Credit rating agencies can have a significant impact on
the on the market place. The rating assigned by the agencies to securities can
impact things such as the price, interest rate and marketability. Yet the inner
workings of these agencies have traditionally been shielded from view and
little understood. Many thought that the agencies were central to the recent
market crisis. Congress confirmed that view by including extensive provisions
regarding the operations of rating agencies into Dodd-Frank.
As Dodd-Frank was signed into law, and the SEC struggled
to retool its Enforcement program, the Commission considered the results of an
enforcement investigation into one of the best know and most powerful rating
agencies, Moody's Analytics. Ultimately, the Commission chose to issue an Exchange
Act Section 21(a) Report on the matter rather than bring an enforcement action.
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange
Act of 1934: Moody's Investors Service, Inc., Exchange Act Rel. 34-62802 (Aug.
31, 2010). The matter centered on an error in the rating process discovered by
the firm in its European operations. It significantly impacted ratings and was
covered-up. There was also a claim that an application filed with the
Commission was incorrect. The Commission chose not to bring an enforcement
action, citing jurisdictional concerns but emphasizing that in the future it
might chose a different course of action.
Just weeks before the Moody's Report, the Supreme
Court handed down its decision in Morrison v. National Australia Bank Ltd., 130 S.Ct.
2869 (2010). That decision limited the reach of Exchange Act Section 10(b) to
the shores of the U.S. Weeks later the President signed Dodd-Frank into law
giving the SEC and DOJ a purported legislative fix for Morrison. While
the Report did not cite Morrison, it seems clear that the decision
influenced the Commission, although it would not impact filings made with the
Now however the Commission seems poised to follow through
on the warning in the Moody's Report. Last week the agency issued an
Order for Proceedings naming as Respondents rating agency Egan-Jones Company
and its co-founder Sean Egan. In the Matter of Egan-Jones Co., Adm.
Proc. File No. 3-14856 (April 24, 2012)(discussed here). The firm is not as
well known as the two industry giants, Moody's and S&P. Egan-Jones traces
its roots to 1995 when it was formed by Mr. Egan, who had worked in various
capacities in the industry for years, and Bruce Jones, formerly of Moody's. It
has been an NRSRO since December 2007. The firm has "developed and continues to
enjoy an impeccable record and reputation as an issuer of credit ratings . .
.The accuracy and predictive nature of Egan-Jones' ratings consistently surpass
and continue to surpass those of Moody's Investors Services, Inc. and Standard
& Poor's Financial Services LLP . .. " according to papers the firm has
furnished the Commission.
The crux of the Order is a claim by the Enforcement
Division that the representations made by the firm regarding its prior
experience with two classes of issuers in July 2008 on Form NRSRO are false and
misleading. The firm initially represented that it had 150 outstanding credit
ratings on issuers of ABA and 50 on government securities. Later it revised the
numbers down to, respectively, 14, and 9. Egan-Jones claimed to have issued
ratings on both classes since 2005. These statements are false, according to
the Order, because "at the time of its July 2008 application, EJR had not
issued - that is, made available on the Internet or through another readily
accessible means -any ABS or government issuer ratings." Later the Order does
note that Mr. Egan had "asked a member of his staff to post ABS and government
issuer ratings on its website . . ." in January 2010. These claim is bolstered
by the assertion that "EJR does not have reports, work papers, or other
contemporaneous reports showing that it had issued fourteen ABS issuer ratings
or nine government issuer ratings at the time of its 2008 Annual
Egan Jones disputes the staff's claims, arguing that it
does in fact have experience with these two classes of issuers. According to
the firm the dispute centers not on a lack of experience but standards. First,
the Firm notes in its Wells Submission that the "Commission, through its Staff,
has not issued any guidance whatsoever to define with greater clarity the words
'credit ratings,' or how an applicant or an NRSRO should count to determine the
'approximate number currently outstanding' within the meaning of Form NRSRO."
When the application was filed the firm tabulated its numbers by counting each
tranche rated, a fact Mr. Egan explained during his investigative testimony.
Later the firm revised the application and reduced the numbers by counting the
number of issuers, a methodology it believed to be more conservative. Electing
to use an alternative method in the absence of specific guidance and on a
voluntary basis is "neither incorrect nor suggestive of anything untoward . . .
" the Wells asserts.
Second, the statute does not require that the rating c
lasses be "readily accessible" as claimed by the Oder, according to the firm.
The Wells goes on to note that "The definition of whether ratings are 'readily
accessible' is also open to interpretation. Section 15E, enacted in 2006, defines
a CRA [credit rating agency] as a firm which issues ratings which are readily
accessible. Aside from internet access, 15E does not further define what
'readily accessible" means . . . We recognize that the Instructions to and Form
NRSRO requests that information. We do not see that statutory requirement in
the 2006 Act or in Section 15E."
The dispute here is significant. Egan Jones is
perhaps the most significant proceeding involving a rating agency since theMoody's
Report and the market crisis. Previously, the Division was unable to
sustain its claims in a significant market crisis administrative proceeding. In
the Matter of John P. Flannery, Adm. Proc. File No. 3-1408 (Initial
Decision Oct. 28, 2011),appeal pending.
Here the Division's allegations go to the core of the
rating process. At the same time Egan Jones is tying its carefully built
reputation to the assertion that it accurately summarized its experience in the
area, told the staff during the investigation and is now the victim of
undefined or what might be viewed as shifting requirements and perhaps
inconsistent prosecution standards which allows giants such as Moody's escape
liability as illustrated by the Section 21(a) Report while relative new comers
are prosecuted. These issues will be vetted at a hearing later this year.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.
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