Thursday, August 11, 2011

Key Senator Urges SEC to Adopt Regulations Requiring Audit Certification of Rating Agency Internal Controls

In a letter to the SEC on the proposed regulations implementing Dodd-Frank credit rating agency reform, Senator Carl Levin (D-MI) urged the Commission to use its authority to rank the performance of the credit rating agencies in terms of accuracy, and ensure that the rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity. Senator Levin, who chairs the Permanent Subcommittee of Investigations, also said the proposed regulations should establish mandatory minimum standards for rating agency internal controls and require annual compliance reports subject to a third party audit.

Given the importance of rating agencies to the U.S. financial system, their complex work, their history of poor compliance with their own ratings criteria, and the devastating impact of inaccurate credit ratings, said the Senator, an audited annual report certifying compliance with the Dodd-Frank statutory requirements, the SEC's implementing regulations, and the rating agency’s own internal control requirements is warranted. An audited report would not only alert the rating agency to any internal control deficiencies, he noted, but it would also provide the SEC with greater confidence in the annual report as a useful tool for evaluating the adequacy and effective implementation of a particular rating agency’s internal controls and compliance efforts.

Dodd-Frank requires rating agencies to establish effective internal controls governing the implementation of and adherence to procedures and methodologies for determining credit ratings, taking into consideration such factors as the Commission my prescribe. It also requires them to file an annual report assessing their compliance with the statutory and regulatory requirements and its own policies and procedures related to credit ratings. The SEC proposes deferring the identification of any factors that rating agency internals controls should take into account until after the SEC has conducted additional examinations of the rating agencies and reviewed their annual compliance reports.

Senator Levin asks the SEC not to defer prescribing factors. He fears that the proposal would postpone for an unspecified period of time, likely a year or longer, the issuance of any standards for intema1 controls, even though they clearly need improvement. The proposed rule indicates deferral is needed to gather additional information and conduct additional reviews, noted the Senator, but credit rating problems have already been a subject of study for years, he said, adding that his Subcommittee uncovered a host of troubling practices that could have been prevented by effective internal controls.

To ensure effective internal controls for credit rating agencies, emphasized Senator Levin, it is critical for the SEC to establish a framework against which the relevant internal controls of a specific rating agency can be measured. This framework would identify the objectives to be achieved by the internal controls, a set of mandatory minimum components, and how a material weakness, which he described as a serious deficiency in an internal control that would prevent it from achieving its objective, would be handled. Without this framework, reasoned the Senator, each rating agency would formulate its own approach, making SEC oversight more time consuming, subjective, and expensive, and inviting disagreements and conflicts between rating agency and SEC personnel over acceptable practices.

He urged the SEC to strengthen the proposed regulations by establishing the objectives that rating agency internal controls should be aimed at achieving, including the issuance of accurate and reliable credit ratings; the disclosure of information related to each ratings action in a timely and organized way; the monitoring and updating of existing ratings, and the avoidance of conflicts of interest that undermine ratings accuracy. Moreover, regulations should identify the minimum components of an effective credit ratings internal control structure.

What is of paramount importance, said the Senator, is that these factors should be issued, not as voluntary guidelines or best practices to which a rating agency should aspire, but as mandatory minimum standards for establishing effective internal controls. Unless the specified factors are issued as mandatory minimum standards, he said, history shows that rating agencies are likely to ignore them in response to competitive pressures to win market share and please clients by issuing inflated ratings.

In his view, the proposed regulations would also be strengthened if they clarified how the internal controls mandated Dodd-Frank are intended to interact with the internal control requirements of the Sarbanes-Oxley Act, with one aimed at supporting accurate credit ratings and the other at accurate financial reporting.

Among the most important of the proposed internal controls are those that would require a rating agency to determine if it has sufficient competency and access to information before commencing the rating of either a class of financial products that that it has not previously rated, or before commencing the rating of an exotic or bespoke product, which is a product customized for a particular firm or transaction.

The regulations should make it plain that rating agencies must assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity. To counter the competitive pressure on rating agencies to rate new financial products quickly and grant investment-grade ratings, there should be minimum internal control standards automatically requiring the assignment of a larger financial cushion or greater credit enhancements for novel and complex products, with the size of the financial cushion corresponding to the extent to which the particular product lacks reliable performance data.

According to the Senator, the proposed regulations should also specify a maximum amount of time, such as 60 days, during which a rating agency must retest existing ratings after making a material change to new or existing rating and surveillance criteria, methodologies, or procedures. A material change to a ratings model may be a significant indicator that existing ratings are inaccurate. If the change also requires higher levels of credit enhancements, he reasoned, rating agencies may be reluctant to downgrade existing ratings, which is what happened in the years leading up to the financial crisis.

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