Tuesday, the Securities and Exchange Commission released a Report of Investigation resulting from an inquiry by the SEC Enforcement Division into whether Moody’s Investors Service, Inc. (“Moody’s”) violated federal securities laws by concealing a coding error in a new ratings model. The Report also cautioned Nationally Recognized Statistical Rating Organizations (“NRSRO”) that “deceptive ratings conduct is unlawful under the antifraud provisions of the federal securities law” and reminded them that the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) requires 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.”

The Moody’s inquiry was related to ratings of certain constant proportion debt obligation (“CPDO”) notes issued by European banks and marketed in Europe. In September 2006, the Report states that Moody’s developed a model to rate CPDO notes, a new financial instrument at the time, and used the model to rate the notes of twelve CPDO issuers. In January 2007, a Moody’s analyst discovered a coding error in the model that incorrectly increased the ratings of the CPDO notes by 1.5 to 3.5 notches.

According to the Report, an internal Moody’s rating committee held a number of meetings in France and the United Kingdom, and ultimately determined in April 2007 not to downgrade the ratings of the CPDO notes despite being aware of the coding error. In making this determination, the SEC concluded that the committee inappropriately considered non-analytical factors, most notably the protection of Moody’s reputation. In January 2008, the committee finally voted to downgrade the CPDO notes. However, according to the Report, the downgrade was attributed to other factors, and the coding error was not disclosed.

The Report indicates that “Because of uncertainty regarding a jurisdictional nexus to the United States in this matter, the Commission declined to pursue a fraud enforcement action.” However, the Report puts ratings agencies on notice of the SEC’s expanded jurisdiction under the Dodd-Frank Act: “The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions of the Securities Act of 1933 or the Exchange Act involving ‘conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors’ or ‘conduct occurring outside the United States that has a foreseeable substantial effect within the United States.’”