Federal Court partially rules in SEC’s favor in lawsuit against legacy Morningstar Credit Ratings

A federal court has allowed parts of a Securities and Exchange Commission (SEC) complaint against the former credit rating agency Morningstar Credit Ratings to continue, saying that the former independent rating agency failed to adequately provide investors with a general understanding of its CMBS rating methodology or exert proper internal controls.

Morningstar acted in a way that put investors at a disadvantage when assessing risks on $30 billion in commercial mortgage-backed securities (CMBS) between 2015 and 2016, the regulator claimed.

In its initial response, Morningstar said the SEC violated its legally protected independence as a credit rating agency, and was an attempt to exert undue control over Morningstar through regulations.

U.S. District Judge Ronnie Abrams in Manhattan wrote that Morningstar failed to implement effective internal controls, according to an opinion and order issued on January 5.

The court agreed with the SEC’s claim that Morningstar lacked criteria for how, why or when analysts could make certain loan-specific adjustments to ratings. Morningstar ended up applying these individual adjustments on a portfolio-wide basis, which contravened Morningstar’s claim that they were loan-specific.

“A control structure governing adherence to a methodology cannot be said to exist or be effective if the controls that govern adherence to the components of that methodology are themselves nonexistent or ineffective,” Abrams wrote in the opinion. “After all, what is a control structure made of if not one or more individual controls?”

It was not a complete victory for the SEC, however. The federal court also found that the regulator failed to demonstrate how Morningstar failed to identify the methodology it used to determine individual credit ratings.

“Neither the text of the regulation nor the SEC’s commentary on it suggests that ‘identification’ should be read to mean “fully and accurately describe,” or that there is a specific amount of “further information” that is necessary to satisfy the identification requirement,” Abrams wrote.

In its initial response, Morningstar said that “the SEC is attempting to impose a novel and unprecedented regulatory standard on MCR.” It added that “SEC regulations require credit ratings agencies to provide only a “general description of the procedures and methodologies” used in the ratings process—not their entire model or every detail of their methodology.”

The court also denied the SEC’s request for a permanent injunction. The SEC hadn’t reasonably argued that Morningstar would go on to violate securities laws in the future, Abrams noted.

Morningstar noted that it had retired its CMBS rating methodology in 2018, had withdrawn its SEC registration in December 2019 after it acquired DBRS the previous July. It has no current credit ratings outstanding.

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