As part of its financial regulatory reform program, the Obama Administration, through the Treasury, submitted to Congress proposed legislation that would reform SEC regulation of credit rating agencies (“CRAs”) by (a) requiring all CRAs to register with the SEC, (b) requiring CRAs to implement additional controls and procedures, including designation of a compliance officer, (c) increasing SEC oversight of credit rating agencies, (c) addressing conflicts of interest in the rating process and (d) providing for additional disclosure regarding credit ratings and the rating process. Under the proposed legislation, the Comptroller General would conduct a study regarding (1) the appropriateness of using credit ratings in federal, state and local securities and banking regulations and (2) alternative methods of compensating CRAs that could improve the accuracy of credit ratings. (In a related announcement, the Treasury indicated that it will work with the SEC and the President’s Working Group on Financial Markets to determine where references to ratings can be removed from regulations.) The proposed legislation is designed to implement recommendations made in the Treasury’s June 2009 White Paper on financial regulatory reform (as discussed in the June 23, 2009 Alert).
Expanded NRSRO Registration and Regulation. Unlike the current system of registration, under which a CRA registers with the SEC only if it wants to qualify as a “nationally recognized statistical rating organization” (an “NRSRO”) for purposes of various requirements under the federal securities laws, the proposed legislation would make registration mandatory for all CRAs. CRAs would be required to adopt procedures to manage conflicts of interest in the rating process, including governance measures. Each CRA would have to document its policies and procedures for the determining ratings, including internal controls and due diligence practices. Each CRA would have to designate a compliance officer responsible for overseeing the CRA’s polices and procedures and addressing conflicts of interest and remediation of violations. The compliance officer would not be allowed to engage in any rating activities, marketing, sales, or setting of compensation. The compliance officer would also be responsible for producing an annual compliance report, which would accompany financial statements required to be filed with the SEC. SEC rules would govern the process of approving and revising ratings methodologies.
Expanded SEC Oversight. The proposed legislation directs the SEC to establish a separate office dedicated to credit rating agency oversight. For all CRAs, the SEC would review the credit ratings assigned and the internal controls, due diligence, and other procedures the CRAs would be required to maintain. The SEC would publish reports summarizing its findings from these reviews. The SEC would also conduct periodic reviews of each CRA’s conflict of interest policy and code of ethics, and make those documents publicly available. The SEC would be required to adopt rules establishing “a system of payment for each nationally recognized statistical rating organization that requires that payments are structured to ensure that the nationally recognized statistical rating organization conducts accurate and reliable surveillance of ratings over time, as applicable, and that incentives for accurate ratings are in place.” The SEC’s rulemaking powers would include authority to specify records to be kept by CRAs.
Conflicts of Interest. The proposed legislation requires the SEC to adopt rules to prohibit, or require the disclosure and management of, a broad range of conflicts of interest involving compensation for ratings and relationships with issuers and underwriters and their affiliates. Similar to the rules governing public company auditors, a CRA and each of its affiliates and associated persons would be subject to prohibitions on the non-rating services they could provide an issuer, underwriter or placement agent that engaged the CRA to provide a rating. CRAs would have to adopt “look back” procedures for determining whether conflicts of interest for CRA personnel subsequently employed by issuers or underwriters influenced ratings. Under the proposed look back provision, if an issuer hired a rating agency employee and the employee had worked on ratings for that issuer in the preceding year, the rating agency would be required to conduct a review of ratings for that issuer to determine if any conflicts of interest influenced the rating, and adjust the rating as appropriate.
Disclosure. Under the proposed legislation, CRAs would have to make public disclosures designed to facilitate review of rating performance. CRAs would also have to disclose compensation received from parties such as issuers for individual ratings and in the aggregate over specified time periods. SEC rules would also require CRAs to make disclosures related to changes in ratings methodologies and procedures, and would mandate differentiation of ratings for structured products from those for non-structured products. The SEC would develop a form to accompany each rating assigned by a CRA in which the CRA would explain the methodology and data underlying the rating and would provide assessments of data reliability, the probability of default, the estimated severity of loss in the event of default and the sensitivity of a rating to changes in assumptions. The requirements for this report would be designed to facilitate comparisons across different securities and institutions. To address the concern that an issuer might attempt to “shop” among rating agencies by soliciting “preliminary ratings” from multiple agencies and then only paying for and disclosing the highest rating it received for its product, issuers would be required to disclose any preliminary credit ratings.
Existing Credit Rating Reform Initiatives. The SEC has already undertaken rulemaking initiatives consistent with the goals of the proposed legislation. In February 2009, the SEC adopted several measures to increase the transparency of NRSRO methodologies, strengthen disclosure of ratings performance, prohibit certain practices that create conflicts of interest, and enhance recordkeeping and reporting obligations to assist the SEC in performing its regulatory and oversight functions. The SEC also proposed to require NRSROs to disclose, on a delayed basis, ratings history information for 100% of all issuer-paid credit ratings. (For more on these rulemaking initiatives, see the December 9, 2008 Alert.) In July 2008, the SEC proposed revisions to various rules and forms under the federal securities laws that would eliminate references to credit ratings. More recently, in connection with proposing comprehensive reform of money market funds, the SEC again requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds as a way to reduce reliance on ratings.
Other Legislation. A number of bills addressing credit rating reform have been introduced in Congress in 2009. H.R. 1181 introduced in February 2009 would require the SEC to establish standards for, and a process for approving, classes of asset-backed securities and would require NRSROs to annually review each outstanding rating and provide a formal affirmation, re-rating or ratings removal. The bill would also require formal determinations by the SEC as part of its regular surveillance of NRSRO models, systems, assumptions, and performance. H.R. 1445 introduced in March 2009 would give the SEC rulemaking power to require disclosures to NRSROs by originators, issuers and underwriters regarding the collateral underlying structured securities and to require public disclosure by NRSROs of historical default rates of all classes of financial products that they rate. S.927 introduced in April 2009 would require the SEC to conduct an annual audit of each NRSRO and require each NRSRO to furnish an annual report that (a) reviews its rating procedures and methodologies, its adherence to those rating procedures and methodologies, how the NRSRO manages conflicts of interest and complies with the securities laws and (b) provides a narrative response agreeing or disagreeing with the SEC’s audit results and a certification by a duly authorized senior executive officer of the NRSRO. S.1073 (which has been introduced in the House as H.R.3214) is notably more extensive in its reach than the prior bills, but is not as comprehensive as the proposed legislation. S.1073 does, however, have many of the same features as the proposed legislation, including establishment of a separate SEC office dedicated to NRSROs, SEC oversight of the application of NRSRO methodologies and controls, NRSRO use of an SEC established form for disclosures about ratings, public disclosure by NRSROs of rating performance information, a compliance officer requirement and anti-conflict of interest measures including a one-year look back for an NRSRO employee subsequently employed by an issuer.