Is the SEC Going Soft on Credit Rating Agencies?

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Auditors were the first to be besieged by Congress and the sec for conflicts of interest and lack of independence in the Enron failure. Enron's collapse questioned the effectiveness of audits and challenged accounting firms' practices, including the purported effects of consulting services on independence. A major outcome of this scrutiny was the Sarbanes-Oxley Act of 2002, which prohibits audit firms from providing certain types of consulting services and created the Public Company Accounting Oversight Board (PCAOB) to oversee auditors of publicly traded firms.

Next came the brokerage and investment banking houses, rife with conflicts of interest from buy-side analysts promoting stocks in order to maintain lucrative investment-banking fees. In April 2003, federal and state regulators reached a settlement with the big Wall Street investment firms that is expected to improve analyst independence as research is separated from investmentbanking activities. As part of the agreement, the firms are paying penalties totaling $1.38 billion, which many industry observers consider minor given that the industry's annual profits are approximately $16 billion.

Finally came the credit rating agencies' turn to be scrutinized. Credit rating firms are partly blamed in the major corporate failures for their lack of diligence in identifying credit problems. Indeed, Standard & Poor's (S&P) and Moody's did not reduce Enron's credit ratings from investment grade to junk level until four days before Enron's doors shut.

Considering that WorldCom and Global Crossing were also rated investment grade only months before bankruptcy, an unfavorable pattern emerges. Last year, Congress was keen to target the credit rating sector for failing to identify weaknesses at Enron and other companies as it pressured the sec to reexamine the role of credit rating agencies and to propose greater oversight of the rating firms' anticompetitive practices and conflicts of interest.

Given how important credit ratings are to securities markets, section 702 of Sarbanes-Oxley contains a directive for the sec to reexamine the role and function of credit rating agencies in the securities markets. Pursuant to section 702, the sec released an initial report in January 2003, followed in june 2003 by a Concept Release, "Rating Agencies and the Use of Credit Ratings Under the Federal securities Laws."

Although the sec readily challenged accounting firms and investment houses, major credit rating agencies have thus far remained unscathed. The sec appears to perceive that rating firms have been doing an acceptable job and is uneager to make waves. But for the rating agencies to miss Enron, WorldCom, Global Crossing, and others suggests fundamental problems with the current debt rating system. Possibly out of fear that they weren't reacting in a timely manner, the rating firms subsequently became hypersensitive and quickly downgraded some debt issues, which compounded rating problems.

Clearly, the credibility of rating firms is eroding, as reflected by the results of a recent survey of treasury and finance managers. A 2002 survey of the Association for Financial Professionals (www.afponline.org) reveals that about 30% of finance managers perceive the credit ratings of their own organizations to be inaccurate; about 40% perceive rating changes to be untimely. Such factors have concerned Congress and led the sec to reexamine conflicts of interest, lack of competition, information flow, the ratings process, and regulatory oversight of rating firms.

Links Between Credit Rating Agencies and Accounting Firms

The credit rating and audit functions are interrelated in that the rating analyst relies upon audited, financial statements as a primary information source in making rating determinations. Going forward, the major rating firms must attend more closely to accounting policies and aggressive financial reporting, particularly because they overlooked accounting issues related to special purpose entities for several corporations, including Enron. …