Wednesday, April 24, 2013

The Defense of Puffery at the Expense of Reputation: S&P

The Defense of Puffery at the Expense of Reputation: S&P

Standard & Poor’s is asking a judge to dismiss a lawsuit filed by the Justice Department because the alleged misconduct wasn’t fraud, but rather normal business “puffery.”  S&P also claims that a series of emails cited in the complaint might be embarrassing, but don’t demonstrate the requisite intent for fraud. 

We’ve already seen embarrassing emails figure in many pieces of litigation, including alleged overbilling by lawyers, disingenuous Wall Street Research reports, and cynical comments from investment bankers.  Regulators and plaintiffs claim that these emails are evidence of bad intent.  Meanwhile, defendants always dismiss these missives as the writings of disgruntled or immature employees.  In the case of S&P, the emails seem to confirm other evidence brought out in Congressional hearings and inquiries.  Clearly, S&P was under enormous pressure to provide Wall Street with favorable evaluations of mortgage-backed securities.  Moreover, it is hard to dispute that S&P and the other rating agencies were, and still are, managing an enormous conflict of interest, because issuers of the mortgaged backed securities pay S&P to rate their securities.
Subsidiary Needs (1999)
I’m less interested in the evidentiary debate about emails.  Rather, I’m fascinated by S&P’s assertion that any statements they made about the integrity or objectivity of their ratings were mere “puffery.”   The Justice Department claims that S&P committed fraud when they violated the basic principles espoused on the company’s website, in its marketing materials, and in its internal code of ethics.  For example, the Justice Department complaint alleges that S&P committed fraud because it violated the following statement in one its official documents:

“We are intensely aware that our franchise rests on our reputation for independence and integrity.  Therefore, giving into ‘market capture’ would reduce the very value of the rating, and is not in the interest of the rating agency.”[1]

The defense is basically saying that these claims are mere marketing hyperbole, or “puffery.”  They aren’t to be taken as inviolable statements that, if violated, might constitute fraud.   From what I can tell, the defense may have a valid legal defense.  Most of the representations are, in deed, the kinds of assertions you see in marketing materials, advertising copy, and annual reports.

While the defense’s assertion may help to solve S&P’s legal problems with the US Government, it is an enormous reputational indictment for a business entirely dependent on the integrity of its ratings. Unlike almost any other product or service, S&P’s product – ratings -- is worthless if investors can’t rely on the impartiality and honesty of S&P’s assertions. 

Few would disagree that the credit markets need an objective and truthful evaluator of debt instruments.  The legal system is the place to hold executives or companies responsible for their actions during the credit bubble.  However, it is ill-equipped to address the inherent conflict of interest built into S&P, Moody’s, and Fitch's business model.  Once again, we’re left with regulators and Congressmen who rail against the improper practices of the rating agencies and then do nothing to foster reform.

[1] United States v. McGraw Hill, Inc. and Standard & Poor’s Financial Services, LLC,  Case No. CV 13-00779, Complaint, page 35.

CORRECTION: An earlier version of this post referred to Duff & Phelps  in the last paragraph.  They are no longer in the ratings business, having sold their interest to Fitch.

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