Jurists (perhaps aspirationally) claim, “The mills of justice grind slowly, but they grind exceedingly fine.” [1] The U.S. Securities and Exchange Commission (the “SEC”) arguably realized the first part of this maxim on January 21, 2015, when it brought (and settled) its first-ever enforcement actions against a credit rating agency, Standard & Poor’s Rating Services (“S&P”).[2] The trio of orders, which found that S&P misrepresented the methodology it used to rate certain commercial mortgage-backed securities in 2011, came almost twenty years after the SEC first suggested credit rating agencies be subject to regulation[3] and eight years after Congress gave the SEC authority to regulate the agencies.[4]
Credit rating agencies (also known as NRSROs, or nationally recognized statistical rating organizations) rate a variety of fixed-income instruments, including bank loans, corporate and sovereign debt, and structured finance instruments like mortgage-backed securities. An NRSRO’s rating is meant to indicate an instrument’s quality and safety. For example, the three major NRSROs (S&P, Moody’s Investors Service, and Fitch Ratings) are unanimous in reserving (or purporting to reserve) the “AAA” rating for “investment-grade” instruments of the highest water: those with the lowest credit (default) risk.[5]
Optimally, NRSROs are meant to provide objective and reliable assessments of instrument quality. Investors heavily rely on NRSRO ratings in making investment decisions; therefore, NRSRO ratings have a real impact on capital markets. However, the integrity of NRSRO ratings can be questionable. For example, in 2001 NRSROs rated Enron Corporation a “good credit risk” until just four days before its massive bankruptcy.[6] More recently, in August 2007, all three major NRSROs gave AAA ratings to portions of a $1.6 billion collateralized debt obligation (“CDO”), only to downgrade those ratings to “junk” (generally reserved for highly speculative instruments with a high risk of default) by the end of 2008.[7] Criticism of inflated NRSRO ratings and subsequent, unavoidable downgrades was particularly prevalent in the period following the 2008 financial crisis.[8]
Lawmakers have generally attributed NRSROs’ ratings follies to a combination of conflicts of interest (significantly, issuers pay NRSROs to rate their instruments; NRSROs who provide more appealing ratings naturally win business over other NRSROs) and imperfect internal controls (i.e., failures of diligence and rating methodologies). The Enron scandal prompted Congress to mandate study of some of these problem areas,[9] but only the past decade has seen escalating, concrete regulatory measures. In 2006, Congress passed the Credit Rating Agency Reform Act, which codified the NRSRO registration process (previously done by the SEC on an ad hoc basis) and made the SEC responsible for NRSRO oversight.[10] 2010’s Dodd-Frank Act mandated further regulation and reform; however, SEC rulemaking implementing the law has been slow and enforcement nonexistent.[11]
That is, until the SEC’s January 21, 2015 orders. Mission accomplished, then? Perhaps the mills of justice have (slowly, over many years) finally done their work. And yet, perhaps not. S&P will pay $58 million to settle the SEC’s charges and has agreed to a one year “time-out” from rating the narrow class of instruments at the center of the enforcement actions. Yet, in 2014, S&P generated over $1.1 billion in new ratings and ratings estimates revenues alone.[12] Against that backdrop, can we really say $58 million and a closely-cabined “time-out” for ratings misconduct is “exceedingly fine?”
Ashley Hersutamto
[1] See, e.g., Vineberg v. Bissonnette, 548 F.3d 50, 59 (1st Cir. 2008).
[2] SEC Announces Charges Against Standard & Poor’s for Fraudulent Ratings Misconduct, SEC.gov (Jan. 21, 2015), http://www.sec.gov/news/pressrelease/2015-10.html.
[3] See generally Nationally Recognized Statistical Rating Organizations, Release No. 34-34616, 59 FR 46314 (Sept. 7, 1994).
[4] See generally Credit Rating Agency Reform Act of 2006, Pub. L. No. 109-291, 120 Stat. 1327.
[5] See Krista Santos, Corporate Credit Ratings: A Quick Guide, in Treasurer’s Companion 45, 46, http://www.treasurers.org/system/files/CMF_corpcredit_ratings_what_info.pdf.
[6] Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets, SEC.gov 3 (Jan. 2003), http://www.sec.gov/news/studies/credratingreport0103.pdf.
[7] Shira Ovide, Inside S&P: Fears over an Ill-Fated CDO Deal, Wall St. J. Deal J. (Sept. 27, 2011, 8:05 AM), http://blogs.wsj.com/deals/2011/09/27/inside-sp-fears-over-an-ill-fated-cdo-deal.
[8] See, e.g., Alessi et al., The Credit Rating Controversy, Council on Foreign Rel., http://www.cfr.org/financial-crises/credit-rating-controversy/p22328 (last updated Oct. 22, 2013).
[9] See generally Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets, supra note 6.
[10] See generally Credit Rating Agency Reform Act of 2006, Pub. L. No. 109-291, 120 Stat. 1327.
[11] Dodd-Frank Act Rulemaking: Credit Rating Agencies, SEC.gov, http://www.sec.gov/spotlight/dodd-frank/creditratingagencies.shtml (last visited Feb. 16, 2015).
[12] McGraw Hill Fin., Inc., Annual Report (Form 10-K) (Feb. 13, 2015) (S&P is a division of McGraw Hill Financial, Inc.).