Friday, 26 June 2020

Ernst & Young (EY) and Moody’s Under Attack as Gatekeepers’ Failures Continue to be Revealed with Wirecard

The Wirecard scandal has made for an engrossing account of corporate failure since the news emerged that the German financial payments processing company had been inflating its accounts. Now that the company has collapsedthe first time that a member of the German Dax index has failed – the ramifications are starting to be revealed. The EU is now investigating the role played by BaFin, the German regulator tasked with regulating the company, whilst the FCA in the UK has ordered the British arm of the company to freeze all of their customers’ accounts. Now that the aftermath is continuing to fold, the focus is now rightly turning to why the alarm bells were not sounded earlier by those both paid and expected to do so.


Of particular concern has been the auditing conducted by Ernst & Young (EY), and the credit rating conducted by Moody’s. With investors standing to lose out considerably because of this collapse, the performance of these gatekeepers is a massively important issue. Unfortunately, for the two concerned, the information that is slowly-but-surely being revealed does not make for comfortable reading.


Starting with Moody’s, there has been some criticism from industry professionals today regarding their role. During last Friday (19th June) Moody’s had downgraded the company’s rating by six notches, before removing the rating altogether on Monday. This came after EY refused to sign off on the company’s accounts, with Moody’s declaring that it had decided to withdraw ‘because it believes it has insufficient or otherwise inadequate information to support the maintenance of the ratings’. The decision to downgrade prompted Wirecard to seek new financing strategies, although those plans will not be needed now the insolvency process is underway. However, as Gene Phillips of PF2 helpfully pointed out yesterday, the wording attached to Moody’s downgrading of Wirecard reveals a crucial issue for credit rating agencies more generally. It was not until June 2nd that Moody’s downgraded Wirecard, which came less than a year after it had rated the company Baa3 – or, investment grade – citing that despite a number of challenges ranging from competition to its size relative to its US counterparts, the company had a strong market position in Asia and Europe, was diverse, had scalability, and a sound financial profile. Now, less than a year later, the agency stated that it would first place the company on review of a downgrade (on the 2nd June) based on ‘ongoing uncertainties around the allegations regarding fraudulent accounting practices and concentration risks on third party acquirers’. In defence of Moody’s, Wirecard was hovering just above the cut-off for investment-grade, and there were a number of warnings attached to the rating, especially concerning governance. Yet, there is a sentence in the attached dialogue that will prove to damning for the agency: ‘The company’s strong and swift expansion led to some instances in its Asian operations where a lack of corporate control resulted in periodic restatement of booked revenues. Management had immediately taken meaningful measures to avoid such issues in the future. Considering the opinion of external auditors, we assumed that these events have been isolated, regionally concentrated events’. We now know that this ‘assumption’ was a dramatic error, with the sequence of events now being shown to have been quite the opposite from what had been believed by the agency.


Therefore, the question to ask is likely a simple one: what purpose do the rating agencies actually serve if they are assuming critical issues such as those highlighted above? A number of societally important investors are bound to invest only in instruments which agencies deem to be of investment-grade, but we now have the admittance that one of the major agencies was assuming key information to be case, when in fact deeper investigation would, or at least should have revealed greater issues and affected the creditworthiness of the firm in question. One might well argue that this is an issue of disclosure, and that the rating agencies are not either a. set up or b. supposed to uncover fraudulent activities – the argument being that this is the role of the auditor. Perhaps that is the case, and it is why we shall turn our attention to EY next. However, the continued usage of the rating agencies’ products must continue to critically analysed because it is clear that there are important issues that need to be considered when understanding the usefulness of a rating, like how much of it can be relied upon to be objectively true? How much is assumed? Why and when would an agency make critical assumptions, and when would it not? It is questions like these that lead prominent critics to suggest ratings have very little to no value. I argue that they do, but not in the traditional sense, in that they serve more of a signalling purpose required for the functioning of the financial system, and not much else. But, to admit to assuming key material information, irrespective of whether it came from an auditor or not, is telling. Important journalistic investigations conducted by the FT had demonstrated, at least enough to inject doubt into the picture being painted, that more caution should have been afforded to the allocation of an investment-grade rating, with all that entails. Other examinations, like that conducted by Sigma Ratings, demonstrated quite clearly that much greater caution should have been afforded when assigning this particular rating. Why that caution was not afforded is solely for Moody’s to answer; saying ‘we assumed’ is not enough.


Yet, Moody’s will receive some criticism for the Wirecard scandal but, for the gatekeepers, the majority of the criticism will rightly be reserved for EY. The audit firm had provided clean audits for Wirecard for a number of years. However, despite journalistic investigations and whistleblowers raising the alarms, together with internal investigations (which were ultimately mothballed), the auditor continued to give clean audits. It was revealed today that they actually went further, and not only turned a blind eye but actively did not perform as they were supposed to. Billions of Euros were said to be housed in Wirecard’s Asian arms, but rather than investigate this and perform the due diligence that is expected of a Big Four auditor, the FT revealed that EY failed to even request the bank statements from a bank in Singapore where Wirecard had claimed it had more than €1 billion. EY has not commented on these allegations yet, but other auditors and expert onlookers have. One auditor said ‘the big question for me is what on earth did EY do when they signed off the accounts?’, whilst another said that obtaining independent financial information is akin to one of the fundamentals of auditing. A Professor of Accounting declared, quite rightly, that is was ‘not sufficient’ for an auditor to accept account confirmations from third parties, but a head of a rival auditor went even further when they suggested that ‘it is beyond the realms of reality that EY wouldn’t have had [the bank balance confirmations] unless they did a very poor audit’. If it is the case that this is just extremely poor auditing, EY will be in trouble. However, if it is the case that EY had the information it needed to know that Wirecard did not have the money it said it had, and still signed off on key audits, then EY will be in serious trouble. It is elements such as these which are causing people to liken this collapse to the collapse of Enron, at least in terms of the damage it will do for the auditing sector.


As investors, regulators, and politicians line up to blame and punish, the gatekeepers stand in a particularly vulnerable position. This will be added to Moody’s’ long list of instances where they have fallen short, but for EY it could be extremely problematic. Akshay Naheta, a SoftBank executive who was involved with SoftBank’s investment into Wirecard last year, neatly summed up why this is potentially such an impending issue for EY; ‘I’m totally baffled by the lack of competence and responsibility displayed by E&Y… as an organisation that is meant to protect all stakeholders – creditors and shareholders – in companies, both public and private, they have materially failed in their fiduciary duties’. Auditors have a massively important role in the efficient running of the economic system, and their unique position between the company and the outside world is one which will, inevitably, lead to some failures which are usually massive in scale. According to Moody’s account, their whole system relies upon the auditor-company relationship too, which only adds weight to the philosophical importance of that relationship. However, is it too much for just a few auditors to bear? Are there too many engrained conflicts of interest within that relationship? The dynamics of that relationship were considered at length after the Enron/WorldCom scandals but, like most instances of reform-laden eras with regards to gatekeepers, the economic cycles brought around other issues which caused audit-related concerns to become of less importance. The rules implemented after those scandals, most notably concerning the enforced division of the major auditors away from their commercial consulting arms, were overridden by the industry not long after. The cyclical nature of reform and regulation must be brought to an end, with rules designed to increase the effectiveness of the said gatekeeper within the financial system needing to be consistently applied, not just for the economic cycle (mostly because we do not seem to have so-called ‘Quiet Periods’ any more!).


Keywords – Wirecard, Moody’s, EY, Audit, @finregmatters

Monday, 8 June 2020

The SEC Receives Renewed Calls for Credit Rating Industry Reform, but Will it Act?

There have been a number of developments recently with regards to the Securities and Exchange Commission receiving advice on how best to regulate the credit rating industry. Last month, a panel was convened so that the Investor Advisory Committee could hear from a number of experts on some of the issues facing the industry, and some potential solutions. Then, at the beginning of this month, the Credit Ratings Subcommittee of the Fixed Income Market Structure Advisory Committee (FIMSAC) produced a recommendation outlining three key areas for regulatory development. In light of this, this post will review the developments, and also examine whether the calls are realistic, or whether they may spurn the SEC into more action in this area.


The meeting of the SEC’s Investor Advisory Committee took place on the 21st May, virtually – recording available here. In the afternoon, a panel was convened that was made up of: Professor Frank Partnoy of the University of California, Berkeley; Marc Joffe of the Reason Foundation, Yann Le Pallec who is the Head of Global Rating Services at S&P; Van Hesser who is the Chief Strategist for Kroll Bond Rating Agency; and Professor Joe Grundfest of Stanford University. Van Hesser addressed the Committee first, noting that increased business in the past few years indicates that KBRA is progressing in the market. The point was made that KBRA aimed to offer a differentiated experience for the industry in the wake of the Crisis, and that this recent and consistent upturn in their fortunes was an indication of that model being accepted by the marketplace. In discussing the pandemic, Van Hesser mentioned how there are a wide range of factors that affect credit ratings, and that the current situation is very fluid and, in many ways, unprecedented.


Professor Frank Partnoy then followed with a succinct overview of the industry’s regulation and some of the issues that have emerged since the Crisis. One of which was the fact that, despite some successes, a number of regulatory initiatives have failed. One such failure is with regards to the attempted to reduce ‘regulatory reliance’, which is based on a concept Partnoy developed known as the ‘regulatory licence’. Partnoy noted how a number of pieces of legislation, and ensuing regulation that dictated that references to ratings should be entirely removed, simply have not been implemented. This is on top of the behavioural difficulties in removing reliance on the ratings. As potential solutions to such issues, Partnoy suggests a number of approaches. First, he suggests that financial entities, such as banks, should have to disclose what they are holding if they are using rated investments, and preferably on a granular level. Also, as he has long since championed, a number of other more market-based approaches to understanding creditworthiness should be utilised by the market. He then turned his attention to the way in which the SEC actually provides details of its investigations and examinations. A point of issue has been that the SEC will not ‘name names’ when it comes to providing information on who it has found to be transgressing – it will often say things like ‘we found that a mid-sized agency did not…’, which Partnoy suggests affects the regulatory capital in this area; he argues that there is a benefit in the market knowing who has been found to be falling below the standards set. Finally, he discusses the issues with regards to aspects such as the protection being afforded to the agencies via the exemption of the application of Section 11, which was repealed in the wake of the Crisis to expose the agencies to liability, something which has never taken hold.


Marc Joffe then followed, and addressed issues regarding the negative effects of increased competition i.e. increased rates of ‘ratings shopping’. He followed this with a discussion around higher CMBS ratings, which appear to be inconsistent with the push by the Dodd-Frank Act to implement ‘universal ratings’ which would increase transparency and clarity in the area. Joffe then produced a number of interesting proposals, including insightful declarations of the alternatives to credit ratings that exist within the marketplace (he cited analytics firms/ regulator-developed methodologies/ the incorporation of Universities [he cited the work at the NUS in Singapore] and non-profits/ and open-sourced methodologies) as well as a number of distinct policy recommendations. Those included avoiding the use of NRSROs in standards, eliminating the concept of NRSROs altogether, enforcing the 17g-5 program better, and potentially incorporating machine-readable financial disclosures into the financial system more.


Following on from Joffe, S&P’s Yann Le Pallec introduced the viewpoint of one of the ‘Big Two’, and discussed a number of elements and initiatives that S&P have undertook. He mentioned how S&P have invested heavily in a number of safeguards to prevent, or at least reduce the impact of a number of recognised conflicts of interest. This was adjoined to the interesting point that the company deals with more than 20 regulators worldwide, perhaps hinting at the need for more joined-up regulatory thinking. He then detailed how S&P has invested heavily in its compliance functions, although this has been noted in the literature (not just related to S&P) as being a negative outcome of the regulatory era i.e. simply moving to a tick-box culture as opposed to focusing on the underlying causes of such failures. In addition to this, Le Pallec discussed how new training initiatives and standards have been developed. To address some of the more obvious criticisms of the rating industry, he concluded by discussing how both S&P has long since supported the reduction of regulatory reliance, and that every remuneration model in the rating industry comes with conflicts and that, ultimately, the responsibility lies with the investor to utilise the information they have available to them responsibly.


Professor Grundfest then followed, with the initial part of his segment addressing the view that the stable duopoly in the sector produces very little innovation. He then clarified that, in his view, the issuer-pays remuneration model is the only realistic model for agencies who are the largest in the industry. He then discussed an idea that he has championed. This is the ‘Buyer-owned and Controlled Rating Agency’, or BOCRA. Essentially, the idea is that these entities would be owned and operated by some of the larger investors, with the concept being that the entity would have ‘strong incentives to promote an investor’s point of view in the rating process’. The financial support for such entities would be gained from a partnering arrangement whereby every time an issuer pays for an NRSRO’s rating, they would have to pay for a rating from a BOCRA. Grundfest suggests that there would be no limit on the amount of BOCRAs, but that in reality only two would likely emerge and that the market would dictate its prices. This approach contains many more details - available in the link above – but Grundfest did begin with acknowledging that it is slightly ‘controversial’.


The section concluded with some interesting Q&As, with one in particular (from JW Verret of George Mason University) raising the issue of the Office of Credit Ratings being particularly underfunded in relation to other bodies in other industries that have similar mandates (like PCAOB).


Then, on June 1st, the Credit Ratings Subcommittee of FIMSAC announced that it was recommending a number of proposals with regards to the regulatory needs within the rating sphere. In its recommendations, that were based on a number of months of research and testimony, the subcommittee focused on three elements in particular: the need for increased NRSRO disclosure; the need for enhanced levels of issuer disclosure; and a mechanism for bondholders to vote on the issuer-selected NRSROs.


On the first point, the recommendation is that NRSROs should provide more in-depth information about their models and how the models differ by industry. Furthermore, if there are any inputs that effect a model, for example any qualitative inputs, then these should also be declared publicly. With regards to deviations from stated methodologies – which is not allowed unless expressly declared and with good reason – the subcommittee suggests that additional summary statistics on how often, and to what extent NRSROs have deviated would be useful for further research.


With regards to increased disclosure from issuers, the subcommittee first finds that for corporate issuers, the process of how NRSROs are selected should be more transparent, and to this end they suggest that the SEC should work alongside trade groups so that ‘best practice’ in this area can be identified and replicated. For securitised issuers, the same selection process is of interest to the committee, with it suggesting that more transparency is needed. In addition to a similar establishment of ‘best practices’ in this area, the subcommittee also suggests that any time a rating agency is selected but the rating not subsequently published, then this should be made public so that investors can be aware of any potential instances of ‘rating shopping’.


Finally, in relation to the bondholders voting on the selection of NRSROs, the subcommittee suggests that, like public auditors, the bondholders should be able to vote on whether to ratify, or simply to confirm confidence in the NRSRO selected to develop the rating for the bond. The subcommittee argues that this may provide for additional discipline on the rating agencies. The report concludes with a number of acknowledgements regarding the issues with such policy recommendations, with the most prominent being that the current regulatory framework may prevent some or all of the policies being implemented.


The thing to note is that there is certainly no shortage of proposals with regards to what may be done to ‘fix’ the rating arena. If we proceed on the basis that this ‘fix’ is desired, which in certain points I suggest is not actually the case – my forthcoming research on ‘rating addiction’ argues that the system is addicted to ratings quite simply because they fulfil a number of purposes – then the issue is whether such policies are reasonable. A number of the above are reasonable, but some of the above may need a lot of regulatory capital, or better still ‘regulatory will’ to eventually succeed. Whether this ‘will’ exists is, perhaps, truly the question. I have argued in the past, and will no doubt argue in the future, that the real question is ‘who does the current system serve?’ I believe that the answer to this question dictates how much regulation, and by that I mean truly impactful/altering regulation, will be implemented. Partnoy noted in his section that a number of elements of Dodd-Frank have not been adopted – the question then becomes ‘why not?’ If it is because the proposed regulations were not workable within the current regulatory framework, then the issue is that either the legislators are out of touch, or that the framework is not fit for purpose and needs to be changed. Perhaps on the back of these currently proposed policies, the actions of the SEC will be telling.


Keywords – CRAs, regulation, @finregmatters

Thursday, 4 June 2020

Scope Ratings Fined by ESMA

We have covered the European-based Scope Ratings a number of times in Financial Regulation Matters, here, here, and here. Also, recently the agency has received positive reviews in the financial press, with one outlet prescribing Scope Ratings as ‘the new challenger’ to the credit rating space, complete with a new approach. However, it was announced today that Scope Ratings had been fined by ESMA for a practice which is particularly familiar in the ratings arena – saying one thing and doing another.


The news broke this morning that ESMA had fined Scope for breaches of the Credit Rating Agencies Regulations (CRAR), to the tune of €640,000. ESMA also published a ‘public notice’ explaining the reason for the regulatory action. The regulator found that there were a number of breaches, with the fine being divided between: a failure to apply a methodology systematically (€550,000); and a failure to revise methodologies (€90,000). The action revolves around the time of 2015, a point in time which the regulator has since discovered that Scope adopted a particular ‘covered bonds methodology’ (CBM) and then never actually applied it. The methodology consisted of an analysis of an issuer’s strength, but also supposedly an analysis of the legal framework and also an analysis of the cover pool. Yet, when the ratings were issues Scope never actually applied this methodology properly even though it had declared it had, with the result being that ‘559 ratings [had been] issued without analysis being conducted according to the publicly disclosed CBM, our of a total of 622 ratings issued under the 2015 CBM’. Furthermore, ESMA also found that when changing to the 2016 version of the methodology, Scope did so without consulting the regulator nor, publicly at least, any stakeholders (in breach of CRAR).


Scope has the right to appeal against the decision, and it remains to be seen whether it will do so. Scope, for its part, has said that ‘at the time, Scope had inadvertently taken a different interpretation of relevant parts of EU legislation on credit rating agencies which turned out to be different from ESMA’s… since 2016, Scope has entirely remedied the issues identified by ESMA and reinforced its internal controls regarding he application of the relevant regulations’. The report from Nasdaq suggests that Scope have already made provisions for the fine, which suggests that it will not appeal.


Keywords – Scope Ratings, Scope, ESMA, regulation, business, @finregmatters

Monday, 1 June 2020

Start-up Profile – CRED iQ

Last year we reviewed a new entrant into the financial information landscape, with the start-up Sigma Ratings which exists to provide focused and specialised information regarding anti-money laundering and its effects on creditworthiness (amongst a number of other aims). In today’s short post we will be introduced to another start-up aiming to impact the marketplace, this time in the field of information relating to commercial real estate intelligence, which is particularly apt given the market shift in focus to commercial mortgage-backed securities over the past few years – that company is CRED iQ.


CRED iQ, founded by Bill Petersen and Michael Haas, has the expressed aim of providing the marketplace with a flagship platform which provides for interactive commercial real estate valuation, CMBS monitoring, and also involves a ‘lead generation platform delivering objective risk assessments to CRE (Commercial Real Estate) and capital market investors’. The innovative platform provides users with commercial real estate valuations that is based on in-depth and relevant market data, trend analysis, and more than 20 years of valuation experience, whilst the interactive valuation scenarios (MyQ) enables users to navigate user-friendly software that can adjust CRED iQ valuations and observe the adjustments across loans, deals, and portfolios. There are also elements of the platform that provides information on loss projections, portfolio analytics, and there is also the opportunity to set real-time alerts so that changes in the marketplace that may be relevant to a portfolio can be incorporated instantly into the decision-making process. Additionally, the company is launching what it calls Investment Quality Scores (iQ), which it says are ‘numerical tranche and deal level objective risk assessments free from market perceived conflicts of interest’.


The company states that it serves a number of industries, including mortgage brokers, leasing agents, investment sales, and capital markets amongst a large list of others. The independence that the company is seeking to display should be of real benefit to those potential industries that may use the new company’s platform and services. To subscribe to the platform, the rates are $149 per month per user for the Standard package, and $249 per month per user for the Ultra package. The new company is growing well, as evidenced by a current recruitment drive for software engineers and their recent contribution to a Wall Street Journal article which saw their valuation of the Fontainebleau Hotel in Miami incorporated into the analysis being developed by the WSJ. For those readers who may be interested in learning more about the company and the platform it offers, there is a free trial available. If more information is required, then the company can be contacted here.


The aim to inject impartial and considered information into the CRE landscape is a welcome one, particularly as the company aims to develop useful information that is free from the conflicts of interest that can cause so much damage in a field such as this one. Hopefully the company will continue to grow and we shall monitor its progress here in Financial Regulation Matters. You can follow the company on LinkedIn here.


Keywords – CRED iQ, Analytics, CMBS, Commercial Real Estate, @finregmatters.