SEC Suspends S&P from Rating CMBS Transactions, Issues Orders on Ratings Misconduct

Practical Law Legal Update 1-596-8650 (Approx. 6 pages)

SEC Suspends S&P from Rating CMBS Transactions, Issues Orders on Ratings Misconduct

by Practical Law Finance

First Order: Fraudulent Practices in Conduit-Fusion CMBS Ratings Methodology

The SEC's first S&P order bars S&P from making preliminary or final ratings on any new-issue US conduit-fusion CMBS (CF CMBS) for a period of one year. The term conduit-fusion refers to CMBS transactions that:

Include a pool of at least 20 loans made to unrelated borrowers.
Are diversified by geographical location.
May include several relatively larger loans, but do not include single-borrower or large-loan floating-rate CMBS, nor CMBS consisting solely of investment grade commercial mortgage loans.

This penalty settles the SEC allegations that S&P's public disclosures affirmatively misrepresented that it was using one approach to rating CMBS in 2011 when it actually used a different methodology to rate eight transactions that year. The first S&P order stems from a July 2014 Wells Notice issued by the SEC notifying S&P that it could face enforcement action for these violations (see Legal Update, SEC Sends Wells Notice to S&P for CMBS Ratings).

In the first S&P order, the SEC found that actions taken by S&P in connection with rating certain CMBS during 2011 were sufficient for a finding that it violated:

Section 17(a)(1) of the Securities Act of 1933, as amended (Securities Act) (15 U.S.C. 77q(a)(1)), which prohibits fraudulent conduct in the offer and sale of securities.
Section 15E(c)(3) of the Securities Exchange Act of 1934, as amended (Exchange Act) (15 U.S.C. 78o-7(c)(3)), which requires credit rating agencies (referred to as 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 its credit ratings.
Rules 17g-2(a)(2)(iii) (17 CFR 240.17g-2(a)(2)(iii)) and 17g-2(a)(6) (17 CFR 240.17g-2(a)(6)) of the Exchange Act, which require NRSROs to make and retain complete and current records of the rationale for any material difference between the credit rating implied by a model and the final credit rating issued on the security and of the established procedures and methodologies used by the NRSRO to determine its credit ratings.
For more information on internal controls, including the effectiveness of Amended Rule 17g-2, see Practice Note, Credit Ratings and Credit Rating Agencies: Public Disclosure of NRSRO Credit Rating Histories (Amended Rules 17g-1, 17g-2 and 17g-7).

The CMBS disclosures at issue concerned S&P's application of the debt service coverage ratio (DSCR), which is a key quantitative metric used to rate CF CMBS transactions. S&P used DSCRs to estimate term defaults of loans in CF CMBS transactions as part of its analysis of appropriate levels of credit enhancement required to obtain particular credit ratings for the securities. Credit enhancement (CE) is a critical consideration for a credit rating determination. Asset-backed securities (ABS), including CMBS, with higher CE levels are more conservative and provide greater protection against loss for investors. In late 2010, S&P changed its methodology for calculating DSCRs, which lowered the amount of CE necessary to achieve a particular rating.

Despite the change in its calculation methodology, during the first half of 2011, S&P published ratings on six CF CMBS transactions and issued preliminary ratings on two more CF CMBS transactions in which it failed to described the change in its DSCR calculation methodology. Instead, the reports included DSCRs calculated using its prior methodology, which were misleading because they communicated that the ratings were more conservative than they actually were. Further, S&P's internal controls failed to identify and respond adequately to red flags that S&P's CMBS division had changed its methodology for rating CF CMBS transactions without appropriate process or disclosures.

As a result of the order, S&P is barred from rating new US CF CMBS transactions until January 21, 2016.

Second Order: False and Misleading Publication Regarding New Ratings Criteria

The SEC's second S&P order found that S&P published a false and misleading article in June 2012 showing average commercial mortgage loan pool losses at about 20% under Great Depression-era levels of economic stress to demonstrate the relative conservatism of the new ratings criteria it began using in mid-2012 (see Request For Comment: Rating Methodology And Assumptions for U.S. And Canadian CMBS).

In connection with this, the SEC found that S&P violated:

Section 17(a)(1) of the Securities Act (for details, see First Order: Fraudulent Practices in its Conduit-Fusion Ratings Methodology).
Rule 17g-2(a)(6) of the Exchange Act, which requires NRSROs to make and retain books and records that must be complete and current documenting the established procedures and methodologies used to determine credit ratings.

The SEC concluded that S&P's research relied on flawed and inappropriate assumptions and was based on data that was decades removed from the Great Depression. The SEC supported its finding by showing that the original author of the S&P study expressed concerns that the firm's CMBS group had turned the article into a "sales pitch" for the new criteria.

The SEC separately found that S&P failed to accurately describe certain aspects of its new criteria in the formal publication setting forth the changes in the ratings criteria.

Without admitting or denying the findings in the order, S&P agreed to:

Publicly retract the false and misleading Great Depression-related study.
Correct the inaccurate descriptions included in the publication regarding its CMBS ratings criteria.

Third Order: Failure to Maintain and Enforce Internal Controls

The SEC's third S&P order found that S&P allowed breakdowns in the way it conducted ratings surveillance of previously-rated RMBS from October 2012 to June 2014.

In connection with this, the SEC found that S&P violated:

Section 15E(c)(3)(A) of the Exchange Act (15 U.S.C. 78o-7(c)(3)) (for details, see S&P's Fraudulent Practices in its Conduit-Fusion Ratings Methodology).
Rules 17g-2(a)(2)(iii) and 17g-2(a)(6) of the Exchange Act (for details, see S&P's Fraudulent Practices in its Conduit-Fusion Ratings Methodology).

According to the SEC, S&P changed an important assumption in a way that made S&P's ratings less conservative, and was inconsistent with the specific assumptions set forth in S&P's published criteria describing its ratings methodology. The criteria set forth S&P's established methodology for determining the appropriate "loss severity" (LS) assumptions to be used in surveilling these ratings. S&P's LS assumptions represent the estimated losses that would be incurred if a mortgage defaults. They serve as a significant part of S&P's ratings analyses.

However, from late 2012 through January 2014, S&P did not apply the LS assumptions set forth in the criteria to its surveillance reviews in connection with bonds supported by seasoned, short-amortizing loans with low loan-to-value (LTV) ratios. S&P applied ad hoc workarounds that were not fully disclosed to investors, rather than following its internal policies for making changes to its surveillance criteria.

Without admitting or denying the findings in the order, S&P:

Agreed to extensive undertakings to enhance and improve its internal controls environment.
Self-reported this particular misconduct to the SEC and cooperated with the investigation.

For more information on internal controls, including the effectiveness of Amended Rule 17g-2, see Practice Note, Credit Ratings and Credit Rating Agencies: Public Disclosure of NRSRO Credit Rating Histories (Amended Rules 17g-1, 17g-2 and 17g-7).

This Update is based, in part, on material provided by the Accelus service Compliance Complete (http://accelus.thomsonreuters.com/products/accelus-compliance-complete), which provides regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges.

SEC Suspends S&P from Rating CMBS Transactions, Issues Orders on Ratings Misconduct | Practical Law