Over the past two years, there has been a considerable amount of regulatory activity related to credit ratings and rating agencies. Each of these developments has impacted in some way the structured products industry. However, the frequency of these developments has made it difficult for many people to track them. Accordingly, we set forth below the answers to a number of common questions that industry participants are asking about these developments.
When can an issuer’s specific credit ratings be disclosed in structured note offering documents?
Prior to July 2010, it was a fairly common practice (but by no means a uniform practice) for prospectuses and free writing prospectuses (“FWPs”) to disclose the applicable issuer’s credit rating.
However, effective July 2010, the Dodd-Frank Act repealed SEC Rule 436(g). In a nutshell, the impact of this repeal was to require the consent of the relevant rating agency to state its credit rating in the prospectus for a registered public offering. Since rating agencies generally were not willing to do so, mainly due to liability concerns, issuers were removed the credit ratings from prospectuses. As a result, it remains the market practice not to include the issuer’s specific ratings in the prospectus for the offering.
That being said, the following types of documents were not directly impacted by the repeal of Rule 436(g), and may continue to state the issuer’s credit rating:
- Free writing prospectuses.
- Offering documents for non-registered offerings, such as Rule 144A offerings, bank note(3(a)(2)) offerings, and offerings of structured certificates of deposit.
Of course, if such an offering document does include ratings information, it would be appropriate to consider the use of appropriate cautionary information about the limitation of credit ratings and related disclosures.
Must an issuer’s ratings downgrade be disclosed to investors?
Issuers and underwriters of structured products should be appropriately careful to disclose to investors material information about an issuer’s credit quality, particularly if there is any deterioration of the issuer’s financial condition. For example, FINRA’s April 2011 consent agreement with UBS,1 relating to the sale of Lehman Brothers notes, critiques the broker-dealer for not having procedures in place to ensure that its investors were aware of Lehman Brothers’ deteriorating financial situation.
Different circumstances may dictate the types of information that should be communicated to investors. In some cases, it is the downgrade of a credit rating that may be relevant. In other cases, it will be other factors, such as a weakening balance sheet, or significant increases in the issuer’s credit spreads. Issuers and underwriters should carefully consider the relevant information in the context of any particular issuer and offering.2
Can structured note offering documents disclose the risk that declines in the issuer’s credit rating may impact the value of the structured notes?
Yes. Following the repeal of Rule 436(g), the SEC indicated that no consent from a rating agency would be required when an issuer includes disclosures in its prospectuses as to credit ratings, when used in the context of a discussion about the impact to the issuer of changes to its credit ratings.3 To the extent that a downgrade of an issuer’s rating could reduce the value of a structured product, it may be potentially material disclosure.4
The SEC is removing references to credit ratings from a variety of its rules. Must our offering documents also remove them?
No. The Dodd-Frank Act requires the SEC to consider how its reliance on credit ratings can be reduced, and to take steps to remove references to those ratings from its own rules.5 However, except with respect to the consent issue discussed above as to the disclosure of actual ratings, neither the Dodd-Frank Act nor any regulation adopted thereunder instructs or requires issuers to remove references to their credit ratings. To the extent that this information is significant to an investor, such as in the case of the potential adverse impact of a ratings downgrade discussed above, it remains appropriate to disclose this possibility.
Where and how should “issuer credit risk” be disclosed?
In the aftermath of the Lehman Brothers’ bankruptcy, most parties in the structured products market have sought to enhance the disclosures relating to issuer credit risk, and to better clarify any disclosures relating to “principal protection.” The SEC and FINRA have both commented on the need for disclosure of “principal protection” to be appropriate and balanced.6 The U.S. District Court for the Southern District of New York, in a recent decision relating to the UBS litigation,7 emphasized the importance of ensuring that any disclosure of principal protection is properly balanced with disclosure of issuer credit risk. Accordingly, issuers and underwriters should be vigilant to ensure that their offering documents, to the extent that they reference the possibility of repayment of principal, provide appropriate and properly placed disclosures as to the issuer’s credit risk.
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The regulation of credit rating agencies, and disclosure of credit ratings, remains an active area. The repeal of Rule 436(g) may have limited the ability of some issuers and underwriters to disclose actual credit ratings in certain offering documents. However, rating downgrades, the potential impact of rating downgrades, and issuer credit risk all remain areas for consideration of proper disclosure in the structured products industry.