The Moody's Investors Services, Inc. Section 21(a) report
released on August 31, 2010 gives an indication of the potential impact of
Dodd-Frank. It is based on an existing limitation of the enforcement program,
but reflects the removal of that impediment by the legislation. Report of
Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934:
Moody's Investors Services, Inc., Exchange
Act Release No. 62802 (Aug. 31, 2010).
The Report details the cover-up of a rating error by
Moody's European operations and the Commission decision not to bring an
enforcement action because of a question regarding its jurisdiction. In the
summer of 2006, Moody's Investor Services, Inc. developed a new rating
methodology for constant proportion debt obligation notes or CPDOs. These are
special purpose vehicles that sell unfunded CDS on corporate debt indices. The
issuers use the proceeds from the notes to purchase liquid instruments which
can be sold to pay CPDO issuer obligations when specific events occur.
MIS developed a new model to rate the instruments which
resulted in a rating of Aaa. The instruments were marketed in Europe.
Subsequently, it was determined that the metric in the rating model was
inadvertently set too high. Several internal meetings were held at Moody's
Investor Services in France and the U.K. to analyze the matter. In April 2007,
the rating committee voted not to downgrade the ratings for the affected notes.
This decision was based in part on concerns regarding the reputation of MIS.
In May 2008 the Financial Times published an
article exposing the error. Following an internal investigation, the company
acknowledged it. Prior to that time however, Moody's registered with the SEC as
an NRSRO. Those papers detailed the Core Principles for the Conduct of Rating
Committees. The ratings here did not adhere to those principles.
Based on these facts, the Commission declined to bring an
enforcement action "[b]ecause of uncertainty regarding a jurisdictional nexus
to the United States in this matter . . ." While the Release did not cite any
authority on this point, clearly the Supreme Court's decision in Morrison v.
National Australia Bank Ltd., No. 08-1197 (June 24, 2010) (discussed here)
delimiting the reach of Exchange Act Section 10(b) to the U.S. had an impact.
Dodd-Frank however gives the Commission a predicate for warning rating agencies
regarding the type of conduct detailed in the Release. The new legislation
effectively overrules Morrison as to the SEC and the Department of
Justice (discussed
here): "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 . . . 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 that has a foreseeable substantial
effect within the United States.'" Citing other provisions of the reform bill,
the Commission also cautioned rating agencies that they are now required to
maintain effective systems of controls and procedures which must be followed.
For those wondering about the impact of the huge new reform bill, the Moody's
Release is a good example of its potential impact.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.