THE IMPACT OF DODD-FRANK – AND A WARNING TO RATING AGENCIES
The Moody’s Investors Services, Inc. Section 21(a) report released on August 31, 2010 gives an indication of the potential impact of Dodd-Frank. It is based on an existing limitation of the enforcement program, but reflects the removal of that impediment by the legislation. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Moody’s Investors Services, Inc., Exchange Act Release No. 62802 (Aug. 31, 2010).
The Report details the cover-up of a rating error by Moody’s European operations and the Commission decision not to bring an enforcement action because of a question regarding its jurisdiction. In the summer of 2006, Moody’s Investor Services, Inc. developed a new rating methodology for constant proportion debt obligation notes or CPDOs. These are special purpose vehicles that sell unfunded CDS on corporate debt indices. The issuers use the proceeds from the notes to purchase liquid instruments which can be sold to pay CPDO issuer obligations when specific events occur.
MIS developed a new model to rate the instruments which resulted in a rating of Aaa. The instruments were marketed in Europe. Subsequently, it was determined that the metric in the rating model was inadvertently set too high. Several internal meetings were held at Moody’s Investor Services in France and the U.K. to analyze the matter. In April 2007, the rating committee voted not to downgrade the ratings for the affected notes. This decision was based in part on concerns regarding the reputation of MIS.
In May 2008 the Financial Times published an article exposing the error. Following an internal investigation, the company acknowledged it. Prior to that time however, Moody’s registered with the SEC as an NRSRO. Those papers detailed the Core Principles for the Conduct of Rating Committees. The ratings here did not adhere to those principles.
Based on these facts, the Commission declined to bring an enforcement action “[b]ecause of uncertainty regarding a jurisdictional nexus to the United States in this matter . . .” While the Release did not cite any authority on this point, clearly the Supreme Court’s decision in Morrison v. National Australia Bank Ltd., No. 08-1197 (June 24, 2010) (discussed here) delimiting the reach of Exchange Act Section 10(b) to the U.S. had an impact. Dodd-Frank however gives the Commission a predicate for warning rating agencies regarding the type of conduct detailed in the Release. The new legislation effectively overrules Morrison as to the SEC and the Department of Justice (discussed here): “The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions . . . involving ‘conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States that has a foreseeable substantial effect within the United States.’” Citing other provisions of the reform bill, the Commission also cautioned rating agencies that they are now required to maintain effective systems of controls and procedures which must be followed. For those wondering about the impact of the huge new reform bill, the Moody’s Release is a good example of its potential impact.
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