SEC Adopts Amendments to Rules for Nationally Recognized Statistical Rating Organizations

Introduction

On February 2, 2009, the Securities and Exchange Commission (the “SEC”) issued final rules regulating disclosures and recordkeeping requirements by nationally recognized statistical rating organizations (“Rating Agencies”). These amendments are intended to address concerns regarding the credit rating process for structured finance products. The final rules, which amend the Instructions to Exhibits 1 and 2 of Form NRSRO, Rule 17g-2, Rule 17g-3, and Rule 17g-5(c), require enhanced disclosure and recordkeeping for ratings procedures and methodologies, require Rating Agencies to file with the SEC an annual report of credit rating actions, and prohibit three additional conflicts of interest of Rating Agencies. The final rules will become effective on April 10, 2009, with the exception of the amendment to Rule 17g-2(d) requiring the use of XBRL disclosure of ratings histories, which will become effective on August 10, 2009.

In a separate, but related February 2, 2009 release, the SEC proposed further amendments to Rule 17g-2 and Rule 17g-5 regarding additional disclosure requirements applicable to conflict of interest situations.

Final Amendments

Instructions to Exhibits 1 and 2 to Form NRSRO

Form NRSRO is used by credit rating agencies to register with the SEC as a Rating Agency. Final amendments to the instructions to Form NRSRO require enhanced disclosures by applicants and by current Rating Agencies that provide updated information to the SEC.

Exhibit 1 to Form NRSRO requires disclosure of credit ratings performance measurement statistics. The amendments to the instructions require a Rating Agency to provide default and transition statistics for each asset class of credit ratings for which it is registered or is seeking registration for 1-, 3-, and 10-year periods. As proposed, the transition statistics must include all its rating transitions, including upgrades and downgrades. While default statistics must still include defaults relative to the initial rating, the amendment as adopted does not require the inclusion of defaults that occur after a credit rating is withdrawn, as was initially proposed. Rating Agencies will have to provide these statistics for any security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction, including those that do not fall within the statutory definition of “issuers of asset-backed securities.” Although a Rating Agency will not have to provide statistics for any other broad class of credit ratings it issues, as originally proposed, the SEC has divided government securities into three classes—sovereigns, United States public finance, and international public finance—for which Rating Agencies will have to provide statistics.

Exhibit 2 to Form NRSRO requires information regarding the procedures and methodologies used by Rating Agencies to determine credit ratings. The final amendments require Rating Agencies to disclose three types of information:

• whether and, if so, how verification performed on assets underlying or referenced by the structured finance product is relied on in determining credit ratings;
• whether and, if so, how it considers qualitative assessments of the originators of structured finance products in the rating process for such products; and
• more detailed information on the surveillance process, including how frequently credit ratings are reviewed, whether different models or criteria are used for ratings surveillance than for determining initial ratings, whether changes made to models and criteria for determining initial ratings are applied retroactively to existing ratings, and whether changes made to models and criteria for performing ratings surveillance are incorporated into the models and criteria for determining initial ratings.

Under the amendments, Rating Agencies will have to provide information on their surveillance process for all classes of credit ratings, including structured finance products.

Rule 17g-2—Rating Actions and Recordkeeping

The final amendments to Rule 17g-2 impose several additional recordkeeping requirements on Rating Agencies and require that certain records be made publicly available.

First, the amended rules require Rating Agencies to make and retain a complete record for each of their outstanding credit ratings. The record must show each rating action of the Rating Agency, from the initial rating to the current rating, the date of such action identified by the name of the security or obligor rated and, if applicable, the CUSIP for the rated security or the Central Index Key (“CIK”) number for the rated obligor. Amended paragraph (d) of this rule requires a Rating Agency to post on its web site in XBRL format,1 within six months of the rating action, the complete ratings histories, for a random sample of 10% of its issuer-paid credit ratings in each class of credit ratings for which the Rating Agency is registered and has issued 500 or more issuer-paid credit ratings. The SEC does not prescribe a specific random selection process, but instead requires Rating Agencies to develop a process that they can demonstrate to be random. Additionally, when a Rating Agency’s sample falls below 10% of its total issuer-paid credit ratings, either because the Rating Agency withdraws a rating or a rated instrument matures, the Rating Agency must replace such rating with a new randomly selected rating from the class. It should be noted that the final rule requires disclosure only for a limited number of issuer-paid ratings since Rating Agencies generally make these ratings publicly available for free. Conversely, subscriber-paid credit ratings need not be disclosed at this time because Rating Agencies derive most if not all of their credit rating revenues from selling subscriptions to these credit ratings.2

Second, the amended rules require Rating Agencies to make a record of the rationale for their credit ratings when a final credit rating on structured finance products materially deviates from the rating implied by a quantitative model used in the rating process when the model was a substantial component of the rating process. Rating Agencies are responsible for determining when a model constitutes a “substantial component” of the rating process and when a difference between the rating issued and the rating implied by the model is “material.” The rule as amended applies only to ratings of structured finance products, rather than all products as originally proposed.

Finally, the SEC amended Rule 17g-2 to require Rating Agencies to retain any written communication that contains complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating.3 The SEC also amended its rules to clarify that it requires Rating Agencies to retain all internal and external communications that relate to all aspects of the credit rating surveillance process as well as the initial rating process by adding the term, “monitoring,” to the list of surveillance activities which already includes initiating, determining, maintaining, changing, or withdrawing a credit rating.

Rule 17g-3—Annual Report of Credit Rating Actions

Rule 17g-3 requires Rating Agencies to furnish the SEC with certain reports annually. The SEC amended Rule 17g-3 to require that each Rating Agency provide the SEC with an unaudited annual report of the number of credit rating actions that occurred during the fiscal year for each class of security for which the Rating Agency is registered.4 The final rule specifies that the credit rating actions to be reported to the SEC include upgrades, downgrades, placements on credit watch, and withdrawals. The SEC clarified that Rating Agencies must include credit rating actions on any security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction.

Rule 17g-5(c)—Conflicts of Interest

Rule 17g-5 identifies various conflicts of interest arising from determining credit ratings. The SEC amended Rule 17g-5(c) to prohibit three additional conflicts of interest.

The amended rule prohibits a Rating Agency from issuing or maintaining a credit rating if a person associated with the Rating Agency or its affiliate had made recommendations to the obligor, issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security. The SEC does not view an explanation by a Rating Agency of the assumptions and rationales it uses to arrive at ratings decisions and how they apply to a given rating transaction as a recommendation. The objective of the amended rule is not to restrict the flow of information during the rating process, but rather to prohibit a conflict whereby Rating Agencies effectively rate their own work.

The amended rule also prohibits a Rating Agency from issuing or maintaining a credit rating where the fee paid for the rating was negotiated, discussed, or arranged by a person within the Rating Agency who has responsibility for participating in, determining,5 or approving credit ratings, or for developing or approving procedures or methodologies used for determining credit ratings. Because this rule change could potentially create difficulties for thinly staffed Rating Agencies, the SEC will consider requests by small Rating Agencies for exemptions from the rule under Section 36 of the Securities Exchange Act of 1934 based on their specific circumstances.

Finally, the amended rule prohibits a Rating Agency from issuing or maintaining a credit rating where a credit analyst who participated in determining or monitoring a credit rating, or a person responsible for approving a credit rating received gifts, including entertainment, from the obligor being rated, or from the issuer, underwriter, or sponsor of the securities being rated, except for items provided in normal business activities, such as meetings, provided they do not have an aggregate value in excess of $25 per analyst, per interaction. This rule is intended to be applied prospectively, so the fact that an analyst received a gift from a person seeking a credit rating prior to the rule’s effective date will not preclude the Rating Agency from issuing a credit rating determined by the analyst.

Questions

Any person who has a question regarding the issues raised in this Corporate and Securities Update may obtain additional guidance from a member of our Public Companies Group.

1. The instructions to Exhibit 1 to Form NRSRO have also been amended to require that Rating Agencies disclose where on their Web site this information can be accessed.
2. The SEC, however, is soliciting comment in its companion release on whether Rating Agencies should disclose subscriber-paid credit ratings.
3. The rule, as adopted, does not apply to oral communications, nor does it apply to complaints sent from within a Rating Agency, for example, from employees of the Rating Agency.
4. The SEC notes that the report required under Rule 17g-3(a)(6) will be ­furnished on a confidential basis, to the extent permitted by law.
5. The SEC clarifies that, for the purposes of Rule 17g-5, the terms “determine,” “determined,” and “determining” include both persons who develop credit ratings and persons who approve credit ratings.