CHADBOURNE

30 Rockefeller Plaza, New York, NY 10112

& PARKE LLP

tel 212-408-5100 fax 212-541-5369

 

Peter K. Ingerman
direct tel (212) 408-5422
pingerman@chadbourne.com

July 28, 2003

Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

Attention: Mr. Jonathan G. Katz, Secretary

Re: File No. S7-12-03 - Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws

Ladies and Gentlemen:

We are submitting this letter in response to the request of the Securities and Exchange Commission (the "Commission") for comments on the Commission's Concept Release regarding Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws (Release Nos. 33-8236; 34-47972; IC-26066) (the "Concept Release"). We would like to comment upon and suggest clarification by the Commission with respect to a matter involving rating agencies and the federal securities laws that was not specifically identified in the Concept Release but which is closely related to the issues raised in the Concept Release and the Commission's Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets, As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002, January 2003 (the "Report"), with respect to transparency of the ratings process, equal access to ratings by subscribers and non-subscribers of rating agency reports and public availability of ratings.

In order to permit investors to obtain the maximum benefit from the ratings process, we suggest that the Commission clarify that ratings, rating agency reports and press releases of rating agencies with respect to their ratings and reports, the provision by issuers and other distribution participants of information to rating agencies for use in the ratings process and preparation of their reports and the review and confirmation by issuers and other distribution participants of factual information contained in rating agency reports and press releases would not cause the ratings, rating agency reports or press releases of the rating agencies to be considered selling or soliciting material attributable to an issuer or other participant in the distribution of the issuer's securities. Specifically, we suggest that the Commission confirm through rule-making or interpretive advice that the issuance by rating agencies of so-called "presale reports" and the broad dissemination of such reports, including posting on their websites, the issuance by the rating agencies of press releases with respect to their presale reports and the limited participation in that process by issuers and other distribution participants in the form of provision of information and the review and confirmation of factual information prior to an issuer's sale of its securities does not:

  • constitute an offer by the issuer or an underwriter of the issuer's securities for sale through such presale report or press release for purposes of Section 2(a)(10) or Section 5 of the Securities Act of 1933, as amended, in connection with an offering registered under the Securities Act;

  • constitute a public offering or a general solicitation or general advertising for purposes of Rule 502(c) under the Securities Act and thus would not prevent an issuer from relying on a private placement exemption from the registration requirements of the Securities Act in connection with an offering made in reliance on a private placement exemption; or

  • constitute an offer or directed selling efforts in the United States for purposes of Rule 903 under the Securities Act in connection with an offering made in reliance on Regulation S.

We have encountered these issues while representing issuers of asset-backed securities, although we think these issues may be relevant to issuers of all types of fixed-income securities. Issuers of asset-backed securities frequently engage rating agencies to assign ratings to the securities. We have become aware that rating agencies frequently prepare presale reports for transactions that they rate. The presale reports describe the offering, the rating agency's preliminary rating and the rating agency's rationale for the preliminary ratings they assign to the issue. The rating agencies issue press releases announcing their preliminary ratings and a brief description of the transaction. The presale reports are posted on the rating agencies' websites and the press releases are issued before the pricing of the offering, i.e., while the offering is being marketed. We understand that practices of the rating agencies with respect to permitting access to their websites are not uniform. In some cases, the presale reports are available to anyone who visits the websites and who provides identifying information and in other cases access to the presale reports is limited to subscribers. However, we believe that none of the rating agencies restricts access to these websites to investors who have established their sophistication and status as accredited investors or qualified institutional buyers.

We believe that there is investor demand for these presale reports because of their perceived usefulness. See, Rating Agencies Pressed for More Presales, Asset-Backed Alert, April 19, 2002, at 1, 8. We also believe that that the preparation and dissemination of presale reports is hindered by uncertainty with respect to the legal ramifications of the broad dissemination of presale reports by the rating agencies. Id..

Background

As is documented in the Report, issuers and broker-dealers participating in the distribution of an issuer's securities today play an active role in the rating process. The issuer and the broker-dealer acting as underwriter, initial purchaser or selling agent provide the rating agencies detailed information concerning the issuer and the securities and meet with and answer questions posed by the rating agencies. The issuer or the underwriter, initial purchaser or agent may also be asked to review and confirm the factual accuracy of a draft of a rating agency report or a related press release of a rating agency. While the issuer or the underwriter, initial purchaser or agent will usually initiate contact with the rating agencies, the rating agencies regard themselves as being independent of the issuers. The rating agencies impose a fee on the issuer for the initial rating and the continuing coverage. While the issuer compensates the rating agencies, the rating agencies believe that this does not affect their independence.

Registered Public Offerings

Section 5(b)(2) of the Securities Act prohibits transmitting a "prospectus" relating to a security for which a registration statement has been filed under the Securities Act unless the prospectus meets the requirements of Section 10 of the Securities Act. The term "prospectus" is defined in an extremely broad manner under Section 2(a)(10) of the Securities Act and can encompass virtually any written communication which offers a security for sale. As a result, during the period following filing of a registration statement but before it has become effective when securities in registration are typically marketed, issuers and underwriters do not distribute written materials for soliciting indications of interest from prospective investors other than the preliminary prospectus forming part of the registration statement. Once the registration statement has become effective, written selling materials that do not meet the requirements of Section 10 may be used only if accompanied or preceded by a prospectus that meets the requirements of Section 10.

The concern raised by presale reports in connection with a registered offering is that an issuer's and underwriters' involvement in the rating process might cause the presale report to be attributed to the issuer or the underwriters and constitute a non-conforming prospectus that could not be used to offer a security for sale prior to the effectiveness of a registration statement or that would have to be accompanied or preceded by a prospectus that meets the requirements of Section 10 following effectiveness of the registration statement. The General Counsel of the Commission addressed the possible attribution of a rating agency report to a distribution participant in an interpretative letter issued two years after enactment of the Securities Act. The General Counsel advised a rating agency in a letter dated August 19, 1935 that the distribution by the rating agency to its subscribers of a bulletin prepared by the rating agency containing the ratings of the rating agency and the rating agency's opinion as to the investment value of the rated securities would not violate the Securities Act. The General Counsel said, however, that the redistribution of such bulletin during the pre-effective period by underwriters and dealers to prospective investors "creates a substantial risk that underwriters or dealers, in circulating the bulletins, where such opinion material is favorable, be held to have violated the [Securities] Act through their participation in a recommendation of the security for purchase." Release No. 33-464 (August 19, 1935), 17 CFR 231.464. Both the ratings process and the means of dissemination of rating agency reports have changed significantly in the intervening years. However, the restrictions on "free writing" imposed by Section 5 continue to cast doubt on the permissibility of broad dissemination of rating agency reports prior to the effectiveness of a registration statement.

We wish to make clear that we are not suggesting that the Commission authorize issuers and underwriters to redistribute rating agency presale reports during the pre-effective period. Our intention is merely to point out that the greater involvement today of issuers and underwriters in the rating process makes it desirable for the Commission to clarify the status of rating agency reports and press releases of the rating agencies when they are disseminated by the rating agencies.

Private Placements and Regulation S Offerings

Asset-backed securities and other fixed-income securities for which ratings are sought are frequently sold in institutional private placements to qualified institutional buyers pursuant to Rule 144A, to institutional accredited investors (i.e., investors who qualify as accredited investors pursuant to paragraphs (a) (1), (2), (3) and (7) of Rule 501 under the Securities Act) pursuant Section 4(2) of the Securities Act and Regulation D under the Securities Act and in "offshore transactions" pursuant to Regulation S under the Securities Act. These offerings are made through registered broker-dealers acting as initial purchasers or agents.

The universe of potential investors in these institutional private placements is quite small. The major securities firms that act as initial purchasers or agents have preexisting relationships with most qualified institutional buyers who invest in these types of offerings. The initial purchasers or agents may also market these securities to their customers who qualify as institutional accredited investors but not qualified institutional buyers.

The issuers of these securities prepare extensive private placement memoranda for prospective investors that contains information similar to the information that would appear in a prospectus for an offering registered under the Securities Act. The issuers and the initial purchasers or agents meet with prospective investors or provide prospective investors with access to Internet based "road shows" in which prospective investors can view a presentation by representatives of the issuer concerning the offering. Representatives of the issuer also respond to questions and provide additional information requested by prospective investors.

The nature of asset-backed securities makes the involvement of the rating agencies critical to investor acceptance even among sophisticated institutional investors. See, Rating Agencies Pressed for More Presales, supra. However, the strict prohibitions on general solicitations and general advertising in private placements and on directed selling efforts in Regulation S offerings cast doubt on the permissibility of broad dissemination of rating agency reports while these offerings are being marketed.

Legal Analysis

Registered Public Offerings

The August 19, 1935 letter of the General Counsel of the Commission confirmed that the provision by rating agencies of their bulletins to their subscribers would not violate the Securities Act. However, changes in the ratings process and the means of disseminating rating agency reports make it appropriate for the Commission to clarify the status of rating agency reports in light of modern practices. The General Counsel's letter states that it is the General Counsel's understanding that the rating agency "receives no consideration, either directly or indirectly, from any issuer, underwriter or dealer, for describing the securities in the rating agency's bulletins and that the bulletins are prepared from information in the rating agency's files and from the registration statements and prospectuses filed under the Securities Act in connection with the rated securities." The General Counsel stated that the distribution of such bulletins by the rating agency to its subscribers (as opposed to the redistribution of the bulletins by underwriters and dealers to prospective investors) would not violate the Securities Act. As recognized by the Commission in the Concept Release and the Report, the relationship between rating agencies and the issuers of rated securities has changed dramatically in the intervening years so that it is now common for issuers to pay the rating agencies fees for rating securities and to provide confidential information to rating agencies to assist them in their analysis.

In the intervening years, the Commission has also recognized the value of ratings and other objective third-party analysis to investors. The Concept Release and the Report both note that commenters have stressed the importance to investors of transparency in the ratings process and the need for investors to know not just the rating agencies' ratings but the key information on which those ratings are based.

The Commission has already adopted rules authorizing the issuance by securities firms of research reports during public offerings. In adopting Rules 137, 138 and 139 under the Securities Act, the Commission has acknowledged that the publication of objective third-party analysis during the pendency of a registered public offering is permissible.

The Commission discussed the benefits of and the potential problems with third-party analysis during offerings in the context of securities analysts in the "Aircraft Carrier Release," Release Nos. 33-7606A, 34-40632A, IC-23519A (Nov. 13, 1998):

Investors acquire useful information regarding companies from sources other than Commission-mandated disclosure. One such source is analysts' research reports. As the Commission has long acknowledged and the Supreme Court recognized in Dirks v. SEC, analysts fulfill an important function by keeping investors informed. They digest information from Exchange Act reports and other sources, actively pursue new company information, put all of it into context, and act as conduits in the flow of information by publishing reports explaining the effect of this information to investors. They also express opinions and recommendations about investment in issuers' securities. Unlike small investors, analysts can arrange to interact with key company insiders and ask them pertinent questions. Where analysts are acting independently and objectively, investors gain from the publication of their insights.

Analyst reports, however, also potentially can be misused to hype a company's securities. Because they could do so under the guise of providing objective, independent analysis, they could unduly influence investors.

We believe that issuance by the rating agencies of their presale reports and press releases benefits investors in the same way that analyst reports benefit investors. In order to clear away uncertainty as to the legal ramifications of the broad dissemination of rating agency reports by rating agencies, we suggest that the Commission make clear that the issuance by rating agencies of presale reports and press releases does not constitute an offer by an issuer or an underwriter of the issuer's securities for sale through such presale report or press release for purposes of Section 2(a)(10) or Section 5 of the Securities Act in connection with an offering registered under the Securities Act. The primary reason supporting this conclusion is that the rating agencies are independent of the issuer and underwriters and the actions of the rating agencies therefore should not be attributed to the issuer or the underwriters. An additional reason supporting this conclusion is that rating agency presale reports contain material that is factual, objective and often cautionary in tone. As a result, the rating agency material should not be regarded as soliciting or selling material.

Private Placements and Regulation S Offerings

The Commission has expressed concern with respect to use of media permitting broad dissemination of information for exempt offerings. In Release Nos. 33-7856, 34-42728, IC-24426 (April 28, 2000), the Commission made the following observation:

Broad use of the Internet for exempt securities offerings under Regulation D is problematic because of the requirement that these offerings not involve a general solicitation or advertising. When we first considered whether exempt offerings could be conducted over the Internet, we concluded that an issuer's unrestricted, and therefore publicly available, Internet web site would not be consistent with the restriction on general solicitation and advertising. Specifically, the 1995 Release included an example indicating that an issuer's use of an Internet web site in connection with a purported private offering would constitute a "general solicitation" and therefore disqualify the offering as "private." (footnotes omitted.)

* * *

Our Securities Act analysis assumes that the information posted on a Web site would, were we to deem it to occur in the United States, constitute an "offer" within the meaning of Section 5(c) of the Securities Act and Regulation S, a "public offering" prohibited under Section 4(2) of the Act, a "general solicitation or general advertising" prohibited under Rule 502(c) of Regulation D, and a "directed selling effort" prohibited under Regulation S.

The Commission has expressed these concerns with respect to websites maintained by issuers and underwriters and with respect to websites maintained by third parties acting on behalf of the issuer or an underwriter. Id.; Release Nos. 33-7516. 34-39779, IA 1710, IC-23071 (March 23, 1998).

We believe that the issuance by the rating agencies of presale reports and press releases should not constitute a "general solicitation" or a "directed selling effort" for the same reasons that we expressed with respect to the issue of whether these actions should be considered an offer by an issuer of its securities for sale through such presale report or press release for purposes of Section 2(a)(10) and Section 5 of the Securities Act in connection with an offering registered under the Securities Act.

We thank you for the opportunity to comment on the Concept Release. We would be happy to discuss with you our comments or any other matters you feel would be helpful in your review of our comments. Please do not hesitate to contact the undersigned if you would like to discuss these matters further.

Very truly yours,

Peter K. Ingerman