Public Harmed by Rating Agencies – Are Fines Enough?

This question, attributed to the 1^st Century Roman satirist Juvenal, originally referred to enforcing marital fidelity and controlling a wife’s behavior. Over the centuries however, it has more frequently been asked by citizens in regards to those who exercise power and judgment over them.

Case in point – credit rating agencies.

Credit rating agencies, or CRAs, are similar to – but should not be confused with – the consumer credit reporting bureaus that themselves wield tremendous power over individuals. Credit rating agencies exist to report on institutions that issue debt obligations and debt services – including private and public corporations, non-profits and government entities – including entire nations. CRAs also rate securities and “debt instruments,” such as government and municipal bonds, certificates of deposit (CDs), preferred stock and other “financial instruments.” A higher rating means lower interest rates on these instruments.

80% of the credit ratings industry is controlled by two companies – Moody’s Investors Services, and Standard & Poor’s. Along with Fitch Ratings, these “Big Three” dominate 95% of the credit ratings market.

If this situation seems to you as if it would provide ample opportunity for misconduct, you’d be right.

On Wednesday, January 21, 2015, the Security and Exchange Commission (SEC) announced that Standard & Poor’s (S&P) had violated a number of federal securities laws in its fraudulent ratings of “certain commercial mortgage-backed securities.”

Commercial-backed mortgage securities (CBMS) differ from the residential mortgage-backed securities (RMBS) that were behind the near-economic collapse of 2008 – for which the institutions responsible received taxpayer-funded bailouts while millions of those same taxpayers were thrown to the wolves.

For the uninitiated, a simple explanation is in order. “Mortgage-backed securities” are basically shares of a mortgage, which are sold to individual or (more often) institutional investors. The bank that makes these loans to homeowners “bundles” several of these home loans and sells them to a larger bank, which in turn sells the bundle to an even larger bank, which then turns around and offers shares (known as tranches, literally “slices”) to investors. The investors then collect the monthly mortgage payments as dividends.

Unlike the RMBS that were responsible for the near economic-collapse of October 2008 and derived from personal home loans, CMB securities use commercial properties – office buildings, rental properties, shopping malls, manufacturing plants and such – as collateral. Although CMB securities carry far less risk than RMB securities, their complexity make it difficult for investors to monitor those risks. They rely on CMAs to provide a clear picture.

This is where Standard & Poor’s ran afoul of the law. According to Director of SEC Enforcement Andrew Ceresney, “Standard & Poor’s elevated its own financial interests above [those of] investors” when it relaxed its rating standards in order to grow its client base. In its recent press release, the SEC states that S&P told investors it was using one set of criteria for its ratings while actually using a different method, based on badly out-of-date information (in fact, the data was from the 1930s; in an article, S&P stated that its “new credit enhancement levels could withstand Great Depression-era levels of economic stress”).

Significantly, the author of that article expressed concerns that it had been turned into a “sales pitch” for S&P’s new rating criteria – and that the omission of certain details could attract unwanted attention from the SEC.

The author was correct on both counts. The reason that S&P engaged in this fraudulent behavior was because of having been “frozen out” of the ratings market by the competition. The “new criteria” was an attempt to “re-enter the market” by attracting new clients.

As a result of this misconduct, S&P – while naturally, not admitting to anything – has agreed to pay $58 million in order to settle charges by the SEC as well as a total of $19 million to the Attorneys General of New York and Massachusetts, were parallel cases have been filed.

It doesn’t end there. Recall that earlier, there was reference to the “Residential Mortgage-Backed Securities” that nearly brought down the entire U.S. economy in October of 2008. Amazingly, these are still available to investors – though nowadays, lending institutions are far more selective as to whom they approve for mortgages (it was the practice of writing “sub-prime” mortgages that ultimately led to the chain of events that culminated in the economic meltdown). Nonetheless, these RMB securities are – or should be – subject to intense scrutiny. This is where S&P once again dropped the ball. According to the SEC, S&P failed to follow its own policies, instead coming up with “ad hoc workarounds that were not fully disclosed to investors.” Again, S&P refuses to admit to any wrongdoing or failures – but has agreed to “enhance and improve its internal controls.”

All together S&P has been found in violation no less than four provisions of the federal Securities Act. The ratings agency is now suspended from rating certain CMB securities for the next twelve months.  In addition, the former head of S&P’s CMBS Group, Barbara Duka, is facing charges over her alleged role in the entire scheme. Ms. Duka is scheduled to go before an administrative law judge later this year in order to determine which allegations are true and what penalties may be applicable.

For more information regarding this topic visit Levin Papantonio Securities Litigation web page.