New US regulations for nationally recognized statistical rating organizations (NRSROs)1 took effect earlier this year, with compliance required starting June 2, 2010.2 Among other changes, the US Securities and Exchange Commission (the SEC) amended rule 17g-53 to facilitate unsolicited ratings from NRSROs that were not hired to rate particular asset-backed securities (ABS) and other structured finance products. The amendments (collectively referred to as the Web Site Rules) enable non-hired NRSROs (Accessing NRSROs) to access the same ratingrelated information as NRSROs that are hired (Hired NRSROs).
The Web Site Rules are relevant to any issuer of a structured finance product that is rated by an NRSRO, including non-US issuers and even transactions that have no US investors or other connection to the United States. We will discuss the territorial scope of these rules, the types of products they cover and some basic compliance issues below.
In Europe, the European Commission adopted a proposal4 on June 2, 2010, which, among other things, amends the existing EU regulation on credit rating agencies5 to include web site rules modeled on rule 17g-5. This proposal has now been passed to the Council of Ministers and the European Parliament for consideration. If adopted, the EU web site rules are expected to come into force sometime in 2011. We discuss this proposal below after explaining the US Web Site Rules.
Overview of the Web Site Rules
While the Web Site Rules only apply directly to NRSROs,6 they also necessitate significant efforts by issuers, sponsors and financial intermediaries that assist with the rating process.7 The adopting release for the Web Site Rules (the Adopting Release) uses the term “arranger” to refer collectively to issuers, sponsors and underwriters that may be required to maintain Arranger Sites (as defined below). However, we expect that issuers or sponsors will usually be the parties that actually carry out these new responsibilities since they generally hire NRSROs and have a significant interest in controlling rating-related information.
New paragraph (b)(9) of rule 17g-5 identifies the following practice as a conflict of interest for an NRSRO: 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 (a Structured Finance Product) that was paid for by an arranger. In order to be permitted to engage in this practice, notwithstanding such conflict of interest, new paragraph (a)(3) requires Hired NRSROs to take specified steps, which the SEC intends as mitigants to the impact of the conflict of interest by facilitating unsolicited ratings.8 Specifically, a Hired NRSRO that wishes to issue or maintain ratings on Structured Finance Products where the rating is paid for by an arranger must:
- Maintain on a password-protected web site (a Hired NRSRO Site) a list (the Ratings in Process List) of each Structured Finance Product for which it is currently in the process of determining an initial credit rating, with specified information including the name of the issuer, the date the rating process was initiated and the address of a passwordprotected web site (an Arranger Site) where an arranger is maintaining the information described below;
- Provide access to its Hired NRSRO Site to Accessing NRSROs (subject to the certification requirement discussed below); and
- Obtain a written representation, that can reasonably be relied upon, from an issuer, sponsor or other arranger of each Structured Finance Product on the Hired NRSRO’s Ratings in Process List to the effect that the issuer or other arranger will maintain an Arranger Site containing rating-related information and will:
- Provide Accessing NRSROs access to such Arranger Site (subject to the certification requirement discussed below); and
- Post on such Arranger Site all of the information that the arranger provides (or contracts with a third party to provide) to the Hired NRSRO for the purpose of (i) determining the initial credit rating for the Structured Finance Product or (ii) rating surveillance, all in a manner indicating which information currently should be relied on to determine or monitor the credit rating.
While arrangers are not directly subject to the Web Site Rules, it is clear that the SEC intends to take seriously any failures by arrangers to perform the obligations they undertake,9 and NRSROs will essentially not be permitted to provide ratings unless arrangers undertake those obligations.
The Web Site Rules are silent as to their territorial reach, focusing instead on the activities of the NRSROs. Prior to adoption of the Web Site Rules, the major credit rating agencies active in the United States had registered not only themselves but also all or most of their foreign affiliates as NRSROs. As a result, it appears that the Web Site Rules apply by their terms to all ratings on Structured Finance Products issued by any of such US rating agencies or any of those foreign affiliates. This would include transactions conducted wholly outside the United States where the only US connection is a rating by an entity that is registered as an NRSRO. In other words, an NRSRO that provides a rating for a Structured Finance Product that has a non-US issuer and a non-US sponsor and is sold entirely to non-US investors would be subject to these rules and would need to seek compliance by the arrangers of that transaction.
As the June 2 compliance date for the Web Site Rules approached, staff from several non-US securities regulators, as well as a number of market participants, notified the SEC that arrangers of Structured Finance Products located outside the United States generally had not been aware of the extra-territorial reach of the rules and would not be prepared to comply with them by June 2. This created the potential for disruption of any new issuance activity in local securitization markets. The non-US securities regulators and European issuers also expressed concern about possible conflicts between the Web Site Rules and European Union data protection and bank secrecy law, rating regulations and possibly other EU and national laws.
Responding to these concerns, in May 2010, the SEC issued an order10 granting a temporary exemption from the Web Site Rules for transactions in which:
- The issuer of the structured finance product is a non-US person.
- The Hired NRSRO has a reasonable basis to conclude that the Structured Finance Product will be offered and sold upon issuance, and that any arranger linked to the structured finance product will effect transactions in the structured finance product after issuance, only in transactions that occur outside the United States.
The exemption only applies until December 2, 2010, and it does not apply if a Structured Finance Product issued by a non-US person is being offered in the United States or otherwise to US persons (for example, in a combined Rule 144A/Reg S offering). The SEC also asked for comments on various issues relating to the extraterritorial application of the Web Site Rules but did not give any indication as to whether it might consider further relief after December 2, 2010.
What Types of Deals are Covered?
The Web Site Rules apply to “a security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction” (where the rating is paid for by an arranger). The Adopting Release makes clear that this category is meant to cover “the full range of structured finance products, including, but not limited to, securities collateralized by static and actively managed pools of loans or receivables (e.g., commercial and residential mortgages, corporate loans, auto loans, education loans, credit card receivables, and leases), collateralized debt obligations, collateralized loan obligations, collateralized mortgage obligations, structured investment vehicles, synthetic collateralized debt obligations that reference debt securities or indexes, and hybrid collateralized debt obligations.”11 At a minimum, it should cover any “asset-backed security” within the Regulation AB definition, which the Adopting Release characterizes as a “narrower” definition.12
Because the Web Site Rules apply directly to NRSROs, any uncertainties as to whether or not a particular transaction is a Structured Finance Product will be determined primarily by the Hired NRSROs. The major NRSROs active in rating ABS have published preliminary guidance as to some of the transactions that they do or do not view as subject to the Web Site Rules. In each case, conventional ABS (including residential and commercial mortgage-backed securities) are clearly covered, as is asset-backed commercial paper (ABCP). Generally, the deciding factor is whether or not the NRSRO applies what it views as a structured finance analysis to the transaction as opposed to a traditional corporate or municipal debt rating analysis.
Some particular points that may be of interest to cross-border issuers are:
- Future Flow Transactions. Neither the Web Site Rules nor the Adopting Release specifically addresses future flow transactions, and none of the major NRSROs have published a position as to whether or not future flow transactions are Structured Finance Products and thus subject to the Web Site Rules. We think it is possible that an NRSRO, when faced with the issue, will decide that future flow transactions are subject to the rules because it is our understanding that the NRSROs analyze these transactions using a combination of structured finance and general corporate credit criteria (since these transactions typically focus on particular future-arising assets but involve full recourse to the sponsor).
- Loans vs. Securities. Often cross-border future flow or asset-backed transactions involve loan agreements between one or more lenders and a special-purpose entity rather than issuance by the special-purpose entity of tradable debt securities. We do not believe the use of a loan agreement will keep a transaction outside of the scope of the Web Site Rules if the transaction is rated by at least one Hired NRSRO using structured finance criteria. Although the Web Site Rules refer to “securities or money market instruments,” the SEC and the NRSROs have interpreted the Web Site Rules broadly, and we believe they would focus on the presence of a rating and type of rating methodology rather than the legal form (such as loan vs. security).
- Covered Bonds. Both Moody’s Investors Services and Fitch Ratings have indicated that they do not view conventional covered bonds as subject to the Web Site Rules. This may be a useful precedent in considering whether or not future flow transactions are subject to the rules, but neither NRSRO provided enough explanation of this conclusion to enable us to predict whether such an argument would be persuasive.
- Public Offerings vs. Private Placements. The scope of the Web Site Rules is not limited to publicly offered securities. Ratings on Structured Finance Products that are paid for by arrangers are covered, regardless of whether the product is offered publicly or in a private placement or other offering exempt from registration under the Securities Act (including offerings under Rule 144A or, subject to the territorial issues addressed above, Regulation S).
- Published vs. Confidential Ratings. The major NRSROs have taken the position that the Web Site Rules apply only to “published” or “public” ratings, as opposed to ratings that they provide on a confidential basis. The NRSROs have not provided detailed guidance on exactly how many people can see a rating before it is considered to be public. Moody’s has provided the most detail, indicating that it will only treat a rating as confidential (and exclude it from the Web Site Rules) if an arranger (i) represents to Moody’s that the arranger does not intend to obtain a published or definitive credit rating of the Structured Finance Product from Moody’s and (ii) acknowledges that Moody’s cannot publish or make available to any other person the private rating, assessment or a definitive credit rating of the Structured Finance Product. Standard and Poor’s has said that it will treat ratings that are “kept strictly confidential by the issuer and sponsor” as not covered by the Web Site Rules, while Fitch Ratings has indicated that it will apply the Web Site Rules to ratings that it publishes, without indicating how broad that publication must be.
- Using Existing Multi-Seller ABCP Conduits. Under the terms of the Web Site Rules, it was not initially clear that transactions entered into by multi-seller conduits established prior to the June 2 compliance date would be subject to the rules, unless the transaction was itself rated. However, in discussions prior to the compliance date, the SEC made it clear that the SEC intended to cover pre-existing conduits. As a result, even unrated transactions funded by these conduits going forward are being treated as subject to the rules. The level of information provided to NRSROs relating to these transactions varies based on the structure and history of the particular conduit.
It is important to determine at the outset whether any NRSRO hired to rate a transaction views the transaction as subject to the Web Site Rules, so that the arrangers can begin to comply as soon as they start providing rating-related information to the Hired NRSRO. In practice, the NRSROs will generally take the initiative on this since they are the parties directly subject to the rules. If an NRSRO views a transaction as covered, it will provide a form of letter agreement relating to compliance with the rules to whoever is hiring the NRSRO (in our experience, generally the issuer or sponsor).
Although issuers or sponsors usually hire NRSROs, often an “underwriter” (including a placement agent in a traditional private placement or an initial purchaser in a Rule 144A offering) or other financial intermediary helps with the rating process. Any information provided by an underwriter or other financial intermediary to a Hired NRSRO in connection with a rating is subject to the Web Site Rules in the same manner as information provided directly by the issuer or sponsor. Consequently, it is also important for an issuer or sponsor and the underwriter or other financial intermediary to set up “rules of the road” on communicating with the NRSROs, setting up the required Arranger Site and posting information to that site. These understandings are generally memorialized in the underwriting or similar agreement for the transaction or sometimes in a separate agreement executed earlier in the process.
An arranger is required to post all information that the arranger provides (or contracts with a third party to provide) to any Hired NRSRO for the purpose either of determining the initial credit rating for the Structured Finance Product or of rating surveillance. Unfortunately, this includes information provided orally, which presents some logistical problems and is leading many issuers to record their telephone calls with Hired NRSROs and post the recordings. As to the initial credit rating, the Web Site Rules specifically mention (i) information about the characteristics of the assets underlying or referenced by the Structured Finance Product and (ii) the legal structure of the Structured Finance Product.
As to surveillance, element (i) above is repeated, with additional reference to information about performance – for example, periodic servicing reports should be made available on the Arranger Site. Element (ii) is not repeated. However, we would not place too much importance on these differences. The main point is what we emphasized above: “all information” relevant to the initial rating or surveillance that is provided by (or on behalf of) an arranger to a Hired NRSRO is to be posted. All of the required information is to be posted at the same time such information is provided to the Hired NRSRO and in a manner indicating which information currently should be relied on to determine or monitor the credit rating.
Arrangers will have to consider the facts and circumstances of each visit, but in our experience most rating agency visits relate to the process of determining an initial rating, surveillance of existing ratings or both. Consequently, we would expect arrangers will usually conclude that they should post any written information provided at these meetings, as well as recordings of conversations at the meetings.
Unfortunately, neither the Web Site Rules nor the Adopting Release provide much guidance on how long an arranger must maintain information on its Arranger Site once it has been posted. It is clear that an NRSRO can remove securities from its Ratings in Process List once the rating has been issued. However, the Adopting Release contemplates that even after a security is removed from a Ratings in Process List, “the information on the arranger’s Website would remain available.”13 There does not seem to be a clear end date for the arranger’s maintenance requirement, though once the deal has paid off there would be little point in keeping the information posted. The same would be true if the rating request was withdrawn.
Confidentiality and Access Issues
In order to be entitled to access either a Hired NRSRO Site or an Arranger Site, an Accessing NRSRO must furnish the SEC, for each calendar year for which it is requesting a password, a certification as to the matters set out below.14 Hired NRSROs and arrangers are entitled to receive a copy of such certification before providing access. The required certification must indicate that the Accessing NRSRO:
- Will access the Hired NRSRO Sites and Arranger Sites solely for the purpose of determining or monitoring credit ratings
- Will keep the information it accesses confidential and treat it as material nonpublic information subject to its written policies and procedures.15
In addition, the certification must include representations as to the Accessing NRSRO’s intent and track record relating to the actual use of accessed information to issue ratings.
Besides obtaining these certifications, most arrangers are setting up a click-through confidentiality agreement as part of the procedure for signing into Arranger Sites. The Adopting Release permits this, stating:
the representations an NRSRO must obtain from an arranger will not prevent the arranger from employing a simple process requiring non-hired NRSROs to agree to keep the information they obtain from the arranger confidential, provided that such a process does not operate to preclude, discourage, or significantly impede non-hired NRSROs’ access to the information, or their ability to issue a credit rating based on the information. For example, an arranger could interpose a confidentiality agreement in a window (click-through screen) on the Internet Web site that appears after the NRSRO successfully enters its password to access the information and which requires the NRSRO to hit an ‘‘Agree’’ button before being directed to the information to be used to determine the credit rating. Presumably, this confidentiality agreement would contain the same terms as the confidentiality agreement between the arranger and the hired NRSRO.16
Also, the Web Site Rules do not preclude due diligence procedures that enable the arranger to ensure that an individual accessing an Arranger Site is entitled to do so, provided that “such a process does not operate to preclude, discourage, or significantly impede non-hired NRSROs’ access to the information, or their ability to issue a credit rating based on the information.”17 For example, arrangers may take any or all the following steps:
- Ask for information such as the name, company and email address of an individual requesting a password to access the Arranger Site and only provide a password to valid email addresses at the NRSRO’s proprietary domain rather than, for example, an email address at “gmail.com”
- Require a click-through certification that the NRSRO meets the requirements to access the web site
- Call the main telephone number of the requesting NRSRO and interview an appropriate employee regarding such topics as the number of times the NRSRO has accessed Arranger Sites and the number and percentage of unsolicited ratings the NRSRO has issued.
Proposed EU Legislation
As mentioned at the start of this Update, the European Commission has adopted a proposal (the Proposal) to amend the existing EC Regulation 1060/2009 on credit rating agencies (the EC Regulation). The Proposal would add new Articles 8a and 8b, which set out web site rules modeled on the US rule 17g-5.
Specifically, proposed Articles 8a and 8b would require the following:
- That the issuer or related third party to a structured finance instrument must:
- on a password protected web site that such party shall manage, provide to the hired credit rating agency all information necessary for it to set a rating and to monitor such a rating on a structured finance instrument;
- give access without delay to other credit rating agencies that request access to the web site if they are registered or certified under EC Regulation 1060/2009 and:
- have the systems to ensure the information remains confidential; and
- provide ratings on a yearly basis on at least 10 percent of structured finance instruments to which they request access.
- That a hired credit rating agency must:
- maintain a password protected web site containing:
- a list of the structured finance instruments for which it is in the process of providing credit ratings, identifying the type of instrument, name of issuer and date when the rating process was initiated; and
- a link to the web site maintained by the issuer or related third party as soon as it is available.
- give access without delay to any non-hired credit rating agency registered or certified under EC Regulation 1060/2009 and complying with the access conditions under 1(b) above.
- maintain a password protected web site containing:
These amendments broadly look to introduce what rule 17g-5 has already enacted in the United States. However, there are differences between the US Web Site Rules and the Proposal, and there are open issues surrounding the Proposal and how it will operate in practice.
Possibly the most important difference between the Proposal and the US Web Site Rules is that the Proposal would impose obligations directly on issuers and related third parties to supply all information to the hired credit rating agencies. Under the US rules, if an issuer, sponsor or underwriter failed to place required information on a password protected web site and make that information accessible to non-hired credit rating agencies, the main consequence would be that it would not get its transaction rated. Under the Proposal, the issuer’s or related third party’s failure to comply would contravene the EC Regulation and be subject to sanctions including fines.
Scope of the Proposal
At the moment, the Proposal is just that, and a number of areas remain unclear as to exactly who and what it is meant to cover.
Article 8a would impose obligations on an “issuer or related third party.” The EC Regulation defines related third party as ‘‘the originator, arranger, sponsor, servicer or any other party that interacts with a credit rating agency on behalf of a rated entity, including any person directly or indirectly linked to that rated entity by control.” So the range of parties and information would be at least as wide as, or wider than, under the US rules.
Under the Proposal, the web site rules would apply to “structured finance instruments,” which the EC Regulation defines by reference to the definition of securitization in the Capital Requirements Directive.18 That definition of securitization is very wide and has been interpreted differently by regulators and market participants, so there could be uncertainty about which types of transactions will be covered by the rules. Like the US rules, the EU web site rule is likely to cover a wide range of structured finance products, but not traditional covered bonds.
Existing EU Data Protection and Bank Secrecy Laws
Further clarification is also required as to how Articles 8a and 8b would work in conjunction with existing EU data protection and bank secrecy laws. The EU Data Protection Directive19 already stipulates that the transfer of personal data to countries outside the European Economic Area (EEA)20 is forbidden unless certain rules are complied with. In addition, certain banking laws of EU Member States are stricter than others when it comes to passing on personal data. As such, it is so far unclear as to whether the provision of information to credit rating agencies which can be accessed from outside the EEA would contravene these existing laws.
How far the Proposal will extend territorially is another area that may need further interpretation. Article 8a(1) requires an issuer or related third party to provide information to the hired credit rating agency (apparently, whether or not that agency is registered under the EC Regulation), but Article 8a(2) requires the party to make that information available upon request to any other credit rating agency only if that agency is registered or certified under the EC Regulation.
As noted above, prior to the implementation of the US Web Site Rules, the major credit rating agencies in the United States also registered their affiliates worldwide as NRSROs. Though the exemption for offshore-issued transactions discussed above is in place until December 2, 2010, EU issuers of structured finance securities will still be subject to the Web Site Rules if any of those securities are sold in the United States, and if the current exemption is not extended then even securities issued only outside the United States would be affected. In either case EU issuers will be caught by both the Web Site Rules and the new EU legislation as well. As a result, both EU and US transaction parties and regulators will need to consider how these similar but not identical systems will work together.
As one example of the potential difficulties, the US rules deal in some detail with confidentiality issues between transaction parties and hired and non-hired rating agencies in relation to information required to be posted on the password protected web site. In the Proposal, Article 8a(3) merely states that the European Commission shall in the future adopt more detailed procedures and rules on ensuring the confidentiality and accuracy of data and personal data, especially in respect of the EU Data Protection Directive.21 Considering the implied worldwide effect of the Web Site Rules, it is not yet clear whether the forms and procedures developed in the United States for compliance with the Web Site Rules will be also be consistent with the amended EC Regulation and other applicable EU law.
Article 8a would require that the issuer or related third party provide “all information necessary ... to determine or monitor a credit rating.” The information required by rating agencies from transaction to transaction can vary a great deal, so it could be difficult for an issuer or related third party to comply with this obligation. In addition, it is often the case that issuers or related third parties will not be in the possession or control of all the required information that the credit rating agencies may need. As a result, a party could inadvertently fail to comply with its obligations under Article 8a and so become subject to fines or other sanctions.
Furthermore, it is yet to be seen how non-hired credit rating agencies will meet the 10 percent yearly rating stipulation as set out in Article 8a(2)(b). Granting access to the password protected web sites maintained by either the issuer/related third party or the hired credit rating agency is, on the face of it, the only way another credit rating agency can provide a rating. The most likely way this will work in practice is that non-hired credit rating agencies will not have to fulfill this requirement for the first year, as long as they do so thereafter. However, further clarification is needed as to how this requirement will work in practice.
Process to Law
On June 6, 2010, the Proposal was passed to the EU Council of Ministers and the European Parliament for further consideration and approval. It is likely that, as the Proposal passes through both these bodies, some changes will be made, maybe addressing some of the issues highlighted above, as interested market participants make known their concerns. Because the Proposal relates to an EC regulation, once it is passed into law at EU level it will have direct applicability and become law in each EU Member State at the same time without the need for local enabling laws or rulemaking in each Member State. The consideration and approval process is likely to take up the remainder of this year, with a likely final implementation of the Proposal in 2011.