Regulation Fair Disclosure's Effect on the Information Content of Bond Rating Changes

• Author: Dorla A. Evans,Winnie P. H. Poon
• Published date: 01 September 2013

1.

The US Securities and Exchange Commission (SEC) implemented Regulation Fair Disclosure (Reg FD) on 23 October 2000 (Securities and Exchange Commission ). Reg FD requires firms to release information having a material impact on markets to everyone simultaneously. The purpose of Reg FD is to reduce information asymmetry caused when favoured stock analysts receive critical insider information about a firm's financial performance before the information is released to others. The SEC regulators assume that favoured analysts are in a position to reciprocate the receipt of insider information with benefits to the firm, e.g., reduced fees to issue new securities. Another concern is that favoured analysts may be pressured to slant information to the firm's advantage in order to maintain insider access (Securities and Exchange Commission ). The SEC's goal is to improve the transparency and fairness of information disclosures. During the period when Reg FD was proposed and outlined, bond rating agencies lobbied to exempt all bond rating agencies (both certified and non‐certified) from the law. The former are called Nationally Recognised Statistical Ratings Organisations (NRSROs) and includes Moody's Investor Services, Standard & Poor's, and Fitch Ratings, among others. The agencies received the exemption.

Investigations into the causes of the financial crisis make clear that bond rating agencies failed to meet market expectations for the accuracy or transparency of their ratings, particularly ratings of derivatives. In a 23 April 2010 hearing of the Senate Permanent Subcommittee on Investigations, Chairman Senator Carl Levin (D‐Michigan) grilled Moody's Chairman and CEO Ray McDaniel and former S&P President Kathleen Corbet on the incentives rating agencies have in setting ratings. Senator Levin presented evidence that the agencies continued to grant investment‐grade ratings in order to gain market share and to maximise income when their analysts worried about the integrity of the ratings and the ratings process (Hall, ). The executives refused to take blame for the rapid and extreme downgrades of previously highly‐rated issues, testifying that any errors in the rating process have been corrected (McDaniel) or that these errors were not their responsibility (Corbet).

Public outrage combined with political will put the rating agencies into the regulation spotlight. On 21 July 2010, President Obama signed into law the Wall Street Reform and Consumer Protection Act (Dodd‐Frank Act), the most comprehensive financial regulation bill since the 1930s (GPO, ; McGrane, ). In an attempt to improve the transparency of bond ratings and the bond rating process, the law significantly changes the responsibilities and privileges of bond rating agencies. Lawmakers repealed the rating agencies' exemption from Reg FD. In response, the major bond rating agencies notified issuers of the necessity of putting mechanisms in place for future confidential information releases (FT.com/Alphaville, ).

The Dodd‐Frank Act also requires that the federal regulation of financial institutions be conducted without reference to credit ratings by July 2011. This sweeping change is already complicating the duties of regulators. Both the Chairman of the SEC and the acting Comptroller of the Currency are struggling to find alternatives to credit ratings for such duties as setting capital requirements for banks (Eaglesham and Solomon, ). The Act also repeals Rule 436(g) to the Securities Act of 1933, effectively increasing the rating agencies' legal liability for ratings contained in SEC filings. The major rating agencies acted swiftly to forbid the use of their ratings in SEC filings for security issues, emphasising their ratings are merely opinions not expert judgments. The full impact of the Act on bond rating agencies and on markets will take time to reveal.

Bond rating agencies have played a quasi‐regulatory role in the markets. The SEC requires bond issues to be rated (Beaver et al., ). Institutional investors, banks, insurance firms, bank auditors, etc. use their ratings to determine capital adequacy requirements, although the Dodd‐Frank Act is phasing out some of these purposes. Arguably, bond rating agencies exist due to their comparative advantages: access to information relevant to creditworthiness and/or expertise in analysing that information (Tang, ). Prior to the Dodd‐Frank Act, rating agencies received private firm information, such as firm strategies embedded in 5‐year financial forecasts, pro‐forma statements, and internal reports. The bond rating agencies were granted the exemption from Reg FD with the understanding that they set high informational requirements on rated firms, especially on high‐risk bond issuers (Reynolds, ). Consistent with a quasi‐regulatory role, the SEC expected the rating agencies to protect financial markets by having access to insider information.

Both Reg FD and bond rating agencies' exemption from Reg FD were controversial. Criticism of Reg FD during its review stage suggests ways in which it may affect financial markets negatively. The criticism included (Securities Industry Association, ): (1) firms may issue fewer material and non‐material disclosures; (2) the disclosures made may contain less valuable information; (3) costs of issuing securities may rise; (4) volatility in security prices may increase; (5) the accuracy of analysts' forecasts may decline; and (6) the wealth of investors who depend upon stock analysts' recommendations may fall. The first five of the criticisms of Reg FD relate to the quality or quantity of public or private firm information and, therefore, any combination may affect both the stock and bond markets.

For example, suppose a firm eliminates (as required) its release of material information to favoured stock analysts (reducing private information). Further, suppose the firm reduces the quality and/or quantity of public information it releases, either due to increased dissemination costs (Sidhu et al., ) or to fear of litigation (Cornett et al., ). The total amount of information for forecasting cash flows is reduced as is the breadth of information dissemination (Duarte et al., ). However, material financial information should have flowed to bond rating agencies while they were exempt from Reg FD. Therefore, bond rating agencies would continue to receive material private information when stock analysts and the public would not. The implication of the exemption is that bond rating changes would affect the formation of stock prices and bond yield premia more significantly after the implementation of Reg FD.

Alternatively, if the loss of private stock analyst information is exactly compensated with increased or better publicly‐released information – we see no change in the quality or quantity of information – then stock prices and bond yield premia may have behaved as before Reg FD was implemented. Or, if a firm releases more information publicly than it suppresses to favoured analysts, then the total amount of information is increased. This richer information environment may have reduced the impact bond rating changes had on stock returns and bond yield premia.

Beaver et al. () demonstrates that NRSROs with access to insider information have different impacts and roles to play in capital markets than non‐NRSRO bond rating agencies. They conclude that Moody's (an NRSRO) better predicts bond defaults, and its ratings are more highly associated with yields on newly‐issued speculative‐grade bonds. Moody's behaves more conservatively by focusing on negative rating changes, consistent with its quasi‐regulatory role set by the SEC. Ratings from Egan Jones Investor Services, then a non‐NRSRO that chose to rely strictly on public information, are more highly associated with newly‐issued investment‐grade bonds and have bigger impacts on stock returns. The authors conclude that non‐NRSROs focus more on investor clients, who are the source of their revenue. Their findings imply that bond rating agencies use private material information to form their ratings. Therefore, when exempt from Reg FD, NRSRO rating agencies may have played a larger role in bond markets.

The Bond Market Association described its own concerns with Reg FD (SIFMA, ). Specifically, it noted anecdotally that the volume and quality of information provided by high‐yield issuers had declined leading to lower quality analyses. Price volatility of high‐yield bonds (especially those of small businesses) had increased and liquidity for these bonds had decreased. And private placement of high‐yield bonds had become more expensive and time‐consuming.

Researchers have noted the importance of Reg FD through significant numbers of studies. Jorion et al. () recognises the possible information advantage granted to bond rating agencies with their exemption from Reg FD. The authors compare the effect of bond rating changes on stock prices between the pre‐ and post‐Reg FD periods. They find that the informational effect of both bond rating downgrades and upgrades is much greater in the post‐Reg FD period. Hence, the informational advantage to bond rating agencies from their exemption from Reg FD is confirmed in these results.

Duarte et al. () explores the impact of Reg FD on the cost of equity capital (excluding the cost of debt capital), controlling for information asymmetry and information dissemination. Information dissemination is realised in the cost of capital through the informativeness of changes in stock prices. Stock prices become more informative when more public information is released to a broader audience. More information in stock prices reduces the risk to uninformed investors who, in turn, decrease the returns they demand. Information asymmetry occurs when more information that was previously announced publicly is kept private. They find that Reg FD had no impact on the cost of equity for NYSE/AMEX firms and only a...