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Ratings Firms Exposed to Fraud: Expert

NEW YORK ( TheStreet) -- The Securities and Exchange Commission has a good shot at proving civil fraud charges against Moody's Investors Service (MCO - Get Report) and McGraw Hill Cos. (MHP), according to one of the nation's most prominent securities law experts.

The SEC is looking at "whether the ratings companies committed fraud by failing to do enough research to be able to rate adequately the pools of subprime mortgages and other loans," underwritten by big banks like Citigroup (C - Get Report), Bank of America (BAC - Get Report), Goldman Sachs (GS - Get Report), Morgan Stanley (MS - Get Report) and JPMorgan Chase (JPM - Get Report) that blew up, causing the credit crisis, according to a report in The Wall Street Journal Friday.

Columbia University Securities Law Professor John Coffee argues the SEC may have a case, stating in an email exchange that evidence compiled by several economic researchers shows strong evidence the ratings firms systematically engaged in grade inflation.

"That kind of adjustment does sound like fraud, whereas passivity can be defended as simply non actionable negligence. Thus, the strength of such a suit will likely depend on what is alleged," Coffee writes. "It is important to go beyond charges of inactivity and assert (as the economic evidence seems to show) that they deviated from their own models to inflate their ratings."

Investors appear to be taking the report seriously, as shares of both Moody's and McGraw Hill, which have been strong performers this year, were down sharply Friday morning.

Despite the hot water the ratings agencies could be in, they are better off with the SEC, Coffee said in a follow-up phone conversation, than they would have been if the U.S. Justice Department had brought the case. That's because "the SEC tends to settle cheaply," he argued.

"I think that there may have been some jurisdictional rivalry and probably a compromise in the SEC pursuing the case because it would not make sense to have everyone piling on and suing the rating agencies. If I were the defendants, I would prefer to be sued by the SEC than the Department of Justice--even civilly," he said.

Calls to spokespeople at the SEC, the two ratings agencies and the Justice Dept. were not immediately returned.

-- Written by Dan Freed in New York.

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