Alternative remuneration models

Another performance-based proposal that has been put forward is one that would require issuers to pay a minimum initial rating fee, with the balance of the fee being earned by the CRA based on the ultimate accuracy of the rating within a pre-agreed time horizon.²⁰⁵ The advantage of adopting such a staggered payment approach is that it would allow qualifying dissatisfied issuers to withhold further payment from a CRA should the rating diverge significantly from the security’s actual performance.²⁰⁶ A parallel can be

205 See e.g., John Kiff, Reducing Role of Credit Rating would aid markets 10, IMF Global Financial Stability Report (2010); Bowden, Roger and Peter Posch. “Quality signalling and ratings credibility:

regulatory reform for the ratings agency”.

http://www.wellesley.org.nz/uploads/Signalling%20value%20of%20registration_2.pdf (last accessed March 5, 2015), at 6, 13 (proposing a partial sequester of the fee earned by CRAs to be set as a performance bond over agreed horizon, (i.e. subject to a due diligence defense)). See also, James C.

Spindler, IPO Liability and Entrepreneurial Response, 14-17 (Univ. of Chi. John M. Olin Law & Econ., Working Paper No. 243, 2005) (proposing embedding put options into issue not clear (i.e., “IPO”

securities to protect investors against poor firm performance.), at 14-17 (2005), available at

http://ssrn.com/abstract_id=719768 and at http://www.law.uchicago.edu/Lawecon/WkngPprs_226-50/243-jcs-ipo.pdf (on file with the Columbia L. Rev.)

206 See, Frank Partnoy, Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective, CII, April 2009, at 12-13 (a fee-for-service format would allow CRA to earn-out their fees based on meeting agreed thresholds); Yair Listokin & Benjamin Taibleson, If You Misrate, Then You Lose:

Improving Rating Accuracy Through Incentive Compensation, 27YALE L.J. ON REGULATION 91, 112 (2010) (deferred instalment payments is the “only way” to ensure CRAs are appropriately incentivized

drawn from the February 2013 announcement from the US investment bank, Morgan Stanley, that it planned to pay its bankers bonuses staggered over “four equal installments.²⁰⁷ Other proposals include a variation of a“Subsidy Reserve Plan” to serve a reserve fund against losses from flawed ratings²⁰⁸ and a performance-based suggestion which would see CRAs compensated with the debt that they rate²⁰⁹ while requiring CRAs to hold these to maturity²¹⁰ in order to ensure that their earnings are directly impacted if it overrates a debt security. At first blush the two aforementioned performance-based compensation approaches seem significantly less complicated and potentially less litigious than alternative approaches that would place reliance on the successful disgorgement-of-fees as has been suggested by some authors:²¹¹ but that would be overly

through to maturity). Contrast, Katherina Pistor, Towards a Legal Theory of Finance 7 (Columbia Public Law Research Paper No. 12-323, 2012) (asserting that due to fundamental uncertainty, long horizon inflexible commitments and contracts are actually counter-productive and potentially system-threatening).

207 See e.g., Brett Philbin, Wall Street’s $20 Billion Pile, WALL ST.J., Feb. 28, 2013, at 25.

208 William Isaac & Cornelius Hurley, At Last – how America can solve the ‘too big to fail’ problem, FINANCIAL TIMES, Feb. 18, 2012, at 9.

209 Yair Listokin & Benjamin Taibleson, If You Misrate, Then You Lose: Improving Rating Accuracy Through Incentive Compensation, 27YALE L.J. ON REGULATION 91, 94-95 (2010), (inaccurate over-ratings directly impact CRA income; the downside is that under-rating may consequently be incentivised. The authors suggest that requiring the rating CRA to write call options on the debt could dissuade under-rating by CRAs).

210 Id. Listokin & Taibleson, at 111 (2010).

211 See e.g., Brigitte Haar, Nachhaltige Ratingqualität durch Gewinnabschöpfung? - Zur Regulierung und ihrerImplementierung im Ratingsektor 21 ZBB (3) 177, 185-86 (2009); Brigitte Haar, Civil Liability of Credit Rating Agencies - Regulatory All-or-Nothing Approaches between Immunity and Over-Deterrence, 19 (University of Oslo Faculty of Law Legal Studies Research Paper Series No.2013-0, 2013) (disgorgement of profits as alternative to drawbacks of exposing CRAs to excessive liability); John Patrick Hunt, Credit Rating Agencies and the Worldwide Credit Crisis: The Limits of Reputation, The Insufficiency of Reform, and a Proposal for Improvement, 2009 COLUM.BUS.L.REV.,(1) 109, 191-92, 195 (on novel products, and three advantages of disclosing or other alternatives: i) ignores scienter; ii) foregoes

simplistic.²¹² For instance, Listokin and Taibleson conclude that competition and collusion cause over-rating in both the debt compensation model and the cash model that is currently in use.²¹³

Since 2007, CRAs for their part have also recognized and taken expedited steps to incorporate new regulatory proposals in their own corporate practices in order to better manage the potential conflicts of interest posed by the issuer-pays model. S&P for example, have compared their adoption of a distinct “separation of function between those who negotiate the business terms for the ratings assignment and the analysts who conduct the credit analysis and provide the ratings opinions²¹⁴ […] to the way newspapers distinguish their editorial and advertising sales functions, since they report on companies from which they may also collect advertising fees”.²¹⁵ A further safeguard provision that has been highlighted is the rating by the committee process aimed at limiting the influence any single analyst or executive can have on S&P’s ratings opinions. The role of the committee is to review and assess the lead analyst’s recommendation for a new rating or

determining ex ante “reasonableness”, and iii) disgorgement preferable to damages remedy as it dis-incentivizes production of low-quality ratings); and Stephen M. Bainbridge, Dodd-Frank: Quack Federal Corporate Governance Round II, 95MINN.L.REV., 1779, 1806 (2011) (citing the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) §954 10D amendment to the Securities Exchange Act permitting the clawing back of incentive-based compensation).

212 Listokin & Taibleson, If You Misrate, Then You Lose: Improving Rating Accuracy Through Incentive Compensation, 27YALE L.J. ON REGULATION 91, 105-107, (see debt compensation model mechanics). Id., at 109 (use of puts and call options to discipline under- and over-rating).

213 Id. at 107.

214 Contrast, Matt Taibbi, The Last Mystery of the Financial Crisis, ROLLING STONE, June 19, 2013 (on negotiations between S&P’s rating analysts and its executives managing the business terms of the CRA with issuers), available at http://www.rollingstone.com/politics/news/the-last-mystery-of-the-financial-crisis-20130619, (last accessed May 9, 2016)

215 Standardandpoors, Understanding Ratings: Guide to Credit Ratings Essentials (last accessed Nov. 15, 2013)

a rating revision thereby providing additional checks and balances regarding adherence to the agency’s ratings criteria.²¹⁶

Krugman posits that a fundamental change to the incentive drivers for CRAs is necessary in order to “end the fundamentally corrupt nature of the issuer-pays system”.²¹⁷ He lends qualified support to the proposal authored by Matthew Richardson and Lawrence White of New York University which would require the SEC itself to determine which CRA should provide the initial credit rating to any issue²¹⁸. Their model aims to deter the practice of “rate-shopping” and to improve transparency as multiple rating issues could be allocated to different CRAs.²¹⁹

216Richard Cantor & Frank Packer, The Credit Rating Industry, Federal Reserve Bank of New York, Q. Rev.

5, (1994), at 5 (ratings are decided by staff committee majority’s vote on the recommendation by a senior analyst following a presentation and subsequent debate). For a general discussion on rating issue process see Louis H. Ederington & Jess B. Yawitz, passim, The Bond Rating Process (Working Papers Series 85 (2),1985). See also, FCIC, comments by Jay Siegel, a former Moody’s MD, to FCIC Committee in FCIC Report at 121 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

217 Paul Krugman, Berating the Raters, N.Y.TIMES, Apr. 26, 2010 at A23. See also Matt Taibbi, The Last Mystery of the Financial Crisis, ROLLING STONE, June 19, 2013, (comments by Brain Clarkson, later S&P President regarding power of issuers to rate shop), available at http://www.rollingstone.com/politics/news/the-last-mystery-of-the-financial-crisis-20130619(last

accessed, May 9, 2016)

218 Jacques de Larosiere, The High-Level Group on Financial Supervision in the EU, at 9 (2009) (“Issuers shopped around to ensure that they could get a [CRA to issue] an AAA rating for their products”). Contrast, Efraim Benmelech & Jennifer L. Dlugosz, The Credit Rating Crisis 27, NBER,May 15, 2010, at 25 (study of ABS CDOs found no clear evidence that rating shopping led to the ratings collapse).

219 Edward I. Altman, et al., What Should Be Done about the Credit Rating Agencies? (NYU Stern Regulating Wall Street Blog, April 6, 2010)

CRARA (2006) ²²⁰ tasked the Government Accountability Office to prepare a report providing a framework for evaluating alternative models for compensating NRSROs.²²¹ In keeping with CRARA’s directive for the GOA to review the Act’s implementation, in September 2010 the GOA published the ‘Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures’ report²²². The report was addressed to congressional committees with recommendations such as the removal of the NRSRO’s designation and developing workable alternative compensation models for existing NRSROs.²²³

The five alternative methods identified by the GOA report included:

i. the Random Selection method (NRSRO selection for rating an issue to be done by a clearing house (i.e. non-profit organization, a governmental agency such as the SEC, or a private-public partnership));²²⁴

ii. an Investor-Owned CRA model (operated by highly sophisticated institutional purchasers of ratings) to publish a rating alongside that of the issuer-selected NRSRO;

220 Pub. L. No. 109-291, 120 Stat. 1327, 1327 (“An Act [t]o improve ratings quality for the protection of investors and in the public interest…”).

221 Pub. L. No. 109-291, 120 Stat. 1327 (Sept. 29, 2006) (amending the Securities Exchange Act of 1934 and codified at various sections of title 15 of the U.S. Code).

222 US Gov-GAO-b, Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures, U.S. Government Accountability Office, at 96-97, Sept. 2010, available at http://www.gao.gov/assets/310/309849.pdf (last accessed May 9, 2016)

223 Id., USGov-GAO-b, at 79.

224 See e.g., Otmar Issing, Jörg Asmussen, Jan-Pieter Krahnen, Klaus Regling, Jens Wiedmann & William White, New Financial Order Recommendations by the Issing Committee, Part II 23 (CFS White Paper, Mar., 2009) (positing the IMF or the BIS as suitable supervisory bodies to oversee the registration and regulation of the CRA industry).

iii. a Stand Alone model (where the NRSRO would not be able to charge fees for providing advice, but would earn fees from transactions’ revenue in primary and secondary markets);

iv. a Designation model (all CRAs would be able to rate an issue, but a central third-party administrator would decide on the allocation of the issuer-paid fee to one or several participating CRAs);

v. a User-pays model (which requires all users to pay, and defines a ‘user’ as any entity that included a rated security, loan, or contract as an element of its assets or liabilities as recorded in an audited financial statement”).²²⁵ Without venturing to assess the viability of either model, the report however outlined a framework of seven²²⁶ attributes by which ostensibly Congress and others could evaluate and determine the most appropriate model.

In practice however, the challenge between an equitable allocation of rating issues among CRAs and differences in expertise and capacity cannot be ignored. For example, this author is not aware of evidence suggesting how the SEC would deal with situations such as that presented by A.M. Best’s industry leading position as the eminent specialist among CRAs for rating insurance securities and firms²²⁷ when a rating is required. In addition, the question of how the proposed model would deal with the possibility that CRAs would instead become more incentivized to lobby the SEC in order to get allocations of the large and attractive issues, remains unclear.

225 US-Gov.-GAO-a, Action Needed to Improve Rating Agency (2010) at 84.

226 US-Gov.-GAO-a, at 85-93 (7 factors: Independence; Accountability; Competition; Transparency;

Feasibility; Market acceptance and choice; and Oversight).

227 See, Figure 3 and 4 above, (A.M. Best; 68 percent and 71 percent of its outstanding ratings -- in 2008 and 2010, respectively -- cover the Insurance Companies class).

The option proposed by Richardson & White could surely expose the SEC to litigatory charges of bias if patterns were to arise which could be interpreted to reflect favouritism for one firm over another. Furthermore, by selecting the CRA, the SEC could also be charged as a co-defendant in a gross negligence case if it could be later claimed that the selected CRA was not able to adequately rate the security. Although Section 939F of the Dodd-Frank Act, also commonly referred to as the Franken Amendment, was restricted to the rating of structured financial products, there could be merit in the SEC implementing the lottery allocation system proposed to get around this legal exposure.

Issuers could then be offered two or three CRAs to choose from.

For such a model to work one would have to assume that all CRAs registered as having expert competence in rating a given class of security would be acceptable to the issuers and subsequently to the market. At the moment, because of its established position as an industry leader, an option of CRAs that did not include A.M. Best for the rating of an insurance company might not be acceptable to issuers due to their recognized expertise.

It is conceivable that either issuers or potential investors would still approach A.M. Best for an additional rating if they were not included among the selection options resulting in duplication and thus higher transaction costs.

Subsequently, the argument that allowing the allocation to be automated via a lottery process in order to increase transparency and avoid accusations of bias, while intended to improve fairness, might just not be practical. Premised on the view that all CRAs avail equal competence in the absence of agreed standards is literally putting the cart before the horse and hoping for the best. Moreover, a recommendation to introduce a comply or disclose approach along the lines of the Code of Conduct Fundamentals for Credit Rating Agencies²²⁸ proposed by the IOSCO in December 2004, would not reduce the

228 IOSCO’s voluntary Code of Conduct Fundamentals for Credit Rating Agencies (Dec. 23, 2004), is voluntary and therefore is neither binding on CRAs nor does it carry the threat of sanctions. See Frank Partnoy, Credit Rating Agencies versus Other Gatekeepers, in FINANCIAL GATEKEEPERS: CAN THEY PROTECT INVESTORS?, 97 (Yasuyuki Fuchita & Robert E. Litan eds., Brookings Institution Press, 2006).

accountability gap²²⁹ in the absence of agreed standards.²³⁰ Nonetheless, if the market is efficient in successfully sorting out the “winners” from “losers”, the process could over the long-term be useful: the question is, at what cost, and to whom would these costs accrue?

Other alternative payment methods that have been put forward include: the proposal of a “bond-pays”²³¹ model which would deny the issuers the option of choosing a CRA to rate their issue to negate the conflict of interest argument, while forcing issuers to pay a fee in order to finance the ratings; and Germany-based consultancy Roland Berger’s proposal of a variation of the investor-pays model²³² that requires issuers to disclose information to a shared platform. Under the Roland Berger model, CRAs could then access the information, assess and subsequently disclose their rating on the platform.

Investors could then access the ratings for a fee.

The proposal’s reported reliance on the success of Roland Berger’s lobbying attempts for regulatory changes that would either require issuers to disclose data to the

229 Dieter Kerwer, Holding Global Regulators Accountable: The Case of Credit Rating Agencies, 18 GOVERNANCE: INT’L J. POL’Y,ADMIN.,&INST’S (3), 453, at 466 (2005) (proposes limiting their scope of operation because he does not see solutions to the accountability gap – mismatch between supply and demand of accountability).

230 Stephane Rousseau, Enhancing the Accountability of Credit Rating Agencies: The Case for a Disclosure-Based Approach, 51 MCGILL L.J. 620, at 660 (2006).

231 Jérôme Mathis, James McAndrews & Jean-Charles Rochet, Rating the Raters: Are Reputation Concerns Powerful Enough to Discipline Rating Agencies? 56J.MONETARY ECON. 657, 657-674 (2009) (proposing a model where an issuer approaches a clearing house with a set fee and the clearing house responds by allocating a CRA to rate the debt instrument).

232 See e.g., Rachel Wolcott, Financial Regulatory Forum: Start-up rating agencies urge national regulators to promote competition, change, REUTERS, Aug. 15 2011, available at http://blogs.reuters.com/financial- regulatory-forum/2011/08/15/start-up-rating-agencies-urge-national-regulators-to-promote-competition-change/

platform or force investors to buy ratings from the platform would appear to be a hindrance in seeing the measure eventually adopted in the EU.²³³

Among the proposals reviewed thus far, the “issuer-and-investor-pay” model along the lines adopted by the Municipal Securities Rulemaking Board (MSRB),²³⁴ which is funded by primary and secondary market transaction fees, or the version proposed by Kotecha et al.,²³⁵ which in part straddles the issue, appears to achieve the desired objective of incentivizing both parties to share the costs and the benefits accruing from a rating issue. This seems to be a most convincing proposal, particularly in terms of addressing the inherent conflicts of interest that arise from both the issuer pay and investor pay models.

Within the EU, Germany and Sweden have openly voiced their resistance against the introduction of a transaction tax. Sweden in particular experienced significant loss of business to London when it introduced a similar tax; moreover, the business did not return even when the tax was later rescinded.²³⁶ In the absence of an acceptable and superior alternative to the issuer-pays model, one that is free of the documented conflicts of interest

233 See e.g. Jérôme Mathis et al., Rating the Raters: Are Reputation Concerns Powerful Enough to Discipline Rating Agencies? 56J.MONETARY ECON. 657, 657-674 (2009).

234 See annual financials and Rule A-13, available at http://www.msrb.org

235 Mahesh Kotecha, Sharon Ryan, Roy Weinberger, Roy & Michael DiGiacomo, Proposed Reform of the Rating Agency Compensation Model, 18 J.STRUCTURED FIN. (1) 71, 71-75 (2012).

236 Harald Kindermann, Rating of States – A German perspective, Conference on Credit Rating Agencies, Stockholm Uni., June 14, 2012 (comments by German Ambassador to Sweden, Harald Kindermann, on EU’s worries that a transaction tax will scare business to move to the US and similarly not return).

s identified and adopted, regulators market participants and scholars are advised to prioritize improving the disclosure, surveillance²³⁷ and enforcement mechanisms.²³⁸

Im Dokument Russell Mutingwende Xavier, (Seite 80-89)