WASHINGTON — Market participants are pushing back against attempts by Standard & Poor’s to rate municipal bond deals on the condition that the issuer agrees to accept both greater liability if the rating turns out to be faulty and an ongoing obligation to inform it of any material change to any information provided to the agency.
“I’ve heard from many of our members who are very concerned about these new contracts,” said Susan Gaffney, director of the Government Finance Officers Association’s federal liaison center here. “We’re hoping to have a conversation with [Standard & Poor’s] about the purpose of them to help provide our members with guidance.”
Concerns about the “terms and conditions” language in Standard & Poor’s rating documents have simmered for weeks and are similar to — but more nuanced than — the indemnification language that Moody’s Investors Service sought from issuers this summer.
Moody’s, which tried to pass onto municipal issuers the legal costs of practically any investor lawsuit resulting from its ratings even if the information the issuer provided was accurate, dropped its indemnification requests two months ago after market participants complained.
“This is similar to concerns we had with Moody’s language and I’ve heard that some of our members are reluctant to sign the contracts as they are presented,” Gaffney said.
While Standard & Poor’s is not asking for indemnification, it is writing its agreements so that it could sue the issuer if any information the issuer or its agents provided contained material misstatements or omissions — the same high standard as under federal antifraud laws.
The information provided by the issuer and its agents would potentially have to be tracked on a day-to-day basis for material changes, even long after the issuer sells its bonds, market participants warned.
“There is language that potentially exposes issuers to substantial liability that could be far in excess of the cost of the rating and substantial ongoing disclosure obligations to S&P,” said Roger Davis, a partner at Orrick, Herrington & Sutcliffe LLP in San Francisco. “Issuers should be informed of these new conditions and obligations and should consider them carefully.”
If a rating proves faulty, it could be difficult to determine who was responsible, said a financial adviser who did not want to be named.
As with the language Moody’s ultimately dropped, market participants argue that the ongoing obligation Standard & Poor’s is proposing twists the intent of a key provision in the new financial regulatory reform law. Specifically, the provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act aims to expose rating agencies to greater liability if they “knowingly or recklessly fail” to adequately investigate the information they rely on to rate a security.
“Standard & Poor’s is supposed to be performing surveillance, but instead this imposes a huge burden on the issuer,” said one bond attorney who did not want to be identified.
At least one bond lawyer said the rating agency’s efforts are somewhat understandable.
“It certainly makes sense that they are attempting to discharge their obligation to do surveillance by contractually shifting the burden to the issuer,” he said, noting that issuers probably already have an obligation to provide accurate information under state or local laws. But he doubts the duty is one Standard & Poor’s can fully delegate to issuers.
Several market participants said the expanded liability language for issuers goes well beyond any of the Securities and Exchange Commission’s disclosure requirements for either muni or corporate borrowers.
“If you take this agreement literally, it is something that no issuer would comply with because it requires constant monitoring for material changes in information not only that the issuer might provide, including the official statement, but also that the issuers’ attorneys and advisers and perhaps underwriters provide,” said Robert Doty, president of American Governmental Financial Services in Sacramento. “The issuer might not know what those are and it’s not limited to information provided in writing but also includes oral communications.”
In addition, the rating agency is seeking to limit its own liability to the issuer to instances of “gross negligence” and to cap its potential damages to three times its rating fee — making the option of an issuer lawsuit against the agency uneconomical. However, the issuer’s damages would not be capped if it is sued by the rating agency.
Some issuers said the Standard & Poor’s expanded liability language has been around for awhile but that they have been able to get around it by simply ignoring it. However, the agency has begun to dig in its heels.
Earlier this month, it told issuers it would not provide them with rating letters needed to close bond transactions unless they signed the new terms, according to market participants who asked not to be named. At least one large state issuer pricing bonds this week did not obtain a Standard & Poor’s rating on the transaction because of its concerns over the language, market participants said.
Fearful that other issuers would also stop using its ratings, Standard & Poor’s has allowed a few borrowers to move forward with existing transactions without signing the new terms and conditions, vowing to come back to them on future transactions, according to the financial adviser who declined to be identified.
Several issuers declined to speak about their concerns in detail for fear of backlash from Standard & Poor’s, but some of them said they are negotiating with the agency to alter the language.
“We have not signed that in the past and we’re working with S&P right now on some [new] language,” said Joe DeAnda, a spokesman for California Treasurer Bill Lockyer.
Asked about the concerns regarding the its terms and conditions, Standard & Poor’s spokesman Mark Tierney said in a statement: “We are aware of the concerns raised by some public finance issuers and have been reviewing our public finance terms and conditions accordingly.”
Sources familiar with the matter said that in late 2009, the rating agency began revising its engagement letters to further clarify its expectations. Its current engagement letter was finalized in May of 2010, although a new version is expected this fall.
Matt Fabian, managing director at Municipal Market Advisors, said that issuers may end up with slightly higher borrowing costs if they are rated by only two of the three rating agencies that rate muni debt.
“In this market, the more ratings the better because people are so starved for credit information that they want to read three reports and not two,” he said.
But Fabian said the pricing impact is difficult to predict because spreads are compressed in the primary market, especially for state-level issuers.
“The actual penalty would be small but the market would prefer that there be three” ratings, he said.