Friday, October 9, 2009

Pressure mounts to make credit agencies legally liable for ratings

Posted on FinReg21 by Darrell Delamaide:

The pressure is increasing for Standard & Poor’s, Moody’s and other nationally recognized statistical rating organizations (NRSROs) to have some sort of legal liability attached to their ratings, so that they cannot waltz away from the rubble that their mistakes – due perhaps to carelessness, recklessness or even conflict of interest – can create.

But the industry – which is willing to accept greater transparency about their procedures, stricter control of conflicts of interest, more wide-ranging supervision by the SEC, adjustments to their governance structures, and less dependence on their ratings in regulations – is drawing the line at legal liability, which they reject.

In addition to the traditional defense that their forecasts of future events can at best be only an opinion protected by the right to free speech, they argue that making them liable for their ratings would only reinforce investor reliance on them, instead of lessen it, while stifling the agencies’ freedom to express controversial opinions.

Rep. Paul Kanjorski (D-Pa.) reiterated his intention to impose some liability on the agencies at a hearing last week before his Capital Markets subcommittee.

While the Justice Department belatedly should track down wrongdoers in last year’s financial meltdown, Kanjorski said, going forward, all responsible parties, including credit rating agencies, should be held accountable for their actions.

“We can promote accountability in credit ratings through the threat of liability,” Kanjorski said. “While these legal reforms are an important change from current law, I want to assure everyone that I am committed to working to refine them as we move through the legislative process.”

The lawmaker has included provisions for collective liability of the agencies in his draft bill on rating agency accountability that was the subject of the hearing.

Coming from a different direction, the SEC is looking at revisions of securities laws to remove the current exemption for credit rating agencies from liability as experts cited in securities offering documents.

Daniel Gallagher, co-acting director of the SEC’s Trading and Markets division, testified at the Kanjorski hearing that a concept release from the agency would seek comment on the proposed removal of the exemption.

In that case, if a rating is used in connection with a registered offering, the issuer would have to obtain the consent of the rating agency to be included in the liability scheme under the Securities Act that affects other experts in such offerings.

The SEC duly posted the release on its Web site this week, with a comment period extending for 60 days.

The pressure to make credit rating agencies liable comes as the SEC, the Federal Reserve and other regulators seek to wean investors from dependence on the ratings and to lessen the role ratings play in regulations.

The National Association of Insurance Commissioners is reportedly considering a plan to have private investment managers analyze the creditworthiness of securities held by insurers, instead of accepting the credit ratings as the final and only word.

At last week’s subcommittee hearing, Moody’s chief executive Raymond McDaniel rejected the imposition of any liability regime on the credit rating agencies.

He noted that the agencies are not at all immune from liability and face numerous lawsuits around the country right now because they can be held accountable for false or fraudulent statements.

Imposing further legal liability would only lead to increased litigation or threat of litigation that would muzzle the agencies and keep them from expressing opinions that would anger the issuers or be at odds with market sentiment, he argued.

In addition, added liability would increase over-reliance on the ratings because investors would assume that in this environment the agencies had fully considered all potential risks and not just the creditworthiness of the security that is actually the subject of the rating.

Deven Sharma, president of S&P, also objected to some of the proposals in the Kanjorski bill. “These proposals include amendments to the federal securities laws that would treat NRSROs far more harshly than any other defendant in securities fraud lawsuits, and other measures that would interfere with NRSROs’ analytical independence,” he said in testimony before the subcommittee. “These proposals would inevitably curtail the scope and availability of credit ratings on a broad spectrum of businesses and the debt they issue.”

But the moves by Congress and the SEC to increase the liability of the agencies found support from professional and investor groups.

Kurt Schacht, managing director of the CFA Institute Centre for Financial Market Integrity, testified that the financial analysts association together with the Council of Institutional Investors had formed an Investor Working Group that also found the exemption of the credit rating agencies from expert liability should be eliminated.

“This change would make the rating agencies more diligent about the ratings process,” Schacht said in his testimony, “and, ultimately, more accountable for sloppy performance.”

However, Schacht went on to say that investors themselves ultimately have to take responsibility for their decisions and they share the blame for the financial crisis insofar as they relied exclusively on ratings and did not take other steps to vet their investments.

“Blind reliance on the rating as the one and only due-diligence step happened with such frequency and ease that it had become the accepted industry practice,” he said. “The fact that this unprofessional and careless practice became, in many cases, industry custom seems clear, but it must never again be acceptable practice for investment managers holding themselves out as experts.”

No comments: