Moody's Declines After Ratings Company Says It Got Wells Notice From SEC

Moody’s Corp. fell 6.8 percent to its lowest price since October after saying it may be sued by the U.S. Securities and Exchange Commission for filing false and misleading descriptions of its credit-rating policies.

Moody’s, Standard & Poor’s and Fitch Ratings face scrutiny by Congress and state insurance regulators after assigning top grades to U.S. subprime-mortgage bonds just before that market collapsed in 2007. Moody’s said May 7 in a regulatory filing that it received a “Wells” notice from the SEC in March related to its application to become a nationally recognized statistical ratings company.

“The SEC doesn’t usually go after the ratings agencies,” said Elizabeth Nowicki, a former lawyer with the regulator who is now a visiting professor at Boston University. “It’s impossible to ignore the fact that folks at the SEC have indicated they’re concerned with the role the credit ratings agencies had in supporting the crisis.”

The SEC notified New York-based Moody’s on March 18 that the company’s process for assigning credit ratings may lead to a lawsuit, Moody’s said in its filing after the end of regular U.S. stock market trading. A finding by Moody’s that a rating committee policy had been violated by an employee sparked the SEC action, according to the filing.

Stock Decline

Moody’s dropped $1.59 to $21.77 in New York Stock Exchange composite trading, the lowest since Oct. 7. Earlier, shares fell as much as 12 percent to $20.52. Moody’s has declined 19 percent this year. McGraw-Hill Cos., owner of the Standard & Poor’s credit-ratings unit, fell $1.13, or 3.7 percent, to $29.15, the lowest since Nov. 4.

Harold “Terry” McGraw III, chief executive officer of McGraw-Hill, said today that S&P hasn’t received a Wells notice from the SEC, according to a transcript of the Jefferies & Co. Global Internet, Media & Telecom conference.

“The timing of this action suggests the SEC may be motivated by a desire to show a ‘tough’ approach to oversight of the rating agencies rather than by a particularly strong case against Moody’s,” Peter Appert, an analyst with Piper Jaffray & Co., said today in a note to clients. “The SEC action creates a new source of uncertainty.”

Moody’s disagreed with the SEC that a violation by an employee rendered the policy itself false and misleading and has submitted a response to the Wells notice explaining why it believes an enforcement action is unwarranted.

‘Doesn’t Bode Well’

“That doesn’t bode well for Moody’s that it couldn’t get the SEC to back off,” Nowicki said. Typically, a company has some back and forth with the SEC before the agency decides to issue a notice, she said. “None of the ratings agencies can credibly argue they didn’t see this coming.”

A Moody’s spokesman didn’t return calls seeking comment.

Warren Buffett’s Berkshire Hathaway Inc., Moody’s largest investor, cut its stake in March after the ratings company was hit by profit declines, lawsuits and regulator criticism. Buffett began reducing his Moody’s position in July, with six previous sales of the stock since then, according to filings.

Berkshire sold a total of about 1 million shares in three transactions in March, according to regulatory filings. Omaha, Nebraska-based Berkshire’s stake of 30.8 million shares is down about 36 percent from the 48 million shares on June 30.

The SEC sends a Wells notice when it decides it may bring a civil action against a company or individual, giving the recipient an opportunity to say why enforcement shouldn’t take place. It isn’t a formal allegation or finding of wrongdoing.

Structured Finance

Moody’s ousted the head of its structured finance unit in 2008 after saying employees broke rules by failing to change the way constant proportion debt obligations were analyzed after discovering a fault in its rating model. Moody’s awarded the top Aaa ratings to at least $4 billion of the securities, funds backed by credit-default swaps, before they lost as much as 90 percent of their value.

Two months later, it revealed a second error in the way it assessed the securities, which were sold by banks including ABN Amro Holding NV, JPMorgan Chase & Co. and Lehman Brothers Holdings Inc.

Moody’s disclosure of the Wells notice was preceded in its quarterly regulatory filing by a description of its investigation into the “coding error” related to constant- proportion debt obligations.

CPDOs sell contracts based on indexes of credit-default swaps, contracts conceived to protect bondholders against default. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Market Rally

The ratings company’s price decline came as U.S. stocks rallied, with the S&P 500 Index gaining 4.4 percent, the most since March 2009, after European policy makers unveiled a loan package valued at almost $1 trillion to contain a sovereign-debt crisis.

Appert cut his Moody’s rating to neutral from overweight and reduced his price target to $30 from $38.

“The increasing call for regulatory retribution comes at a time when the debt markets are looking increasingly healthy,” Appert said in his note. “A sharp rebound in debt issuance volumes is translating into improved revenue and earnings dynamics for Moody’s, a trend we think is sustainable.”

Moody’s said last month that first-quarter profit rose 26 percent as growing corporate and junk-bond issuance helped boost demand for debt rankings.

The SEC notice said it is considering cease-and-desist proceedings against the company. That wouldn’t likely affect Moody’s business of assigning credit ratings, Nowicki said.

‘Candid’ Assessments

“It won’t stop them from doing business. It will force them to be more candid about how they assign ratings,” she said. “The cease-and-desist order might be the SEC affirmatively ordering Moody’s to make better disclosures.”

Moody’s, S&P and Fitch Ratings have been criticized for wrongly assigning top grades to U.S. subprime mortgage bonds that caused the financial crisis. Ohio Attorney General Richard Cordray sued the debt raters in November on behalf of five state retirement funds, saying “improper” ratings cost them more than $457 million.

Members of Congress have said they want to overhaul the credit-rating industry. The House Financial Services Committee passed a measure in October that would make it easier to sue credit-rating companies while aiming to rein in conflicts of interest.

State insurance regulators, led by New York and Illinois, are seeking to reduce their reliance on ratings firms and in November hired Pacific Investment Management Co., manager of the world’s largest bond fund, to replace Moody’s and S&P analysis on home-loan investments held by insurers.

To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net.

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