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Statement on the Removal of References to Credit Ratings from Regulation M

June 7, 2023

Credit rating agencies have been a feature of the securities markets since 1909, when John Moody began providing investors with credit information about railroad bonds, helping to finance the expansion of the railroad industry.[1]

Credit rating agencies initially used what is referred to as a subscriber-pays business model, meaning that investors paid to access ratings for securities they were interested in purchasing. However, in the 1970s the agencies moved instead to an issuer-pays model, meaning that issuers paid for ratings on the securities they wished to sell.[2] This model, which continues to be the model for today’s credit ratings, created a fundamental conflict of interest.

Specifically, credit rating agencies now are incentivized to inflate their ratings to please their paying clients – the issuers – to the potential detriment of investors relying on those ratings to make investment decisions. Investors, like banks and insurance companies, may also desire inflated ratings, which could allow them to invest in higher-yielding, riskier securities while holding less capital.

In the lead-up to the 2008 financial crisis, credit ratings that understated the risks of complex securities encouraged the build-up of excessive leverage throughout the financial system. When the ratings were suddenly downgraded, uncertainty about asset values contributed to the global financial panic. A Senate report that cited testimony from then-CFTC chair Gary Gensler, among others, attributed the rating agencies’ errors in part to conflicts of interest in the ratings process.[3] The SEC staff[4] and the President’s Working Group on Financial Markets[5] each reached similar conclusions.

Thus, rating agencies were a primary focus for the post-crisis Dodd-Frank reforms, which included a mandate for the SEC to study the issuer-pays model and consider alternatives; the creation of the SEC’s Office of Credit Ratings; and increased regulatory oversight of the nationally recognized statistical rating organizations, or NRSROs, among other initiatives.[6] As with the first rule we discussed today, this rule we’re currently voting on represents the implementation of a Dodd-Frank directive: the requirement that the Commission remove from its regulations any references to credit ratings and substitute in their place alternative standards of creditworthiness.[7] The Commission has previously taken a number of regulatory actions to fulfill this mandate, including with respect to references to credit ratings by broker-dealers[8] and under the Investment Company Act.[9]

Today, we are replacing the references to credit ratings in Regulation M, a set of prophylactic anti-manipulation rules designed to preserve the integrity of the securities markets by prohibiting activities that could artificially influence the market for an offered security.[10] Regulation M references credit ratings in twin exceptions for investment grade Nonconvertible Securities and asset-backed securities.[11] As my colleagues have explained, the exceptions referencing credit ratings will be replaced with a new set of exceptions. First, for distributions of Nonconvertible Securities, the Commission is adopting exceptions based on the issuer’s probability of default as derived from a structural credit risk model. Second, for distributions of asset-backed securities, the Commission is adopting identical new exceptions for securities offered pursuant to an effective shelf registration statement filed on Form SF-3. These substitutions should help ensure that the exceptions to Regulation M are only available for securities that trade on the basis of their yield and creditworthiness, meaning that they are largely fungible and less susceptible to the type of manipulation that Regulation M seeks to prevent.[12]

Credit ratings were an important aspect of the post-crisis reforms, and I am pleased that we are acting today to complete this aspect of our Dodd-Frank mandate. However, there is more that we can and should do to further the goals of that statute. Rulemaking to address issuer pays conflict is on the agency’s agenda, and I hope to be able to work with my colleagues to consider how to proceed on this important issue. Additionally, the agency could review no-action relief from 2010 that effectively shields credit rating agencies from certain private rights of action—rights of action that provide recourse for investors against artificially inflated or otherwise erroneous ratings—to determine whether that letter strikes the right balance.[13] The Commission should also consider whether there are areas of credit rating oversight we could improve upon, such as internal supervisory controls, the implementation of policies and procedures, and the management of conflicts of interest, all of which have been cited repeatedly by SEC staff reports as areas of risk.[14]

Thank you to all the staff, in particular the staff in the Division of Trading and Markets, the Division of Economic and Risk Analysis, and the Office of the General Counsel. I appreciate your hard work to complete this Dodd-Frank initiative, and I am pleased to support the rule.

[1] See Alice M. Rivlin and John B. Soroushian, Credit rating agency reform is incomplete (March 2017).

[2] Id.

[3] See S. Rept. 111-176 at 36 (April 2010).

[4] See U.S. Securities and Exchange Commission, Staff of the Office of Compliance, Inspections, and Examinations, Division of Trading and Markets, and Office of Economic Analysis, Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies (July 2008)

[5] See President’s Working Group on Financial Markets, Policy Statement on Financial Market Developments (March 2008).

[6] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) at Sec. 931-939H.

[7] Id. at Sec. 939A.

[9] See Removal of Certain References to Credit Ratings Under the Investment Company Act, Release Nos. 33-9506; IC-30847 (Dec. 27, 2013).

[10] Removal of References to Credit Ratings from Regulation M, Release No. 34-97657 (June 7, 2023).

[11] See 17 CFR 242.101(c)(2), 17 CFR 242.102(d)(2). Both of these rules except Nonconvertible Securities and asset-backed securities that are rated by at least one nationally recognized statistical rating organization, as that term is used in 17 CFR 240.15c3-1.

[12] Removal of References to Credit Ratings from Regulation M, Release No. 34-97657 (June 7, 2023) at 6.

[13] See Consumer Federation of America et al., Rulemaking Petition for Policy Clarification on Credit Rating Agencies (Jan. 13, 2023) (proposing, inter alia, that the SEC repeal its no-action letter to Ford Motor Credit Company LLC and Ford Credit Auto Receivables Two LLC and stating that it is contrary to Congressional intent). See also Americans for Financial Reform Education Fund et al., Letter Calling on the SEC to Rescind the 2010 Ford Motor Credit No-Action Letter (calling on the SEC to “rescind the Ford Motor Credit no-action letter from 2010 and reinstate this important path to accountability for NRSROs consistent with the intentions of Congress in Dodd-Frank.”).

[14] U.S. Securities and Exchange Commission Office of Credit Ratings, Staff Report on Nationally Recognized Statistical Rating Organizations (Feb. 2023).

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