When Congress reviewed the financial damage resulting from numerous questionable acts and omissions that led to the 2007-9 Great Recession, one of the many market activities that drew scrutiny was the way nationally recognized statistical rating organizations (“NRSRO’s”) performed, frequently with ratings on securities that in hindsight seem to have been generated without regard to either facts or economic analysis. Indeed, there were many allegations that the rating agencies, whose fees are paid by the issuers of the securities being rated, functioned as marketing arms for those issuers, rather than as objective assessors of the risks inherent in investing in the securities. As a result, Congress found that rating agencies face conflicts of interest “that need to be carefully monitored.” Accordingly, Congress included sections of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) that directed the U.S. Securities and Exchange Commission (“SEC”) to issue rules to prevent sales and marketing considerations from influencing the ratings awarded by NRSRO’s.
NRSROs had been required to register with the Commission beginning in 1975, using a no-action letter process that was criticized for its opacity and limited oversight. In 2006 Congress passed the Credit Rating Reform Act, which addressed registration and oversight issues for NRSRO’s. In Dodd-Frank, Congress required stricter, ongoing oversight of rating agencies. There are currently nine SEC-registered NRSRO’s, some of which are household names for investors, e.g., Moody’s Investor Services, Inc., S&P Global, Inc., and Fitch Rating, Inc. Another NRSRO is Egan-Jones Rating Company, a private Delaware corporation (“EJR”) headquartered in Haverford, Pennsylvania. Sean Egan (“Egan”) is the founder and CEO of EJR. EJR’s application to be registered as an NRSRO was approved by the Commission on Dec. 21, 2007, for three classes of securities: financial institutions, insurance companies, and corporate issuers. A year later, on Dec. 4, 2008, EJR was also approved to rate asset-backed securities, government securities, municipal securities, and securities issued by foreign governments.
On Jan. 22, 2013, the SEC issued an administrative Order (the “2013 Order”) finding that EJR and Egan had made material misstatements in its Form NRSRO then on file with the Commission. In addition to requiring both to cease and desist from violating SEC rules, the SEC revoked EJR’s registration to rate asset-backed securities, government securities, municipal securities, and foreign government securities and barred EJR from associating with any other NRSRO registered in those classes. EJR was allowed to reapply after 18 months but was also required to disclose prominently that it was not registered to rate the specified securities until its application after 18 months had been accepted. Nonetheless, EJR rated two asset-backed securities and two municipal securities in 2017 and 2018 WITHOUT the required prominent disclosure, each constituting an additional violation.
Part of the SEC NRSRO rules bar the rating agency from rating securities for an issuer responsible for 10% or more of the agency’s revenue for the year. In 2017 EJR solicited business from a client that the Commission asserts EJR knew might provide over 10% of its revenue. In fact, EJR did receive over 10% of its revenue from that client in 2018. EJR entered the gross amount received from that client in EJR’s financial statements, disclosing in a footnote that an amount equal to 10% of what the client paid was ”excess revenue refundable.” Then in 2019, EJR issued a rating on security while, at the same time, Egan engaged in sales and marketing activities with respect to the client while also heading the EJR rating group and participating in rating that client’s securities, all of which the SEC stated, “violated the SEC’s NRSRO conflict of interest rules.”
Without admitting the accuracy of the SEC allegations, EJR agreed to cease and desist further violations; conduct training to identify and deal with conflicts of interest; retain an independent consultant to assess EJR’s policies and procedures concerning conflict of interest; disgorge $146,000 in fees and interest; pay $1.7 million as a civil penalty and prohibit Egan from participating in determining or monitoring credit ratings issued or maintained by EJR. In addition, Egan agreed to pay a civil penalty of $300,000.
The Commission’s June 21 Press Release quotes the SEC Director of Enforcement as saying, “Credit rating agencies play a vital role in assessing the credit risk of an issuer and must be vigilant in avoiding potential conflicts of interest to promote the integrity, impartiality, and quality of credit ratings,” and further, that EJR and Egan “now are being held accountable for their actions.”
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