Speech by SEC Commissioner:
Statement at SEC Open Meeting
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
September 17, 2009
Thank you, Chairman Schapiro. Today, the Commission will vote on a series of releases relating to credit rating agencies. I am pleased to support them and would like to recognize the chairman for her leadership on these important issues.
We would not be here this afternoon without the hard work of our dedicated staff in the Commission's three rulemaking divisions and the offices of General Counsel and Economic Analysis.
The bulk of today's recommendations come from the Division of Trading and Markets. TM's lead attorney on these rating agency releases, and the ones preceding them, is Randall Roy. I would like to again congratulate Randall on his well-deserved promotion to Assistant Director, and commend TM's Acting Co-Director, Dan Gallagher, for his contributions to the releases, and for the good sense to promote Randall. I would also like to recognize Meredith Cross, Director of the Division of Corporation Finance, and her staff for their work on this rulemaking.
I apologize in advance for my lengthy statement, but this is an important subject directly implicated by the financial crisis, and so there is much to say.
Before offering detailed views on the releases before us today, I would first like to make some general observations about the state of rating agency regulation.
I. SEC must act consistently with the congressional intent to improve competition
First point. For decades, competition has been virtually absent from a rating industry that is controlled by only two firms. If you include the third largest rating agency, the top three firms together have issued 98% of the outstanding credit ratings. In response to this concentration of market power, Congress passed the Credit Rating Agency Reform Act of 2006, which was designed primarily to increase competition in the rating industry by:
- eliminating artificial barriers to entry;
- establishing clear, well-defined rules;
- avoiding both excessive regulation and imposition of additional liability under the securities laws; and
- prohibiting anticompetitive behavior.
There have been new entrants in the NRSRO business since passage of the Rating Agency Act, but particularly encouraging are the indications that other firms are waiting in the wings, including some with deeper pockets who are presumably poised to more readily compete with established market leaders.
Although the rating industry is not a natural oligopoly, as some have suggested, we should not be under any illusion that robust competition will emerge in the near term. But patience is necessary, and warranted. The registration and oversight program established by the Rating Agency Act has been in effect for only two years, and was not in place until after the now infamous inflated ratings on subprime RMBS and CDOs were issued by the largest rating agencies.
Congress made its intentions crystal clear in the 2006 legislation. Act to increase competition in the rating industry. Let's not lose sight of that.
II. Obsession with conflicts of interest misses the point
Second, we must not become so obsessed with conflicts of interest to the point that it detracts from more important policy considerations. We are now at or beyond that point, or at least perilously close. Indeed, an obsessive and myopic focus on conflicts could become a sideshow that diverts our attention from more significant issues, the most important of which are enhanced access to information and the regulatory use of ratings.
If we truly believe that trying to mitigate or eliminate all conflicts, or potential conflicts, should be the overriding concern of our regulatory program, then why don't we just skip the small stuff and adopt a rule banning the biggest conflict of all, the issuer-pays system of compensation? I am not recommending that we do so, by the way. That would result in a situation where the solution is worse than the problem.
The Rating Agency Act provided the Commission with broad authority to prohibit conflicts or require the management and disclosure of such conflicts. The Commission has used this authority aggressively. By my count, we have banned outright seven different types of conflicts and required the management and disclosure of eight additional conflicts.
But continuing to adopt conflicts rules after such substantial action has already been taken by the Commission will not improve ratings quality or enhance investor protection. In fact, it will only increase the regulatory costs and burdens associated with being or becoming an NRSRO, and lead to predictably anticompetitive effects. Ironically, these costs are manageable to the incumbent rating agencies, but serve as a competitive barrier to those contemplating entering the NRSRO space.
What is the best antidote to conflicts of interest? Competition.
The Commission has noted that "[R]educing the barriers to entry in the market for providing NRSRO ratings and, hence increasing competition, may, in fact, reduce conflicts of interest in substantive ways. This market disciplining mechanism will be less effective the more difficult it is for investors to determine the true credit quality of the rated debt security or obligor."
This is an important observation for two reasons. One, it suggests that improving competition should reduce conflicts, and two, it explains that enhanced access to information underlying ratings is essential to creating a more competitive environment.
III. Too much regulation will not foster investor protection
Third — and this is related to the first two points about competition and conflicts of interest rules — before adopting still more regulations that are not market-based, the Commission needs to step back and take stock of all the new rules it has adopted over the past two years. The simple fact is that rating agencies are highly regulated today. That is not to say that they will always issue accurate ratings for investors. Government regulation could never deliver such results. And it does not mean that we can second-guess their rating judgments or seek to regulate their rating methodologies. The Rating Agency Act precludes the Commission from such actions, and properly so, in my view. But what it does mean is that we have adopted comprehensive regulations in many key areas. We should seek to establish regulatory certainty. At some point, we need to be able to see if the rules we have on the books are having their intended effect.
In many cases, particularly in structured finance, rating judgments are more art than science. We need to stop pretending that adopting more rules and regulations will lead to higher quality ratings. Some policymakers want to sanction rating agencies for inaccurate ratings. Absent fraud, that is the wrong approach. Higher quality ratings will come when rating agencies are punished by investors who abandon NRSROs for consistently misrating debt securities and migrate to those who get it right. Therefore, what we need to do is to empower investors with greater access to information and reduce the government's role in the rating industry by eliminating NRSRO references in our rules.
As noted earlier, and this cannot be overemphasized, there is considerable interest among firms in entering the NRSRO space and competing based on ratings quality. And there is pent-up investor demand for higher quality ratings. But the resources, funding, and brainpower will not be deployed efficiently or to maximum effect if we continue to pile one regulation on top of another.
I am going to save you all from the tedium of my highlighting all of them right now. My full written statement, posted at sec.gov, includes a three-page summary of the NRSRO rules that the Commission has already adopted since enactment of the Rating Agency Act.
In June 2007, the Commission approved rules implementing a registration and oversight program for NRSROs under the Rating Agency Act. Specifically, the Commission adopted six rules (Rules 17g-1, 17g-2, 17g-3, 17g-4, 17g-5 and 17g-6) and an application and ongoing disclosure form ("Form NRSRO").
Rule 17g-1, among other things, requires an NRSRO to disclose information about the: (1) firm's ratings performance statistics (e.g., default and transition statistics); (2) firm's methodologies for determining credit ratings; (3) firm's policies for preventing the misuse of material non-public information; (4) firm's organizational structure; (5) firm's code of ethics; (6) conflicts of interest inherent in the firm's activities; (7) firm's policies for managing conflicts of interest; (8) general qualifications of the firm's credit analysts; and (9) identification and qualifications of the firm's designated compliance officer.
Rule 17g-2, among other things, requires an NRSRO to make and retain certain financial records; document the identities of the credit analysts who determine a rating action and persons who approve the rating action; document the identities of issuers that have paid for ratings and the ratings determined for them; and document all ratings methodologies. NRSROs also are required to retain records such as compliance and internal audit reports, marketing materials, and communications (e.g., emails) relating to determining ratings actions.
Rule 17g-3, among other things, requires an NRSRO to furnish the SEC with annual reports that include: (1) audited financial statements; (2) an unaudited report of revenues received from the different types of rating services offered by the NRSRO; (3) an unaudited report of the aggregate and median compensation of the NRSRO's credit analysts; and (4) an unaudited report of the 20 largest clients of the NRSRO as determined by revenues received.
Rule 17-4, among other things, requires an NRSRO to have procedures to address the handling of material non-public information received during the rating process; the trading of securities while in possession of material non-public information; and to avoid the selective disclosure of a pending ratings decision.
Rule 17g-5, among other things, requires an NRSRO to disclose and manage each conflict of interest inherent in its business activities, including from the issuer-pay and the subscriber-pay models. It also prohibits an NRSRO from having the following conflicts: (1) receiving more than 10% of its annual revenues from a single client; (2) having an analyst rate or approve the rating for a security the analyst owns; (3) rating an affiliate; and (4) having an analyst rate or approve the rating for a security of a company where the analyst is a director or officer of the company.
Rule 17g-6, among other things, prohibits an NRSRO from engaging in certain practices that are unfair, coercive or abusive. Such practices include: (1) conditioning a rating on the rated person buying another service of the NRSRO; (2) deviating or threatening to deviate from established methodologies for determining credit ratings because an issuer did not agree to pay for the rating; (3) modifying or threatening to modify a rating because the issuer does not agree to continue to pay for the rating; and (4) employing a methodology for rating structured finance products that discounts or "notches", for anticompetitive purposes, the ratings of other NRSROs for assets underlying the structured finance product.
In response to the role played by credit rating agencies in the credit market turmoil and informed by the Commission's first round of NRSRO examinations, the Commission adopted a second round of rules in February 2009. Most of the new requirements specifically target the rating process for structured finance products. The new requirements require the following, among other things:
Enhanced performance statistics. The Commission amended Form NRSRO to require an NRSRO to provide greater specificity — and therefore better comparability — as to how performance statistics are generated.
Enhanced disclosure of ratings methodologies. The Commission amended Form NRSRO to require more detailed disclosures concerning the procedures and methodologies an NRSRO uses to determine credit ratings. Specifically, the NRSRO must disclose (as applicable):
whether and, if so, how, information about verification performed on assets underlying or referenced by a structured finance product is relied on in determining the rating;
whether and, if so, how, assessments as to the quality of originators of assets underlying or referenced by a structured finance product factor into the determination of credit ratings; and
with respect to rating surveillance, how frequently credit ratings are reviewed, whether different models are used for surveillance, and whether changes to initial rating or surveillance models are applied retroactively to existing ratings.
Record of model deviation. The Commission amended Rule 17g-2 to add a new recordkeeping requirement relating to the use of models in rating structured finance products. Specifically, if a quantitative model was a substantial component in the process of determining a credit rating for a structured finance product, the NRSRO is required to make a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued.
Record of ratings history. The Commission amended Rule 17g-2 to add a new recordkeeping requirement to allow examiners to track the history of all current ratings. Specifically, for each outstanding credit rating, an NRSRO is required to make a record showing all rating actions and the date of such actions from the initial credit rating to the current credit rating. In addition, NRSROs with 500 or more issuer-paid credit ratings in a credit rating class must publicly disclose the ratings histories for 10% of the current credit ratings in that class.
Written complaints. The Commission amended Rule 17g-2 to add a new recordkeeping requirement to allow examiners to review how an NRSRO handles complaints about credit analysts from, for example, issuers or underwriters of structured products.
Rating actions report. The Commission amended Rule 17g-3 to add a new financial report that must be furnished to the SEC annually. The report is designed to alert the SEC when an NRSRO takes an inordinate number of rating actions (e.g., upgrades or downgrades) during the year.
Prohibited conflict — recommendations. The Commission amended Rule 17g-5 to add a new conflict prohibition to prevent an NRSRO from making recommendations to issuers and others about how to obtain desired ratings.
Prohibited conflict — fee discussions. The Commission amended Rule 17g-5 to add a new conflict prohibition to prevent credit analysts and the persons who establish ratings methodologies from participating in fee discussions with issuers and others who pay for ratings.
Prohibited conflict — gifts. The Commission amended Rule 17g-5 to add a new conflict prohibition to prevent credit analysts from being influenced by gifts from issuers and others who pay for ratings.
IV. More liability is not the solution
My fourth point. I sincerely believe that exposing NRSROs, which are subject to the antifraud provisions of the securities laws, to additional, costly, and inefficient private litigation from class action lawyers will not serve to protect investors, it will not improve ratings quality, and it absolutely does not reflect in any way the explicit policy goals of Congress as reflected in the statute that we are charged with administering, the Rating Agency Act.
V. What the Commission should do now
(a) Disclosure of information underlying ratings
There are two critical areas where I do believe we need to go ahead at full speed. First, the Commission should require the disclosure of more information to other NRSROs, and ultimately to investors, so that they can generate unsolicited ratings. We are making progress on this disclosure concept today, but ultimately need to expand the scope to include disclosure to investors and disclosure of outstanding transactions.
Just think for a moment: what if we had had additional rating opinions in 2004, 2005, and 2006, and not just those from the two or three government-anointed ratings firms that dominate structured finance?
I think that it is probable, if not likely, that other market participants possessing the same information as the dominant rating agencies would have identified the outdated models and analytical defects that led to so many undeserving Triple A ratings, and published superior credit analysis. Investors could have been made aware that these were, in fact, high risk securities mischaracterized as safe investments. Information is king. We are a disclosure agency, and so we need to do what we do best: get information — as much as possible — to as many market participants as possible.
(b) NRSRO references
The second essential reform involves the regulatory use of credit ratings. The Commission should adopt its proposal to address overreliance on NRSRO ratings by removing the regulatory requirements embedded in numerous SEC rules. The considerable unintended consequences of the regulatory use of ratings — preserving a valuable franchise, inoculating the preferred rating agencies from competition, and promoting undue reliance — have been evident for some time.
We are making some progress on this reform today, but ultimately — and preferably sooner rather than later — we need to remove the government imprimatur from all SEC rules, particularly those relating to money market funds. I would say that we need to muster the political will to reduce undue reliance on ratings, except for the fact that there appears to be only support, not opposition, from Congress and the Administration. The market, not the government, should decide which credit ratings have value.
Now, on to the releases before us today.
TM adopting release
I am very pleased that we are considering voting to adopt rule amendments that would require public disclosure of ratings histories and disclosure to NRSROs of information that will be used to determine additional ratings on structured products. Both amendments are market-based approaches; the first is designed to empower investors with the information necessary to compare NRSRO ratings performance and the second is designed to provide NRSROs with the information necessary to develop unsolicited ratings for structured products and potentially expose mis-rated securities. I strongly support this adopting release and commend TM for its outstanding work.
TM proposing release
In addition to its recommendation on the adopting release, Trading and Markets also is recommending that the Commission vote to propose two rule amendments and a new disclosure rule. The rule amendments would require that NRSROs furnish an annual compliance report to the Commission and disclose information about sources of revenues. Like one of the rule amendments, the new rule would also require additional NRSRO disclosures relating to revenues.
I have concerns about these proposals. My preliminary view is that the proposals add costs and burdens to NRSROs, yet provide at best minimal value to investors and the markets. When we add costs and burdens to NRSROs, we are not actually punishing — as some appear eager to do — the Big Three rating agencies for their well-catalogued errors in the middle part of this decade. Rather, we are rewarding them by entrenching them even deeper by erecting higher barriers for those rating agencies, financial media companies, private equity firms, and others who are actively considering the costs and benefits of NRSRO registration, but for the time being remain on the sidelines carefully scrutinizing the regulatory actions of this agency.
The approach proposed in this release is not one that I would prefer. At this time, I would have difficulty voting to adopt them, but I will support putting them out for comment.
In addition to the three rule proposals, the release requests further comment on how the Commission might construct a rule that could provide investors with an enhanced understanding of how structured finance products and ratings can be differentiated from traditional debt offerings and ratings. The release also seeks comment on whether the Commission could expand the scope of the information disclosure program we are voting to adopt today to include outstanding structured finance deals, rather than just new transactions. I strongly support this portion of the proposing release and look forward to reviewing the comments.
CF proposing release
In addition to TM's adopting and proposing releases, the Division of Corporation Finance is recommending that the Commission adopt rules requiring registrants to disclose information relating to credit ratings. Ratings used in connection with registered offerings would need to be disclosed, as would information relating to conflicts of interest, any preliminary ratings not issued by the hired NRSRO, and ratings changes. Although none of these proposals appears entirely objectionable, I do question the value of some of the contemplated disclosures, and worry about the potential unintended consequences, particularly with respect to the preliminary ratings disclosure.
CF concept release
As noted earlier, I do not believe that increasing potential liability for NRSROs will help investors by improving the quality of ratings or enhancing competition. Therefore, I am deeply skeptical that the Commission's contemplated repeal of Rule 436(g) would deliver the results promised by the release. I am concerned about unintended consequences and the resulting market effects. The release asserts that exposing NRSROs to liability under Section 11 of the Securities Act would lead to improved ratings quality and to enhanced competition in the ratings industry. There does not appear to be any credible evidence for either assertion. Moreover, it runs entirely counter to the spirit and letter of the Rating Agency Act, which explicitly disavows any new private rights of action. However, and despite serious misgivings about going down this path, I will vote to publish this concept release for public comment and look forward to reviewing all of the comments.
Last, but certainly not least, the issue of government-sanctioned ratings firms. The divisions of Trading and Markets and Investment Management are recommending that we adopt removal of NRSRO references from certain Exchange Act and Investment Company Act rules and forms. I support these recommendations, but as noted earlier, believe that the Commission needs to eliminate the government imprimatur given to certain debt analysts by removing NRSRO references in all of our rules. When we crafted those rules, I think it is fair to say that we did not intend to anoint certain firms with a government seal of approval.
Thank you and I look forward to my round of questions on the releases.