December 19, 2012 / 12:49 AM / 5 years ago

UPDATE 1-US SEC seeks to reduce credit raters' conflicts of interest

By Sarah N. Lynch

WASHINGTON, Dec 18 (Reuters) - U.S. securities regulators on Tuesday outlined potential ways to reduce conflicts of interest at the country’s largest credit-rating agencies, but failed to take a strong stand on specific industry reforms.

Instead, the Securities and Exchange Commission’s report abstained on the next steps and recommended further discussion of the matter.

The SEC’s report was required by a provision known as the “Franken” amendment in the 2010 Dodd-Frank Wall Street reform law.

Named for Democratic Senator Al Franken of Minnesota, the provision required the SEC to conduct a review of the feasibility of a new system in which a public or private utility or board would assign work to the agencies on structured product ratings.

Assigning ratings work would represent a sea change for the country’s three largest credit-rating firms, Moody’s Corp , McGraw-Hill Cos Inc’s Standard & Poor’s, and Fimalac SA’s Fitch, which are all paid by the companies they rate.

That “issuer-pay” model came under attack during the 2007-2009 financial crisis, with critics saying the agencies gave overly rosy ratings to toxic subprime mortgage securities that soured as the housing market crashed.

A U.S. Senate investigative report found that the inherent conflicts of interest from the issuer-pay model likely contributed to the slowness of the rating agencies in downgrading the securities.

The question of how to tackle potential conflicts by raters remains one of the largest issues still looming over the SEC since the crisis.

The SEC’s report on Tuesday said that having a board assign ratings “could mitigate the issuer-pay conflict” and also help open the doors for more competition in the industry.

At the same time, however, the SEC warned that such a system may not address the practice of “ratings shopping” because companies would still be allowed to hire credit-rating firms to supplement the initial assigned rating.

The SEC’s report suggests other options for handling conflicts, such as enhancing rules on the books designed to make sure that credit raters who are not hired by a company to determine a rating can still get the same information to do their own review.

The idea behind the rule was to make it difficult for companies to exert influence over the rating agencies they hire “because any inappropriate rating could be exposed to the market through the unsolicited ratings” of competitors, the SEC said.

But the SEC noted that while the industry is already well-versed in the rule and has established systems for information sharing, most credit raters are not using it to produce unsolicited ratings.

Although the agency has previously instituted some rules to help prevent conflicts, critics say those are not enough and that the issuer-pay model cannot be properly managed without an overhaul of the system. The largest raters, by contrast, say such conflicts can be properly managed with the right rule set.

Last month, SEC examiners said they continued to find numerous compliance issues at large and small firms alike, including one instance in which a larger rater may have let “market share and business considerations” lead the company to change its rating methods for asset-backed securities without disclosing the change to the public.

Fitch said it supported the idea of open information for each rating agency to do its own review, even if it is not hired by the company to do so.

“We are pleased that the report recognizes that alternative payment models each have their own conflicts,” a Fitch spokesman said. “What matters most is that potential conflicts are identified and managed in a thoughtful and transparent manner.”

A spokesman for S&P said it was important to address conflicts of interest, but implementation of the amendment could result in “unintended consequences,” without specifying them.

A Moody’s spokesman had no immediate comment on the SEC’s report.

Franken said in a statement: “I’m pleased that the SEC confirmed what I’ve always believed - that dangerous conflicts of interest continue to put investors at risk - and I’m going to work with the SEC to implement a solution to this problem.”

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