- In an Effort to Encourage Unsolicited Ratings, SEC Requires Disclosure of All Information Provided to NRSROs Hired to Provide Credit Ratings; Also Adopts and Proposes Various New Disclosure Requirements for NRSROs
- December 8, 2009 | Author: Charles A. Sweet
- Law Firm: Bingham McCutchen LLP - Washington Office
The U.S. Securities and Exchange Commission has continued its recent history of incremental changes to the credit rating process by adopting additional rules that further address perceived conflicts of interest on the part of nationally recognized statistical rating organizations (“NRSROs”), and by proposing rules that would impose additional regulatory requirements on NRSROs. These rule changes will amend and add to the NRSRO regulations adopted by the SEC in 20071, 20082 and earlier in 2009.3
Earlier, the SEC had proposed rules that would have required public disclosure of information provided to NRSROs in connection with the assignment or surveillance of issuer-paid ratings of structured finance products, including asset-backed securities and collateralized debt obligations. The SEC did not adopt this proposal, but proposed an alternative that it has now adopted in substantially the form proposed. These rules will require any NRSROs providing issuer-paid ratings of structured finance products, and arrangers (including sponsors and underwriters) of those products, to make available to other NRSROs, by means of password-protected websites, all information provided (whether oral or in writing) for the purpose of determining the initial credit ratings or monitoring those ratings. Other NRSROs seeking to access this information would need to certify annually to the SEC that they are using the information solely to determine credit ratings, and that they will in fact determine a minimum number of ratings based on this information. To facilitate compliance, the SEC also has adopted an amendment to Regulation FD to permit disclosure of material, nonpublic information to NRSROs regardless of whether they make their ratings publicly available. While the effective date for all of these new rules will be 60 days after publication in the Federal Register, the compliance date has been delayed until 180 days after publication in the Federal Register.
Among earlier-adopted rules was a requirement that NRSROs post on their websites in XBRL (eXtensible Business Reporting Language) format a random sample of 10% of their issuer-paid credit ratings and histories of ratings actions for each class of rating for which the NRSRO is registered and has issued 500 or more issuer-paid ratings. At the same time, the SEC proposed to require NRSROs to disclose ratings histories for all of their issuer-paid ratings assigned on or after June 26, 2007, starting 12 months after the rating action was first taken. The SEC has now adopted this proposal, requiring NRSROs to disclose in XBRL format ratings action histories for all credit ratings (not just issuer-paid ratings) initially determined on or after June 26, 2007. For issuer-paid ratings, ratings actions must be disclosed 12 months after they were taken, but for other ratings, ratings actions need not be disclosed until 24 months after they were taken.
The SEC deferred action on a proposed rule that would have required issuance by an NRSRO in connection with each assignment of a structured finance product rating of a report describing the differences between rating methodologies used for such products and other types of securities (or, in the alternative, to use an identifier that distinguished those ratings). However, the SEC also is requesting comment on various other possible methods of disclosing the differences in credit risks and ratings between structured finance products and other types of debt.
Finally, the SEC also proposed new rules that would require NRSROs to furnish to the SEC a new annual compliance report, to disclose additional information about their sources of revenues, and to make publicly available a report containing information about their revenues attributable to those paying the NRSRO for issuing or maintaining credit ratings.
This alert summarizes significant aspects of both the adopted new rules, as set forth (together with commentary) in an adopting release,4 and those that were proposed, as summarized in a new proposing release.5
The Final Rules
Disclosure of Information Provided to Hired NRSROs
Under current SEC rules, certain conflicts of interest by an NRSRO are prohibited, while other conflicts are permitted if the NRSRO has disclosed the conflict in its SEC registration and has instituted procedures to manage the conflict of interest. The SEC proposed and then re-proposed a rule that would add the following as a conflict of interest:
Issuing or maintaining a credit rating for a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction that was paid for by the issuer, sponsor, or underwriter of the security or money market instrument.
When this provision originally was proposed, the SEC indicated its belief that the issuer/underwriter-pay conflict is particularly acute because certain arrangers of structured finance products (meaning any party, such as sponsors or underwriters, that oversees the process of creating structured finance products) repeatedly bring ratings business to the NRSROs. While some commenters objected to the broad coverage of this rule, in adopting it the SEC reiterated its intent that the rule apply to all types of structured finance products, not just “asset-backed securities” within the meaning of Regulation AB.
As a condition to assigning a rating to any structured finance product, the original proposal would have required an NRSRO to manage this conflict by making sure that all information provided to the NRSRO “by the issuer, underwriter, sponsor, depositor or trustee that is used in determining the initial credit rating” was publicly disclosed “through a means designed to provide reasonably broad dissemination of the information.” The SEC also proposed interpretations of how the required information could be disclosed in the context of public, private and offshore securities offerings. Commenters raised substantial legal and practical questions about the original proposal, so the SEC re-proposed it in a different form, which has now been adopted substantially as re-proposed.
NRSROs that are hired by arrangers to determine credit ratings for structured finance products transactions will be required to disclose to other NRSROs (and only NRSROs) the transactions for which they have been engaged to determine an initial credit rating, by means of a password-protected Internet website. The list must be in chronological order and identify the type of security, the name of the issuer, the date the ratings process was initiated, and the website address where information provided by the issuer, sponsor or underwriter (as discussed below) may be found. Access must be given to any other NRSRO that provides a copy of the SEC annual certification described below, to the effect that it determined and maintained ratings for at least 10% of the products for which it obtained similar access in the previous calendar year (or did not access such information 10 or more times during that calendar year). Because information must be provided only as to a pending rating, the information about a particular product may be removed when its rating is published or when the ratings process is terminated.
Each NRSRO engaged to rate a structured finance product must obtain representations from the arranger that it will post on a password-protected Internet website accessible by other NRSROs all information given to that NRSRO for the purpose of determining the initial rating. The arranger also must represent to the hired NRSRO that it will post on a password-protected website accessible by other NRSROs all information given to the hired NRSRO for the purpose of credit rating surveillance. As indicated by the SEC when the rule was first proposed, this information generally would “consist of reports from the trustee describing how the assets in the pool underlying the [products] are performing,” and the website would have to indicate which information currently should be relied upon to determine or monitor the credit rating. Therefore, if more than one loan tape were provided, the arranger would be required to identify which one is currently being relied upon. It also would have to indicate which information is final and will be used by the hired NRSRO to determine the final published credit rating. The hired NRSRO may be given access to this information by means other than posting it on the arranger’s website, so long as all of the information is posted at the same time as it is provided to the hired NRSRO. Access must be given to any other NRSRO that provides a copy of the SEC certification described below, to the effect that it determined and maintained ratings for at least 10% of the products for which it obtained similar access in the previous calendar year (or did not access such information 10 or more times).
While the proposed rule would have applied only to written information provided by the arranger, as adopted the rule applies to all information provided by the arranger, whether written or oral. The SEC recognizes that this “likely will formalize the process of information exchange from the arranger to the NRSRO . . . , including the written submission of information that may, in the past, have been provided orally,” but concludes that this would be a positive development. In addition, the final rule specifically includes information provided to the NRSRO under contract from a third party, such as trustees and loan servicers.
An NRSRO desiring to access the websites of other NRSROs or arrangers will be required to provide an annual certification to the SEC as to certain matters. These include a certification that the NRSRO will access these websites solely for the purpose of determining or monitoring credit ratings, and that the NRSRO will treat the accessed information as material nonpublic information pursuant to its internal policies. They also include a certification that the NRSRO will determine and maintain ratings for at least 10% of the securities for which it accesses information, if it accesses information for 10 or more securities in the relevant calendar year. The SEC states that the purpose of this threshold is to require an NRSRO to determine a meaningful amount of ratings without forcing it to undertake work that it may not have the capacity or resources to perform. Finally, these matters also include a certification either as to the number of securities for which the NRSRO accessed information and for which it determined and maintained ratings, or that it did not access information 10 or more times, each in the previous calendar year. Any NRSRO desiring to access the website of another NRSRO or arranger will be required to furnish a copy of its certification to that NRSRO or arranger in order to obtain the website’s password.
Some commenters argued that NRSROs accessing arranger information should be required to provide confidentiality agreements to the arranger. While the SEC did not incorporate this requirement in the final rule, it indicated that it would be permissible for the arranger to employ a simple process to obtain a confidentiality agreement from non-hired NRSROs, such as a “click-through” confidentiality agreement that contains the same terms as the confidentiality agreement between the arranger and the hired NRSRO.
The SEC has requested comment on whether it should undertake other measures that would allow non-hired NRSROs access to sufficient information to provide alternate credit ratings for structured finance products issued before the compliance date for these rules.
Disclosure of 100% of Ratings Actions
Among the earlier-adopted rules was a requirement that NRSROs post on their websites in XBRL format a random sample of 10% of their issuer-paid credit ratings and histories of ratings actions for each class of rating for which the NRSRO is registered and has issued 500 or more issuer-paid ratings. The SEC had proposed to also require that NRSROs disclose ratings actions for 100% of their current ratings that are paid for by the issuer, sponsor or underwriter (i.e., issuer-paid ratings) on their websites in an XBRL format, with a 12-month time lag for publicly disclosing any actions to help mitigate any loss of revenue from selling data feeds and downloadable packages of ratings actions.
The SEC requested comment on whether this requirement should apply equally to issuer-paid and subscriber-paid credit ratings as well as unsolicited ratings, and based on commenters’ input, the final rules were broadened to include all credit ratings. In the SEC’s view, the purpose of the rule is to facilitate comparisons of ratings performance across all NRSROs, and excluding certain types of ratings could undermine this goal. The SEC acknowledged that this might result in the loss of some NRSRO revenue, but addressed this problem by increasing the time until a non-issuer-paid rating action is required to be disclosed from 12 months to 24 months. The SEC believes this longer period is appropriate because issuer-paid credit ratings are generally made publicly available anyway for a designated period of time, whereas NRSROs operating under the subscriber-paid model may only make their ratings available to paying subscribers. The SEC indicated its intent to monitor the impact of the rule on NRSRO revenues.
As proposed, this requirement will begin with ratings initially determined on or after June 26, 2007, the effective date of the Credit Rating Agency Reform Act of 2006. The requirement that the information be provided in XBRL format is delayed until 60 days after the SEC publishes a “List of XBRL Tags for NRSROs” — until that time, an NRSRO may publish the required data in an interactive data file in any machine-readable format.
Conforming Changes to Regulation FD
Regulation FD requires that an issuer, or any person acting on its behalf, publicly disclose material nonpublic information if the information is disclosed to certain specified persons. Currently, one exception to this requirement is disclosure of information to an entity whose primary business is the issuance of credit ratings, so long as the information is disclosed solely for the purpose of developing a rating and the entity’s ratings are publicly available. The SEC has adopted, substantially as proposed, an expansion of this provision to permit the disclosure of material nonpublic information to NRSROs even if their ratings are not public. According to the SEC, this change will accommodate both subscriber-based NRSROs that do not make their ratings publicly available for free, as well as NRSROs that access information under the new disclosure rules but which do not ultimately issue a rating.
The Proposed Rules
Differentiation of Ratings for Structured Finance Products
The SEC earlier had proposed rules that would have required each publication by an NRSRO of a structured finance credit rating to be accompanied by a report describing how the credit rating procedures, methodologies and credit risk characteristics for those products differ from those of other types of rated debt instruments -- or, in the alternative, to use different rating designations for structured finance products. The purpose of this proposal was to “spur investors to perform more rigorous internal risk analysis so that they would not overly rely on NRSRO credit ratings.” Commenters criticized the proposal as burdensome and of little benefit to investors. The SEC concluded that the use of an alternative symbology would have limited usefulness in encouraging investors to perform their own analysis, and could create an inaccurate impression that other types of debt instruments are less risky. Therefore, the SEC deferred action on this proposal.
This deferral, however, may not be permanent. While the SEC acknowledged that some risks of structured finance products are well understood by investors, it still wants to further awareness by investors of their unique risks. Therefore, the SEC requested comment on a wide variety of questions about the differences between structured finance products and other debt instruments, the differences between credit ratings for such instruments, and potential ways of communicating those differences to investors. Among other things, the SEC requested comment on whether issuers of asset-backed securities and other structured finance products should be required to disclose how the risks associated with those products and the credit ratings assigned to them differ from those of corporate, municipal and sovereign debt. It appears that the SEC is considering whether to require NRSROs to disclose: (1) the diligence they have performed on assets underlying structured finance products; (2) the characteristics and sensitivities of their ratings models; (3) their reliance on arranger representations and warranties; (4) the assumptions about future events embedded in their ratings models; (5) “what if” scenarios that quantify the impact of changes in assumptions; and (6) additional information regarding default probability, loss sensitivity, severity of loss in the event of default, and various risk metrics.
New Annual Compliance Report for NRSROs
Each NRSRO must have a compliance officer, as required by Section 15E(j) of the Securities Exchange Act of 1934, but the SEC is concerned that some compliance officers may not be fulfilling their statutory duties. Therefore, the SEC has proposed that NRSROs be required to furnish to the SEC an annual unaudited report describing the steps taken by the compliance officer during the fiscal year to implement the requisite policies and procedures and ensure compliance with securities laws and rules and regulations. The report would include a description of any compliance reviews of the NRSRO’s activities, the number and a brief description of material compliance matters identified during each review, a description of any remediation measures, and a description of the persons within the NRSRO who were advised of the results of the reviews. The report would be accompanied by a statement signed by the compliance officer stating that he or she has responsibility for the report and, to the best of his or her knowledge, the report fairly presents, in all material respects, steps taken by the designated compliance officer for the period presented.
Changes to Form NRSRO and New NRSRO Report on Revenues
Form NRSRO is used by credit rating agencies to apply for NRSRO status, and by NRSROs to provide annual informational updates within 90 days after the end of each calendar year. The SEC is proposing to amend the instructions for Exhibit 6 to Form NRSRO to require disclosure of the percentage of the net revenue of the applicant/NRSRO attributable to the 20 largest users of credit rating services of the applicant/NRSRO, and the percentage of the net revenue of the applicant/NRSRO attributable to other services and products of the applicant/NRSRO.
The SEC also has proposed a new rule that would require each NRSRO to post on its website an annual report containing information about revenues earned by the NRSRO and its affiliates as a result of providing services and products to persons who paid the NRSRO to issue or maintain a credit rating. Among other things, the report would require the NRSRO to include the percentage of the NRSRO’s net revenue attributable to each such person that was earned from providing services and products other than credit rating services to that person, the relative standing of that person in terms of its contribution to the NRSRO’s net revenue, and the identity of all outstanding credit ratings paid for by that person. The NRSRO would be required to prominently include a generic disclosure statement each time the NRSRO publishes a credit rating, indicating where on its website the report may be found.
The new rules that require arrangers of credit ratings for structured finance products to make available to other NRSROs all information provided to hired NRSROs that they engage to provide credit ratings will have an immediate impact on the credit rating process. Among other things, it is likely that all information provided to NRSROs will be given in writing, and that posting on a password-protected website will be the primary method of communicating even with hired NRSROs.
The requirement that NRSROs post on their websites ratings actions for 100% of their current issuer-paid ratings may provide some additional means for market participants to gauge the relative quality of NRSROs’ ratings work but, as with the already-effective requirement to post a random sample of 10% of their issuer-paid ratings, the ultimate impact of these rules remains to be seen.
While there have been three years of adopted and proposed changes to the regulatory scheme for NRSROs and credit ratings, there are still a number of proposals and re-proposals in the credit rating agency arena on which the SEC has not taken final action. Moreover, rating agency “reform” remains a major subject of consideration by both houses of Congress as part of the various larger financial services reform proposals. The comprehensive list of questions posed by the SEC surrounding the differences between structured finance products and other debt instruments suggests that the end game is not yet in sight.
1 Those rules generally identify conflicts of interest that an NRSRO must avoid or may disclose and manage; prohibit certain unfair, coercive or abusive practices; and impose reporting and recordkeeping requirements, among other things.
2 Those rules generally prohibit NRSRO recommendations on structure of a rated structured finance product; require records of the rationale for any material difference between a rating implied by any quantitative model that is a substantial component of the rating process and the issued rating; prohibit analysts from involvement in fee negotiations; prohibit the receipt of gifts by rating agency analysts; and require posting of a random sample of issuer-paid credit ratings and histories of ratings actions for certain classes of ratings, among other things.
3 Those rules remove references to credit ratings in several rules and forms under the Securities Exchange Act of 1934 and the Investment Company Act of 1940.
4 Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Release No. 34-61050 (November 23, 2009) available at http://sec.gov/rules/final/2009/34-61050.pdf.
5 Proposed Rules for Nationally Recognized Statistical Rating Organizations, Release No. 34-61051 (November 23, 2009), available at http://sec.gov/rules/proposed/2009/34-61051.pdf.