Client Alert

SEC Proposes New Rules for Credit Ratings Organizations

July 30, 2008

The SEC recently proposed rule amendments to the Securities Exchange Act of 1934 in an effort to reduce conflicts of interest, foster competition and comparability, increase transparency and improve investor understanding in the credit rating process. On June 16, 2008, the SEC proposed rule amendments that would impose additional requirements on nationally recognized statistical rating organizations ("NRSROs") related to disclosures, conflicts of interest and structured finance products' rating symbols. Additionally, on July 1, 2008, the SEC released three proposals intended to reduce undue reliance on NRSRO ratings by removing or altering references to ratings in SEC rules and forms. These proposals were made further to the Credit Rating Agency Reform Act of 2006,¹ which gives the SEC authority to determine NRSRO registration guidelines, regulate NRSRO record-keeping and guard against conflicts of interest.

Background

Over the past year, NRSROs that rated subprime residential mortgage-backed securities ("RMBSs") and collateralized debt obligations ("CDOs") have come under intense criticism and scrutiny. The new proposals were guided by an SEC investigation into NRSROs that determined that rating agencies struggled to keep up with the growth of RMBS and CDO deals and the quality of the ratings suffered as a result.² Specifically, the investigation report found several conflicts of interest, insufficient disclosure and documentation of significant aspects of the rating process, and inadequate review of current ratings. The proposed rules intend to:

• Address potential conflicts of interest in the rating process;
• Increase disclosure of information used in rating structured finance products;
• Enhance comparability of credit ratings performance statistics;
• Require more documentation concerning the procedures and methodologies employed in rating structured finance products;
• Strengthen internal control processes at NRSROs through reporting requirements; and
• Reduce undue reliance on NRSRO ratings in the SEC's rules and forms.

Discussion

The June 16, 2008 Proposed Rules:

The proposals released on June 16, 2008 propose to amend Rules 17g-5, 17g-2 and 17g-3, Form NRSRO and to add
new Rule 17g-7.³

Amendments to Rule 17g-5 (Conflicts of Interest)

Rule 17g-5 of the Exchange Act addresses conflicts of interest relating to the issuance of credit ratings by requiring the disclosure of certain types of conflicts and the prohibition of others. The SEC is proposing four amendments to require enhanced disclosure and procedures to manage an additional conflict of interest and to prohibit three other conflicts outright that could impair the objectivity and quality of a credit rating:

• Adding the Conflict of Repeatedly Being Paid by Certain Arrangers to Rate Structured Finance Products to the Current List of Managed Conflicts. To address this conflict, the proposed amendments would require the disclosure of all relevant information the NRSRO used during the rating process.⁴ Other NRSROs could then use this information to rate the instrument. The resulting unsolicited ratings could be compared to the ratings of the hired NRSRO to determine the credibility of such ratings and potentially expose a hired NRSRO using inappropriate factors seeking to appease the arranger. Additionally, giving more market participants the ability to rate an instrument will foster greater competition.
• Prohibiting the Rating of an Obligor or Debt Security that Received Ratings Recommendations from the NRSRO. The proposed amendments would prohibit the NRSRO from making recommendations to obligors, issuers, underwriters and sponsors about how to structure the security during the rating process.
• Prohibiting Certain Personnel from Participating in Fee Discussions. The proposed amendments would prohibit personnel active in determining credit ratings from participating in fee discussions with the transaction parties.
• Prohibiting the Conflict of Receiving Gifts. The proposed amendments would prohibit an NRSRO from issuing or maintaining a credit rating where a person involved in the credit rating analytical process received gifts valued at over $25.

Amendments to Rule 17g-2 (Recordkeeping)

Rule 17g-2 of the Exchange Act requires an NRSRO to create and retain certain records related to its business, such as the identity of the credit analysts involved in a rating action and the date of such actions, for a prescribed period of time. The SEC is proposing to amend this rule to require NRSROs to make and retain certain additional records, some of which would be made publicly available:

• A Record of Rating Actions and the Requirement that they be made Publicly Available. The proposed amendments would require registered NRSROs to make and retain a record of all rating actions (including downgrades) and their corresponding date. The NRSRO would make this record publicly available in an interactive data file on the NRSRO corporate web site, creating an opportunity for the marketplace to use the information to develop performance measurement statistics.
• A Record of Material Deviation from Model Output. The proposed amendments would require a record of any material deviation from the model used to proscribe an initial rating that explains the reasoning for the difference. This record would allow SEC examiners to reconstruct the analytical process and ensure that a deviation occurred by appropriate qualitative factors, rather than undue influence.
• Records Concerning Third-Party Analyst Complaints. The proposed amendments would require an NRSRO to retain records of any complaints regarding the performance of a credit analyst in determining credit ratings. This record would help the SEC review how NRSROs address conflicts of interest that could impair the integrity of their credit rating processes.
• Clarifying Amendment to Rule 17g-2(b)(7). Rule 17g-2 currently requires an NRSRO to retain all internal and external communications that relate to "initiating, determining, maintaining, changing, or withdrawing a credit rating." The SEC proposes to add the word "monitoring" to this list to clarify that NRSRO recordkeeping rules extend to all aspects of the credit rating surveillance process.

Amendments to the Instructions of Form NRSRO

Form NRSRO, established under the Credit Rating Agency Reform Act, is the application credit rating agencies use to register with the SEC and registered NRSROs use to provide updated information. The SEC is proposing two changes to Form NRSRO:

• Enhanced Ratings Performance Measurement Statistics on Form NRSRO. The first proposed amendment provides four modifications to the instructions to Exhibit 1 of Form NRSRO to enhance the comparability of the performance measurement statistics:

- The first modification would require the disclosure of statistics for each asset class of credit rating for which the NRSRO is, or is applying to be, registered. This disclosure would result in class specific performance statistics that would facilitate comparisons of NRSRO credit rating accuracy.

- The second modification would require such class-by-class disclosures to be partitioned in 1, 3 and 10-year periods, ensuring the statistics cover comparable periods of time. This comparison could provide an early warning for flaws or conflicts in an NRSROs rating processes.

- The third modification would clarify that the performance measurement statistics include upgrades, as well as downgrades, by replacing the term "downgrade and default rates" with "ratings transition and default rates." This clarification would enhance investor understanding and eliminate certain ways an NRSRO could use to "pad" statistics.

- The final modification would specify that the default statistics must include defaults occurring after a credit rating is withdrawn in addition to defaults from the initial rating. Without this specification, an NRSRO could manipulate the performance statistics by not including defaults occurring after a rating has been downgraded or withdrawn.

• Enhanced Disclosure of Ratings Methodologies. The second proposed amendment to Form NRSRO would modify the instructions to Exhibit 2 of Form NRSRO to require enhanced disclosures concerning an NRSRO's procedures and methodologies in determining credit ratings. The SEC is proposing three new areas for the Exhibit 2 disclosures that would further reveal actions an applicant and NRSRO is, or is not, taking in determining credit ratings:

- The first modification would require an NRSRO to disclose whether it considers the due diligence of others concerning the assets underlying the instrument in its rating process.

- The second modification would require an NRSRO to disclose whether it considers the originator's qualitative assessments of the instrument.

- The final modification would require an NRSRO to disclose the frequency and manner in which it reviews their outstanding ratings.

Amendment to Rule 17g-3 (Report of Credit Rating Actions)

Rule 17g-3 of the Exchange Act requires an NRSRO to furnish the SEC with certain financial reports for the public interest or protection of investors. The SEC is proposing to amend Rule 17g-3 to add an additional annual report for the number of credit rating actions (upgrades, downgrades and placements of securities on watch for an upgrade or downgrade) in each registered security class. This report would assist the SEC in examining NRSROs and could potentially expose when an inappropriate factor compromises the rating process.

Proposed New Rule 17g-7 (Use of Symbols to Differentiate Credit Ratings for Structured Finance Products)

The SEC is proposing new Rule 17g-7 under the Exchange Act, which would require NRSRO's to differentiate structured finance product ratings from other types of rated instruments, such as bonds. This could be done by either issuing a report explaining the difference, or, alternatively, by using distinct symbols to distinguish the instruments. The purpose behind this report is to alert investors that different instruments carry different risk characteristics.

The July 1, 2008 Proposed Rules

On July 1, 2008, the SEC released three proposals relating to security ratings.⁵

The proposed rules are designed to clarify that references to NRSRO ratings in law and regulations are not an endorsement of such ratings. In three releases, the SEC proposes to change the way its rules and forms refer to NRSRO credit ratings:

• Reliance on Security Ratings - administered by the SEC Division of Corporation Finance. The SEC proposes to replace rule and form requirements under the Securities Act of 1933 and the Exchange Act that rely on security ratings (for example, Forms S-3 and F-3 eligibility criteria) with alternative requirements. This change will eliminate the current requirement that money market funds and investment companies hold highly rated securities, shifting the focus to a security's liquidity and other credit risk standards. Additionally, the rule would replace the current requirement that registered asset-backed securities be investment grade with a new requirement that the initial sale and resales must be sold in at least $250,000 denominations and initial sales can only be sold to qualified institutional buyers (QIBS).
• References to Ratings of NRSRO in the Investment Company Act of 1940 and Investment Advisers Act of 1940 - administered by the SEC Division of Investment Management. Currently, four of the SEC's rules under the Investment Company Act (Rules 2a-7, 3a-7, 5b-3, and 10f-3) and one rule under the Investment Advisers Act (Rule 206(3)-3T) use NRSRO ratings to distinguish various grades of debt and other rated securities. The SEC is proposing to remove each such reference.
• References to Ratings of NRSROs in the Exchange Act - administered by the SEC Division of Trading and Markets. Currently, several rules and forms under the Exchange Act rely on NRSRO ratings. The SEC is proposing to remove the NRSRO references in the following rules and forms: Rule 3a1-1, Rule 10b-10, Rule 15c3-1, Rule 15c3-3, Rules 101 and 102 of Regulation M, Regulation ATS, Form ATS-R, Form PILOT, and Form X-17A-5 Part IIB. A small number of rules and forms that are unlikely to cause any undue reliance on NRSRO ratings will retain the reference.

Conclusion

The SEC's proposed rules reflect a growing concern with NRSROs and the credit ratings process. Recently, the credit rating process has come under increased scrutiny by other governmental institutions, such as the office of the New York Attorney General,⁶ leading to an agreement with Standard & Poor's, Moody's, and Fitch providing for increased transparency in the credit rating process, as well as non-governmental groups such as the American Securitization Forum,⁷ which recently proposed an initiative providing for the collection and disclosure of over 100 types of data relating to mortgage-backed securities.

Comments on the proposed amendments issued on June 16, 2008 were due to the SEC by July 25, 2008. Comments on the proposed amendments issued on July 1, 2008 are due by September 5, 2008. Information on submitting comments to the SEC can be found on the SEC's website at www.sec.gov/rules/submitcomments.htm.

Our client alerts are for general informational purposes and should not be regarded as legal advice

<sup>1.Available at http://www.govtrack.us/congress/billtext.xpd?bill=s109-3850 (hereafter, the "Credit Rating Agency Reform Act").
2. Please see Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies, available at http://www.sec.gov/news/studies/2008/craexamination070808.pdf.
3. SEC Release No. 34-57967; File No. S7-13-08. A copy of the release is available on the SEC's website at www.sec.gov/rules/proposed/2008/34-57967.pdf  
4. As the Securities Act of 1933 restricts the disclosure of certain offering communications, the means used to disseminate the information would depend on whether the structured finance product is a public, private, or offshore offering.
5. SEC Release No. 34-58070; File No. S7-17-08, available at www.sec.gov/rules/proposed/2008/34-58070.pdf; SEC Release No. 33-8940; 34-58071; File No. S7-18-08, available at www.sec.gov/rules/proposed/2008/33-8940.pdf; and SEC Release Nos. IC-28327; IA-2751; File No. S7-19-08, available at http://www.sec.gov/rules/proposed/2008/ic-28327.pdf.
6. See http://www.oag.state.ny.us/press/2008/june/june5a_08.html
7. See http://www.americansecuritization.com/uploadedFiles/Project_RESTART_RFC_%207_16_%2008.pdf</sup>