Tuesday, October 25, 2011

Senators Franken and Wicker Urge SEC to Implement Their Amendment to Reduce Conflict of Interest in Assigned Credit Ratings

In a letter to the SEC, Senators Al Franken (D-MN) and Roger Wicker (R-MS) urged the Commission to implement the Franken-Wicker Amendment on assigned credit ratings. The current issuer-pays model and its inherent conflicts of interest is flawed and makes true competition in this credit rating industry nearly impossible, said the Senators. A system, in which issuers are pursuing the highest rating possible but are also the source of revenue for ratings agencies, created a market in which accuracy was discouraged and competition was stifled.

While Dodd-Frank and the Credit Rating Agency Reform Act both gave the SEC as yet underutilized authority to address conflicts of interest, noted the Senators, the Franken-Wicker Amendment is the only proposal included in the Dodd-Frank Act that gets at the root of the problem of the inherent conflicts of interest in the issuer-pays system. The Franken-Wicker Amendment would reduce the conflicts of interest, eliminate ratings shopping for initial ratings, encourage the market to reward accuracy, and promote competition and thereby fundamentally reform the industry and break up its oligopoly, while seeking to preserve the credit rating industry. Once the market is functioning properly, incentives will be aligned to promote quality ratings and increase competition.

According to Senators Franken and Wicker, their Amendment provides a simple solution by creating an independent, self-regulatory board to administer a system in which issuers are assigned a credit rating agency to provide an initial rating. NRSROs could opt-in in to this system, and apply to become a qualified NRSRO (QNRSRO), which would allow them to participate in the assignment process. The process would not be random, emphasized the Senators, since the board could consider institutional capacity, expertise, and track record in developing its assignment system.

For example, the board could determine that a certain set of QNRSROs are qualified to rate a particular subset of securities, and another set of QNRSROs are qualified to rate a different subset. The board would not randomly assign a large, complex, sophisticated structured finance product to a newly registered ratings agency with limited expertise for that type of product. The Amendment also permits a selected NRSRO to refuse to rate a product. Also, the Franken-Wicker Amendment does not affirmatively prescribe the criteria that should be used in its assignment system, but does prohibit issuer preference as one of those criteria.

The majority of the new self-regulatory board would be comprised of investors, but would also include representatives from the credit rating industry, the issuer community, and at least one independent member. While the initial members of the board would be selected by the SEC, the board would eventually develop a selection process for subsequent members. To promote transparency, the Franken-Wicker Amendment requires that the board publish its assignment methodology.

The Senators emphasized that the Amendment would apply only to initial ratings, would not affect non-initial ratings or unsolicited ratings. Also, citing evidence suggesting that oversight is most needed in the structured finance sector, they noted that, under the Franken-Wicker Amendment, the board’s rating agency assignment process is mandatory only in the structured finance sector. Also, the Amendment would have no effect on the government or corporate bond market.

A little-noticed provision in the Franken-Wicker Amendment instructs the board to issue a report to Congress within five years of beginning to assign ratings, with its recommendations regarding the continuation of the board, and modifications to the procedures of the board or provisions in the authorizing language. According to Senators Franken and Wicker, this provision recognizes that the industry may shift in a way that necessitates fundamental changes in the board's operations, or the discontinuation of the board itself.

Under the Franken-Wicker Amendment, the board would have the authority to intervene if credit rating agencies were charging unreasonably high fees for initial ratings compared with fees it charged for similar products outside the assignment process. But the Senators anticipate that the grant of authority to the board to ensure reasonable fees will go largely unutilized, because of the market indicators readily available, and because of the increased competition that will result from the assignment process system.

The Franken-Wicker Amendment does not prescribe a structure in which the board serves as an intermediary for the collection and distribution of fees. The board's assignment system is intended to eliminate direct conflicts of interest and ratings shopping, reasoned the Senators, and it can accomplish this objective without becoming a fee intermediary.

The Franken-Wicker Amendment calls for the levy of fees from QNRSROs to fund the operation of the board. While this option strikes the Senators as the most straightforward, they are open to the idea that a fee-sharing scheme among the rating agencies, issuers, and investors might also be formulated in a way to fairly distribute costs.

Finally, the Franken-Wicker Amendment makes clear that a rating received through the assignment system has not been approved or certified by the US Government or by a federal agency.