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 SEC.

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 Certification.”

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.