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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before Catholic Law School Annual Securities Alumni Luncheon


Daniel M. Gallagher, Jr.

Co-Acting Director, Division of Trading and Markets
U.S. Securities and Exchange Commission

Washington, D.C.
November 12, 2009

Good afternoon. It is a pleasure to be here today among so many fellow Catholic law grads. Before I begin, I want to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

For the last seven months I have served as Co-acting director of the Commission's Division of Trading and Markets. To say that it has been an interesting and busy time at the Commission would be an understatement. Within the Division, we are working on a wide range of matters relating to the recent financial crisis, including regulatory reform initiatives such as over-the-counter derivatives regulation and the creation of a systemic risk regulator, the SIPC liquidation of Lehman Brothers, and engaging with international counterparts on various regulatory issues. Today, I would like to speak about one area that has been the subject of much Commission rulemaking and Congressional debate over the last three years — the oversight of credit rating agencies.


Credit rating agencies have been heavily criticized regarding the performance of their structured finance ratings, especially ratings on securities linked to subprime residential mortgages. They have been faulted for initially assigning ratings that were too high; for failing to adjust those ratings sooner as the performance of the underlying assets deteriorated; and for not maintaining appropriate independence from the issuers and underwriters of those securities.

The intense scrutiny of credit rating agencies in the US and abroad is a reflection of the prominent role they play in the securities markets. Notwithstanding the criticism, their ratings continue to be widely used by investors to evaluate whether to purchase securities. Additionally, regulators continue to favor credit ratings over more idiosyncratic, subjective standards when needing to classify debt instruments for regulatory purposes. For example, just last month the Federal Reserve proposed a process for the New York Fed to determine the eligibility of credit rating agencies and the ratings they issue for use in the Term Asset-Backed Securities Loan Facility ("TALF"). The threshold requirement for eligibility is that the credit rating agency be registered with the Commission as a nationally recognized statistical rating organization ("NRSRO").

Brief History of Credit Rating Agencies and the Term NRSRO

The term "NRSRO" is a relatively recent creation, but credit rating agencies have existed for over a hundred years. In fact Standard & Poor's traces its origins to the 1860 publication of Henry Poor's History of Railroads and Canals in the United States, a precursor of modern stock reporting and analysis.1 John Moody & Company published Moody's Manual of Industrial and Miscellaneous Securities in 1900, the company's founding year.2 The manual provided information and statistics on stocks and bonds of financial institutions, government agencies, manufacturing, mining, utilities, and food companies.3 Fitch Ratings was founded in 1913 and began as a publisher of financial statistics, and in 1924, the Fitch Publishing Company introduced the "AAA" to "D" rating scale.4 When the rating agencies were first established they did not operate under the "issuer-pay" model, their ratings were purchases by subscribers.

It was in the 1970s that the largest rating agencies began the practice of charging issuers as well as investors for rating services. The stated rationale for this change was based on the belief that issuers should pay for the substantial value objective ratings provide in terms of market access. In addition, some rating agencies believed that the complexity of the capital markets required a more sophisticated level of staffing and compensation than could be supported only by issuer fees.5

It was also in the 1970s that the term "NRSRO" was first used by the Commission. Specifically, in 1975 the Commission adopted the broker-dealer net capital rule and used the term "NRSRO" to classify debt instruments in terms of the amount they would be haircut for regulatory capital purposes. I would note, however, that the concept to distinguish between debt instruments was already in use before the Commission adopted this rule. The New York Stock Exchange had its own net capital rule, which distinguished between investment grade and non-investment grade instruments.

Despite the use of the NRSRO designation in its rules, however, the Commission had no explicit authority to regulate credit rating agencies as such. So, the credit rating agencies that could be treated as NRSROs were identified by the staff through the staff no-action letter process. In that process, the staff would review information and documents submitted by the credit rating agency, including how broadly its credit ratings were used in the securities markets, to determine whether the agency had achieved broad market acceptance for ratings. If in the staff's view such acceptance was evident, the staff would issue a letter stating that it would not recommend enforcement action against broker-dealers who used the agency's credit ratings for purposes of complying with the Commission's net capital rule. While the staff's no-action letters only referenced the Commission's net capital rule, they effectively "conferred" NRSRO status for the purposes of all US statutes and regulations using that term. In the 1970s the three largest rating agencies first received no action letters as NRSROs from the staff through this process.

Over time, the NRSRO concept was incorporated into additional SEC rules, including rules adopted under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. Congress has used the NRSRO concept in legislation as have other supervisors, including banking regulators, at home and abroad. Additionally, a number of other federal, state, and foreign laws and regulations today employ the NRSRO concept. For example, the U.S. Department of Education uses ratings from NRSROs to set standards of financial responsibility for institutions that wish to participate in student financial assistance. In the years since 1975, the Commission issued a concept release and rule proposals meant to formalize the NRSRO definition. Without statutory authority, however, these efforts were compromised.

NRSRO Legislation

In September 2006, Congress enacted the Credit Rating Agency Reform Act of 2006, which, among other things voided the staff no-action letter process. In lieu of national recognition, the Rating Agency Act requires a credit rating agency applying to register with the Commission to provide certifications from 10 qualified institutional buyers that they have used the ratings of the applicant to make investment decisions for the proceeding three years.

While the Rating Agency Act lowered barriers to becoming an NRSRO, it provided the Commission with broad authority to oversee NRSROs. In particular, the statute provided the Commission with authority to require NRSROs to disclose information about their activities, to make and retain records, to furnish annual reports to the Commission, to implement procedures to protect material nonpublic information, to implement procedures to disclose and manage conflicts of interest, to refrain from engaging in activities that the Commission determined created unmanageable conflicts of interest, and to refrain from activities that the Congress and the Commission determined were unfair, coercive, or abusive. The Rating Agency Act amended Section 17 of the Exchange Act to provide the Commission with authority to examine all books and records of an NRSRO and to bring enforcement action against NRSROs for violations of the federal securities laws.

Commission NRSRO Oversight

Over the last two years, the Commission has engaged in several rounds of rulemaking and has conducted NRSRO examinations. The first round of rulemaking established the Commission's rating agency oversight program. Specifically, in June 2007 the Commission adopted six rules and created an application and ongoing disclosure form ("Form NRSRO"). These rules included requirements for NRSROs 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 2007, the first seven credit rating agencies were registered with the Commission as NRSROs. Around that time, and in response to gradually worsening market conditions, the Commission used its new oversight authority to initiate examinations of the three largest NRSROs. Specifically, the Commission staff examined Fitch, Moody's, and Standard & Poor's and reviewed their policies and practices relating to ratings of structured finance products linked to aggressively underwritten mortgages. The period reviewed by the examination generally covered January 2004 through July 2008. All three NRSROs agreed to undertake remedial actions as a result of the examinations. The staff published a summary of their findings and observations in July 2008.

To put it bluntly, the examinations revealed a number of serious problems. In particular, the examinations raised serious questions about the NRSROs' management of: (1) conflicts of interest, (2) internal audit processes, and (3) due diligence activities.

Management of Conflicts of Interest

Each of the examined NRSROs prepares the majority of its ratings under the "issuer pays" model. While each NRSRO had policies and procedures restricting analysts from participating in fee discussions with issuers, the policies and procedures at each of the firms still allowed key participants in the ratings process to participate in fee discussions. For example, the examiners found that analysts appeared to be aware, when rating an issuer, of the firm's business interest in securing the rating of the deal; that there did not appear to be any internal effort to shield analysts from emails and other communications that discussed fees and revenues from the issuers; and that in some instances, analysts were involved in fee discussions for a rating. In addition, the NRSROs did not appear to take steps to prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria. Accordingly, the staff recommended that each NRSRO consider and implement steps that would insulate or prevent the possibility that considerations of market share and other business interests could influence ratings or ratings criteria.

Internal Audits

The examiners found that the internal audits of the ratings processes of two NRSROs appeared to be inadequate. For example, at one NRSRO, the internal audits of its RMBS and CDO groups constituted a one-page checklist limited in scope to evaluate the completeness of deal files. As a consequence of the examinations, the staff recommended that two of the NRSROs review whether their internal audit functions are adequate and whether they provide for proper management follow-up.

Due Diligence Practices

The staff found that the NRSROs did not engage in any due diligence or otherwise seek to verify the accuracy or quality of the loan data underlying the RMBS pools they rated during the review period. The NRSROs each relied on the information provided to them by the sponsor of the RMBS.

The findings from these initial examinations informed another round of rule amendments, which the Commission proposed in June 2008 and adopted in February 2009. These amendments enhanced requirements to disclose ratings performance statistics and ratings methodologies, and imposed additional recordkeeping and reporting requirements. They also prohibited additional conflicts of interest, in particular the conflict of rating a product that the NRSRO or its affiliate had provided advice on how to structure.

In September of this year, the Commission voted to adopt additional amendments, two of which I'd like to highlight. The first is 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 new amendments require an NRSRO that is hired to provide an initial credit rating for a structured finance product to disclose on a password-protected Internet web site: (1) that it is in the process of determining such a credit rating; and (2) the location where information provided by the issuer to determine and monitor the credit rating can be located. The hired NRSRO must make this information available to any other NRSRO that provides it with a copy of a certain certification. The hired NRSRO also is required to obtain representations from the arranger that, among other things, the arranger will provide the same information to the non-hired NRSROs. The goal of this rule is to enable non-hired NRSROs to provide unsolicited ratings in the structured finance market, just like they are able to do in the corporate debt market where they can use information filed with the Commission by public companies to determine and monitor unsolicited ratings. There have been calls to make the structured finance market more transparent by enhancing issuer disclosure requirements. This new rule — by requiring issuers to disclose information to all NRSROs — is an incremental step in that direction, and the Commission staff is studying increased disclosure by issuers.

The Commission also voted in September to adopt amendments that require an NRSRO to disclose, on a delayed basis, ratings history information in a downloadable format for all credit ratings initially determined on or after June 26, 2007. This new disclosure requirement is designed to foster greater transparency of ratings quality and accountability among NRSROs, by making it easier for persons to analyze the actual performance of credit ratings. In addition, the ratings history information will generate "raw data" that market observers can use to statistically analyze performance across NRSROs.

Proposed Legislation

There is also a flurry of activity on Capitol Hill. The House Financial Services Committee recently voted credit rating agency legislation out of committee for consideration by the full House. As you may have heard, private liability for rating agencies is a highly debated topic, and the analysis is complicated by First Amendment Concerns. The proposed legislation, among other things, proscribes a state of mind that investors need to plead in order to sue NRSROs. The state of mind would be that the NRSRO "knowingly or recklessly" violated the securities laws. The House also proposes to add three additional "enforcement tools" available to the SEC. First, there is a proposed amendment to add "fine" and "bar" as potential disciplinary actions against NRSROs. Second, the bill would permit the SEC to take disciplinary actions against any person associated with the NRSRO. Third, the bill would amend the Exchange Act to include two new "triggering events" that, if found by the SEC, would allow the SEC to take any of the disciplinary actions available to it under the provision up to and including revoking the NRSRO's registration. The two triggering events are: (1) failure to supervise; and (2) failure to conduct sufficient ratings surveillance.

On the Senate side, Banking Committee Chairman Dodd has released draft legislation which also addresses credit rating agencies. Senator Dodd's legislation also addresses private liability, and his proposed pleading standard for suing NRSROs would be that the NRSRO knowingly or recklessly failed to conduct a reasonable investigation of the factual elements relied upon in determining a credit rating or to obtain reasonable verification of such factual elements from a competent third party. The Senate bill also proposes additional enforcement mechanisms against NRSROs, and includes a "failure to supervise" provision. Additionally, there is an amendment that would authorize the Commission to temporarily suspend, or permanently revoke an NRSRO's registration if the Commission finds that the NRSRO does not have adequate financial and managerial resources to consistently produce credit ratings with integrity.

International Initiatives

There have also been several relevant developments internationally that pertain to regulation of credit rating agencies. The European Union ("EU") passed laws governing the conduct of credit rating agencies that will go into effect in 2010.

Japan also recently release for public consultation a new set of rules regarding credit rating agency regulation. Japan's proposed rules include requirements for establishment of control systems and information disclosure, among other things. Comments are due November 16, 2009, and the Japan FSA expects to finalize the new rules several months after that date.

And, Canada and Australia may also undertake legislation.


Given all the proposed legislation and discussion surrounding oversight of credit rating agencies, it will be interesting to see what the regulatory environment looks like this time next year. One thing, however, is for sure, the oversight of NRSROs will continue to be an important area of responsibility for the Division.

Thank you.



Modified: 11/19/2009