The financial crisis starkly exposed the need for rating agency reform, yet the most important questions of how to enhance rating agency competition, accuracy, and accountability remain largely unanswered.  My article,  Downgrading Rating Agency Reform, assesses the shortcomings in the design and implementation of the Dodd-Frank Act reforms.  It suggests how regulators can promote competition and heighten rating agency accountability by using regulatory incentives to break up the three leading rating agencies that account for 96% of the market.  It argues exposing rating agencies to investor suits for grossly negligent conduct coupled with caps on damages would balance the need for greater scrutiny of the ratings process with limits on frivolous suits.

The Dodd-Frank Act promised to overhaul the industry through sweeping reforms.  But the Securities & Exchange Commission (SEC) has struggled to implement the Act’s competing, if not contradictory, objectives simultaneously to marginalize ratings, to expose rating agencies to greater sunlight and private liability exposure, and to treat rating agencies as a regulated industry.  The SEC has made progress in increasing oversight and addressing the most egregious abuses that fueled the financial crisis, but the SEC’s implementation of the Act has failed to transform the industry in any meaningful way.

The greatest strengths of the Dodd-Frank Act are the procedural requirements designed to heighten rating transparency and strengthen internal controls.  For example, the board of directors for each rating agency must approve the qualitative and quantitative approaches used in rating methodologies.  Rating agencies must publicly disclose the methods underpinning each rating, consistently apply changes to methodologies and procedures, and disclose methodological changes as well as significant errors.

But procedural reforms have intrinsic limits in addressing qualitative biases and herding effects, and the other provisions of rating agency reform have had far less impact. Efforts to marginalize rating agencies by removing requirements for ratings from federal statutes, rules, and regulations have failed to undercut ratings’ centrality to markets.  Attempts to expose rating agencies to private liability have also had limited impact.  The SEC swiftly abandoned efforts to subject rating agencies to expert liability under Section 11 of the Securities Act when rating agencies refused to allow ratings to be included in registration statements for asset-backed securities.  The Dodd-Frank Act lowered the pleading standards for Rule 10b-5 anti-fraud actions, but this provision merely incentivizes greater due diligence and larger paper trails.  While the Department of Justice has been creative in dusting off a twenty-year old bank fraud statute to sue Standard & Poor’s, this legal strategy faces uncertain prospects at best and does not address the need for private oversight of rating agencies.

But the biggest shortcomings of the Dodd-Frank Act are its failure to resolve the basic questions of how to create meaningful competition in an oligopolistic industry and how to incentivize accurate and timely ratings.  Congress sidestepped directly addressing these difficult questions, leaving the SEC with the unenviable task of providing some degree of coherence to Congress’s spectrum of solutions.

The most important part of the Dodd-Frank Act remains the most unresolved: the SEC’s mandate to design an alternative for the conflicts of interest created by debt issuers’ selecting their rating agency gatekeepers.  Commentators, who have long bemoaned the inherent conflict of interest of having debt issuers select their rating agency gatekeepers as raters, understandably do not want to bite the hands that feed.   The Government Accountability Office and the SEC have conducted a series of studies on alternatives for the current issuer-pays system, yet have shied away from concrete action to overhaul the industry.  Reform proposals have coalesced around creating an independent board or commission to select rating agencies for structured finance products.  But prospects for this approach have foundered due to the challenges of crafting benchmarks for rating agency performance that are necessary for selecting rating agencies and holding them accountable.  The danger is that any standard chosen for rating agencies could fuel herding effects.  Rating agencies may shape their methodologies to game the system rather than to enhance the accuracy and timeliness of credit risk assessments.

For this reason this article advocates an alternative approach to heightening rating agency competition: breaking up the rating agency oligopoly.  Anti-trust law does not regulate oligopolies unless there is express collusion or review of a prospective merger.  But regulators could incentivize the leading rating agencies to divest by creating separate certifications for rating categories of debt, such as government and corporate bonds, and barring raters from issuing evaluations for more than one asset category.  Raters would face the choice of vacating segments of the market or spinning off parts of their business into freestanding companies.  For example, if raters of asset-backed securities had to be independent from rating agencies for other types of debt issues, then raters would have a single-minded focus on determining the risks of this asset class that played such a prominent role in triggering the financial crisis.  This approach would remove the potential for rating agencies to give deferential ratings to asset-backed securities in exchange for kickbacks of retaining or securing other aspects of an issuers’ business.  Phasing in this reform over a number of years would give the leading rating agencies time to break up their business into multiple entities to maximize shareholder value and provide smaller rating agencies or new entrants with time to focus on a particular sector.

This article also suggests a complementary strategy to heighten rating agency accountability: exposing rating agencies to investor suits for gross negligence combined with caps on damages. Both the original House version of the Dodd-Frank Act and recent European Union legislation called for imposing gross negligence liability on rating agencies.  The virtue of this approach is that it is difficult to prove outright fraud by rating agencies.  The nature of rating agencies’ screening role is that their wrongdoing will be subtle and fall within or near the boundaries of negligent or grossly negligent conduct.  The adoption of negligence-based liability could open the floodgates to litigation about the contours of reasonable care in the ratings context.  But the lighter touch of applying a gross negligence approach may offer a better balance of incentives for gatekeeper compliance and private monitoring.  Capping liability to a multiple of raters’ annual fees for a given security would dampen incentives for private monitoring and suits.  But coupling limited liability exposure with a gross negligence standard would provide incentives for a balance of greater oversight and plausible liability burdens.

The full article is available here.