There Was a Surprise in the Dodd-Frank Act?
... to assure that disclosure regarding securities is accurate. It was also designed to give investors additional protection not available under common law due to the barriers to recovery presented by the common law fraud requirements of scienter, reliance and causation. Liability under Section 11 extends to the issuer, officers and directors who sign the registration statement, underwriters, and persons who prepare or certify any part of the registration statement or who are named as having prepared or certified a report or valuation for use in connection with the registration statement.An expert may be held liable for an untrue statement or omission of material fact "unless he can establish that he had, after reasonable investigation, reasonable grounds to believe and did believe" that the statements were true and material facts needed to make the statements not misleading had not been omitted. (This is not all that different from the standard under which as a sell side analyst, I published my analysis, commentary and recommendations. Violating that standard risks firing and being barred from the securities industry. I am not distressed to see it imposed on the raters.) Rule 436(g) was adopted in 1982, after the SEC reversed a long standing policy of discouraging the disclosure of credit ratings. The rationale for for discouraging disclosure of ratings is difficult to ferret out of the SEC site. The 1977 concept release 33-5882, proposing the change, appears not to be available electronically. Subsequent discussion, in SEC 33-6336 (I found on lawyerlinks.com, not SEC.gov) for instance, suggest that a common objection to ratings is that, by compressing too much information into a single grade, they could confuse investors. The shift was simply to allow voluntary disclosure. In proposing the change in policy, the SEC asked comments on whether raters should be treated like other experts under Section 11. The 2009 release indicates that comments generally opposed subjecting NRSROs to liability because, among other things, it would interfere with the substance and timing of the registration process, it would change the way credit ratings were issued, and it would result in higher costs and increased uncertainty over the scope of liability. In particular, "The NRSROs in existence in 1977 indicated that they would not provide consents to be named in the registration statement." Subsequent comments revealed concerns that the raters independence would be affected if they were "participants" in the offering. And, get this - the quality of ratings would be diminished because raters "would rely only on objective, quantifiable information." Hunches, gut guesses, fingers to the wind and wishful thinking would not be admissible. Please note, these arguments were advanced long before the rise of private MBS and ABS markets. In fact, the discussion took place even before the junk bond market took off. Even then, however, the issues were the same as they are now. The commenters who favored subjecting NRSROs to liability under Section 11 argued that doing so would incline them to take more care in determining ratings. Whatever. Rule 436(g) was adopted. Will the Real Expert Please Stand Up Fast forward to last year's SEC proposal to rescind 436(d). One of the arguments the Commission made for doing so was that NSRSOs "represent themselves to registrants and investors as experts at analyzing credit and risk." Although the raters describe their credit ratings as "opinions" protected under the First Amendment, many other professionals provide legal opinions, valuations opinions, fairness opinions and audit reports that are incorporated in filings and on which investors rely. Those professionals are treated as "experts" and are subject to the consent requirements under the Securities Act. Furthermore, many types of professionals can rate the claims paying ability of a bond issuer (in the case of an ABS, the issuer is the legal structure - e.g. a limited purpose corporation, trust or combination of such entities - created to issue bonds to buy assets used to service the bonds). However, only NRSROs enjoyed the 436(g) exemption - the others, regardless of their track records, market shares, marketing clout and so forth, were held accountable as experts. Consider this scenario. As a consultant with long experience of various sorts in structured products, I hang out my "rater" shingle and a lender retains my services on an asset-backed issue. I rate the bonds triple-A, with a very high probability that all interest and principle payments will be made as described in the prospectus. I am an expert and must consent to the use of my opinion. And it better be the best, most fact-based and defensible opinion I can devise, because I am legally liable. Investors might respect my research over the years, there could even be those who made investment decisions under its influence, but there is not one, currently active or retired from the market, who would invest in those bonds based on an understanding that I have staked my reputation and business and affordable liability insurance premiums on that rating. On an understanding that my conscience is as invested in that rating as the lawyer's is in her true sale opinion. A huge NRSRO, in the rating business for decades, with published criteria, the budget for historical asset performance data, legions of analysts and a credit committee to review their work rates it as well, but does not consent to be treated as an expert. Step Up and Be Experts My hope is that the raters use the next six months to adjust to their newly legislated expertise. Big picture, in a world where liabilities trump responsibilities, it seems to me that if obstetricians close their practices because they can't afford malpractice insurance, it's only fair to make rating agencies liable as the experts they want to be paid for being. And how handsomely they get paid has already been read into the public record. Now that rescinding 436(g) is a done deal, it should be possible for the ratings firms' legal counsel to form a less reactive picture of the real, expanded potential for law suits. After all, the language of Section 11 (summarized above) has given comfort to the accountants, attorneys and other experts who do give their consent. I'm not the only structured product analyst to read the 1933 Act as comforting, either. Alan Todd, Matthew Jozoff and Amy Sze at JP Morgan Securities write in their weekly that the wording of Section 11 suggests that "at the time a deal is issued, rating agency personnel, which base their ratings on both empirical as well as forward looking scenarios, need only prove that they believed their results to be accurate, complete and not misleading."
NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine.
Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.