Shares of Moody’s fell sharply on Monday after it disclosed that the Securities and Exchange Commission had warned that it might sue the firm for making “false and misleading” statements as part of its application as a ratings organization.
The S.E.C. sent the New York-based company a Wells notice, the regulator’s way of signaling that it was considering legal action against a firm. Moody’s said it received the notice on March 18 and disclosed it in a quarterly filing on Friday.
The company said that the notice stemmed from actions by members of a European rating surveillance committee who “may have violated Moody’s professional code of conduct,” according to a spokesman, Michael N. Adler. Moody’s reported the incident to the S.E.C. in 2008, Mr. Adler said in a statement, and has complied with the commission’s subsequent requests for information.
“Moody’s policy clearly prohibits the conduct in which these employees engaged,” Mr. Adler said, “and we do not believe that a single violation of our policy renders that policy false.”
According to regulatory filings, Raymond W. McDaniel Jr., Moody’s chief executive, sold or exercised options worth about $4.3 million on March 18, the same day that his company received the Wells notice.
Moody’s shares closed at $29.66 the day of Mr. McDaniel’s sale, near their high of $30.54 so far this year. Moody’s shares have traded as low as $18.50 over the last 52 weeks. On Monday, the shares fell as much as 12 percent, but finished the day down 7 percent at $21.77.
Moody’s said Mr. McDaniel’s sales in March were part of a prearranged plan established about a month before the Wells notice arrived.
Berkshire Hathaway, the investment vehicle for Warren E. Buffett and a major Moody’s shareholder, also sold more than one million shares worth more than $30 million on March 19, March 24 and March 26. The sales represent a small portion of Berkshire’s overall stake in Moody’s. Berkshire did not return a call seeking comment about its sales.
A spokesman for the S.E.C. would not comment on Moody’s disclosure.
Scrutiny of the ratings agencies is increasing. Moody’s and the other two major ratings agencies — Standard & Poor’s and Fitch — have been widely criticized for the high grades they affixed to billions of dollars of subprime mortgages that were rendered worthless, or nearly so, by the credit crisis. Critics have contended that the companies failed in their roles as independent risk analysts, in part because they were paid by the investment banks whose products they were analyzing.
The companies now face more than two dozen private lawsuits and cases by attorneys general in Ohio and Connecticut. In the Congressional debates on financial reform, lawmakers are considering measures that would enhance the S.E.C.’s capacity to regulate the ratings agencies.
But the action disclosed by Moody’s suggests that the S.E.C. is not waiting for greater powers to flex whatever muscle it now has — a show of strength that some experts contend is long overdue.
“I think that the credit crisis embarrassed the S.E.C. with the question of why they weren’t more concerned about the ratings agencies before 2007,” says Edward J. Kane, a professor of finance at Boston College. “With this Wells notice, along with the action against Goldman Sachs, it seems clear that the S.E.C. is gearing up to try to deal with the potential fraud and deception that occurred during the securitization bubble.”
According to Moody’s, the S.E.C. was prompted by a report in May 2008 in The Financial Times. The article stated that in 2007, members of a committee that oversaw a certain type of European derivative — called constant proportion debt obligations — knew that some of the products had been given inflated ratings because of a problem in the company’s risk modeling software.
Without that problem, The Financial Times reported, the bonds would have received ratings as many as four notches lower. Moody’s corrected the software error, but the bonds maintained their Triple A ratings until January 2008.
Moody’s hired an outside law firm to investigate the matter, and subsequently took disciplinary actions that included terminations, according to Mr. Adler. He declined to provide further detail.
In June 2007, the company submitted an application to become a nationally recognized statistical rating organization, as required by S.E.C. regulations. That application included a code of conduct. The Wells notice essentially says that because Moody’s employees had violated that code, the application included a false and misleading statement.
What the S.E.C.’s action will mean for lawsuits against the ratings agencies is unclear, though Adam Savett of RiskMetrics, which has tracked the litigation, predicts that it might serve as a thumb on the scale for plaintiffs’ lawyers.
“Judges are human and when they look at the facts of a case, if this Wells notice turns into an actual lawsuit, it will become part of the gestalt when judges weigh whether to allow cases to go forward,” he said. “Then again, if you take a step back, the judges in these cases have been focusing very narrowly on the facts before them, taking each case on its merits, teasing out the true culpability. There was a concern in the business community initially that there would be mass lynchings for the ratings agencies in courts across the country. But that has not happened.”
All that is certain, he added, is “the S.E.C. has just upped the stakes.”