The Curious Case of the SEC vs. Egan-Jones

The credit-rating agency Egan-Jones and its founder, Sean Egan, have agreed to be barred for a year and half from rating asset-backed and government securities in a settlement with the Securities and Exchange Commission.

The SEC had charged the rating agency and its founder with making “willful and material misstatements and omissions when registering with the SEC to become a nationally recognized statistical rating organization (NRSRO) for asset-backed securities (ABSs) and government securities” four years ago, says a statement from the SEC.

But there is a curious history to the Egan-Jones matter, one that raises the issue of government retaliation.

The SEC started its probe after Egan-Jones was first to downgrade the U.S. debt, subsequently downgrading the U.S. debt three times in total. An SEC official notes that a public document Egan-Jones filed in court indicates the agency’s enforcement division had informed Egan-Jones that it had opened an informal inquiry in February 2010, and that “a "formal order of investigation" was issued on July 30, 2010,” a year ahead of the downgrade.

Egan-Jones officials tell FOX Business that “a full year went by before the SEC filed a Wells notice” indicating an enforcement action was likely coming, which came after Egan-Jones had downgraded the     U.S. in July 2011.

Egan-Jones is a privately owned, 20-person firm based in Haverford, Pa., and is one of the few rating agencies that does not get paid by issuers to rate securities, instead it gets paid by investors.

Standard & Poor’s (owned by McGraw-Hill Cos. (NSYE:MHP)), Moody’s Corp. (NYSE:MCO) and Fitch Ratings Ltd. get paid by banks and Wall Street investment houses that underwrite the debt securities of corporate issuers, a business model numerous Congressmen have already said helped lead to the worst economic meltdown since the Great Depression.

An Egan-Jones spokesman told FOX Business the company is “very pleased the firm has settled issues with the SEC on mutual terms.” The spokesman notes Egan-Jones is “still a nationally recognized statistical rating organization for all of our corporate, bank, finance and insurance company ratings” and that the company is “free to reapply after 18 months” to rate asset-backed and government securities.

Specifically, Egan-Jones and its founder consented to an SEC order that found Egan-Jones had “falsely stated in its registration application that the firm had been rating issuers of asset-backed and government securities since 1995 – when in truth the firm had not issued such ratings prior to filing its application.”

The SEC had charged Egan and his company with falsely stating on their July 2008 application to the SEC that it had “150 outstanding asset-backed securities (ABS) issuer ratings and 50 outstanding government issuer ratings, and had been issuing credit ratings in these categories on a continuous basis since 1995.”

The moves were made, the SEC had charged, “to conceal the fact that it had no experience issuing ratings on ABS or government issuers.”

Robert Khuzami, outgoing director of the SEC’s Division of Enforcement, says in a statement that Egan-Jones’ “misrepresentation of the firm’s actual experience rating issuers of asset-backed and government securities is a serious violation that undercuts the integrity of the SEC’s NRSRO registration process.”

Sean Egan, who could not be reached for comment, “signed and certified the application as accurate,” the SEC says.

According to the SEC’s order, the company had not issued any ABS or government issuer ratings “that were made available through the Internet or any other readily accessible means.”

Egan-Jones’ lawyer has already told FOX Business that the SEC has indicated to Egan-Jones that the firm actually did rate all of the securities at issue, but that the problem was the firm did not widely publicize its ratings.

“There’s nothing in this complaint that suggests or alleges that any rating was without integrity or was not accurate or was not predictive,” Egan’s lawyer has said.

The SEC also found that the ratings company “continued to make material misrepresentations about its experience in subsequent annual certifications,” as well “violated recordkeeping and conflict-of-interest provisions governing NRSROs.”

The Egan-Jones spokesman added that the “SEC settlement lets us focus on what we do best—producing the most accurate and independent ratings in the business,” a model in which the firm gets paid by investors.

Congress has already publicly chastised the ratings agencies for a big conflict of interest as leading to the housing bubble, for deferring to the sellers of the securities they are supposed to pass judgment on. The companies got paid hundreds of millions of dollars by Wall Street, and in turn gave triple-A ratings to high-risk securities that turned out to be junk.

The rating agencies have also met with withering criticism since for failing to do anything but remind investors of the losses they have already been hit with, rather than assisting the markets in avoiding losses, with some critics attacking them as “selling astrology” and for doling out triple A ratings to banks that let them avoid capital standards and avoid socking away adequate reserves.

“We rate every deal,” and S&P analyst said in an email uncovered by Congressional investigators (SEC examiners had unearthed the email as well). “It could be structured by cows and we would rate it.”

To date, there has been little government backlash, and few to no government lawsuits against the ratings agencies who operate on the issuer-pays model which still dominates at the ratings firms, the same model that aided and abetted the housing bubble.

On July 16, 2011, Egan-Jones downgraded the U.S.’s sovereign debt by one notch, to double-A plus from triple-A due to “the relatively high level of debt and the difficulty in significantly cutting spending.”

Two days later, the SEC’s Office of Compliance Inspections and Examinations called Egan-Jones demanding information about its downgrade. That following month, S&P downgraded the U.S.’s sovereign debt, and also met with a government backlash.

That October, the SEC called Egan-Jones to inform the firm it was filing a Wells Notice, often meaning an SEC probe had been launched. Wells Notices are an indication SEC “staff is nearing a completion point of its investigation and is potentially going to recommend an enforcement action to the commission,” notes an SEC spokesman.

Undaunted, in early April of 2012, Egan-Jones again downgraded U.S. sovereign debt one notch. Later that same month, the SEC filed its complaint.

Egan, the firm’s founder, has already publicly questioned the SEC’s complaint. Egan has noted that the SEC up until 2012 had never raised any issues or concerns with his firm’s annual applications.