The Franken and Cantwell Amendments

As mentioned earlier, the Franken amendment²⁵⁰ proposed that CRAs be assigned on a lottery basis by a Ratings Advisory Board (i.e. RAB) appointed by the SEC to rate securities.²⁵¹ In instances where an issuer would insist on an additional rating by a CRA of their choice, then the amendment would require any differences between the ratings to be disclosed publicly. Since the RAB’s lottery allocation system would take into account CRAs’ past performances, it is unclear to this author how this would not either favour the longer established CRAs or encourage CRAs to rate less complex securities or those issued by more financially sound issuers.

In the absence of an allocation system capable of taking the complexity of the rated security into account, opting to rate plain vanilla securities instead of more complex securities would offer CRAs with a higher probability of achieving a greater ratings accuracy track record.²⁵² While attractive in principle, scoring, taking into account the complexity of rated securities, will remain difficult to implement in practice.

250 Restore Integrity to Credit Ratings amendment (S.A.3991).

251 See also, Jérôme Mathis et al., Rating the Raters: Are Reputation Concerns Powerful Enough to Discipline Rating Agencies? 56J.MONETARY ECON. 657, 669 (2009) (suggest addressing conflicts of interest and curtailing rate-shopping by creating an independent central exchange “platform” that would be paid by issuers and be responsible for assigning securities to one or more rating agencies for rating.)

252 Larry P. Ellsworth & Keith V Parapaiboom, Credit Rating Agencies in the Spotlight: A New Casualty of the Mortgage Meltdown, 18BUS.L.TODAY (4) 1, 1-4 (2009) (noting that SEC’s July 2008 study found that the sharp increase in volume and complexity of subprime residential mortgage-backed securities and collateralized debt obligations overwhelmed CRAs), available at http://apps.americanbar.org/buslaw/blt/2009-03-04/ellsworth.shtml; SEC, ‘July 2008 Summary Report of Issues Identified’ (substantial increase in complexity of RMBS and CDO deals since 2002), at 10-13; and Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U. L.Q. 43, 49 (2004) (noting that CRAs struggle to determine whether an instrument is in fact debt or equity – this creates an opportunity for market participants to game the system). See also, FRANK PARTNOY, Credit Rating Agencies versus Other Gatekeepers, in FINANCIAL GATEKEEPERS:CAN THEY PROTECT INVESTORS?, 74-80 (Yasuyuki Fuchita &

In keeping with the “bitter medicine” solution suggested by Partnoy, White and others,²⁵³ the Cantwell Amendment proposed removing all references to credit ratings from the Securities Exchange Act, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. Although the Amendment sought to eliminate credit ratings in regulations, it did not offer alternatives to the status quo. The Cantwell Amendment instead called for agencies such as the FDIC or the Comptroller of the Currency to “come up with appropriate standards of creditworthiness and not rely on the monopoly of the rating agencies”.²⁵⁴ While apparent that something significant needed to be done to address the standing problems, the post-GFC political and economic climate presented legislators with a unique opportunity to introduce far-reaching legislative changes with bi-partisan support; this author finds significant shortcomings in both of the proposed amendments.

Three potentially negative consequences of adopting the Franken Amendment come to the fore: Firstly, the proposal would require either the SEC or RAB to measure and publish rating performance itself, both before the selection of the CRA to determine who gets to rate, as well as afterwards to keep track of the quality of rating offered. The Ministry of Finance in Japan is one institution that not only rates the performance of its CRAs but also publishes censures for failure to meet expected standards of CRA performance. It should also be noted that unlike the Fair Fund provision established under the Sarbanes–Oxley Act SOX,²⁵⁵ the penalties collected by the Ministry of Finance are

Robert E. Litan eds., Brookings Institution Press, 2006)(for general overview of the role of CRAs in the CDO and RMBS markets leading up to the 2007 crisis).

253 Frank Partnoy, The Siskel and Ebert of Financial Markets 77 WASH.U.L.Q.REV. (3) 619, 624 (1999).

See also, Lawrence J. White, Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response, 25 J.INT’L BANKING LAW AND REG., 170-180 (4)(2010).

254 David M. Herszenhorn, Senate Amends Financial Overhaul Bill, N.Y.TIMES, May 13, 2010, at B2.

255 15 U.S.C. § 7246(a) (the provision gave the SEC the right to distribute penalties at its discretion to defrauded investors). See also, Pub. L. 107–204 (SOX 2002), §308 (Fair funds provision).

not paid-on to private investors as compensation.²⁵⁶ Although their penalties tend to be relatively small in dollar value (i.e. up to several hundred thousands of dollars), the public loss of face suffered by the CRA as a result of censure disclosure is considered by both the authorities and market participants to be the greater, if not “truer”, punishment.²⁵⁷

This contention is further advanced by the findings from an empirical 2011 study by Armour et al.,²⁵⁸ which determined that while the penalties charged by the UK’s Financial Services Authority (“FSA”) and London Stock Exchange (“LSE”) for securities misconduct were a relatively limited deterrence,²⁵⁹ and the ostensibly unwelcome dose of peer and public embarrassment experienced by guilty parties notwithstanding, it was investors, through their actions on the market, who effected the significantly greater punishment on bad actors. Their study, which observed a sizeable fall in the stock price of firms that were sanctioned, on average almost nine times larger than the actual financial penalty amount imposed by regulators, makes a very compelling and convincing argument

256 Russell Mutingwende, Interview with Professor T. Harada from Kansai University, Japan, Goethe Univ., Frankfurt am Main, Germany, April 2, 2012.

257 Id., Harada interview (2012).

258 John Armour, Colin Mayer, & Andrea Polo, Regulatory Sanctions and Reputational Damage in Financial Markets, passim (Oxford Legal Studies Research Paper No. 62/2010; ECGI - Finance Working Paper No. 300/2010, April 2011), avialable at http://ssrn.com/abstract=1678028.

259 Id., John Armour et al., at 2 (“The threat of fines from the FSA are seen as a footling expense, just another cost of doing business, no different from paying the quarterly phone bill. The embarrassment factor no longer counts for much, alas. There is not much shame in being on the receiving end of a fine.

Only the size of the fine has come to matter. In some areas, this has proved laughably inadequate in producing better behaviour.”) citing THE TIMES, July 7, 2009 (emphasis added). See also, John C. Coffee Jr., Law and the Market: The Impact of Enforcement 39-41, nn.73-75 (Colum. Law & Economics Working Paper No. 304, 2007) (noting that in 2005/06, the financial penalties imposed by the SEC exceeded those imposed by the U.K.’s Financial Services Agency by a thirty-to-one ratio, and a ten-to-one ratio after adjustment for differences in market capitalization), available at SSRN: http://ssrn.com/abstract=96748;

and Howell E. Jackson, Response. The Impact of Enforcement: A Reflection,156UNIV. OF PENN.L.REV. 400-411 (2008).

for the true effectiveness of regulatory sanctions.²⁶⁰ This point was well illustrated in the recent fallout following S&P’s self-reported admission of “inconsistencies” arising from potentially conflicting methodologies of the rating process for new and existing CMBS deals. Not only did the S&P share price fall by at least five percent,²⁶¹ but issuers also responded by withholding their CMBS business from the firm.²⁶²

For instance, Goldman Sachs and Citigroup cancelled a $1.5 billion commercial mortgages securitization transaction in July 2011. Firstly, such actions allow a real fear of credible sanctioning to exist, and secondly, it allows for greater efficiency in re-allocating any collected penalty amounts by relying on the market rather than on regulators. The second potential consequence lies in merit in the assertion that there would merely be a shift of lobbying focus and effort by the issuers away from CRAs and towards the RAB

260 Id., John Armour et al., at 27 (Judge rules that S&P misled derivative investors).

261 See, Aline Darbellay, Competition and CRAs, Credit Rating Agency Conference, Stockholm University, Stockholm, Sweden, June 14, 2012.

262 See, e.g., Stephen Foley, Rating agencies clash over standards, FINANCIAL TIMES, Nov. 6, 2012, at 25;

Nicole Bullock, S&P to overhaul property bond ratings, FINANCIAL TIMES, June 4, 2012 (“… [N]o issuer has since hired S&P to rate a commercial property deal backed by a pool of loans …”), available at http://www.ft.com/intl/cms/s/0/a1eb1e3a-ae8d-11e1-94a7-00144feabdc0.html (last accessed May 5, 2016).

panelists,²⁶³ which would present a less efficient outcome.²⁶⁴ The third potential consequence is that the proposal seems to ignore the fact that one of the main reasons why the banks were able to game the ratings process prior to the 2007 crisis was because disclosure and insight into the CRA’s rating models and methodologies, however acquired (i.e. either through knowledge transfer, personnel transfer or by trial and error), allowed the banks to reverse-engineer their securities in order to gain higher ratings. The Bathurst Regional Council v. Local Government Financial Services Pty Ltd. (No 5) (2012)²⁶⁵ case

263 See e.g., Sarah N. Lynch, S&P balks at SEC proposal to reveal rating errors, REUTERS, Aug. 10, 2011 (noting an OpenSecrets.org report that the Big Three spent over $1 million to lobby Congress and federal agencies in the eight months to August 2011 to influence changes and revisions to the DFA regulations), available at http://www.reuters.com/article/2011/08/10/us-financial-regulation-sandp-idUSTRE77901S20110810 (last accessed Aug 15, 2012). See also, Coffee, 97 Cornell L. Rev., 10 January:

1019, 1029-30 (2012) (arguing against the mandatory sunset system suggested by Romano, and instead favouring the oscillative characteristics - which he terms the “Regulatory Sine Curve” - of the relationship between the enactment of tough legislation as a response to public outcry and the subsequent period of parrying back or rescission of these clauses in response to political lobbying directed by and on behalf of the regulated industry’s players). Contrast, Robert Teitelman,‘John Coffee and his theory and practice of financial reform’, (comment, The Deal Economy, 13 Mar. 2012)(critical review highlighting several possible conflicts in Coffee’s ‘regulatory sine curve’ proposition, and concluding that with all stakeholder groups lacking in trust, whether, even in a democracy, finance is too important to be entrusted to voters), available at http://www.thedeal.com/thedealeconomy/john-coffee-and-his-theory-and-practice-of-financial-reform.php#ixzz2Eff52bhM (last accessed Dec 18, 2015).

264 Coffee, 97 Cornell L. Rev., 10 January: 1019, 1026 (2012) (suggesting that the implementation process, which may be construed to include the impact of lobbying efforts, results in a refinement (read, improved efficiency and effectiveness) of the original legislation).

265 Bathurst Regional Council v Local Government Financial Services Pty Ltd. (No 5) (2012) (No 5) [2012]

FCA 1200, Nov. 5, 2012, (Court noting that ABN Amro had employed two former S&P employees with knowledge of the S&P rating model to reverse engineer the rating, and thereby game the S&P model), at 1, remark 13 and 14, available at http://www.austlii.edu.au/au/cases/cth/FCA/2012/1200.html, (last accessed May 5, 2016); and Jan-Pieter Krahnen, In Rating Regulation, Sometimes Less is More, CENT.FIN.STUD., (2) at 2, 2009 (disclosure of rating methodologies encourages banks and companies to devise financial products that game the CRA models).

is a landmark case which looked at the aforementioned issues, and this dissertation reviews the case in greater detail under chapter 6 and 7.

On the other hand, the Lemieux–Cantwell Amendment sought to erase the grandfathering problem by removing references to CRAs from the rules and regulations.

However, it does so without offering an alternative. The absence of a practical alternative will more likely than not lead consumers towards the Big Three (and the other more established CRAs), thereby further entrenching their market positions. Moreover, it shifts the burden of creating such an alternative to other governmental agencies. The greater governmental role championed by both amendments also shifts the discussion towards the question of the government’s own exposure to liability lawsuits in the event that investors are dissatisfied with a rating generated by a CRA which has been selected by the RAB.

Overall, it is worth noting that the final version of the Dodd-Frank Act preferred the more accommodating Lemieux–Cantwell Amendment²⁶⁶ over the seemingly stricter measures proposed in the Franken Amendment.