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SEC Says Dodd-Frank Law Lets Agency Chase Overseas Ratings Fraud

The U.S. Securities and Exchange Commission said it plans to use new financial laws to pursue credit-rating fraud initiated overseas after dropping a case against Moody’s Corp. amid uncertainty over its authority.

The SEC’s investigation found that a Moody’s ratings committee based in Europe refused to lower inflated grades on almost $1 billion of debt in 2007, the agency said in a report released yesterday. The committee declined to correct errors produced by a flawed ratings model out of concern for the firm’s reputation, the SEC report said.

“Uncertainty regarding a jurisdictional nexus between the U.S. and the relevant ratings conduct” led the SEC to drop the probe, the agency said in the report. That uncertainty was removed by the Dodd-Frank law, enacted in July, which clarifies the SEC’s power to sue for misconduct that has a substantial effect within the U.S., the report said.

Ratings companies Moody’s, McGraw-Hill Cos.’ Standard & Poor’s unit and Fitch faced scrutiny from Congress and state regulators after they assigned top marks to U.S. subprime- mortgage bonds before that market collapsed in 2007. The ensuing credit crisis resulted in $1.8 trillion in writedowns from financial firms worldwide, according to Bloomberg data.

Ratings Methodology

Moody’s developed methodology for rating constant proportion debt obligations in 2006 that resulted in top ratings for 11 of the products being marketed in Europe. A Moody’s analyst in New York later discovered a flaw that had inflated ratings for the CPDOs, which had a combined value of almost $1 billion, the SEC said.

The company’s rating committee voted in April 2007 not to downgrade the CPDOs based on several “inappropriate” factors, including the impact on Moody’s reputation and potential harm to investors who relied on the original ratings, the SEC said.

“In this particular case we seem to face an important reputation risk issue,” a rating committee member said in a Jan. 24, 2007, e-mail cited in the SEC report. The issue “is so important that I would feel inclined at this stage to minimize ratings impact” rather than “even allow for the possibility of a hint that the model has a bug,” the e-mail said.

The committee, which met in France and the U.K., voted to begin downgrading the CPDOs in January 2008, citing market conditions rather than the coding error. Moody’s “effectively concealed its prior failure to downgrade,” the SEC said.

Executive Ousted

Moody’s ousted the head of its structured finance unit in 2008 after saying employees broke rules by failing to change the way CPDOs were analyzed after discovering the error in its rating model. 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.

The SEC told Moody’s on March 18 that the company’s process for assigning credit ratings might lead to a lawsuit, the New York-based company said in a regulatory filing.

“We fully support the commission’s message that every rating decision must be based only on credit considerations, and we are committed to maintaining robust procedures to ensure that our internal company policies are followed,” Moody’s spokesman Michael Adler said today in an interview.

The SEC told credit-rating firms that it will use the Dodd-Frank law to pursue fraud that has an impact in the U.S. even if it occurs in other countries. The agency cautioned the firms “that they should implement sufficient and requisite internal controls over policies, procedures, and methodologies used to determine credit ratings,” the report said.

CPDO issuers sell contracts based on indexes of credit-default swaps, financial products that protect bondholders against default. They pay buyers face value in exchange for underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

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