Credit Rating Agency Investigated for Fraud

The SEC brought an action against LACE Financial for issues with its independence. We also learned that the SEC had investigated whether rating agency Moody’s Investors Service, Inc. violated the registration provisions or the antifraud provisions of the federal securities laws.

Moody’s was working on a rating for some new European securities. They ended up giving the security an Aaa rating. They later discovered a problem with their model and found a coding error. After finding the error, a Moody’s rating committee met and discussed the problem.

They made no change to the outstanding credit rating. The SEC found smoking gun emails that showed rating committee members were concerned about the impact on Moody’s reputation if it revealed an error in the rating model.

“In this particular case we seem to face an important reputation risk issue. To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug.”

That does not sound like the company was living up to the principle of the Rating Agency Act to “improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.”

The SEC declined to bring an enforcement action “of uncertainty regarding a jurisdictional nexus to the United States in this matter.” The rating committee responsible for the credit ratings of the rated securities met in France and the United Kingdom. The rated securities were arranged by European banks and marketed in Europe.

The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions of the Securities Act of 1933 or the Exchange Act involving “conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors” or “conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act, Pub. L. No 111-203, § 929P(b)(1), (2) (2010) (to be codified at 15 U.S.C. §§ 77v(c), 78aa(b)). NRSROs should expect that the Commission, where appropriate, will pursue antifraud enforcement actions, including pursuant to such jurisdiction.

It sure sounds like the SEC is looking hard at rating agencies and their culpability for the Great Panic of 2008.