‘X-Rated’: SEC Sues Morningstar
On Tuesday, February 16, 2021, the U.S. Securities and Exchange Commission (“SEC”) filed a civil lawsuit in the U.S. Federal District Court for the Southern District of New York against Morningstar Credit Ratings LLC for “violating disclosure and internal controls provisions in rating commercial mortgage-backed securities (‘CMBS’).” Morningstar, Inc., is a diversified financial services firm founded in 1984, which went public in 2005. As it grew it added new financial services. In 2010, Morningstar, Inc., acquired Realpoint, LLC, which had been a privately-owned, nationally-recognized statistical rating organization. Realpoint was renamed Morningstar Credit Ratings LLC (“Morningstar”) and provides research and ratings of structured debt products, including mortgage-backed securities and asset-backed securities including CMBS, RMBS, and CLO’s. On May 29, 2019, Morningstar acquired Dominion Bond Rating Service of Toronto, Canada, to significantly expand both its rating services and its geographic reach. In October 2017, the Wall Street Journal published a front-page feature story criticizing Morningstar’s influence in rating these types of securities and questioning the predictive accuracy of its ratings systems.
SEC Sues Morningstar
Now the SEC has alleged, essentially, that the Wall Street Journal’s story was correct. The SEC’s complaint alleges that in 30 CMBS transactions totaling $30 billion, rated from 2015 to 2016, Morningstar permitted analysts to make undisclosed adjustments to key parts in the Morningstar model that it used to rate those securities. According to the complaint, the SEC alleges that the analyst eased the stress points in the rating model, which allowed Morningstar to reduce the amount of credit enhancements Morningstar required for the level of Morningstar rating. The SEC alleges that this benefitted the issuers of those securities by allowing those issuers to sell the securities with a lower rate of interest than they otherwise would have had to pay.
The complaint also alleges that Morningstar failed to establish and enforce an effective internal control structure governing these undisclosed adjustments in a total of 31 transactions. The SEC’s February 16, 2021, Press Release includes a statement from Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit:
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. In this action, the complaint alleges that Morningstar failed on both counts by permitting analysts to make undisclosed adjustments over which Mornningstar had no effective internal controls.
Rating agencies like Morningstar can be a key to both the success and cost of any issuance of these complex securities. In response to the Great Recession of 2007-2009 and the passage of the Dodd-Frank Act in 2010, substantial new regulatory requirements concerning rating agencies were adopted. One of the abuses identified as facilitating the financial market collapse in the Great Recession was the inflated rating of Mortgage-Backed Securities, Collateralized Debt Obligations, and similarly structured securities. When the rater is corrupt, it is the investor who suffers.