Statement on Proposal to Increase Investor Protection by Reducing Reliance on Credit Ratings
Chairman Christopher Cox
U.S. Securities and Exchange Commission
June 25, 2008
Good morning. This is an open meeting of the U.S. Securities and Exchange Commission under the Government in the Sunshine Act on June 25, 2008.
Today we are continuing our consideration of several rules that would reform the regulation of credit rating agencies. We have divided consideration of these several rules into three parts. Two weeks ago, on June 11, the Commission proposed the first two parts. Today we will consider the third part.
The entire package of reforms is born of the subprime mortgage crisis, and the resulting credit crunch. These events of recent months have had a profound effect on our economy and our markets, and they have galvanized regulators and policymakers not only in this country but around the world to re-examine every aspect of the regulatory framework governing credit rating agencies.
Following from that re-examination, the first portion of our package of reforms contained a number of provisions addressed to conflicts of interest in the credit ratings industry. The proposed rules also include requirements for new disclosures designed to increase the transparency and accountability of credit ratings agencies.
The second portion, which we also proposed two weeks ago, would require credit rating agencies to differentiate the ratings they issue on structured products from those they issue on bonds. They would have to do this either through the use of different symbols, such as attaching an identifier to the rating, or by issuing a report disclosing the differences between ratings of structured products and other securities. This rule, if adopted, would help ensure that investors appreciate the different risk characteristics of structured products and the fact that structured product ratings rely on qualitatively different kinds of information and ratings methodologies than do ratings for bonds.
The third part of this rulemaking, which we take up today, is focused on the way the Commission's own rules refer to and rely upon credit ratings. For some time before the recent subprime crisis, we had been re-evaluating the basis for the SEC's use of ratings as a surrogate for compliance with various regulatory conditions and requirements. The recent market turmoil, and the role that credit ratings played in it, has only further motivated our consideration of reform in this area.
To begin with, the SEC's own rules don't distinguish between ratings for corporate bonds and ratings for structured finance products. As a result, our own regulatory regime might be vulnerable to criticism on the same grounds as the ratings agencies' use of common symbology: namely, that it doesn't properly reflect the different risk characteristics of structured products, and the different kinds of information and ratings methodologies that go into ratings for structured products.
Second, several of our regulations implicitly assume that securities with high credit ratings are liquid and have lower price volatility. But since structured finance products can be very different from other rated instruments in these respects, there is good reason for us to examine the precise way that credit ratings are used in our rules as a surrogate for measurements of liquidity and volatility.
Third, several observers, including the Financial Stability Forum, have leveled the criticism that the official recognition of credit ratings for a variety of securities regulatory purposes may have played a role in encouraging investors' over-reliance on ratings.
To the extent that the marketplace views the SEC's references to credit ratings in our rules as giving those ratings an implied official seal of approval, they have argued, our own rules may be contributing to an uncritical reliance on credit ratings as a substitute for independent evaluation. Of course, it should go without saying that it should be neither the purpose nor the effect of any SEC rule to discourage investors from paying close attention to what credit ratings actually mean.
The recommendations we consider today are designed to ensure that the role we assign to ratings in our rules is consistent with the objective of having investors make an independent judgment of the risks associated with a particular security. There are references to credit ratings sprinkled throughout the Commission's rules, in substantive areas that fall within the domains of several different Divisions within the agency.
In preparing the staff recommendations to the Commission today, the Division of Trading and Markets, the Division of Corporation Finance, and the Division of Investment Management all have conducted thorough evaluations of the way credit ratings are used in the rules and forms within their areas of expertise. What those evaluations have found is that in some rules and forms, the reference to credit ratings isn't really necessary at all. In those cases, the proposed new rules would simply eliminate the reference.
In other cases, the staff has found that there is value in the use of a credit rating, but that the current way ratings are incorporated in the particular rule or form should be changed. In these cases the proposed rules would clearly state the regulatory purpose we are seeking to achieve, and then permit reliance on a credit rating as one way to achieve that purpose.
Finally, in just a few cases, the staff has concluded that the reference to a credit rating continues to be appropriate exactly as it is. In these cases, because there is no hazard of inducing undue reliance on the ratings by investors, the recommendation before us is to leave the rules as they are.
All told, the three Divisions have examined the references to credit ratings in 44 of our rules and forms. The staff is recommending changes to 38 of them. Specifically, they are recommending the complete elimination of any reference to credit ratings in 11 rules and forms. They are recommending the substitution of a standard based on a more clearly stated regulatory purpose or other concept in 27 rules and forms. And they are recommending leaving the reference unchanged in 6 rules and forms.
I'll next recognize the other Commissioners for their opening remarks, but before I do that I want to thank the staff from each of the three Divisions for the extraordinary work and professional analysis that have gone into today's recommendations.
I'll begin by thanking Erik Sirri, Director of the Division of Trading and Markets; John White, Director of the Division of Corporation Finance; and Buddy Donohue, Director of the Division of Investment Management. I greatly appreciate the excellent work by you and all of your staff who contributed. In the Division of Trading and Markets: Erik Sirri, Bob Colby, Catherine Moore, Tom McGowan, Michael Gaw, Josh Kans, and Elizabeth Sandoe. In the Division of Investment Management: Buddy Donohue, Bob Plaze, Liz Osterman, Penelope Saltzman, Vince Meehan, and Smeeta Ramarathnam. And in the Division of Corporation Finance: John White, Paula Dubberly, Steven Hearne, Katherine Hsu, and Eduardo Aleman. I also would like to thank the leaders and professional staff in the Office of the General Counsel and the Office of Economic Analysis. Finally, I would like to thank the other Commissioners and all of our counsels for their work and comments on this proposed rule.
I will now turn it over to our three Division Directors to present the staff recommendations in detail.