Federal Court partially rules in SEC’s favor in lawsuit against legacy Morningstar Credit Ratings
A federal court has allowed parts of a Securities and
Exchange Commission (SEC) complaint against the former credit rating agency
Morningstar Credit Ratings to continue, saying that the former independent
rating agency failed to adequately provide investors with a general
understanding of its CMBS rating methodology or exert proper internal controls.
Morningstar acted in a way that put investors at a
disadvantage when assessing risks on $30 billion in commercial mortgage-backed
securities (CMBS) between 2015 and 2016, the regulator claimed.
In its initial response, Morningstar said the SEC violated
its legally protected independence as a credit rating agency, and was an
attempt to exert undue control over Morningstar through regulations.
U.S. District Judge Ronnie Abrams in Manhattan wrote that
Morningstar failed to implement effective internal controls, according to an
opinion and order issued on January 5.
The court agreed with the SEC’s claim that Morningstar
lacked criteria for how, why or when analysts could make certain loan-specific
adjustments to ratings. Morningstar ended up applying these individual
adjustments on a portfolio-wide basis, which contravened Morningstar’s claim
that they were loan-specific.
“A control structure governing adherence to a methodology
cannot be said to exist or be effective if the controls that govern adherence
to the components of that methodology are themselves nonexistent or
ineffective,” Abrams wrote in the opinion. “After all, what is a control
structure made of if not one or more individual controls?”
It was not a complete victory for the SEC, however. The federal
court also found that the regulator failed to demonstrate how Morningstar
failed to identify the methodology it used to determine individual credit
ratings.
“Neither the text of the regulation nor the SEC’s commentary
on it suggests that ‘identification’ should be read to mean “fully and
accurately describe,” or that there is a specific amount of “further
information” that is necessary to satisfy the identification requirement,”
Abrams wrote.
In its initial response, Morningstar said that “the SEC is
attempting to impose a novel and unprecedented regulatory standard on MCR.” It
added that “SEC regulations require credit ratings agencies to provide only a
“general description of the procedures and methodologies” used in the ratings
process—not their entire model or every detail of their methodology.”
The court also denied the SEC’s request for a permanent
injunction. The SEC hadn’t reasonably argued that Morningstar would go on to
violate securities laws in the future, Abrams noted.
Morningstar noted that it had retired its CMBS rating
methodology in 2018, had withdrawn its SEC registration in December 2019 after
it acquired DBRS the previous July. It has no current credit ratings
outstanding.
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