Regulators may charge Standard & Poor's with securities law violations after the ratings agency gave top grades to a package of securitized mortgages in 2007 that quickly soured.
The possible action could be the first by the United States against one of the major credit rating agencies, which have been accused of enabling the lending excesses that led to the subprime mortgage crisis in 2008.
The disclosure follows S&P's downgrade of the debt of the U.S. government in August, an unrelated action that was not followed by other rating agencies and that drew darts from the Obama administration and a bipartisan group of politicians.
Wells notices give potential defendants an opportunity to explain why civil charges should not be brought. The company said SEC staff are considering recommending that commissioners take action against S&P for violating securities laws in its ratings of a 2007 collaterized debt obligation known as "Delphinus CDO 2007-1."
While Wells notices are not always followed by lawsuits from the SEC, they represent a serious threat. "A Wells notice ups the ante," said Alan Palmiter, professor, Wake Forest University School of Law, Winston-Salem, North Carolina. "It is clear the SEC has identified something it sees as a problem with ratings issued during the subprime mortgage heyday."
If the SEC presses charges, McGraw-Hill would likely try to settle them, and may have to change its ratings practices, Palmiter added.
S&P warned it might have to pay civil penalties in the case.
Shares of McGraw-Hill fell 1 percent in early afternoon trading.
McGraw-Hill earlier this month announced plans to split into two publicly traded companies to satisfy activist investors unhappy with its depressed value.
S&P is the flagship business of the ratings and market information services company that will be spun off. The other business is being structured around McGraw-Hill's textbook publishing business.
Institutional shareholders, led by Jana Partners, have pushed the conglomerate to take further steps, including completely severing the ratings business from the company's analysis and information operations.
A Senate subcommittee report in April cited the Delphinus deal as a "striking example" of a CDO moving from top ratings to junk in a matter of months.
Moody's Investors Service and Fitch Ratings, which also rated the CDO, have not announced receiving Wells notices in the case.
WHEELS OF JUSTICE GRIND
S&P issued the CDO ratings in question at a time when the credit boom that had lifted mortgage lending and house prices was already collapsing, said Janet Tavakoli, a structured finance expert at Tavakoli Structured Finance in Chicago.
S&P ratings covered at least $947 million of liabilities in the Delphinus CDO, which was originated August 2, 2007. Within five months the CDO was in technical default, according to a notice S&P issued at the time. S&P's AAA ratings on the bonds were marked down to junk by the end of 2008.
The CDO was largely backed by subprime-mortgage securities, according to a Fitch report.
"There is no excuse for rating these deals in the way they were," said Tavakoli.
She said "it is a shame" that the SEC investigations are still going on four years after the events in question and months after the Senate subcommittee report came out. "The wheels of justice move much too slowly," she said.
S&P is facing other regulatory pressure as well. Last month a source said the U.S. Justice Department was investigating S&P and Moody's Investors Service actions on mortgage securities.
S&P's failures with structured finance ratings were recently cited by Washington politicians as reason to doubt the agency's decision in August to cut its rating on U.S. government debt from AAA to AA-plus. No other major rating agency has downgraded U.S. government debt.