Review of the US SEC Staff Report on Nationally Recognized Statistical Rating Organizations (January 2025)

Today’s focus is on the Staff Report released by the US Securities and Exchange Commission’s Office of Credit Ratings (OCR) which focuses on Nationally Recognized Statistical Rating Organizations (NRSROs). The SEC are mandated by Congress – via Section 6 of the Credit Rating Agency Reform Act of 2006 and Section 15E(p)(3)(C) of the Securities Exchange Act of 1934 – to collate information on the previous years’ worth of investigation into the NRSRO industry, as well as pertinent data on the shape of the industry. This piece reviews that report and presents the more important and relevant highlights. All aspects of this piece are derived from the Staff Report, unless otherwise stated.

Monitoring

The Report starts out with an overview of what the OCR suggests as key issues that they have been monitoring over the past year. Interestingly, the Report focuses on two areas of direct relevance to the NRSROs: the commercial real estate market, and private credit. On commercial real estate and CMBS ratings (Commercial mortgage-backed securities), the Report says that NRSROs had reported a deterioration in the sector and that subsequently the NRSROs had been conducting increased reviews, stress tests, and had issued downgrades. NRSROs appeared to agree that the sector outlook will remain unclear in the near future until rents and vacancies started to stabilise. On the issue of private credit, and its proliferation, the Report notes several concerns. One main issue was the variety of instruments that are backed by collateral that has originated in the private credit market, including private credit funds, business development companies, and collateralised loan obligations. The rise in the private credit market has led to responses from NRSROs, with specialised departments now existing and the rate of private credit ratings provided by NRSROs – not to be made public – increasing markedly.  

Essential Findings and Responses to Material Regulatory Deficiencies

Apart from the useful statistics that the Report brings to the field every year (which will be reviewed next), one critical aspect of the Report is when the OCR reveal its findings regarding breaches of law and code by the NRSROs. For a variety of reasons, most of which are challenged, the SEC has maintained its approach of anonymising its findings so that we do not get to know which NRSRO has transgressed in particular. Instead, we are told whether a ‘large’, ‘medium’, or ‘small’ NRSRO has transgressed. Most transgressions are often concluded with a comment akin to: ‘the Staff recommended to the NRSRO that they take a particular action to prevent this from happening again’. However, what the Report does help with is revealing the culture within NRSROs and how they seek to resolve the issues (if at all).

The large NRSROs (either S&P Global, Moody’s, or Fitch) committed the following material breaches:

1.      One large NRSRO did not enforce policies relating to conflicts of interest around securities ownership, resulting in ‘several instances’ where analysts continued to own securities that ought to have been divested and, in one instance, one of these analysts participated in a credit rating committee for an obligor in whom the analyst owned securities. The NRSRO responded that they had convened a new committee, suspended and then terminated the contract of the analyst, and reviewed policies and hiring rounds to see if there had been any further breaches of the same type. It went on to update analyst training as a result.

2.      For the same NRSRO, a non-independent director did not preclear three securities transactions or subject their related brokerage accounts to monitoring by the NRSRO, in breach of internal policy. There is no additional information to reveal what happened in this instance.

3.      Another large NRSRO’s independent directors used personal email accounts to conduct NRSRO business, including transmitting nonpublic information and potential material nonpublic information. The Staff recommended new controls, but no information is provided on what happened next.

4.      The same NRSRO was found to have an analyst who sent a draft rating report to an issuer ‘that inadvertently disclosed a contemplated rating action’, contrary to NRSRO policy. Again, while Staff recommend action, we do not get to find out what happened next. The theme is clear and I will not repeat it from this point on.

5.      The same NRSRO did not disclose complete and correct credit rating histories in mandatory disclosures. For ‘several years’, the NRSRO posted disclosures that ‘did not include a significant number of credit ratings of a particular rating category’.

6.      The remaining ‘large’ NRSRO was cited for not making nor retaining a rationale for a material difference between the credit rating it assigned to a security issued as part of an ABS transaction ‘and the credit rating implied by a model that was a substantial component of the process of determining the credit rating’. In simple English, the NRSRO said they would do one thing, and then did another. Further investigation found this issue to be replicated in other sectors.

7.      The same NRSRO’s policies and procedures did not require that it promptly publish notice of the existence of a significant error in a procedure or methodology used to determine credit ratings.

The ‘medium’ NRSROs – A.M. Best, DBRS, and Kroll – also had a litany of breaches cited. They included:

·         The process of submitting complaints anonymously was not apparent nor intuitive.

·         A medium NRSRO did not enforce a policy designed to ensure adequate records are made and retained to allow for after-the-fact reviews of a rating action.

·         A medium NRSRO’s board of directors did not approve the entirety of a methodology, with a quantitative tool that was not approved then being used by the NRSRO.

·         A medium NRSRO did not made or retain records of the rationale for a material difference between the rating assigned to an ABS transaction and the model used to create it.

·         Another medium NRSRO did not apply all applicable methodologies when determining an entity’s credit rating.

·         An independent director used a personal email account to conduct NRSRO business, including potentially sensitive and material nonpublic information.

·         A medium MRSRO’s complaints policies and procedures did not adequately address the receipt, retention, and treatment of employee complaints.

Smaller NRSROs, like Demotech, Japan Credit Rating Agency, Egan-Jones Ratings, and HR Ratings de Mexico also were cited in the report. Their breaches collectively included:

·         Not enforcing policies relating to withdrawing ratings when not receiving the required surveillance information.

·         Did not ensure that annual surveillance reviews were conducted on a timely basis.

·         Sales and marketing employees had discussed ratings with rating analysts (although the NRSRO disagreed with and challenged this conclusion).

·         A small NRSRO did not adhere to policies relating to the receipt, retention, and treatment of complaints relating to credit ratings, models, methodologies, and more.

·         A small NRSRO did not complete and correct credit rating histories in their mandatory disclosures.

The Report concludes this section by reviewing some of the instances where changes were requested by the Staff. However, it concludes with confirming that many changes have not been actioned, but this is because it is difficult to confirm with the NRSROs because some changes are actively being actioned and can only be judged upon completion of the revised process or provision.

Important Statistics

The Report is often cited throughout the field and especially for its data. Every year it provides for information relating to market share, outstanding rating ratios, areas of ratings, and more. Below are some of the key statistics from this year’s Report with some short commentary to each.

Market Share by Outstanding Rating

The amount of ‘outstanding ratings’, i.e. ratings that are live and active, is usually the marker by which the field understands the relevant positions of a NRSRO with respect to other NRSROs. This year’s Report confirms a similar trend, with S&P Global dominating the space in front of Moody’s, with Fitch rounding out the oligopoly and the rest operating in much less smaller circles. Collectively, the Big Three accounted for 94.15% of all ratings that were outstanding for 2023 (virtually unchanged). It is interesting to note that the year-on-year change indicates that only Fitch are rating more this year (of the largest NRSROs). Additionally, in the second chart, we can see in what areas the NRSROs are rating:

It is also important to understand the constitution of the rating sector by looking at the staffing levels. This year’s Report indicates that despite S&P Global rating a lot more than Moody’s, Moody’s actually has more analysts:

However, whilst outstanding ratings and staffing levels are good indicators for the development of the NRSROs, the financials usually take priority. This year’s financials reveal that the large NRSROs are capturing more of the income from the collective NRSRO pot than ever before. Additionally, Moody’s revenue for 2023 was up 6% from 2022, now reported at $2.9 billion, and S&P Global was up 9%, now at $3.3 billion (the Report does not cite Fitch’s financials here).

Barriers to Entry and Conflicts of Interest

The Report concludes with assessing key issues that affect the credit rating sector. Two, selected here, are pertinent. There was considerable regulatory, political, and legislative capital wasted after the Global Financial Crisis on increasing competition in the credit rating sector and the statistics above demonstrate the size of that failure – today, the credit rating sector is become less competitive, not more. The Report cites many barriers to entry that exist, including pressure on the issuer side, the investor side, and in terms of organisational difficulties to offer ratings at scale. The Report chooses to focus on the actions taken by the SEC in terms of creating space for appropriate regulations whereby smaller NRSROs are not as burdened in certain areas to allow for growth.

In terms of conflicts of interest, the Report provides generalised information on the different conflicts of interest (and categories them by who is involved, i.e. rating analysts, relationship with issuers, internal relationships etc.) It does then provide links to interventions where they have involved themselves and recommend development in particular areas within NRSRO to prevent conflicts from occurring or being repeated.

Summary

The Report provided by the OCR is a useful addition to the field. However, despite its usefulness, some of the signals it sends are not positive. It shows a regulator intent on protecting the sector and a sector that continuously transgresses. Many of the identified transgressions in this year’s report are found in previous additions. The protection of the sector, via anonymity, has not merit. The damage that agencies may face if they were to be identified ought not to be deciding factor when determining whether anonymity should be provided. If a registered NRSRO breaches not only their own codes of conduct and procedures, but those of the regulator (or the law) then the public should be made aware. The anonymity is a moral hazard that needs to be reconsidered.

Beyond that, the Report makes clear that attempts to affect competition amongst credit rating agencies in the US has been an abstract failure. The largest credit rating agencies grow ever larger, bring in more and more revenues, and continue to dominate the act of providing credit ratings in the world’s largest economy and afar. This realisation ought to correct the reform agendas being presented in various fields, ranging from debt treatment to sustainability. The signal this Report sends is that the credit rating agencies are getting bigger, more important, and there is simply no evidence to suggest that is going to change any time soon.

Are Debt-for-Nature Swaps a Viable Alternative? The Credit Rating Agency Issue

El Salvador recently concluded a $1bn Debt-for-Nature swap (DFN) which, according to White & Case who facilitated the swap, is ‘both the world’s largest conservation-focused operation of this kind to date and the world’s largest DFN conversion for river conservation’. As a result, the team at White & Case have suggested that such swaps ‘offer a promising alternative to traditional financing sources’.  At the same time, Ecuador has also just completed a large DFN. The question is whether this is really the case?

The concept of a project-based ‘swap’ is increasingly becoming common parlance. The concept is a simple one, as explained by the African Legal Support Facility (ALSF): ‘Debt-for-Nature swaps are financial transactions whereby a portion of the foreign debt owed by a developing nation is eliminated, decreased, or erased in return for locally supported conservation initiatives being funded by (at least in part) the reduced debt burden the nation will face after the swap’. This ASLF report provides a really good review of the concept and its history, including criticisms relating to DFNs not focusing on the underlying issue of unsustainable debt. For this post though, the issue is in the detail of the description above. As the IGSD mention in relation to Debt-for-Climate swaps, ‘much of the world is awash in unsustainable public and private debt… efforts to relieve the debt crisis provide opportunities to advance the climate protection, health, and economic goals together, specifically through Debt-for-Nature swaps’. From a credit rating perspective, it is accepted that ‘Official’ debt – that from bilateral or multilateral sources – is not of concern, but ‘Private’ debt certainly is. In the description above from the ASLF, everything points to altering the original contract-based agreement between Issuer and Creditor. For a Credit Rating Agency (CRA) examining the relationship between Issuer and Private Creditor, this is a potential problem.

How CRAs judge DFNs varies and for good reason. For example, when Belize issued a DFN swap in 2021 totalling $364 million, complete with credit enhancement from the US Development Finance Corporation, the DFN rating was higher than Belize’s sovereign rating from Moody’s and, subsequently, S&P Global upgraded Belize’s sovereign credit rating to B-. The precise details of the Belize swap are available here and reveal that the reason for the credit rating was based almost solely on the fact that the swap constituted ‘US risk with a little sprinkle of Belize’. This is just one example that has led onlookers to conclude that ‘as a country’s external debt decreases thanks to DFC swaps, it can lead to better credit ratings, which can, in turn, lead to favourable borrowing conditions in international markets…’ It is worth noting an inconsistency in the field’s literature at this point. Many point to a seeming fact that ‘in the recent debt-for-nature swaps, the debt buy-back was assessed by Moody’s as “distressed exchange” for Ecuador and Belize, but not for Gabon and Barbados’. The problem is that this view contradicts the common view that Belize were actually positively-rated by Moody’s (at least, their swap was, and S&P upgraded the Sovereign Rating) and these views seem to all stem from the very same source – an article by Thorsten Nestmann, a Group Credit Officer for Sovereign and Supranational Issuers at Moody’s – in which he says: ‘by contrast, Belize had already missed debt payments a few months before the swap, indicating extreme credit stress at its Caa3 rating. Similarly-rated Ecuador appeared to lack market access as it was going through a period of severe political turmoil around the time of the transaction. Bond yields for both Ecuador and Belize were also at highly distressed levels, trading north of 20%. This was reflected in the deep discount that the bonds were bought back at, at 45% for Belize and over 60% for Ecuador’. At the time of writing, I have been unable to verify this understanding with even one other source, not even the Moody’s website itself – Moody’s, on its website, actually said that the superbond buyback was credit positive, but that future default risk remains high.

If there is potential confusion over Belize, there was none over Ecuador. The South-American Country had attempted the largest swap on record, organising for nearly $1.6 billion with funds to be directed to conserving the Galapagos Islands. However, Moody’s took a dim view of this, stating in a report that ‘the operation retired 10.5% of the total $15.6 million value of the three bonds but did so by repurchasing them at deeply distressed prices, constituting a loss to investors compared to the original promise of the bond contracts and generating a substantial reduction on principal for the sovereign’. As a result, Ecuador was deemed to have undertaken a ‘distressed exchange’ and was placed into default by Moody’s as a result.

The aforementioned Thorsten Nestmann explained why there is a difference. He said that: ‘with regard to bond buyback offers, Moody’s analyses factors including the size of the buyback relative to total debt and/or market debt with the likelihood that larger transactions, affecting around 5% or more of outstanding debt, are more likely to help avoid an eventual default. Furthermore, the loss severity, measured as the discount to par, often signals the likelihood of the issuer being unable to meet its debt obligations and impacts the magnitude of debt reduction. Moody’s takes into account sources of cash used to buy back the debt. If new cash is being raised externally in the debt markets, this can signal that the issuer has access to the debt markets and is not in distress’. S&P, in a report earlier this year, confirmed that they view each swap on its own merits and that debt restructurings qualify as distressed if they meet two conditions: (i) the investors receive less than the original promise, and (ii) should the debt restructuring not take place, there is a realistic possibility of a conventional default on the instrument over the medium term. S&P later confirms that both conditions must be met. Furthermore, S&P reveal that they generally view an Issuer’s sovereign credit rating as an indicator i.e. ‘if the issuer credit rating is “B-” or lower, the debt restructuring “would ordinarily be viewed as distressed”’. Fitch, in relation to Ecuador’s exchange this month, essentially confirmed that they deploy the same two-stage conditionality test to determine whether a swap is a distressed exchange.

It does appear that it is Moody’s leading the way in constraining the development of DFNs, as they are the only CRA seemingly to penalise a given DFN with a downgrade for the country involved. Nevertheless, the understanding from the CRAs above really brings into question the mainstream insistence that DFNs can be an ‘alternative’ form of finance for the developing world. First, the DFNs already contain issues in relation to their transparency and how to verify that the resources have been used for the stated purposes. But, from a credit rating perspective, the use of proceeds is not of concern. The call for more countries to utilise DFNs is somewhat blind to this reality. As a researcher at the International Institute for Environment and Development said, ‘these transactions (DFNs) are not necessarily suitable for countries in severe debt distress, as by that point they would need extensive debt restructuring and relief… debt swaps are more suitable for countries with high but not prohibitive debt burdens who want to manage their to improve their economic situation’. If we believe this to be true, then the takeaway message is a simple one: debt-for-nature swaps are a good option for particular countries, but certainly not all. Therefore, promoting them as a ‘viable alternative’ during a debt crisis is potentially irresponsible and feeds into the major criticism of those who are advocating for the systemic adoption of such products – that energy takes away the necessary energy for resolving an underlying debt crisis that has no modern debt treatment system. More focus on developing a debt treatment infrastructure fit for modern purpose is a better way forward. There is a lesson to be learned from the DFN experience for all involved – ignore the credit rating infrastructure at your peril. The involvement of Private Creditors means that the credit rating infrastructure must now become front and centre and for all aspects – be it relating to DFNs, debt-for-climate, ‘pause clauses’, debt jubilees, or alterations to the International Financial Architecture. Not doing so will inevitably result in failure, on many levels.

The EU’s New ESG Rating Regulation Reveals Familiar Regulatory Patterns

Back in June 2023 when the EU revealed its proposed regulations for ESG Rating Agencies, I pondered whether the EU had gone far enough. Now, the EU has confirmed and published its final Regulation for ESG Rating Activities, titled Regulation (EU) 2024/3005 on the transparency and integrity of Environmental, Social and Governance (ESG) Rating activities. Many fantastic scholars have already opined on the Regulation and reviewed it more than adequately – see the excellent Prof. Andreas Rasche’s review here – so instead I will assess some more nuanced takeaways from the Regulation (and also respond to some issues identified in the 2023 commentary).

The first issue identified in the 2023 commentary was that the Regulation has seemingly decided to avoid bring ‘Second-Party Opinions’ (SPOs) within the regulatory perimeter, which I had indicated was a missed opportunity. This has been maintained in the final Regulation, with SPOs being categorically placed outside of the regulatory perimeter. I discussed why this is an important failure in a recent chapter as part of Danny Busch et al.’s Sustainable Finance in Europe book (available here) and you can also find an interesting discussion on SPOs here via Alexander Coley. The effect of SPOs and their growing importance, together with the prospective conflict of interests that arise from their provision, mean this is very much a missed opportunity for the European legislators.

The second issue identified was that, like the Credit Rating regulatory frameworks, the Regulation was allowing anonymity to dominate the regulatory reviewing system. In the credit rating regulatory frameworks, regulators are permitted to only publicise the broad category of those who infringe the rules – for example, they will say that a ‘large credit rating agency’ has broken this rule or that rule, or that a ‘medium-sized credit rating agency’ has transgressed. I have long since called for this practice to be stopped and that those guilty of breaching the rules are adequately identified for the public. It was interesting to see whether the legislation would force the regulator – ESMA – to break this practice, but no such luck. In the final Regulation, there are only two references to the ‘annual report’ the regulator must file, and no details about particular elements within it.

This is a particular theme of the Regulation which warrants scrutiny. The most obvious section to examine is Article 28, which reads: ‘in carrying out their duties under this Regulation, ESMA, the Commission or any Member States public authorities shall not interfere with the content of ESG Ratings or methodologies’. This same sentiment is seen across each and every credit rating-focused Regulation and for good reason. Any perceived amount of interference has the potential to negatively affect one of the core tenets of a ‘rating’ system – the rating must be produced by an independent and impartial third-party. There is a balance that a Regulation must find and the question here is whether the EU have found that balance.

It appears that the answer depends on one’s perspective. I do not believe they have gone hard enough, leaving out key elements like SPOs, as well as providing quite a soft-touch approach to the general constraining sentiment of the Regulation. However, consider it from the EU’s perspective… they are essentially first out of the gate (in terms of a full formal piece of legislation for leading ESG Raters), this is the first time they have regulated the industry, and the industry itself is quite the moving target. In between the proposal and the final Regulation, Moody’s have completely vacated the space, leaving really only two main players – MSCI and S&P. Also, it is becoming abundantly clear that the ESG Rating game is perhaps not as impactful as people first feared, with it starting to resemble a side-business for those who primarily sell indices. Add to this that, across the board, there appears to be a general retreat from ESG by the business sector (even before Donald Trump re-assumes the Presidency in the US). Take all that and put it together, the real question becomes whether the EU have just regulated the industrial version of a ghost – it was there when they started, but is it any longer?