Update: SEC drops Moody's fraud case

The Securities and Exchange Commission let Moody's off the hook for failing to heed its own rating guidelines.

The SEC blamed "uncertainty" tied to the regulatory reforms enacted last month in dropping the widely watched case, which stemmed from Moody's 2007 failure to fix some European debt ratings after it discovered an error in their calculations. The Dodd Frank Act limits the SEC's jurisdiction to cases with a strong tie to the United States, the agency said.

But the securities regulator sternly admonished Moody's and other officially favored rating agencies -- known as nationally recognized statistical ratings organizations, or NRSROs -- not to let it happen again.

"Investors rely upon statements that NRSROs make in their applications and reports submitted to the Commission, particularly those that describe how the NRSRO determines credit ratings," said Robert Khuzami, director of the SEC's Division of Enforcement. "It is crucial that NRSROs take steps to assure themselves of the accuracy of those statements and that they have in place sufficient internal controls over the procedures they use to determine credit ratings."

The SEC made the announcement Tuesday afternoon. The decision comes three months after Moody's (MCO) rocked the market by announcing it had received a Wells Notice, indicating the staff of the SEC had recommended the agency pursue a civil case against the firm's Moody's Investors Service unit.

According to the report, an MIS analyst discovered in early 2007 that a computer coding error had upwardly impacted by 1.5 to 3.5 notches the model output used to determine MIS credit ratings for certain constant proportion debt obligation notes. Nevertheless, shortly thereafter during a meeting in Europe, an MIS rating committee voted against taking responsive rating action, in part because of concerns that doing so would negatively impact MIS's business reputation.

The report then goes on to explain why the SEC isn't pursuing a case that only three months ago it seemed to have been pursuing.

The report says that because of uncertainty regarding a jurisdictional nexus between the United States and the relevant ratings conduct, the Commission declined to pursue a fraud enforcement action in this matter.

The report notes that the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act provided expressly that federal district courts have jurisdiction over SEC enforcement actions alleging violations of the anti-fraud provisions of the securities laws when conduct includes significant steps, or a foreseeable substantial effect, within the United States.

The report also notes that the Dodd-Frank Act amended the securities laws to require nationally recognized statistical rating organizations (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.

Not everyone was impressed by this latest exercise in finger-wagging.

"The SEC's failure to pursue an enforcement action against Moody's based on 'uncertainty regarding a jurisdictional nexus' is not convincing to say the very least and does nothing to restore confidence in the Commission as an effective enforcement agency," said Boston University law professor Cornelius Hurley.

Moody's, which has tumbled 10% since the news of the SEC probe came out and since investors started mulling over the effects of the Dodd Frank Act, rose modestly in Tuesday afternoon trading. McGraw-Hill (MHP), parent of Standard & Poor's, was off fractionally.

(Update 5:19 p.m.: Added Hurley comment.)