Subtitle C of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) reflects Congressional findings that credit ratings are systemically important and that “inaccurate” credit ratings played a role in the mismanagement of risk by large financial institutions and investors, which contributed to the crisis in the financial markets. Accordingly, the Act substantially expands the scope of regulation and accountability of credit rating agencies generally and nationally recognized statistical ratings organizations (“NRSROs”) in particular. Interestingly, the goals reflected by the Act appear to be somewhat inconsistent. On the one hand, the Act aims to improve the overall quality and integrity of credit ratings issued by credit rating agencies through implementing internal and external control structures, increasing the potential liability of credit rating agencies and promoting a more transparent credit rating process. On the other hand, the Act seeks to reduce the deference and reliance that investors, regulators, and other users of credit ratings may give to such credit ratings.
Internal and External Controls
The Act evidences a concern that business pressures on NRSROs to generate revenue may have led NRSROs to loosen their credit rating procedures or to apply them inconsistently. In an attempt to mitigate the potential conflicts of interest associated with the issuer-pay model prevalent in the credit rating industry, the Act requires NRSROs to comply with a number of internal and external controls. Among other things, each NRSRO is required to establish and document internal policies and procedures for determining credit ratings. Each NRSRO is also required to segregate its sales and marketing personnel and efforts from its credit rating operations pursuant to rules to be issued by the SEC. Each NRSRO is required to have a compliance officer (whose compensation may not be tied to the financial performance of the company) to monitor compliance with these policies, procedures, and rules. The Act further requires each NRSRO to have a Board of Directors with independent directors compris-ing at least one half (and no fewer than two) of its members.
The Act also requires each NRSRO to monitor instances where certain of its employees subsequently become employees of customers of the NRSRO. If an employee who was employed at an 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, leaves the NRSRO to obtain employment with an obligor, issuer, underwriter, or sponsor of a security or money market instrument rated by that NRSRO during the one-year period prior to the employee’s departure, the NRSRO must report this transition to the SEC. Additionally, if any employee of an NRSRO who participated in any way in determining a credit rating subsequently becomes employed by the related issuer, underwriter, sponsor, or other entity subject to such credit rating, the NRSRO is required to “look-back” for a one-year time period preceding the date an action was taken with respect to that credit rating to determine whether such employee was influenced by a conflict of interest and, if so, to revise the credit rating.
The Act calls for a new Office of Credit Ratings to be established by the SEC, with the stated purposes of protecting users of credit ratings, promoting accuracy in credit ratings, and ensuring that ratings are not influenced by conflicts of interest. This Office will be required to audit each NRSRO annually and make its inspection reports publicly available. The internal and external controls required by the Act may lead to some degree of improved confidence in the integrity of credit ratings. Whether these measures lead to improved accuracy of credit ratings depends on the extent to which conflicts of interest actually affected credit rating decisions. If the inaccuracy of credit ratings was caused primarily by flawed analytical models or errors in judgment, these measures may not play much of a role in improving credit ratings accuracy.
The Act increases the potential liability that NRSROs face through the addition of penalties that may be imposed by the SEC and the elimination of a potential defense to an SEC anti-fraud action based on the SEC’s prohibition against regulating the substance of credit ratings. For public deals that include an NRSRO’s credit ratings in the public offering registration statements with the consent of the NRSRO, the Act also creates potential securities law liability for the NRSRO as an expert. The Act also provides for a private right of action against an NRSRO for securities law violations based on the NRSRO’s failure either 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 to obtain reasonable verific-ation of such factual elements from other sources it considered to be competent and that were independent of the issuer and underwriter.
While the goal of these provisions is to promote more accurate credit ratings through increased accountability on the part of credit rating agencies, there may be some potentially undesirable side effects. The expanded liability and associated increased litigation risks NRSROs will be facing will probably increase their costs of doing business, as well as lead to more transactions being issued through private placements, which is a less liquid market. In fact, the four largest NRSROs have stated that they currently will not consent to inclusion of their ratings in public registration statements without further internal review.1 Some or all of the increased costs incurred by the credit rating agencies in connec-tion with the Act may end up being passed on to the customers of the credit rating agencies, which may increase the costs of issuing rated securities and result in higher credit costs to the ultimate borrowers.
The increased risk of liability might also stifle innova-tion, as credit rating agencies may be more reluctant to issue ratings for new products. The expanded scope of liability may also deter new credit rating agencies from entering the marketplace, which is contrary to another stated Congressional goal of fostering greater market competition on the basis of rating accuracy.
Several provisions of the Act are directed at increasing the transparency of the credit rating process, reflecting the notion that credit rating agencies will have an incentive to maintain a robust credit rating process if their processes and credit ratings can more easily be evaluated by users of credit ratings. To promote this transparency, the Act requires greater disclosure of credit ratings and credit rating methodology and procedures, disclosure of certain third-party information used in the credit rating process, and the use of universal symbols for credit ratings.
The Act requires each NRSRO to ensure that: (i) its credit rating procedures are in compliance with standards approved by its senior credit officer or board of directors, (ii) material changes to credit rating procedures and methodologies are applied consistently to all credit rating, and (iii) credit rating users are notified of any such changes. NRSROs will be required to publicly disclose their initial ratings and any changes to such ratings, which is intended to make it easier for users of credit ratings to evaluate the accuracy of those ratings and compare such accuracy with the ratings performance by other NRSROs. In addition, each NRSRO will be required to disclose the extent to which third-party due diligence services have been used in the credit rating process, and any such third party 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. NRSROs are also required to consider information received from credible outside sources when determining credit ratings.
In an attempt to make credit ratings more consistent and understandable, the Act requires each NRSRO to clearly define and disclose the meaning of any symbols used in connection with its credit ratings. Any symbol used by an NRSRO to denote a credit rating must be used in a consistent manner with respect to all securities for which that symbol is used. An NRSRO may, however, use different symbols, designations or highlighters to identify ratings for different types of securities. Meanwhile, the SEC is required to conduct a study regarding the feasibility and desirability of creating standardized credit rating terminology across credit rating agencies and across asset classes.
Reduced Reliance on Credit Ratings
Effective as of two years after the date of 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 Federal Deposit Insurance Act and the Investment Company Act of 1940. In general, the responsible governmental agencies will be required to establish alternative standards for determining creditworthiness. Relying on ratings by credit rating agencies may thus provide less cover to some market participants, and there will probably be greater uncertainty as to whether securities or obligations rated by credit rating agencies will satisfy various regulatory purposes. It is also uncertain whether the alternative standards will lead to better investment decisions.
SEC Study on Feasibility of Assigning NRSROs to Rate Structured Finance Products
The Act requires the SEC 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 that would create greater incentives for accurate credit ratings. The SEC is explicitly instructed to evaluate the feasibility of establishing a public or private utility or self-regulating organization that would select the NRSROs to rate structured finance transactions, including assessing appropriate methods for determining and paying fees to NRSROs, whether such a system would be viewed as creating a moral hazard, whether there are constitu-tional issues associated with such a system, and means to determine the accuracy of credit ratings. After completion of this study, the SEC is instructed to determine whether to establish such a system for assigning NRSROs to determine the initial credit ratings of structured finance products.
The Act does not provide much guidance as to how such a governmental or quasi-governmental entity would assign NRSROs to transactions and how it would assess various factors that may enter into the decision to select a credit rating agency for any individual transaction, such as investor preference, workload of each NRSRO and its capacity to handle the deal flow, an NRSRO’s expertise with respect to a complicated or specialized security class and the fees charged by an NRSRO to rate a transaction.
The Act requires that several additional studies be performed with respect to NRSROs, including:
Study on Strengthening Credit Rating Independence. The SEC is required to conduct a study of the independence of NRSROs and its impact on credit rating issues. This study will include, among other things, an evaluation of how NRSROs manage conflicts of interest resulting from NRSROs providing other non-credit rating services and the potential impact of a prohibition on NRSROs providing such services.
Study on Alternative Business Models. The Comptroller General of the United States is re-quired to conduct a study of alternative means for compensating NRSROs to create incentives to provide more accurate ratings.
Study on the Creation of an Independent Professional Analyst Organization. The Comptrol-ler General of the United States is required 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 and oversee the profession. This study supplements another portion of the Act which requires NRSRO employees to be tested for knowledge of the credit rating process or to otherwise meet stan-dards necessary to produce accurate ratings.
The Act reflects the perception of Congress that the inaccurate ratings of structured finance products played a significant role in the financial meltdown. While Congress could have addressed its concerns by enacting legislation that either reduced reliance on credit ratings or included measures designed to increase the quality and integrity of credit ratings, the Act incorporates both approaches, which is an indication of the unpopularity of credit rating agencies on Capitol Hill. The full impact of the Act on credit rating agencies and the market for structured finance products will not be known until after the SEC completes the mandated studies and enacts the rules and regulations contemplated by the Act.