Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Tuesday, August 31, 2010

SEC Cautions Rating Agencies about Deceptive Ratings Conduct and Internal Controls

The SEC today issued a report cautioning credit rating agencies about deceptive ratings conduct and the importance of sufficient internal controls over the policies, procedures, and methodologies the firms use to determine credit ratings.  The SEC's Report of Investigation stems from an Enforcement Division inquiry into whether Moody's Investors Service, Inc. (MIS) — the credit rating business segment of Moody's Corporation — violated the registration provisions or the antifraud provisions of the federal securities laws.

The Report says that because of uncertainty regarding a jurisdictional nexus between the United States and the relevant ratings conduct, the Commission declined to pursue a fraud enforcement action in this matter. The Report notes that the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act provided expressly that federal district courts have jurisdiction over SEC enforcement actions alleging violations of the antifraud provisions of the securities laws when conduct includes significant steps, or a foreseeable substantial effect, within the United States. The Report also notes that the Dodd-Frank Act amended the securities laws to require nationally recognized statistical rating organizations (NRSROs) to "establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings."

According to the Report, an MIS analyst discovered in early 2007 that a computer coding error had upwardly impacted by 1.5 to 3.5 notches the model output used to determine MIS credit ratings for certain constant proportion debt obligation notes. Nevertheless, shortly thereafter during a meeting in Europe, an MIS rating committee voted against taking responsive rating action, in part because of concerns that doing so would negatively impact MIS's business reputation.

MIS applied in June 2007 to be registered with the Commission as an NRSRO. The Report notes that the European rating committee's self-serving consideration of non-credit related factors in support of the decision to maintain the credit ratings constituted conduct that was contrary to the MIS procedures used to determine credit ratings as described in the MIS application to the SEC.

In the Report of Investigation, the Commission makes clear that credit rating agencies registered with the SEC must implement and follow appropriate internal controls and procedures governing their determination of credit ratings, and must also take reasonable steps to ensure the accuracy of statements in applications or reports submitted to the SEC.

The Report cautions NRSROs that, when appropriate, the Commission will pursue antifraud enforcement actions against deceptive ratings conduct, including actions pursuant to the Dodd-Frank Act provisions regarding conduct that physically occurs outside the United States but involves significant steps or foreseeable effects within the U.S.

Under Section 21(a) of the Securities Exchange Act of 1934, the Commission may investigate violations of the federal securities laws and at its discretion "publish information concerning any such violations."

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