Kroll Bond Rating Agency the latest to settle with the SEC - evidence of an inherent problem?


In May of this year, Morningstar settled with the SEC for $3.5 million for violating regulations designed to protect against internal conflicts of interest. On Tuesday, the SEC announced that Kroll Bond Rating Agency (KBRA) had agreed to pay more than $2 million to settle charges relating to the ratings of commercial mortgage-backed securities (CMBS) and collateralised loan obligation combination notes (CLO Combo Notes). In this short post, we will discuss the reality that transgressive behaviour is being witnessed across the industry, not just in the Big Three, and why that may be.

 

The settlement has been reported widely in the business press (here and here for good examples). In relation to the actual charges that were put forward by the SEC, it argued that Kroll had permitted its analysts to make adjustments which went on to have material effects to the final rating, although those adjustments were not made on any analytical basis. Furthermore, it was alleged that there were no internal mechanisms to record these adjustments. For the CLO Combo Notes issue, the SEC alleged that the necessary policies and procedures were not designed reasonably enough to ensure that the Combo Notes were rates in accordance with the terms of the securities. Kroll has said that it stands behind the integrity of its ratings, methodologies, and processes, whilst not admitting any wrongdoing or guilt. The SEC, for its part, were emphatic when they declared, via Daniel Michael, the Chief of the Enforcement Division’s Complex Financial Instrument Unit: ‘rating agencies play a crucial gatekeeping role in the securities market. With this responsibility comes the requirement that they establish and enforce policies and controls to ensure the consistency and integrity of credit ratings’.

 

We saw only recently that the EU are updating their guidance on internal controls, so it is clearly still a pressing issue all this time after the era-defining (especially for the credit rating industry). This we know. However, what is massively interesting is that it is not the oft-decried “Big Three” who the only ones transgressing – such behaviour is spread throughout the marketplace. We saw that Scope Ratings was recently fined, and the link at the top of this post describes how Morningstar were fined earlier in the year. Interestingly, Cezary Podkul of the Wall Street Journal, makes the valid point that both firms have been engaged in a battle for market share recently, particularly with regards to the ratings of different asset-backed securities. Can we infer from this that with the potential for increased market share comes the potential of folding and bending to the will of those who pay the agencies? Probably. Anecdotally, the evidence is in front of us. Yet, under the surface there is a lesson to be learned for regulators here. There is, unless there is evidence to the contrary, clearly a link between the battle for market share and the increasing prevalence of rating agencies to cater for their revenue base, irrespective of the financial penalties that are eventually levied if they are caught. Leaving aside the issue of the negligible effects of these small fines, the reality is that the regulatory push to increase competition within the sector comes with an inherent risk – one subsequently increases the potential for transgressive behaviour in the marketplace. Can we really say that this behavioural development is inherent within the industry? Is it perhaps inherent within the issuer-pays system instead? Would an investor-pays system generate such imbalances and transgressive behaviour? It is difficult to say with any certainty, but it appears, especially from research conducted into the effects of the issuer-pays system, that the urge to encourage market share by being as hospitable as one can towards the issuer is proving to be incredibly strong. Even those smaller firms who, theoretically, have to fight to earn a reputation, are willing to risk that reputation for market share. However, may be we are thinking of this from the wrong angle. Perhaps market share is gained by demonstrating one’s willingness to cater for the needs of the issuer? Perhaps. What is clear to see is that there are inherent issues within the sector that are not going away; in fact, they are getting worse all the time.

 

Keywords – Credit rating agencies, Kroll, SEC, KBRA, @finregmatters

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