August 5, 2011 is a day that will live in infamy in both the US and the world's financial history. In an unprecedented and unsolicited credit rating opinion, Standard & Poor's (S&P) downgraded US treasury bonds from a perfect AAA credit rating to a AA+ credit rating. Within a moment, US debt fell from grace and was no longer a risk-free investment. However, the US Department of the Treasury (DOT) refused to accept such a downgrade without justification. Once S&P explained that, at least according to its calculations, projected government deficit was too high, the DOT zeroed in on S&P's significant error. The credit rating agency overstated projected government deficit by $2.1 trillion.
Committing such an error seemed both ridiculous and ironic in light of the recent enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). One section of Dodd-Frank, 15 USC § 78o-7(r)(3)(C), requires that credit rating agencies notify users of their ratings when a "significant error" is identified in the credit rating process. Taken at face value this requirement appears to be an excellent way to keep investors apprised of information necessary to make informed investment decisions. However, neither Congress, nor the Securities and Exchange Commission (SEC), has defined what constitutes a significant error.
The SEC, therefore, should define significant error using the "materiality standard" that the US Supreme Court has consistently used in securities laws. That is, a significant error should be defined as any error that a reasonable investor would view as significantly changing the overall message of the information made available. Fortunately, Dodd-Frank's congressional findings regarding credit rating agencies support defining significant error using a materiality standard. In its findings, Congress stated that credit rating agencies are functionally similar to securities analysts and auditors. The SEC, moreover, has previously adopted the Supreme Court's materiality standard to regulate disclosures by financial statement auditors. Thus, the SEC should again be able to adopt that materiality standard to define significant error in order to regulate the disclosure of credit rating agencies.
Using a materiality standard to define significant error would also resolve an issue that has traditionally been associated with credit rating agencies' unsolicited opinions. In the past, credit rating agencies have been able to defend unsolicited and incorrect ratings by arguing these opinions are protected by the First Amendment. Milkovich v. Lorain Journal Co., an opinion that relates to matters of public interest and which does not contain a factual implication that is provably false, will have complete constitutional protection. How then can a credit rating, which is an opinion, ever contain a provably false factual implication? Defining significant error using a materiality standard will provide an opportunity to prove that a credit rating agency's unsolicited opinion contains a false factual implication. Such a definition of significant error would give credit rating agencies the ability to discern when an error would significantly change the overall message of the information made available to a reasonable investor. If the credit rating agency knows of such an error, fails to disclose it and publishes an opinion based on it, the error would be a provably false fact and would eliminate the opinion's First Amendment protection.
Defining significant error using a materiality standard will also aid the SEC in utilizing its penalization authority over credit rating agencies. It will provide an external measure that the SEC can use to determine the severity of a penalty. For example, in regard to the US downgrade, S&P completely disregarded its $2 trillion mistake in calculating the US's projected deficit by saying it was unimportant. Given that the agency said the reduction of the deficit was $2 trillion too small, it is likely a reasonable investor would consider a mistake, which overstated projected deficits by $2 trillion, as significantly changing the overall message of the information made available. Therefore, such a large mistake may validate the SEC in requiring S&P to reevaluate the credit rating of US treasury bonds. The credit rating agency should also be required, in a private and confidential procedure, to disclose to the DOT the calculations and assumptions it used during the reevaluation. Admittedly, such a penalty may be brushing the line that strives to prevent government influence over private enterprises, however, a private company would be required to reissue a corrected annual report in the event it published one filled with significant errors.
The historical downgrade of US treasury bonds in S&P's unsolicited opinion illustrates why defining significant error is necessary. Although the credit rating agency acknowledged its mistake, it labeled the error as unimportant in an effort to avoid compliance with 15 USC § 78o-7(r)(3)(C). Had Dodd-Frank defined significant error using the proposed materiality standard, such an action would have been illegal and would have enabled the SEC to levy penalties against S&P. The agency would have been required, pursuant to 15 USC § 78o-7(r)(3)(C), to disclose the error and in turn would have been required to reevaluate its unsolicited rating.
However, without an established definition of significant error, as S&P's August 5, 2011, downgrade demonstrates, credit rating agencies will continue to describe significant errors as unimportant and continue to avoid compliance with 15 USC § 78o-7(r)(3)(C).
Anthony Constatine is an executive articles editor on the Journal of Civil Rights and Economic Development. Constantine's experience includes internships with the Bronx County District Attorney's Office, New York State Office of the Inspector General, St. John University's School of Law Elder Law Clinic and the STV Group, Inc.
Suggested citation: Anthony Constatine, 'Significant Error' in Dodd-Frank Relating to Credit Agencies' Rating Methodologies, JURIST - Dateline, Oct. 29, 2012, http://jurist.org/dateline/2012/10/anthony-constatine-financial-crisis.php.
This article was prepared for publication by Michael Micsky, an associate editor for JURIST's student commentary service. Please direct any questions or comments to him at email@example.com