The Department of Justice recently brought charges of mail fraud, wire fraud, and financial institution fraud against Standard and Poor’s Rating Service, owned by parent company McGraw-Hill. It was filed in federal court in Los Angeles. (Read full complaint here).

The DOJ’s civil action against S&P calls for at least $1 billion in civil penalties, and the complaint alleges the rating agency defrauded investors out of as much as $5 billion. The fraud is claimed to have occurred as S&P purposely misled investors in an effort to increase the use and revenue of its ratings service. S&P’s press release denied any allegations that the company behaved in any manner other than “good-faith” when grading RMBSs and CDOs, and further questioned the legal merit of DOJ’s case.

The complaint states that DOJ is going to use the Financial Institutions Reform, Recovery, and Enforcement Act to extract civil penalties from S&P for misrepresenting material facts to investors in an effort to increase profits and market share for its rating business. FIRREA was enacted in 1989 in response to the Savings and Loan Crisis. The statute was little used before it was resurrected by prosecutors who realized the statute might be of particular value for pursuing fraud that occurred during the sub-prime mortgage crisis.  FIRREA is a particularly strong tool for prosecutors because it imposes large civil penalties (up to $1 million per offense), has a long statute of limitations period (10 years), and allows prosecutors to have much greater investigative tools than they would normally enjoy in a civil case (e.g. prosecutors can take testimony from individuals).

Perhaps most importantly, FIRREA only requires that prosecutors prove their case by a preponderance of the evidence. The statute could essentially give DOJ many powerful evidentiary tools and punitive remedies, most commonly seen in criminal cases, but would not require them to demonstrate their case to the onerous reasonable doubt standard.

Because DOJ lawsuit against a ratings agency is uncharted legal waters, much remains to be seen about the merits of the case. Berkeley Law Professor Stavros Gadinis notes that courts have required a high evidentiary burden in the context of fraud litigation in order to curb frivolous or unmeritorious claims. “In Tellabs v. Makor, which concerned 10b-5 litigation, the Supreme Court held that, in order to establish scienter (broadly speaking, intent to defraud or knowledge), courts must look at the evidence as a whole, and not at just excerpts hand-picked by the plaintiffs.” Professor Gadinis explained, “In the S&P’s case, this could mean that, if one looks at email correspondence as a whole, their employees have expressed enough support for their ratings to disprove the claim that these ratings were clearly part of a scheme to defraud.” However, because FIRREA has been rarely been utilized, there is little case law to aid in forecasting how a court might rule. Gadinis emphasized that the reasoning in Tellabs pertained to 10b-5 litigation, thus the extension of the Court’s reasoning to FIRREA “remains an open question.”