Dodd-Frank Wrinkle Reshapes Rating Process
Asset-Backed Alert (August 6, 2010)
Rating agencies are asking issuers and underwriters of asset-backed bonds to insure them against damages from investor lawsuits, with mixed results.
Moody's, S&P, Fitch and DBRS have each either made or considered such a request. The culprit is a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as section 933, that makes it easier for bondholders to pursue fraud complaints against rating agencies.
The change means buysiders need only demonstrate to the courts that the shops failed to base their evaluations on reasonable investigations or verifications of underlying data. They no longer must provide evidence of intentional deception.
What the major rating agencies want is for issuers and underwriters to indemnify them against potential damages, in a more extensive and specific manner than those players have granted in the past. That is, the agencies want issuers and underwriters to absorb any costs stemming from lawsuits over ratings of their deals.
Some issuers have agreed. Others are pushing back. For example, one source said Goldman Sachs resisted a request by S&P that it supply indemnification on a recent deal. But that dispute may have involved an insistence on Goldman's part that it retain the right to seek unlimited damages from S&P if the bank were to lose a rating-related lawsuit. S&P, meanwhile, wanted to cap its liability.
While the outcome of that disagreement remains unclear, additional impasses over rating-agency indemnification may be part of the reason asset-backed bond supply has remained at a trickle since Dodd-Frank bill was signed into law on July 21.
That would represent something of a compound effect. Section 933 is separate from the higher-profile section 939G, which essentially holds rating agencies liable for grades listed in SEC documents. That measure initially brought issuance to a halt with the Dodd-Frank act's passage - as the agencies responded by blocking publication of their reviews even though such information was required of issuers under the SEC's Regulation AB.
That matter also saw some talk of rating-agency indemnification. But it was put to rest, at least temporarily, when the SEC agreed on July 22 to suspend rating-publication requirements in Reg AB.
However, section 933 isn't contingent on whether grades are included in SEC documents. Instead, it applies to any statements made by rating agencies, including press releases and presale reports. "We now have a different liability standard than any other market participant," one rating executive said.
Indemnity agreements with issuers and underwriters are spelled out in rating-engagement letters. Securitization attorneys say the agencies are now demanding stronger language, including detailed explanations of the legal costs and damages they can recover from issuers and underwriters. In doing so, they are creating direct contractual obligations that didn't exist in the past.
An S&P spokesman acknowledged that the agency "periodically updates the terms of its engagement agreements with issuers, and S&P has entered into revised agreements with many issuers over the last several months."
An official at another agency said his firm has strengthened its indemnification requirements in response to a general sense that legislative and regulatory shifts could bring greater liability, as opposed to specific concerns about section 933.
The rating agencies are also looking at other measures. They might include hiring outside auditors to verify issuer information, although it's unclear how those reviews would be handled or who would pay. It's also possible that the agencies will be more selective about the issuers whose deals they grade.