Speech by SEC Staff
Opening Remarks before the Commission Open Meeting: Final Rules and Proposed Rules Implementing the Credit Rating Agency Reform Act of 2006
Erik R. Sirri
Director, Division of Trading and Markets,
U.S. Securities and Exchange Commission
December 3, 2008
Thank you Mr. Chairman. Before you today are a series of final rule amendments that would further implement the Credit Rating Agency Reform Act of 2006. Also before you is a proposal to adopt new amendments to Rule 17g-2 and a re-proposal to adopt certain amendments to Rule 17g-5.
Final Rule Amendments
The final rules we recommend adopting today are based on proposed rules the Commission released in June. The recommended rules are designed to promote the substantive goals of the Credit Rating Agency Reform Act of 2006 — to increase transparency and disclosure, to diminish or eliminate conflicts of interest, and to strengthen the oversight of NRSROs. Sixty-one comments were received on the proposed rules and these comments were used to revise the rules you have before you now.
There are several amendments to the disclosure requirements. First, the instructions to Exhibit 1 of Form NRSRO would be amended to require, among other things, that the performance measurement statistics cover all relevant ratings actions and be broken out by classes of credit ratings and by 1, 3, and 10 year periods. We believe these enhancements would allow users of credit ratings to better compare the competence of NRSROs.
The final rules would also amend the instructions to Exhibit 2 of Form NRSRO to require, among other things, enhanced disclosures about the procedures and methods an NRSRO uses to determine and monitor credit ratings. First, an NRSRO would need to disclose whether and, if so, how much verification performed on assets underlying or referenced by a structured finance transaction is relied on in determining credit ratings. Second, an NRSRO would need to disclose whether and, if so, how assessments of the quality of originators of structured finance transactions play a part in the determination of the credit ratings. Finally, an NRSRO would need to disclose the frequency of its surveillance efforts and how changes to its quantitative and qualitative ratings models are incorporated into the surveillance process. We believe these enhanced disclosures would allow users of credit ratings to gain a better understanding of the methods employed by the NRSROs to determine and monitor credit ratings.
In addition, the final rules would add new recordkeeping requirements to Rule 17g-2 and make one minor change to an existing requirement. First, NRSROs would be required to make and retain records of all rating actions including the date of such actions from the initial rating to the current rating. This full record of credit rating histories would be maintained by the NRSRO as part of its internal records that are available to Commission staff. This internal record of the complete ratings histories will be useful to the Commission in performing its examination and oversight functions. The data could be analyzed to determine if NRSROs were following their own methods in their ratings actions and whether further disclosure was necessary. This could provide valuable information that could be indicative of problems in the ratings process unrelated to the analytical process, such as conflicts of interest.
The new rules would require this record to be publicly disclosed under certain circumstances. Significantly, paragraph (d) of Rule 17g-2 would be amended to require an NRSRO operating under the issuer-pay business model to make publicly available on its corporate Internet Web site in an XBRL format a random sample of 10% of the credit ratings and their histories documented for each class of credit rating for which the NRSRO is registered and has issued 500 or more ratings, with a six-month delay. We believe that having this data publicly available will foster greater accountability of the NRSROs by making it easier for persons to analyze the actual performance of each issuer-pay NRSRO and compare this performance among those NRSROs. At the same time, the Commission is sensitive to the comments it received about the potential loss of business for NRSROs if all ratings actions were made immediately available. Thus, the Commission has limited this proposal to 10% of credit ratings for each class of credit rating for which an NRSRO is registered and has issued 500 or more ratings and implemented a six month lag before a new ratings action needs to be made publicly available.
Rule 17g-2 would also be amended to require that if a quantitative model is a substantial component of the credit rating process for structured finance products, an NRSRO would need to keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. We believe that this amendment would enhance the recordkeeping processes of the NRSROs and assist Commission examiners in reviewing whether an NRSRO followed its stated methods.
Finally, Rule 17g-2 would be amended to require an NRSRO to retain any written communications received from persons not associated with the NRSRO that contain complaints about the performance of a credit analyst in initiating, determining, maintaining, monitoring, changing, or withdrawing a credit rating. The purpose of this amendment is to allow Commission examiners the opportunity to review external complaints and how the NRSRO responded to them.
The minor change to Rule 17g-2 would amend paragraph (b)(7) to clarify that an NRSRO should retain all records relating to "monitoring" a rating. This amendment is designed to better clarify that an NRSRO should retain records relating to the surveillance process (in addition to the initial rating process) as the term "monitoring" is a term of art used in the industry to refer to that process.
We are also proposing final rules that would amend Rule 17g-3 to require an NRSRO to provide the Commission with an additional annual report indicating the number of credit rating actions taken during the past year in each class of security for which the NRSRO is registered. This amendment is intended to assist the Commission in its examination function. An increase in the number of ratings actions in a particular class of ratings could signal that a rating process had been comprised by conflicts or other inappropriate practices. The report, then, can help to focus examination resources on potentially problem areas.
Finally, the final rules would add three new prohibited conflicts to Rule 17g-5(c). The first amendment would prohibit an NRSRO from issuing a credit rating with respect to an obligor or security where the NRSRO or a person associated with the NRSRO made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security. This amendment, in effect, would prohibit an NRSRO from rating its own work.
The second amendment would prohibit a person within an NRSRO who has responsibility for participating in determining credit ratings or for developing or approving procedures or methods used for determining credit ratings from participating in any fee discussions, negotiations, or arrangements. The purpose of this amendment is to remove the persons most directly involved in making the judgments that credit ratings are based on from fee negotiations and, thereby, insulate them from a process that could make them more or less favorably disposed toward a client or class of clients.
The third amendment would prohibit NRSRO personnel who participated in determining or monitoring a credit rating from receiving gifts, including entertainment, from the obligor being rated, or from the issuer, underwriter, or sponsor of the securities being rated, other than items provided in the context of normal business activities such as meetings that have an aggregate value of no more than $25. The purpose of this rule is to eliminate the potential undue influence that gifts can have on those responsible for determining credit ratings.
Proposed Rule Amendments
The proposed amendments to Rule 17g-2 would amend the version of Rule 17g-2(d) that is being adopted today. Although we believe that the amendments to paragraph (d) of Rule 17g-2 being adopted today will provide users of credit ratings with information to begin assessing the performance of NRSROs, we continue to believe that the original proposal to require public disclosure of ratings action histories for all current credit ratings could provide substantial benefits to users of credit ratings. Thus, we are proposing amendments that would require NRSROs to disclose ratings history information for 100% of their current issuer-paid credit ratings in an XBRL format. The rule would apply only to issuer-paid credit ratings determined after June 25, 2007 (the effective date of the Rating Agency Act). The prospective nature of the proposed rule is designed to ease the burden of compliance. In addition, to protect the revenues NRSROs derive from selling downloads and data feeds to their current outstanding issuer-paid credit ratings, a credit rating action would not need to be disclosed until 12 months after the action is taken. At the same time, we are requesting comment on whether this proposal should extend beyond issuer-pay NRSROs to include all NRSROs.
The purpose of this proposed amendment is to provide users of credit ratings, investors, and other market participants and observers with the maximum amount of raw data with which to compare how NRSROs initially rated an obligor or security and, subsequently, adjusted those ratings, including the timing of the adjustments. The Commission believes that requiring the disclosure of the ratings action history of each issuer-paid credit rating would create the opportunity for market participants to use the information to develop performance measurement statistics that would supplement those required to be published by the NRSROs themselves in Exhibit 1 to Form NRSRO.
In addition, we are re-proposing for comment amendments to Rule 17g-5 that would prohibit an NRSRO from issuing a rating for a structured finance product paid for by the product's issuer, sponsor, or underwriter unless the information about the product provided to the NRSRO to determine the rating and, thereafter, monitor the rating is made available to other NRSROs. As originally proposed in June, the amendments to Rule 17g-5 would have required, as a condition to the NRSRO rating a structured finance product, that the information provided to the NRSRO and used by the NRSRO in determining an initial credit rating and, thereafter, performing surveillance on the credit rating be disclosed through a means designed to provide reasonably broad dissemination of the information. The June proposal did not go into details about how this information should be disseminated.
Based on comments received on this amendment, we are re-proposing amendments that would require NRSROs that are hired by arrangers to perform credit ratings for structured finance products to disclose to other NRSROs - and only other NRSROs - the deals for which they were in the process of determining such credit ratings. The arrangers would need to provide the NRSROs they hire to rate structured finance products with a representation that they will provide information given to the hired NRSRO to other NRSROs and NRSROs seeking to access information maintained by the NRSROs and the arrangers would need to furnish the Commission an annual certification that they are accessing the information solely to determine credit ratings and will determine a minimum number of credit ratings using the information.
In addition, the Commission is proposing to amend Regulation FD to accommodate this information disclosure program that would be established under the re-proposed amendments to Rule 17g-5. Specifically, the Commission is proposing to amend Rule 100 of Regulation FD to permit the disclosure of material non-public information to NRSROs irrespective of whether they make their ratings publicly available. The goal of these new amendments is to increase the number of ratings outstanding for a given structured finance security or money market instrument and, in particular, promote the issuance of ratings by NRSROs that are not hired by the arranger.
I would like to thank Dan Gallagher, Bob Colby, Mike Macchiaroli, Tom McGowan, Randall Roy, Carrie O'Brien, Joe Levinson, Sheila Swartz, and Rose Russo Wells on my staff for their hard and diligent work on this project as well as James Overdahl, Amy Edwards, Charles Dale and Stas Nikolova in the Office of Economic Analysis; David Fredrickson and Mike Bloise in the Office of the General Counsel; Paula Dubberly in the Division of Corporation Finance; and David Blaszkowski and Jeff Nauman in the Office of Interactive Disclosure.
We are happy to take any questions you might have.