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Morningstar fined $3.5 million for violating conflict of interest rules on ABS ratings

SEC investigation found that ABS analysts were soliciting new business

One of the many issues that contributed to the Great Recession was the intense competition between the credit ratings agencies for business, which led to bond issuers “shopping around” for the best ratings for their bonds.

That ratings shopping led to a race to the bottom in credit ratings, where the various ratings agencies were handing out AAA ratings to mortgage bonds and other offerings that did not deserve those scores in any form or fashion.

In the wake of the housing crisis, the government put rules in place to prevent these types of issues from bubbling back up. One of those rules stipulates that the ratings agencies must separate their analysts from any of the firm’s sales or marketing activities, to ensure the ratings are issued without influence from the business side of the office.

But, according to the Securities and Exchange Commission, one of the nation’s largest ratings agencies violated that rule, asking its analysts to solicit bond issuers for new business.

The SEC announced Friday that it is ordering Morningstar Credit Ratings to pay a $3.5 million fine for violating conflict of interest rules designed to protect against credit ratings malfeasance.

According to the SEC, an investigation found that from mid-2015 through September 2016, credit rating analysts in Morningstar’s asset-backed securities group “engaged in sales and marketing to prospective clients.”

The SEC found that Morningstar’s head of business development told analysts to identify targets for new business and pursue them through marketing calls, meetings, and offers to provide sample ratings on coming issuances.

In one example, the investigation found that one ABS analyst at Morningstar “wrote a commentary specifically aimed at a potential client issuer and sent it to the issuer for the purpose of obtaining the business of the issuer, which eventually became a Morningstar client.”

It’s important to note that she SEC does not define which asset class or classes were involved in these actions.

The investigation also found that Morningstar’s head of business development also encouraged analysts to communicate with their various contacts in the industry to try to earn new business for the company.

From the SEC’s order:

In an effort to grow MCR’s ABS rating business, MCR’s ABS business development director instructed ABS analysts to identify and initiate contacts with potential clients (referred to as “targets”), set up marketing calls and marketing meetings with them, and offer them indications. MCR’s ABS business development director also instructed ABS analysts to (i) solicit potential clients at industry conferences, (ii) repeatedly follow up with those potential clients, and (iii) encourage potential clients to attend marketing meetings with MCR. Analysts understood that the goal of their contacts was to persuade potential clients to hire MCR to rate ABS. These activities were undertaken with the knowledge of senior MCR managers.

According to the SEC, senior managers at Morningstar were keenly aware of the analysts’ actions, receiving “regular reports on the status of MCR’s client recruitment efforts, including sales and marketing by ABS analysts.”

Additionally, the SEC found that between at least June 2015 and November 2016, Morningstar “failed to maintain written policies and procedures reasonably designed to sufficiently separate the firm’s analytical and business development functions.”

The SEC investigation determined that Morningstar violated several federal laws, including the Securities Exchange Act of 1934, which requires credit rating agencies to establish, maintain, and enforce policies and procedures reasonably designed to address and manage conflicts of interest.

According to the SEC, without admitting or denying the findings, Morningstar agreed to pay a $3.5 million penalty and committed to conduct training and implement changes to its internal controls, policies, and procedures.

“Credit rating agencies must be vigilant to prevent potential conflicts of interest between their ratings functions and their sales and marketing activities,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit.  “As the SEC’s order finds, Morningstar sometimes enlisted its analysts in business development efforts, introducing the exact conflict of interest that the rule is intended to eliminate.”

In a statement, Morningstar said that it cooperated in the SEC’s investigation and will work to improve its policies to ensure a recurrence of these actions.

“MCR, which will pay $3.5 million as part of the settlement, did not admit or deny the SEC’s charges,” the company said in a statement.

“MCR cooperated with the SEC’s multi-year investigation and believes the settlement is in the best interest of the company. There are no allegations that any credit ratings issued by MCR were affected by the conduct described in the settlement,” the company continued.

“MCR takes its regulatory obligations seriously, and the integrity of its credit ratings is of paramount importance. As part of its integration with DBRS, which Morningstar acquired last year and well after the investigated activity took place, the combined DBRS Morningstar has enhanced and will further strengthen policies, procedures, and internal controls,” the company added. “It will also conduct additional training to reinforce compliance with regulations.”

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