The SEC has recently proposed to require credit ratings disclosures in securities offerings registered under the Securities Act of 1933, as amended (the “Securities Act”), the Securities Exchange Act of 1934, as amended, and in offerings by closed-end management investment companies, or closed-end funds, registered under the Securities Act or the Investment Company Act of 1940.1 If adopted, the proposal would require certain disclosures if credit ratings are used by the registrant, any selling security holder, any underwriter or any member of a selling group in connection with a registered offering, whether the credit ratings were used in oral or written communications. If a credit rating is used in connection with a private offering under Rule 144A, the disclosure requirements would apply to a registered exchange offering occuring shortly thereafter for substantially identical securities, even if the credit rating is not used in connection with the registered exchange offering. The proposal would also require disclosures to address conflicts of interest with credit rating agencies and disclosures of preliminary and unused ratings designed to identify the practice of seeking the highest rating from multiple rating agencies, or ratings shopping. Unsolicited credit ratings, however, if not used in connection with a registered offering of the registrant’s securities, would not be subject to the disclosure requirements. Under current practice, companies often utilize credit ratings as part of the sales process without disclosing the credit rating in the offering document or discussing the limitations and conditions of the rating. Accordingly, adoption of the proposal would result in a change to market practice by requiring substantive disclosures about the credit rating and the credit ratings process in the offering document.
The proposal would also add a new disclosure item to Form 8-K. If a credit rating previously disclosed under the proposed rule has changed, is no longer being updated by the credit rating agency or has been withdrawn, a company would be required to file a Form 8-K within four business days that would disclose the date of the change, the name of credit rating agency and the nature of the credit rating agency’s decision.
Registrants would be required to provide the proposed disclosure when they use a credit rating in connection with a registered offering of their securities if the registrant, any selling security holder, any underwriter or any member of a selling group uses a credit rating from a credit rating agency with respect to the registrant, or a class of securities issued by the registrant, in connection with a registered offering.2 The SEC included groups beyond the registrant to prevent companies from structuring offerings to avoid triggering the disclosure requirements.
Use of Credit Ratings. The release provided that registrants may “use” credit ratings in connection with a registered offering in a number of ways. For example, a registrant would be considered to use credit ratings in connection with a registered offering if credit ratings are disclosed in a prospectus or term sheet filed pursuant to Rule 433 or Rule 497 under the Securities Act. The disclosure requirements would also apply to oral disclosures. The disclosure requirements would be triggered if the registrant orally provided credit ratings to investors or in response to a question from an investor. In current practice, it is common for companies to provide credit ratings orally or in response to questions. It is also common for underwriters in launching a transaction to provide potential investors with ratings information (including through the use of Bloomberg communications). Furthermore, the rating agencies often issue a press release describing their rating for new transactions.3 A registrant would be required to provide the disclosures if a potential investor is referred to a website where credit ratings are posted.
If a credit rating is used in connection with a private offering of securities under an exemption from registration under the Securities Act where the securities are exchanged shortly thereafter for substantially identical registered securities (commonly referred to as an “Exxon Capital” exchange offer), the disclosure requirements would apply to the registered exchange offer. The SEC included this requirement to avoid companies using credit ratings in connection with a private offering but not providing the required disclosure in a registered exchange offering to the same investors of substantially identical securities.
Disclosure Requirements. If a credit rating is used in connection with a registered offering, the registrant would be required to provide several disclosures about the credit rating and process.
When the use of a credit rating triggers the requirement, the registrant would need to provide a series of disclosures aimed at providing investors (i) the elements of the security that the credit rating addresses, (ii) the material limitations or qualifications on the credit rating and (iii) any related published designation, such as non-credit payment risks, assigned by the credit rating agency with respect to the security. Accordingly, the SEC has proposed to require disclosures of:
- the name of the credit rating agency assigning the credit rating and whether it is a Nationally Recognized Statistical Rating Organization (“NRSRO”);
- the credit rating assigned by the agency, the date the rating was assigned and the relative rank of the credit rating within the agency’s classification system;
- the credit rating agency’s definition or description of the category in which the security was rated;
- disclosure of any material scope limitations (for example, for a credit rating that assesses less than the promised or expected return on a security);
- any published designation reflecting the results of any other evaluation performed by the credit rating agency in connection with the credit rating, along with an explanation of the designation’s meaning and the relative rank of the designation;
- any material differences between the terms of the securities as assumed or considered by the agency in rating the securities and (i) the minimum obligations of the security as specified in the security’s governing instruments and (ii) the terms of the securities as provided in any marketing efforts; and
- a statement that (i) a credit rating is not a recommendation to buy, sell or hold securities, (ii) the credit rating may be subject to revision or withdrawal at any time by the assigning credit rating agency, (iii) each credit rating is applicable only to the specified class of securities to which it applies and (iv) investors should perform independent evaluations as to whether to invest in the security.
The proposal would require preliminary prospectuses to disclose information about any credit rating used in connection with a registered offering of securities. If a final rating is not available until after a registration statement is effective, the initial rating assigned by the agency may be used. If a rating changes or is updated prior to effectiveness, the company would be required to disclose the rating change to the purchaser. In addition, final prospectuses would be required to be updated with the final rating and all disclosures required under the proposal. Final ratings would be provided in a prospectus supplement for delayed shelf offerings.
In addition to the disclosures regarding the credit ratings and relative ranking, the proposal would also require disclosures the SEC believes would address conflicts of interest and ratings shopping.
Payment of Fees Disclosure. Registrants would be required to disclose the identity of the party compensating the rating agency providing the credit rating. If during the last completed fiscal year and any subsequent interim period the agency provided non-ratings services to the registrant or its affiliates, the proposal would also require a description of the non-ratings services and the aggregate fees paid for (i) the credit rating and (ii) the non-ratings services. The proposal would not require disclosure of the amount of fees paid for the credit rating if no non-ratings services were provided to the registrant because the SEC believes that the conflict of interest would be adequately addressed by identifying the party paying for the rating.
Preliminary and Unused Ratings. To ensure proper disclosure of ratings shopping to investors, the SEC has also proposed to require registrants who have obtained a credit rating subject to the disclosure requirements to also provide any preliminary ratings of the same class of securities as the final rating that are obtained from agencies other than the agency providing the final rating. The proposal would apply to credit ratings, including preliminary ratings, obtained by or on behalf of the registrant, including ratings obtained by underwriters, sponsors or depositors on behalf of a company. The SEC intends the phrase “preliminary rating” to be read broadly and to include unpublished ratings, oral indications of ratings, ranges of ratings and any other preliminary indications of a rating. In addition, if a credit rating is subject to the disclosure requirements, any final credit rating obtained by the registrant but not used must also be disclosed. Preliminary ratings and unused ratings would be subject to the same disclosure requirements contemplated for the final ratings, although registrants would be permitted to rely on Rule 409 under the Securities Act if the information may not be obtained without unreasonable effort or expense.
The proposal does not contemplate requiring disclosure of preliminary ratings if the final ratings are used in connection with a registered offering. In omitting this requirement, the SEC noted that this disclosure may interfere with the communication process between companies and credit rating agencies used to evaluate the securities and to monitor ratings. In addition, the SEC has not proposed to extend the disclosure requirements to unsolicited credit ratings if the credit ratings are not used in connection with a registered offering. The SEC recognized the burden companies would encounter in attempting to monitor and disclose all available credit ratings on their securities.
Exempted Uses of Credit Ratings. The proposal would include an exemption from the requirements for certain uses of credit ratings routinely provided in registration statements under the Securities Act and in periodic reports. Under the proposal, registrants would not be required to provide the additional disclosures if the only disclosure of a credit rating in an SEC filing is related to changes to a credit rating, the liquidity of the registrant, the cost of funds for the registrant or the terms of agreements that refer to credit ratings, and the credit rating is not otherwise used in connection with a registered offering. For example, the disclosure in a risk factor that changes to a particular credit rating may affect the registrant’s business or reference to a credit rating in a registrant’s MD&A would not trigger the disclosure requirements. In addition, use of credit ratings in discussions of debt covenants, interest or dividends that are tied to the ratings would not trigger the proposed disclosure requirements. The SEC reasoned that the proposed additional disclosures would not be necessary under these circumstances because these discussions indicate that a credit rating may materially impact the registrant.
Current Report Requirement
If a credit rating subject to the disclosure requirements included in the proposal has been changed, including if it has been withdrawn or is no longer being updated by the credit rating agency, a company would be required to provide disclosure of the event under a new Form 8-K item. The current report would be required to be filed within four business days after receipt of a notice or other communication from the credit rating agency that the agency has decided to change or withdraw a rating assigned to the registrant (including any class of debt or preferred security or securities or obligations guaranteed by the registrant) with respect to a rating previously disclosed and subject to the proposed requirements. The new Form 8-K item would require disclosure of:
- the date the registrant received the communication or notice;
- the name of the credit rating agency; and
- the nature of the credit rating agency’s decision.
Companies would be required to explain any material impact of the change to the credit rating in their periodic reports. A registrant would not be subject to the new Form 8-K item for changes to credit ratings obtained or used prior to the effectiveness of the new disclosure requirements.
The SEC provided four primary concerns behind its recent proposal. First, the SEC is concerned that investors may not be provided with sufficient information to understand the meaning and limitations of credit ratings that are used in the marketing process. The release pointed out that the value of AAA-rated mortgage-backed securities fell 70% from January 2007 to January 2008, and that investors need additional information about credit ratings in order to determine what impact, if any, credit ratings should have on investment decisions. As discussed in prior roundtables and releases, the SEC remains concerned about the conflicts of interest faced by credit rating agencies, and believes that additional disclosures about credit ratings will allow investors to evaluate whether conflicts of interest may impact the ratings. Third, the SEC is concerned about the impact of ratings shopping by registrants, and believes that investors should be aware of this process in order to evaluate the reliability of credit ratings. Finally, the SEC believes that credit ratings, while not currently a line-item disclosure requirement for prospectuses, are basic information about a company that may weigh heavily on investment decisions.
If adopted, the new credit ratings disclosures would require companies to monitor and generate the necessary information when preparing registration statements. If the rules are adopted, depending on the final terms of the rules, practices are likely to evolve and issuers may want to consider private offerings of rated securities without any registration rights if the scope of the disclosure requirements for any particular transaction could be problematic.
Companies using credit ratings in registered offerings will also need to monitor and coordinate with several parties regarding the use of preliminary or unused ratings. Because the release considers underwriters, selling securityholders, sponsors and other third parties to be acting on behalf of the registrant in requesting credit ratings, and preliminary and unused ratings are subject to the disclosure requirements, companies will want to ensure that individuals responsible for drafting disclosures are aware of all communications that may include preliminary ratings, including oral conversations. Companies may also wish to carefully consider whether to seek preliminary ratings, as preliminary ratings from agencies whose final ratings are not used in connection with the registered offering would be subject to the disclosure requirements. Due to the proposed new disclosure obligations, companies will also need to ensure they are communicating closely with their advisors (particularly their underwriters) about any interactions they are having with rating agencies on behalf of the company. Finally, if disclosure is provided under the proposed rules, companies will need to monitor the credit rating for any changes that would trigger the new Form 8-K requirement.