At an open meeting this morning, the SEC adopted, by a vote of three to two, rule amendments and new rules to implement provisions of Dodd-Frank applicable to credit rating agencies registered as nationally recognized statistical rating organizations (NRSROs), as well as providers of third-party due diligence services for asset-backed securities, and issuers and underwriters of asset-backed securities. Dodd-Frank expanded the authority of the SEC with regard to credit rating agencies because Congress astutely suspected that something might be awry when CDOs related to a bunch of subprime mortgages, half of which were in default, received AAA credit ratings. As Commissioner Aguilar observed during the open meeting, many believe the credit rating agencies were “not just facilitators of the financial crisis,” but rather “its linchpin.” By one estimate, he indicated, global losses from the financial crisis could be as high as $15 trillion.
The new rules regarding credit rating agencies were originally proposed in May 2011 (as discussed in this news brief ). Consumer advocates criticized the proposed rules as inadequate. While the final rules are more rigorous than those proposed, last-minute changes designed to address concerns raised in comment letters appear to have driven two of the SEC Commissioners off the reservation, as Commissioners Gallagher and Piwowar voted against adoption.
The new package of reforms is designed to enhance transparency and accountability by addressing internal controls, conflicts of interest and procedures designed to protect the integrity of rating methods. (Here is the press release and related fact sheet, which provides more details on the final rules, and here are the final rules, a measly 729 pages.)
First, Dodd-Frank required that a credit rating agency establish and enforce an effective internal control structure, as well as submit to the SEC an annual internal control report, with an attestation as to effectiveness by the CEO. The internal control report required by the new rules must describe material weaknesses and how they were addressed. The new rules also prescribe specific factors to be taken into account in developing, maintaining and enforcing the internal control structure, although it is expected that the structure would be tailored to the risks affecting the specific rating agency. Chair White emphasized that the identified factors are not intended to create a safe harbor, although Commissioner Gallagher believes that the factors suggest a safe harbor. The two dissenting Commissioners took issue with the prescriptive nature of incorporating all of these factors into the rule “at the last minute” without having first re-proposed the rule, as well as the excessive focus on process.
Dodd-Frank also required the adoption of rules to prevent sales and marketing considerations from influencing an agency’s credit ratings. Conflicts of interest affecting rating agencies have been an enormous concern. Commissioner Aguilar expressed the view during the meeting that, in the years just prior to the financial crisis, the paramount concern of credit rating agencies was maximizing revenues and market share rather than fulfilling their gatekeeper function and protecting investors; the new rules addressing conflicts of interest were, therefore, the “centerpiece” of the new regulatory framework. First, the rules prohibit an agency from issuing or maintaining a credit rating where a person within the agency who participates in determining or monitoring the credit rating or in developing methodologies used for the credit rating also participates in sales or marketing of a product or service of the agency or its affiliate. Second, the rule prohibits an agency from issuing or maintaining a credit rating where an employee similarly involved in producing the credit rating is “influenced” by sales or marketing considerations. According to Chair White, this second component of the conflicts rule is designed to address other channels of influence beyond sales and marketing, including incentives to inflate ratings produced by compensation arrangements or performance evaluation systems, pressures on analysts by rated entities to produce inflated credit ratings and pressures by agency managers outside of sales and marketing to inflate credit ratings to increase the agency’s market share. It’s this component of the rule that drew the most criticism from the two dissenters. In particular, Commissioner Gallagher would have preferred that the rule address specific conflict loopholes rather than creating a “thought crime” that captures all persons whose state of mind was “influenced “ by sales and marketing considerations. In his view, the rule was too vague to withstand judicial scrutiny. Commissioner Piwowar agreed that the rule created an “impossible standard,” without any limiting principle. Looking to the future, Commissioners Aguilar and Stein commented that one priority that remains to be addressed is the challenge of the “issuer-pays” model, under which the issuer that is being rated by the rating agency selects the agency and pays for the rating, creating an incentive for agencies competing for business to boost ratings.
Another key issue addressed in the new rules is the issue of agency employees who may be tempted to inflate ratings by the prospect of future employment at a rated entity. The new rule requires agencies to conduct a look-back review for former employees to determine if they had conflicts of interest that may have influenced ratings. In that event, the agency is required to determine whether the particular rating must be revised, to promptly publish that revision or an affirmation of the rating, along with disclosure regarding the conflict. If the revision is not made within 15 days, the rating must be placed on watch or review with disclosure regarding the conflict. Commissioner Aguilar contended that future rules should prescribe specific policies regarding the look-back review, implying that the current process that allows the agencies to develop those policies themselves may not be as effective as desired. To illustrate, he noted that, in 2013, there were many look-back reviews, but no revisions of ratings resulted.
In addition, with the credit ratings, the agencies must publish required quantitative and qualitative information regarding ratings, including limitations, assumptions, sensitivity, uncertainty, probability of default and performance statistics. Each rating must include an attestation by a person within the agency responsible for the credit rating stating that the rating was not influenced by any other business activities and was based solely on the merits. Standardized information regarding each agency’s changes to credit ratings and default rates will also be required to allow investors to compare performance across the industry. The rules also create training, experience and competence standards for those participating in the ratings process at credit rating agencies.