Rating Agencies: Disease and Cure
Today Congress put credit rating agencies on the hot seat during intense hearings. Rating agencies, including Moody’s and Standard & Poor’s, gave top grades to debt the credit crisis is now showing everyone was junky. Scholars have long berated the rating agencies, especially Frank Partnoy. The fundamental problem is that securities issuers pay the rating agencies their fees. The proverbial result: whose bread I eat, his song I sing. Also, law requires very little of rating agencies and essentially insulates them from liability to investors harmed by irresponsible ratings.
As Congress turns hearings into policymaking, Members should consider new scholarship from Jeffrey Manns forthcoming in North Carolina Law Review. He proposes that investors, not issuers, pay rating agencies. The so-called user fee system is coordinated mainly by investors, those owning rated bonds, with a government agency coordinating the system in the pre-issuance stages of a rated debt offering. In addition, rating agencies would have to certify their ratings much as auditors certify their audits. Also like auditors, agencies would be required by law to disclose discovered fraud or illegal acts at issuers whose securities they rate.
The proposal is timely and sensible. Inevitably, it contains elements worthy of debate as well. In particular, the proposal contemplates applying a standard of gross negligence for investor recovery for rating agency violations. The standard for auditors generally is the tougher one of recklessness. In addition, the proposal caps rating agency damages measured in relation to earnings from the botched rating. Despite decades of campaigning by auditor lobbyists for such a cap on their damages, they have not been able to win this victory. Also, alas, auditors continue to be paid by the clients whose financial statements they audit (which I’ve proposed addressing by using financial statement insurance or capital market funding to prevent destroying the auditing industry).
Those interested in preliminary diagnosis of causes and cures for the current crisis should read Manns’ new article. My guess is that everyone who has written or thought about the rating agency’s role in our corporate finance system will consider the piece must reading.