In its latest round of rulemaking pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act”), on May 18, 2011 the Securities and Exchange Commission ("SEC”) published a 517-page release containing proposed rules for Nationally Recognized Statistical Rating Organizations ("NRSROs”).1 NRSROs, such as Standard & Poor's, Moody's and Fitch, provide credit ratings widely used to value various assets. Because financial institutions rely heavily on credit ratings to purchase, sell and securitize assets, changes to NRSRO regulations also will affect those institutions as well.
The Dodd-Frank Act included new NRSRO rules2 in response to the view that the economic meltdown was caused in part by inaccurate credit ratings on asset-backed securities and structured financial products. Facially, the SEC's proposed rules have two primary objectives: (1) increase the reliability of credit ratings; and (2) allow investors to compare information across the various NRSROs by requiring information to be presented in a more standardized format. The proposed rules address the following areas:
- Internal Controls: The proposed rules would clarify Section 932's self-executing requirement that NRSROs establish internal controls to ensure adherence to credit rating policies.
- Conflicts of Interest: Under the proposed rules, a NRSRO would be subject to suspension if the same person fills both marketing and credit rating functions, unless the NRSRO is so small that it is not practical to have different people perform these duties.
- "Look Back” Review: NRSROs would be required to establish criteria for determining whether to revise a rating based on a conflict of interest where an employee involved in determining a credit rating subsequently becomes employed by the entity he/she rated.
- Fines and Penalties: The SEC declined to establish new fines and penalties in the rulemaking process, but has proposed a new instruction to Form NRSRO to alert rating agencies to the existing fines and penalties for violations of the Securities and Exchange Act of 1934 ("Exchange Act”).
- Performance of Credit Ratings: The proposed rules would require NRSROs to provide more information regarding both performance statistics and rating histories in a standardized format so that investors may easily compare NRSROs' rating accuracy.
- Credit Rating Methodologies: The proposed rules would require NRSROs to use rating procedures and methodologies approved by their boards that are reasonably designed to ensure consistency of ratings and prompt disclosure of changes.
- Form and Certifications to Accompany Credit Ratings: Whenever a NRSRO takes any rating action, the proposed rules would require the NRSRO to publish both detailed information about the change and any certification that the NRSRO received from a provider of third-party due diligence services related to the credit rating.
- Third-Party Due Diligence for Asset-Backed Securities: The SEC's October 2010 proposed rules3 to implement Section 932's requirements concerning third-party due diligence services were never adopted. In its revised rules the SEC sets out a procedure for issuers, underwriters and NRSROs to make public the third-party due diligence reports on Exchange Act asset-backed securities. In addition to providing a new form with new definitions, the proposed rules also prescribe the format and content of required third-party due diligence service certifications. The SEC also requests practical comment on how the certification process will work, implying that a due diligence service may not always know when a NRSRO uses its services in connection with a credit rating.
- Training, Experience and Competence: To ensure the accuracy of credit ratings, the proposed rules would require that NRSROs establish and document training standards based on consideration of four enumerated factors. In addition, NRSROs must periodically test their employees on rating procedures, and have at least one person with three or more years of experience participate in all credit rating determinations.
- Universal Rating Symbols: The proposed rules would mirror statutory text from Section 938, and would require NRSROs to assess the probability of default of a rated obligation. NRSROs also would be required to apply the same clearly defined rating symbols to all investment vehicles.
- Annual Report of Designated Compliance Officer: The proposed rules would clarify self-executing portions of Section 932 by requiring an annual report of a designated compliance officer to be filed with the SEC.
- Electronic Submission: The proposed rules require NRSROs to file certain forms electronically through EDGAR, but would retain paper filing for all others. Significantly, the SEC also proposes to exclude certain NRSRO filings from the temporary exemption for late electronic filing due to technology problems.
- Miscellaneous Amendments: The proposed rules contain a number of miscellaneous conforming amendments, primarily related to definitions that have changed elsewhere in the statutory or regulatory scheme. Additionally, the proposed rules clarify instructions to be included on Form NRSRO.
Considering the importance of credit ratings to their business models, financial institutions must pay close attention to the NRSRO regulatory changes. While this Alert provides only an overview of the proposed rules, our attorneys are happy to provide greater detail on any particular area of interest and, if desired, assist you in developing comments by the SEC's August 8, 2011 deadline.
1 Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 34-64514 (May 18, 2011), available here.
2 See, e.g., Dodd-Frank Act, 111th Cong. §§ 932, 936, 938 (2010).
3 Issuer Review of Assets in Offerings of Asset-Backed Securities, 75 Fed. Reg. 64,182 (Oct. 19, 2010), available here.