NRSROs Still Under Scrutiny

Conflicts relating to the work of credit rating agencies, also known as Nationally Recognized Statistical Rating Organizations (NRSROs), are not new. And debate about their ability to handle conflicts of interest is not about to go away, thanks to a recent Securities and Exchange Commission staff report.

In its first-released report on the examinations of the NRSROs since adoption of the Dodd-Frank Act, the SEC staff noted concerns about each of the 10 NRSROs registered with the regulator. While recognizing that the three largest ratings agencies (Moody’s, S&P, and Fitch) had made changes to improve operations, the report also noted that all NRSROs had failed to follow ratings procedures in some instances. A range of shortcomings was noted, including the failure to establish effective internal controls for the rating process, to make accurate disclosures, and to adequately manage conflicts of interest.

And all this after being in the spotlight dance since early 2009 when attention to the NRSROs’ involvement in assigning high ratings to failing institutions first surfaced. While the report did note that all NRSROs had taken steps to comply with new governance provisions and procedures for handling complaints, the range of cited concerns once again raises questions about the integrity of NRSRO operations and their ability to manage conflicts.

NRSROs had already come under a new framework of regulation as a result of the Rating Agency Reform Act (2006) which gave the SEC recordkeeping, reporting, and examination authority over NRSROs that are registered with the SEC. Amendments to Section 15E of this Act imposed by the Dodd-Frank Act resulted in even more stringent requirements for NRSROs. Among other things, Section 15E directed the SEC to implement rules in a number of areas, including:

• Addressing conflicts of interest in sales and marketing areas
• Conducting “look back” reviews of ratings in which employees of NRSROs participated before they left to join the company or issuers that received the rating
• Disclosing information on initial ratings and subsequent changes to them in order to track the NRSRO’s credit ratings performance

In addition to noting deficiencies and areas needing improvement, the report noted emerging trends among the 10 NRSROs. Of particular interest was the trend of moving “even more toward employing the issuer-pay business model.”

What’s next? In accordance with its mandate, upcoming SEC staff reports will consider the progress the NRSROs make on each noted deficiency and in responding to recommendations for improvement. But perhaps one of the most valuable tools for the SEC in overseeing NRSROs remains on hold. While Dodd-Frank requires the SEC to create an Office of Credit Ratings to administer a slew of new rules and conduct annual exams, the SEC has yet to receive the required Congressional appropriation approval to establish the office. Until then, it appears to be business as usual.