The SEC yesterday finalized rules proposed in May 2011 intended to reform nationally recognized statistical rating organizations (NRSROs), more colloquially known as credit rating agencies. The rules, mandated by the Dodd-Frank Act, split the Commission along party lines and come after much prodding by Congress.
The Commission moved to mitigate the influence of an NRSRO's sales and marketing on ratings. Specifically, an NRSRO cannot issue a rating where a person involved in the issuance is also involved in sales or marketing “or is influenced by sales or marketing considerations.” Commissioner Daniel Gallagher took specific issue with this provision, calling it a “thought crime” and opining that the requirement would not hold up if challenged in court.
The rules also seek to address conflicts of interest and require an NRSRO to disclose whether a rating was solicited or unsolicitied, and if solicited, whether the NRSRO provided any other services to the rating subject during the previous fiscal year. The amendments also add additional requirements to existing “look-back” reviews, which are required when an NRSRO employee that participated in a rating subsequently works for the subject of that rating. The changes require that the review is “prompt” and that the results of the review are disclosed publicly, even if the result is an affirmation of the rating.
In an attempt to add consistency and clarity to the ratings process, the rules introduce factors for NRSROs to consider when implementing a control structure. The rules suggest a review and approval process for methodologies that, among other things, allows for public consultation. Further, upon the issuance of a rating, or any change to a rating, the NRSRO must publish a form listing "quantitative and qualitative information" about the rating. Lastly, the rules require clear definitions and consistent application of rating symbols.
The rules impose other disclosure requirements as well. Each NRSRO must submit an annual report to the Commission detailing the control structure and its effectiveness, including an attestation from the NRSRO's CEO. The report must disclose any material weaknesses in the control structure identified during the previous year, the existence of which would prevent the NRSRO from finding that its internal controls were effective. The rules also require additional levels of disclosure for existing reporting related to default and transition (i.e. upgrade or downgrade) rates, and new disclosure relating to the NRSRO’s reliance upon third-party due diligence services and the findings of the provider.
For new or complex products, an NRSRO must determine whether it has sufficient information and competency upon which to base a rating. The rules also require procedures detailing training, testing, and required experience levels, including a requirement that at least one individual with experience “commensurate with the type of obligor or obligation being rated,” but not less than three years of experience performing credit analysis, participate in the rating determination.
Commissioners Daniel Gallagher and Michael Piwowar dissented, arguing that the rule was too vague. Gallagher criticized “hasty additions,” while Piwowar felt that the changes were too discretionary and beyond the requirements imposed by Dodd-Frank.
While the Commission continues the process of attempting to reform credit rating agencies, it also continues to remove references to credit ratings from its own rules. For example, we recently highlighted the Commission’s recent proposals to eliminate references to credit ratings from the rules governing money market funds. That said, credit ratings will undoubtedly continue to be used extensively in the private sector for a variety of purposes. The Commission’s efforts in this area may therefore have significant effects.
The SEC’s adopting release can be found here.