The U.S. Credit Rating Agency Reform Act of September 2006 (the "Rating Agency Act") was passed by Congress to protect investors by improving the quality of credit ratings through increased transparency, accountability, and competition in the credit ratings industry. In the period following the adoption of final rules implementing the Ratings Agency Act (the "Rules"), and in the context of widespread public criticism of Nationally Recognized Statistical Rating Organizations ("NRSROs") resulting from their role in the current global financial crisis, in June 2008, the U.S. Securities and Exchange Commission (the "SEC") in the first of three related actions, proposed a series of amendments (the "Proposed Amendments") to the Rules for NRSROs1. The Proposed Amendments were designed to address concerns about the integrity of the process by which NRSROs rate structured finance products, particularly mortgage-based securities. On 2 February 2009, the SEC adopted a majority of the Proposed Amendments in the first action (the "Revised Rules").
The Revised Rules are intended to increase the transparency of NRSROs' rating methodologies, strengthen NRSROs' disclosure, prohibit NRSROs from engaging in certain practices that create conflicts of interest, and enhance NRSROs' recordkeeping and reporting obligations.
In summary, the Revised Rules require an NRSRO to:
- provide enhanced disclosure of performance measurements statistics, procedures and methodologies used in credit ratings for structured finance products and other debt securities2;
- make and preserve additional records regarding credit ratings rationales, changes in credit ratings, and outside communications related to credit ratings3;
- make publicly available in electronic format a random sample of 10 percent of the ratings histories of credit ratings paid for by the obligor being rated, or by the issuer, underwriter, or sponsor of the security being rated in particular classes of credit ratings4;
- furnish a new annual report on all credit rating actions in certain credit ratings classes5; and
- refrain from issuing or maintaining a credit rating in certain conflict-of-interest situations.
The Revised Rules were designed, in part, by SEC staff as a result of an examination of the three largest NRSROs—Fitch Ratings, Ltd, Standard and Poor's Rating Services and Moody's Investor Services, Inc6.
The Amendments in Detail
Amendments to the Instructions for Form NRSRO
The SEC has amended the instructions to Exhibit 1 to Form NRSRO to require the disclosure of more detailed performance statistics. Currently, the instructions require the disclosure of performance measurement statistics of the credit ratings of the NRSRO over the short-term, mid-term and long-term periods (as applicable) through the most recent calendar year end. The new amendments refine these instructions to require, in addition:
- the disclosure of separate sets of default statistics and statistics on the number of downgrades and upgrades for each class of credit ratings; and
- class-by-class disclosure to be broken over one-, three- and ten-year periods.
The SEC also amended the instructions to Exhibit 2 to Form NRSRO to require enhanced disclosures about the procedures and methodologies an NRSRO uses to determine credit ratings, including:
- whether verification has been performed by or on behalf of the NRSRO on assets underlying a structured finance transaction in determining credit ratings, and if so, how much;
- whether the NRSRO has taken into account the experience and quality of the originators of the assets underlying a structured finance transaction and specifically whether those originators have a sufficient expertise and a good track record of originating quality assets in determining credit ratings; and
- how frequently credit ratings are reviewed by the NRSRO and whether different models or criteria are used for ratings surveillance than for determining initial ratings, and whether changes made to models and criteria for determining initial ratings are applied retroactively to existing ratings.
Amendments to Rule 17g-2 (Recordkeeping Requirements)
The revisions of Rule 17g-2 require NRSROs to make and retain three additional categories of records' and retain a fourth type of record. The records to be made and retained are:
- if a quantitative model is a substantial component in the process of determining a credit rating, a record showing the rationale for any material difference between the credit rating implied by the NRSRO's model and the final credit rating issued; (the SEC noted that the NRSROs are responsible for determining what constitutes "substantial component" and "material" in this context);
- a record showing the history and dates of all previous rating actions and, with respect to each, the initial ratings, upgrades, downgrades and placements on watch for upgradings and downgradings;
- a record of all communications related to the monitoring of ratings; this increases the current rule 17g-2(b)(7) requirement to retain only communications related to initiating, determining, maintaining, changing or withdrawing a credit rating; and
- a record showing any written communications that contain any complaints by an entity being rated, issuer, underwriter or sponsor about the performance of the NRSRO credit analyst. In addition, under the Revised Rules the SEC requires that NRSROs make publicly available a random sample of 10 percent of the Issuer-paid Credit Ratings actions histories, in XBRL format, within six months of a new rating posting, for each ratings class for which they have issued 500 or more Issuer-paid Credit Ratings.
Amendment to Rule 17g-3 (Reports of Credit Rating Agencies)
The revision of Rule 17g-3 requires an NRSRO to furnish the SEC with a new unaudited annual report of all credit rating actions (updgrades, downgrades, placements on credit watch, and withdrawals) that were changed during the fiscal year in each class of credit ratings for which the NRSRO is registered with the SEC.
Amendments to Rule 17g-5 (Conflicts of Interest)
The SEC amended paragraph (c) to Rule 17g-5 to add three additional conflicts of interest. The Revised Rules prohibit an NRSRO from issuing or maintaining a credit rating where:
- the NRSRO made recommendations to the entity being rated or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the entity being rated or issuer of the security;
- the fee paid for the rating was negotiated, discussed, or arranged by a person within the NRSRO who has responsibility for participating in determining or approving credit ratings, or for developing or approving procedures or methodologies used for determining credit ratings, including qualitative and quantitative models. The SEC has clarified that for the purposes of Rule 17g-5, the terms "determine", "determined", and "determining" include both persons who develop credit ratings and persons who approve credit ratings; and
- where a credit analyst who participated in determining or monitoring the credit rating, or a person responsible for approving the credit rating, received gifts, including entertainment, from the entity being rated, or from the issuer, underwriter, or sponsor of the securities being rated, other than items provided in the context of normal business activities, such as meetings, having a total value not exceeding $25.