Skip to content

How to untangle the credit rating agency’s conflicts of interest

The House and Senate conferees worked hard to today to reconcile their versions of financial reform. Agreement was reached on private funds, insurance regulation and the merger of bank regulators.

A sticking point was on Subtitle C of Title IX which covers credit rating agencies.

I’d like to recommend to Chairman Barney Frank and others that they propose a slight modification to section 5 related to removing the exemption for credit raters from Regulation FD.

The current legislative language requires the SEC to write rules that would require issuers to share material non-public information with all investors and market participants in a similar manner to the equity markets.

I’d suggest a more tailored approach for the fixed income markets.

This would be the requirement that an issuer disclose material non-public information to all Nationally Recognized Statistical Rating Organizations [NRSRO] if they disclose information to any NRSRO.

This sharing of issuer material non-public information with all NRSROs is called “equivalent disclosure“.

This simple requirement would substantially reduce “ratings shopping” and empower all rating agencies to develop ratings on new issues. It would greatly negate the conflicts of interest that the issuer paid rating agency has by allowing other rating agencies equal access to information to develop an assessment of risk.

The SEC has already adopted this broadened disclosure requirement for structured finance products. The new disclosure regime went into effect on June 2.

We propose that the Congress adopt “equivalent disclosure” rules for all issuer communications with NRSROs.

Equivalent disclosure would require an issuer, or person acting on its behalf, to disclose material nonpublic information to all NRSROs if it discloses that information to one NRSRO. Equivalent disclosure would remove the issues associated with issuer selective disclosure primarily “rating shopping”.

The institution of equivalent disclosure would strengthen financial markets by ensuring that all NRSROs have adequate and equivalent information from issuers upon which to base their credit analysis.

Issuer disclosure would be required to all NRSROs that rate securities in the specific asset category (as outlined in the Credit Rating Agency Reform Act of 2006) for which the issuer has securities outstanding.

This broadened disclosure will increase the volume of information available to NRSROs and help unbind a market that has relied on the opinions of creditworthiness from a very small group of credit rating agencies.

This proposal does not alter the ability of NRSROs to have any form of business model that they choose. Issuers can continue to pay NRSROs to rate their securities. Issuers may likely continue this practice because of the bundle of services offered by the NRSROs to market participants.

Fitch, Moody’s and Standard & Poor’s have satisfactory track records in predicting defaults but current events in the credit markets suggest that a broader array of opinions from more NRSROs would be useful for the integrity of the markets. We are currently expecting too much from a small handful of firms to provide timely, aggressive, and consistent credit analysis for the entire universe of fixed income securities.

The Credit Rating Agency Reform Act of 2006 creates a new framework for rating agencies to become NRSROs but the important problem of information asymmetry from issuers to the NRSROs persists. The adoption of equivalent disclosure will go a long way to improve the current shortcomings in the credit markets.

It would beneficial for investors to have a wide variety of NRSROs providing credit analysis. We believe a wealth of credit rating firms will only come about when there is a wealth of information from issuers.

Donaldson on the dangers of “selective disclosure”

SEC Chairman William Donaldson made the following remarks to the Subcommittee on Capital Markets, Insurance, and GSEs, House Committee on Financial Services, May 21, 2001 in reference to the adoption of Regulation Fair Disclosure for the equity markets.

“Selective disclosure raises several concerns. The primary issue is the basic unfairness of providing a select few with a significant informational advantage over the rest of the market. This unfairness damages investor confidence in the integrity of our capital markets. To the extent some investors decide not to participate in our markets as a result, the markets lose a measure of liquidity and efficiency, and the costs of raising equity capital are increased.

Further, if selective disclosure is permitted, corporate management can treat material information as a commodity to be used to gain or maintain favor with particular analysts or investors. This practice could undermine analyst objectivity, in that analysts will feel pressured to report favorably about a company or slant their analysis to maintain access to selectively disclosed information. Thus, selective disclosure may tend to reduce serious, independent analysis.”

John Coffee of Columbia on “equivalent disclosure”

Professor John Coffee, of Columbia Law School, made the following comments to the Senate Banking Committee in his testimony of Sept, 26, 2007 concerning the proposal for “Equivalent Disclosure”:

“Indeed, the issuer may withhold access to non-public information for precisely the same reason that public companies use to withhold data from securities analysts who were skeptical of them: to punish them. Thus, some have sensibly proposed that an equivalent of Regulation Fair Disclosure (“Reg FD”) should be adopted to require “equivalent disclosure” to all NRSROs of any information that is given by an issuer to any NRSRO.”

Broader information distribution restored confidence in markets

When the adoption of Regulation Fair Disclosure was being debated representatives of issuers claimed that it would cause equity issuers to share less information with the markets. In fact, the implementation of Regulation Fair Disclosure was a significant step forward for equity markets. Information is more transparent and available to market participants at all levels from the largest institutions to the smallest retail investors. Reg FD restored an enormous amount of confidence to the equity markets.

It was also unclear how equity issuers would discharge their responsibility to disclose information fairly. Although this required the adoption of new market practices solutions were developed and implemented.

Handling material non-public information

The CRARA requires that NRSROs disclose their procedures for handling confidential and material non-public information as part of NRSRO recognition process. NRSROs have a long history of working with issuers and carefully protecting information that must remain confidential from information that can be shared with the public and subscribers. We do not believe that this condition will pose a hurdle to the adoption of “equivalent disclosure”.