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Analysis - U.S. lawsuit casts a pall over S&P

By Lauren Tara LaCapra and Karen Freifeld

(Reuters) - Lawyers for Standard and Poor's, responding to a U.S. government probe, have tried for months to show it did nothing wrong in rating exotic securities in the run-up to the financial crisis.

In one meeting, the McGraw-Hill Cos Inc unit, which owns Standard & Poor's Financial Services LLC, made a two-hour presentation in front of about 50 lawyers from the Department of Justice and the Securities and Exchange Commission, a source familiar with the matter said on Tuesday.

But the Justice Department stood firm, telling S&P lawyers that their views were "miles apart," the source said.

The government asked for a payment of "10 figures-plus" - or at least $1 billion - and for S&P to admit to wrongdoing to settle the probe, another source familiar with the situation said. The company refused, fearing a settlement would not only be prohibitively expensive but also open the floodgates for investors and others to bring suit, the source said.

The ratings agency will now face the government in court and potentially more lawsuits from private parties, including shareholders.

The Justice Department filed a civil lawsuit against S&P on Monday night. It is seeking $5 billion in civil damages, which one of the sources said came to about 385 times the $13 million in revenue it earned from the transactions at issue.

The federal government's accusations - of double-dealing, fraud and conflicts of interest - renew questions that have dogged ratings agencies since the onset of the financial crisis.

"This is a very serious challenge," said Edward Atorino, an independent analyst with The Benchmark Company. "It resurrects all the legacy concerns about ratings agencies."

At issue in the case are dozens of collateralized debt obligations backed by dicey mortgage bonds that S&P rated from 2004 to 2007. When borrowers stopped making payments on those bonds, the derivatives backing them fell apart and led to huge losses for investors, including some of the biggest U.S. banks.

In the years covered by the Justice Department's accusations, $1.41 trillion worth of CDOs were issued globally, according to the Securities Industry and Financial Markets Association. S&P rated most structured products during that time, according to Inside Mortgage Finance.

RISK OF CONTAGION

Since reports of the lawsuit surfaced on Monday, shares of McGraw-Hill have slid 23 percent, wiping away $3.7 billion in market value. In a possible sign that investors fear litigation could spill over to other rating agencies as well, shares of Moody's Corp have fallen 18.5 percent.

Armed with information from the government's 119-page complaint, some institutional investors who didn't feel they had enough information to prove fraud may now take a run at S&P, said New York attorney Daniel Brockett, a partner at Quinn Emanuel Urquhart & Sullivan LLP.

Manal Mehta, founder of Sunesis Capital in San Francisco, said the lawsuit "will end up costing rating agencies a lot of collateral damage. There's significant risk."

Experts said the government's case, filed in a Los Angeles court, is far from a sure shot.

S&P has had a successful track record in winning dismissals for similar actions by private and public parties. Of 41 such cases that have made it through court, 31 were dismissed by judges and 10 were voluntarily withdrawn. Another 30 cases are pending.

S&P said it would "vigorously defend" against the government's "unwarranted claims."

"When the full facts are revealed in court, it will be clear the emails and anecdotes being cited do not prove any wrongdoing," S&P said.

The government's case is a civil complaint filed after years of investigations. That could indicate the Justice Department has not unearthed enough evidence to meet the higher standards of proof required to bring more serious criminal charges.

Investors and other private parties looking to bring cases against S&P would also face the statute of limitations, said Joel Laitman, a partner at Cohen Milstein Sellers & Toll in New York. The statute would bar cases over securities that were bought more than five years ago, he said.

"People who bought mortgage-backed securities in 2006 are out of luck in terms of federal securities laws," he said.

KING KONG IN THE COURT

Still, the government's lawsuit could likely drag on for years and in the near term could trigger a new round of litigation against S&P.

Brockett said while statutes of limitations could limit federal cases, common law fraud claims still could be brought in certain states.

"If you can prove fraud, I think you can pierce many of their defenses," Brockett said.

Benchmark's Atorino said that while S&P's business appears to still be surging in the first quarter, with a flood of bond issuance, uncertainty surrounding the outcome of the lawsuit could be a drag on McGraw-Hill's stock for some time.

"This is huge; it's the Department of Justice," said one McGraw-Hill investor who spoke on the condition of anonymity. "It's not even 800 pounds; it's the 80,000-pound gorilla."

(Reporting by Lauren LaCapra and Karen Freifeld in New York; Editing by Paritosh Bansal and Prudence Crowther)

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