Rating the Raters

I applaud CalPERS for proposing that credit rating agencies (CRAs) should be hired by investors instead of by corporate management. This proposal was in CalPERS’ October 4, 2010 comment letter to the SEC:

“Current legislation through the Dodd-Frank Act … appoints the Comptroller General through Section 939D, to study an alternative means to compensate the CRAs in order to create incentives for them to provide more accurate credit ratings, including statutory changes that would be required to facilitate the use of alternative means of compensation.

CalPERS believes an alternative payment model should include the following:

  • Issuers still pay for services rendered to obtain a CRA ratings. CRA revenues should be pooled and allocated to CRAs based on periodic voting process by “customers” – investor constituents.
  • The voting process will be administered through a “proxy like” process and paid by CRAs.
  • We believe this model should be transitioned over a 4-5 year period with increasing amounts of revenue at risk.
  • Revenue at risk to CRAs will:
    – Create a market based results oriented feedback loop to CRAs;
    – Motivate CRAs to improve and maintain ratings process as opposed to relying on regulator edicts and audits;
    – Motivate CRAs to be more conservative in ratings new financial instruments or companies professing new business models;
    – Align the interests of CRAs with investors, who are true customers or user of information as opposed to issuers.
  • Investors will utilize information gained from increased transparency and their customer experience to assess CRA relative skills, abilities and performance.”

This is similar to proposals I have made for investors to allocate corporate funds to competing proxy advisors. In my 2007 article “Proxy Voting Brand Competition” (available at votermedia.org/publications), I suggested that organizations hired by investors in this way could also provide other services such as compensation consulting, finding potential candidates for board seats, and auditing financial statements. Like these services, the determination of credit ratings would be more trustworthy and effective if performed by organizations loyal to investors rather than to corporate management.

If the competition for investor-allocated corporate funds is open to all types of service providers, then investors can choose which services and providers are most valuable, thus maximizing the benefit of this system.

At VoterMedia.org, we have developed, tested and implemented methods for allocating funds by vote among competing service providers. There are many possible ways of designing such a system, and some work much better than others. The paper “Global Voter Media Platform” (at votermedia.org/publications) explains the factors that determine success, and describes our test implementations.

As we have seen in our shareowner proposal campaign, CEOs and boards generally oppose such reforms. This is not surprising, since the proposals would increase accountability of CEOs and boards, thus reducing their power. These reforms will need more support from investors, whether via proposals in corporate proxies or via proposals to regulators.

We welcome CalPERS’ powerful voice in the push for corporate accountability by aligning the incentives of “infomediaries,” such as credit rating agencies, with the investors they are supposed to serve!

This guest post by Mark Latham, Founder of VoterMedia.org is also posted on his VoterMedia Finance Blog.

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One Response to Rating the Raters

  1. James McRitchie 10/18/2010 at 12:16 pm #

    Mark: Thank you so much for this post. You have been one of the most prolific innovators in advocating for market-based solutions to resolve conflicts of interest, instead of total reliance on regulatory agencies.

    This CalPERS proposal, where bond raters are paid by issuers according to investor votes is, indeed, very similar to proposals you have long advocated for auditors, proxy advisers and others. I’m delighted to see CalPERS now picking up this mechanism for greater accountability.

    Readers who support this concept can lend weight to the recommendation by sending a e-mail to rule-comments@sec.gov. In the subject line, include: DF Title IX – Credit Rating Agencies. Your e-mail can be something as simple as the following:

    I write in support of the recommendation made by CalPERS in their October 4, 2004 letter calling on CRA revenues to be pooled and allocated to CRAs based on periodic voting by ‘customers’ – investor constituents.

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