Rule 436(g): What’s Missing from Rating Agency Reform

Yesterday we discussed the Franken and Lemieux amendments that passed in the Senate which regulates the Ratings Agencies. It’s important to realize how strong the House bill was in this manner, and how the Senate is still missing some things.

Shahien Nasiripour has the best overview of what did not happen yesterday with rating agency reform, Senate Approves New Curbs On Rating Agencies, Though One Provision Overlooked:

But in passing a measure that attempts to end their oligopoly, the Senate purposely did not include a provision in the House bill that forces major credit rating agencies to be accountable to investors by scrapping a Securities and Exchange Commission rule that has shielded them from civil lawsuits for nearly 30 years.

The provision, known as Rule 436(g), insulates the 10 credit rating agencies recognized by the government as “Nationally Recognized Statistical Rating Organizations” from liability if they knowingly make false or misleading statements in connection with securities registration statements to dupe investors. Other experts — like the rating agencies not part of the group of 10 — are legally liable for their statements “to assure that disclosure regarding securities is accurate,” according to a 2009 SEC document supporting the removal of the exemption.

In short, if a Standard & Poor’s or Moody’s Investors Service knowingly tries to deceive an investor, under current law that investor can’t sue….

“In the eyes of investors, regulators and the market at large, rescinding the exemption would remove [the 10 major credit rating agencies] from the pedestal they have come to occupy,” according to the Council’s letter.

“Nearly 30 years ago, the SEC adopted a rule that effectively exempts recognized credit rating agencies from experts’ liability under the Securities Act,” wrote David Becker, the SEC’s general counsel and senior policy director. “No other experts have this protection.”…

From the final House bill, the removal is pretty blunt and quick:

SEC. 6012. EFFECT OF RULE 436(G).

Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.

That’s it. No more rule 436(G) from the House. No study, no discretion, no punting. This isn’t in the Senate at all, so the liability protection still exists, where other fields have no such protection at all.

When I think about financial ethics, I sometimes falls back on “what if my dentist acted this way?” quick-test threshold for the financial sector. If my dentist could recommend a root canal he knew I didn’t need, and then if I tried to sue him he was able to claim that the first amendment protected him, I would think that’s a bad thing. That’s the kind of bad situation we’ve written into law years ago with the ratings agencies, and though it’s been fixed in the House it’s not moving in the Senate.

Shahien also points out that there is some language that helps with this in the Senate Bill, but that the Lemieux amendment isn’t as good as the equivalent in the House:

But the Senate bill, like the House bill, does provide investors with an improved ability to sue credit raters for faulty ratings. A spokesman for LeMieux pointed to these provisions when asked why his amendment did not include the House language on the 436(g) rule.

The agencies have enjoyed a near-perfect legal record by claiming that their ratings fall under the protection of the First Amendment — free speech, they’ve successfully argued. The House and Senate bills attempt to address this by strengthening investors’ hand when it comes to suing the rating agencies, but the First Amendment defense may be hard to overcome, as ultimately the courts decide — not Congress…

However, there are open questions about the LeMieux-Cantwell provision. The House bill, largely authored by Rep. Paul Kanjorski (D-Pa.), directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness “to the extent feasible.” The Senate provision includes no such language.

Also, the House bill compels federal agencies to look for other such references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards. The Senate amendment doesn’t include this, either.

The measures in the LeMieux-Cantwell amendment won’t take effect until two years after the bill is enacted into law; the House provisions take effect within six months.

It’s important to remember that in some areas, the House bill was quite strong. And two big areas for weakening, derivatives and state pre-emption, are still vulnerable.