Investment Management Alert
October 2009
Authors:
Gordon F. Peery
gordon.peery@klgates.com
+1.617.261.3269
Sweeping Reforms of Credit Rating Agency
Practices Move Forward
dan.crowley@klgates.com
Recent actions by the U.S. Congress, the Administration and the SEC point towards
reform of credit rating practices that will be sweeping in their breadth, depth and
implementation:
+1.202.778.9447
•
In July 2009, the Obama Administration proposed draft legislation on rating
agencies, the “Investor Protection Act of 2009,” which, among other things,
establishes a regulatory office to administer SEC rules pertaining to nationally
recognized statistical rating organizations (“NRSROs”).1
•
On September 25, 2009, U.S. Congressman Paul Kanjorski (D-PA) circulated a
discussion draft of the Accountability and Transparency in Rating Agencies Act
(the “Kanjorski draft bill”), which is based in part on the Obama
Administration’s draft legislation; the discussion draft would provide enhanced
regulation of NRSROs, including new provisions enabling litigants to collect
monetary damages from multiple rating agencies.2
•
On September 30, 2009, the U.S. House Financial Services Committee examined
credit rating agency reform and heard testimony from the heads of Moody’s
Corporation (“Moody’s”), Standard & Poor’s (“S&P”) and Fitch Inc. (“Fitch”),
as well as an official from the Securities and Exchange Commission (“SEC”).3
•
Also in September 2009, the SEC announced that it had taken some and
proposed other rulemaking actions to enhance credit rating agency oversight and
make more meaningful the ratings issued by these agencies, including:
Daniel F. C. Crowley
Mark D. Perlow
mark.perlow@klgates.com
+1.415.249.1070
Karishma Shah Page
karishma.page@klgates.com
+1.202.778.9128
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corporations, in addition to growth and
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www.klgates.com.
o
Adopting rules to provide greater information concerning rating histories
and to enable competing credit rating agencies to offer unsolicited ratings
for structured finance products by granting them access to structured
products data, actions that are intended to engender more competition
between rating agencies;
o
Proposing amendments to existing law that would strengthen rating agency
compliance programs by requiring annual compliance reports and enhancing
disclosure of possible revenue-related conflicts;
o
Removing references to credit ratings by NRSROs in certain rules (e.g., rule
10f-3 and Regulation ATS) in order to (a) reduce investors’ reliance on
reliance on credit ratings, which the SEC states may have been encouraged
by the SEC’s “seal of approval” on credit ratings, and (b) improve the
quality of investors due diligence and investment analysis;
o
Re-opening for comment SEC proposals to eliminate references to credit
ratings by NRSROs in certain other rules and forms, particularly rule 2a-7
under the Investment Company Act of 1940 (which regulates the credit
quality of money market fund investments), rule 15c3-1 under the Securities
Exchange Act of 1934 (which sets requirements for broker-dealers’ net
capital, and sets haircuts on assets for these purposes), and rule 415 under
Investment Management Alert
the Securities Act of 1933 (“Securities
Act”) (the shelf offering rule, which covers
certain mortgage-related ABS);
o
o
•
Proposing new rules requiring issuers,
including closed-end funds, that “use” credit
ratings in connection with securities
offerings to disclose certain information,
including:
o
Details concerning what a credit rating
covers and any material limitations on
the scope of the rating,
o
Who paid for the rating, and
o
Whether any preliminary ratings were
obtained from other rating agencies
(i.e., “ratings shopping”); and
Seeking comment on whether to subject
NRSROs to expert liability under the
Securities Act when a rating is used in
connection with a registered offering.4
Following the recent G-20 Summit, the U.S.
Senate Banking Committee heard testimony on
September 30, 2009 that the International
Organization of Securities Commissions
(“IOSCO”) issued a Code of Conduct
Fundamentals, which has been adopted by at
least seven rating agencies, and that the IOSCO
will continually evaluate and seek international
consensus on the regulation of credit rating
agencies.5
The common theme in this recent flurry of action
appears to be that the government intends to
radically change the way credit ratings are issued,
paid for and litigated. In particular, the government
is trying to break up what it sees as an oligopoly
among the major rating agencies on the theory that a
lack of competition among the agencies led to
perceived laxity in their practices, and to address the
potential conflict of interest arising from the “issuer
pays” business model.
Background
Credit ratings and the way in which they have been
issued have come under close scrutiny in hearings
on the roots of the recent financial crises. The U.S.
House of Representatives Committee on Oversight
and Government Reform, for example, received this
testimony:
The current credit rating system is designed for
failure, and that is exactly what we are
experiencing. AIG, Fannie Mae, Freddie Mac,
Bear Stearns, Lehman Brothers, Countrywide,
IndyMac, MBIA, Ambac, the other model lines,
Merrill Lynch, WaMu, Wachovia and a string
of structured finance securities all have failed or
nearly failed to a great extent because of
inaccurate, unsound ratings. The ratings of …
Moody’s, S&P and Fitch were a major factor in
the most extensive and possibly expensive
financial calamity in recent American history.
The IMF has estimated financial loss from the
current credit crisis at $1 trillion, but other
estimates have pegged it at twice that amount…
We have been here before, specifically in 2002,
after Enron failed, despite the fact that the
major rating agencies had its debt at investment
grade up through and including just before the
company filed for bankruptcy protection.6
Principal Targets of Regulation and
Law
Recent legislative and regulatory action is focused
in four principal areas:
1. Conflicts of Interest
The primary focus of legislative and regulatory
proposals is on perceived conflicts of interest in the
credit rating process.
In urging passage of his Accountability and
Transparency in Rating Agencies Act, U.S. House
Financial Services Capital Markets Subcommittee
Chairman Kanjorski stated on September 30, 2009
that rating agencies betrayed “their special status
under our laws” through an “ask me no questions,
I’ll tell you no lies” approach to grading complex
financial products such as asset-backed securities in
general and mortgage-backed securities in
particular. The bill that Chairman Kanjorski
proposes would preserve credit rating agency
independence and simultaneously impose standards
for policing agency conduct.7 If enacted into law,
the Kanjorski draft bill would, for example:
October 2009
2
Investment Management Alert
•
Require each NRSRO or its parent entity to have
one-third of its board of directors consisting of
independent directors whose compensation is
not correlated to the performance of the
NRSRO, and require the independent directors
to police the rating practices of the NRSRO;
•
Require the SEC to impose a host of rules
designed to eliminate conflicts of interest,
including requiring disclosure of a wide range of
conflicts of interest in order to deter
inappropriate business relationships (e.g.,
underwriter affiliations with NRSROs and
conflicts that arise out of consulting or other
services);
•
Bring about a payment system based on
performance;
•
Require NRSROs to conduct periodic reviews of
the implementation of code of ethics and
conflict of interest procedures; and
•
Establish an office to better coordinate
regulation of NRSROs.
The SEC voted on September 17, 2009 to propose a
rule that would require NRSROs to disclose
conflicts of interest, including the percentage of the
NRSRO’s net revenue attributable to the twenty
largest users of credit rating services of the NRSRO,
as well as the net revenue attributable to other
services and products of the NRSROs.8
2. “Rating Shopping”
The SEC will require disclosure of the extent to
which underwriters and issuers attempt to acquire
the best possible ratings by preliminarily polling
credit rating agencies. Compliance with the new
SEC rules will result in investors having information
about whether an issuer or sponsor “shopped
around” before selecting an agency to provide
ratings.
3. Modeling and Rating Methodologies
Prior to the recent market crises, credit rating
agencies had invested heavily in modeling the risks
inherent in the financial products that they rated.
However, commentators have argued that the
agencies’ models did not take into account all
necessary data concerning, for example, defaults on
residential mortgages and the impact of alternative
mortgage products underwritten on a stated income
basis. This was at least partially due to the fact that
much of the necessary data was not available to the
agencies because of decades of sustained growth in
housing markets and because many of the products
were of very recent vintage.
The Kanjorski draft bill requires SEC rulemaking
that would require:
•
The use of proper rating methodologies;
•
The provision of information to investors to
help them better understand the ratings;
•
Notification to investors and issuers of the
various models used by the agencies and
updates or changes in model versions; and
•
Each NRSRO to use ratings that are more
clearly defined with symbols and apply those
symbols consistently.
The Investor Protection Act of 2009 gives the SEC
authority to prescribe rules to require disclosure of
procedures and methodologies and the use of
qualitative and quantitative models. Perhaps most
importantly, the Investor Protection Act of 2009
requires that rating agencies issue ratings that are
determined using models that are approved by a
board of NRSROs.9 These laws, if enacted, would
build upon the SEC’s current registration and
oversight program for NRSROs, in particular a
series of rules adopted in 2007 that required
NRSROs to make detailed disclosures regarding
their rating methodologies.
4. Liability.
Proponents of change in this area argue that certain
aspects of the current law governing credit rating
agencies effectively shield those agencies from
liability. For example, rule 436(g) under the
Securities Act exempts credit ratings from being
considered part of a registration statement, which
has the effect of exempting rating agencies from
liability as experts under the private right of action
in § 11 of the Act. The Kanjorski draft bill takes the
legislation proposed by the Obama Administration
several steps further by removing existing hurdles to
private causes of action and empowering the SEC to
bring civil lawsuits against the agencies. Moreover,
the Kanjorski draft bill would make credit rating
October 2009
3
Investment Management Alert
agencies collectively liable for inaccuracies in order
to incentivize the agencies to work together to
improve credit rating practices.
following global market crises, there appears for the
first time to be real traction for comprehensive
government action addressing credit rating
practices.
Conclusion
We will continue to track the vast array of new law
and regulations in the credit rating, derivatives and
structured finance areas and will monitor progress
in the regulatory and lawmaking life cycle, and the
specific ways in which the new regime will require
changes in market practice. In the event that you
have any questions concerning these recent
legislative or regulatory initiatives, please do not
hesitate to contact the authors.
The NRSROs have been the targets of intense
criticism, legislation and regulation at least since the
demise of Enron Corp, whose debt was rated
investment grade just before it filed for bankruptcy.
Critics have asserted that the resulting reforms did
not go to the heart of the problems that were factors
in recent market crises. However, as the world
economy appears to be on the path to recovery
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©2009 K&L Gates LLP. All Rights Reserved.
1
The Investor Protection Act, as proposed by the Obama
Administration is available at
http://www.treas.gov/press/releases/docs/tg205071009.pdf.
2
The discussion draft of the Accountability and
Transparency in Rating Agencies Act is available at
http://www.house.gov/apps/list/press/financialsvcs_dem/nrs
ro_005b_092509.pdf.
3
Prepared testimony of the witnesses is available at
http://www.house.gov/apps/list/hearing/financialsvcs_dem/p
ressCM_093009.shtml.
U.S. Senate Banking Subcommittee on Security and
International Trade and Finance (Sept. 30, 2009), available at
http://banking.senate.gov/public/index.cfm?FuseAction=Files.Vi
ew&FileStore_id=a3381afe-030b-4c16-97df-d4b3e6d01c96.
6
Statement of Sean J. Egan, Managing Director of Egan-Jones
Ratings, submitted as Congressional testimony before the U.S.
House of Representatives Committee on Oversight and
Government Reform on October 22, 2008, at 26-28, available
at http://oversight.house.gov/documents/20081023162631.pdf.
7
Arthur D. Postal, “Rating Agencies Come Under Fire,” National
Underwriter (Sept. 30, 2009), available at
http://www.lifeandhealthinsurancenews.com/News/2009/9/Pag
es/Rating-Agencies-Come-Under-Fire.aspx.
4
SEC Votes on Measures to Further Strengthen Oversight
of Credit Rating Agencies, SEC Press Release 2009-200,
available at http://www.sec.gov/news/press/2009/2009200.htm. A list of all laws affected at this juncture by the
recent SEC rules relating to credit rating agencies is
available at http://www.sec.gov/news/press/2009/2009-200rulesformsaffected.htm.
5
Testimony Concerning International Cooperation to
Modernize Financial Regulation by Securities and
Exchange Commissioner Kathleen L. Casey before the
8
Securities and Exchange Commission Rules and Forms at
Issue in Removal of References to NRSRO Credit Ratings
(Sept. 30, 2009), available at
http://www.sec.gov/news/press/2009/2009-200rulesformsaffected.htm.
9
Investor Protection Act of 2009, at 12 (section 931(r)(1)),
available at
http://www.treas.gov/press/releases/docs/tg205071009.pdf.
October 2009
4