The rating agencies’ refusal to allow ratings to be included prospectuses and other offering documents highlights the haphazard reform embodied in the new financial regulation. This adds one more fire for the US Securities and Exchange Commission to fight, as it tries to implement the tall orders given it by the US Congress.
Rating agencies are implementing a ‘seller’s strike’ in response to increased liability imposed by the recently passed financial reform legislation. The legislation subjects ratings agencies to ‘expert status’, making the raters as liable as the underwriters of a security issue.
The legislation repealed Rule 436(g) under Section 11 of the 1933 Act, which exempted NRSROs from expert status. 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).
Ratings agencies are not just concerned with the reduced levels of legal protection, but are also spooked by the heightened levels of liability. Realpoint LLC CEO Robert Dobilas explains, “When you think about it, the liability level is equivalent to the issue amount. For a $350 million security, the liability is $350 million.”
Realpoint, which was recently acquired by Morningstar, specializes in rating structured debt, and has attempted to develop an alternative business model to issuer-paid ratings. Frustratingly to Realpoint and other agencies which have tried to create subscription-oriented business models, the recent regulation did nothing to encourage alternative business models.
Perversely, the heightened liability may further entrench the issuer paid business model. Although ratings fees charged on structured transactions are the highest, ratings agencies do not feel they are high enough to justify the new levels of liability. It remains to be seen whether the market will support higher ratings fees, but it most definitely makes a lower-fee subscription model more tenuous.
It is possible that one work-around to the current impasse would be to deliver ratings directly to investors, rather than through offering documents. However, fixed income investors have been so far reluctant to pay for ratings analysis that they have heretofore received gratis.
Other than the repeal of 436(g), Congress punted on all the other rating agency reform it was contemplating. Instead it tasked an already over-burdened SEC to study the problem, and come back with recommendations. And now the SEC has one more problem to address, which is how to get the structured bond markets going again without including ratings in offering documents.