Academic journal article Journal of Corporation Law

Ratings Recall: Will New Reform Proposals Make Lasting Impact?

Academic journal article Journal of Corporation Law

Ratings Recall: Will New Reform Proposals Make Lasting Impact?

Article excerpt


Within the corporate world, credit rating agencies (CRAs) wield great power. One commentator opined that "[t]here are two superpowers in the world. . . . There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful..1 CRAs' influence often transcends national boundaries, which prompted another observer to note that "credit raters often have more sway over foreign fiscal policy than the U.S. government..2

In light of the great power they possess, CRAs have historically been subject to surprisingly little regulatory oversight.3 In the early 2000s, however, CRAs came under fire for their failure to adequately warn investors about the impending problems with Enron, WorldCom, and other troubled companies.4 In response, Congress passed the Credit Agency Reform Act of 2006 (Reform Act of 2006) to improve the Securities and Exchange Commission's (SEC) ability to create and enforce ratings standards.5 Since the passage of the Reform Act of 2006, the SEC has promulgated new rules, the last of which took effect in April 2009, and is still considering additional changes.6 Europe has also entered into the regulation foray and adopted a new regulatory structure in April 2009.7

Despite these important changes to CRA regulation, critics continue to claim that the regulations do not go far enough and that more needs to be done.8 Some argue that former proposals for reform were superior to those that the SEC ultimately adopted.9 In any case, the issue of how to effectively regulate CRAs is far from decided. This Note analyzes additional options for regulating CRAs.

Part II provides background information on CRAs and shows how they became powerful players in the U.S. corporate regulatory framework. It then describes the historical problems with the structure of rating agencies, which many critics believe have contributed to CRA failings. It then outlines reforms that the United States and Europe have formally adopted. Finally, it outlines additional options for regulatory reform of CRAs.

Part III analyzes the various regulatory options, pointing out the practical benefits and limitations of each. Specifically, it looks at five important factors that any regulatory reform should include. Based on this framework, it then analyzes reform options set forth by the Securities Industry and Financial Markets Association (SIFMA), the SEC, and others.

Part IV recommends a mix of the SIFMA and European Community (EC) approaches and adds a critical structural feature to ensure consistent enforcement through time. This Part points out that to increase investor confidence, any solution must provide for long-term, consistent enforcement of CRA regulations. It also details some of the important features of the SIFMA and EC approaches that the United States should adopt.


A. How Rating Agencies Work and Their Role in the Economy

CRAs such as Moody's Investors Services, Inc. (Moody's), Standard & Poor's Rating Services (S&P), and Fitch Investor Services, Inc. (Fitch) earn revenue by analyzing investment products, such as bonds,10 and distilling their findings into a simple alphabetical rating.11 The ratings range from triple-A to D.12 Ratings of triple-B or higher are considered "investment grade,.13 which signifies that the level of risk is relatively low.14

A rating is both practically and legally important for many reasons. Of primary importance to the issuer is the rating's effect on the issuer's cost of capital. All else being equal, a lower rating.which signals higher risk.results in the bond's issuer paying investors higher interest rates for the bond.15 Low ratings may also make it harder for issuers to sell such bonds because some investors.typically institutional investors and trustees. …

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