Morningstar to pay $3.5M for conflicts of interest violations

According to the SEC’s order, filed Friday, from mid-2015 through September 2016, credit rating analysts in Morningstar’s asset-backed securities (ABS) group engaged in sales and marketing to prospective clients. The SEC alleged Morningstar’s then-director of business development for ABS “often encouraged and directed” analysts to identify business targets and pursue them through marketing calls, meetings, and offers “to provide indicative ratings to potential clients and had follow-up communications and interactions with prospective clients, all for the purpose of persuading potential clients to hire MCR to rate ABS.”

“For example, an ABS analyst at MCR wrote a commentary specifically aimed at a particular issuer and sent it to the issuer with the purpose of persuading the issuer to become a client of MCR,” the SEC order stated. “In certain instances, ABS analysts at MCR made multiple solicitations to prospective clients over the course of months. These activities were undertaken with the knowledge of other senior MCR managers.”

The order further finds Morningstar issued and maintained ABS ratings for certain entities where an analyst who participated in determining or monitoring the credit rating also participated in the sales or marketing of a Morningstar product or service. In addition, the order finds between at least June 2015 and November 2016, Morningstar failed to maintain written policies and procedures reasonably designed to sufficiently separate the firm’s analytical and business development functions.

“Credit rating agencies must be vigilant to prevent potential conflicts of interest between their ratings functions and their sales and marketing activities,” said Daniel Michael, chief of the SEC Enforcement Division’s Complex Financial Instruments Unit. “As the SEC’s order finds, Morningstar sometimes enlisted its analysts in business development efforts, introducing the exact conflict of interest that the rule is intended to eliminate.”

The SEC’s order finds Morningstar violated Rule 17g-5(c)(8)(i), which prohibits a rating agency from issuing or maintaining a credit rating where an analyst who participates in determining or monitoring credit ratings also participates in sales and marketing activity, and Section 15E(h)(1) of the Securities Exchange Act of 1934, which requires credit rating agencies to establish, maintain, and enforce policies and procedures reasonably designed to address and manage conflicts of interest.

Morningstar responds

Morningstar (MCR) neither admitted nor denied the findings. In a statement, the company said it “cooperated with the SEC’s multiyear investigation and believes the settlement is in the best interest of the company. There are no allegations that any credit ratings issued by MCR were affected by the conduct described in the settlement.”

“MCR takes its regulatory obligations seriously, and the integrity of its credit ratings is of paramount importance,” the credit rating agency added. “As part of its integration with DBRS, which Morningstar acquired last year and well after the investigated activity took place, the combined DBRS Morningstar has enhanced and will further strengthen policies, procedures, and internal controls. It will also conduct additional training to reinforce compliance with regulations.”

Broader issue

Enforcement actions like the Morningstar case fit into a broader problem with controlling conflicts of interest. “As the coronavirus pandemic sweeps over the country, we see fresh evidence that inflated credit ratings are again contributing to chaos in the financial markets,” said Stephen Hall, legal director and securities specialist for Better Markets, a non-profit group founded in the wake of the 2008 financial crisis to promote the public interest in the financial markets.

“Waves of credit rating downgrades appear almost daily, and we’re seeing reports that the dominant firms continue to inflate ratings to win and retain lucrative business from companies that need high marks for their investment offerings,” Hall added. “These conflicts of interest lure countless unsuspecting investors into risky and complex investments. They also lead to the dramatic downgrades we’re seeing today, which intensify market instability.”

In the 2010 Dodd-Frank Act, Congress required the SEC to fix the problem by implementing a new assignment system, but the SEC never followed through, Hall said. Better Markets has issued a fact sheet, calling upon the SEC to eliminate such conflicts of interest.