• SEC Proposes Stringent New Disclosure Requirements for Credit Ratings Used in Registered Offerings, Issues Concept Release on Imposing New Liabilities on NRSROs
  • October 23, 2009 | Author: Charles A. Sweet
  • Law Firm: Bingham McCutchen LLP - Washington Office
  • Introduction

    The Securities and Exchange Commission has proposed stringent new requirements for disclosures regarding credit ratings used by registrants, including closed-end funds, in registered securities offerings. In connection with these proposed requirements, the SEC is seeking comment on whether mutual funds should be subject to similar requirements regarding their use of ratings. The SEC also seeks comment on the possibility of rescinding Rule 436(g) under the Securities Act of 1933 (the “Securities Act”), which would subject nationally recognized statistical rating organizations (“NRSROs”) (which include all of the major rating agencies) to liability as “experts” under Section 11 of the Securities Act.

    These releases follow in short order the adoption of final rules removing references to credit ratings in several rules and forms under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Company Act of 1940 (the “Investment Company Act”), and the reopening of the comment period on a wider variety of similar proposed changes to rules under the Securities Act, the Exchange Act, the Investment Company Act and the Investment Advisers Act of 1940, which are discussed in our previous Client Alert dated October 9, 2009.1

    The proposed disclosure rules would mandate much of the specific disclosure regarding credit ratings that is now optional for registered debt securities, convertible debt securities and preferred stock, as well as disclosure of material scope limitations of the credit rating and any related published designation. They also would require disclosure of the source of any payment for the credit rating as well as the services and fees paid for non-rating services to the registrant and its affiliates. In certain circumstances, registrants also would have to disclose preliminary credit ratings as well as final credit ratings, in an effort to avoid “ratings shopping.” Finally, periodic reports under the Exchange Act also would be required to disclose certain subsequent changes in credit ratings. The same basic scheme would apply to credit ratings of senior securities issued by closed-end funds registered under the Investment Company Act.

    In the companion concept release, the SEC seeks comment on the possible rescission of Rule 436(g) under the Securities Act. This rule provides an exemption for credit ratings provided by NRSROs from being considered part of a registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the Securities Act, effectively removing NRSROs from the liability scheme for experts set forth in Section 11. Removing this exemption would subject NRSROs to liability, which would put them on an equal footing with other experts, including accountants whose reports are included in a registration statement agency and non-NRSRO credit rating agencies whose ratings are referenced in a registration statement.

    This memorandum summarizes significant aspects of both the proposed new disclosure rules, as set forth in a proposing release (the “Proposing Release”),2  and the commentary regarding the possible rescission of Rule 436(g) contained in a companion concept release (the “Concept Release”).3

    In the Proposing Release, the SEC identifies four principal areas of concern that the proposed new disclosure rules are intended to address.

    The SEC’s first concern is that investors may not be provided with sufficient information to understand the scope or meaning of ratings being used to market securities. In the SEC’s view, credit ratings originally were intended to measure the registrant’s ability to repay its debt, but as investment products have become more complex, returns have become more dependent on other factors. Therefore, ratings of different types of securities have become less comparable, and investors may not be aware of their differences.

    The SEC’s second concern is that investors may not appreciate the potential effects of conflicts of interest. The foremost example is that most credit rating agencies are paid by the registrants who receive the ratings, which in the SEC’s view creates the potential for ratings inflation. The provision of additional services for fees may create additional conflicts.

    The SEC’s third concern is that “ratings shopping” may lead to inflated ratings.

    The SEC’s fourth concern is that even though credit ratings are a key part of many investors’ investment decisions and are used to market securities, no specific disclosure about those ratings is required. Therefore, investors may not be receiving even basic information about a key element of their investment decisions.

    Proposed Mandatory Disclosure of Credit Ratings
    Proposed Disclosure Triggers

    The SEC’s current policy on credit ratings disclosure is embedded in Item 10(c) of Regulation S-K, which permits voluntary disclosure of credit ratings of debt securities, convertible debt securities, and preferred stock in registration statements and periodic reports. All of the disclosures contemplated by that item are suggested, not mandated. The SEC proposes to amend Item 202 of Regulation S-K, Item 9 of Form S-3, Item 4(a)(3) of Form S-4, Item 12 of Form 20-F and Item 10.6 of Form N-2 to require registrants to provide detailed disclosure regarding credit ratings if the registrant, any selling security holder, any underwriter or any member of a selling group uses a credit rating from a credit rating agency with respect to the registrant or a class of such securities issued by the registrant, in connection with a registered offering.

    According to the Proposing Release, actions that constitute the “use” of a credit rating include oral and written selling efforts of the registrant and other members of the selling group, and disclosure in a prospectus or a term sheet filed with the SEC. A credit rating also would be considered to be used in connection with a registered offering if it is used in connection with an exempt private offering and the privately offered securities are exchanged shortly thereafter for substantially identical registered securities (i.e., an A/B exchange offer). Unsolicited ratings would not trigger the disclosure requirements unless used in connection with a registered securities offering. Discussion of a registrant’s credit ratings would not trigger the disclosure requirements if it relates only to changes to a credit rating, liquidity, cost of funds or terms of agreements that refer to credit ratings, and is not otherwise used in connection with a registered offering. Therefore, risk factor and management’s discussion and analysis (“MD&A”) disclosures on these topics would not trigger the credit rating disclosure requirements. 

    Among the topics on which the SEC requests comment are whether disclosures by mutual funds as to their investment policies relating to ratings of portfolio securities, and disclosures of non-credit ratings obtained by mutual funds (e.g., credit quality ratings for fixed-income funds, volatility ratings and stability ratings), should trigger similar disclosures.

    Proposed Registration Statement Disclosure of General Information
    The proposed disclosures would be included in registration statements under the Securities Act and the Exchange Act (including Forms 10 and 20-F), and in registration statements filed by closed-end funds on Form N-2 under the Securities Act and the Investment Company Act.

    Item 202(g) of Regulation S-K would be amended to require, among other things, the following information:

    • The identity of the credit rating agency and whether it is an NRSRO;
    • The credit rating;
    • The date the credit rating was assigned;
    • The relative rank of the credit rating within the credit rating agency’s classification system;
    • The credit rating agency’s definition or description of the category of the credit rating;
    • All material scope limitations of the credit rating;
    • How any contingencies related to the securities are or are not reflected in the credit rating;
    • Any published designation reflecting the results of any other evaluation done in connection with the rating, along with an explanation of the designation’s meaning and its relative rank;
    • Any material differences between the terms of the securities as considered by the credit rating agency in rating the securities, the minimum obligations specified in the security’s governing documents and the terms used in any marketing efforts; and
    • A statement informing investors that a credit rating is not a recommendation to buy, sell, or hold securities; that it may be subject to revision or withdrawal at any time by the assigning credit rating agency; that each credit rating is applicable only to the specific class of securities to which it applies; and that investors should perform their own evaluation as to whether an investment in the security is appropriate.

    A preliminary prospectus would disclose the initial rating (if any) assigned by the credit rating agency if a final rating is not assigned until after the effectiveness of a registration statement. If a disclosed rating is changed or if a different rating becomes available before effectiveness, it would have to be conveyed to the purchaser. The final prospectus would reflect the final rating assigned and all related disclosure. In shelf offerings, the final rating would be disclosed in a prospectus supplement.

    An example of a material scope limitation that would have to be disclosed is when the credit rating addresses less than the full promised return on a security, such as in the case of residual asset-backed securities (“ABS”) that represent an interest in the remaining cash flows after all other payment obligations are fulfilled, but which incorporate a nominal fixed obligation that is rated. Similarly, if a security is subject to contingent payment obligations, the registrant would have to disclose how the contingency is reflected in the rating.

    Item 10.6 of Form N-2, which now subjects closed-end funds to much more limited credit rating disclosure requirements, would be amended to require the same information required by Item 202(g) of Regulation S-K.

    Proposed Registration Statement Disclosure of Conflicts of Interest
    The Proposing Release proposes disclosure regarding potential conflicts of interest in the credit ratings process. Specifically, the proposed rules would require disclosure of the identity of the party who compensates the credit rating agency for providing the credit rating. In addition, if during the registrant’s last fiscal year and any subsequent interim period, the credit rating agency or any of its affiliates has provided non-rating services to the registrant or its affiliates, the proposed rules would require a description of those services, with separate disclosures of the fee paid for the credit rating and the aggregate fees paid for those non-rating services. No fee disclosure would be required unless disclosure of non-rating services is required, though the SEC requests comment on whether fees should be required to be disclosed in all cases.

    Proposed Registration Statement Disclosures Regarding Ratings Shopping
    The SEC believes that “ratings shopping” raises serious issues about the integrity of the credit ratings process. This occurs when registrants solicit preliminary credit ratings from different rating agencies and choose only the most favorable ratings to disclose. In the SEC’s view, this leads to inflation of credit ratings.

    Under the proposed rules, if a registrant solicits and obtains a credit rating and is required to disclose that credit rating, then all preliminary ratings of the same class of securities from other credit rating agencies also must be disclosed, as must any credit rating obtained by the registrant but not used. The proposed rules would not require disclosure of preliminary ratings issued by the same credit rating agency that issues the final rating, on the theory that this would impede useful communication between credit rating agencies and registrants, and because other NRSRO regulations (such as Rule 17g-5 under the Exchange Act, which prohibits credit rating agency recommendations on a security’s structure) already address problematic practices in this area.

    Disclosure of any preliminary rating or unused final rating would require disclosures similar to those required for a final rating. However, because preliminary ratings may vary in form and detail, not all of that information may be available, so the SEC proposes to allow registrants to rely on Securities Act Rule 409 if the information cannot be obtained without unreasonable effort or expense. It is not clear whether the “unreasonable effort or expense” standard would require a registrant to expend more funds or effort to obtain the required information than it otherwise would in the ordinary course.

    These rules would apply whether the registrant directly solicits the credit rating or the solicitation is made by the underwriter or others involved in structuring the deal (e.g., in an ABS transaction, the sponsor or depositor) on behalf of the registrant.

    Proposed Disclosures in Exchange Act Reports
    Under the new proposals, if a credit rating that was previously disclosed changes, is withdrawn or is no longer being updated, that change would be required to be disclosed in a current report on Form 8-K. A new disclosure item would require a registrant (including a closed-end fund) to file a report within four business days of receiving a notice or other communication from any credit rating agency that has decided to change or withdraw a credit rating assigned to the registrant or any class of security (including where the registrant is a guarantor or has a contingent financial obligation) that was previously disclosed pursuant to proposed disclosure regulations described above.

    The registrant would have to disclose the date that the registrant received the credit rating agency’s notice, the name of the rating agency and the nature of the decision. The Form 8-K disclosure item would not specifically require any discussion of the impact of the change. The SEC notes that any such disclosure would be required to be disclosed in the registrant’s periodic Exchange Act reports, if material, either in MD&A or in another appropriate location.

    Disclosure would not be required until the rating agency notifies the registrant that the rating agency has made a final decision to change the credit rating.

    Closed-end funds would be required to make the same disclosures in a current report on Form 8-K pursuant to proposed amendments to Exchange Act Rules 13a-11(b) and 15d-11(b), unless substantially the same information has been previously reported. Foreign private issuers would be required to provide disclosure regarding changes to credit ratings annually in their reports on Form 20-F.

    Potential Rescission of Rule 436(g)

    Section 7 of the Securities Act requires that if an “expert” prepares or certifies a portion of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement, the expert’s written consent must be filed as an exhibit to the registration statement. Section 11 of the Securities Act imposes liability on various parties who are involved in the preparation of a Securities Act registration statement, including the issuer, officers and directors who sign the registration statement, underwriters, and experts. An expert may be held liable if, when the registration statement became effective, the expertized part of the registration statement contained a material misstatement or omission, unless the expert can establish a “due diligence” defense — that it had, after reasonable investigation, reasonable grounds to believe and did believe that there was no such material misstatement or omission. Persons other than the issuer may be able to assert that they relied upon an expert named in the registration statement as a defense to Section 11 liability.

    Rule 436(g) currently excludes credit ratings provided by NRSROs from being considered a part of the registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the Securities Act. If adopted, such a rule would cause NRSROs to be included in the liability scheme of Section 11. In the Concept Release, the SEC expresses its concern that there is no longer a sufficient basis to exempt NRSROs, but not other credit rating agencies, from the liability scheme of Section 11.

    In connection with past rule proposals, commenters have asserted that it is inappropriate to subject NRSROs to Section 11 liability for a variety of reasons. These include arguments that ratings published by NRSROs are expressions of opinion about risk, not statements, and even if the security defaults in an individual case it would not necessarily be an indication that the opinion was wrong, that Section 11 liability would violate the NRSROs’ First Amendment rights and that Section 11 liability could eliminate the disclosure of security ratings in prospectuses. More recently, some commenters have expressed contrary views, including skepticism regarding the First Amendment argument because credit rating agencies have become involved in the structuring of complex securities and no longer rate most or all securities, and arguments that NRSROs must be subject to a credible threat of liability if they are to be held more accountable.

    In the Commenting Release, the SEC expresses its belief that it may be appropriate to rescind Rule 436(g), for four reasons. First, the SEC asserts that the original reasons supporting adoption of the rule are no longer a sufficient basis for the exemption. Potential liability for disclosures may have served as a deterrent to disclosure when disclosure was voluntary, but if the requirements discussed above are adopted then disclosure will be mandatory whenever a credit rating is used in connection with a registered offering. Second, when credit ratings are used to sell securities, it is appropriate for the expert liability scheme to apply to them. In the SEC’s view, NRSROs represent themselves as experts in analyzing credit risks, and investors rely on their judgments. Third, increased potential liability would promote investor protection by encouraging NRSROs to improve the quality of their ratings and analysis. Fourth, the distinction between NRSROs (which are not subject to Section 11 liability) and other credit rating agencies (which are) may create an untenable competitive barrier.

    The Concept Release suggests the following practical scheme for obtaining and filing NRSRO consents. For an offering registered on Form S-1, the consent would be filed prior to the effectiveness of the registration statement. For a shelf offering, different ratings might result in different consent filing requirements. A credit rating with respect to the issuer that does not necessarily change with each offering would be disclosed in the prospectus filed prior to the time the registration statement is declared effective. For a credit rating that applies to a specific program or type of security, such as a credit rating assigned to a medium-term note program or one for long-term debt and one for short-term debt, only a new or changed rating issued after the date of the last consent or change in any other expertized information would require a new consent. For a credit rating that is specific to each issuance of a security, a new consent would always be required.

    The Concept Release seeks comment on all aspects of this proposal.

    Conclusions

    The proposed disclosure requirements for security ratings used in connection with public offerings are quite stringent. The SEC clearly believes that unreliable ratings were key drivers of the ongoing credit crisis. This set of proposals attempts to address the problem of unreliable ratings with additional disclosure, on the theory that shining the spotlight on the risks of credit ratings will make investors more cautious in relying on them. However, it is not clear that investors will be any less willing to “buy the ratings” with additional disclosure than they already are.

    On the other hand, proposals to increase the potential liability of credit rating agencies for inaccurate ratings, such as the proposed rescission of Rule 436(g), may increase the quality of credit ratings — in addition to their cost and the difficulty of obtaining them. Rescinding Rule 436(g) is one method of increasing NRSROs’ potential liability within the rulemaking authority of the SEC. The last word on this topic may well come from Capitol Hill, as provisions that would subject credit rating agencies to increased liability are key components of draft legislation that has been circulated by Congressional leadership.

    ENDNOTES

    1Available at http://www.bingham.com/Media.aspx?MediaID=9794&eID=9794.

    2Credit Ratings Disclosure, Release Nos. 33-9070, 34-60797 and IC-28942, available at http://sec.gov/rules/proposed/2009/33-9070.pdf.

    3Concept Release on Possible Rescission of Rule 436(g) Under the Securities Act of 1933, Release Nos. 33-9071, 34-60798 and IC-28943, available at http://sec.gov/rules/concept/2009/33-9071.pdf.