Speech by SEC Commissioner:
Reinvigorating Credit Rating Agencies to Maintain a Vital Investor Protection
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
September 17, 2009
Let me begin by adding my voice to the chorus of those on this dais offering thanks to our staff. Our staff undertook significant efforts to move forward today's many regulatory actions in a short time, and the public will be better for it. My thanks to all involved with today's matters.
As demonstrated by the many news articles heralding the occasion, this week marks the one-year anniversary of the collapse of Lehman Brothers and the subsequent financial crisis. While there still remains a great deal of confusion and uncertainty as to what caused the crisis, there is a general consensus that credit rating agencies significantly contributed to the damage and widespread loss of investor confidence.
There is broad agreement on this dais and in the marketplace that Credit Rating Agencies must be appropriately reformed and regulated. In the last three years, following the enactment of the Credit Rating Agency Reform Act of 2006, the Commission has undertaken a massive amount of rulemaking efforts and some of these regulatory requirements have just recently become effective.
Today we have a series of Commission votes that continues the effort to strengthen NRSRO operations and ratings disclosures and to remove NRSRO references from our rules.
Strengthening NRSRO Operations and Ratings Disclosure
Credit rating agencies raise a host of concerns, ranging from the level of competition in the industry, to a lack of transparency about what is included in the rating and what factors exist that could reduce the accuracy of the rating. The Commission's actions today are a further step to address the whole spectrum of concerns — and to work toward improving transparency, competition, and accountability.
To improve the transparency of credit ratings in the market, information is needed from NRSROs themselves and, additionally, from registrants when they offer securities. The Commission is adopting rules that would require ongoing public disclosure of NRSRO's historical ratings so that investors can compare the performance of rating agencies and evaluate which agency does a better job. In addition, the Commission is proposing that NRSROs provide greater disclosures about their revenue streams, allowing investors to evaluate the impact of any conflicts of interest that may result. Lastly, the Commission is proposing that registrants who use ratings in a securities offering provide investors with important information about the limitations of the rating, and conflicts of interest, as well as whether the registrant engaged in ratings shopping. An aim of all these rules is to give investors better information to assist them in evaluating credit ratings.
Another concern we are attempting to address today is competition. One way that the Commission is working to improve competition in the credit rating industry is by adopting rules that would establish a system whereby all NRSROs can access the same information about a structured finance product, so that any NRSRO can prepare its own rating, and, thereby, enhance its ability to compete on the quality of its ratings.
I believe it is also important to increase the accountability of NRSROs. Two of our actions today touch on this issue.
First, the Commission is proposing to require compliance officers of NRSROs to prepare a report to the Commission that describes what compliance reviews were undertaken, what problems were discovered, and what steps were taken to correct them.
Second, the Commission is issuing a concept release on removing a special exemption that NRSROs have enjoyed since the 1980s that shields them from Securities Act liability for misstatements in registration statements. If NRSROs face that liability for such misstatements, the expectation is that they would be more accountable to investors, and investors would have a greater ability to recover losses caused by an NRSRO misrepresentation. This exemption from liability is unique to NRSROs — ordinary credit rating agencies do not have it. I fully recognize that repealing this exemption may increase accountability while potentially creating some disruptions in the offering process. However, the special exemption is over 25 years old, and the credit rating industry has changed a great deal, so I am particularly interested to hear whether the reasons that the Commission originally stated for granting this exemption are still viable today.
Removal of References
Proper Analysis to Evaluate Reference
Let me now address some of the specific actions being taken concerning the removal of references to credit ratings in our rules.
Removing NRSRO references from SEC rules sounds simple in concept but in execution it is much more complex. The fundamental question one has to ask relative to each reference is . . . what role does it have within a given rule? Sometimes it is simply administrative convenience. But, quite often, the answer is investor protection. Many of the rules containing NRSRO references are exemptive in nature — meaning that the rule allows market participants to engage in activity that would otherwise be unlawful. As just one example, many of the Investment Company Act rules containing NRSRO references allow a fund to operate in a way that it otherwise could not. In most of the rules in question, the rating references often function as a condition designed to permit particular conduct, otherwise prohibited, while preventing possible abuses.
Given that ratings often serve as an investor protection, one has to look hard to understand whether the reference to a credit rating in a rule has a viable alternative that offers equivalent protection, or whether the exemption itself should be rescinded if the reference is removed.
References to be Removed
In my view, certain of the ratings references in our rules — those related to SROs and alternative trading systems that categorize securities by their credit rating merely for tracking purposes or for analysis of market concentration — do not appear to provide an important protection, and I agree that these references can be removed.
I do want to concentrate for a moment on the amendments being adopted to Investment Company Act Rule 10f-3. The Investment Company Act broadly prohibits funds from purchasing any security from an affiliated underwriter during the existence of an underwriting or selling syndicate for that security. The goal of the prohibition was to prevent the "dumping" of unmarketable securities on affiliated funds, and it guards against the affiliate forcing the fund to purchase unmarketable securities from a member of the syndicate. This is a serious concern. Rule 10f-3 is one of those exemptive rules I mentioned previously. It provides an exemption from this important protection against dumping. Rule 10f-3 allows funds to purchase from affiliates, notwithstanding the conflicts of interest, so long as there is an external determination that the securities are of adequate quality — and that is the current role of the NRSRO rating in this rule.
In addition to the rating requirement regarding municipal securities, however, Rule 10f-3 also has various safeguards designed to fight against dumping concerns. This existing additional infrastructure requires that the fund's board of directors, including a majority of the independent directors,
- Approve procedures under which the fund can make purchases under the rule;
- Approve any needed changes to those procedures; and
- Review purchases quarterly to assure that they conform to the fund's procedures.
By today's removal of the rating requirement, the board will now only need to create additional procedures to implement the new standards in the rule regarding liquidity and credit quality for municipal securities — rather than developing a whole new process. I anticipate the changes to 10f-3 will not impose an undue burden because the board is already charged with reviewing these purchases on a quarterly basis.
Based on discussions with the staff, I expect that — in practice, the rating and rating standards will continue to operate as a point of reference for the securities acquired. In addition, the board (or its delegate) will be required to engage in, and document, its own determination as to whether the acquired security meets the same high standard as is in the current rule. Because the board will be reviewing all the 10f-3 transactions quarterly, it will be able to quickly ascertain if these standards are not being successfully implemented. If Rule 10f-3 did not already require such vigilance by the board, and if the release did not explicitly state that the Commission expects the quality of securities to be very similar to what we require under the current standard, I may have had to withhold my support from this amendment.
I will caution that I am becoming increasingly concerned that the Commission is imposing too large of a burden on Boards of Directors of investment companies by blurring the line between appropriate oversight and day-to-day management. I do not think that it is in the best interests of investors for directors to be expected to be in the business of day-to-day credit determinations.
Now I will discuss the release that re-opens the comment period on all of the other rules that contain rating references.
The Commission has asked for comment on whether or not it should remove ratings references from its rules multiple times, and every time the commentators have been overwhelmingly in support of retaining the references. Most recently, the Commission's request for comment in June 2008 resulted in letters in which approximately 90% or more of the comments asked the Commission not to remove the ratings references in our rules. The general consensus seems to be that many ratings references make sense and that it would be harmful to remove them. I am concerned that re-opening the comment period and asking for comments on this topic again will create comment fatigue. I know it is not easy to continuously keep up with rulemakings coming from the Commission, particularly right now with the blizzard of Commission activity.
Despite my concerns, I am going to support re-opening this comment period. Given the events of the last year, commentators may be in a better position to discuss whether ratings in our rules provide investor protection by creating an objective, minimum standard of credit quality or whether an acceptable alternative exists. I also look forward to hearing from commentators whether allowing market participants more discretion in their search for alpha — by removing the external discipline of credit rating — will be harmful or helpful to investors.
One approach to ratings that has worked well is the one currently used in Rule 2a-7 of the Investment Company Act. In Rule 2a-7, the credit rating sets a floor for the quality of a security but then there is a requirement of an internal evaluation in addition to the NRSRO rating. In particular, the Commission today is seeking comment on whether Investment Company Act Rules 3a-7 and 5b-3, and Advisers Act Rule 206(3)-3T should do just this by replacing the ratings standard with alternate standards that would (i) use credit ratings as a minimum standard and (ii) require an additional internal determination of credit quality. This approach could reduce undue reliance on ratings by requiring an additional evaluation of credit quality, while retaining the external or objective measure of the NRSRO rating.
I look forward to the comment letters we will receive discussing if this concept should be implemented in other of our rules.