But are they worried?
Dear readers,
It has all the makings of a classic courtroom drama: a powerful and wealthy, yet apparently unrepentant, defendant; a prosecutor backed by the US government; an alleged fraud; hundreds of billions of dollars on the line; European investors; and an angry public out for blood.
Sadly, the case never made it to a courtroom, and the story is only now starting to emerge.
What case is this? SEC v Moody’s. Well, it was never really going to get as far as a courtroom, but it would have been very interesting if it did. The SEC investigated Moody’s for allegedly violating the registration provisions and/or antifraud provisions of federal securities laws.
What did Moody’s do? Basically it incorrectly, and supposedly accidentally, inflated some bond ratings and then decided not to tell anyone about it because it was worried it would damage its business. As the SEC’s Report of Investigation explains, ‘a Moody’s Investor Services 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.’
Investors, had they found out about this error, would have been beyond angry. A rating 3.5 notches higher than reality can have a massive impact on the price of a bond, and thus this error may have cost investors millions of dollars.
That Moody’s knew about the mistake and deliberately decided not to tell anyone is appalling. Making a mistake is one thing, but deliberately covering it up is unacceptable and – in most people’s eyes – criminal.
Moody’s can thank the complicated legal relationship between European and US regulators for its reprieve. ‘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 explains.
I don’t imagine it will come as a great surprise that a ratings agency was engaged in less than ethical behavior. But I for one am a little shocked at the level of duplicity in this situation. And no doubt it will backfire. The bosses at Moody’s were trying to protect the company’s reputation (this is back when ratings agencies still had a good reputation), but once this news comes out it will be even worse.
The greater implication is that the SEC has officially warned all ratings agencies and Nationally Recognized Statistical Ratings Organizations (NRSROs) to behave. Under the newly imposed power of the SEC to oversee these agencies, NRSROs are required to ‘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.’
Failure to ensure accuracy will result in investigation and, where appropriate, fraud enforcement activity.
The problem is, as far as I can tell, that ratings agencies don’t seem to care. The attitude that prevailed in 2007 – in which they believed they could act with impunity – still prevails today. Moody’s certainly doesn’t seem very apologetic for this latest revelation. I fear it will take more than a mere threat to change anything. One of them is going to have to be prosecuted before there is real reform.
My suggestion would be to not pay too much attention to ratings and conduct your own due diligence. On a different note, for companies that are unhappy with their current credit rating, don't get too stressed. Investors don’t take such things as seriously as they used to.
Please send me your thoughts and comments on these or any other topics.
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Brendan Sheehan
Executive editor
Corporate Secretary
