Sam Brotman, JD, LLM, MBA January 15, 2014 6 min read

Conflicts of Interest and Credit Rating Agencies

Effects of the Dodd-Frank Act on Conflicts of Interest

In addition to administering rating and disclosure rules, The Dodd-Frank Act also imposes several requirements on NRSROs to establish internal control systems that prevents conflicts of interest. The bill’s drafters made it a priority to put certain guidelines in place in order to mitigate the temptation toward favoritism within the rating agencies. Without the conflicts, or with the proper steps to mitigate them, the rationale is that more certainty would exist about the objectivity of the ratings.

The first requirement involves the separation of ratings from sales and marketing functions. By creating rules to separate the two, it addresses the glaring problem of the production of ratings being tied to sales and marketing factors. In addition, one of the chief goals of the Act is to expand conditions that deal with conflicts of interest that may exist both inside the credit rating agencies and with the issuers and underwriters that they deal with. The Act also instituted a look-back requirement with respect to previous employment of credit rating agency employees. These look-back requirements are structured to make sure that:

If any employee of an issuer, underwriter, or sponsor of a security…had previously been employed by the NRSRO and participated in determining the credit rating of that entity during the one year period before the rating action, the NRSRO will conduct reviews to determine whether conflicts of interest influenced the rating, and will revise the rating as appropriate.[1]

By implementing this look-back requirement, the bill seeks to eliminate conflicts of interests by closing the 'revolving door' that exists between NRSROs and the agencies which they provide ratings for. The SEC will also be periodically required to examine the look-back procedures put into place by the credit rating agencies in order to ensure adequate standards and uniformity.

Similarly, there is an additional requirement for the NRSRO to report any changes of employment of its employees in certain circumstances to the SEC. This occurs in circumstances where an employee has been employed by an obligator, issuer, underwriter, or sponsor of a security or money market instrument rated by the NRSRO during the year before they switched to new employment. [2]This occurs only in instances where the employee either supervised or otherwise participated in the rating of the instrument and is meant to sure no conflicts of interest existed during the process. Furthermore, there are other regulations under the Act that are designed to prevent conflicts. For example, there are limitations placed on services provided to various parties, including outside consulting and other advisory services.

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[1] “Dodd-Frank Act’s Impact on Rating Agencies as the ABS Market Continues to Evolve.” http://www.bingham.com/Media.aspx?MediaID=11652. Last accessed November 17, 2011

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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