Ethics Case Study of the Week: Changing Ratings Methodology but Not Disclosing It

By Gary Sarkissian posted 13 days ago


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to e volve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard V(B) Communication with Clients and Prospective Clients. 

Changing Ratings Methodology but Not Disclosing It
Dukes is a managing director at a global credit ratings service. She leads and is responsible for the actions of the group that assigns new issue and surveillance credit ratings to commercial mortgage-backed securities. To determine the ratings, Dukes and her group calculate the debt service coverage ratio (DSCR) of each security, a key quantitative metric used to rate commercial mortgage-backed securities. Shortly after the global financial crisis, the ratings agency changed the methodology for calculating the DSCR for certain securities. Dukes’ group published future credit ratings without disclosing the change. Using the new methodology, the securities received higher credit ratings than they would have received if the original methodology had been used. Dukes’ actions are

A. inappropriate because she did not have a reasonable and adequate basis for changing the methodology.
B. appropriate because the new methodology more accurately reflects risk.
C. inappropriate because she did not disclose the change in methodology to the investing public.
D. appropriate because no disclosure is necessary because calculating DSCR is only one element in determining the overall rating of the security.
E. none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

This case involves the ethical principles applicable to communication with investors. CFA Institute Standard V(B): Communication with Clients and Prospective clients requires CFA Institute members to disclose to investors the basic format and general principles of the investment process they use to analyze investments and promptly disclose any changes that might materially affect those processes. Rating agencies’ consistency and transparency are important to investors. Without the consistent application of rating methodologies, ratings may not be readily comparable. Similarly, without transparency, investors can neither assess the methodologies used by the credit ratings agency nor the application of those methodologies, and thus cannot determine what weight to give the rating. Dukes should have disclosed to investors the change in methodology for calculating DSCR.

Although it would be inappropriate to change the methodology without a reasonable and adequate basis, the facts do not indicate that Dukes failed to use diligence or have a reasonable basis for the change. In addition, the facts do not indicate whether the new methodology more accurately reflects risk; however, even if the new methodology does more accurately reflect risk, the change still must be communicated to investors. DSCR is clearly a “key quantitative metric” used to rate the securities because the change in methodology materially affected the credit ratings by moving them higher than the original method. Choice C is the best answer.

This case is based on a December 2018 enforcement action by the US SEC.

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© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.