Financial reform will bring significant changes to credit rating agencies and their clients. In a climate of increased transparency and oversight, rating agencies will not only need to revise their procedures but also protect themselves against new liabilities.
Registration Statements. Under Section 11 of the Securities Exchange Act, a rating agency that consents to its ratings being used in a registration statement will be subject to the same liability standards that accounting firms and securities analysts face. Investors will be able to sue a rating agency if they can show “facts giving rise to a strong inference that the credit rating agency knowingly or recklessly failed (i) to conduct a reasonable investigation of a rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk; or (ii) to obtain reasonable verification of such factual elements … from other sources that the credit rating agency considered to be competent and that were independent of the issuer and underwriter.” It remains to be seen how courts will determine whether a rating agency conducted a “reasonable investigation.”
We have already witnessed an important, and perhaps unintended, consequence of the legislation on the market for structured finance. The major credit rating agencies have stated that they will not consent to their ratings being included in registration statements for asset-backed issuances. Within hours of President Obama’s signing the bill into law, Ford Motor Credit Corporation withdrew a bond offering, stating it could not comply with the requirement to disclose ratings in its offering documents. The SEC quickly issued a No-Action letter allowing asset-backed debt issuances without including ratings – but only until January 24, 2011.
Information Gaps. The omission of ratings from certain securities creates a transparency Catch-22. Most market participants would argue that having ratings available adds value for investors and debt issuers. If rating agencies become targets of litigation due to perceived “errors,” they might restrict the availability of their ratings.
As a result of Dodd–Frank, several important pieces of legislation, including the Federal Deposit Insurance Act, the Investment Company Act, and the Federal Housing Enterprises Financial Safety and Soundness Act, no longer require credit ratings; instead they refer to general statements of creditworthiness that securities must meet. Encouraging investors and government agencies to expand their own analyses and reduce their dependence on the rating agencies may foretell less availability of credit ratings, depriving market participants of critical information.
Rating agencies have, to date, been exempted from requirements allowing debt issuers to share material nonpublic information with them, and have incorporated confidential information into their ratings. For example, a company could discuss the implications and financing of a proposed corporate acquisition with the rating agencies before the deal is publicly announced.
If the end result of the legislation is that companies can no longer have such confidential discussions, firms may be forced to make decisions with incomplete information about the rating implications of their actions. As a result, they may make decisions that surprise both the market and rating agencies.
“Conservative” Ratings. Will the new restrictions cause more conservative ratings, particularly in the highest rating categories? Since the legislation is intended to protect investors, there is an implied incentive for the rating agencies to lower their ratings. Over time this may alter the relationship between credit ratings and historical rates of default associated with each rating category. The whole purpose of ratings is to make distinctions in creditworthiness; it would hardly serve the market well to lump good credits with much weaker ones in low rating categories, just to avoid making “mistakes.” ■
William Chambers, Ph.D., is an Associate Professor at Boston University and a former Managing Director of Standard & Poor's.
This feature appeared in the Winter 2011 issue of Forum.