(HedgeCo.Net) The Securities and Exchange Commission has filed a civil action alleging that former credit ratings agency Morningstar Credit Ratings LLC violated disclosure and internal controls provisions of the federal securities laws in rating commercial mortgage-backed securities (CMBS).
Credit ratings are used by market participants to help evaluate credit risk, price certain securities, and guide the investment decisions of individuals and institutional investors alike. To promote transparency in the process, the federal securities laws require credit rating agencies to publicly and accurately describe the procedures and methodologies used to determine credit ratings, and to implement effective internal controls to ensure that they follow those procedures and methodologies.
According to the complaint, in 30 CMBS transactions totaling $30 billion that Morningstar rated from 2015 to 2016, the credit rating agency permitted analysts to make undisclosed adjustments to key stresses in the model that it used in determining the rating for that transaction. The complaint also alleges that Morningstar failed to establish and enforce an effective internal control structure governing the adjustments for a total of 31 transactions.
According to the complaint, analysts frequently made these undisclosed adjustments to reduce the stress applied in the model and, by easing the stresses, Morningstar lowered the credit enhancement it required for many of the ratings it awarded classes of the CMBS transactions. This, the complaint alleges, in certain instances benefited the issuers that paid for the ratings because it enabled those issuers to pay investors less interest than they would have without the adjustments.
“To increase transparency and guard against conflicts of interest, the federal securities laws require credit rating agencies to disclose how ratings are determined and to have effective internal controls to ensure they adhere to their ratings methodologies,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit. “In this action, the complaint alleges that Morningstar failed on both counts by permitting analysts to make undisclosed adjustments over which Morningstar had no effective internal controls.”
The SEC’s complaint, filed today in federal district court in the Southern District of New York, charges Morningstar with violating disclosure and internal control provisions of the Securities Exchange Act of 1934 applicable to credit rating agencies, and seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.