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Standard & Poor’s Pays $77 Million to Settle Fraud Charges

The SEC suspended Standard & Poor’s Ratings Service from rating certain commercial mortgage-backed securities for a year because the firm allegedly misled investors about the criteria it used for some asset-backed securities. The SEC said in late 2010, the rating firm made an undisclosed shift in the criteria it used for a special class of CMBS trades to boost its share of a segment of the market where it hadn’t been doing well.

The SEC on January 21, 2015, said it suspended Standard & Poor’s Ratings Services from rating some commercial mortgage-backed securities (CMBS) for a year for committing fraud and intentionally misleading investors in 2011 and 2012.

The charges made up the first enforcement action against a major rating agency regulated by the SEC. S&P leads the market with 46 percent of total ratings as of end of 2013.

Without admitting or denying wrongdoing, S&P agreed to pay more than $58 million to settle the charges. The firm also agreed to pay $19 million to settle parallel cases brought by the attorneys general for New York and Massachusetts.

“Investors rely on credit rating agencies like Standard & Poor’s to play it straight when rating complex securities like CMBS,” said Andrew Ceresney, Director of the SEC Enforcement Division. “But Standard & Poor’s elevated its own financial interests above investors by loosening its rating criteria to obtain business and then obscuring these changes from investors.”

S&P’s attorney, Angela Burgess, a partner with Davis Polk & Wardwell LLP, had no comment.

According to one of three orders against the firm, the SEC said in late 2010, the rating firm made an undisclosed shift in the criteria it used for six CMBS trades. The deals were from a class of securities called conduit/fusion and were comprised of geographically diversified pools of at least 20 mortgage loans made to unrelated borrowers.

The shift in the criteria involved what the asset-backed securities market calls credit enhancement. Common forms of credit enhancement include having excess collateral in the loan pool supporting the bonds, allowing the loan servicer to collect more interest from borrowers than is paid out to bondholders and building up a reserve fund, or having the bonds guaranteed by a bond insurer. Investors generally prefer higher levels of enhancements because it makes the bonds safer against losses, while CMBS issuers generally prefer lower levels because the greater the enhancement, the less they realize from the bond offering.

The agency said S&P allegedly secretly used more aggressive assumptions to calculate the credit enhancements, which made its ratings more attractive to issuers, while public disclosures suggested that the assumptions were more conservative than they were. The SEC also uncovered a host of internal control record-keeping violations.

Barbara Duka, the former head of the CMBS group, has been charged separately in an administrative proceeding for her alleged role in instituting the shift to more issuer-friendly ratings criteria, while failing to properly disclose the less rigorous methodology.

Duka has sued the SEC and sought to bring the case to a federal court, where she believes she will have a better chance of defending herself. An administrative hearing gives the SEC far more control over how it proceeds than a court hearing.

” Barbara did not act wrongfully and always performed her duties at S&P in the utmost good faith,” said Guy Petrillo at Petrillo Klein & Boxer LLP. “She looks forward to clearing her name in a public courtroom, as mandated by the Constitution. “

In another order, the SEC said S&P found itself frozen out of the lucrative conduit/fusion CMBS market in late 2011 largely because of disclosure problems with earlier ratings. It tried to overhaul its CMBS criteria to become more attractive to issuers.

The SEC accused S&P of publishing research that was false and misleading to support a change in its criteria that misinterpreted the amount of credit support for some triple-A rated bonds. Instead, S&P touted its conservative criteria deliberately using a weaker set of data and assumptions. Investors were kept in the dark and got the impression that the new credit enhancement levels could weather a downturn comparable to the Great Depression.

In 2012, S&P ranked fifth in terms of conduit/fusion market share with 15.9 percent. The firm’s chief rival, Moody’s Investors Service Inc., dominated the market. In 2013, S&P’s market share increased to 29.7 percent.

“These CMBS-related enforcement actions against S&P demonstrate that ‘race to the bottom’ behavior by ratings firms will not be tolerated by the SEC and other regulators,” said Michael Osnato, chief of the SEC Enforcement Division’s complex financial instruments unit. “When ratings standards are compromised in pursuit of market share, a firm’s disclosures cannot tell a different story.”

In the final order, the SEC charged S&P with failing to maintain internal controls between February 2012 and January 2014 regarding the changes to its monitoring of previously issued ratings on some residential mortgage backed securities.

The order said that S&P changed an important assumption that was inconsistent with the specific assumptions in the rating firm’s published criteria describing its ratings methods and ignored some signs of weakness in the loans. The order also said S&P didn’t follow its internal policies.

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