Using Unsolicited Ratings to Regulate the Credit Rating Agencies

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ABSTRACT

Unsolicited ratings have long been overlooked in the investment landscape and issuer pay models. Although Congress has lost its confidence in the credit rating agencies' reputation theory and is now considering a semi-closed market as the only viable solution to the conflict of interest problem, financial scholars have proposed the Inequality model using unsolicited ratings and focusing on a reputational theory that could lead to more stringent rating standards. This Note argues that it is possible to achieve the Inequality for unsolicited ratings by utilizing the already required disclosures and making a few enhancements. This Note proposes that this will in turn improve accuracy and combat the conflict of interest problem without deviating from free market principles.

INTRODUCTION

Four years after the 2008 financial crisis, the United States economy is still recovering and fingers are being pointed at the credit rating agencies ("CRAs") and the issuer pay model for their role in the economic collapse.1 Many question how CRAs can honestly evaluate entities that are paying their bills.2 Congress and many academics have rejected the long propounded reputation theory, which holds that the mere threat of a loss of reputation curtails CRAs bad behavior, and justifies little to no regulation within the industry.3 Yet, reversing the current approach to an investor-pay model is also inadequate for the task of evaluating the credit risk in the modern economy.4 Congress and the Securities and Exchange Commission ("SEC") have attempted to fix issuer pay problems through the Credit Rating Agency Reform Act of 2006 ("CRARA" or "Credit Reform Act")5 and Title IX of the DoddFrank Wall Street Reform and Consumer Protection Act ("DoddFrank")6 by bringing CRAs within the S EC s regulatory purview, requiring extensive disclosures, and changing the hiring process for ratings to an assignment system.7

Even prior to the investor-pay or issuer pay models, the very first publication by Moody's Investors Services ("Moody's") was a book of unsolicited ratings prepared by Moody's without compensation from issuers, providing information on issuers for the marketplace.8 The practice of issuing unsolicited ratings has persisted under both models,9 but in the last fifteen years, unsolicited ratings have lost their popularity and were not mentioned or used in either the CRARA or Dodd-Frank. Fulghieri, Strobl, and Xia ("Fulghieri") proposed a rational expectation model to identify the circumstances in which unsolicited ratings would lead to more stringent or less stringent ratings standards.10 In forming this rational expectation model, Fulghieri and his colleagues considered both the positive and negative incentives of CRAs, focusing on reputational theory, and concluded that if the long-term reputational costs of inaccurate rating are higher than the short-term gains (the "Inequality" " ), CRAs will issue accurate ratings, including for unsolicited ratings.12

This Note will argue that within the context of unsolicited ratings, the rejected reputational theory will produce accurate and beneficial ratings if the Inequality is achieved. This Note will employ the principles expressed by the Inequality to examine the source of the problems that have plagued the credit rating industry and those who rely on it throughout the last decade.13 In addition, this Note will identify ways that unsolicited ratings will help alleviate these issues, and evaluate the extent to which new proposed reforms, including DoddFrank, succeed in minimizing the harmful effects of the short-term gains CRAs derive from unsolicited ratings while maximizing the positive influence of the long-term reputational costs CRAs suffer as a result of inaccuracies in ratings.

Part I discusses the history of CRAs and the reputational difficulties that plagued CRAs as a consequence of the Enron bankruptcy and the 2008 financial crisis. Part II considers how CRARA and Dodd-Frank tried to solve these problems and explores unsolicited ratings in the context of the Inequality. …