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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the SEC Open Meeting:
Proposed Rules Implementing the Credit Rating Agency Reform Act of 2006


Erik R. Sirri

Director, Division of Market Regulation
U.S. Securities and Exchange Commission

Washington, D.C.
January 31, 2007

Thank you, Mr. Chairman. Good afternoon, Commissioners. The Division of Market Regulation recommends that the Commission propose rules that would implement the Credit Rating Agency Reform Act of 2006. The Rating Agency Act, enacted on September 29, 2006, amended the Exchange Act to provide a new regulatory program for registering and supervising credit rating agencies that elect to be treated as nationally recognized statistical rating organizations. The proposed rules are narrowly tailored, in accordance with the Congressional mandate, and are designed to promote the quality and integrity of credit ratings by fostering accountability, transparency, and competition in the credit rating industry. In particular, the rules are designed to facilitate the entry of new competitors into the registered credit rating agency business.

Credit rating agencies have been providing opinions on the creditworthiness of issuers of securities and other financial obligations since the early twentieth century – when Alfred M. Best was doing business out of a small sub-let room, with a second-hand desk and a couple of chairs. With the passage of time, the importance of credit ratings to investors and other market participants, and therefore the influence of these opinions on the securities markets, has increased exponentially, particularly with the increase in the number of issuers and the introduction of new and complex financial products.

Today, the opinions of credit rating agencies affect securities markets in important ways, including access to, and cost of, capital, the structure of financial transactions and products, and the ability of fiduciaries and others to invest in particular financial instruments.

Increasingly, the Commission and other regulators have used credit ratings as a convenient proxy for credit risk of instruments held by regulated entities. The globalization of the financial markets also has served to expand the role of credit ratings to jurisdictions beyond just the United States.

The rules for nationally recognized statistical rating organizations we are proposing today cover registration, recordkeeping, financial reporting, material non-public information, conflicts of interest, and unfair, coercive, and abusive practices.

Registration (Proposed Rule 17g-1 and Form NRSRO) – Proposed Rule 17g-1 would require a credit rating agency to apply for registration and, if approved, to provide updated information and an annual certification, on proposed Form NRSRO. These proposed rules would provide credit rating agencies with a transparent process to apply for registration as an NRSRO that does not favor a particular business model or larger, established firms. For example, the rules do not distinguish between the technology employed by traditional rating agencies and those that might be employed by a purely quantitative model-based firm.

The credit rating agency would be required to disclose important information such as credit ratings performance statistics, methods for determining credit ratings, organizational structure, procedures to prevent the misuse of material non-public information, conflicts of interest, its code of ethics, and the qualifications of its credit analysts and compliance personnel. The Commission would use this information to determine whether an application should be approved and whether an NRSRO continues to meet the requirements for registration. In particular, it forms a basis for the Commission’s determination of whether the entity meets the statutory definition of “credit rating agency” and whether it has adequate financial and managerial resources to produce credible ratings. Users of credit ratings would benefit from this information as well, as it would provide a means for comparing the rating quality of different NRSROs.

Recordkeeping (Proposed Rule 17g-2) – Proposed Rule 17g-2 would require an NRSRO to make and retain certain records relating to the business of issuing and maintaining credit ratings. The proposed recordkeeping requirements would allow the Commission to conduct effective examinations to determine whether the NRSRO is following its procedures and complying with statutory requirements and other substantive rules, such as those relating to the misuse of material nonpublic information, conflicts of interest, and unfair, abusive, and coercive practices.

Financial Reporting (Proposed Rule 17g-3) – Proposed Rule 17g-3 would require NRSROs to furnish to the Commission financial statements audited by an independent public accountant on an annual basis. The financial statements would include summary financial information that would assist the Commission in carrying out its statutory responsibilities under the Rating Agency Act.

Material Non-public Information (Proposed Rule 17g-4) – The Rating Agency Act requires that NRSROs establish procedures designed to prevent the misuse of material nonpublic information and directs the Commission to issue rules to require specific policies and procedures to that end. Accordingly, the proposed rule would require procedures designed to prevent the dissemination of confidential information, procedures designed to prevent employees of the NRSRO from trading on material nonpublic information, and procedures designed to prevent the misuse of information relating to a pending credit rating action. The proposed rule does not prescribe specific procedures – it describes the end that the procedures must be designed to achieve. We believe that this approach would provide the NRSRO flexibility to design procedures tailored to its business activities and organizational structure.

Conflicts of Interest (Proposed Rule 17g-5) – Proposed Rule 17g-5 would require an NRSRO to disclose and manage those conflicts of interest that arise in the normal course of engaging in the business of issuing credit ratings. These include receiving compensation from persons being rated or from subscribers that use the credit ratings for regulatory purposes. The proposed rule would prohibit other conflicts of interest. For example, an NRSRO could not rate an affiliate.

Unfair, Coercive, and Abusive Practices (Proposed Rule 17g-6) – Proposed Rule 17g 6 would prohibit the NRSRO from engaging in unfair, coercive, or abusive practices that Congress or the Commission have identified as problematic. For example, the proposed rule would prohibit an NRSRO from conditioning or threatening to condition the issuance or modification of credit ratings of an obligor on the purchase of other products or services of the NRSRO. Also, for example, the proposed rule would prohibit a practice referred to as “notching” – whereby a credit rating agency issues or threatens to issue a lower credit rating, lowers or threatens to lower an existing credit rating, refuses to issue a credit rating, or withdraws a credit rating with respect to a structured financial product unless a portion of the assets underlying the structured product also are rated by the NRSRO. At the same time, the proposed rule would not discourage legitimate reasons for an NRSRO to refuse to rate a structured product where the NRSRO has not rated the underlying assets.

We request, and anticipate receiving, detailed comments regarding many aspects of the proposed rules that will need to be fully considered before we can prepare final rules for the Commission’s consideration, and we intend to do whatever is necessary to publish the proposed rules for comment as quickly as possible. The proposed release would provide for a 30 day comment period. One may question whether 30 days is sufficient time for interested persons to comment on the proposed rules, especially considering that the proposed rules cover a broad range of issues that, until now, have not been the subject of Commission regulation. However, given that the statutory deadline for issuing final rules is June 26th, it is important that we receive public comments as quickly as possible.

With respect to the deadlines for issuing final rules in this area, I also would like to mention a timing issue that will arise when the Rating Agency Act becomes effective. On the date the Rating Agency Act becomes effective, which will be the earlier of the date on which regulations are issued in final form or June 26, 2007, the staff’s letters identifying entities as NRSROs become void, and a credit rating agency that has been identified as an NRSRO by the Commission staff may represent itself as an NRSRO only if it has furnished an application for registration as an NRSRO with the Commission.

In conclusion, the proposed rules should improve the quality and integrity of credit ratings. In addition, increased oversight of NRSROS should increase the accountability of an NRSRO to its subscribers, investors, and other persons who rely on the credibility and objectivity of ratings in making an investment decision.

Our recommendation today represents the culmination of efforts by staff from several Divisions and Offices. I would like to thank Janice Mitnick and Michael Bloise of the Office of the General Counsel, Tony Tri and Chuck Dale from the Office of Economic Analysis, Robert Burns from the Office of the Chief Accountant, and the following members of my staff, Mike Macchiaroli, Tom McGowan, Randall Roy, Rose Russo Wells, and Sheila Swartz.

We are happy to answer your questions.


Modified: 02/06/2007