Those eager to try to hold the credit rating agencies responsible for supposedly enabling the subprime mess will undoubtedly be encouraged by a July 8, 2008 SEC Report identifying rating agency “shortcomings.”


The Report, entitled “Summary Report of Issues Identifies in the Commission Staff’s Examinations of Selected Credit Rating Agencies” (here) reflects the SEC’s efforts to “evaluate whether the three leading rating agencies “adhered to their published methodologies for determining ratings and managing conflict of interest.” According to the Commission’s July 8 press release (here), the SEC was “particularly interested in the rating agencies’ policies and practices in rating mortgage-backed securities and the impartiality of their ratings.”


According to a July 8, 2008 article about the Report (here), about 50 Commission staffers reviewed more than 100,000 pages of internal records and more than two million E-mail messages, mostly concerning rating activities related to Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) during the period 2002 through 2006. The SEC’s massive review of electronic communications unearthed exchanges that, while not necessarily incriminating, do not reflect well on the overall integrity of the rating process, to say the least.


The SEC’s Report, which does not cite any particular rating agency by name, concludes that the rating agencies “struggled significantly with the increase in the number and complexity of these securities.”


As evidence that the rating agencies struggled with the transaction volume, the Report cites a number of e-mail communications, including one stating that “our staffing issues, of course, make it difficult to justify our fees.”


As evidence that the rating agencies struggled to keep up with the deal complexity, the Report cites another e-mail communication in which an analyst expressed concern that her firm’s model did not capture “half” of the deal’s risk, but that “it could be structured by cows and we would rate it.”


The Report also examines the “issuer pays” conflicts at length. Under this payment approach, the entity that issues the security pays the rating agency for the rating. The Report found that while each of the rating agencies had policies that prohibited rating analysts from discussing fees with the issuers, “these procedures still allowed key participants in the rating process to participate in the fee discussion process.” The Report also found that the rating agencies “do not appear to have taken steps to prevent considerations of market share and other business interests” that “could influence ratings or ratings criteria.”


Along those lines, the SEC found evidence to suggest that analysts were concerned that specific rating actions might affect business or cost market share. The Report quotes one analyst’s email message as stating “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision and if so how much.”


The Report also found that there are particular aspects of the RMBS and CDO rating process that may exacerbate some of these “issuer pays” conflicts. For example, the Report noted that the deal “arranger” is “often the primary designer of the deal and as such has more flexibility to adjust the deal structure to obtain the desired credit rating as opposed to managers of non-structured asset classes.”


The high concentration of this business among a very small number of “arrangers,” together with the high profit margins associated with the business, potentially could allow or encourage influence on the use, application and revision of credit rating processes.


The SEC said that it found no evidence that these kinds of considerations affected “rating methodology or models.” However, the Report quoted emails inferentially suggesting that analysts at least turned a blind eye to concerns. One email referring to CDOs as a “monster” and went on to observes that “Let’s hope we are all wealthy and retired by the time this house of cards falters.”


The Report noted a number of other deficiencies, including the lack of disclosure about rating processes; insufficient documentation of process and of deviations from models to adjust ratings; and lagging surveillance in updating previously issued ratings.


As a result of September 2007 congressional action, the rating agencies must now register with the SEC as “nationally recognized statistical rating organizations” (NRSRO). In addition, in June 2008, the SEC issued a set of proposed rules that are designed to address many of the kinds of issues identified in the Report, particularly regarding conflicts of interest, documentation and report transparency. Because the SEC has only been regulating the rating agencies since 2007, it is unclear whether or not the SEC has the authority to file enforcement proceedings against the rating agencies in connection with the conduct described in the report, even if the SEC were otherwise so inclined.


Regulatory processes may well be underway to prevent the recurrence of the kinds of “shortcomings” identified in the Report. The Report also notes a variety of other remedial efforts already underway at the rating agencies themselves. But the Report also catalogs a litany of past practices that clearly may have played a role in the events that led up to the collapse of the subprime mortgage market. The ratings shortcomings apparently accompanied (and, it may be argued, enabled) the flood of mortgage securitizations that contributed to the subprime meltdown.


I recently noted (here) that investors and their counsel are starting to try to hold the rating agencies responsible for their investment losses. These claims may well face formidable obstacles (refer here). But, even though the report does not attribute statements or actions to specific rating agencies or to particular transactions, the tenor and content of the SEC’s Report undoubtedly will encourage those who want to try to hold the rating agencies responsible.


Of course, the SEC was able to muster formidable resources and undertake a massive review of electronic communications while passing the cost along to U.S. taxpayers. Those eager to exploit the same communications in separate civil litigation against the rating agencies may be forced to undertake a massive expense just to try to establish whether or not these or similar communications related to the agency or transaction they have targeted.


A July 9, 2008 Wall Street Journal article discussing the Report can be found here. Bloomberg’s July 8, 2008 article about the Report can be found here.


Auditor Liability Cap Alternative: George Washington Law School Professor Larry Cunningham has an interesting post on the Concurring Opinions blog (here) in which he reiterates his proposal for a market-based solution to manage the potentially ruinous liability exposures of auditors. In the post, Professor Cunningham reviews his suggestion that the audit firms “issue bonds in debt markets to provide a backstop against the big judgment,” paying interest commensurate with the risk. I have previously commented on Professor Cunningham’s proposal here.


In his most recent blog post, Professor Cunningham argues persuasively that the auditor liability cat bonds are “a practical, cost-effective solution to the risk that another large auditing firm could disappear.” He also argues that making auditor liability cat bonds a serious point of public debate would reveal the “true stakes” involved in the auditor liability debate.


Special thanks to Professor Cunningham for the link to the blog post.