SECURITIES AND EXCHANGE COMMISSION
SECURITIES EXCHANGE ACT OF 1934
Release No. 62802 / August 31, 2010
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Moody's Investors Service, Inc.
The Division of Enforcement has investigated whether Moody's Investors Service, Inc. ("MIS"), the credit rating business segment of Moody's Corporation ("Moody's"), violated the nationally recognized statistical rating organization ("NRSRO") registration provisions or the antifraud provisions of the federal securities laws.
In early 2007, an MIS rating committee meeting in Europe determined not to take rating action with respect to credit ratings that MIS previously had issued for certain constant proportion debt obligation ("CPDO") notes. Those ratings had been determined based in part on output from a model that contained an inadvertent coding error, the impact of which was 1.5 to 3.5 notches upward. The European rating committee refrained from taking responsive rating action in part because of concerns that doing so would negatively impact MIS's business reputation. In June 2007, MIS applied to be registered with the Commission as an NRSRO, pursuant to Section 15E(a)(1) of the Securities Exchange Act of 1934 ("Exchange Act") and Exchange Act Rule 17g-1(a). Accordingly, MIS furnished an NRSRO registration application that contained requisite information concerning the procedures and methodologies it used to determine credit ratings. The European rating committee's self-serving consideration of non-credit related factors in support of the decision to maintain the credit ratings constituted conduct that was contrary to MIS's procedures and policies used to determine credit ratings, described in the MIS application.
The Commission deems it appropriate and in the public interest to issue this Report of Investigation ("Report") pursuant to Section 21(a) of the Exchange Act.1 This Report cautions NRSROs that deceptive conduct in connection with the issuance of credit ratings may violate the antifraud provisions of the federal securities laws. Further, recent legislative provisions expressly provide that federal district courts have jurisdiction over Commission enforcement actions alleging antifraud violations when conduct includes significant steps within the United States or has a foreseeable substantial effect within the United States. The Report also cautions NRSROs that they should take reasonable steps to assure themselves that statements made in their applications and reports submitted to the Commission are accurate and complete and that they are required to establish, maintain, and enforce effective internal controls over their procedures and methodologies for determining credit ratings.
A. Coding Error
In the summer of 2006, MIS began developing a methodology for rating notes issued by a newly created CPDO. CPDO issuers are special purpose vehicles that sell unfunded credit default swaps on corporate debt indices such as the iTraxx index in Europe and the CDX index in the United States. CPDO issuers use the proceeds of notes they sell to investors to purchase highly liquid instruments which, upon the occurrence of a contractually defined credit event, can be sold to pay the CPDO issuers' obligations under the unfunded credit default swaps. The indices referenced by the credit default swaps typically are re-balanced every six months to remove any issuers that have been downgraded below investment grade and replace them with investment grade issuers. Consequently, the unfunded credit default swaps typically are closed out and new transactions are entered into (i.e., the portfolio of credit default swaps is "rolled over") when the indices are rebalanced. When the unfunded credit default swaps are rolled over, the difference in the spread from the last roll over is multiplied by the amount of the CPDO issuer's leverage and is either a gain or a loss for the note holders. The structure relevant here was designed to pay a high fixed return over a ten-year lifespan, paying out a two percentage point spread above London Interbank Offered Rate or the purported risk-free rate.
Because CPDO notes were new instruments, MIS had no existing model for use in rating them. MIS created a model and in September 2006 gave the notes issued by the newly created CPDO issuer an Aaa credit rating. By the end of 2006, MIS had issued credit ratings for notes issued by an additional eleven CPDO issuers. The notes of all twelve CPDO issuers were marketed in Europe.
In January 2007, an MIS analyst in New York, assisting on a CPDO deal with a United States investment bank, was asked to determine why the MIS CPDO model was not generating the same output as the investment bank's model. Upon examination, the analyst discovered a coding error in the MIS model. The coding error upwardly impacted by 1.5 to 3.5 notches the model output used to determine MIS credit ratings for notes issued by eleven CPDO issuers. (The twelfth CPDO issuer was structured in such a way that the coding error did not affect the credit rating of its notes.) The CPDO notes with affected credit ratings had a combined notional value of just under $1 billion.
B. Rating Committee Conduct
MIS subsequently held several internal rating committee meetings in France and the United Kingdom to address the coding error. MIS corrected the coding error on February 12, 2007, but made no changes to the outstanding credit ratings for CPDO notes at that time. Internal e-mails show that committee members were concerned about the impact on MIS's reputation if it revealed an error in the rating model. A January 24, 2007, e-mail from a rating committee member to the Team Managing Director chairing the committee stated:
In this particular case we seem to face an important reputation risk issue. To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug.
On April 27, 2007, after additional analysis, the rating committee voted not to downgrade the affected credit ratings for the CPDO notes. The committee members felt that because the CPDO notes were generally performing well there would be no ostensible justification for downgrading the credit ratings, absent announcing the coding error. In declining to downgrade the credit ratings, the committee considered the following inappropriate non-credit related factors: (i) that downgrades could negatively affect Moody's reputation in light of ongoing negative media focus in Europe on Moody's Joint Default Analysis; (ii) that downgrades could impact investors who relied on the original ratings; and (iii) the desire not to validate the criticisms of Moody's ratings of CPDOs that had been made by a competitor and covered in the local media. The committee was comprised of senior level staff, including two Team Managing Directors, two Vice President-Senior Credit Officers, and a Vice President-Senior Analyst.
C. MIS Application
On September 29, 2006, the Credit Rating Agency Reform Act of 2006 was enacted. That Act, in relevant part, created Section 15E and amended Section 17 of the Exchange Act. Pursuant to Section 15E(a)(1), a credit rating agency that elects to be treated as an NRSRO "shall furnish to the Commission an application for registration . . . containing . . . the procedures and methodologies that the applicant uses in determining credit ratings." Exchange Act Rule l7g 1(a) requires an applicant to "furnish the Commission with an initial application on Form NRSRO . . . that follows all applicable instructions for the Form." Form NRSRO instructs an applicant to include an Exhibit 2, which must be "[a] description of the procedures and methodologies used in determining credit ratings."
Accordingly, Exhibit 2 to the MIS application provided the procedures and methodologies used by MIS to determine credit ratings and, among other things, stated therein that the "Relevant Credit Rating Process Policies" included the MIS "Core Principles for the Conduct of Rating Committees." The actions of the rating committee that evaluated the affected credit ratings for the CPDO notes did not comply with these Core Principles. Most notably, the Core Principles stated that "Moody's will not forbear or refrain from taking a rating action based on the potential effect (economic, political or otherwise) of the action on Moody's, an issuer, an investor, or any other market participant." The Core Principles also stated that "[i]n arriving at a Credit Rating, the [rating committee] will only consider analytical factors relevant to the rating opinion." Because the committee allowed concerns regarding the potential reputational impact on Moody's to influence decisions not to downgrade the affected CPDOs, the process did not comply with the procedures listed in the MIS application.
When MIS submitted its NRSRO application, the MIS Executive Vice President, Global Regulatory Affairs & Compliance certified the application, representing that "the information and statements in [the] Form . . . are accurate in all significant respects." At the time, the Executive Vice President was not aware of the European rating committee conduct that was contrary to the credit rating procedures listed in the MIS application.
On September 24, 2007, the Commission issued an Order granting registration of MIS as an NRSRO. Shortly thereafter, MIS made its Form NRSRO publicly available on its Web site.
D. Subsequent Actions
In January 2008, the European rating committee finally voted to begin downgrading the affected CPDO note credit ratings, citing factors such as widening spread movements and volatility of the iTraxx and CDX indices. By citing conditions that arose subsequent to its failure to downgrade the credit ratings, the committee effectively concealed its prior failure to downgrade. The committee did not reference or disclose the coding error.
Late in the day on May 20, 2008, the Financial Times published on its Web site an article that disclosed the coding error, citing internal Moody's documents that showed the error had been discovered by MIS almost a year earlier, and alleged that MIS had incorrectly awarded Aaa credit ratings to CPDO notes because of the error. When Moody's was contacted by reporters gathering information for the story, the company began an internal investigation into the coding error and the CPDO rating committee conduct. On July 1, 2008, a year and a half after the coding error had been discovered, and over a year after the European rating committee had declined to downgrade the credit ratings, Moody's issued a press release discussing the investigation results and stating that "some committee members considered factors inappropriate to the rating process when reviewing CPDO ratings following the discovery of the model error." Thereafter, MIS took personnel action with respect to management of the CPDO group and members of the committee, including termination of the Group Managing Director and two Team Managing Directors.
The rating committee responsible for the credit ratings of the CPDO notes met in France and the United Kingdom. The CPDO notes were arranged by European banks and marketed in Europe. Members of the rating committee involved in the monitoring of CPDO ratings allowed concerns regarding Moody's reputation and other non-credit related considerations to influence decisions not to downgrade the affected CPDOs. The Commission cautions NRSROs that deceptive ratings conduct is unlawful under the antifraud provisions of the federal securities laws. Because of uncertainty regarding a jurisdictional nexus to the United States in this matter, the Commission declined to pursue a fraud enforcement action. 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 of the Securities Act of 1933 or the Exchange Act 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 and involves only foreign investors" or "conduct occurring outside the United States that has a foreseeable substantial effect within the United States." Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act, Pub. L. No 111-203, § 929P(b)(1), (2) (2010) (to be codified at 15 U.S.C. §§ 77v(c), 78aa(b)). NRSROs should expect that the Commission, where appropriate, will pursue antifraud enforcement actions, including pursuant to such jurisdiction.
Further, we conclude that, in early 2007, members of the European rating committee believed they could violate MIS's procedures without detection, and in fact the conduct did not come to light until the Financial Times contacted MIS about the error in the CPDO model and an investigation ensued. The Commission notes that recently enacted legislation amended the Exchange Act to require NRSROs to "establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings." Dodd-Frank Act, § 932(a)(2)(B) (to be codified at 15 U.S.C. § 78o-7(c)(3)). The legislation also provides that the Board of Directors of an NRSRO "shall oversee," among other things, "the establishment, maintenance, and enforcement of policies and procedures for determining credit ratings" and "the effectiveness of the internal control system with respect to policies and procedures for determining credit ratings." Dodd-Frank Act, § 932(a)(8) (to be codified at 15 U.S.C. § 78o-7(t)(3)).2 The Commission further cautions NRSROs that they must implement and follow appropriate internal controls and procedures governing their determination of credit ratings, and must also take reasonable steps to ensure the accuracy of statements in applications or reports submitted to the Commission.
This report serves to caution NRSROs that, where appropriate, the Commission will utilize recent legislative provisions granting jurisdiction for enforcement actions alleging otherwise extraterritorial fraudulent misconduct that involves significant steps or foreseeable effects within the United States. The Commission also cautions NRSROs that they should implement sufficient and requisite internal controls over policies, procedures, and methodologies used to determine credit ratings.
By the Commission.