Investor-Paid Credit Ratings and Conflicts of Interest

Credit ratings provide information regarding a company’s default probability.  Ratings are relied upon extensively in regulation and private contracting and play a crucial role in the functioning of the capital markets.  However, since the major credit rating agencies (CRAs) operate under a business model whereby they are paid by their issuers, there is reason to believe that issuer-paid ratings are inflated.  Many market observers view this conflict of interest as a contributing factor of the global recession of 2008-2009.  This indictment has also allowed for the emergence of several CRAs that operate under an alternative “investor-pays” business model, which some believe allows for better aligned incentives.

In a new paper, we focus on whether the investor-pays business model could create a conflict of interest.  While an examination of conflicts of interest in investor-paid credit ratings has been relatively absent in the academic literature, this concern has been raised by regulators.  In particular, in January 2013, the Securities and Exchange Commission (SEC) raised this concern when it sanctioned an investor-paid rating agency (Egan-Jones Ratings Company) for making material misstatements in its application to register as a Nationally Recognized Statistical Rating Organization (NRSRO).  In the report, the SEC states that Egan-Jones Ratings Company (EJR) falsely declared in submissions to the SEC that it was unaware of whether its subscribers held long or short positions in particular securities.  The SEC points out that EJR’s staff was aware of certain clients’ holdings, and in some instances knew whether clients had long or short positions.  In at least three instances, information about whether a client had a long or short position was conveyed to Sean Egan, EJR’s founder and primary analyst.

Our paper examines whether knowledge of an important client’s investment positions will influence investor-paid ratings. We do not focus exclusively on EJR ratings but more broadly on whether and how investors’ motives can create conflicts of interest.  For instance, if investors have a long or short position in a certain company, they might prefer ratings that are favorable for their investment holdings rather than ratings that are accurate.  This conflict of interest may influence credit ratings, especially if investor-paid rating agencies have salient incentives to please their clients.

In a method similar to that used in prior research on CRAs (Jollineau et al. 2014), we conduct an experiment using graduate business students as proxies for rating analysts.  Following Jollineau et al. (2014), we provide participants with output from a general credit rating model.  We vary among participants the investment position of the important client of the CRA (long versus short) and the investor-base sophistication of the rated company (more sophisticated versus less sophisticated).

The investor-base sophistication variable reflects the sophistication of the broad investor base of the company, i.e., the majority of investors other than the CRA’s important client.  We vary the investor-base sophistication because greater scrutiny by sophisticated investors could counteract bias in ratings.  Each participant rates two companies that have different risk profiles: a company with a less risky profile, for which a credit rating model indicates it is above investment grade, and a company with a riskier profile (i.e., below investment grade). We vary the risk profile of the companies, because analysts’ incentives to issue biased ratings in favor of their clients’ investment positions could be inhibited by anticipated scrutiny on ratings for a riskier company (Tetlock 1985, 1992, Lerner and Tetlock 1999).

We find that clients’ positions bias credit ratings.  Participants assign higher ratings when the important client of the CRA holds a long position in the rated companies, and lower ratings when the client holds a short position.  We also find a significant interaction between client position and the sophistication of the rated company’s investor base.  Specifically, the bias in participants’ ratings driven by client position is curbed by higher sophistication of the rated companies’ investor base.  These results hold for both higher and lower risk profile companies.

In summary, our findings suggest that a conflict of interest stemming from investors’ preferences is likely to bias ratings under investor-pays business models, but scrutiny by the company’s investor base can counteract this bias.  We believe that our paper helps fill a gap in the literature that has largely focused on conflicts of interest stemming from issuer-paid ratings.  We provide preliminary evidence that investor-paid ratings may be subject to conflicts of interest and examine the conditions under which those conflicts of interest can result in biased ratings.


Jollineau SJ, Tanlu LJ, Winn A (2014) Evaluating proposed remedies for credit rating agency failures. The Accounting Review 89 (4): 1399-1420.

Kadous K, Kennedy J, Peecher ME (2003) The effect of quality assessment and directional goal commitment on auditors’ acceptance of client-preferred accounting methods. The Accounting Review 78 (3): 759–778.

Lerner JS, Tetlock PE (1999) Accounting for the effects of accountability. Psychological Bulletin 125: 255–275.

Securities and Exchange Commission (2013) Administrative Proceeding File No. 3-14856.

Tetlock PE (1985) Accountability: The neglected social context of judgment and choice. Research in Organizational Behavior 7: 297-332.

Tetlock PE (1992) The impact of accountability on judgment and choice: Toward a social contingency model. Advances in Experimental Social Psychology 25: 331-376.

This post comes to us from professors Leo Tang and Marietta Peytcheva at Lehigh University and Pei Li at Southwestern University of Finance and Economics. It is based on their recent paper, “Investor-Paid Ratings and Conflicts of Interest,” available here.