Regulation of the US credit rating industry and regulatory data disclosures

ABSTRACTThe Credit Rating Reform and Dodd-Frank Acts significantly increased US credit rating regulation, yet few academic studies have examined their impact or capitalized on the regulatory disclosure data. To facilitate research in the area, this paper outlines the evolution of credit rating industry regulations, describes the current regulatory environment, and reviews SEC enforcement actions in recent years. In addition, the paper summarizes the regulatory disclosure requirements, in particular the aggregate rating performance data and individual credit rating.KEYWORDS: Credit Rating Reform ActDodd-Frank Actcredit regulationSEC Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1 L White, ‘Markets: The Credit Rating Agencies’ (2010) 24 Journal of Economic Perspectives 211.2 L White, ‘Credit Rating Agencies: An Overview’ (2013) 5 Annual Review of Financial Economics 593.3 NRSRO registration is voluntary; non-NRSRO CRAs can issue credit ratings without SEC regulation. For example, Rapid Rating International Inc. issues financial health ratings. CRAs discussed in this paper are those with NRSRO registration. See M Livingston, G Nicolosi and L Zhou, ‘A Bird’s-Eye View of the US Credit Rating Industry’ (2021) 31 Journal of Fixed Income 68.4 We are aware of only two published studies outside the law literature that examine the Dodd-Frank Act’s impact on credit ratings: V Dimitrov, D Palia, and L Tang, ‘Impact of the Dodd-Frank Act on Credit Ratings’ (2015) 115 Journal of Financial Economics 505, and H Huang, J Svec, and E Wu, ‘The Game Changer: Regulatory Reform and Multiple Credit Ratings’ (2021) 133 Journal of Banking and Finance 106279.5 Google Scholar searches find just one published academic study utilizing data from the SEC Form NRSRO and two studies utilizing the rating history disclosure data under SEC Rule 17g-7: RP Baghai and B Becker, ‘Reputations and Credit Ratings: Evidence from Commercial Mortgage-backed Securities’ (2020) 135 Journal of Financial Economics 425; Livingston, Nicolosi and Zhou (n 3); N Qin and L Zhou, ‘Are Investor-paid Credit Ratings Superior?’ (2023) SSRN 4354204.6 D Weil and others, ‘The Effectiveness of Regulatory Disclosure Policies’ (2006) 25 Journal of Policy Analysis and Management 155.7 M Joffe and F Partnoy. 2018. ‘Making Credit Ratings Data Publicly Available’ (Oxford Business Law Blog, 2 March 2018) https://www.law.ox.ac.uk/business-law-blog/blog/2018/03/making-credit-ratings-data-publicly-available.8 Similar regulatory reform in the European Union (EU) followed the 2008–2009 financial crisis. Studies that extensively review and analyze the EU credit rating industry regulation include R Jackson, ‘Europe’s Supervisory System for Rating Agencies After the Financial Crisis: Critical Review’ (2012) 11 Hibernian Law Journal 1; E Weemaels, ‘The Regulation of Rating Agencies in Europe’ (2013) 2 Dovenschmidt Quarterly 105; T Wittenberg, ‘Regulatory Evolution of the EU Credit Rating Agency Framework’ (2015) 16 European Business Organization Law Review 669.9 For example, F Partnoy, ‘What’s (Still) Wrong with Credit Ratings?’ (2017) 92 Washington Law Review 1407.10 R Cantor and F Packer, ‘The Credit Rating Industry’ (1995) 5 Journal of Fixed Income 10.11 For lists of bond-rating-based rules and regulations see ibid; F Partnoy, ‘The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies’ (1999) 77 Washington University Law Quarterly 619; A Estrella, ‘Credit Ratings and Complementary Sources of Credit Quality Information’ (2000) Basel Committee on Banking Supervision Working Papers, No.3.12 L White, ‘The Credit Rating Industry: An Industrial Organization Analysis’ in R Levich, G Majnoni and C Reinhart (eds) Ratings, Rating Agencies and the Global Financial System (Springer 2002) 41; White (n 1).13 Cantor and Packer (n 10). Prior to 2007, the NRSRO status was granted through the SEC’s no-action letter process, where the SEC staff issued a no-action letter to a qualified CRA stating that the SEC would not take enforcement action if the CRA’s ratings were used for regulatory compliance purposes.14 White (n 1); Government Accountability Office, ‘Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures’ (2010, GAO Publication No.10-782).15 B Becker and T Milbourn, ‘How Did Increased Competition Affect Bond Ratings?’ (2011) 101 Journal of Financial Economics 493; P Bolton, X Freixas and J Shapiro, ‘The Bond Ratings Game’ (2012) 64 Journal of Finance 85. Concerns about long-term reputation may mitigate potential conflicts of interest: R Smith and I Walter, ‘Rating Agencies: Is There an Agency Issue?’ in Levich, Majnoni and Reinhart (n 12) 289. In addition, S Bonsall, ‘The Impact of Issuer-pay on Corporate Bond Rating Properties: Evidence from Moody’s and S&P’s Initial Adoptions’ (2014) 57 Journal of Accounting and Economics 89, suggests that the ‘issuer-pay’ model helps build a stronger relationship between the CRAs and issuer firms which ‘improves the flow of nonpublic information’ and, consequently, enhances the information content of ratings.16 Partnoy (n 11).17 C Opp, M.Opp and M Harris, ‘Rating Agencies in the Face of Regulation’ (2013) 108. Journal of Financial Economics 46.18 N Doherty, A Kartasheve and R Phillips, ‘Information Effect of Entry into Credit Ratings Markets: The Case of Insurers’ Ratings’ (2012) 106 Journal of Financial Economics 308; Livingston, Nicolosi and Zhou (n 3). Increased competition may also exacerbate conflicts of interest and lead to rating inflation: Becker and Milbourn (n 15).19 W Poon, ‘Are Unsolicited Credit Ratings Biased downward?’ (2003) 27 Journal of Banking & Finance’ 593. Jefferson Country School District’s 1993 lawsuit against Moody’s over an unsolicited rating illustrates the potential market power of oligopolists.20 We do not trace each rule and requirement to its legislative origin nor track the evolution of the SEC rules but instead outline the current outstanding rules.21 While the intent behind mandatory disclosure is increased transparency, the Credit Rating Reform Act‘s regulatory disclosure requirements also enhance ratings credibility, resulting in more information production by other market participants, J Kim, S Park and R Wilson, ‘The Effect of the Credibility of Mandatory Disclosure by Credit Rating Agencies on Managerial Learning from Stock Prices’ (2022) SSRN 4246095.22 A Hamerle, R Rauhmeier and D Rösch, ‘Uses and Misuses of Measures for Credit Rating Accuracy’ (2023) SSRN 2354877; Qin and Zhou (n 5).23 For example, J Cornaggia, K Cornaggia and H Xia, ‘Revolving Doors on Wall Street’ (2016) 120 Journal of Financial Economics 400, identify a ‘revolving-door’ conflict, where credit analysts inflate their future employers’ ratings. L Bai, ‘On Regulating Conflicts of Interest in the Credit Rating Industry’ (2010) 13 N.Y.U Journal of Legislation and Public Policy 253 examines different conflicts of interest in the credit rating industry.24 ibid.25 To date, the SEC had denied at least one application for NRSRO status (Government Accountability Office 2010).26 See the SEC Rule 17g-5(a).27 J Soroushian, ‘Credit Ratings in Financial Regulation: What’s Changed Since the Dodd-Frank Act?’ (2016) Office of Financial Research Brief Series.28 NAIC, 2018. Rating Agencies. The Center for Insurance Policy and Research, National Association of Insurance Commissioners.29 Partnoy (n 9).30 Discussions in this subsection are based on published SEC administrative proceeding orders, which can be accessed from the SEC website https://www.sec.gov/ocr/ocr-commission-orders.html.31 Note that four CRAs have not been sanctioned by the SEC: Fitch, AM Best, Japan Credit Ratings and HR Ratings.32 Credit ratings are opinions of the ‘relative likelihood of whether an issuer may repay its debts on time and in full’: S&P, ‘Intro to Credit Ratings: A Credit Rating Is an Informed Opinion’ (2021). Therefore, credit ratings should cover all expected cash flows from a rated instrument.33 WK Viscusi (ed), Regulation Through Litigation (Brookings Institution Press 2004); ET Schroeder, ‘Tort by Any Other Name in Search of the Distinction Between Regulation through Litigation and Convention Tort Law’ (2005) 83 Texas Law Review 897.34 NJ Gaillard and M Waibel, ‘The Icarus Syndrome: How Credit Rating Agencies Lost Their Quasi-Immunity’ (2018) 71 SMU Law Review 1077.35 472 U.S. 749, 105 S. Ct. 2939 (1985).36 Gaillard and Waibel (n 34).37 e.g. S Harper, ‘Credit Rating Agencies Deserve Credit for the 2007–2008 Financial Crisis: An Analysis of CRA Liability Following the Enactment of the Dodd-Frank Act’ (2011) 68 Washington and Lee Law Review 1925; NS Ellis, LM Fairchild and F D’Souza, ‘Is Imposing Liability on Credit Rating Agencies a Good Idea: Credit Rating Agency Reform in the Aftermath of the Global Financial Crisis’ (2012) 17 Stanford Journal of Law, Business & Finance 175; A Scarso, ‘The Liability of Credit Rating Agencies in Comparative Perspective’ (2013) 4 Journal of European Tort Law 163. N Blumberg, J Wirth and N Litsoukov, ‘The Liability of Credit Rating Agencies to Investors: A Review of the Current Liability Regime and Recent SEC Proposals’ (2011)16 Journal of Structured Finance 34, provides an excellent review of CRA legal liabilities in the US.38 A Shrivastava, ‘Bond Sales? Don’t Quote Us, Requested Credit Firms’ (The Wall Street Journal, 21 July 2010).39 See SEC, ‘No-Action Letter: Ford Motor Credit Company LLC. US Securities and Exchange Commission (22 November 2010). Currently, there is a call for the SEC to reverse its position by several organizations and prominent scholars.40 Livingston, Nicolosi and Zhou (n 3).41 Government Accountability Office (n 14).42 Livingston, Nicolosi and Zhou (n 3) provide a detailed discussion of Form NRSRO rating performance disclosures and survey the US credit rating industry.43 See the SEC Rating History Files Publication Guide at https://www.sec.gov/structureddata/rocr-publication-guide.html.44 The Center for Municipal Finance has developed a program to unlock the data (Joffe and Partnoy (n 7)). Our test of the program suggests that it has some flaws which result in missing observations. In addition, the program does not retrieve all information contained in the XML files.45 Legal Entity Identifier is a 20-character alphanumeric ID issued to a legal entity by a utility endorsed or otherwise governed by the Global LEI Regulatory Oversight Committee or the Global LEI Foundation.