SEC Charges Rating Agency With Internal Controls Failures And Ratings Symbols Deficiencies
On August 28, 2018, the Securities and Exchange Commission (“SEC”) announced two settlements with a rating agency (the “Company”) over allegations that it failed to maintain adequate internal controls and to clearly define and consistently apply credit rating symbols. The SEC’s order instituting proceedings over internal control alleged that the Company failed to establish and document an effective internal control structure over models that it outsourced from an affiliate and used to rate Residential Mortgage Backed Securities (“RMBS”) from 2010 to 2013. See In the Matter of Moody’s Investors Service, Inc., Admin. Proc. No. 3-18688 (August 28, 2018). The SEC’s order instating proceedings relating to rating symbols alleged that the Company assigned ratings for 26 “combo notes” with a total notional value of approximately $2 billion in a manner that was inconsistent with other securities that use the same rating symbols. See In the Matter of Moody’s Investors Service, Inc., Admin. Proc. No. 3-18689 (August 28, 2018). The Company agreed to pay a $15 million civil penalty to settle the SEC’s claims relating to internal controls and a $1.25 million civil money penalty to settle the SEC’s claims relating to rating symbols, both without admitting or denying wrongdoing.
According to the SEC’s internal controls order, in 2010, the Company revised its methodology for rating RMBS by incorporating cashflow waterfall models that were developed by a corporate affiliate. Later in 2010, the Company established policies and procedures relating to oversight responsibility over outsource providers, including its corporate affiliate. The Company allegedly failed to apply those policies and procedures to its outsourcing relationship with its corporate affiliate and failed to establish and document reasonably designed internal controls over the waterfall models. The SEC’s order also cited to internal communications where RMBS analysts observed coding errors and said that confidence in the waterfall models was low. The SEC claimed that the Company failed to conduct, or take reasonable steps to ensure that its corporate affiliate conducted, adequate quality control processes with respect to the models, which led to the Company failing to detect and prevent errors in the models used in the credit ratings process for RMBS.
According to the SEC’s rating symbols order, the Company failed to establish, maintain, enforce and document internal policies and procedures that were reasonably designed to clearly define and consistently apply its credit rating symbols, which it was required to do pursuant to Section 938 of the Dodd-Frank Act and the SEC’s implementing rule, Rule 17g-8(b). As a result of its failure, the Company allegedly issued and maintained ratings of combo notes (a type of re-securitization of collateralized loan obligations) in a way that departed from the objectives of Rule 17g-8(b) and failed to assign ratings to combo notes in a manner that was consistent with other types of securities that used the same rating symbols. The Company revised its methodology for rating collateralized loan obligations (of which combo notes are a type) in late 2015, announcing it would “no longer assign new ratings to combination securities backed by CLO secured debt and equity tranches that have a rated balance that differs from the entire contractual promise of these securities.” Id. at 5. However, the SEC claimed that, between June 15, 2015, when Rule 17g-8(b) went into effect, and April 21, 2016, when the Company stopped rating new issues of combo notes, the Company rated approximately 26 combo notes with a total notional value of approximately $2 billion.
This is a first-of-its-kind settlement by the SEC enforcing the ratings symbols requirement. In announcing the charges, Reid Muoio, Deputy Chief of the Enforcement Division’s Complex Financial Instruments Unit, emphasized that the SEC will be pursuing these types of investigations and enforcement actions. In particular, he stated that the SEC “will continue to pursue failures that render rating symbols unclear or inconsistent.”