Conflicted interests

The two preceding sections above, addressing the remuneration mechanism and lack of competition, together form the basis of the conflict of interest argument that is leveled against CRAs. Moreover, in 2011 US regulators affirmed their intention to achieve two aims, namely: (i) to legally curtail the influence of CRAs by removing the requirement for ratings from legislation, rules and regulations; and (ii) to address the conflict of interest driving CRA incentive structures by re-aligning and strengthening the liability associated with their ratings. ²³⁹ Fitch’s president, Paul Taylor, cautioned however that even if the removal of regulatory references was implemented, strong demand for CRA ratings would nonetheless remain.²⁴⁰

237 See e.g., SEC, Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies, July 2008, at 21-23 (CRA surveillance process is less robust than its ratings issuance process; and Jeffrey D. Manns, 87 N.C.L.REV.1011, 1024 n.7 (2009) (absent effective reputational risk impulsion, CRAs may be tempted to underinvest in surveillance in order to increase profits, or may leverage autonomy to elicit greater profits from issuers).

238 Lynn Bai, On regulating Conflicts of Interest in the Credit Rating Industry, 13 J.LEGIS.&PUB.POLICY, 253, 296 (2010).

239 Phil Mattingly & Jesse Hamilton, Sovereign Ratings Should Be Free of Politics: S&P, BLOOMBERG, July 27, 2011 (noting the SEC’s adoption of its first rule to remove a requirement for CRA ratings from securities offerings rules on July 26^th, 2011), available at http://www.bloomberg.com/news/2011-07-26/sovereign-ratings-should-be-free-of-politics-s-p-s-sharma-says.html (last accessed Mar. 15, 2016).

240 Francesco Guerrera, Current Account: Here's How to Fix Those Credit Ratings, WALL ST.J.ASIA, Aug.

16 2011, at 8.

Bai examines the conflicts of interest at the level of the credit analyst and at the rating agency level.²⁴¹ At the analyst level, these conflicts of interest include concerns arising from analysts’ ownership of securities of rated entities and analysts’ compensation based on rating fees.²⁴² At rating agency level, the conflicts of interest arise from CRAs’

affiliation to issuers, the provision of ancillary services²⁴³ and the compensation models they have adopted.²⁴⁴ This dissertation has explored the advantages and disadvantages of the issuer-pays and the subscriber-pays model, and finds that the literature strongly suggests that neither model is free from conflict of interest.²⁴⁵ Consequently, the adoption of a hybrid model to address the challenges would appear to present the most credible solution.

Mann investigates the conflict posed by “interconnections of interest” between ratings agencies and their commercial clients, as well as a perceived disconnect between

241 Lynn Bai, On regulating Conflicts of Interest in the Credit Rating Industry, 13 J.LEGIS.&PUB.POLICY, 253, 260-65 (2010).

242 See, 17. C.F.R. § 240.17g-5(c) (2) (2009) (prohibits the issuing of rating by an NRSRO if provided by a credit analyst who participated in the rating decision or a person responsible for approving the rating, except for sovereign states or their agencies, who directly holds the rated security. However, the rating of indirect holdings (e.g. mutual funds or blind trusts) is not prohibited).

243 See e.g., Gregory W. Smith, Approaches to Improving Credit Rating Agency Regulation, May 19, 2009 (testimony before the Subcommittee on Capital Markets,Insurance, and Government Sponsored

Enterprises of the House Committee on Financial Services calling for NRSROs to be prohibited from providing ancillary services), http://www.gpo.gov/fdsys/pkg/CHRG-111hhrg51592/html/CHRG-111hhrg51592.htm (last accessed Mar. 15, 2016).

244 Lynn Bai, On regulating Conflicts of Interest in the Credit Rating Industry, 13 J.LEGIS.&PUB.POLICY, 253, 272-77 (2010).

245 See e.g., Steven L. Schwarcz, Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown, 93 MINN.L.REV.373,403 (2008) (“In any event, there is no easy solution to the dilemma of how rating agencies can be paid without creating conflicts with either issuers or investors.”).

ratings agencies and beneficiaries of their screening roles, i.e. investors.²⁴⁶ To address this challenge, some commentators have proposed a model that relies on a user-fee financed clearing house to finance ratings,²⁴⁷ although the model’s merits for the SEC to base its selection of a CRA solely on the lowest price, are open to challenge.²⁴⁸ While acknowledging that such a set-up would lay a significant - albeit manageable - burden on CRAs, Mann suggests that these burdens would be outweighed by the added benefits from increased accountability that would result from the adoption of certification and mandatory reporting requirements for CRAs. However, more convincing were his proposals to deter frivolous litigation from empowered creditors by capping such liability - primarily because they benefit relatively little from issuer misconduct - and to limit it to cases of gross negligence.²⁴⁹

246 Jeffrey D. Manns, Rating Risk After the Subprime Mortgage Crisis, 87 N.C.L.REV.1011, 1014-15 (2009).

247 Id. Jeffrey D. Manns, 87 N.C.L. REV.. at 1061-63 (2009) (discusses merits of user-fee model in conjunction with capped liability to incentivize sound gatekeeping); Jérôme Mathis et al., Rating the Raters:

Are Reputation Concerns Powerful Enough to Discipline Rating Agencies? 56J.MONETARY ECON. 657, 669 (2009). Compare, Yair Listokin and Benjamin Taibleson, If You Misrate, Then You Lose: Improving Rating Accuracy Through Incentive Compensation, 27YALE J. ON REG. 91,102 (2010) (challenge that the user-fee model is burdened by the question of whether shareholders, bondholders or employees should be the payers of the user-fee); and also Dwight M. Jaffee, Comment on "Rating the Raters: Are reputation concerns powerful enough to discipline rating agencies?” J.MONETARY ECON.56,675-677 (2009) (noting the challenge to identify acceptable rating criteria for allocating the rating issues among CRAs, or recourse to a second opinion if the issuer is not satisfied with the initial rating issued through such a system).

248 Jeffrey D. Manns,87 N.C.L.REV.1011, 1064 (2009) (notes risk of underinvestment in due diligence as a result of reliance on price competition, and suggests a cost-based method as a potentially costlier but more flexible and thorough method of effecting due diligence; even though the ability of the SEC to fairly and/or efficiently select between competing CRAs remains unclear).

249 Jeffrey D. Manns, Rating Risk After the Subprime Mortgage Crisis: A User Fee Approach for Rating Agency Accountability. 87N.C.L.REV. 1011, 1033-34, 1069, 1076 (2009).