Speech by SEC Staff:
Staff Statements at SEC Open Meeting — NRSROs
Dan Gallagher, Randall Roy, Penelope Saltzman, Michael Gaw and
U.S. Securities and Exchange Commission
September 17, 2009
Good afternoon. Today, we bring before the Commission recommendations in four areas relating to credit ratings. I will give a brief overview of them and then turn it over to my colleagues to discuss the recommendations in more detail.
The first area is the Commission's rules governing credit rating agencies registered as nationally recognized statistical rating organizations ("NRSROs"). In September 2006, Congress enacted the Credit Rating Agency Reform Act of 2006, which mandated that the Commission adopt final rules establishing a registration and oversight program for NRSROs within 270 days. The Commission met the statutory deadline by adopting six rules and an application form ("Form NRSRO") in June 2007. The rules included requirements to make public disclosures about, among other things, ratings performance statistics, ratings methodologies, conflicts of interest, and analyst experience. The rules also included recordkeeping and annual reporting requirements, provisions requiring procedures to prevent the misuse of material nonpublic information and to manage conflicts of interest, and prohibitions against having certain conflicts and engaging in unfair, coercive, or abusive practices.
In September of 2007, the first seven credit rating agencies were registered with the Commission as NRSROs. Around that time, the Commission staff began extensive examinations of the three largest NRSROs which were most active in rating structured finance products linked to aggressively underwritten mortgages. The preliminary findings from these examinations informed a second round of NRSRO rule amendments, which the Commission proposed in June 2008. The Commission adopted many of these amendments in February 2009. These new requirements enhanced ratings performance statistics, ratings methodology disclosure requirements, and the recordkeeping and reporting requirements. They also prohibited additional conflicts of interest.
Also in February 2009, the Commission proposed additional NRSRO rules. Today, the staff recommends that the Commission adopt the February 2009 rule amendments and that it propose further NRSRO rules.
Specifically, we are recommending that the Commission adopt amendments to Rules 17g-2 and 17g-5, and a conforming amendment to Regulation FD. In addition, we recommend that the Commission publish for public comment proposed amendments to Form NRSRO and Rule 17g-3 and that the Commission propose for comment a new rule — Rule 17g-7. Finally, we recommend that the Commission defer action at this time on a proposal to require an NRSRO to publish a report or use a distinct symbol to differentiate structured finance credit ratings, and we recommend that the Commission seek further comment on measures that can be taken to differentiate structured finance products and credit ratings for structured finance products for other types of debt instruments.
References to NRSROs in Commission Rules
The second area involves the use of the term "NRSRO" in a variety of Commission rules and forms. In July 2008, the Commission proposed removing the references to NRSROs in many of these rules and forms. Today, the staff is recommending that the Commission adopt several of the proposals to remove NRSRO references and to re-open the comment period for other proposals to remove references.
Issuer Disclosures of Credit Ratings
The third area involves the disclosure of credit rating information by issuers of securities. The staff is recommending that the Commission publish for public comment a release that proposes rule and form amendments that would require disclosure in registration statements when a credit rating is used to sell a security. These disclosures are intended to enhance the information investors receive regarding credit ratings. The proposed amendments would require disclosure designed to provide a better understanding of credit ratings and their limitations. These proposals reflect the staff's concerns that even though credit ratings appear to be a major factor in the investment decision for investors and play a key role in the marketing and pricing of securities, investors may not have access to sufficient information about them. The proposed amendments would require the registrant to provide general information about the rating, including the scope of the rating. In addition, so that investors are provided with information about potential conflicts of interest, the proposed disclosure would require the registrant to disclose the identity of the party paying for the rating, and where non-rating services are also being provided, disclosure of the fees paid for those services over a specified period of time.
The staff also is recommending that the Commission propose to require disclosure of preliminary ratings under certain circumstances so that investors are informed when a registrant potentially engages in ratings shopping. The staff believes these proposed rules would improve investor protection by providing information about credit ratings that will place the credit rating in an appropriate context.
Lastly, the fourth area involves the accountability of credit rating agencies. In light of concerns raised about this issue and the proposal for issuers to require disclosure about credit ratings, the staff is recommending that the Commission issue a concept release seeking comment on whether the Commission should propose to rescind Rule 436(g) under the Securities Act. Rule 436(g) currently exempts NRSROs from expert liability under Section 11 of the Securities Act. Rescinding Rule 436(g) would cause NRSROs to be included in the liability scheme for experts set forth in Section 11 if their rating is used in connection with a registered offering. The staff believes the Commission should consider whether it is still appropriate to provide this exemption to NRSROs. At the same time, the staff wants to be aware of all the implications of any possible future proposal to rescind Rule 436(g). Therefore, the staff recommends that the Commission solicit comment on all of the potential implications that a rescission of Rule 436(g) might have.
* Before I turn things over to my colleagues, Meredith Cross and I would like to thank Randall Roy and Paula Dubberly for their tremendous commitment to this project over an extended period. Without their resourcefulness and unwavering commitment, we would not be in a position to be making these recommendations today.
I will now ask Randall Roy from the Division of Trading and Markets to discuss the recommendations in the first area — NRSRO oversight.
Thank you and good afternoon. As Dan mentioned, the staff is recommending that the Commission: (1) adopt two pending rule proposals, (2) propose further amendments to the current NRSRO rules, and (3) propose a new NRSRO rule.
First, we recommend the Commission amend Rule 17g-2 to require a broader disclosure of credit ratings history information (i.e., the initial rating and any actions subsequently taken such as downgrades, upgrades, affirmations and placements on watch). Specifically, the amendment would augment the current requirement to disclose ratings history information for a random sample of 10% of an NRSRO's outstanding issuer-paid credit ratings. Under the new requirement, an NRSRO would need to disclose ratings history information for all credit ratings initially determined on or after June 26, 2007. This new disclosure requirement would apply to all NRSRO credit ratings regardless of the business model under which they are determined; consequently, this requirement would apply to subscriber-paid credit ratings. However, the requirement would permit an NRSRO to delay the disclosure of a ratings action for 12 months if it involves a credit rating that was paid for by the obligor being rated, or the issuer, underwriter, or sponsor of the security being rated. The disclosure of ratings action histories for all other credit ratings (such as subscriber-paid credit ratings) could be delayed for 24 months.
Ultimately, the rule would require an NRSRO to make the ratings history information publicly available using an XBRL format. However, because XBRL Tags are in development, the rule provides that an NRSRO would need to disclose the ratings history information in a machine-readable format until 60 days after the date on which the Commission publishes a List of XBRL Tags. Thereafter, it would need to make the information available in an XBRL format.
We believe that the new disclosure requirements will foster greater transparency of ratings quality, and, thereby accountability among NRSROs, by making it easier for persons to analyze the actual performance of credit ratings. In addition, we believe that the ratings history information will generate "raw data" that market observers can use to statistically analyze performance across NRSROs.
Second, we recommend the Commission adopt amendments to Rule 17g-5 that are designed to create a mechanism for NRSROs not hired to rate structured finance products to nonetheless determine and monitor credit ratings for these instruments. To this end, the amendments would first require an NRSRO that is hired by issuers, sponsors, or underwriters ("arrangers") to determine an initial credit rating for a structured finance product to disclose on a password protected Internet web site that it is in the process of determining such a credit rating and the location where information provided by the arranger to determine and monitor the credit rating can be located. The hired NRSRO would need to make this information available to any other NRSRO. The hired NRSRO also would be required to obtain representations from the arranger that the arranger would provide the same information to the non-hired NRSROs. An NRSRO wanting to access information provided by an arranger to a hired NRSRO would need to furnish the Commission with an annual certification that it is accessing the information only to determine credit ratings and that it will determine a minimum number of credit ratings using that information. The staff recommends that the Commission adopt a conforming amendment to Regulation FD that accommodates the new disclosure requirements by permitting the disclosure of material non-public information to an NRSRO regardless of whether the NRSRO makes its ratings publicly available.
Third, we recommend the Commission propose to amend Rule 17g-3 to require an NRSRO to furnish the Commission with an additional unaudited report containing a description of the steps taken by the firm's designated compliance officer during the fiscal year to administer the policies and procedures that are required to be established pursuant the Exchange Act. The proposed amendments to Rule 17g-3 would require that the report include: (1) a description of any compliance reviews of the activities of the NRSRO; (2) the number of material compliance matters found during each review of the activities of the NRSRO and a brief description of each such finding; (3) a description of any remediation measures implemented to address material compliance matters found during the reviews of the activities of the NRSRO; and (4) a description of the persons within the NRSRO who were advised of the results of the reviews.
Fourth, we recommend the Commission propose to amend the instructions for Exhibit 6 to Form NRSRO to require a credit rating agency applying to be registered as an NRSRO or an NRSRO providing its annual update to Form NRSRO to publicly disclose: (1) the percentage of the net revenue of the applicant/NRSRO attributable to the 20 largest users of credit rating services of the applicant/NRSRO; and (2) the percentage of the revenue of the applicant/NRSRO attributable to other services and products of the applicant/NRSRO.
Fifth, we recommend the Commission propose a new rule — Rule 17g-7 — that would require an NRSRO, on an annual basis, to make publicly available on its Internet Web site a consolidated report that shows three pieces of information with respect to each person that paid the NRSRO to issue or maintain a credit rating. The NRSRO would be required to include the percent of the net revenue attributable to the person earned by the NRSRO for that fiscal for year from providing services and products other than credit rating services. The NRSRO would have to indicate the relative standing of the person in terms of the person's contribution to the net revenue of the NRSRO for the fiscal year as compared with other person's who provided the NRSRO with net revenue. The NRSRO would have to identify all outstanding credit ratings paid for by the person.
Sixth, we recommend the Commission defer action at this time with respect to a proposed rule that would have required an NRSRO to include, each time it published a credit rating for a structured finance product, a report describing how the credit ratings procedures and methodologies and credit risk characteristics for structured finance products differ from those of other types of rated instruments, or, alternatively, to use distinct ratings symbols for structured finance products that differentiated them from the credit ratings for other types of financial instruments. Additionally, we recommend the Commission solicit comments regarding alternative measures that could be taken to differentiate NRSROs' structured finance ratings from the credit ratings they issue for other types of financial instruments through enhanced disclosures of information. Thank you.
References to NRSROs in Commission Rules
Now, I would like to move to the recommendations relating to the removal of NRSRO references from Commission rules. The two proposals we bring before the Commission today are: (1) whether to adopt amendments to various Commission rules and forms to eliminate references to credit ratings by NRSROs; and (2) whether to re-open the comment period to solicit further comment on elimination of NRSRO references from other rules and forms.
I would like to first turn to Penelope Saltzman in the Division of Investment Management to discuss the proposal to remove NRSRO references from rules 5b-3 and 10f-3 under the Investment Company Act.
The staff recommends that you adopt amendments that would remove two references to NRSRO ratings in rules under the Investment Company Act. The first reference is in rule 5b-3, which is a look-through provision. The rule allows a fund, under certain conditions, to treat a refunded bond that the fund acquires as the U.S. government securities that are pledged to make payments under the bond due to investors. One of the rule's conditions is that an independent certified public accountant must have certified that the government securities will satisfy the payments due to investors unless the refunded bond is rated in the highest category by an NRSRO. Because these certifications are typically provided in refunding transactions, we do not believe the exception is necessary and we recommend you remove it.
The second reference to credit ratings that we recommend you remove is in rule 10f-3. This rule permits funds to acquire securities in an underwriting when a fund affiliate is a member of the underwriting syndicate. If a fund purchases municipal securities in reliance on the rule, the securities must have received a certain level of rating from an NRSRO. We recommend you eliminate the references to credit ratings and substitute alternative standards for credit quality and liquidity. The alternative standards we recommend are very similar to those in the current rule but without the reference to NRSROs, and are designed to protect the fund and its investors. Thank you.
Now, I would like to first turn to Michael Gaw in the Division of Trading and Markets to discuss the proposal to remove NRSRO references from Regulation ATS.
The staff is recommending that the Commission adopt certain amendments to Exchange Act rules and forms to eliminate references to NRSROs. These references appear in Rule 3a1-1 under the Exchange Act, Regulation ATS, Form ATS-R, and Form PILOT. All of these references were adopted by the Commission in 1998 in connection with Regulation ATS.
In each of these rules and forms, the staff is recommending that the Commission eliminate separate categories for "investment grade" and "non-investment grade" corporate debt securities — such distinction made by reference to NRSRO ratings — and replace them with a single category for "corporate debt securities." These references to NRSRO ratings do not relate to how market participants evaluate credit risk for risk management purposes. Rather, they simply use NRSRO ratings to categorize trading activity into market segments for purposes of reporting trading volume and certain thresholds set in these rules. The staff believes that these references to NRSRO ratings are no longer necessary to achieve the purposes of these rules, and eliminating them is designed to address concerns that such references may have marginally contributed to an undue reliance on those ratings by market participants.
With respect to Rule 3a1-1, the staff believes that there is no need to analyze for "dominance" of an ATS in separate classes of investment grade and non-investment grade securities. Similarly, the staff believes that a volume threshold for a combined class of all corporate debt securities is sufficient for the fair access requirement and the capacity, integrity, and security requirements of Regulation ATS. The staff believes that the purposes of Regulation ATS will be fulfilled if investment grade and non-investment grade corporate debt securities are combined into a single class, and the operation of these thresholds with respect to other classes of securities would remain unchanged. Thank you.
As I mentioned, the staff also is recommending that the Commission re-open the comment periods for proposals to remove references to NRSROs from various Commission forms and rules under the Exchange Act, the Investment Company Act, the Investment Advisers Act, and the Securities Act. The comment period for the proposing releases ended on September 5, 2008.
With respect to the Exchange Act, the Commission proposed amendments to remove NRSRO references from the exceptions in Rules 101(c) (2) and 102(d) (2) of Regulation M for investment-grade non-convertible debt securities, investment grade non-convertible preferred securities, and investment grade asset-backed securities. Similarly, the Commission proposed deleting paragraph (a)(8) from Exchange Act Rule 10b-10 (the Commission's confirmation rule) because of the present concerns regarding undue reliance on NRSRO ratings and confusion about the significance of those ratings. In addition, the Commission proposed to remove, with limited exceptions, all references to NRSROs from the net capital rule for broker-dealers, substituting references to NRSROs in the Net Capital Rule with two subjective standards for credit risk and liquidity risk. The staff recommends that the Commission re-open the comment periods for all these proposals.
With respect to the Securities Act, the staff recommends the Commission re-open comment on proposals to replace investment grade ratings in certain eligibility criteria that permit issuers to conduct primary offerings "off the shelf" under Securities Act Rule 415 and Forms S-3 and F-3, and in other rules that refer to that eligibility criteria.
Finally, with respect to rules under the Investment Company Act and the Investment Advisers Act, the staff recommends that the Commission re-open the comment period for proposals related to Investment Company Act Rule 3a-7, Investment Company Act Rule 5b-3, and Investment Advisers Act Rule 206(3)-3T.
I will now turn to Blair Petrillo from the Division of Corporation Finance to discuss the recommendations in the remaining two areas - Issuer Disclosures of Credit Ratings and NRSRO Accountability.
Issuer Disclosures of Credit Ratings and NRSRO Accountability
Thank you, Dan, Chairman Schapiro, Commissioners. The staff recommends that you publish for public comment proposed amendments that would require disclosure of information regarding credit ratings used by registrants, including closed-end funds, in connection with a registered offering of securities so that investors will better understand the credit rating and its limitations. In addition, we recommend that the Commission issue a concept release seeking comment on whether the Commission should propose to rescind Rule 436(g) under the Securities Act. Our recommendations are as follows.
First, we recommend that you propose amendments to Item 202 of Regulation S-K, Item 12 of Form 20-F and Item 10.6 of Form N-2 to require that if a registrant, selling security holder, underwriter or other member of a selling group uses a credit rating in connection with a registered offering, certain detailed disclosures regarding the credit rating must be made. Currently, disclosure regarding credit ratings in registration statements is permitted but not required by Item 10(c) of Regulation S-K. The proposed disclosure would build on the disclosure currently permitted under Item 10(c). The proposed disclosure would require disclosure of general information about the credit rating, including all material scope limitations of the credit rating and any related published designation, such as non-credit payment risks, assigned by the rating organization with respect to the security. In addition, in order to highlight potential conflicts of interest, the proposed rule would require disclosure identifying the party who is paying for the credit rating; and if any additional non-rating services have been provided by the credit rating agency to the registrant over a specified period of time, disclosure of the services and the aggregate fees paid for those services would be required. We also are proposing to require disclosure of preliminary ratings, as well as final ratings not used by a registrant, so that investors will be informed when a registrant may have engaged in ratings shopping. We have proposed to require disclosure of preliminary ratings when the final rating is provided by a different credit rating agency than the one providing the preliminary rating because we do not want to limit the conversations that occur between registrants and credit rating agencies with respect to maintenance or surveillance ratings. The proposed disclosure would be required in Securities Act and Exchange Act registration statements.
Second, we recommend that you propose amendments to forms under the Securities Exchange Act of 1934 to provide investors with updated information regarding credit ratings by requiring disclosure of changes in previously disclosed credit ratings. Under the proposed amendments, a change to a credit rating, including when a rating has been withdrawn or is no longer being updated, would be required to be disclosed within four business days pursuant to a new item in Form 8-K. The proposed amendments would require closed-end funds to report changes in a credit rating on Form 8-K and would require foreign private issuers to report changes on Form 20-F.
Finally, we recommend that you issue a concept release seeking comment on whether the Commission should propose to rescind Rule 436(g) under the Securities Act. Rule 436(g) provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the Securities Act. The exemption currently does not apply to credit rating agencies that are not NRSROs. We believe that the original reasons supporting adoption of Rule 436(g) may no longer provide a sufficient basis to continue to provide the exemption to NRSROs. Rescinding the exemption would cause NRSROs to be included in the liability scheme for experts set forth in Section 11, as is currently the case for credit rating agencies that are not NRSROs.
As credit ratings have become more significant, the Commission has sought to protect investors while recognizing the role credit ratings play in the offer and sale of securities. In that regard, we recommend that the Commission issue a concept release to explore whether Rule 436(g) is still appropriate in light of the growth and development of the credit rating industry and investors' use of credit ratings, and in light of the disclosure regarding credit ratings that we are recommending the Commission propose. We are mindful of the potential far-reaching impact that rescinding Rule 436(g) could have on registrants, NRSROs and other credit rating agencies, investors and the financial markets in general, and we believe the Commission should seek comment on the possible elimination of Rule 436(g) from all market participants. Thank you.
At this time, we are pleased to take any and all questions.