Below Investment Grade and above the Law: A Past, Present and Future Look at the Accountability of Credit Rating Agencies
Cane, Marilyn Blumberg, Shamir, Adam, Jodar, Tomas, Fordham Journal of Corporate & Financial Law
"Below Investment Grade and Above the Law: A Past, Present and Future Look at the Accountability of Credit Rating Agencies" by Professor Marilyn Blumberg Cane, co-authored with Adam Shamir and Tomas Jodar is a timely and comprehensive Article focusing on the responsibility, and lack thereof, of credit rating agencies ("CRAs"). The Article is titled "below investment grade" due to the shoddy performance of the CRAs in light of their key role in the financial crisis of 2007-08. It is also titled "above the law" because of the CRAs' lack of accountability due to regulatory sleight of hand and the CRAs' almost completely successful defense against liability to bondholders through the invocation of the freedom of speech under the First Amendment.
This Article covers the evolution of the credit rating industry, in particular, the noteworthy shift from the purchaser-subscriber to issuer-pays model. It then describes the history of SEC CRA regulatory measures, most notably the adoption of SEC Rule 436(g), adopted in 1982, which specifically eliminated liability for the big CRAs (Moody's, Standard & Poor's, Fitch's and Duff and Phelps) as "experts" under Sections 7 and 11 of the Securities Act of 1933. This Article then covers the Credit Rating Agency Reform Act of 2006 and the adoption of SEC Rule 17g-5, in so far as they attempted to control conflicts of interest within CRAs. This Article next turns to the freedom of speech as a defense effectively used by CRAs, although the United States Supreme Court has yet to address this issue directly. The thrust of the CRAs' argument is that their ratings are simply their expression of their opinion, akin to a review of a restaurant or editorial column.4 There is much irony in this as many regulated financial players, such as banks and insurance companies, are required to comply with governmental rules that mandate them to invest in "investment grade securities," a "blessing" conferred only by the privately owned CRAs.
Next, this Article dissects provisions regarding CRAs in the DoddFrank Wall Street Reform and Consumer Protection Act of 2010, which among many other things, reads "Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933 shall have no force or effect."5 As the reader will see, this provision has not been enforced by the SEC, whereas in what could only be seen as a game of hard ball, the CRAs won notwithstanding the Act. For completeness, this Article then turns to the European approach of CRA regulation, including the creation of the European Securities and Markets Authority in January 2011.6
This Article concludes by suggesting, at a minimum, that CRAs be subject to accountability, and that some formal, financially neutral body conduct a periodic assessment rating the performance of the CRAs.
"There are two superpowers in the world today in my opinion. 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," said journalist Thomas Friedman regarding the undeniable power of Credit Rating Agencies ("CRAs").7 In light of the August 5, 2011 downgrade of the United States' long-term federal debt by major credit rating agency Standard and Poor's, Mr. Friedman's words ring truer than ever.8
CRAs have not always enjoyed such a commanding status, and have evolved considerably to become the market-shaping giants they are today.9 Millions of investors across the world rely on rating agencies to help assess the creditworthiness of particular financial instruments.10 While these agencies perform a vital function for the financial community, many individuals, investors, and organizations heavily criticize the rating agencies, notably for their role in the 2007-2008 subprime mortgage crisis." CRAs have been blasted for their shoddy performance in rating various structured financial instruments, raising several questions regarding the accuracy of their ratings and the integrity of the process as a whole. …