There is a distinction to be made when examining REG-FD and comparing what the Securities Exchange Commission expects it to do, with what the effect of the regulation actually has.
Rise to Power
“We live again in a two-superpower world. There is the U.S. and there is Moody’s. The U.S. can destroy a country by levelling it with bombs: Moody’s can destroy a country by downgrading its bonds.”[i] In order to fully explain the role of the rating agencies in the current state of affairs, it is first necessary to provide a brief history of these companies and attempt to explain why they have so much power[ii].
A credit rating agency is a company that reviews a set of factors[iii] for certain types of debt obligations (such as a loan) and the underlying instrument itself. On many occasions, a rating agency will rate the issuer of the underlying debt as well. In theory, a rating agency exists to allow an objective third party to assess the credit worthiness of another person, entity or debt obligation.
An early form of rating agencies emerged in the nineteenth century when investors were dealing with failed railroads and skeptical land schemes.[iv] In 1868 Henry V. Poor released the first Manual of the Railroads of the United States, which reached five thousand subscribers by the early 1880s.[v] John Moody saw an opportunity[vi] because at that time, “A high percentage of corporation securities had to be bought on faith rather than knowledge.”[vii] Moody then went on to begin publishing his Manual of Industrial Statistics in 1900.
It wasn’t until 1909, that Moody began assessing creditworthiness, which was partially based “on the mercantile credit rating of retail businesses and wholesalers by companies like R.G. Dun and Company.”[viii]Materials on the history and development of rating agencies suggest that there were three phases of growth in both reputation and authority. The first phase, was in the early 1930s, when rating agencies became a requirement for selling any issue in the United States. From the 1930s to the 1980s, rating agencies became more prominent as a result of the U.S. bond market prevailing over a series of defaults by major sovereign borrowers.[ix]Rating agencies gained more power and influence as the high-yield junk bond market developed in the 1980s.
During the second phase, legislation was passed that gave the rating agencies broader power and authority over the investments that were made. “In 1975, the SEC further pulled ratings into the regulatory system through Rule 15c3-1, the net-capital rule…the rule gave ‘preferential treatment’ to bonds rated investment-grade by at least two ‘nationally recognized statistical rating organizations’ (NRSROs)…The SEC did not define the substance of an NRSRO in any detail.”[x] This act by the SEC helped to solidify the presence of rating agencies and made it incredibly difficult for other rating agencies to emerge in a meaningful way.
The act on the part of the SEC to create this fiction of NRSROs, has in effect, created a situation where issuers are not only buying the individual investor’s trust, but also the right to issue an item on the open market in a lucrative or meaningful way. Many, if not all regulations require at least one of the NRSROs to rate the issue investment-grade for it to be sold at all.[xi] Moreover, the potential for conflicts of interest to arise is heightened by the fact that rating agencies obtain their “valuable” information from the issuers themselves. So how then, is the rating truly independent, when the agencies themselves admit they haven’t always been?[xii]
Additionally, rating agencies do not conduct any of their own audits, but rather fully rely on the issuer’s “books”. Therefore, it is unclear as to whether the information that they receive from an issuer is even accurate. “Much of the responsibility-though not all-for the still smoldering subprime mortgage blaze falls on the shoulders of the three major bond rating companies. They assured the financial world that subprime mortgage bonds were golden investments; in fact, they were time bombs.”[xiii]
It is undeniable that rating agencies play a very significant and substantial role in the United States and by extension the global market place. As mentioned previously, a conflict of interest is inherent when the rating agencies are structured in a way that allows them, perhaps necessarily so, to receive their revenues from the issuers of financial instruments. This conflict is generally largely publicized when a high-rated company fails. For example, Enron, a company who was still rated at investment grade even four days prior to it’s declaration of bankruptcy, paid over $1.5 million annually to Moody’s alone.[xiv]
Attempts at Regulating CRAs
While the Sarbanes-Oxley Act[xv] required that the SEC come to a determination and report on whether additional regulation of NRSROs was necessary, the SEC later determined that they did not have the authority to regulate credit rating agencies. It was not until four years later that legislation was passed in attempts to regulate rating agencies that had achieved NRSRO status.
The Credit Rating Agency Reform Act of 2006[xvi] required that NRSROs register with the SEC and those who did, were subject to additional restrictions.[xvii] Most recently, the so-called “Paulson Blueprint”[xviii], released on March 12, 2008 also called for additional regulatory requirements to be imposed on rating agencies. These “actions” taken on the part of the government to step in, are a signal of change to come, but have done little to satiate critics of rating agencies.
Disaster Stemming from Disclosure
Legislators, in hopes to spur competition amongst rating agencies, have just passed a rule that will serve to create a larger risk of insider trading. [xix] The rule will require that companies disclose information to other rating agencies, even when those agencies have not provided a preliminary rating. One of the commission’s stated intentions for this rule is to prevent issuers from “shopping” for favorable ratings on their structured financial products.[xx] “The rule adopted last week says that whatever information is given to the agency hired by the issuer to rate the structured finance security must be given to other rating agencies, including those that provide analyses only to investors who pay for them. The result will be that analysts for the other rating agencies, like Egan-Jones Ratings, will have access to information not available to the general public, and their analyses will go only to clients. Those clients will have the benefit of nonpublic information, or at least of their agent’s analysis of what it means.”[xxi]
Expected Effects of New Rule & Conclusion
Because agencies are exempt under REG-FD, this serves as a recipe for disaster if the exemption is not removed. The “safeguards” that the commission has put in place amount to nothing more than hoping analysts will honor a promise not to disclose non-public information.
The rule does seemingly address its primary goal, which is to increase competition. However, if the safeguards in place are to rely on the good faith of rating analysts, the rule only increases potential risks. It has become increasingly more difficult to rely on rating agency reputations, and also increasingly more difficult to explain the purpose of these entities. Removing the exemption would go a long way to ensure fairness in the market. In addition, if rating agencies weren’t privy to non-public information, money managers who lost tons of money in collateralized debt obligations would not be able to use the fact that they relied on a rating as an excuse for their acting on bad assumptions.
[i] Thomas L. Friedman, New York Times, 1995
[ii] “As the free capital flowing through debt markets reaches new heights, the American rating agencies’ lever of upgrading, downgrading or putting on the “watch list” seems to have more weight than most international actions by the American government. But even the IMF [International Monetary Fund], as the only global institution with the power to infringe upon the sovereignty of even the biggest nations by carrying out its regular surveillance, looks weak compared with Wall Street’s mighty rating twins.” Klaus C. Engelen, International Economy, 1994.
[iii] “No complaint is more frequently voiced than the lack of clarity about what the ratings actually measure. While ratings are intended by the agencies to gauge the relative degrees of credit quality…how such factors are weighted-and-why-in making the final rating decision remains unclear.” John E. Petersen, The Rating Game: Report of the Twentieth Century Fund Task Force on Municipal Bond Credit Rating, 1974.
[iv] Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and The Politics of Creditworthiness. (Ithaca, NY: Cornell University Press).
[v] Ibid., at 23.
[vi] “somebody, sooner or later, will bring out an industrial statistical manual, and when it comes, it will be a gold mine.” Moody, John. (1933) The Long Road Home: An Autobiography . New York: Macmillan.
[vii] Moody, 1933, at 90.
[viii] Sinclair, 2005, at 24.
[ix] Sinclair, 2005, at 26.
[x] Sinclair, 2005, at 42.
[xi] “pursuant to the Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”) a security must, among other requirements, be rated in one of the two highest rating categories by at least one nationally-recognized rating organization to qualify as a ‘mortgage related security.’” Kenneth G. Lore & Cameron L. Cowan. Mortgage-Backed Securities Database on Westlaw.
[xii] Morgenson, Gretchen. (2008). “Credit Rating Agency Heads Grilled by Lawmakers” at http://www.nytimes.com/2008/10/23/business/economy/23rating.html?_r=1&pagewanted=print
[xiii] St. Louis Post-Dispatch. 2007 WLNR 21478758.
[xiv] Thomas L. Hazen and Jerry W. Markham. Broker-Dealer Operations Under Securities and Commodities Law Database on Westlaw.
[xv] Public Law No. 107-204, § 702, 16 Stat. 745 (2002).
[xvi] Public Law No. 109-291, 120 Stat. 1327, codified at 15 U.S.C.S. § 78o-7.
[xvii] “As part of that application, the NRSRO must disclose its performance measurement statistics, its rating methodologies, whether it has a code of ethics and financial statements were required to be supplied to the SEC periodically…tying practices such as requiring payment for additional services in order to obtain or retain a rating were prohibited.” Hazen and Markham, supra.
[xix] Please see http://www.sec.gov/rules/final/33-7881.htm
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