On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The legislation covers a wide variety of topics in an effort to address the causes of the recent financial crisis. With regard to credit rating agencies, the legislation covers the following topics: increased accountability, internal controls to avoid conflicts of interest and to better ensure the accuracy of ratings, elimination of reliance on ratings by federal agencies, and public disclosure of the information on which ratings are based to allow investors and other users to evaluate accuracy and to compare the performance of different agencies.
As indicated below, many of the requirements to be imposed have been left by Congress to regulations to be prescribed by the SEC and many actions that had been proposed in Congress have been relegated to studies to be conducted over the next several years. Generally, the SEC is required to issue final regulations with regard to credit rating agencies within one year of the date the legislation is enacted.
This summary describes the provisions of the legislation relating to rating agency regulation generally, and where the summary raises issues particularly relevant to public finance, there are additional comments describing the implications of the law to public finance.
Liability for Information Filed Section 15E of the Securities Exchange Act of 1934 (the '34 Act) includes provisions relating to the registration of Nationally Recognized Statistical Rating Organizations ("NRSROs") with the SEC. In various parts of Section 15E, there had been references to information to be "furnished" to the Commission. NRSROs will now be required to "file" such information with the Commission, and will therefore be subject to liability under Section 18 of the '34 Act in the event that any such filings contain false or misleading statements of material fact.
"Accuracy" The legislation also empowers the SEC to temporarily suspend or permanently revoke the registration of an NRSRO with respect to a particular class of securities if, among other things, the Commission finds that the NRSRO "has failed over a sustained period of time . . . to produce ratings that are accurate for that class or subclass of securities . . ."
"Expert" Liability Rule 436(g) under the Securities Act of 1933 (the '33 Act), which provides that credit ratings assigned by an NRSRO are not considered part of a registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the '33 Act, is nullified. Written consent of an NRSRO must thus be obtained by a registrant in order to include a credit rating in a registration statement, and NRSROs are therefore subject to liability under Section 11 of the '33 Act for misstatements or omissions of material facts in connection with credit rating disclosure.
Rule 436(g), which is rescinded by the legislation, had provided an exception for ratings from the requirement of Rule 436(a), which provides that any issuer that includes a report or opinion of an expert quoted in a registration statement must file with the registration statement a consent of the expert. Most issues of municipal securities are not subject to the registration requirements because of the exemption under Section 3(a)(2) of the '33 Act. The consent requirement of Rule 436(a) does not apply to exempt municipal securities and therefore no consent of the rating agencies is required in order to include ratings in Official Statements for such exempt municipal securities.
The '33 Act Section 11 civil liability for an expert, who has consented to the use of a report or opinion in a registration statement, applies only to issues subject to the registration requirements. Section 11 has no application to municipal securities that are exempt from the registration requirements and, therefore, does not subject a rating agency to such liability merely by reason of inclusion of its rating in an Official Statement for exempt municipal securities.
Section 15E has also been amended to require NRSROs to "establish, maintain and enforce an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings".
Annual Report Requirement The SEC is required by the legislation to prescribe rules requiring NRSROs to submit to the SEC annual internal controls reports describing the responsibility of the NRSRO's management in establishing and maintaining internal controls, assessing the effectiveness of their internal control structures, and containing an attestation of the CEO.
Conflicts of Interest
Separation of Ratings from Sales and Marketing The SEC will also be required to issue rules to prevent sales and marketing considerations from influencing the production of ratings. The legislation mandates that exceptions to the rules be provided for small NRSROs where separation of sales and marketing is not practical.
Look-back Requirement NRSROs will be required to put in place procedures reasonably designed to ensure that, if any employee of an issuer, underwriter, or sponsor of a security or money market instrument subject to a credit rating had previously been employed by the NRSRO and participated in determining a credit rating of that entity during the one-year period before the rating action, the NRSRO will conduct reviews to determine whether conflicts of interest influenced the rating, and will revise the rating as appropriate. The SEC will be required to periodically review the look-back procedures and code of ethics policies of each NRSRO.
Employment Transitions NRSROs will be required to report to the SEC (and the SEC will be required to disclose to the public) when an individual who had been an employee of the NRSRO within the previous five years becomes employed by an obligor, issuer, underwriter, or sponsor of a security or money market instrument that was rated by the NRSRO during the twelve months before the employee transitioned to his or her new position, in cases where the employee was a senior officer of the NRSRO or participated in or supervised someone participating in rating the obligor, issuer, underwriter, or sponsor.
Rule to Prevent Conflicts of Interest The legislation sets forth the sense of Congress that the SEC should exercise its rulemaking authority to prevent improper conflicts of interest arising from NRSRO employees providing services to issuers, including consulting and advisory services, in addition to providing credit ratings to those issuers.
Independent Board Each NRSRO must have a board of directors, at least half but no fewer than two members of which are independent. To be independent, a board member may not, other than in the capacity of member of the board, accept a fee from the NRSRO, be associated with the NRSRO or any affiliated company, or be involved in determining a rating in which it has a financial interest. Some of the independent members must be users of NRSRO ratings.
Duties of Board The NRSRO board of directors will be required to oversee the establishment, maintenance, and enforcement of policies and procedures for determining credit ratings and addressing and dealing with conflicts of interest, the effectiveness of the internal control system, and compensation and promotion policies.
If the SEC determines that compliance with these provisions is an unreasonable burden for a small NRSRO, the SEC may permit such NRSRO to delegate these responsibilities to a committee which includes at least one person who is a user of NRSRO ratings.
Regulation of NRSROs
Office of Credit Ratings The SEC will be required to establish an Office of Credit Ratings within the SEC to administer rules regarding the practice of determining ratings, promoting rating accuracy, and ensuring that ratings are not influenced by conflicts of interest.
Examinations The Office of Credit Ratings will be required to conduct examinations of NRSROs at least annually to review management of conflicts of interest, internal controls, governance, and implementation of its policies, procedures, and rating methodologies.
Inspection Reports The SEC will make available to the public a summary of its findings with regard to material regulatory deficiencies, including whether the NRSRO has appropriately addressed recommendations of the SEC and any responses by the NRSRO.
Penalties The SEC will be required to establish fines and other penalties applicable to NRSROs violating the provisions of Section 15E.
Private Right of Action
Statements Made by Credit Rating Agencies Section 15E(m) of the '34 Act is amended so that the penalty and enforcement provisions of the '34 Act apply to statements made by a credit rating agency in the same manner and to the same extent as they apply to statements made by a registered public accounting firm or a securities analyst under the securities laws. These statements are not deemed to be forward-looking statements for purposes of the safe harbor pursuant to Section 21E of the '34 Act. There is no longer a bar against private rights of action as there previously had been under Section 15E(m). The potential liability of rating agencies under the new legislation applies to statements made by rating agencies in connection with municipal securities as well as to ratings of other types of securities.
State of Mind Section 21D(b)(2) of the '34 Act is amended so that, with respect to private securities fraud actions for money damages against a rating agency or a controlling person, it is sufficient that a complaint state with particularity the facts giving rise to a strong inference that the credit rating agency knowingly or recklessly failed (i) to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk, or (ii) to obtain reasonable verification of such factual elements from other sources the credit rating agency considered competent, and that were independent of the issuer and underwriter. The specific state of mind provisions applicable to private actions against rating agencies would apply in a case brought in connection with municipal securities.
Duty to Report Tips Alleging Material Violations of Law
Each NRSRO must report to the appropriate authority any credible information it receives alleging that an issuer of securities rated by the NRSRO has committed or is committing a material violation of law.
Disclosure of Credit Ratings
SEC Rule as to Disclosure The SEC must issue a rule requiring NRSROs to publicly disclose information on the initial credit rating given to each obligor, security, and money market instrument, and on any subsequent rating change. The direction to the SEC does not have an exception for municipal securities. In fact, the legislative direction to the SEC to adopt transparency rules states that they are to be made "for each type of obligor". Thus, public disclosure rules adopted by the SEC are likely to specifically reference information about municipal ratings as well as other categories of ratings.
Content and Type of Disclosure The disclosures made by each NRSRO must (i) be comparable so that users can compare credit ratings performance across NRSROs, (ii) be clear and informative, (iii) include performance information over a range of years and for a variety of types of credit ratings, including for withdrawn credit ratings, (iv) be freely available and easily accessible on its website, and (v) include an attestation that the rating is based solely on an independent evaluation of the risks and merits of the instruments being rated.
Form Accompanying Ratings The SEC will require each NRSRO to prescribe a form to accompany each publication of a credit rating which is easy to use, comparable across security type, and readily available to credit rating users.
Qualitative Content: The form will be required to include disclosure of (i) the credit rating, (ii) the main assumptions and data used in making the rating determination, (iii) potential limitations of the credit rating, (iv) information on the reliability, accuracy, or quality of the data used in making a credit rating determination, (v) information as to limitations of essential data such as limits on the scope of historical data and limits on accessibility to certain documents, (vi) whether and to what extent third party due diligence services were used by the NRSRO, a description of the information that third party reviewed, and a description of the third party's conclusions, (vii) an assessment of the quality of information available in making the rating determination, and (viii) information as to conflicts of interest.
Quantitative Content: The form will be required also to include disclosure of (i) factors that could lead to a change in the credit rating and the magnitude of change to be expected under various market conditions, (ii) information on the content of the rating, including the historical performance of the rating, and the expected probability of default and consequent loss, and (iii) information on the sensitivity of the rating to assumptions made in the rating process.
Third Party Due Diligence The issuer or underwriter of any asset-backed security will be required to make publicly available the findings and conclusions of any third party due diligence report it obtains. Any third party due diligence provider employed by an NRSRO, issuer, or underwriter must provide written certification to the NRSRO that it conducted a thorough review of the data and documentation used by an NRSRO to make a rating determination in a form to be established by the SEC, and the NRSRO will be required to disclose the certification to the public.
Since the requirements for disclosure of third party due diligence reports applies to "any asset-backed security", it would seem not to apply to issues of municipal securities. However, some public finance issues have the characteristics of an "asset-backed security". The legislation has no definition of asset-backed securities and no exception for issues of municipal securities. The problem has been compounded by recent proposed regulations of the SEC applicable to asset-backed securities or structured products in which the definition of terms do not clearly exclude issues of municipal securities or tender option bonds based on municipal securities. This issue is likely to be the subject of continuing comment letters to the SEC and may require requests to the staff for "no-action" letters.
Elimination of Regulation FD Exemption Under Regulation FD, if an issuer or any person acting on behalf of an issuer discloses material nonpublic information about the issuer or its securities to certain enumerated entities, the issuer must make such disclosure public. The current rule exempts disclosures made to credit rating agencies. The SEC is required to revise Regulation FD within 90 days of enactment of the legislation to remove the exemption for disclosures to credit rating agencies.
The elimination of the Regulation FD exemption is not likely to significantly impact public finance. Regulation FD applies to reporting companies under the '34 Act, which normally include the same companies whose securities are subject to the registration requirements of the '33 Act and, therefore, does not apply to municipal issuers. The primary purpose of Regulation FD is to prevent selective disclosure of nonpublic information that may be used for purposes of insider trading. In public finance there is an insider trading prohibition under section 10 of the '34 Act and SEC Rule 10b-5. Accordingly, some issuers of municipal securities use Regulation FD as a general guide to avoid selective disclosure, but other means of avoiding insider trading can be equally effective.
If Regulation FD is used as a template for disclosure of nonpublic information by municipal issuers to rating agencies, it should be noted that within Regulation FD there are exceptions in addition to the rating agency exemption that is to be removed. Regulation FD is not violated if the nonpublic information disseminated by an issuer will not be obtained by certain classes of persons listed in Regulation FD (such as broker-dealers) that are considered likely to trade on the basis of the nonpublic information. Information given to rating agencies in the course of an issuer obtaining a rating is not likely to be leaked to any person in the listed classes of persons deemed likely to trade. As long as the nonpublic information is not communicated to any person (within the defined classes listed), the issuer has no obligation to disclose the nonpublic information to the public generally. If it is leaked, and the issuer becomes aware of the leak, the issuer is to "promptly" disclose the information to the public. There is a further exception for information given to a person "who owes a duty of trust or confidence to the issuer", or to a person "who expressly agrees to maintain the disclosed information in confidence". An issuer can have a rating agency sign a confidentiality agreement to evidence that this exception is being relied upon. Confidentiality agreements are commonly signed by rating agencies.
The legislation requires the SEC to revise Regulation FD within 90 days to remove the rating agency exemption. Issuers of municipal securities should follow the development of this revision to be sure there is no spillover effect on the usefulness of Regulation FD as a template in public finance.
Methodologies and Procedures
SEC Rules as to Procedures and Methodologies The SEC must prescribe rules requiring NRSROs to:
ensure that credit ratings are determined using procedures and methodologies that are approved by the board of the NRSRO and in accordance with the NRSRO's policies and procedures,
ensure that material changes to credit rating procedures and methodologies are applied consistently to all credit ratings, as applicable, within a reasonable period of time, and that the reasons for the change are publicly disclosed, and
notify credit rating users of the version of a procedure or methodology used to determine a particular rating, when a material change to a procedure is made, when an error is identified, and the likelihood that a material change in procedure will result in a rating change.
Use of Information from Outside Sources NRSROs must consider information about an issuer that it receives from a source other than the issuer or underwriter when producing a rating, if the NRSRO finds the information credible and potentially significant to the rating decision.
Qualifications for Credit Rating Analysts The SEC will be required to issue rules designed to ensure that persons employed by an NRSRO to perform credit ratings meet standards of training, experience, and competence necessary to produce accurate ratings and are tested for knowledge of the credit rating process.
Universal Rating Symbols The SEC must require NRSROs to establish, maintain, and enforce written policies and procedures that (i) assess the likelihood that an issuer of a security or money market instrument will default or fail to make payments in a timely manner in accordance with the terms of the instrument, (ii) clearly define the symbol used to denote the credit rating, and (iii) apply credit rating symbols in a consistent manner.
Removal of Statutory References to Credit Ratings
Removal of Statutory References Certain statutory references to credit ratings are required to be removed, effective two years after the date of enactment. Regulatory bodies will be required to develop their own standards of credit-worthiness to replace these references.
Feasibility Study The SEC will be required to undertake a study on the feasibility and desirability of standardizing credit rating terminology and meanings. The SEC must submit a report of its findings and recommendations to Congress within one year after enactment.
Review and Modification of Federal Agency Reliance on Ratings
Each federal agency is required to review and modify its regulations to remove references to credit ratings and substitute its own standard of credit-worthiness. Upon conclusion of the process, each federal agency must submit a report to Congress describing the modifications made.
NRSRO Independence The SEC must conduct a study of the independence of NRSROs and of how such independence affects the ratings issued. The SEC must evaluate management of conflicts of interest raised by an NRSRO providing services in addition to awarding ratings, and the potential impact of rules prohibiting an NRSRO from providing such other services to issuers it rates. A report on the results must be submitted to Congress within three years of enactment.
Alternative Business Models The GAO must conduct a study on alternative means for compensating NRSROs in order to create incentives for NRSROs to provide more accurate credit ratings. A report on the results must be submitted to Congress within 18 months of enactment.
Creation of Independent Professional Analyst Organization The GAO must conduct a study on the feasibility and merits of creating an independent professional organization for rating analysts employed by NRSROs that would be responsible for establishing independent standards for governing the profession and a code of ethical conduct, and for overseeing the profession. A report on the results must be submitted to Congress within one year of enactment.
Assigned Credit Ratings Study and Rulemaking
Study The SEC must conduct a study of (i) the credit rating process for structured finance products and the conflicts of interest associated with issuer-pay and subscriber-pay models, (ii) the feasibility of establishing a system whereby NRSROs are assigned to determine credit ratings of structured finance products, including an assessment of potential ways to determine fees, appropriate methods for paying fees, and the extent to which such a system could be viewed as the creation of a moral hazard by the Federal Government, (iii) the range of metrics that could be used to determine the accuracy of credit ratings, and (iv) alternative compensation schemes that would incentivize more accurate credit ratings. A report on the results must be submitted to Congress within two years of enactment.
Establishment of Assignment System After submission of the report, the SEC must, as it determines is necessary or appropriate, establish a system for the assignment of NRSROs to determine initial credit ratings of structured finance products, such that the issuer, sponsor, or underwriter of the structured finance product does not make the assignment.
Section 15E(w) of the '34 Act, as that provision would have been added by section 939D of H.R. 4173 (111th Congress), as passed by the Senate on May 20, 2010, would have established a system pursuant to which a self-regulated Credit Rating Agency Board would assign NRSROs to determine initial credit ratings of structured finance products. The SEC will be required to implement the system described in Section 15E(w) unless the SEC determines that an alternative system would better serve the public interest and the protection of investors.