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Quo usque tandem abutere, Egan-Jones, patientia nostra?

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Lawyers all know the old case in which a guy sued another guy over a dead fox that Guy A chased and Guy B caught. Who owns the dead fox?, the case asks. It's hard to care. My professor asked the better question, which was: just how much was a dead fox worth? The answer, it turns out, is "significantly less than the amount you'd have to spend on lawyers to become a famous old case." So why did they spend so much on lawyers? Unclear. But the moral of the story is that if you see a lawsuit over something really trivial, it's probably about something else. My professor added, "usually a love triangle."

So who is Sean Egan sleeping with? He is, of course, the president of Egan-Jones Ratings, which the SEC sued today over ... well, the SEC complaint is amazing:

20. In its July 2008 Application, which Egan signed and certified as being “accurate in all significant respects,” EJR falsely stated that it had 150 outstanding credit ratings on issuers of ABS and 50 outstanding credit ratings on issuers of government securities. Months later, in its 2008 Annual Certification, EJR revised its number of outstanding ABS issuer ratings from 150 to fourteen and the number of outstanding government issuer ratings from 50 to nine. Egan provided these numbers to his staff for purposes of filling out the application and certification. ...

22. In fact, at the time of its July 2008 Application and 2008 Annual Certification, EJR had never issued credit ratings on issuers of ABS or government securities on the internet or though another readily accessible means.

That is:
- Egan-Jones told the SEC "we have issued 200 ratings and they are on the internet."
- The SEC said "sure you have."
- The SEC certified Egan-Jones to be an officially recognized rating agency whose ratings carry legal force in some circles.
- A few months later, Egan-Jones corrected the number of ABS and muni ratings from 200 to 23.
- The correct number was zero.
- Four years later, the SEC noticed.

I know that the SEC wasn't big on using computers back in 2008 but still. Perhaps future applicants could be asked to provide, say, links to some of their ratings? Which are on the internet?

The other main point of the complaint is arguably more substantive. Turns out E-J didn't have much in the way of a conflicts of interest policy, so they would do things like (1) rate companies where they knew that their (buy-side, paying) clients had a position and (2) rate companies where the rating analyst himself had a position. Which: you would think would create bias, in the form of an incentive to give the issuer a higher rating (or lower, if the client was short). Anyway, that would be the case if Egan-Jones ratings were market-moving, which is less clear.

What is going on here? This case is so embarrassing to the SEC that it's pretty surprising they'd bring it. Part of me wants the story to be:

1. The SEC is getting increasingly nervous about the quality of Egan-Jones's work after some recent eccentric decisions.

2. In its nervousness, it took a closer look at Egan-Jones's materials and noticed things like "EJR had no procedures for maintaining work papers used in determining credit ratings, and did not implement procedures until mid-2009. Even after 2009, EJR failed to retain individual copies of the model that was used in determining each rating, and did not retain records of manual adjustments to the model output made by analysts." Also the thing about the conflicts, and the 200 fake ratings it fake issued before 2008.

3. The SEC could have been all "your ratings process sucks and you are not good enough to be an NRSRO," but that is a subjective standard and hard to prove, so instead they went with the more straightforward "when you told us you had issued 200 muni and ABS ratings and had in fact issued zero, you were not strictly speaking telling the truth." It's like Roger Clemens: the government would always rather prove that you lied to them than that you did something independently bad.

In other words, it would be comforting for me to believe that the SEC is basically destroying the only prominent(-ish) non-issuer-paid, untainted-by-the-subprime-meltdown ratings agency not because of some - totally shady and embarrassing - administrative misstatements on its four-year-old application, but because that agency is on balance Bad For Investors.* But that comforting belief requires you to believe #1: that the SEC made some sort of substantive judgment of something. (Also, if you want to be comforted, you have to believe that that substantive judgment was right or at least plausible.) Perhaps the new harder-charging SEC** is in fact doing that. But we know the 2008 SEC not only spent zero minutes substantively reviewing Egan-Jones's ratings prowess; it spent zero minutes reviewing anything at all about Egan-Jones's ratings - it didn't even notice that they didn't exist. The quality of Egan-Jones's ratings was not part of the SEC's decision process in granting Egan-Jones legally recognized status.

It's all very weird. I will say this though: people still say astonishing things like "we need an FDA for financial innovation, which would do a substantive screen of new financial products before they are allowed to be marketed." That has always struck me as ridiculous; even this guy thinks it's "one of the sillier ideas to come down the pike since the onset of the financial crisis five years ago." If by "financial FDA" you understand something like "SEC, but more powerful," then this case made the idea a whole lot sillier.

Egan-Jones Ratings Co. and Sean Egan Charged with Making Material Misrepresentations to SEC [SEC]

* It would be comforting for Egan-Jones, on the other hand, to "believe[] that the SEC’s action is inexplicable except as an effort to silence Egan-Jones and maintain the status quo of a conflicted, issuer-paid ratings agency monopoly in contravention of the Credit Agency Reform Act of 2006 and the Dodd - Frank Wall Street Reform and Consumer Protection Act of 2010." And ... um ... you can't exactly assign that zero probability, can you? Anyway they are not wrong that "[t]he SEC’s action has nothing to do with the quality, integrity or excellence of any rating EJR has ever issued."

** BusinessWeek had a huge cover story last week about how the SEC is "outmanned, outgunned, and on a roll," taking down Raj Rajaratnam and his coterie of insider traders with nothing but gumption, stick-to-it-iveness, and lovingly photographed boxes of documents. (Again: guys! Get some computers!) Ever since, the SEC has seemed determined to prove that its skills extend to basic internet searches but no more. So Marl the fake stock-picking robot: adorable, but also connected to a website called where the robot's human enablers "boasted, 'One email to [the stock picking robot email] list of people rockets a stock price.'" Marl advertised market manipulation on the internet! And it took the SEC 4 years and $1.2mm in subscriptions from 75,000 defrauded customers to catch him. I am going to go register (actually, it's taken, try it, the results are mildly amusing) and see how long it takes the SEC to bother me. Anyway. Not looking at any of Egan-Jones's 200 fake ratings for four years seems worse than that.


Quis Custodiet Ipsos Egan-Joneses?

Let's not stop there with the clichés.* Here's a great one: "never attribute to malice that which can be adequately explained by stupidity." In applied form: your model of all the AAA mortgage CDOs that were maybe not so AAA could be "ratings agencies were paid by banks so they were venal and corrupt and sold the banks good ratings on products they knew were bad." Or it could be "ratings agencies created medium-dumb criteria to make a thing be AAA, and bankers who were smarter than medium-dumb arbed those criteria to make more things be AAA than should have been AAA." The incentives model has good economic theory behind it, and some suggestive evidence; the stupidity model has that lovely cliché but also some evidence, about which more later. But first hilarious contrarian ratings agency Egan-Jones is in trouble: