The SEC is facing the latest challenge to the way it utilizes its Congressionally delegated authority. Specifically, credit rating firm Egan-Jones Rating Company and its founder and principal Sean Egan filed a complaint against the Commission claiming that it can not receive a fair hearing in the administrative proceeding instituted against the firm and its founder because the agency is bias against small rating firms as evidenced by the fact that it has ignored the directives of Congress to foster competition in the ratings business, has tried to crush it with administrative process and is impermissibly seeking to retroactively apply the penalty provisions of Dodd-Frank in the administrative proceeding. The complaint seeks the removal of the administrative proceeding to Federal Court. Egan-Jones Rating Company v. U.S. Securities and Exchange Commission, Case No. 1:12-cv-00920 (D.D.C. Filed June 6, 20120).

Egan-Jones is a small, independent rating agency. The firm’s fees are paid by its subscribers. This contrasts with large Wall Street rating firms who are paid by the issuer whose securities it is rating, an inherent conflict of interest Congress sought to regulate in the Dodd-Frank Act. The small rating firm has consistently performed at a high level, according to the complaint, predicting key events which lead to the corporate scandals at the beginning of the century and the current market crisis before the giants of Wall Street. This record has won the firm accolades from the public and in academic studies.

Nevertheless, the SEC brought an administrative proceeding against the firm in April 2012 predicated on claims that in filing an application to rate two additional lines of securities the firm falsified its experience. There is no claim in the Order for Proceedings that the firm’s ratings were deficient. The Order seeks, among other things, to impose a civil penalty on the Respondents under the provisions of Dodd-Frank which became effective in 2010 despite the fact that the conduct occurred years before the passage of the statute.

The Order instituting the administrative proceeding is the product of a defective, bias and tainted process, according to the complaint. It emanates from a history of inaction by the SEC against the Wall Street rating agencies despite repeated failures. It is the product of repeated failure by the agency to adhere to the direction of Congress to enhance and encourage competition in the ratings industry by encouraging independent firms which would undercut the monopoly of the Wall Street issuer paid rating giants. It follows a crushing regulatory process imposed on the small firm which cost it significant portions of its revenue that began shortly after the Egan-Jones filed its application with the SEC in July 2008 regarding ratings on two additional securities:

  • November 2008 OCIE gives notice of an exam and requests information;
  • May 2009 OCIE requests more information;
  • June 2009 OCIE is on-site for an exam;
  • July 2009 OCIE requests additional information;
  • August 2009 OCIE threatens an enforcement action for inadequate documentation and e-mail retention;
  • February 2010 Enforcement opens an informal inquiry;
  • From March to May 2010 the firm receives four requests for additional information;
  • July 2010 a Formal Order of Investigation is issued;
  • August 2010 OCIE gives notice of another exam;
  • August 2010 Enforcement issues subpoenas;
  • October 2010 Trading and Markets notifies the firm of an exam;
  • January 2011 OCIE conducted an on-site exam;
  • July 2011 the firm downgrades U.S. debt and receives a demand for documentation regarding the decision from OCIE;
  • October 2011 Enforcement makes a Wells call;
  • November 2011 OCIE questions the basis for downgrading Jefferies credit rating;
  • February 2012 OCIE requests additional information;
  • March 2012 OCIE conducts an on-site exam; OCIE staff are moving between the enforcement investigation and the exam functions prior to an amendment of the Formal Order permitting the OCIE staff to participate in the enforcement inquiry;
  • July 2012 the firm again downgrades U.S. debt; OCIE calls again and asks for the basis; and
  • April 2012 there are numerous news stories about non-public Commission deliberations regarding a possible enforcement action being brought against the rating firm before the Order is issued.

Under these circumstances the firm and its founder assert, they can not receive a fair hearing in the administrative proceeding initiated by the Commission. Therefore the complaint seeks: 1) an order that the Dodd-Frank penalty provisions cannot be applied retroactively; 2) a declaration that the delegation of authority to issue formal orders of investigation to the staff is improper; 3) an injunction prohibiting those members of OCIE who serves as officers in the enforcement investigation from participating in future inspections; 4) an injunction halting the administrative proceedings; and 5) an order removing the administrative proceeding to Federal District Court.

Litigants rarely succeed in suits such as this. While the events which form the backdrop of the Egan-Jones complaint were unfolding however, Rajit Gupta brought a similar action against the Commission after being named as a respondent in an administrative proceeding alleging which requested civil penalties based on insider trading allegations. The Commission dropped that proceeding after the District Court let the case proceed past the motion to dismiss stage. Mr. Gupta is, however, currently on trial on criminal insider trading charges. Egan-Jones and its founder have clearly assumed a difficult burden.

Program: Webcast by Thomas O. Gorman: How Corporate Officials Can Get A Good Night’s Sleep Despite Current SEC Enforcement Trends, presented by Celesq and West Legal Ed, June 14, 2012 from 12 -1:00 p.m. EST. For further information please click here.

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