Opinions, Expert Opinions and Fiduciary Responsibility
“It is not advisable…to venture unsolicited opinions. You should spare yourself the embarrassing discovery of their exact value to your listener” Ayn Rand
Business valuation specialists are reminded of the value of their opinions when courts concur with their analysis or when clients pay their bills in full. However it may surprise some to know that in the financial world there are many levels of opinions, with startling differences in the willingness to stand behind them, as well as the credibility given to the opinions by listeners.
I was somewhat surprised to read recently that credit agencies such as Moody’s and Standard and Poor's do not provide “expert opinions”:
According to the article, the credit ratings provided by these agencies are no more legally binding than the editorial opinion page of your local newspaper. A scary thought, since the ratings agencies were key “enablers” in the 2008 mortgage market collapse.
Let me explain further. Unwise provision of credit is part of all financial bubbles. As housing prices reached bubble proportions in 2005-2006, smarter banks (yes there were a few) knew that the housing market had reached unsustainable levels. In the old days, this would have led to them refusing to make further loans, and the market would have corrected with only minor problems. But thanks to the wonders of 21st century financial engineering, specifically a process known as securitization, a bank could continue to make loans and earn fees without endangering its capital base by selling off the securitized loans to someone else. The Federal Government encouraged this process, as it believed securitization would allow people who were not credit worthy to buy homes, as their loans would be “packaged” with better credits in the securitizations.
Who bought these securitized loans? Pensions, mutual funds, hedge funds and other institutional investors were all buyers. Regulators even lowered capital requirements for financial institutions that held mortgage securities approved as investment grade by the rating agencies, providing an incentive for the same banks who sold off their poor quality mortgages to others to buy the “investment grade” rated garbage of their competitors. Thus the rot spread throughout the system.
The problem with the securitization model is that securitized mortgages are not easy to analyze and value, especially for a typical pension fund manager who is not an “expert” in these securities. You need to see the underlying documentation on the individual loans.
Enter the “enablers”. Moody’s and Standard and Poor's assigned ratings to the securities, deeming some “investment grade”, which was all the fund managers needed to hear. Now a fund manager could get a nearly risk–free premium over Treasuries by buying mortgage securities approved by the “experts”, the ratings agencies, who could perform the due diligence and expert analysis necessary. The only problem was the analysis wasn’t “expert”, and they refused to stand behind their opinions. When the duped investors tried to sue the ratings agencies, they claimed a First Amendment right to give a wrong opinion.
The Dodd-Frank financial reform law sought to expose the ratings agencies to the same expert liability standards that accounting firms have to adhere to in doing their work. In other words, they would have to provide “expert opinions" to support their ratings. However, the ratings agencies refused to let their opinions be published, the buyers quit buying, and the SEC gave the agencies an exemption.
This stands in stark contrast to the recent proposals to extend “fiduciary responsibility” to valuation experts performing ESOP and related valuations. This is a significant extension of potential responsibility above and beyond the “expert opinion” level. Such an extension would most likely force may BV experts to quit doing ESOP valuations, or charge much higher fees to justify the risk of doing the work. This change is proposed despite the lack of significant problems in this market. It seems as if the Federal Government is focusing on the easy business of regulating the small business valuation expert, while the real dangers at the giant rating agencies continue unabated.
Raymond J. ("RJ") Dragon MBA, MS, ASA, CFFA is a Principal in Citrin Cooperman's Valuation & Forensic Services practice in the New Jersey / New York City area. His work encompasses valuations for litigation support, marital dissolution, shareholder disputes, estate and gift tax, intangible asset valuation, purchase price allocation and financial reporting.