You could be forgiven for thinking that, in the wake of a credit crisis spurred by the disastrously flawed U.S. credit-rating industry, credit-rating agencies might have been the subject of drastic structural reforms. You would be wrong.
In fact, in some ways the power wielded by the credit-rating agencies has never been greater. Last July, when the Dodd-Frank Wall Street Financial Reform and Consumer Protection Act passed with measures intended to increase the liability exposure of the government-recognized rating agencies known as the nationally recognized statistical rating organizations, the NRSROs threatened to shut down the resurgent asset-backed securities market.
To avoid the tougher new standards, the NRSROs simply refused to give the ratings required for new asset-backed securities offerings, bringing the fragile market to a standstill. In the end, it was the regulators who blinked first, issuing a series of “no-action” letters permitting the NRSROs to continue to give ratings for asset-backed securities offerings, with the assurance that the Securities and Exchange Commission would take no action to enforce the new liability standards.
Just how the NRSROs came to hold regulators and investors over a barrel, and what might be done about it, has become a topic of heated debate.
The key role the NRSROs played in the asset-backed securities market was amplified by Regulation AB under the Securities Act of 1933, which required, among other things, the disclosure of an NRSRO credit rating if the rating is a condition for the issuance of a class of securities.
The regulatory recognition of NRSROs did little to stem the conflicts of interests in those agencies, however. These problems came to a head in the years preceding our recent financial crisis, when the NRSROs gave top ratings to toxic subprime-backed assets. These sterling ratings fueled the vast bubble that collapsed in the crisis of 2007-2008.
While the Dodd-Frank Act did not address the conflicts of interests inherent in the business model of the credit-ratings industry, it did attempt to hold the agencies to a higher standard of conduct. The act repealed section 436(g) of the Securities Act of 1933, a provision that had effectively immunized the NRSROs from liability for making materially misleading statements in connection with registration statements.
The rating agencies, however, had an ace up their sleeves. Because their consent was required to make the disclosures necessary under Regulation AB, they had the power to bring the entire asset-backed securities industry to a halt by simply withholding that consent. And that is precisely what they did, panicking would-be securities issuers like Ford Motor Credit Co. LLC, which immediately wrote to the SEC for assistance.
In response, the SEC issued its first no-action letter on July 22, assuring the NRSROs that it would take no action to enforce the new liability standard for six months. This no-action period was extended indefinitely in a second letter on Nov. 22, in which the SEC stated that the additional time was necessary to determine whether the repeal of 436(g) might “affect the commission's disclosure requirements regarding credit ratings for asset-backed securities offerings.”
In its November letter, the SEC was signaling that, rather than implementing the new standard of liability for NRSROs, it was considering removing the requirement that the ratings for asset-backed securities be disclosed at all — even if the ratings are still a contractual requirement for the offering to be made. Ironically, because the regulations had so embedded NRSROs into the process of asset-backed securities offerings, the regulators had effectively given the ratings companies the power to determine whether they should be exposed to liability under the federal securities laws.
This deadlock might be resolved, however, if at least one NRSRO consents to have its ratings included in offering circulars — that is, if one NRSRO demonstrates some confidence that it can issue ratings without making materially misleading statements.
Until that organization steps up, however, investors should do their own homework before wading into the asset-backed securities industry in reliance on ratings offered by companies so distrustful of their own work. n
Michael W. Stocker is a partner with the law firm of Labaton Sucharow LLP, New York. Lisa Lindsley is director of capital strategies for the American Federation of State, County and Municipal Employees, Washington.