Mortgage Meltdown

New SEC Chair Weighs In On Ratings Agencies

The credit rating agencies that provided securities packaging subprime mortgages with investment grade ratings have been in the cross-hairs of regulators and plaintiffs since the mortgage meltdown first began in the spring and summer of 2007.  Yet very little has been done to change the way that they are regulated.

So last week new SEC Chairwoman Mary Schapiro hosted a round table on what more should be done.  Many see the fundamental problem with the current structure is that the rating agencies are generally paid by the issuer or underwriting of the security they are asked to rate.  This "issuer-paid model" accounts for 98% of all bond ratings.  There is an inherent conflict of interest in this model, where issuers will shop around for the highest rating.

Although the SEC has adopted some new regulations to address this conflict of interest problem (for example prohibiting any employee involved in rating a issue to also be involved in the fee negotiations), Ms. Schapiro acknowledged there was more to do.  Many of the proposals at the meeting focused on solving this conflict of interest dilemma.  Some participants suggested all firms should be required to switch to an investor based model, or have the rating fees paid out of a portion of the bonds' interest payments.  Others went further, suggesting that a new regulatory body, similar to the Public Accounting Oversight Board (PCAOB), should oversee rating agencies.

Ms. Schapiro suggested that the structure the SEC set in place when it settled a 2003 enforcement action with ten of the largest investment banks could be applied to rating agencies as well.  The settlement, which resolved claims that the investment banks provided slanted research in companies in which they had a financial interest, required the banks to distribute independent research along with the firm's own research in certain circumstances.

Legislators are apparently getting involved as well.  According to a Wall Street Journal article (here), Senator Schumer is considering introducing a bill that would require rating agencies to separate any consulting business from the ratings business.  Another Senator, Jack Reed, would outsource the regulation to the class-action bar.  He supports passing legislation that would make it easier for investors to bring class action securities lawsuits against the rating agencies (rating agencies have traditionally had success asserting a first amendment privilege, claiming that, like a newspaper, they simply provide information to the public).

Putting the legislative proposals aside, I think that the PCAOB-like oversight structure may be worth pursuing, particularly if nothing is done about changing the issuer-paid model.  Moreover, the issuer-paid model does seem to support capital formation by allowing the most bonds to get ratings, so we may not want to do away with it entirely.

Coverage of the roundtable is available here, here and here.

New Century Financial Creditors Seek Over Billion Dollars From KPMG

In a what big four auditing firm KPMG would hope was just an April fools day prank, on April 1st a liquidating trust formed for the benefit of creditors in the New Century Financial bankruptcy has initiated a lawsuit against the company's auditor alleging damages in excess of $1 billion.  New Century was one of the largest subprime lenders, until it restated its financial statements in early 2007 which caused the flow of credit required to originate loans to dry up.  New Century filed for bankruptcy only a few months later, in April 2007.  The bankruptcy court appointed an examiner, who investigated the reasons for New Century's collapse.  The reportwas critical of KPMG's work.

KPMG is already a defendant in a securities class action lawsuit based largely on the bankruptcy examiner's report.  Now, New Century's creditors are taking a run at the auditors in two different lawsuits.  The first (here) was filed in California state court against KPMG LLP, the American audit partnership, that performed the audit work for New Century.  The second (here) was filed in federal court in New York against KPMG International, the parent entity of KPMG LLP.

Aside from any factual issues about the audit work, there are several interesting legal issues that should impact the case.  First, as the the California action, KPMG's agreement with New Century contained an arbitration clause.  The complaint alleges that the clause contains a prohibition on punitive damages, which are illegal under California law and which therefore invalidates the entire arbitration provision.  KPMG will certainly argue that even if the punitive damages clause in unenforceable, this should not invalidate the entire arbitration provision.  Next, the liquidating trust has asserted claims for aiding and abetting breaches of fiduciary duty by New Century management.  This claim may be barred by the legal doctrine of in pari delicto, which means that when two or more actors are at fault for the same damage one actor should not be able to sue the other.  Advisers to company's have successfully asserted this defense early on in similar litigation.  When a company's officers are alleged to have acted improperly, those actions typically get imputed to the corporation because it can only act through its managers.  Therefore, the argument provides that the liquidating trust, which stands in the shoes of the corporation, cannot sue an outside adviser for participating in the same wrong that the corporation knew about.  The argument has not been universally accepted, however.

The New York action is based on the legal theory that KPMG LLP is an agent of KPMG International.  It effectively seeks to pierce the corporate veil of KPMG International, which can be done under certain circumstances.  I think that the liquidating trust is fighting in uphill battle in this case.