On August 5, 2009, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies.” Testifying before the committee were the following individuals.
- Michael S. Barr, Assistant Secretary-Designate for Financial Institutions, U.S. Department of the Treasury
- John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School
- Lawrence J. White, Leonard E. Imperatore Professor of Economics, New York University
- Stephen J. Joynt, President and Chief Executive Officer, Fitch Ratings (Fitch)
- James Gellert, President and CEO, Rapid Ratings
- Mark Froeba, Principal, PF2 Securities Evaluations, Inc.
In his introductory remarks, Senator Shelby voiced his opinion that the Credit Rating Agency Reform Act of 2006, passed while he was Chairman of the Committee, has been effective in fixing flaws in the SEC’s regulation of credit rating agencies although it “did not have time to take root before the problems [it was] intended to remedy took their toll.”
Mr. Barr described the Obama administration’s proposed legislation, the Investor Protection Act of 2009, which he said would directly address three problems in the role of credit rating agencies:
- lack of transparency in rating and the ratings process;
- ratings shopping by issuers and underwriters; and
- conflicts of interest.
The proposed legislation would require more disclosure of rating methods and risks. With respect to ratings shopping, an issuer “would be required to disclose all of the preliminary ratings received from different credit rating agencies so that investors could see how much the issuer ‘shopped’ and whether the final rating exceeded one or more preliminary ratings.” The proposed legislation would also bar rating firms from consulting for the companies they pay. While defending the need for regulation of credit rating agencies generally, Mr. Barr argued that the government should not be involved in regulating how the credit rating agencies determine the ratings which, according to him, the proposed legislation does not do. “The government should not be in the business of regulating or evaluating the methodologies themselves or the performance of ratings.”
Professor Coffee praised the proposed legislation but found it lacking in two respects. First, it would not do enough to require due diligence on the part of credit rating agencies. Second, the Act would do nothing to alleviate the apparent immunity of credit rating agencies from liability. “Let me make clear that I do not want to subject credit rating agencies to class action litigation every time a rating proves to be inaccurate. Rather, the goal should be modest: to use a litigation threat to induce the rating agencies not to remain willfully ignorant and to insist that due diligence be conducted and certified to them with regard to structured finance offerings.”
Dr. White argued that regulatory reliance on ratings should be eliminated. “The heightened regulation of the rating agencies is likely to discourage entry, rigidify a specified set of structures and procedures, and discourage innovation in new ways of gathering and assessing information, new technologies, new methodologies, and new models (including new business models) – and may well not achieve the goal of inducing better ratings from the agencies. Ironically, it will also likely create a protective barrier around incumbent credit rating agencies.”
Mr. Joynt testified that conflicts of interests inherent in issuer-pay rating agencies are currently well-managed by Fitch through “policies, procedures and organizational structures aimed at reinforcing the objectivity, integrity and independence” of ratings. He stated that the rating business and analysis are separate, analyst compensation is not based on their ratings, ratings are the result of a committee and all non-ratings related matters are insulated from the ratings operations. Mr. Joynt also argued that a subscriber-pay model contains similar conflicts of interest. With regards to transparency, he explained that Fitch’s rating procedure is disclosed publicly and available to scrutiny. In addition, he argued that due diligence is the sole responsibility of issuers and that increased liability for failure to accurately predict the future is unreasonable. Rating agencies are equally as accountable for securities fraud as any other entity, and should also enjoy the same free-speech rights.
Mr. Gellert testified that the Sarbanes Oxley Act of 2002 and the Credit Rating Agency Reform Act of 2006 created an environment of conflicting interests for rating agencies. According to Mr. Gellert, the proposed legislation contains some steps in the wrong direction that could further complicate the problem. He made the following observations:
- Corrections to the issuer-paid model should not also be applied to subscriber-paid firms.
- The private intellectual property of rating agencies must remain confidential.
- The SEC should not be charged with determining accuracy; that will be done automatically through the competition achieved by the low cost of entry into the rating market.
- If all credit rating agencies are forced to acquire Nationally Recognized Statistical Rating Organization (“NRSRO”) registrations, it will lower the level of competition by raising the cost of market entry.
- If subscriber-pay credit rating agencies are forced to disclose historical ratings, their business will be adversely impacted.
Mr. Froeba argued that the proposed legislation would not accomplish its goals of preventing a future crisis and restoring investor confidence in credit ratings, noting that the legislation would not have prevented the crisis if it had been enacted 5 years earlier. Instead, he made five suggestions.
- The business and analysis of credit ratings should be insulated from each other.
- The way employees of credit rating agencies are compensated should be changed such that employees cannot own stock in the credit rating agency.
- There should be consequences for “unreasonably bad ratings,” or inaccurate ratings.
- Credit rating agencies should be allowed to cooperate and discuss ratings.
- Standards for the credit rating profession should be created.
Mr. Froeba also advocated a hybrid system of payments to credit rating agencies (combining investor and issuer-pay) that will be both sustainable and accountable to the consumers as opposed to the current system in which the issuers pay the rating agencies that evaluate their securities.