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9.10 Improvements to the Regulation of Credit Rating Agencies

<< Title IX Overview

9.10 Improvements to the Regulation of Credit Rating Agencies

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9.10.     Improvements to the Regulation of Credit Rating Agencies.  The Act expands the regulation of credit rating agencies, including nationally recognized statistical ratings organizations ("NRSROs") by the SEC.  It also requires NRSROs to maintain more robust internal supervision of the ratings process, imposes increased accountability on credit rating agencies, including NRSROs and attempts to reduce reliance on ratings from credit rating agencies.  It also requires NRSROs to comply with a number of additional procedures designed to increase transparency and mitigate conflicts of interest in the credit ratings process with the goal of improving the quality and integrity of the credit ratings provided by NRSROs.

9.10.1.  Mitigation of Conflicts of Interest at NRSROs.  A number of provisions of the Act are directed at mitigating actual or perceived conflicts of interest that could impair the integrity of credit ratings provided by NRSROs, which include those described below. [§932]

9.10.1.1.           Internal Controls.  NRSROs must establish an effective internal control structure governing implementation of and adherence to policies, procedures and methodologies for determining credit ratings, taking into account such factors as the SEC may prescribe, and document such internal control procedures.  On an annual basis, each NRSRO must submit to the SEC a report, containing an attestation from the NRSRO's Chief Financial Officer, identifying its internal control structure, and describing the role of management.

9.10.1.2.           Separation of Marketing Considerations from the Production of Ratings.  The SEC is directed to issue rules intended to require NRSROs to manage conflicts of interest by separating their sales and marketing activities from all areas involved in the production of ratings in order to prevent sales and marketing considerations from influencing the production of ratings.  Small NRSROs are exempted from these rules if compliance would pose an unreasonable burden on the NRSRO.

9.10.1.3.           Employee Look-Back Requirement.  If an employee of any issuer, underwriter, sponsor or other entity subject to a credit rating provided by an NRSRO was employed by that NRSRO and participated in any way in determining such credit rating, the NRSRO is required to "look-back" for the one-year time period preceding the date an action was taken with respect to that credit rating to determine whether that employee was influenced by a conflict of interest.  If an NRSRO determines such a conflict of interest existed, the NRSRO must revise the rating, if appropriate, in accordance with rules to be issued by the SEC.  The SEC is required to conduct a review of each NRSRO's compliance with these policies, as well as its ethics procedures, at least annually and whenever such a policy is materially modified.

9.10.1.4.           Report of Certain Employment Transitions.  Each NRSRO must report to the SEC if a person who was employed at such NRSRO over the previous five years as a senior officer, an employee who participated in determining credit ratings or a supervisor of an employee who participated in determining credit ratings left its organization to obtain employment with an obligor, issuer, underwriter or sponsor of a security or money market instrument for which the NRSRO issued a credit rating during the twelve-month period prior to the employee's departure.

9.10.1.5.           Compliance Officers.  Each NRSRO is required to have a compliance officer who is not involved in determining credit ratings, development of ratings methodologies or performing marketing or sales functions.  The SEC may exempt small NRSROs from this requirement if compliance would pose an unreasonable burden on the NRSRO.  The compensation of an NRSRO's compliance officer may not be tied to the NRSRO's financial performance.

9.10.1.6.           Corporate Governance, Organization, and Management of Conflicts of Interest.  Each NRSRO must have a Board of Directors with at least one half (but not fewer than two) of the directors being independent in accordance with specified guidelines.  One or more of the independent directors must be users of NRSRO ratings.  The SEC has the discretion to exempt small NRSROs from this requirement if compliance would pose an unreasonable burden on the NRSRO.

9.10.2.  Additional Penalties and Potential Liabilities for NRSROs.  The Act contains additional penalties which may be imposed by the SEC and broadens the potential liability of an NRSRO in connection with securities offerings. [§§932, 933 and 934]

9.10.2.1.           Additional Penalties.  The SEC may suspend or revoke an NRSRO's registration upon a determination that the NRSRO lacks adequate financial or managerial resources to consistently produce credit ratings with integrity.  In addition, the SEC is authorized to fine an NRSRO, with consideration given to, among other things, an NRSRO's failure to produce ratings with integrity over time. [§932(a)]

9.10.2.2.           SEC Enforcement Actions.  The SEC's prohibition against regulating the substance of credit ratings is expressly stated not to be a defense to an anti-fraud action brought by the SEC.

9.10.2.3.           Private Right of Action; State of Mind in Private Actions.  A private right of action for securities law violations may be brought against a credit rating agency.  Enforcement and penalty provisions now apply to statements made by a credit rating agency in the same manner and extent as statements made by registered public accountants or securities law analysts.  It is sufficient for the purposes of pleading a required state of mind in a private securities action against a credit rating agency that the complaint set forth facts giving rise to a strong inference that the credit rating agency failed either (i)  to conduct a reasonable investigation of the rated security with respect to the factual elements it relied upon in its methodology for evaluating credit risk; or (ii) to obtain reasonable verification of such factual elements from other sources that the NRSRO considered to be competent and that were independent of the issuer and underwriter. [§933]

9.10.2.4.           Referring Tips to Law Enforcement or Regulatory Authorities.  NRSROs must now report information received from a credible third party alleging that an issuer of securities rated by the NRSRO has committed or is committing a material violation of the law.  The NRSRO is not required to verify the accuracy of any such information. [§934]

9.10.3.    Oversight of NRSROs; Improvements to Transparency.  There are new procedures for SEC oversight of NRSROs, as well as new obligations on NRSROs to make the credit rating process more transparent.

9.10.3.1.           Establishment of Office of Credit Ratings.  The SEC is required to establish an Office of Credit Ratings, which must have a Director and sufficient staff.  The stated purposes of this Office are to protect users of credit ratings, promote accuracy in credit ratings, and ensure that ratings are not influenced by conflicts of interest.  The Office is required to audit each NRSRO annually and examine whether each NRSRO adheres to its own standards, manages conflicts of interest, implements ethics policies, and processes complaints.  The Office is also required to examine the activities of each NRSRO's compliance officers and its policies governing post-employment opportunities of former staff.  The SEC is required to make its inspection reports available to the public. [§932(a)]

9.10.3.2.           Transparency of Ratings Performance.  The SEC is directed to issue rules requiring NRSROs to publicly disclose information on their initial ratings of each security and any subsequent changes to such ratings.  These rules are intended to allow users of credit ratings to evaluate the accuracy of those ratings and to compare the performance of ratings by different NRSROs.

9.10.3.3.           Credit Rating Methodologies and Procedures.  The SEC is required to issue rules for the protection of investors and the public interest with respect to each NRSRO's procedures and methodologies, including qualitative and quantitative data models used to produce ratings.  These rules will require each NRSRO to ensure that its credit rating procedures are in compliance with standards approved by its senior credit officer or board of directors (or similar body).  They will also require that, when material changes to rating procedures and methodologies occur, such changes are applied consistently to all ratings to which such changed procedures and methodologies apply.  These rules will also require notification to ratings users of the occurrence of either a material change in a policy or procedure or an error.

9.10.3.4.           Disclosure of Credit Rating Methodology Assumptions and Third-Party Due Diligence Services.  The SEC is to issue rules which will require each NRSRO to disclose assumptions underlying its procedures and methodologies, as well as the data relied upon to determine a rating.  To facilitate the disclosure process, the SEC is directed to develop a form, which is intended to be easy and helpful for users of credit ratings, to accompany the disclosure of the credit ratings.

An issuer or underwriter of any asset-backed security is required to make publicly available any third-party due diligence reports it uses.  Any NRSRO, issuer or underwriter which employs third-party due diligence services must disclose whether and to what extent third-party due diligence services have been used in the ratings process.  Any third parties providing due diligence services to an NRSRO must certify in writing that it has conducted a thorough review of the relevant data and other necessary information.

9.10.3.5.           Consideration of Information from Sources Other than the Issuer.  In producing a credit rating, each NRSRO is required to consider information the NRSRO has or that it receives from outside sources (other than the underwriter or issuer) that it finds credible and potentially significant to a rating decision. [§935]

9.10.3.6.           Universal Rating Symbols.  NRSROs will be required to clearly define and disclose the meaning of any symbols used in connection with its credit ratings and to use each such symbol in a consistent manner with respect to all types of securities for which that symbol is used.  Each NRSRO may, however, use different sets of symbols to identify ratings for different types of securities. [§938]

9.10.3.7.           Qualification Standards for Credit Rating Analysts.  The SEC is required to issue rules requiring NRSRO employees to be tested for knowledge of the credit rating process or to otherwise meet standards necessary to produce accurate ratings. [§936]

9.10.4.    Reducing Federal Agency Reliance on Credit Agencies.  The Act attempts to reduce the reliance of Federal agencies on credit determinations from credit rating agencies. [§§939 and 939A]

9.10.4.1.           Removal of Statutory Reference to Credit Ratings.  Effective two years after enactment of the Act, various statutory references to credit rating agencies and credit ratings will be removed from numerous federal statutes, including portions of the FDI Act and the Investment Company Act of 1940.  Generally, these statutes will now require the responsible governmental agencies to establish alternative standards of determining credit-worthiness, rather than relying on credit rating agencies or their ratings. [§939]

9.10.4.2.           Review of Reliance on Ratings.  Within one year, each Federal agency is required to review any regulation issued by such agency that either requires the use of an assessment of the credit-worthiness of a security or money-market instrument or references regulations regarding credit ratings.  These regulations must then be modified to remove references to or reliance on credit ratings and substitute a standard of credit-worthiness deemed appropriate, taking into account various specified factors. [§939A]

9.10.5.    Timing, Additional Studies and Reports.

9.10.5.1.           Timing of Regulations.  The SEC is required to issue final regulations regarding the regulation of credit rating agencies within one year, except as otherwise set forth in the Act. [§937]

9.10.5.2.           SEC Study on Strengthening Credit Rating Agency Independence.  The SEC is required to conduct a study of the independence of NRSROs and how this affects credit rating issues.  The SEC must evaluate, among other things, management of conflicts of interest raised by NRSROs providing other non-rating services and the potential impact of a prohibition on such services.  The SEC must report to Congress the results of this study within three years. [§939C]

9.10.5.3.           Comptroller General Study on Alternative Business Models.  The Comptroller General is required to conduct a study of alternative means for compensating NRSROs to create incentives to provide more accurate ratings and report the results of this study to Congress within eighteen months. [§939D]

9.10.5.4.           Comptroller General Study on the Creation of an Independent Professional Analyst Organization.  The Comptroller General is directed to conduct a study on the feasibility and merits of creating an independent professional organization that would establish independent standards and an ethics code for NRSRO ratings analysts, as well as oversee the profession, and report the results of this study to Congress within one year. [§939E]

9.10.5.5.           Study and Rulemaking on Assigning NRSROs to Rate Structured Finance Products.  The SEC is required to conduct a study on the credit ratings process for structured finance products and the conflicts of interest associated with issuer-pay and subscriber-pay models, ways to measure the accuracy of credit ratings, and alternative ways to compensate NRSROs to create incentives for accurate credit ratings.  This study will also evaluate the feasibility of establishing a public or private utility or self-regulating organization that would assign NRSROs to determine the credit ratings on structured finance products, including assessing appropriate methods for determining and paying fees to NRSROs, whether such a system would be viewed as creating a moral hazard issue, whether there are constitutional issues associated with such a system, and means to determine the accuracy of credit ratings.  The SEC is required to report the results of this study to Congress within two years.  After completion of this study, the SEC will determine whether it is necessary or appropriate to establish a system for assigning NRSROs to determine the initial credit ratings of structured finance products and issue a rule accordingly. [§939F]

9.10.5.6.           Standardization Study.  The SEC is required to conduct a study regarding the feasibility and desirability of standardizing credit rating terminology across credit rating agencies and across asset classes, standardizing market stress conditions under which ratings are evaluated, and requiring a quantitative correspondence between ratings and a range of default probabilities and loss expectations under standardized stress conditions.  The SEC is required to report the results of this study to Congress within one year from the date of enactment of the Act. [§939]