Massachusetts AG Challenges SEC
The attorney general of Massachusetts, Martha Coakley, has sent a letter to the chairwoman of the Security and Exchange Commission (SEC), Mary Schapiro, asking why the commission is refusing to enforce ratings agencies’ liability requirements. When Dodd-Frank became law, ratings agencies were subject to expert liability from that moment on. This opened the agencies to lawsuits from investors.
The New York Times quotes Ms Coakley as saying in an interview that, “We wanted to make clear that we see this as a problem and important enough that we would like an answer… “They [the SEC] are either going to enforce this or say why they are not. As a state regulator, we don’t enforce Dodd-Frank, but we certainly deal with the fallout when it is not enforced.”
The New York Times also quoted Meredith Cross, director of the SEC’s division of corporation finance. She explained the agency’s decision to not enforce the regulation by saying, “If we didn’t provide the no-action relief to issuers, then they would do their transactions in the unregistered market…You would impede investor protection. We thought, notwithstanding the grief we would take, that it would be better to have these securities done in the registered market.”
SEC Eliminates Ratings Requirement
In a 5-0 vote the Securities and Exchange Commission (SEC) proposed that key
documents intended to expedite the securities offering process no longer require a ratings reference. This action is part of broader initiative required by the Dodd-Frank financial reform law to eliminate ratings reference from all federal rules.
If the proposal is implemented, S-3 and F-3 “short form registration” documents that help to speed the offering process for selling securities “off the shelf” would no longer require that the company offering the bonds show the debt was given an investment-grade rating. Instead the SEC would require that the company be a “well-known, seasoned issuer.”
An SEC study suggests that if this regulation had been implemented between 2006 and 2008, 45 of about 1000 companies that issued debt securities would not have been eligible to use the expedited form.
SEC Denies Dagong Registration
China’s largest credit rating firm, Dagong Global Credit Rating Co. was denied status as an officially recognized bond rater in the United States. The Securities and Exchange Commission (SEC) explained that Dagong’s proposal to have China’s securities regulator review all correspondence between the SEC and Dagong would be inconsistent with federal securities law. Dagong argued that it was necessary to have their securities regulator vet and broker correspondence to insure no state secrets were inadvertently released.
The SEC also denied the application because “it does not appear possible at this time for Dagong to comply with the recordkeeping, production, and examination requirements of the federal securities laws.”
Dagong being a foreign agency did not influence the SEC’s decision. Fitch Ratings is a Nationally Recognized Statistical Rating Organization (NRSRO) and they are part of the French company. Likewise, DBRS Inc. is an NRSRO and they are Canadian.
Never before has a firm been denied NRSRO status. An NRSRO designation makes it possible for a firm’s ratings to be used as benchmarks in U.S. laws and regulations.
Comment Period for Changes to Regulation AB Passes
In May, in an effort to bring trust and greater activity back to the asset-backed securities market, the Security and Exchange Commission (SEC) proposed significant changes to Regulation AB. This regulation dictates what information issuers of asset-back securities must provide to investors in prospectuses. The SEC intends to tighten the rules and the comment period on those changes has now passed.
Issuers of asset-backed securities will no long be able to file a “shelf registration” that they can use again and again to issue bundled securities with no clear disclosure of what is inside. Second, sellers must give investors time to assess the value of these complex securities before they can offer them for sale. And third, independent parties will be required to monitor these asset-backed securities to ensure they are performing as anticipated.
By requiring so much new information, the SEC is reducing the role of ratings agencies and urging investors to do more of their own analysis. The New York Times quoted the reaction that Ann Rutledge had to the rule changes. Ms. Rutledge is the co-founder of R & R Consulting, a structured credit analytics firm in New York. “My reading of this proposed ruling is it’s a very practical way of closing loopholes,” said Ms. Rutledge. “The regulators are now beginning to understand why they put the rules on the books and how the market worked around them.”
Moody’s Avoids Lawsuit
The Securities and Exchange Commission (SEC) announced that they were not going to file suit against Moody’s for fraud even though it had evidence that the firm had knowingly misled investors.
According to The Washington Post, Moody’s executives discovered they had provided ratings that were too optimistic but had chosen not to correct them because, “downgrades could negatively affect Moody’s reputation.”
The SEC explained that it did not file suit because of “jurisdictional” limitations; the activity occurred in Europe and was, at the time, outside the agency’s authority.
The agency did say, however, that the decision may have been different if the fraudulent activity had taken place after it was given the power by Congress to sue credit-rating firms engaged in “otherwise extraterritorial fraudulent misconduct” in the financial regulation overall legislation that was enacted this summer.
The SEC usually does not issue a report when it is not going forward with a suit, but The Washington Post clarifies that in this case, “…agency officials said they wanted to send a message in reviewing their findings in the Moody’s probe that credit-rating firms would face increased scrutiny.”
SEC Seeking Public Input To Rules Making
The Securities and Exchange Commission (SEC) has announced an unusual open-door rulemaking procedure to facilitate the development of new credit rating agency regulations required by the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act.
The public can provide preliminary comments over the next 18 months, and comments will be posted on the SEC website.
The new procedure goes beyond what is required by the Administrative Procedure Act that governs federal rulemakings, and SEC Chair Mary Shapiro promised greater public disclosure of meetings with SEC staff as well.
Ms. Shapiro also said commission staff would meet with as many interested parties as possible, seek out parties with different points of view, and solicit opinions from those who do not appear to be fully represented. Good news, and a potential for a balanced, market-based solution.
SEC Steps In To Untangle Conflicting Regulation
The Securities and Exchange Commission (SEC) was needed recently to unravel an impossible situation that resulted from the newly passed financial reform act.
The new law creates legal liability for the evaluations that the ratings agencies assign to new bond issues. As a result, the ratings agencies refused to allow clients to use their ratings in documents needed to register new bond products. However the issuers are required by the SEC to include these ratings in their registration documents.
Bond issuers found themselves in an unworkable position and, in this case, the market selling new bundles of auto and consumer loans came to a full stop.
To circumvent the problem, the SEC announced that for the next six months ratings would not be required to register new bond products.
In a prepared statement Meredith Cross, director of the SEC’s corporate finance division said, “This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement while still conducting registered ABS (asset-backed securities) offerings.”
The confusion caused concern among the investment community. The Washington Post quotes Jeffery Elswick of Frost Investment Advisors as saying, “It’s still kind of murky…I’ve been involved in the asset-backed markets for 18 years, and I don’t understand [the legislation] at this point. If I don’t understand it, a lot of people don’t.”
Financial Reform Act Includes New Rules for Ratings Agencies
The Dodd-Frank Wall Street Reform and Consumer Protection Act has passed into law. It immediately subjects ratings agencies to greater liability and limits their protection under the First Amendment that they had historically used to defend themselves from investors angry about highly rated securities that later turned sour. Specifically, rating agencies can now be sued if the plaintiff can prove that an agency “recklessly” neglected to review key information when creating a rating.
The Securities and Exchange Commission (SEC) was also directed to find a way to alleviate the risk of conflict of interest at rating agencies who are paid by the issuers whose debt they rate. If after two years the SEC does not find a solution, they are required to implement the Franken amendment and to create a board that assigns a rating agency to a debt issuer. The issuer would still be free to hire their own rating agency in addition to the one it was assigned; however, the rating provided by the assigned agency must be made available to investors.
Eventually, federal regulators will be required to remove all credit rating references from their rules to reduce reliance on the credit rating agencies. Congress will hold hearings in 12 months to review this action.
Rating Agencies Are Looking More Vulnerable To Lawsuits
For over 70 years, when faced with lawsuits challenging the ratings they assigned to investments that later turned sour, rating agencies have successfully defended themselves by invoking their First Amendment rights. Although the agencies’ string of victories is still impressive, they are beginning to appear more vulnerable.
There are several major lawsuits that have progressed beyond the pretrial phase. These could possibly end with settlements that would prove very expensive for the agencies as well as establish a model for future litigation.
Two judges have also rejected the rating agencies’ First Amendment defense. In one case, Federal Judge Shira Scheindlin in Manhattan, ruled that the First Amendment did not apply because the rating agencies had, “disseminated their ratings to a select group of investors rather than to the public at large.”
Additionally, it was disclosed recently that the Securities and Exchange Commission has warned Moody’s that it may sue. At issue is how several of Moody’s executives allowed some European derivatives to keep high ratings even after they had learned that the grades were the result of a computer error.
2008 Congressional Hearings Sheds Light On Rating Problems
From Congressional testimony in 2008, only 2.2% of corporate bonds rated “investment grade” by Moody’s defaulted between 1983 and 2005. However, 24% of complex structured financial products like collateralized debt obligations (CDOs) based on sub-prime mortgages, also rated “investment grade” by Moody’s, defaulted between 1994 and 2005.
Congressional testimony records that CDO issuers had shopped around for ratings until their high-risk securities came to be rated as safe. According to a 2008 study published by the U.S. Securities and Exchange Commission (SEC), the “issuer pays” model leads to serious conflicts of interest for credit rating agencies. An issuer can have a security evaluated by multiple rating agencies and then choose to use the best rating it can get. However a rating agency is paid only when its rating is used. The incentive, therefore, is to give a security the highest rating possible in order to be paid for the work.
There were only several mortgage companies and investment banks that were issuing CDOs and other complex instruments, and they paid large fees for these ratings. Between 2002 and 2007, Standard & Poor’s, Moody’s, and Fitch saw their revenues rise twofold to $6 billion a year, mostly from work with CDOs.
