal prosecutors can only subpoena witnesses to give depositions, but they cannot compel them to testify at trial, as can be done in a criminal matter.
S&P is headquartered in New York.
The Justice Department is using the Federal Institutions Reform, Recovery and Enforcement Act, a tough civil fraud law passed in the wake of the savings and loan crisis of the late 1980s, to pursue its fraud claim against S&P.
The main advantage of FIRREA is its longer, 10-year statute of limitation, which allows authorities to pursue lawsuits that might normally be barred by the typical five-year statute of limitations for fraud cases, and the ability to go for larger than normal damages.
But some experts said there are problems with using FIRREA.
They said the act requires the government to identify federally insured institutions that were affected by S&P's actions: in this case two credit unions in California and Florida that lost hundreds of millions of dollars on complex mortgage investments, as well as Citigroup and Bank of America.
Critics say those credit unions, Western Financial Corporate Credit Union of California (WesCorp) and Eastern Financial Florida Credit Union (EFFCU), which both collapsed in 2009, are hardly blameless themselves.
The federal officials who examined the demise of WesCorp and EFFCU pointed the finger at a different culprit: the management teams at both institutions. WesCorp's supervisor sued five former top executives in 2010 for their role in aggressively expanding investments into risky mortgage products.
"The government has to show that the alleged misconduct was a proximate cause of the loss," said Douglas Baruch, a litigation partner at Fried Frank. "If they can't establish that connection, there are no damages."