Standard & Poor’s Resolves Three SEC Actions, Makes Admissions

Standard & Poor’s Ratings Services was named as a Respondent in three settled administrative proceedings by the SEC. Each is tied to the Rating Services’ role in the conduit/fusion Commercial Mortgage Backed Securities market after the market crisis. In resolving one action S&P admitted certain facts attached as Annex. The firm did not admit to violating the federal securities laws. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P I). S&P did not make any admissions in resolving two related proceedings. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16346 (Jan. 21, 2015)(S&P II); In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015)(S&P III). A fourth proceeding named as a Respondent Barbara Duka, a managing director of S&P, responsible for new issue ratings of Commercial Mortgage Backed Securities or CMBS. In the Matter of Barbara Duka, Adm. Proc. File No. 3-16349 (Jan. 21, 2015). This proceeding was not settled.

The actions tie to the disclosures and statements made regarding the methodology for rating conduit/fusion Commercial Mortgage Backed Securities or CF CMBS – those comprised of geographically diversified pools of at least 20 mortgage loans made to unrelated borrowers. In 2010 and 2011 fees for rating CF CMBS were paid by the issuers. S&P sometimes competed for rating assignments for these transactions. The firm would spend about two months analyzing the loans and properties after which final feedback was provide to the issuer concerning recommended ratings for levels of the capital structure proposed by the issuer. The feedback included summary data concerning the Debt Service Coverage Ration or DSCR, a key metric using in rating the transactions as well as others which reflected the stress placed on the loans.

When the issuer announced the transaction S&P would publicly disseminate Presale reports with a preliminary recommendation and the rationale. Investors would them make their investment decision.

In 2009 S&P published what was called the Criteria Article. It told market participants how key calculations were made by the firm. The Criteria Article in part contained loan constants for an “archetypical Pool” of loans called Table 1. S&P concluded that it would use Table 1 loan constants to calculate DSCR.

The next year the firm decided to use the “higher of” the actual constants or Table 1 to determine debt service payments. This methodology was incorporated into the model that was used to analyze CF CMBS transactions. Subsequently, S&P published a commentary on a CF CMBS transaction which it did not rate but in which the firm stated that it used the Table 1 loan constants to calculate DSCRs in the analysis of CF CMBS transactions. Several months later the S&P published a Presale for a CF CMBS transaction in which it stated the higher of the actual loan constants or Table 1 loan constants were used to calculate DSCRs.

In 2010, after its CF CMBS business declined, the CMBS Analytical Group of S&P decided to change the assumption embodied in its model for analyzing these transactions. Under the new method the “higher of” approach was dropped in favor of using an average of the “higher of” the actual loan constant or Table 1 and the actual loan constant. This approach generally resulted in making the transaction more attractive.

The modified approach was used in 2011 to rate six CF CMBS transactions. When investors questioned certain aspects of the ratings for some transactions, S&P’s senior management reviewed the ratings and discovered the use of blended constants. The ratings were withdrawn for two transactions. Later the other transactions were reviewed and a press release issued stating that the ratings were consistent with S&Ps rating definitions. Investors were not told about the change in methodology.

S&P had internal controls designed to ensure that the ratings assigned used approved criteria. Those controls were deficient. S&P I alleges violations of Exchange Act Section 17(a)(1), which prohibits fraudulent conduct, Section 15(E)(c)(3), regarding internal controls and certain record keeping rules.

To resolve S&P I, the firm admitted the facts in Annex A which basically outline those on which the Order is based. The firm also entered into certain undertakings which included an agreement to refrain from making preliminary or final ratings for any new issue U. S. conduit/fusion CMBS transaction for twelve moths and to adopt, implement and maintain polices and procedures and internal controls that address recommendations and issues identified in a specified letter and to submit a report on those new policies and procedures. In addition, the firm consented to the entry of a cease and desist order based on the Sections and Rules cited in the Order and to a censure. S&P will pay $6.2 million in disgorgement, prejudgment interest and a civil penalty of $35 million.

S&P II centers on the publication in 2012 of an article describing an internal study regarding CMBS Criteria. Specifically, the article depicted what it called an average commercial mortgage loan pool losses of about 20% under Great Depression levels of economic stress. The article was based on significant assumptions that were not disclosed. The firm also failed to accurately describe certain aspects of its 2012 CMBS Criteria used to determine credit ratings on 25 CF CMBS between October 2012 and 2014. The Order alleges violations of Exchange Act Section 17(a)(1) and Rule 17g-2(a)(6) which requires NRSROs to make and retain books and records which are complete and that document the established procedures and methodologies used to determine ratings. S&P resolved the proceeding by agreeing to certain undertakings and consenting to the entry of a cease and desist order based on the Section and Rule cited in the Order. In addition, the firm agreed to pay a civil penalty of $15 million.

S&P III is based on the failure of the firm to maintain and enforce internal controls regarding changes made to an assumption used in evaluating certain RMBS. S&P self reported this issue to the SEC and took voluntary steps to remediate the issue. The Order alleges violations of Exchange Act Section 15E(c)(3)(A) regarding internal controls and the related rules. The firm resolved the proceeding by consenting to certain undertakings which include developing measures to enhance its written polices and procedures and internal control structure. The firm also agreed to the entry of a cease and desist order based on the Section and Rules cited in the Order and to a censure. The firm will pay a penalty of $1 million.

The Barara Duka proceeding alleges that she was responsible for the actions of the analytical group within S&P that analyzed and assigned ratings to new issues of CMBS. It alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and certain related rules. The proceeding will be set for hearing.

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