Friday, 4 May 2018

Article Preview – ‘Credit Rating Agency Regulation: Has the “Rule 17g-5 Program” Worked?’ – International Company and Commercial Law Review

In today’s post, the focus will be on a recently accepted article produced by this author. The article, which is concerned with examining a particular aspect of the post-Crisis regulatory approach to affecting the industrial structure of the ratings industry, has recently been accepted by the International Company and Commercial Law Review. This author has examined this particular aspect of the U.S. response to the Crisis before in a previous article, but from a different perspective; in this article, the emphasis is upon using the time that has passed since the establishment of the provision to examine whether it has had any effect and, if not then why not.

The provision in question is a very small section of the Dodd-Frank Act 2010, and whilst the section covers a few aspects the article is concerned with the attempt to encourage competition within this particular sector. The multiple aspects can be best classified as the ‘Rule 17g-5 Program’ and it was the Dodd-Frank Act that amended the relevant sections of the Exchange Act of 1934 which is the relevant Act in the U.S. when it comes to governing the securities markets. The new provisions take aim at a number of aspects, including the relationship between the commercial and rating elements of the rating agencies, the relationship between the agencies and issuers who use the ratings of a given agency over a certain threshold, and also the independence of ratings analysts. For the article however, the focus is upon a system that was established which was designed to break, or at least lessen the barriers to entry. The system itself attempts to achieve this aim by way of allowing non-commissioned rating agencies the same information that commissioned rating agencies receive from issuers, with the sentiment being that the non-commissioned agencies would conduct ratings in parallel to the commissioned agencies to act as a sort of ‘check’ within the marketplace. Technically, the commissioned NRSRO (Nationally Recognised Statistical Rating Organisation) would create a password-protected internet site whereby the information would be stored, and non-commissioned NRSROs could apply to gain access to the information. One underlying sentiment of the provision is that this procedure would allow lesser known agencies to gain recognition and reputation by way of producing accurate ratings. However, there are a number of issues with this procedure, and they are identified and examined within the article.

Perhaps the biggest issue is that attempting to affect an oligopolistic industrial structure takes a concerted campaign, not just a small amendment to procedure. This author has argued this on a number of occasions, but in this author’s forthcoming monograph Regulating Credit Rating Agencies: Restricting Ancillary Services, the point is made that the problems that have (and continue to) emanate from the credit rating industry, in part, stem from a misaligned regulatory focus – regulators continue to develop actions that take aim at the desired version of the industry, and not the industry as it actually operates. This divergence is demonstrated here on a number of levels. Firstly, there is a time-delay in the non-commissioned NRSROs receiving of the information, which serves to reduce the effectiveness of any rating they produce. Secondly, only NRSROs are allowed to request access, and for an agency to gain NRSRO status they must be ‘nationally recognised’, which means they really should not have to undertake certain actions to gain reputation anyway. With that in mind, the next issue is that the provision is asking for-profit rating agencies to produce ratings and not receive compensation for their efforts, which is one of the more obvious reasons as to why no ratings have been produced under the 17g-5 Program. All that has been produced so far are ‘commentaries’, which have been discredited on the basis of allowing for agencies to promote their own services to the detriment of others. In another example of the divergence, regulators/legislators have seemingly overlooked the position of issuers, who have responded in a predictable manner to the Program – to protect themselves, they have endeavoured to essentially codify the majority of their information as ‘confidential’, meaning that the information contained within the password-protected sites is rarely enough to allow for an effective rating to be constructed.

There are a few other issues with the Program which are discussed in the article. However, the article proposes that the Program can be a vehicle for positive change in the industry, but that its parameters must be reconsidered in order to make it so. There are a few aspects which need to be changed to bring about this reality, but the clearest one is that the NRSRO designation attached to the Program needs to be removed. The previous article introduced this point from within the dynamic of non-profit rating agencies; the first article identified the International Non-Profit Credit Rating Agency and the Credit Research Initiative as just two offerings which could fill this proposed role for a number of reasons. These non-profit offerings, in theory, perfectly demonstrate the characteristics the 17g-5 Program calls for: they will be able and willing to produce ratings without looking for compensation, they require a reputational increase to compete, and they are perceived as independent (in theory) by the marketplace on account of not being blighted by the ‘issuer-pays’ remuneration model. The first article argued that these two initiatives should be merged together to encompass their relative skillsets (sovereign and corporate bond ratings), which would only further add to the effectiveness of the 17g-5 program.

Ultimately, it is important to consider such regulatory initiatives as progressive, although there is still plenty to be done. The credit rating agency problem that persists can be lessened to some extent, but essentially the regulators and legislators must fundamentally incorporate the reality of the situation into their considerations. It was clear that issuers would rebel, and also that CRAs would not be inclined to provide what are essentially free ratings to the marketplace (particularly when they are for-profit agencies). Yet, whilst it is important to remain positive, it is difficult to overlook the fact that 8 years from the Dodd-Frank Act, very little has changed in this industry – the oligopoly is now even more prevalent than it was, the record-breaking fines have been easily absorbed by the two leading agencies, and their core practice of protecting their methodological freedom has been maintained. As this author focuses solely on the ratings industry, it is important to note that the aim is not dismantle the ratings industry (as some scholars have suggested), but simply to establish provisions which make the traditionally transgressive approach of the industry something which operates within defined constraints. Aspects such as those have been proposed in a number of works by this author, but initiatives such as the Rule 17g-5 program can be a positive factor if it is incorporated and progressed in a realistic manner.

Keywords – Credit Rating Agencies, SEC, United States, Financial Regulation, @finregmatters

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