SEC – Morningstar Litigate Validity of its Ratings Process

Seldom does the Commission litigate with a major business entity. Conventional wisdom says that the cost in terms of executive time, the distraction and of course the legal fees to contest an agency enforcement action are not worth it. The prudent course is to settle, pay the fines and move on. Yet recently, a major credit rating agency chose not to settle with the agency. Rather, an enforcement action was filed claiming disclosure violations and inadequate internal controls. The case is in litigation. SEC v. Morningstar Credit Ratings, LLC, No. 1:21-cv-01359 (S.D.N.Y. Filed February 16, 2021).

Morningstar is a New York City based nationally recognized statistical ratings organization. The credit rating agency, along with affiliate DBRS, Inc. whose ratings services are integrated with those of Morningstar, is a wholly owned subsidiary of Morningstar, Inc. The parent’s shares are traded on Nasdaq Global Select Market.

This action centers on ratings for $30 billion of commercial mortgage-backed securities for 30 transactions. The ratings and transactions span a two-year period beginning in 2015.

Morningstar used a two-step process to prepare the ratings. The first step focused on key cash flow and valuation amounts for the properties and associated values backing the securities. The second employed a subordination process and model. The results from the two steps, each of which was disclosed, spawned the ratings. Those ratings are viewed as a crucial step in the sales process for the “certificates” issued on the securities.

In the first step, the firm underwrote a representative sample of the pool of commercial real estate loans that collateralized each CMBS transaction. Morningstar calculated the expected net cash flow that each commercial property would generate over the life of the loan. This step was disclosed and published on the firm’s website.

The second step – the subordination step and model – was also disclosed on the website. Here the cash flow and the capitalization rate were put on an excel spreadsheet. The Subordination Model was used to subject the values to what are called “defined sets of stresses.” The point is to determine the likelihood of default under select stresses. The result is expressed as a percentage.

What was not disclosed were certain loan specific adjustments made during step two of the process. The adjustments were made on the excel spreadsheet that reflected the model used in the step. There were no guidelines to direct the analysts making the adjustments. The model did not constrain how the analyst made the adjustments or the size.

The loan specific adjustments had a material impact. Most of the adjustments decreased the stress. The result was an increase in the rating. The net impact was that “investors were not able to assess the ratings determined by Morningstar and their associated risks.” The ratings that resulted from the process were, however, beneficial to those who paid for them.

The firm failed to disclose the adjustments or identify them on forms filed with the Commission. Morningstar also did not have effective internal controls regarding the use of the loan-specific adjustments. The complaint alleges violations of Exchange Act Section 15E(b)(2) and Rule 17g-1(f).