The Securities and Exchange Commission's (SEC) proposal issued May 18 to implement rules mandated by the Dodd-Frank Act tasks rating agencies with measures most have sought to address, but the proposal's detailed requirements could instead overwhelm smaller agencies.
The nationally recognized statistical rating organizations' (NRSROs) attorneys were still digesting the 517-page proposal in the latter part of May, and the larger agencies - Moody's Investors Service, Standard & Poor's and Fitch Ratings - declined to comment about it.
Smaller NRSROs, however, were quick to point out elements of the proposal that, if left unchanged, could severely crimp their businesses and ultimately strengthen the much-criticized hold the big three agencies have on debt ratings.
The proposal would codify several areas, including internal control structures, eliminating conflicts of interest between analysts and sales executives, and "look back" reviews that the NRSROs have sought to strengthen since Dodd-Frank's passage last summer and even before.
"We've done a lot of what's been requested," said Joseph Petro, a managing director at Realpoint, which was acquired by Morningstar last year and plans to begin rating RMBS later this year. "[The proposal] is going to provide a formal framework, and we'll have to adjust what we're doing to comply with the specific regulations."
Petro said many of the proposals provisions are, for the most part, prudent measures, but in some cases the costs and complexity to comply with them may overwhelm smaller competitors' resources. "Adding on these layers of control could make it difficult from a cost perspective for new rating agencies to enter the space," Petro said.
More specifically, Mary Keogh, managing director of regulatory affairs at DBRS, pointed to the 15 categories of disclosures the proposal would require the NRSROs to make with each rating, including the assumptions behind the methodologies to reach the ratings.
"The combination of the proposed scope and depth and number of disclosures that must accompany each and every rating in a standard form might cause [NRSROs] to standardize the approach in an effort to produce timely ratings," Keogh said.
She added that each corporate issuer has "unique features," and while DBRS likes to see certain features from a risk or financial perspective that are spelled out in its disclosed methodologies, those methodologies cannot realistically incorporate the unique features of each issuer. If the more detailed disclosures required by the proposal are approved, she said, NRSROs may end up standardizing some disclosures, such as the methodology assumptions, to make the process more efficient.
"The amount of detail as a part of our methodology that they're requiring in disclosures may have the unintended consequence of resulting in less information provided," Keogh said.
Petro said that such standardization could potentially reduce innovation among the NRSROs. "It could prohibit people from challenging the norm and coming up with better ways of doing things," he said.
That outcome would run contrary to long-standing criticism that the top three rating agencies hold quasi-monopolistic positions. In addition, Dodd-Frank lowered the pleading standard by which to sue the rating agencies, a change that will make compliance with rules stemming from the recent proposal that much more critical - and potentially another strike against the NRSROs.
The new standard requires obtaining "reasonable verification" of the factual elements relied upon by its own methodology for evaluating risk. Keogh said that the law's language notes that such verification does not amount to an audit, "but it's unclear what type of verification would suffice. [NRSROs] are not auditors."
"The issuer and its brokers are doing the due diligence," said Dana Eddis, compliance officer at Morningstar. "Although we receive and review information and documentation from the issuers, the rating agencies should be able to reasonably rely on this information being true and correct, and not have to investigate the truth of these statements."
Keogh said the lower standard could likely spur more lawsuits filed against the NRSROs, resulting in greater company resources devoted to legal matters. "The cost of defending spurious lawsuits through the discovery phase could simply overwhelm the smaller rating agencies."
The other liability-related bugaboo stemming from Dodd-Frank is the law's repeal of the 436(g) exemption, exempting ratings from being a part of issuers' registration statements, a move that would also ramp up the NRSROs' liability. So much so that when Dodd-Frank was passed last summer, the rating agencies stopped providing ratings until the SEC temporarily delayed the effectiveness of the provision.
Since then, the SEC has postponed the effectiveness of that repeal indefinitely, although the issue must ultimately be dealt with as Dodd-Frank is implemented, and Congressman Steve Stivers (R-OH) introduced a bill April 15 to restore Rule 436(g).