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Sustainability Reporting in capital markets: A Black Box? (ZIFO nr. 30) 2019/5.3
5.3 Problems credit rating agencies may face
A. Duarte Correia, datum 20-11-2019
- Datum
20-11-2019
- Auteur
A. Duarte Correia
- JCDI
JCDI:ADS169122:1
- Vakgebied(en)
Financieel recht / Bank- en effectenrecht
Ondernemingsrecht / Jaarrekeningenrecht
Voetnoten
Voetnoten
Sarbanes-Oxley prohibited accounting firms from providing a specified list of non-audit services to their public audit clients. See, https://www.sarbanes-oxley-act.biz/SarbanesOxleySection201.htm SEC. 201. Services Outside The Scope Of Practice Of Auditors.“(g) PROHIBITED ACTIVITIES.–Except as provided in subsection (h), it shall be unlawful for a registered public accounting firm (and any associated person of that firm, to the extent determined appropriate by the Commission) that performs for any issuer any audit required by this title or the rules of the Commission under this title or, beginning 180 days after the date of commencement of the operations of the Public Company Accounting Oversight Board established under section 101 of the Sarbanes-Oxley Act of 2002 (in this section referred to as the ‘Board’), the rules of the Board, to provide to that issuer, contemporaneously with the audit, any non- audit service, including–“(1) bookkeeping or other services related to the accounting records or financial statements of the audit client;“(2) financial information systems design and implementation;“(3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;“(4) actuarial services;“(5) internal audit outsourcing services;“(6) management functions or human resources;“(7) broker or dealer, investment adviser, or investment banking services;“(8) legal services and expert services unrelated to the audit; and“(9) any other service that the Board determines, by regulation, is impermissible.
Higher competition does not necessarily means better performance of credit rating agencies. See, (Coffee, Jr., 2014 pp. 241 explaining that Moody’s and S&P become more generous in their ratings when Fitch Ratings business rose after the year 2000). See also, section 2 above.
Association for Financial Professionals, 2002 & 2004. Rating agencies survey: accuracy, timeliness, and regulation. Bethesda, Maryland. See also, Xia, H, “Can investor-paid credit rating agencies improve the information quality of issuer-paid rating agencies?” November 2013, Journal of Financial Economics 111, (2014) 450-468: Available at https://www.sciencedirect.com/science/article/pii/S0304405X13002778.
See above in section 2.
“…meaningful reform must encourage a “subscriber pays” model that can compete with the current “issuer pays” model. Still, because of the “public goods” nature of financial information, a “subscriber pays” (or “platform pays”) model will not arrive naturally, and regulatory interventions are necessary to prod it into existence. The Franken Amendment is one (but not the only) means to this end, and a role for investor choice should be found.” See, John C. Coffee, Jr., “Ratings Reform: The Good, The Bad, And The Ugly” available at: https://www.hblr.org/wp-content/uploads/2014/09/Ratings-Reform.pdf. See, supra note.
See, Dodd-Frank Act Section 933(b)(2)(B).
In Europe, the European Commission regulates credit rating agencies. More information is provided below under section 6.2.
Generally, credit rating agencies may struggle with the problems introduced below.
Independency ; as we saw above in the brief history of the development of credit rating agencies, independent credit rating agencies seem to better contribute to a healthier financial market. They are less subjected to Government influence and still have the motivation to fight for their credibility. It leads them to produce better quality ratings and find their place in the market. The independence of rating agencies and the integrity of the rating process can be compromised by potential conflicts of interest. In 2002, in response to the Enron and WorldCom’s collapse in the US, additional regulatory intervention was needed. The Sarbanes Oxley Act (Section 201 (g)) contributed to assure credit rating agencies’ independence and avoid conflicts of interest.1
Monopolistic credit rating agencies ; Credit rating agencies may benefit from the development of a transparent and competitive credit ratings’ industry, avoiding the creation of a monopoly. Known as the “Big Three”, the monopoly is formed by the credit rating agencies Moody’s, Standard & Poor’s and Fitch Ratings.
It may become more problematic with the possibility of creating Nationally Recognized Statistical Ratings Organizations, which gives a “licensing power” (Coffee, Jr., 2014) to these agencies, it is believed to hinder innovation, competition,2 ratings accuracy and standard’s quality. In any case, regulation seems beneficial to set the basic common denominators for credit rating agencies, its supervision/ monitoring and to avoid conflicts of interest. The possibility of reducing the delegation of regulatory licensing authority status to certain credit rating agencies by the regulator (national Governments or the European Commission) may contribute to avoiding a monopoly formed by the largest and most powerful credit rating agencies.
Lack of ratings accuracy; increased competitionmay favor the investors and increase ratings accuracy (Coffee, Jr., 2014); As Coffee, Jr. (2014) explains, competition and deregulation let alone might not be beneficial to increase ratings’ accuracy (as it happened when Fitch ratings entered the ratings’ market in 2000 and started competing with Standards & Poor’s and Moody’s, which is considered since 2000 to be the main reason for the low quality of the credit ratings.345
The “subscriber pays” model (where investors pay a subscription fee) avoids the conflict of interest generated by the “issuer pays model” (where the issuer chooses the rating agency and pays the rating agency’s fee), however, once the information is provided, it becomes a “public good” and it starts having a market utility function (Robert J. Rhee, 2015). When the information becomes a public good it may trigger the “free rider” problem, allowing investors to benefit from it without having to pay for the information. This may hurt credit ratings revenues. This model might need the support and guidance of the regulator (J.C. Coffee, Jr., 2014).6 Both models allow for conflicts of interest, the “subscriber pays” model promotes the issuer’ power and the “issuer pays model” may favor the investor’s power. Coffee, Jr., (2014) (pp. 273) suggests encouraging a “subscriber pays” model, in the same line of the steps taken by the SEC and European Commission to promote this model, adding that these steps seem insufficient for bringing a “subscriber pays” market into existence.
Lack of factual verification of the information.Credit rating agencies have reduced factual verification of information since the year 2000 (Coffee, 2014 pp. 241 and 266). This fact has contributed to the financial crisis in 2008. Coffee (2014) has suggested rating agencies to require factual investigation to independent experts (as they had done before the year 2000) as an alternative for rating agencies’ own factual verification (Coffee, 2014 pp. and 266, 267). In the US, the Dodd-Frank Act (Section 933 - State of Mind in Private Actions) has promoted the use of due diligence.78
Also the lack of Governmental oversight may contribute to the reduced factual verification of information. It is largely recognized that credit rating agencies need to be registered and continuously monitored by a governmental agency (Coffee, 2014 pp. 271). Self-regulation of credit rating agencies is no longer an option (Coffee, 2014 pp. 271).