As credit-rating agencies, including Standard & Poor’s, Moody’s and Fitch try to rebuild their image and credibility in the wake of the U.S. financial Crisis, the SEC proposed new rules to promote transparency and eliminate conflicts of interest. The proposed rules target a select group of credit-rating agencies called Nationally Recognized Statistical Rating Organizations (“NRSROs”). NRSROs have been under intense scrutiny since regulators and other industry watchers began examining their role in the sub-prime mortgage crisis. Critics argue that NRSROs provided
AAA bond ratings on mortgage backed securities and other collateralized debt obligations that should have received significantly lower credit-ratings. Historically, NRSROs have served as “financial gatekeepers” that assess the risks associated with certain public and private bonds and other securities. NRSROs are primarily funded in two ways: (i) by issuers, sponsors, or underwriters of securities (commonly known as “arrangers”) that seek ratings to sell securities; or (ii) subscribers (e.g bond purchasers) who pay to have access to and rely upon NRSROs credit rating data. NRSROs, however, have several other sources of revenue. Many NRSROs are also paid to advise arrangers on how to structure complex financial products that are later rated by the same NRSROs. The structuring of these complex financial products often lead to lucrative commissions for the NRSRO’s, which creates an inherent conflict of interest. Some critics also accuse arrangers of seeking undisclosed “preliminary ratings” from NRSROs in an effort to “shop” for the most favorable credit-rating. Among other goals, the SEC’s proposals seek to address concerns about conflicts of interest and “ratings shopping.” The key proposals are as follows:
- Disclosure of Conflicts of Interest: Require NRSROs to disclose (i) their net revenue attributable to the 20 largest users of credit rating services; and (ii) the percentage of their net revenue attributable to other services and products. In addition, the NRSROs would have to post a consolidated report at the end of each fiscal year that discloses the name of any person (or company or institution) that purchased services and products other than credit-rating services from the NRSRO and disclose the relative percentage of net revenue earned by the NRSRO from that person (to 10%, top 25%, top 50%, bottom 25%).
- Annual Compliance Reviews: Require NRSROs provide to the SEC an annual report describing their compliance reviews for the most recently completed fiscal year. The reports will outline the steps the NRSROs have taken to comply with securities laws and describe any material compliance issues.
- Disclosure of Credit Rating Reviews: Require NRSROs disclose to all other NRSROs when they are in the process of determining the credit rating of a structured financial product for an arranger. The rule would also require NRSROs to obtain a representation from the arranger that the arranger will provide the same information to other NRSROs seeking to rate the product.
- NRSRO liability under the Securities Act: Require that if an issuer or registrant includes a credit-rating issued by an NRSRO in a registration statement then the issuer or registrant would be required to file the consent of the NRSRO, which would subject the NRSRO to potential liability as an expert under the Securities Act.
The SEC’s proposals come on the heals of the California Attorney General’s announced investigation of credit-rating agencies’ role in fueling the financial crisis and a federal court ruling that held credit-rating agencies can’t use a “free speech” defense to avoid liability for faulty ratings reports. On September 17, 2009, California Attorney General, Jerry Brown, launched an investigation of whether Standard & Poor’s, Moody’s, and Fitch broke state consumer protection or unfair business practice laws in connection with the ratings they issued on mortgage backed securities. NRSROs typically claim that their ratings are protected “opinions” under the First Amendment, but a federal judge recently ruled in a case against several NRSROs that such a defense is not available to an NRSRO due to the widely disseminated nature of the opinions and the reliance on the opinions by investors. The federal court ruling was in a case brought by investors that lost millions of dollars in a structured investment product containing over valued highly rated mortgage backed securities.
The NRSROs are expected to survive this latest round of regulations, investigations and lawsuits, but the question remains—will they ever retain their unquestioned credibility? Many industry observers believe that the industry titans Standard & Poor’s, Moody’s, and Fitch are going to be the ultimate losers. The new SEC regulations are targeted to promote competition and reduce their industry leading market share. Moreover, the mounting investigations and lawsuits against Standard & Poor’s, Moody’s, and Fitch continue to erode their remaining credibility.