SEC Hits Morningstar

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SEC Hits Morningstar

SEC hits Morningstar Credit Ratings with $3.5 million penalty

What happens when a company mixes independent analysis and advertising? Nothing good.

In a recent order filed by the Securities and Exchange Commission (SEC), analysts at Morningstar Credit Ratings (MCR), a subsidiary of the research and analytics company Morningstar, Inc., did precisely that by simultaneously marketing products and/or services for the ratings agency to the companies it intended to rate. This lack of oversight and deliberate violation will cost Morningstar $3.5 million in penalties.

From mid- June 2015 through September 2015, the credit rating agency’s director of business development for asset-backed securities (ABS) encouraged analysts to arrange marketing calls and meetings with potential clients to entice them to hire Morningstar to rate their securities – with the added enticement of beneficial results. However, this “pay for play” scheme directly contraindicated the SEC’s 2015 Exchange Act Rule that outlawed employees involved in determining credit ratings from helping to market products and services for clients. Morningstar also failed to update its policies and procedures to ensure sufficient separation between the firm’s analytical and business functions, so conflicts of interest would not occur.

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In at least one instance, a Morningstar ABS analyst wrote a commentary specifically aimed at a potential client issuer and sent it to the issuer with the intent of securing that issuer’s business – which indeed happened. Morningstar continued to issue and maintain ABS ratings for entities where the analyst responsible for determining or monitoring that entity’s rating also participated in the sales or marketing of a Morningstar product or service.  

According to Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, Morningstar’s failure to prevent conflicts of interest between its ratings functions and sales and marketing activities introduced “the exact conflict of interest that the rule is intended to eliminate.”

The SEC’s order finds that Morningstar violated Rule 17g-5(c)(8)(i), which prohibits a rating agency from issuing or maintaining a credit rating where an analyst who participates in determining or monitoring credit ratings also participates in sales and marketing activity. Morningstar also violated Section 15E(h)(1) of the Securities Exchange Act of 1934, which requires credit rating agencies to establish, maintain, and enforce policies and procedures reasonably designed to address and manage conflicts of interest.

What prompted MCR’s overstep?

In 2010, MCR sought to expand its footprint in the credit rating business. It focused on growing its rating business in credit sectors not already dominated by large, well-established rating agencies. In 2015, the agency turned its focus to esoteric ABS, such as bonds with cash flow from aircraft leases and whole businesses serving as the securitized collateral.

The firm’s ABS analysts were tasked with creating analytical methodologies, using them to rate particular deals, and generating research and commentary regarding topics such as the creditworthiness of particular asset classes and the effects of certain market events. These findings would be presented as MCR’s credit analysis and views on the market. MCR’s ABS business development director was responsible for identifying, contacting, and maintaining relationships with potential clients (including issuers and bankers who arrange deals), persuading potential clients to hire MCR to rate deals, and persuading investors to accept deals rated by MCR.

Why did Morningstar not separate analysts from sales?

Could it be money? MCR’s written policies and procedures failed sufficiently to address and manage the conflict of interest relating to sales and marketing prohibited by Rule 17g-5(c)(8)(i). In fact, its Analytical Firewall Policy and Code of Conduct only prohibited analysts from discussing fees for ratings services or negotiating engagement terms. It did not prohibit analysts from engaging in other sales and marketing activities.

So, in July 2015. MCR’s ABS business development director requested one of the company’s analysts to attend a prospect company’s event in his stead. After the event, the analyst followed up with an email pitch to the CEO of Company, saying, “As discussed, we would love to meet you and the team to show you how we are different. We have recently rated an unsecured consumer loan-backed transaction, and have a strategic focus on emerging and esoteric assets…Please let us know who on your team can help us set up a brief introductory meeting.”

The analyst copied the ABS business development director on his email and the director later used that email as a prompt to pursue the company as a prospective client further. According to the ABS business development director, the analysts’ communications with the company were efforts to market MCR’s ABS ratings services.

What happened if a company was nonresponsive?

In one instance, an analyst undertook extensive efforts to recruit an issuer in the ABS marketplace as an MCR client. He noted that MCR was “very interested in putting its experience/knowledge in structured settlement ABS to work,” and expressed the hope that MCR would be “given the chance to assist in future ratings (whether your upcoming ABS or the anticipated residual securitization that is contemplated).”

When the company failed to respond to follow-up contacts, the analysts further offered to provide the prospect company with an indicative rating on a security that the company had issued. When the company did not respond to that follow-up, the analyst wrote and published a commentary on the credit strength of certain notes in the company’s deals, and to follow up with the company again after the publishing the commentary—all to secure the business. MCR was eventually hired to rate one of the company’s securitizations.

The credit ratings agency cooperated with the SEC’s investigation and believed the settlement was in the company’s “best interest,” according to a Morningstar release concerning the settlement.

“There are no allegations that any credit ratings issued by the MCR were affected by the conduct described in the settlement,” the statement read. “MCR takes its regulatory obligations seriously, and the integrity of its credit ratings is of paramount importance.”

“Senior MCR managers and the ABS analytical staff received regular reports on the status of MCR’s client recruitment efforts, including sales and marketing by ABS analysts,” the SEC order read. “In self-evaluations, ABS analysts touted their business development efforts.”

Morningstar did not agree or deny the charges in the order. It was censured and agreed to update its policies and conduct training to avoid instances like those described in the order.

Could Morningstar’s costly lack-of-oversight have been avoided?

Yes. A vigilant, well-run compliance system can spot irregularities and give an attentive compliance team a chance to nip exposures before they get out of hand. Patrina can help. We’ve built our business based on helping organizations keep track of “bad apples,” and stay on the “straight and narrow” efficiently and cost-effectively. So, let’s talk. Call 212-233-1155 to ask about Patrina’s cost-effective systems specifically designed for the financial services and insurance industries. Be smart. Be covered. Let’s talk.