Rating Agencies May Squeak Through


New York – Senator Al Franken’s rating agency amendment has grabbed headlines, but the Senate’s version of rating agency reform would be less damaging to the rating agencies than the House version.  Rating agencies may not acknowledge it, but they will owe much to Senator Franken if his amendment makes it into the final legislation.

Franken’s Amendment

Senator Al Franken (D-MN), the former Saturday Night Live comedian, introduced an amendment to the Senate’s financial overhaul legislation which passed the Senate 64 to 35, garnering support from 10 Republicans.  Franken’s measure requires the SEC to establish a Credit Rating Agency Board to assign an NRSRO (‘Nationally Recognized Statistical Ratings Organization’, which are rating agencies approved by the SEC) to provide an initial credit rating on a structured product when an issuer seeks a rating.  To be eligible for selection by the Board, an NRSRO must apply to the Board to become a “qualified NRSRO” for the class of structured product (such as mortgage-backed or asset-backed securities) in question.

The Board is to be comprised primarily of representatives of the investor industry, with at least one representative of the issuer industry, one from the credit rating industry, and one independent member.  The bill directs the Board to “evaluate a number of selection methods, including a lottery or rotating assignment system.”  It also requires the Board to evaluate each qualified NRSRO each year, with the findings made available to Congress.

The idea behind the Franken amendment is similar to mechanisms which various stock exchanges have put in place to provide issuer-paid coverage of under-followed stocks.  The London Stock Exchange launched a program in 2008.  Previously NASDAQ, along with Reuters, had set up an ‘Independent Research Network’ in 2005, which was shut down in 2007.  None of the equity market mechanisms have been especially successful, primarily because the equity markets, unlike the debt markets, have never embraced the issuer-paid model.

What the Senate Bill Left Out

As we have been saying since 2007, the most certain ratings agency reform is to weaken the rating agencies’ liability protections.  Each version of proposed ratings agency reform includes language to this effect.  However, little attention seems to have been paid to a very important component of ratings agency liability defenses, which is an obscure SEC rule which exempts rating agencies from the liabilities faced by underwriters, legal counsel and other insiders to a security transaction.  Rule 436(g) exempts NRSROs from ‘expert status’ under Section 11 of the 1933 Act, which makes it easier for investors to sue experts than would be the case under common law.

Under Section 11, an expert may be held liable if the expert is responsible for an untrue statement of material fact or omitted a material fact necessary to make statements not misleading, unless the expert can establish that it had reasonable grounds to believe and did believe at the time that the statements were true.  Expert status wipes away the common law protections of scienter (intent to deceive), reliance (proof that the investor relied on the rating when making the investment) and causation (that the misleading information from the expert caused the loss to occur).

The House rating agency reform bill nullifies Rule 436(g).  The Senate bill makes no mention of the rule, although it does contain language to increase rating agency liability.

Different Approaches to Rating Agency Reform

Besides increasing rating agency liability, the House version of rating agency reform moves to systematically expunge references to credit ratings in existing regulation and to make government agencies reliant on different standards than credit ratings issued by NRSROs.  The House bill, largely authored by Rep. Paul Kanjorski (D-PA), compels federal agencies to look for references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards.  It also directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness “to the extent feasible.” The Senate provision includes none of this language.

The House approach is to remove the regulation and legislation that encourages the use of NRSRO ratings, distancing government from ratings.  The Senate approach, through Franken’s amendment, inserts government in the middle of the rating process as a mechanism to reduce conflicts.  While not wholly incompatible, the two bills have very differing underlying philosophies.

Which is Worse?

The ratings agencies became an oligopoly largely because of government support.  Thanks to government regulations, credit ratings determine bank, investment banking and insurance capital levels, define what money market funds can or cannot own, and are allowed to have access to material non-public information.  Rule 436(g) exempts ratings from expert status. Eliminating these privileges would weaken credit ratings significantly.  However, the impact would take time, partly because of the size and difficulty of the task of eliminating ratings from regulation.

Under any scenario, rating agency liability will increase.  All versions of legislation have language to this effect.  Even if the repeal of Rule 436(g) is not included in the final legislation, the SEC may rescind the rule anyway.  It issued a concept release late last year considering whether to eliminate the rule.

The Franken amendment, unlike the House approach, does not upend the status quo.  Rather it preserves the current regime while trying to reduce the inherent conflict.  Conflicts remain, however.  Franken’s amendment allows issuers to get ratings from other agencies as long as the initial credit rating is provided by the agency assigned by the Board.  Since the structured market has tended to require two ratings, this would allow the ‘majors’ (Moody’s, Standard & Poor’s and Fitch) to retain market share.

The Franken amendment will be positive for new competition (contrary to public statements made by some of the NRSROs opposing the legislation).  It will make it easier for upstart firms to get ratings assignments.  Overall, the Franken amendment perpetuates the implicit support which government agencies have provided rating agencies.  The House ‘cold turkey’ approach would be far more damaging, but it does not offer the quick fix of the Franken amendment.

Another Approach

One way to radically reform the rating agencies is to cut their tie with investment banks.  As we have noted in the past, the rating agencies are the creation of the investment banks.  The current NRSRO regime was implemented after Goldman Sachs was nearly destroyed by the bankruptcy of Penn Central in 1970.  Goldman decided it no longer wanted the liability associated with credit research, preferring to outsource it to the ratings agencies.  To upgrade the staff of the sleepy ratings agencies to produce the kind of research required, they had to generate higher fees.  Goldman, and other investment banks, brought the deals to the ratings agencies, facilitating the adoption of the new business model.  The investment banks also used their lobbying power to obtain Rule 436(g) and other regulatory perks.

So, if Congress really wants to change the rating agencies, require the investment banks to provide credit analysis as part of a new bond issue.  Investment banks already have the expertise to evaluate the debt since they are instrumental in creating it.  They are already highly regulated, as is the research they currently provide for equities and other asset classes.  And they already have liability standards as experts which hold them more accountable than under common law.  Conflicted?  Sure, but no less than the current issuer-pay model.

This would very quickly deflate the rating agencies ability to charge issuers, because most issuers would balk at paying incremental fees for an analysis already covered by their banking fees.  (Banking fees might increase, of course, to cover the incremental costs to the investment banks.)  Investors would continue to have credit analysis available if they do not have the willingness or ability to invest in their own credit staff.

Rating agencies have been impervious to previous attempts at reform.  They will not be so lucky this time.  However, the degree of damage to their models varies greatly in proposed legislation, and, thanks to the Franken amendment, it is possible that they can come through the current crisis with their model relatively intact.


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