SEC Sues Morningstar, Alleging Undisclosed Changes to Bond Ratings

Morningstar has made a push to become a big player in the bond-rating business, buying rival DBRS Inc. from two private-equity firms for $669 million in 2019. In May 2020, Morningstar paid $3.5 million to settle a separate SEC enforcement investigation that alleged a former credit-ratings division violated conflict-of-interest rules by mixing ratings work with sales and marketing efforts.

Morningstar said in a statement that it followed all laws and rules. The SEC didn’t allege that credit ratings were improperly determined, the company said. “The SEC overstepped its regulatory limitations by imposing requirements that would regulate the substance of credit-rating methodologies,” the firm said. “Morningstar prides itself on the integrity and independence of its research and analysis. Morningstar will continue to be motivated by the objective of bringing clarity and diverse opinions to the market.”

Regulators have given scrutiny to credit-ratings firms and their conflicts of interest since the business was criticized for giving rosy assessments of troubled real-estate securities before the 2008 financial crisis. Credit raters are paid by entities that sell debt, which fosters an incentive for issuers to shop around for the best ratings and hire a firm that gives the most favorable grades.

“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,” said

Daniel Michael,

chief of the SEC enforcement division’s complex financial instruments unit. “Morningstar failed on both counts by permitting analysts to make undisclosed adjustments over which Morningstar had no effective internal controls.”

Internal controls are a set of policies that firms use to guard against methodological errors and deviations from regulations.

Commercial mortgage-backed securities are bonds tied to loans on malls, office buildings, hotels and other properties. The loans are typically pooled into separate tranches that are assigned different investment ratings, from AAA to BB+ and below, depending on their credit risk.

A Wall Street Journal analysis of about 30,000 ratings across the structured credit market showed that smaller challengers, including Morningstar, tended to give higher grades on debt than the three incumbent ratings firms. The findings suggest that a key remedy to improve ratings after the financial crisis—increasing competition—has backfired. The problem has been particularly acute in the structured debt market, which includes CMBS deals.

Morningstar’s models stress-tested cash flows and valuation measures for commercial properties based on different economic environments. But the company failed to disclose that its analysts could make changes to the stress-testing factors that benefited issuers, the SEC said.

The analysts worked at Morningstar Credit Ratings LLC, a division that no longer operates, the SEC said. Morningstar’s credit-rating activity is now done under the name DBRS Morningstar Inc.

The adjustments were “overwhelmingly used to ease those stresses, which lowered expected losses for many classes” of bonds that Morningstar rated, the SEC said in its federal court complaint. The lower losses were used to assign higher ratings to at least 100 classes of bonds, which benefited the issuers that hired Morningstar to assign the grades, the SEC said.

Morningstar didn’t provide analysts with any “criteria or guidance for when or how to employ these adjustments,” the lawsuit states. The analysts could make adjustments to better align a rating with expectations, such as grades on similar bond deals, the SEC said. The discretion that analysts had was a “central feature of the model,” the SEC said, citing an internal Morningstar review done in 2017.

Write to Dave Michaels at dave.michaels@wsj.com