Smells Like 2008 Spirit: SEC Charges Morningstar Credit Ratings

Morningstar Credit Ratings LLC is under fire after being charged with violating disclosure and internal controls provisions of the federal securities laws in rating commercial mortgage-backed securities (CMBS).

The Securities and Exchange Commission alleged that 30 commercial mortgage-backed securities (CMBS) transactions totaling $30 billion that Morningstar rated from 2015 to 2016 suffered undisclosed adjustments.

Analysts frequently made undisclosed adjustments to reduce the stress applied in the model in order to benefit the issuers that paid for the ratings because it enabled those issuers to pay investors less interest than they would have without the adjustments, said the SEC.

Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, commented: “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. 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 is charged with violating disclosure and internal control provisions of the Securities Exchange Act of 1934 applicable to credit rating agencies. The regulator seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.

The subprime crisis and the role of credit agencies in the collapse of the financial system are still very vivid memories. The size of Morningstar Credit Ratings’ “adjustments” – 30 commercial mortgage-backed securities (CMBS) transactions totaling $30 billion – are peanuts compared to what happened back in 2008.

U.S. law requires rating agencies to disclose their ratings methodologies and stick to those frameworks. Morningstar previously paid $3.5 million to settle SEC charges it violating conflict of interest rules designed to separate credit ratings and analysis from sales and marketing.

It was in 2019 that Morningstar acquired Canada-based DBRS, the fourth largest credit ratings agency in the world, for $669 million funded with a mix of cash and debt. The deal allowed Morningstar Credit Ratings to expand from its U.S. operations to a worldwide business, including global asset class coverage.

At the time, DBRS reported $167 million in revenue for the fiscal year ended November 30, 2018, which represented approximately 17% of Morningstar’s total revenue.