The Securities and Exchange Commission (SEC) has filed a civil action against Morningstar Credit Ratings (MCR) alleging the former credit ratings agency violated disclosure and internal controls provisions of the federal securities laws in rating commercial mortgage-backed securities (CMBS).

The details: According to the SEC’s complaint, filed Tuesday in federal district court in the Southern District of New York, MCR violated disclosure requirements when it rated $30 billion in 30 CMBS transactions, from at least 2015 to 2016. Specifically, MCR failed to disclose the CMBS rating methodology it used “permitted analysts to make undisclosed adjustments to key stresses in the model that it used in determining the rating for that transaction,” the SEC said.

“By using the undisclosed adjustments, Morningstar often lowered the credit enhancement for many classes of certificates of the CMBS transactions that it rated,” the complaint states. “This allowed Morningstar to assign higher credit ratings to those classes to the benefit of the issuers that hired and paid Morningstar.”

The SEC complaint further alleges MCR “failed to establish and enforce an effective internal control structure governing the adjustments in at least 31 CMBS transactions,” because MCR’s internal control structure “omitted elements designed to assess whether its analysts appropriately implemented the ‘loan-specific’ stress adjustments,” the complaint stated.

The SEC charges MCR with violating disclosure and internal control provisions of the Securities Exchange Act of 1934 applicable to credit-rating agencies and is seeking injunctive relief, disgorgement with prejudgment interest, and civil penalties.

Compliance message: “To increase transparency and guard against conflicts of interest, the federal securities laws require credit rating agencies to disclose how ratings are determined and to have effective internal controls to ensure they adhere to their ratings methodologies,” said Daniel Michael, chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, in a press release. “In this action, the complaint alleges that Morningstar failed on both counts by permitting analysts to make undisclosed adjustments over which Morningstar had no effective internal controls.”

This is not the only run-in MCR has had with the SEC. In May 2020, MCR reached a $3.5 million settlement with the Commission for violating a conflict of interest rule designed to separate credit ratings and analysis from sales and marketing efforts.

Morningstar response

In response to an e-mail inquiry to the SEC lawsuit, an MCR spokesperson responded, “Analytical independence is a cornerstone of the diversity of opinion in credit ratings. U.S. federal securities laws guarantee the analytical independence of credit rating agencies. In this case, the SEC overstepped its regulatory limitations by imposing requirements that would regulate the substance of credit-rating methodologies. Morningstar prides itself on the integrity and independence of its research and analysis.”

The response continued, “To clarify, the complaint relates to MCR’s legacy commercial mortgage-backed securities rating methodology that was voluntarily retired in 2018. It was last used to rate a CMBS transaction in 2017. No MCR credit ratings are currently outstanding and MCR no longer issues or monitors credit ratings.”

“The SEC alleges technical violations of the rules that formerly applied to MCR when it was a credit rating agency. In fact, MCR complied with the regulatory requirements in question,” MCR said. “The SEC’s position in this case is inconsistent with its own rules and the SEC’s stated policies. The SEC does not allege that MCR improperly determined any credit rating or that there was any investor harm related to MCR’s use of its legacy methodology.

“Morningstar is committed to transparency of its ratings and methodologies. We’re reviewing the complaint and will look to provide more information as needed.”