U.S. Securities and Exchange Commission v. Morningstar Credit Ratings, LLC

Background

The U.S. Securities and Exchange Commission sued Morningstar Credit Ratings, LLC, formerly a nationally recognized statistical ratings organization, over its ratings of commercial mortgage-backed securities in 2015 and 2016. The SEC alleged that Morningstar publicly described its rating methodology without disclosing that analysts could make discretionary, loan-level adjustments to two stresses used in the methodology. According to the SEC, those adjustments generally eased the stresses, lowered expected losses, and allowed higher ratings than the disclosed methodology would have produced.

The SEC also alleged that Morningstar lacked effective internal controls governing those adjustments. The SEC said Morningstar had no criteria explaining how, why, or when analysts could make the adjustments and did not require analysts to document their reasons. The SEC asserted three violations: failing to provide a sufficiently detailed general description of its rating methodology; failing to identify the version of the methodology used for individual ratings; and failing to establish, maintain, enforce, and document an effective internal control structure.

Morningstar moved to dismiss the complaint for failure to state a claim. On that type of motion, the court accepted the complaint’s factual allegations as true and considered whether they plausibly showed a legal violation.

First Cause of Action: General Description of the Methodology

The court denied Morningstar’s motion to dismiss the first cause of action. It interpreted the applicable disclosure requirement to mean that an NRSRO’s general description must give credit-rating users an understanding of the processes used to determine ratings. The requirement was not defined merely by the description’s length or by a high-level summary.

The SEC plausibly alleged that the undisclosed adjustments were a central feature of Morningstar’s methodology and that omitting them, or describing the methodology in a way that suggested they did not exist, prevented users from understanding how Morningstar produced its ratings. Whether users would need to know about the adjustments to understand the methodology was a factual question that could not be resolved on a motion to dismiss.

The court also rejected Morningstar’s argument at this stage that the SEC’s interpretation violated due process. The court found that the applicable requirement gave Morningstar reasonable notice of the factual question that would determine liability, even if proving a violation could be difficult.

Second Cause of Action: Identification of the Methodology Version

The court granted Morningstar’s motion to dismiss the second cause of action. The relevant regulation required an NRSRO to identify the version of the procedure or methodology used for a particular rating. The SEC argued that Morningstar failed to make that identification because the documents it identified did not accurately describe the full methodology.

The court distinguished identifying a methodology from fully or accurately describing it. Morningstar had identified the CMBS New-Issue Ratings Opinions and the CMBS Subordination Model and referred users to those documents. The SEC did not persuasively explain why the regulation requiring identification imposed the same requirements as the separate regulation governing the level of detail in a general description.

Third Cause of Action: Internal Controls

The court denied Morningstar’s motion to dismiss the third cause of action. The court held that a control structure governing adherence to a methodology cannot be effective if the controls governing components of that methodology are nonexistent or ineffective.

The SEC plausibly alleged that Morningstar’s internal controls had material weaknesses because they did not establish criteria for the discretionary adjustments or require documentation of the reasons for making them. The SEC also alleged that analysts applied adjustments across entire portfolios or rating categories, for reasons unrelated to specific loans or properties, even though Morningstar described the adjustments as loan-specific and case-by-case.

The court rejected Morningstar’s argument that the SEC was improperly trying to regulate the substance of its credit-rating methodology. The court explained that requiring an effective control structure to ensure adherence to a methodology did not amount to dictating the substance of that methodology.

Permanent Injunction

The court dismissed the SEC’s request for a permanent injunction without prejudice. An injunction requires a reasonable likelihood that the alleged violation will be repeated. The SEC alleged that Morningstar no longer operated as an NRSRO, but did not allege that Morningstar planned to renew its registration or would continue using the same disclosures and internal controls if it did so.

Because the dismissal was without prejudice, the SEC could renew the request later in the litigation if it presented facts supporting a reasonable likelihood of future violations.

Disposition

The court held that Morningstar’s motion to dismiss was granted in part and denied in part. The motion was denied as to the first and third causes of action and granted as to the second cause of action. The request for a permanent injunction was dismissed without prejudice. The court lifted the stay, terminated the motion, and directed the parties to submit an updated proposed case-management plan and scheduling order.