Rebuilding the Fallen House of Cards: A New Approach to Regulating Credit Rating Agencies

Olivia Schmid, Rebuilding the Fallen House of Cards: A New Approach to Regulating Credit Rating Agencies, 2012 Colum. Bus. L. Rev. 994.

The financial crisis highlighted key problems in the structure and business model of credit rating agencies (“CRAs”).  With the growth of securitization and innovative, structured finance products, the inherent conflicts of interest present in the issuer-pays model followed by CRAs became even more problematic, as rating agencies faced greater competitive pressures to appease their clients—the issuers of debt—than they did when they were rating only corporate bonds.  Both the United States and the EU responded to these concerns with enhanced regulation.  In the Dodd-Frank Act, the United States mandated a study on the advantages of the so-called “Franken Proposal,” which would create a centralized government platform to assign issuers to rating agencies on a randomized basis.

This Note evaluates the Franken Proposal and its alternatives, rejecting them in favor of a new proposal, which consists of three primary elements: (1) a requirement that issuers obtain a vote from their largest institutional investors, the outcome of which would determine which CRA the issuer hires; (2) the creation of a governmental agency or a self-regulatory organization that evaluates and ranks the performance of individual CRAs; and (3) a requirement that issuers obtain a second rating from a better-performing CRA when they choose to hire one whose performance has proven inadequate for a particular asset class.

Requiring issuers to hire a rating agency chosen by voting investors ensures that CRAs will compete for the favor of investors rather than the conflicted issuers.  To help investors make educated voting decisions, a ranking of rating agency performance will give investors standardized information about the quality of the CRAs.  By requiring issuers who initially purchase a rating from a low-performing CRA to buy a second rating from a better-performing CRA, the penalty provision ensures that business will be diverted to the most efficient rating agencies.  This Note concludes that the new proposal is therefore a better solution than the Franken Proposal for the conflict of interest problem faced by CRAs.

Author Information

J.D. Candidate 2013, Columbia Law School; B.A. Economics 2010, Columbia College.