Tag: Rating Agency Act

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.

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Credit Rating Agencies and Conflicts of Interest

Personally, I place a big chunk of blame on the Credit Rating Agencies for the Great Panic of 2008. They were throwing AAA ratings at piles of garbage. There is an inherent conflict in the rater being paid by the security issuer instead of the security purchaser. They are beholden to the customer and the customer wants a great rating for its security.

Exchange Act Rule 17g-5(c)(1) prohibits a Nationally Recognized Statistical Rating Agency from issuing or maintaining a credit rating solicited by a person that, in the most recently ended fiscal year, provided the NRSRO with net revenue equaling or exceeding 10 percent of the total net revenue of the NRSRO for the fiscal year.

“The Commission’s rules were designed to further the goals 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.” To meet these goals, it is critical that firms provide accurate information to the Commission and the public in their Form NRSROs and financial reports, that they do not have prohibited conflicts, and that they establish, maintain, and enforce policies and procedures to address conflicts of interest.”

LACE Financial submitted an application to register as an NRSRO on October 31, 2007. LACE also requested an exemption from the 10 percent rule, which the SEC granted. LACE requested the exemption because LACE’s largest client (“Firm A”) provided LACE with more than ten percent of LACE’s total revenue during fiscal year 2007. Firm A managed Collateralized Debt Obligation (“CDO”) and hired LACE to prepare regular reports that Firm A distributed to investors in these CDOs.

According to the SEC Release, in an attempt to keep the 2007 revenue from Firm A as close as possible to ten percent of its total revenues for the year, LACE postponed billing Firm A for reports completed during December 2007 until January 2008. In its exemption request letter, LACE stated that its estimated annual revenues from Firm A for 2007 would be $119,000 when calculated on a cash basis and $179,000 when calculated on an accrual basis. “The total value of work performed for Firm A by LACE during 2007 was in fact $233,268.28, approximately 28 percent of LACE’s revenues for the year when properly calculated on an accrual basis as required by GAAP.”

LACE got slapped with a civil money penalty in the amount of $20,000 and an injunction not to break the law again. They also charged Damyon Mouzon, the president of LACE, blaming him for trying to shift revenue and deliberately hide the conflict of interest.

It seems clear to me that the rating agencies were not trying to protect investors. They were trying to generate revenue. That means keeping their clients, the securities issuers happy.

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