The financial crisis starkly exposed the need for rating agency reform, yet the most important questions of how to enhance rating agency competition, accuracy, and accountability remain largely unanswered. The Dodd-Frank Act promised to overhaul the industry through sweeping reforms. But the Securities & Exchange Commission has struggled to implement the Act’s competing, if not contradictory, objectives: marginalizing ratings; exposing rating agencies to greater sunlight and private liability exposure; and treating rating agencies as a regulated industry.
I advocate a new approach to reform: breaking up the rating agency oligopoly.
Anti-trust law does not regulate oligopolies unless there is express collusion or review of a prospective merger. But regulators could incentivize the leading rating agencies to divest by requiring independent, non-affiliated firms to rate each category of debt, such as government and corporate bonds, and barring raters from issuing evaluations for more than one asset category.
Raters would face the choice of vacating segments of the market or spinning off parts of their business into freestanding companies. For example, if raters of asset-backed securities had to be independent from rating agencies for other types of debt issues, then raters would have a single-minded focus on determining the risks of this asset class that played such a prominent role in triggering the financial crisis. This approach would remove the potential for rating agencies to give deferential ratings to asset-backed securities in exchange for kickbacks of retaining or securing other aspects of an issuers’ business. Phasing in this reform over a number of years would give the leading rating agencies time to break up their business into multiple entities to maximize shareholder value and provide smaller rating agencies or new entrants with time to focus on a particular sector.
Much Further To Go
The SEC has made progress in increasing oversight and addressing the most egregious abuses that fueled the financial crisis, but the SEC’s implementation of the Act has failed to transform the industry in any meaningful way.
The greatest strengths of the Dodd-Frank Act are the procedural requirements designed to heighten rating transparency and strengthen internal controls. For example, the board of directors for each rating agency must approve the qualitative and quantitative approaches used in rating methodologies. Rating agencies must publicly disclose the methods underpinning each rating, consistently apply changes to methodologies and procedures, and disclose methodological changes as well as significant errors.
But procedural reforms have intrinsic limits in addressing qualitative biases and herding effects, and the other provisions of rating agency reform have had far less impact.
Efforts to marginalize rating agencies by removing requirements for ratings from federal statutes, rules, and regulations have failed to undercut ratings’ centrality to markets. Attempts to expose rating agencies to private liability have also had limited impact. The SEC swiftly abandoned efforts to subject rating agencies to expert liability under Section 11 of the Securities Act when rating agencies refused to allow ratings to be included in registration statements for asset-backed securities. The Dodd-Frank Act lowered the pleading standards for Rule 10b-5 anti-fraud actions, but this provision merely incentivizes greater due diligence and larger paper trails. While the Department of Justice has been creative in dusting off a 20-year old bank fraud statute to sue Standard & Poor’s, this legal strategy faces uncertain prospects at best and does not address the need for private oversight of rating agencies.
But the biggest shortcoming of the Dodd-Frank Act is its failure to resolve the basic questions of how to create meaningful competition in an oligopolistic industry and how to incentivize accurate and timely ratings. Congress sidestepped directly addressing these difficult questions, leaving the SEC with the unenviable task of providing some degree of coherence to Congress’s spectrum of solutions.
The most important part of the Dodd-Frank Act remains the most unresolved: the SEC’s mandate to design an alternative for the conflicts of interest created by debt issuers’ selecting their rating agency gatekeepers. Commentators have long bemoaned the inherent conflict of interest of having debt issuers select their rating agency gatekeepers as raters understandably do not want to bite the hands that feed them. The Government Accountability Office and the SEC have conducted a series of studies on alternatives for the current issuer-pays system, yet have shied away from concrete action to overhaul the industry.
The proposal that appears to have garnered the most support during the SEC’s comment period is the creation of an independent board or commission to select rating agencies for structured finance products. This approach would build on the Franken Amendment. But prospects for reform have foundered due to the intrinsic shortcomings of the potential methods to select and compensate rating agencies based on either random assignment, rotation of rating agencies, or performance-based metrics.
For example, a random assignment or rotation approach would eliminate the problem of issuers’ selecting rating agencies, yet neither approach would do anything to create incentives for rating agency accuracy. In the name of fostering the growth of smaller rating agencies, it could potentially create an entitlement system for private rating agencies that would receive assignments and funding solely due to their NRSRO status.
The challenge of any performance-based selection and compensation is that no clear consensus exists on what performance-based standards to use to assess rating agencies. Proposals have suggested creating peer comparison models to examine whether rating agencies’ percentage of predicted default of debt instruments deviated from that of their peers and whether annual yields of identically rated debt securities from different asset classes varied in a significant way. The dilemma of either of these performance-based metrics is that they may accentuate herding effects. Rating agencies would have greater incentives to engage in conscious parallelism to avoid liability, which could undercut the objectives of greater accuracy and accountability. Herding effects are already an issue in an oligopolistic industry, and the solution could exacerbate the problem. Additionally, whatever benchmark is used would swiftly become the centerpiece of rating agencies’ methodologies, regardless of whether the standards incentivize accuracy and timeliness.
Breaking up the rating agency oligopoly would avoid the pitfalls that each of the other proposals face and effectively boost competition. Creating incentives for the leading rating agencies to break themselves up would foster the creation of smaller entities that would share in the reputational umbrella of their larger predecessors. In this way, policymakers could fast-track the creation of a competitive pool of smaller rating agencies that enjoy market credibility. This approach would also open up the possibility for smaller rating agencies to more plausibly compete, because a set of industry monoliths would not crowd out their competitors.
I also suggest a complementary strategy to heighten rating agency accountability: exposing rating agencies to investor suits for gross negligence combined with caps on damages. Both the original House version of the Dodd-Frank Act and recent European Union legislation called for imposing gross negligence liability on rating agencies. The virtue of this approach is that it is difficult to prove outright fraud by rating agencies. The nature of rating agencies’ screening role is that their wrongdoing will be subtle and fall within or near the boundaries of negligent or grossly negligent conduct.
The adoption of negligence-based liability could open the floodgates to litigation about the contours of reasonable care in the ratings context. But the lighter touch of applying a gross negligence approach may offer a better balance of incentives for gatekeeper compliance and private monitoring. Capping liability to a multiple of raters’ annual fees for a given security would damp incentives for private monitoring and suits. But coupling limited liability exposure with a gross negligence standard would provide incentives for a balance of greater oversight and plausible liability burdens.
Jeffrey Manns is an Associate Professor at the George Washington University Law School. The points made this op-ed are developed further in his paper Downgrading Rating Agency Reform http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2174802