Regulators on Thursday proposed rules designed to stem conflicts of interest and provide more transparency for credit rating companies. They also proposed banning “flash orders,” which give some traders a split-second edge in buying or selling stocks.
The changes, which were opened to public comment for 60 days, could eventually be adopted by the agency, possibly with revisions.
The credit rating industry was widely faulted for its role in the subprime mortgage debacle and the financial crisis. The five members of the Securities and Exchange Commission voted at a public meeting to propose rules that could reshape an industry dominated by three firms: Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. Their practices would be opened wider to public view and subject to some restraints.
Regulators say they also hope to spur more competition in the rating industry, with possibly new entrants — as well as the other seven existing agencies — challenging the dominant firms. One of the SEC’s proposals is intended to bar companies from “shopping” for favorable ratings of their securities, by requiring companies to disclose whether they had received preliminary ratings from other agencies.
Meanwhile, flash orders have become a hot-button issue in recent weeks amid questions about transparency and fairness on Wall Street. A flash order refers to certain members of exchanges — often large institutions — buying and selling information about ongoing stock trades milliseconds before that information is made public.
Nasdaq OMX Group Inc., which operates the Nasdaq Stock Market, and the BATS exchange have voluntarily stopped using flash orders, which made up an estimated 3 percent of stock trading. The New York Stock Exchange has never used them.
In July, Sen. Charles Schumer, D-N.Y., had called on the SEC to ban flash orders, threatening legislation if it failed to act. “This proposal will once and for all get rid of flash trading, which if left untouched, could seriously undermine the fairness and transparency of our markets,” Schumer said in a statement Thursday.
The rating agencies are crucial financial gatekeepers, issuing ratings on the creditworthiness of public companies and securities. Their grades can be key factors in determining a company’s ability to raise or borrow money, and at what cost which securities will be purchased by banks, mutual funds, state pension funds or local governments.
But the rating agencies have been criticized for failing to identify risks in securities backed by subprime mortgages. They had to downgrade thousands of the securities last year as home-loan delinquencies soared and the value of those investments plummeted. The downgrades contributed to hundreds of billions in losses and writedowns at big banks and investment firms.
In a rule that was formally adopted Thursday, the agencies will have to disclose the history of their ratings actions, which normally include reasons for them, back to mid-2007 — when the SEC gained authority to regulate the agencies by law.
Also, agencies that are paid by companies to rate complex securities — such as those underpinned by mortgages or student loans, as opposed to more traditional corporate or municipal bonds — must now notify the other agencies that it is in the process of determining the rating.
Under another proposed rule, the agencies would have to publicly disclose every entity that paid for a credit rating. They also would have to provide more information about income earned from companies they rate.
“These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security,” SEC Chairman Mary Schapiro said before the vote. “That reliance did not serve them well over the last several years, and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process.”
In California, Attorney General Jerry Brown launched an investigation into the three big credit rating agencies to determine what role they might have played in the collapse of the financial markets. Brown said he had subpoenaed the three firms to determine whether they violated state law in “recklessly giving stellar ratings to shaky assets.”
In July, the California Public Employees’ Retirement System sued the agencies, saying they had lured the fund into bad investments. The nation’s largest public pension fund blames them for more than $1 billion in investment losses.
The SEC commissioners took their action during a week when memories of the collapse of Lehman Brothers a year ago were fresh in Washington.
“There is general consensus that the rating agencies contributed significantly to the damage and the widespread loss of confidence,” said Commissioner Luis Aguilar.
Spokesmen for Standard & Poor’s had no immediate comment. Representatives of Fitch and Moody’s couldn’t immediately be reached for comment. The three firms have said they already have taken steps to increase transparency and will continue to make further enhancements in the future.