"It could be structured by cows and we would rate it."
--Standard & Poor's analyst (1)
When two Bear Steams hedge funds collapsed in July 2007, it quickly became clear that investment products tied to subprime mortgage loans were overvalued. (2) What little was left of the once-booming business of structuring complex securities and collateralized debt obligations came to a screeching halt. The market for these investment products dried up and investors watched as the ratings agencies finally slashed credit ratings. (3) Unfortunately, for most it was already too late to withdraw. Investors suffered crippling losses on supposedly safe investment products that bore the stamps of ratings-agency approval. How could this have happened? Weren't the ratings agencies supposed to prevent just this kind of marketwide valuation crisis? What were these gatekeepers doing with nonpublic information if not protecting the investing public? The ratings agencies became the target of scholarly, political, and mass-media censure. (4) Critics began to reevaluate the role of the ratings agencies and how the regulatory framework in which they operate did not adequately control misconduct.
Despite this widespread and often scathing criticism of the credit ratings agencies (CRAs) (5) for their role in the subprime and credit crises, there have been no criminal prosecutions for CRA misconduct. (6) The ratings agencies have taken a major blow in the court of public opinion, (7) and investor confidence in their ratings has plummeted. (8) Civil litigation against the CRAs has marched forward: individual investors have sued the CRAs in lawsuits for negligence, fraud, and deceit; (9) class actions have named the CRAs as co-defendants; (10) and the federal government has sued the CRAs for civil violations. (11) The failures of the ratings agencies precipitated a push for regulatory reform, (12) but the possibility of reshaping or strengthening the criminal disincentives that control the ratings agencies has not been under serious consideration. (13) The integrity of our markets is so dependent on the good faith of the CRAs that their wrongdoing, which we might elsewhere address with civil liability, should face stricter criminal disincentives. The absence of any criminal prosecutions, let alone convictions, under the existing law should signal to Congress that the existing criminal law is not providing a sufficient check on the ratings agencies.
Not only the CRAs but the entire financial sector faced public and academic scrutiny for the credit crisis. The investing public was furious at Wall Street when the economy began to cave in; many wanted heads on the chopping block. (14) Many top executives seemed to be in a vulnerable position, widely despised for their complicity. From an outsider's perspective, it looked like criminal prosecutions might bring some catharsis to the investors who suffered catastrophic losses. But as the crisis wore on and court dockets filled up with complex civil cases seeking damages, the high-stakes white-collar criminal cases that many anticipated did not materialize. (15) At first glance, potential white-collar criminal cases looked promising. There were substantial harms caused by decisions and actions of high-level market players: the only hurdle for prosecutors was proving the requisite mens rea of knowledge or intent. (16) And yet only a handful of cases went forward. (17)
This Comment argues that misconduct at the ratings agencies should be subject to criminal punishment even absent a mens rea of knowledge or intent. (18) When the entire investing public bears a risk of catastrophic losses for misconduct at the ratings agencies, there should be a strict criminal code controlling that conduct. The integrity of the markets depends on accurate credit ratings provided in good faith. With the stakes so high, criminal sanctions are justified both as deterrents and as desert for the wrongdoers. Traditional theories of punishment generally fall into two categories: (1) utilitarianism and (2) retributive justice. (19) From a utilitarian perspective, the financial crisis was a perfect opportunity to exact punishments that deter future misconduct. There were market players who needed stronger deterrence at all levels of the market, from mortgage brokers all the way up to CEOs of bulge-bracket banks.
The case for retributive justice is perhaps even stronger with so many millions of people suffering harm from the misconduct: not only did investors around the world suffer huge losses, but also the job market constricted, foreclosures skyrocketed, and citizens across the country became collaterally damaged. (20) The scene was set for a series of heated trials to captivate the public consciousness and restore some faith in the rule of law. But as of yet, no high-profile criminal cases have made it onto the dockets.
This Comment examines why there have been no prosecutions against individuals at the ratings agencies. The ratings agencies have a long and storied history in the American markets that dates back more than a century. (21) Part II of this Comment will explain how the CRAs operate, paying particular attention to their role leading up to the subprime and credit crises. This section will also describe how flaws in the CRA model led to their complicity in the crisis and will briefly outline some of the suggestions that scholars and politicians have offered to fix the ratings agencies.
Part III argues that the existing criminal law is not adequately deterring misconduct by CRAs. Subpart III.A will analyze criminal liability under the existing law. This section will focus on the difficulty of establishing mens rea and the causation component of criminal liability. The progress of civil suits against the ratings agencies indicates that a prosecutor could prove the actus reus (22) elements of a crime. The case for causation is slightly more difficult because there were so many factors at play in the decline and fall of the subprime and credit markets. However, the most significant barrier to a criminal conviction is the existing mens rea requirement of knowledge or intent. (23)
After exploring the theories of criminality, subpart III.B will propose a stronger set of criminal disincentives. This section will recommend that Congress enact a narrowly tailored federal criminal law targeted at the ratings industry. This Comment argues that such a law would be both more efficient and effective than a purely civil regulatory regime, and justifiable under traditional theories of criminal punishment. (24) Although a more stringent civil regulatory system could deter misconduct by the CRAs, compliance with civil regulations would drive up systematic costs. Strict civil regulations are expensive and not necessarily effective. (25) Moreover, criminal punishment of wrongdoing in the ratings industry is justifiable in light of the high stakes. CRA actors can currently hide behind the sophistication of the rating process to defend against a criminal charge that requires knowledge or intent. Thus, I propose a criminal law prohibiting misconduct at the CRAs that requires only a mens rea of recklessness.
The subprime market collapse had immediate consequences on the financial sector. High-powered Wall Street executives were shown the door (26) and subprime lending shops were shut down. (27) Scholars, journalists, and politicians collectively tried to explain how the walls came tumbling down. (28) The causes identified include (1) high-risk, experimental structured finance, including complex instruments such as collateralized debt obligations and mortgage-backed securities, (2) the iron fist of mark-to-market accounting, and (3) recklessly loose lending standards. (29) In the search for villains, most scholars and critics agree that the storm would not have been nearly so fierce were it not for the failures of the credit ratings agencies. (30)
THE AMERICAN CREDIT RATINGS AGENCIES: THE DEBT MARKET'S TRIUMVIRATE
This Comment provides an abridged version of the interesting history of the CRAs and the circumstances that resulted in our current credit ratings system. (31) The ratings agencies' primary role in the credit markets is to provide information about the creditworthiness of securities and other debt instruments that are bought and sold. (32) The credit ratings industry has been dominated by three players--Standard & Poor's, Moody's Investors Service, and Fitch Ratings--and until recently, they were the "only three with an official stamp of approval from the SEC, designated as nationally recognised statistical-rating organisations, or NRSROs." (33) These agencies are supposed to serve a crucial function to investors--that of gatekeepers--a function in which they wholly failed leading up to the financial crisis. (34) For any given corporation or security, the CRAs use information, including "the issuer's quality of assets, its existing liabilities, its borrowing and repayment history and its overall business performance," to generate a credit rating. (35) These ratings provide investors a barometer to evaluate the risk and probability of repayment of a security. (36) Investors are free to perform their own due diligence on most of the information available to the CRAs; however, the ratings agencies have access to some nonpublic information that gives them a distinct advantage. (37) The CRAs have carved out a space in the market as specialized intermediaries, assessing risk based on both public and nonpublic information. (38)
The agencies take in specific information and process it according to specific protocols; (39) this assembly-line feature of the ratings industry provides a solid shield against criminal liability. The analysts and executives can blame their own failures on the mechanics of their risk-models, and the standardized process offers a promising method of defeating the mens tea...