Dodd-Frank's Act Impact on Credit Rating Agencies

Section 939G: Dodd-Frank's Act Impact on Credit Rating Agencies.

Summary:

Standard & Poor's, Moody's Investor Service, and Fitch Ratings are the so-called "Big Three" credit rating agencies (CRA). They are referred to as Nationally Recognized Statistical Rating Organizations (NRSROs) under Section 6 of the Credit Rating Agency Reform Act of 2006 Act. Credit ratings issued by Nationally Recognized Statistical Rating Organizations (NRSROs) are used to fulfill a wide range of regulatory and contractual requirements in the United States and abroad. Over time, NRSRO ratings have become woven into federal and state laws, regulations, and private contracts. As legal requirements for ratings have proliferated, the rating agencies have evolved from information providers to purveyors of "regulatory licenses." A regulatory license is a key that unlocks the financial markets. Credit rating agencies profit from providing ratings that unlock access to the markets, regardless of the accuracy of their ratings. The global credit crisis has called into question this role of rating agencies as financial gatekeepers. The debacle was fueled in part by credit rating agencies "licensing" complex, risky financial instruments with triple-A ratings they did not deserve. Both regulators and institutional investors relied on those ratings, to their peril.

I. The CRA operating environment prior to the passage of Dodd-Frank Act

A) Credit Rating agencies were governed by the Securities Act of 1933 Rule 436(g).

1) Credit rating agencies were exempt from being considered "experts" for purposes of liability under the securities laws in respect of ratings information contained in registration statements

2) This rule gives the agencies protection not afforded other "experts", like accountants and attorneys .

B) The credit-rating agencies have enjoyed significant barriers to liability

1) Maintained they offer forward-looking "opinions" on the credit-worthiness of offerings

2) Argued that First Amendment protection applies; their "opinions" are protected from suit so long as the false statements do not involve "actual malice". The following are cases in which the credit agency successfully used the First Amendment defense.

(1) First Equity Corp. of Florida v. Standard & Poor's Corp.

(2) Jefferson County School District v. Moody's Investor's Services, Inc.

3) Plaintiff would have to show that an agency acted with "actual malice" in order to pursue a claim .

(1) New York Times Co. v. Sullivan, United States Supreme Court case which established the actual malice standard which has to be met before press reports about public officials or public figures can be considered to be defamation and libel.

(2) The actual malice standard requires that the plaintiff in a defamation or libel case prove that the publisher of the statement in question knew that the statement was false or acted in reckless disregard of its truth or falsity

(3) Curtis Publishing Co. v. Butts found SATURDAY EVENING POST had shown "actual malice" by relying on single source who they knew to have a criminal record, in situation where they had adequate time for further investigation. [Butts was accused of having fixed football game scores]

4) Litigation against the credit rating agencies often is deterred by statutory provisions and judicial precedent that limit the liability

C) Limitations of the Credit Rating Agencies' Liability.

1) Lack of monetary risk for poor ratings provides the temptation to provide more favorable credit ratings.

2) The credit rating agencies had successfully transferred the increased cost and risk to customers.

3) A credible threat of civil liability would force credit rating agencies to be more vigilant in guarding against negligent, reckless, and fraudulent practices.

D) The economics of the credit rating industry creates a business environment of conflicting interest

1) Ratings agencies are compensated for their "opinions" by the same issuers they are opining about .

2) Credit rating agencies have long served two masters the investors and the issuers. This created an incentive whereby the agency with the better rating got the issuer's business.

3) The issuers pay fee to get the rating the agencies provide, even though the agencies say their ratings are based on impartiality, and doing the due diligences that investors need to base on their buying.

4) The market structure for credit ratings reduces economic pressure for rating agencies to produce the best product. Usually, a market encourages company due diligence as a result of competition for business, but in the ratings market there is a lack of competition among the agencies.

5) The credit rating market has an oligopolistic market structure.

6) There are no close substitutes for credit ratings. This leaves issuers of debt only the credit rating market to validate the quality of the debt for investors.

7) Much of the revenue, profits, and stock prices growth of the major credit rating agencies were tied to the structured mortgage backed securities industry.

(a) Moody's stock price tripled and profits climbed by 27% from 2003 to 2006 .

8) Given the high profile nature of the problems with rating agencies and the continuing profitability of the ratings business, recent court decision indicate that the law was beginning to question liability protection of the rating agencies.

(a) Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc

(b) California Public Employees' Retirement Systems v. Moody's Corp. et al

The Ramifications of the Dodd-Frank Act on Credit Agencies

A) Effective July 22, 2010 Congress eliminated Rule 436(g) exemption of the Securities Act.

1) Rating Agencies could now be named as an "expert" in any securities registration statement.

2) Exposes