Commentary: Legal View: The future of credit rating agencies

By Mark J. Kovaleski The Daily Record Newswire The first credit ratings appeared in the United States in 1909, when John Moody began analyzing the stocks and bonds of America's railroads after the stock market crash of 1907. The ratings were based on letter rating symbols that were adopted from the mercantile and credit rating system that had been used by credit reporting firms since the late 1800s. Thus John Moody & Co. became the first to rate public market securities. In a September 2007 speech, Christopher Cox, former chairman of the U.S. Securities & Exchange Commission, noted that beginning in 1975, the SEC began to make explicit reference to credit ratings in its rules, using credit ratings by market-recognized rating agencies to distinguish among grades of creditworthiness for various purposes under the federal securities laws. The SEC originally adopted the term "NRSRO" (Nationally Recognized Statistical Rating Organizations) in 1975 solely for determining capital charges on different grades of debt securities under the SEC's net capital rule for broker-dealers. The credit rating agencies have been subject to much criticism, and even some blame, for the financial crisis which started with the collapse of the subprime mortgage market. The criticism comes from the failure of the credit ratings to accurately reflect the risks embedded in the complex structured securities that had become so popular. This failure stems from a number of factors, from possibly being overly optimistic in awarding higher ratings to many offerings, to potential conflicts of interest between the rating agencies and the issuers of structured products, which the U.S. government sought to address, first in the Credit Rating Agency Reform Act of 2006, and subsequently in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act contains a series of rules for NRSROs designed to address internal controls, transparency, and other factors contributing to the ratings failures. The Dodd-Frank Act creates a new office at the SEC's Office of Credit Ratings, with its own compliance staff and the authority to fine agencies. The SEC is required to examine NRSROs at least once a year and make key findings public. The Dodd-Frank Act also contains a number of other requirements discussed below. The Dodd-Frank Act requires each NRSRO to have a board of directors in which at least half are independent members, some of whom must be users of NRSRO ratings. In addition, the Act requires the board to oversee policies for conflicts of interest; procedures for determining ratings; and the effectiveness of internal controls regarding procedures and policies for compensation and promotion. A compliance officer in a NRSRO cannot perform credit ratings or marketing or sales functions, participate in developing ratings or engage in setting compensation levels. The compliance officer must establish procedures for treatment of complaints regarding credit ratings and compliance with securities laws as well as complaints by employees or users of ratings. The Act requires each NRSRO to submit an annual report to the compliance officer addressing compliance with policies and procedures. The act establishes penalties that the SEC can impose on persons associated with an NRSRO. The act includes as a misconduct the failure to reasonably supervise an individual who commits a violation of the securities laws. The act allows the SEC to suspend or revoke the registration of an NRSRO with respect to a particular class of securities upon determining, after a hearing, that the NRSRO lacks sufficient financial or managerial resources to consistently produce ratings with integrity. This means the SEC must consider whether an NRSRO failed to produce accurate ratings over a sustained period, which places the SEC in the position of assessing the quality of ratings and the means necessary to produce accurate ratings. Each NRSRO must refer to law enforcement or regulatory authorities any credible information received by a third party that alleges an issuer of securities rated by NRSRO committed a material violation of law. The act establishes that the enforcement and penalty provisions of the act apply to statements made by credit rating agencies in the same manner and to the same extent as they apply to statements made by registered public accounting firms or securities analysts under the securities laws. The act modifies the requisite "state of mind" requirements for a private securities fraud action seeking money damages from a credit rating agency or controlling person. It is sufficient to state with particularity facts giving rise to a strong inference that the credit rating agency knowingly or recklessly failed to conduct a reasonable investigation of the rated security. Factual elements of the rated security are based upon its own methodology for evaluating credit risk or failure to obtain reasonable verification of such facts. Some critics and commentators have asserted that the use of credit ratings permitted under U.S. laws and regulations contributed to an over-reliance on credit ratings and to incorrect assumptions that such credit ratings had an implicit government seal of approval. The obvious goal of this latest round of rulemaking is to establish a more reliable, transparent, and sound rating system through oversight. The assumptions that credit ratings have an implicit government seal of approval will no longer be incorrect. ---------- Mark J. Kovaleski, CPA, is a partner with Mengel, Metzger, Barr & Co. LLP. He may be reached at Mkovaleski@mmb-co.com. Published: Tue, May 17, 2011

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