NCRA Issuer-Paid Model Reform
Table of Contents
In § II.C this paper examined the various conflicts of interest arising out of an NCRA business and how Congress and the SEC addressed those issues. However, the conflict of issuer-paid credit rating services was still not addressed – the only such attempt is the 10% prohibition imposed by rule 17g-5(c)(1), which suffice it to say is a very lax prohibition.[1] The problem with rule 17g(c)(1) is two-fold. Firstly, the three large credit rating agencies are unlikely to trigger the 10% level due to the number of clients they have and their diverse lines of business. Secondly, smaller institutions are likely to receive an exemption from the SEC[2] in order to promote competition in the credit ratings industry.[3]
Simply doing away with the issuer paid model is not a reasonable solution to this problem. NCRAs serve an important public purpose and prohibiting issuers from paying for credit rating services would only serve to reduce transparency in the long run. This section proposes a way to solve this problem by introducing two different models for structuring this industry.
Self-Regulatory Organization Model
One way of addressing the 17g-5(c)(1) problem is to directly admit to the public purpose of credit ratings, and run the business like a SRO – namely, FINRA (the Financial Industry Regulatory Authority).[4] One of FINRA’s top priorities that closely resembles the purpose of NCRAs is “to advance investor confidence in the security markets through vigorous, fair and effective enforcement.”[5]
FINRA is a non-profit association regulated by the SEC that also exercises regulatory authority over member organizations, where registration is required of all broker-dealers but subject to certain exemptions.[6] FINRA serves in its SRO capacity alone,[7] with some overlap with national exchanges, further discussed below. FINRA is primarily funded through various fees paid by member firms – trading activity fee, gross income assessment, personnel assessment and branch office assessment. As such, FINRA also follows a model similar to an issuer-paid model.
FINRA was initially criticized for levying smaller fines each year on a gross annual basis during the period of 2005 to 2008 – a steady decline from $184 million in 2005 to $28 million in 2008.[8] However, this trend did not continue, and in 2015 FINRA levied about $95 million in fines.[9] The organization has generally been positively received by both the industry and the SEC – in particular, the industry has an incentive to maintain integrity because it promotes higher capital investments.
In a similar manner, the SEC can enact only one non-profit ratings association in charge of issuing ratings for a certain class of securities or issuances. The association would be funded by issuers, but the 17g-5(c)(1) problem would be solved by removing potential credit rating shopping by issuers. If an issuer, or sponsoring firm, would like to benefit from NCRA ratings or comply with rules that require the issuance of NCRA ratings, then they must become members.
However, this model would go in direct opposition to the SEC’s current goal of promoting competition in the NCRA space. And unlike enforcement actions, credit ratings are much more susceptible to varying opinions by different analysts and the process is not subject to anything resembling judicial oversight. Therefore, while this model may present a long run approach toward which the SEC must strive, it may be more practical to consider an intermediate approach in the short term, as outlined in the following section.
National Exchange Model
National exchanges are organizations or associations designed as a venue for trading securities[10] by setting rules to regulate the trading activities of member firms.[11] Only brokers or dealer may become exchange members,[12] and other investors seeking to trade exchange traded securities must do so through a broker-dealer. Thus, exchanges are a type of broker-dealer for broker-dealers, and for the most part a registered broker-dealer can function as an exchange, but it would fail to meet the definition of an exchange if it does not regulate its clients – these broker-dealers typically fall under the definition of an alternative trading system.
The primary regulatory framework for exchanges is known as Reg NMS, which is a set of rules designed to unify an otherwise fragmented market system and facilitate a national market system in its place.[13] These rules are designed to promote competition not through exemption but by requiring that exchanges route orders to other exchanges if a better price exists at the other exchange.[14] And so exchanges generally compete across other factors, like the type of services they may offer.
Similarly, we offer two ways that the NCRA industry can be reformed, but explain why only one of those ways is the better option. In the first way, the SEC can require that NCRAs must bid for rating business in some type of auction system. This would mean that NCRAs would compete on price rather than on their willingness to issue better ratings. However, this would also create a race-to-the-bottom problem that is seen in other industries that compete on price at the expense of quality – e.g. insurance. The second way would involve establishing a price setting committee that would establish a flat fee for rating services across the industry, however, any NCRA would be permitted to issue a rating and may share in the fee. As a quid-pro-quo, an NCRA that partakes in the fee must publicly publish their rating.
There are a few reasons why this second approach would be superior. Firstly, it removes the conflict of interest problem created by the issuer-paid model by removing the choice of where issuers purchase rating services. Secondly, while NCRAs must publicly publish the rating, they may also offer additional analysis for a fee to subscribers, and so NCRAs would compete among each other on quality of service from the perspective of an investor – rather than quality from the perspective of an issuer. Thirdly, because NCRAs are designated by the SEC through a rulemaking process, there is at least some level of control that would prevent an inundation of services by agencies that are simply seeking to make a grab at a share of the flat fee, and in this way the NCRAs can exercise some control over issuers rather than issuers exercising control over NCRAs. Finally, by publishing more than one credit rating, investors receive several analyst opinions and, thus, a more transparent view of new issuances. The second method displays stark similarities to the NMS model, because it provides a way for competing NCRAs to access clients of other NCRAs, while at the same time keeping competition on quality of service and removing the influence of issuers on the selection and price setting process. And just as how Reg NMS has helped improve the national market system, the reform explained in this section can help improve the NCRA system. The only real drawback to this system is that the three big NCRAs are likely to heavily lobby against it because it challenges their monopoly over issuer-paid credit rating services.
Read on to the next section…[1] See supra n. 15.
[2] See supra n. 16
[3] See e.g. Order Granting Temp. Exemption of Morningstar Credit Ratings, LLC from the Conflict of Interest Prohibition in Rule 17g-5(c)(1) of the Sec. Exch. Act of 1934, Release No. 66514 (Mar. 5, 2012), Order Granting Temp. Exemption of Kroll Bond Rating Agency, Inc. from the Conflict of Interest Prohibition in Rule 17g-5(c)(1) of the Sec. Exch. Act of 1934, Release No. 65339 (Sept. 14, 2011), Order Granting Temporary Exemption of LACE Financial Corp. from the Conflict of Interest Prohibition in Rule 17a-5(c)(1) of the Securities Exchange Act of 1934, Release No. 57301 (Feb. 14, 2008).
[4] FINRA is a SRO dedicated to investor protection and market integrity through effective regulation of broker-dealers. See FINRA, About FINRA, https://www.finra.org/about
[5] See FINRA, Enforcement, https://www.finra.org/industry/enforcement
[6] See 15 U.S.C § 78o(b)(1)(B).
[7] This was the result of combining the National Association of Securities Dealers with the New York Stock Exchange Regulation, Inc.
[8] See Deborah Heilizer, Brian Rubin, and Andrew McCormick, Annual Sutherland Analysis of FINRA (Feb. 24, 2014), available at: http://www.sutherland.com/NewsCommentary/Press-Releases/161244/Annual-Sutherland-Analysis-of-FINRA-Sanctions-Shows-27-Decrease-in-Fines-Number-of-Cases-Nearly-Identical
[9] See FINRA, What We Do, https://www.finra.org/about/what-we-do
[10] 15 U.S.C § 78c(a)(1).
[11] 17 C.F.R. § 240.3b-16(a)(2).
[12] 15 U.S.C § 78c(a)(3).
[13] See Regulation NMS, 70 Fed. Reg. 37,496, 37,498-501 (“NMS Principles and Objective”).
[14] See 17 C.F.R. §§ 242.610, 242.611 (the “Access Rule” and “Trade-through Rule,” respectively).