the SEC Going Soft on Credit Rating Agencies?
Danvers and B. Anthony Billings
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.
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 investment-banking 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
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.
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.
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.”
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.
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.
Between Credit Rating Agencies and Accounting Firms
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.
heightened scrutiny of accounting and financial reporting issues,
rating agencies are hiring more accounting professionals and seeking
increasing interaction with independent auditors. These concerns
were demonstrated when in October 2002 S&P hired its first
chief accountant, a former Ernst & Young partner, to focus
on accounting quality. Further connections between audit and credit
rating functions include the following:
of credit information. Both the CPA and the rating
analyst function as information-processing agents for the capital
markets. Moreover, both agents exercise information-based judgments
and depend on the willingness of investors to accept these judgments.
While auditors are compensated through annual audit fees, rating
firms assess bond issuers initial fees based on the size of the
issue. These fees are intended to cover expenses for initial rating
services as well as ongoing monitoring. Such an arrangement provides
rating firms with incentives to minimize rating surveillance costs
and maintain favorable ratings, to retain clients.
of firms’ management and representations.
Evaluating management representations and “certification”
functions are commonly associated with accounting firms and auditors.
From the auditor’s perspective, investors seek unqualified
or “clean” opinions on firms’ financial statements;
similar functions are also attributed to credit rating agencies.
Within a principal-agent setting, agency costs can be reduced
when a firm engages rating firms, in addition to auditors, to
monitor managers that have incentives to undertake risky projects
that adversely affect bond values. Similar to many accounting
firms, rating firms are clear that they do not accept responsibility
for detecting fraud.
and value-added through independence. Independence
is critical to ensuring credibility of the audit function. The
Sarbanes-Oxley Act attempts to promote auditor independence by
prohibiting consulting services that are perceived to impair independence.
Rating agencies also contend that credibility is vital to their
independent performance. While independence is highlighted and
safeguarded in the auditing profession, in the rating industry
it is merely presumed.
auditor has an inherent conflict between independence and client
retention, an identical conflict exists for rating agencies, although
it may be less because the industry is an extreme oligopoly, duopoly,
or cartel. Client fees can be significant for rating firms; S&P
may charge particular issuers as much as $1.5 million for rating
services. It has been suggested that conflicts of interest, stemming
from client relationships and rating fees, restrained S&P
and Moody’s in downgrading firms such as WorldCom and Enron.
In sum, the
political process has significantly affected accounting firms
and the auditing profession through increased regulation. Political
pressure has also forced the SEC to scrutinize rating firms and
reexamine several industry issues, the results of which were presented
in its January 2003 report.
Resulting from Sarbanes-Oxley
November 2002 Congressional hearings that focused on credit rating
deficiencies and directed the SEC to examine the role and function
of the rating agencies, the SEC issued its January 2003 report,
“Report on the Role and Function of Credit Rating Agencies
in the Operation of the Securities Markets.” The House Financial
Services—Capital Markets Subcommittee conducted further
hearings in April 2003. Testimony by Annette L. Nazareth, director
of the SEC’s Division of Market Regulation, highlights the
Commission’s position regarding further examination of credit
firms as contained in the January 2003 report.
process and information flow. Credit rating firms
are very guarded about the specific methodologies and information
they use in the credit rating process, often deferring to the
required “judgment” associated with the decision.
Contrast this with a purported SEC consideration for determining
Nationally Recognized Statistical Rating Organization (NSRSO)
status in the use of systematic rating procedures.
a more complete understanding of the methods underlying rating
decisions, as well as specific information on which analyses are
based. A further concern relates to asymmetric information disclosure,
which occurs when subscribers directly contact rating analysts
who inappropriately disclose information. In particular, analysts
may reveal information to subscribers that they obtain through
a Regulation FD exemption.
disclosure of rating triggers in debt instruments also needs to
be examined. The Association of Financial Professionals survey
indicates that over 25% of firms have debt with rating triggers,
while other reports suggest that only 20% of these firms provide
sufficient disclosure. Such triggers may require an issuer to
repay debt on an accelerated schedule, or restrict access to further
borrowings, thus setting the stage for liquidity crises.
and conflicts of interest. Lack of independence
in accounting and brokerage firms has been a significant issue.
A fundamental impairment of independence also arises through the
fee structures and reliance of rating agencies on issuer fees,
which may diminish the diligence of the rating agency in identifying
and acting upon negative credit information.
concerns about auditor–client relationships, a rating agency
may be reluctant to downgrade a company if it risks losing future
fees. U.S. Representative Michael G. Oxley (R-Ohio), Chairman
of the House Financial Services Committee, expressed this concern
in his opening statement in April 2003 hearings on rating agencies,
commenting that “the similarities between the potential
conflicts of interest presented in this area (rating agencies)
and those that were addressed in the area of accounting firms
in Sarbanes-Oxley are impossible to ignore.”
rating firms contend that their internal processes and controls
mitigate adverse independence effects. To illustrate, S&P
President Leo C. O’Neill describes the rating change process
as beginning with two analysts who make recommendations to a committee
that votes on the credit change recommendation, with peer review
being an additional check in the process. These “controls”
are similar to those typically found within accounting firms before
to independence issues are widespread conflicts of interest in
the rating agencies. The provision of ancillary consulting, including
hypothetical rating assessment services, further compounds independence
problems. Such hypothetical analyses, based on proposed transactions
(e.g., merger, acquisition, stock buyback), may oblige the rating
agency to align actual to hypothetical rating decisions.
the tone set at the top of the rating organizations alarms many
observers. Consider Moody’s chairman Clifford Alexander,
who was a board member of WorldCom and resigned only one year
before the firm became the largest bankruptcy in U.S. history.
It is interesting that Alexander believes this relationship did
not compromise Moody’s ratings of WorldCom’s debt
instruments, notwithstanding that Moody’s did not downgrade
WorldCom’s debt to subinvestment grade until shortly before
practices and barriers to entry. Credit rating agencies
are permitted to operate as an oligopoly, or duopoly in some cases,
with Moody’s and S&P partnering to share monopolistic
rents. In addition, these rating agencies have allegedly abused
their monopolistic positions by refusing to rate new issues unless
the agency has already been engaged to rate a substantial portion
of certain classes of the issuer’s outstanding securities
(sometimes called notching). Other strong-arm practices by the
rating agencies include requesting payment from issuers for unsolicited
ratings. Northern Trust Corporation describes such practices in
its response to the SEC’s July 2003 concept release. The
company states that rating agencies have implicitly forced it
to pay for unsolicited ratings in order to receive desired ratings.
the SEC has been reluctant to admit new entrants into the NSRSO
business, perhaps partly because it hasn’t clearly established
the requirements. Given that major users of credit ratings, such
as financial institutions, are required to have NSRSO-based ratings
to meet capital requirements, rating agencies without this coveted
designation cannot easily compete. Clearly, the NSRSO arrangement
has created regulatory barriers to entry into the credit ratings
additional credit rating agencies as NSRSOs would significantly
improve the competitive environment. At least one rating agency
is loudly protesting the lack of competition. The cofounders of
Egan-Jones Ratings argued, in a letter it submitted to the SEC
as part of the November 2002 hearing on credit rating agencies
(as well as in its comment letter following the SEC’s 2003
concept release), that the industry is best described as a “partner
monopoly.” Because two ratings are usually obtained to issue
bonds, the gains of one partner do not reduce the gains of the
other (i.e., S&P and Moody’s jointly enjoy the gains
of issuing ratings).
Due to increased
pressure, the SEC granted NSRSO status in February 2003 to a fourth
rating agency, Dominion Bond Rating Service Limited of Canada—the
only additional firm to be recognized by the SEC since 1991. The
SEC agreed to recognize Dominion Bond only one month after submitting
its initial study to Congress. Considering the SEC’s recent
concept release on the rating agencies, the NSRSO market will
probably become open to a few more participants in order to improve
competition and promote better ratings.
oversight. Legislators continue to call for increased
government oversight of the relatively unregulated rating industry.
In the absence of increased SEC supervision, Congress may legislate
periodic auditing of credit-rating firms, as suggested by Senator
Joseph Lieberman and proposed in the SEC’s concept release.
The SEC concept release, discussed below, proposes that increased
oversight may include establishing standards for ratings and training,
as well as monitoring compliance with those standards, which ultimately
means a more active role for the SEC in operational reviews. Similar
to general auditing standards, the SEC is considering imposing
minimum standards for analyst training and qualifications, as
well as for diligence in performing credit analysis. In addition,
a formal program of recordkeeping, inspections, and reviews may
become part of the Commission’s final proposal.
June 2003 Concept Release
In June 2003,
the SEC followed up on its January 2003 report with a concept
release (CR) regarding the use of credit ratings for regulatory
purposes, the process of determining which credit ratings to use,
as well as the degree of regulatory oversight. The CR presents
possible approaches to address the above-mentioned issues of concern,
and has received at least 50 comment letters as of February 2004.
alternatives. The CR considers the possibility of
eliminating the NSRSO designation, but expresses concerns about
whether alternatives will support regulatory objectives. For example,
the SEC could permit, with regulatory approval, internally developed
ratings by broker-dealers for computing capital charges under
the Net Capital Rule (Rule 15c3-1). Statistical models or credit
spreads could also be used as alternatives to the NSRSO-based
of the Investment Company Act of 1940, however, requires objective
(NSRSO-based) investment-grade ratings, as well as subjective
components (internal credit analysis by the fund manager). In
the absence of NSRSO ratings, the SEC appears to be open to considering
the subjective test component only. Comment letters, such as one
submitted by Federated Investors, Inc., appear to favor retaining
the objective basis for credit quality standards. Because these
comments reinforce the SEC’s apparent desire to retain the
NSRSO designation, all additional issues presume an ongoing NSRSO
criteria for NSRSOs. In the likely event that NSRSO
designation is retained, the SEC seeks to improve the clarity
of the recognition process for ratings firms. For instance, information
requirements would be more explicitly specified and ratings firms
within limited sectors could be considered. It is critical for
the SEC to establish and define the appropriate criteria for NSRSO
flow and ratings process. The SEC may make the credit
rating process more transparent by requiring greater disclosure
about the underlying assumptions that influence rating decisions.
Rating firms could implement procedures to ensure appropriate
disclosure about ratings and related processes. In addition, specific
events and key assumptions that influence ratings decisions would
need to be routinely disclosed. Such requirements would be rolled
into NRSRO criteria.
of interest. To control conflicts of interest, the
SEC proposes that employee compensation not be linked to new business
development or client maintenance. Rating firms may also need
to establish procedures that restrict direct contact between subscribers
and analysts. Moreover, the SEC may require firms to establish
firewalls across ratings and ancillary business development. The
SEC suggests that adequate financial resources and a limited revenue
percentage (e.g., 3%) derived from a single source would improve
independence, but a 3% rule is unlikely to affect major rating
firms; nor would such a rule have eliminated conflicts of interest
at the big accounting and brokerage firms. These requirements
would be operationalized through NRSRO recognition criteria.
practices. Rating firms might be required to implement
procedures to control unfair and anticompetitive practices. Firms
would not be able to engage in strong-arm tactics or require issuers
to purchase ancillary services in order to receive other rating
services. Again, the SEC would incorporate these requirements
into the NRSRO recognition criteria.
triggers. The SEC solicited comments on improving
disclosure by issuers and rating agencies of financial covenant
triggers. In addition, further disclosure regarding special purpose
entities and material future liabilities has been recommended.
At least some improvement from the current level of disclosure
should be forthcoming.
oversight. The SEC might require rating firms to
file annual certifications of compliance with any established
NSRSO criteria. In addition, firms would be required to maintain
internal records about ratings decisions and other activities.
it appears that the SEC proposes making the NSRSO designation
a more formal process with better-defined criteria. Ongoing review
of firm compliance with the criteria incorporates a regulatory
oversight that has not previously existed. Although the CR addresses
Congress’ concerns, several proposals are inoffensive to
the big rating firms and in step with the industry’s earlier
assertions, particularly with respect to conflicts of interest.
planning. It is increasingly important to identify
rating triggers within credit facility agreements. Although many
companies have such triggers, often this information is not disclosed
to investors. Bear in mind that such triggers could make a business
lose significant control over debt repayment and liquidity. Auditors
should also be prepared to increase disclosure of such triggers
within footnotes to financial statements. In addition, auditors
will need to spend more time explaining accounting policies and
procedures associated with complex financial transactions to the
rating firms. This will increase the time and cost of audit engagements.
To the extent
that the rating process becomes more transparent, more-detailed
information will be available about the credit prospects of rated
firms. Such changes should improve the ability to make informed
and policymakers. The SEC appears to be accommodating
the interests of big rating firms by permitting ancillary consulting
services. For example, providing hypothetical rating services
inherently compromises rating firm independence and may lock in
the agency’s response when a particular scenario materializes.
Given the steps the SEC has taken to improve levels of independence
for accounting firms and equity analysts, similar action should
be required to restore the credibility of and confidence in the
rating system. The authors recommend that rating firms be prohibited
from offering any consulting-related ancillary services. Opening
the supplier market to additional firms, closely monitoring internal
processes, and taking further steps to prevent conflicts of interest
are also critical to accomplishing the objectives of Sarbanes-Oxley.
Sarbanes-Oxley Act, audit committees have direct responsibility
for appointing, overseeing, and compensating external auditors.
This provision is intended to reduce management’s influence
over the auditor and to enhance independence from management.
However, no such provision has been required for credit rating
agencies. Thus, there is a clear role for the audit committee
to oversee relationships with credit rating agencies as well as
auditors, in order to mitigate management influence over credit
disclosure about rating processes and decision outcomes would
also improve transparency in the rating process. Credit firms
must be more forthcoming in explaining the “black box”
workings of their ratings. In addition, the current rating system
implies greater precision than is actually available regarding
issuer creditworthiness. While equity analysts have moved to a
three-tier system (buy/hold/
sell), rating agencies use scales with more than 20 different
levels. Some simplification of rating schemes should be considered
in the NSRSO criteria.
for a Smoking Gun
the SEC reexamined rating agencies and prepared recommendations
for NSRSO criteria in 1997, far greater political pressure arising
from Sarbanes-Oxley should result in definitive changes. The SEC’s
reports to date portray favorably the rating industry’s
performance, however, and this relatively soft stance suggests
that any reform in this area will be limited.
In an attempt
to solidify its reputation, S&P has begun a corporate governance
rating system to evaluate the quality of corporate boards. The
rating firm has also compiled a study of financial statement disclosures
for S&P 500 companies and beefed up its in-house accounting
expertise to begin addressing the disclosure concerns. In light
of recent rating industry action and SEC inaction, perhaps the
accounting industry would have achieved a more favorable outcome
if the profession had been similarly proactive in its response
to legislative criticism.
Danvers, PhD, CPA, is an assistant professor of accounting,
B. Anthony Billings, PhD, is a professor of accounting,
both at the School of Business Administration, Wayne State University,