July 2, 2010
Authored by: Bryan Cave Leighton Paisner
On June 28, 2010, the House and Senate conferees approved the financial regulatory reform conference report (known as the “Dodd-Frank Wall Street Reform and Consumer Protection Act”), and on June 30, 2010, the House approved a bill that has almost was almost identical to the conference report, except for a change in the so-called “pay-for” amendment (as discussed here). The Senate is now poised to vote on the legislation. The final version of the bill includes provisions that are intended to significantly improve the regulation of credit rating agencies (see Title IX, Subtitle C).
Unlike many of the other areas in the regulatory reform bill, the improvements to the regulation of credit rating agencies begins with a section describing Congress’s findings regarding credit rating agencies. These findings seem intended to explain and justify the significant changes that Congress is making in the regulation of credit rating agencies. Specifically, Congress indicates that because credit ratings and the reliance placed on credit ratings are systemically important the activities of credit rating agencies, including nationally recognized statistical rating organizations (“NRSROs”), are a matter of public interest, because their activities are central to capital formation, investor confidence, and the efficient performance of the U.S. economy. Further, credit rating agencies play a “gatekeeper” role, similar to securities analysts and auditors, and this role justifies a similar level of public oversight and accountability, as well as the same standards of liability. Finally, the ratings on many structured financial products have turned out to be inaccurate, and these inaccuracies have adversely affected the health of the U.S. and world economies, which necessitates increased accountability on the part of credit ratings agencies.
Office of Credit Rating
An Office of Credit Rating will be established, with its own staff and the authority to fine credit rating agencies, to administer the rules of the SEC regarding the practices of NRSROs. The rules will be developed to protect users of ratings and in the public interest, to promote accuracy of credit ratings, and to assure that ratings are not unduly influenced by conflicts of interest. To ensure that the Office is meeting these requirements, the Office will examine all NRSROs at least annually, with each examination to review the following: the NRSRO’s established procedures for assigning ratings (described below); whether conflicts of interest are effectively managed; the NRSRO’s ethics policy; the NRSRO’s corporate governance procedures; and the processing of complaints. The Office of Credit Rating will publish annual reports summarizing the findings of the examinations of the NRSROs.
The Office of Credit Rating will also be responsible for prescribing rules for the protection of investors and in the public interest. These rules will set forth procedures and methodologies to determine credit ratings to ensure that credit ratings are established using appropriate methodologies and any changes in methodologies are made consistently.
Internal Controls, Regulatory Compliance, and Corporate Governance
All NRSROs will be required to establish, maintain, enforce, and document an effective internal control structure for determining credit ratings. The internal control structure must consider any factors that the SEC may prescribe by rule. NRSROs must submit annual internal controls reports, attested to by the CEO, to the SEC, describing management’s responsibility to establish and maintain effective internal controls for determining credit ratings. NRSRO compliance officers must prepare certified annual reports and submit those reports to management and the SEC.
All NRSROs will also be required to increase transparency by disclosing information on each initial credit rating assigned and for any subsequent changes to a credit rating. This information must be prepared to allow users of the credit rating to evaluate the accuracy of ratings and to compare the performance ratings of NRSROs. Further, NRSROs will have to disclose their use of third parties used for due diligence efforts, and if an NRSRO is made aware of credible and significant information from other sources, the NRSRO must consider that information was assigning a rating.
For each credit rating issued, the NRSRO must include an attestation that the rating was not influenced by any other business activity, that the rating was based solely on the merits of the instrument being rated, and that the NRSRO undertook an independent evaluation of the risks and merits of the instrument when assigning the rating. All NRSROs will be held to the same standards of accountability for statements made by registered public accounting firms and securities analysts. Further, investors will have the ability to bring private rights of action against NRSROs for a knowing or reckless failure to conduct a reasonable investigation, and NRSROs may be subject to “expert liability” because credit ratings will no longer be exempt from consideration as part of a registration statement.
Compliance officers of NRSROs may not work on ratings, methodologies, or sales. Each NRSRO must establish and implement policies and procedures to address conflicts of interest when an NRSRO employee goes to work for an issuer, underwriter, or sponsor of an instrument rated by the NRSRO. The SEC will issue rules to ensure that any person employed by an NRSRO to perform credit-rating functions has the requisite training, experience, and competence for credit rating, and such person will have to be tested for such experience. At least half, but not fewer than two, of the members of the board of directors of all NRSROs must be independent.
Subtitle C of Article IX contains a number of other important provisions including the following:
– An issuer or underwriter of any asset-backed security must make publicly available the findings and conclusion of any third-party due diligence report obtained by the issuer or underwriter, and the due diligence provider must submit to the NRSRO using the third party for due diligence service a certification, on an SEC-approved form, ensuring that the data, documentation, and other relevant information provided to the NRSRO has been thoroughly reviewed.
– References to credit ratings in various other statutory schemes, including the Federal Deposit Insurance Act, the Federal Housing Enterprises Financial Safety and Soundness Act, the Investment Company Act, and the Exchange Act, have been removed to eliminate over-reliance on credit ratings. All Federal agencies must substitute references in regulations to credit ratings with other standards of credit-worthiness.
Businesses whose primary business is the issuance of credit ratings will no longer be exempt from Regulation FD. This may require credit rating agencies to maintain disclosed nonpublic information in confidence.
The SEC must commission a study regarding the feasibility or desirability of standardizing credit ratings for all NRSROs, standardizing stress testing, requiring a quantitative correspondence between credit ratings and a range of default probabilities, and standardizing credit rating terminology.
The Government Accountability Office must conduct a study to evaluate different methods for compensating NRSROs to create more incentives to provide accurate ratings.
The Government Accountability Office must conduct a study on the feasibility and desirability of creating an independent professional organization for rating NRSRO analysts.