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SEC Sues Morningstar's Former Credit Ratings Agency

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The Securities and Exchange Commission has filed a civil suit against Morningstar Credit Ratings (MCR) for violations related to the ratings of 30 collateralized mortgage-backed securities in 2015 and 2016.

MCR ceased operations in late November 2020 after withdrawing all its credit ratings in October 2020 and its registration with the SEC in December 2019 and retiring its CMBS ratings methodology in 2018, according to a spokeswoman.

She said the SEC’s enforcement action relates solely to the legacy MCR, not to DBRS Morningstar, the credit ratings agency formed after Morningstar acquired the DBRS rating agency in July 2019.

The SEC’s Complaint

According to the SEC complaint, MCR violated disclosure and internal control provisions of the federal securities laws in rating commercial mortgage-backed securities when it permitted analysts to make undisclosed adjustments to key stresses in the model that it used in determining the rating for that transaction.

The undisclosed adjustments lowered the credit enhancement that Morningstar required for many of the ratings it awarded classes of the CMBS transactions, according to the SEC. These adjustments, in certain instances, benefited issuers because they could pay investors less interest as a result, the SEC says.

The complaint also alleges that Morningstar failed to establish and enforce an effective internal control structure governing the adjustments for a total of 31 transactions.

The SEC complaint was filed Tuesday in U.S. District Court for the Southern District of New York. It charges Morningstar with violating disclosure and internal control provisions of the Securities Exchange Act of 1934 applicable to credit rating agencies, and seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.

“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 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.”

Morningstar’s Response

In a rebuke to the SEC lawsuit, Morningstar issued a press release on Feb. 17, saying that MCR “complied with the regulatory requirements in question” while the SEC’s position is “inconsistent with its own rules and … policies” and that the agency has “overstepped its regulatory limitations by imposing requirements that would regulate the substance of credit rating methodologies.”

In an accompanying position paper, Morningstar said that by questioning MCR’s use of qualitative factors in its legacy CMBS ratings model, the SEC is “attempting to dictate the substance of MCR’s rating methodology,” which it is prohibited to do by law. “If the SEC believes additional rules are required — consistent with the analytical independence of a credit rating agency — the agency should go through the rule-making process, not file an action against MCR.”

Morningstar noted its cooperation with the SEC’s investigation, which dates back to February 2016, and its disappointment in the SEC for pursuing litigation.