Rating the raters: restoring confidence and accountability in credit rating agencies.

• Author: Voorhees, Ryan

The recent financial crisis has caused long-term damage and lasting effects to the global financial system. Credit rating agencies contributed to the boom by giving their highest ratings to poorly understood new financial instruments. During this time, they lacked accountability or oversight, and they suffered from intense conflicts of interest. The U.S. and E.U. have recently enhanced regulatory power in this area, but they should explore additional options at both the international and national level, including adopting an international advisory board or creating public rating agencies.

"From 2000 to 2007, Moody's rated 45,000 mortgage securities as AAA. In the beginning of [2010], there were six U.S. companies with that rating. In 2006, it gave its stamp of approval to some 30 such securities each and every working day. The results were disastrous. None of what happened was an act of God. The greatest tragedy would be to accept the idea that no one could have seen this crisis coming and thus, nothing could have been done. If we accept this notion, it will happen again." (1)

"Everything was investment grade. It didn't really matter. "(2)

"[N]obody gives a straight answer about anything around here .... [H]ow about we come out with new [rating criteria] and actually have clear cut parameters on what the hell we are supposed to do." (3)

1. INTRODUCTION II. THE CURRENT SYSTEM'S FLAWS A. The "Issuer-Pays" Model B. Little Accountability for Error C. Connection Between Credit Ratings and Laws III. RECENT DEVELOPMENTS A. IOSCO's Voluntary Compliance Regime B. Regulation in the U.S. C. Regulation in Europe IV. ALTERNATIVE APPROACHES A. International Oversight and Accountability Board B. Public Rating Agencies V. CONCLUSION I. INTRODUCTION

   These are tumultuous times for global financial markets. In 2007 and 2008, severe financial disruptions nearly collapsed the global economy and caused a worldwide crisis. In the wake of the crisis, millions of individuals found themselves unemployed, and trillions of dollars of wealth had evaporated: Many believe that the crisis was avoidable and was caused by widespread failures in financial regulation: Thus, policymakers and regulators worldwide now confront the formidable challenge of restoring confidence in markets and formulating long-term responses to the crisis.

   The past few years bore witness to countless reports and studies that sought to identify and analyze potential sources of the crisis. (6) Most conclude that, in part, credit rating agencies (CRAs) played a role in and exacerbated the crisis. (7) Studies focus primarily on the ratings that CRAs assigned to the many of the exotic financial instruments at the heart of the recent crisis: asset-backed securities, collateralized debt obligations, credit default swaps, and structured investment vehicles. (8) While investments with the highest ratings (AAA or Aaa) have traditionally defaulted at only a 1% rate, these complex, novel instruments--many of which enjoyed AAA or Aaa ratings before the crisis--defaulted or lost value at an alarming rate. (9) The result was "a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets." (10)

   The vast majority of ratings worldwide come from the three largest CRAs: Moody's Corporation, Standard & Poor's (S&P), and Fitch Ratings (collectively, the "Big Three"). (11) These three companies have, for some time, dominated the credit rating industry. (12) Thus, the Big Three are at the center of the inquiry into CRA regulation and are the focus of this Note. Part II highlights some recurring criticisms leveled against the CRAs in recent years, especially against the Big Three. Part III reviews domestic and foreign approaches to CRA oversight in the wake of the recent crisis. Part IV presents alternative regulatory structures that could help restore worldwide confidence and accountability in CRAs.

2. THE CURRENT SYSTEM'S FLAWS

   Academics, politicians, and others have repeatedly criticized CRAs, especially the Big Three, in the wake of the recent financial crisis. Their complaints generally relate to (1) the intense conflicts of interest that pervade the industry-standard "issuer-pays" model used by CRAs; (2) the lack of accountability that CRAs face regarding rating errors and the market turmoil that they create; and (3) the immense power that CRAs wield as a result of the deep connection between their work and banking, real estate, and insurance laws. This Section examines these problems.

   1. The "Issuer-Pays" Model

      Historically, CRAs operated under a "subscriber-pays" model, earning their revenues from paid subscribers. (13) When a CRA rated a bond or a company, the CRA would not freely publish the credit rating that it assigned to the investment. (14) Rather, investors paid a monthly fee to gain access to lists of credit ratings of major companies and important bonds. (15)

      By the 1970s, however, CRAs (including the Big Three) experienced revenue shortfalls and began searching for alternative sources of revenue. (16) They determined that they could substantially increase profits by shifting to an "issuer-pays" compensation model, which has now become an industry standard. (17) Under the issuer-pays model, companies--not paid subscribers--themselves seek ratings and pay for the CRA services. (18)

      Supporters of the issuer-pays model contend that the Big Three have implemented adequate measures to prevent or eliminate conflicts of interest. (19) They also argue that the issuer-pays model increases the public's access to information and ultimately lowers investment costs. (20) Nonetheless, it is widely believed that the issuer-pays system creates unacceptable conflicts of interest in the rating industry.

      Detractors contend that CRAs fail to operate objectively because the issuer-pays system provides incentives for them to attract clients by offering high--but often inaccurate--ratings. (21) A Senate report notes that former Moody's and S&P employees have stated that before the crisis, "gaining market share, increasing revenues, and pleasing investment bankers ... assumed a higher priority than issuing accurate [] credit ratings." (22) Indeed, at that time relationships with issuers and investment banks took on a higher priority than high quality research. (23) Internal e-mails suggest that managers at the Big Three were willing to adjust rating criteria to enhance their market share. (24) Likewise, a 2010 U.S. Senate investigation confirmed that investment banks hired from the ranks of former CRA employees based on those individuals' knowledge of how to structure deals to secure the highest credit ratings. (25)

      Another conflict of interest arises when a CRA not only rates a client's credit, but also provides additional ancillary consulting services. (26) These ancillary services typically include, among other things, services such as scoring models, systems support, and empirical data reports. (27) Admittedly, the CRAs' consulting services are miniscule compared with their credit rating lines of business. (28) However, it is questionable whether a CRA can be an unbiased, objective observer under these circumstances.

   2. Little Accountability for Error

      Another complaint about the Big Three is that the justice system does not hold them accountable when they issue erroneous ratings, even when they downgrade a company shortly before it declares bankruptcy.

      Suits against CRAs regarding erroneous ratings have typically failed at the earliest stages of litigation. (29) Plaintiffs see their suits dismissed because, among other things, CRAs enjoy extensive First Amendment free-speech protection for those ratings that are freely distributed and widely available to the public. (30) The result is an "actual malice" standard that few plaintiffs can prove before discovery. (31) Courts tend to apply this standard when the defendant CRA failed to issue a downgrade until shortly before the client's bankruptcy, as illustrated by the bankruptcies of Orange County, CA and the now-defunct Enron Corporation. (32)

      In 1994, Orange County lost $500 million from poorly performing bonds and subsequently declared bankruptcy. (33) The county filed a $2 billion suit against S&P regarding two groups of bonds, claiming that S&P failed to accurately assess the bonds' quality. (34) The court held that because the ratings were "matters of public concern," Orange County must show that S&P maliciously published the ratings. (35) Orange County could not do so, and the court granted summary judgment to S&P. (36) Similarly, in the wake of the 2001 Enron bankruptcy scandal, a Texas court applied the same free-speech protection to the Big Three's faulty credit ratings of that company. (37) The court held that the ratings were matters of public concern and were not published with actual malice, dismissing all charges against the CRAs. (38)

      Congress enacted the Sarbanes-Oxley Act shortly after the Enron scandal. (39) While the Sarbanes-Oxley Act dramatically enhanced corporate accountability and insider trading laws, it did not significantly address the role of rating agencies in corporate scandals. (40) CRAs emerged relatively unscathed.

      Recent court decisions, however, indicate...