Wednesday, October 3, 2012

SEC Sues the One Rating Firm Not on Wall Street’s Take

William D. Cohan

The Securities and Exchange Commission, it seems, has finally lost its mind.

In April, motivated by what I consider pure maliciousness, the SEC initiated a “cease and desist” administrative proceeding it deemed “necessary for the protection of investors and in the public interest” against Egan-Jones Ratings Co., a privately owned, 20-person firm based in Haverford, Pennsylvania, and against its principal owner, Sean Egan.

Egan-Jones, founded in 1995, is one of nine ratings companies that the SEC has accredited as “nationally recognized,” allowing the firm to rate the debt of sovereign nations, companies and asset-backed securities, among others. Notably, it is the only one of the nine that gets paid by investors instead of by the issuers of securities.
The bigger and better-known ratings companies -- Standard & Poor’s (owned by McGraw-Hill Cos. (MHP)), Moody’s Corp. (MCO) and Fitch Ratings Ltd. -- are paid by the Wall Street banks that underwrite the debt securities of corporate issuers. That is, the companies are beholden to the sellers of the products they are supposed to pass judgment on, not the buyers. That’s akin to allowing the Hollywood studios to pay the nation’s film critics for their opinions.

Shopping Around

We all saw the result in 2007 and 2008. A major cause of the financial crisis was that S&P, Moody’s and Fitch, while being paid hundreds of millions of dollars by Wall Street, gave AAA ratings to complicated, risky securities that turned out to be anything but AAA. If a big bank didn’t like a proposed rating, it just shopped the deal until it found a firm that would provide something it liked better.
Who can forget this memorable April 2007 instant-message exchange between two S&P analysts, Rahul Dilip Shah and Shannon Mooney?
“Btw, that deal is ridiculous,” Shah wrote to Mooney about some mortgage securities they were asked to rate.
“I know, right . . . model def(initely) does not capture half the risk,” she replied.
“We should not be rating it,” he answered.
“We rate every deal,” Mooney replied. “It could be structured by cows and we would rate it.”
You would have thought that after the crisis exposed this kind of abhorrent behavior -- to say nothing of the obvious conflict of interest -- the SEC would have considered scrapping the issuer-pays model on ratings. You might have even thought the SEC would have sued S&P, Moody’s and Fitch for their reckless conduct.
Alas, such obvious steps are out of the question at an SEC headed by Mary Schapiro, who previously led the Financial Industry Regulatory Authority, Wall Street’s self-financed, self-serving watchdog organization. (When Schapiro left Finra, it gave her a $9 million bonus).
True, for a while, the SEC put on a good show of wanting to reform the ratings companies. It held round-table discussions with interested parties to discuss rectifying the horrific shortcomings of S&P, Moody’s and Fitch. Robert Khuzami, the SEC’s chief enforcement officer, suggested in an interview with Reuters a year ago that the SEC was considering a lawsuit against S&P for its role in the financial collapse. But in the end, nothing changed. The issuer-pays model is still the dominant architecture for the ratings firms.

Debt Downgrade

Now, incredibly, Egan-Jones is the sole rater that the SEC has decided to attack. The trouble for the firm started on July 16, 2011, when Egan-Jones downgraded the U.S.’s sovereign debt by one notch, to AA+ from AAA. Egan-Jones cited “the relatively high level of debt and the difficulty in significantly cutting spending.” Two days later, the SEC’s Office of Compliance Inspections and Examinations contacted the firm seeking information about its rating decision. (The next month, S&P also downgraded the U.S.’s sovereign debt, but neither Moody’s nor Fitch did.)
Then, on Oct. 12, Egan-Jones received a call from the SEC notifying the firm of a Wells Notice, an indication that it was being investigated. On April 5 of this year, Egan-Jones again downgraded the U.S. sovereign debt, to AA from AA+. On April 19, leaks started emanating from the SEC that it had voted to start an “administrative law proceeding” against the firm. And on April 24, the SEC filed its complaint.
Just what does the SEC object to so vehemently about Egan- Jones? The commission claims that on its 2008 supplemental application to be a “nationally recognized” ratings firm, Egan- Jones “falsely stated” that it had already rated the credit of 150 asset-backed securities and of 50 sovereign-debt issues. The SEC claims Egan-Jones “willfully made these misstatements and omissions to conceal the fact that it had no experience issuing ratings on ABS or government issuers.” The SEC intends to fine Egan-Jones and to possibly censure Sean Egan -- neither move would be good for business.
Egan says the SEC is making a mountain out of a molehill. He says the paperwork requirements to comply with the Credit Rating Agency Reform Act, which had been passed by Congress in 2006, was still being worked out, and that the SEC has had no problem with his firm’s annual applications since then.
His lawyer, Alan S. Futerfas, told the Wall Street Journal that the SEC knows that Egan did rate the securities in question but it is “saying he didn’t disseminate it publicly.” Futerfas continued: “It’s a very technical argument the SEC is using; it’s not substantive. There’s nothing in this complaint that suggests or alleges that any rating was without integrity or was not accurate or was not predictive.”
If he is right, that raises a question: Is the SEC retaliating against Egan and his firm for downgrading the U.S. sovereign debt?

Principled Stand

Egan told me he is determined to fight the charges because “the issuer-paid rating firms were identified as a significant source” of the worst economic catastrophe since the Great Depression, and yet the SEC’s “response has been to hobble, in any way possible, the most vocal counterbalance to those inflated ratings.”
Egan is standing on principle even though his legal fees will probably far exceed a fine if he loses. “Anybody who looks at this would realize that this is wrong,” he said. “It provides an opportunity for a spotlight on what’s been going on over the recent past, and hopefully it will change so that it’s a more even playing field.”
Don’t get your hopes up for that, Mr. Egan.
(William D. Cohan, the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)
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