July 2010
Authors:
Mary C. Moynihan
Financial Reform Bill Strengthens Regulation,
Expands Potential Liability of Credit Rating
Agencies
molly.moynihan@klgates.com
+1.202.778.9058
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
Clair E. Pagnano
clair.pagnano@klgates.com
+1.617.261.3246
Gwendolyn A. Williamson
gwendolyn.williamson@klgates.com
+1.202.778.9251
K&L Gates includes lawyers practicing out
of 36 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
On July 21, 2010, U.S. President Barack Obama signed into law the Dodd-Frank Wall
Street Reform and Consumer Protection Act (“Dodd-Frank”) following earlier passage
of the legislation by a 237 to 192 vote in the U.S. House of Representatives and a 60 to
39 vote in the U.S. Senate. Dodd-Frank represents Congress’s response to what the
House Committee on Financial Services calls “years without accountability for Wall
Street [and] the worst financial crisis since the Great Depression.”
Subtitle C of Title IX of Dodd-Frank – “Improvements to the Regulation of Credit
Rating Agencies” (“Subtitle C”) – establishes an almost wholly new framework for
governing and regulating credit rating agencies, including nationally recognized
statistical rating organizations (“NRSROs”). The overhaul stands to dramatically
change the role NRSROs play in the markets, and is based on Congressional findings
that “the systemic importance of credit ratings and the reliance placed on credit ratings
by individual and institutional investors and financial regulators” makes the activities
and performance of NRSROs “matters of national public interest, as credit rating
agencies are central to capital formation, investor confidence, and the efficient
performance of the United States economy.”
Dodd-Frank imposes new requirements covering key areas of NRSRO function and
oversight, including:
•
Increased Authority of the Securities and Exchange Commission (the “SEC”):
Subtitle C gives the SEC substantial rulemaking authority and establishes an Office
of Credit Ratings (the “OCR”) within the SEC.
•
Liability Provisions: By lowering pleading requirements, removing safe-harbor
protections, and imposing filing and other requirements, Subtitle C heightens the
liability that NRSROs face.
•
NRSRO Governance: Subtitle C contains many provisions aimed at minimizing
the impact of conflicts of interest on the integrity of NRSROs’ issuance of credit
ratings.
•
Public Disclosure: Under the terms of Subtitle C, NRSROs are required to
disclose an array of new information, such as the performance record of their credit
ratings and the procedures and methodologies used in the credit ratings process.
•
Impact on Existing Federal Securities Laws: Subtitle C removes a wide range
of statutory references to NRSROs and, among other matters, calls for the SEC and
other federal agencies to develop new standards of creditworthiness.
Financial Services Reform Alert
•
Asset-Backed Securities (“ABS”): DoddFrank includes many provisions designed to
improve the asset-backed securitization process,
including new disclosure requirements and an
SEC study to identify the appropriate way to
reconstruct the current issuer-pays business
model of obtaining credit ratings for ABS (also
referred to as structured finance products).
•
Looking Forward: In addition to the SEC
study on the issuer-pays model, Dodd-Frank,
and Subtitle C in particular, requires that the
SEC, the Government Accountability Office
(the “GAO”) and others conduct studies that
may result in additional rules and regulations
affecting the role and import of NRSROs and
credit ratings in the markets.
Background
Credit ratings and the practices of the agencies
issuing them are widely regarded to have been
factors in the 2008 credit crisis, and, unsurprisingly,
NRSROs have been the focus of inquiry and reform
efforts by Congress, the Obama Administration, and
the SEC for several years. This reform process has
brought to light a variety of conflicts of interest
inherent in the existing credit ratings structure as
well as the impact of those conflicts on the health of
the U.S. and global economies. For example, the
U.S. House of Representatives Committee on
Oversight and Government Reform considered
testimony in October 2008 that the credit meltdown
occurred to a great extent because of inaccurate and
unsound ratings, driven by a variety of factors that
included conflicts of interest, competitive pressure to
lower standards, and the “cliff risk” in structured
products, which could fall from a high rating level to
junk status based on relatively small differences in
the default and recovery experience of underlying
assets. The 2008 credit crisis was not the first time
that such concerns had been expressed about the
fitness of credit ratings, as evidenced by
commentary and hearings after the major rating
agencies found Enron Corporation’s debt to be
investment grade up to the eve of its bankruptcy.1
Congressional concerns about credit ratings, as
articulated in Subtitle C and throughout DoddFrank, also mirror those identified by the SEC in its
February 2, 2010 amendments to certain disclosure
and conflicts of interest requirements for NRSROs.
In adopting those amendments, the SEC “cited
concerns about the integrity of NRSROs’ credit
rating procedures and methodologies in light of the
role they played in the credit market turmoil.”
Increased Authority of the SEC
Subtitle C establishes the OCR as a part of the SEC,
and requires that the OCR have a staff of experts in
corporate, municipal, and structured debt finance.
The OCR is tasked with administration of SEC rules
covering the credit ratings determination practices
of NRSROs, promoting the accuracy of NRSRO
credit ratings, and ensuring that credit ratings issued
by NRSROs are not unduly influenced by conflicts
of interest. To effectuate these goals, the OCR will
conduct annual examinations of NRSROs’
compliance with federal statutes and with their own
internal controls, policies, procedures, and
methodologies, including ethics policies and
corporate governance procedures. The OCR will
publish its report on “the essential findings” of each
annual NRSRO review.
Subtitle C gives the SEC broad rulemaking,
examination, and enforcement authority,
significantly augmenting the SEC’s existing
regulatory authority with respect to NRSROs.
Among other matters, the SEC is authorized to:
•
impose fines and other penalties on noncomplying NRSROs;
•
issue rules to prevent “the sales and marketing
considerations” of an NRSRO from influencing
its production of credit ratings;
•
temporarily or permanently revoke an
NRSRO’s registration with respect to a class or
subclass of securities if it is found to be
incapable of consistently producing “credit
ratings with integrity”;
1
The history and progress of reforms of credit rating agency
practices, including the testimony heard by the U.S. House of
Representatives Committee on Oversight and Government
Reform, was the subject of our Investment Management Alert
in October 2009.
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Financial Services Reform Alert
•
require NRSRO applications to be formally
filed; and,
•
under certain circumstances, limit the activities
of, censure, suspend, or bar individuals
associated with NRSROs.
Each of the new rules and regulations that the SEC
must establish pursuant to Subtitle C is required to
be issued no later than one year after the enactment
of Dodd-Frank.
Liability Provisions
The provisions of Subtitle C generally increase an
NRSRO’s risk of liability. For example, the
requirement that applications for NRSRO status be
formally filed, rather than simply furnished to the
SEC, subjects NRSROs to the risk of liability under
the Securities Exchange Act for making false or
misleading statements. This and the other rule
amendments discussed below reflect the
determination of Congress that NRSROs “perform
evaluative and analytical services on behalf of
clients, much as other financial ‘gatekeepers’ do
[that are] fundamentally commercial in character
and should be subject to the same standards of
liability and oversight as apply to auditors, securities
analysts, and investment bankers.”
Subtitle C specifically exposes NRSROs to liability
resulting from both public and private litigation.
Subtitle C removes the restriction on private actions
against NRSROs under Section 15E(m) of the
Securities Exchange Act and, by lowering certain
pleading requirements, essentially grants investors
the right to seek damages stemming from an
NRSRO credit rating if they can assert that the
NRSRO knowingly or recklessly failed to conduct a
reasonable investigation of the facts or to obtain
analysis from an independent source. Subtitle C also
(i) rescinds the safe harbor provided by Section 21E
of the Securities Exchange Act that protected
NRSROs from potential SEC enforcement action for
statements made regarding credit ratings, and
(ii) repeals Rule 436(g) under the Securities Act,
which excluded NRSRO ratings from being
considered part of a company’s registration
statement under the Securities Act and thereby
shielded NRSROs from SEC enforcement action for
false statements and/or omissions made by an
“expert” under Sections 7 and 11 of the Securities
Act. This additional litigation exposure has already
led at least one NRSRO to state that it will not allow
its ratings to be included in SEC filings.
In addition, Subtitle C creates a duty for NRSROs
to report to the appropriate law enforcement or
regulatory authorities any credible information
received from a third party alleging that an issuer of
rated securities has violated or is violating the law.
NRSRO Governance – Internal
Controls, Management of Conflicts of
Interest
Subtitle C establishes a number of requirements
regarding the governance and operations of
NRSROs. These new standards are rooted in
Congress’s finding that inaccurate credit ratings
brought to light by the 2008 financial crisis
“necessitate increased accountability on the part of
credit rating agencies” and that “in certain
activities…credit rating agencies face conflicts of
interest that need to be carefully monitored and that
therefore should be addressed explicitly in
legislation.”
•
NRSROs are required to establish, maintain,
enforce, and document, “an effective internal
control structure governing the implementation
of and adherence to policies, procedures, and
methodologies for determining credit ratings,
taking into consideration such factors as the
[SEC] may prescribe, by rule.”
•
In an annual internal controls report to be
submitted to the SEC, NRSROs must
(i) describe “the responsibility of the
management of the [NRSRO] in establishing
and maintaining an effective internal control
structure,” (ii) assess the effectiveness of that
internal control structure, and (iii) provide an
attestation of the CEO or equivalent individual
regarding the effectiveness of the internal
controls.
•
NRSROs must consider independent
information, “from a source other than the
issuer or underwriter,” when making securities
credit ratings.
•
In accordance with rules to be issued by the
SEC, NRSROs are required to ensure that their
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Financial Services Reform Alert
ratings analysts (i) meet “standards of training,
experience, and competence necessary to
produce accurate ratings for the categories of
issuers whose securities [they] rate,” and (ii) are
tested for knowledge of the credit rating process.
•
•
•
Under the so-called “Look-Back Requirement,”
each NRSRO must conduct a one-year lookback review when an employee responsible for
making credit ratings goes to work for an
obligor or underwriter of a security or money
market instrument subject to a rating by that
NRSRO; the policies and procedures that
NRSROs must establish, maintain, and enforce
with respect to these reviews must be reasonably
designed to identify whether any conflicts of
interest of the employee at issue influenced
credit ratings issued by the NRSRO and whether
the NRSRO should take action to revise any
credit rating. Similarly, NRSROs will be
required to report to the SEC when certain
employees, including senior officers and
individuals involved in the credit rating process,
go to work for an entity rated by the NRSRO
during the preceding 12 months.
The compliance officers of NRSROs must file
with the SEC an annual report on the
organization’s compliance with the federal
securities laws and its own internal policies and
procedures. The report will include a
description of any material changes to the code
of ethics and conflicts-of-interest policy of the
NRSRO as well as a certification that the report
is accurate and complete. The SEC will review
the code of ethics and conflicts of interest policy
of each NRSRO at least annually and following
any material revision of such code and/or policy.
Each NRSRO must have a board of directors, at
least half of whom are independent of the
NRSRO, and whose compensation is in no way
“linked to the business performance” of the
NRSRO. In addition to its overall
responsibilities, the board will oversee the
establishment, maintenance and enforcement of
policies and procedures for (i) determining
credit ratings, (ii) addressing, managing and
disclosing conflicts of interest, (iii) ensuring the
effectiveness of the internal control system for
determining credit ratings, and (iv) monitoring
the NRSRO’s compensation and promotion
policies and practices.
•
Compensation of NRSRO compliance officers
also may not be linked to the financial
performance of the NRSRO. Compliance
officers are not permitted to be involved with
the ratings, methodologies, or sales of the
organization.
Public Disclosures
Subtitle C includes a number of new disclosure
requirements designed to make credit ratings and
the process by which they are generated more
transparent.
•
NRSROs are required to disclose and publish
their “ratings track record” so that “users of
credit ratings [may] evaluate the accuracy of
ratings and compare the performance of ratings
by different [NRSROs].” This record will
present “performance information over a range
of years and for a variety of types of credit
ratings” that is “clear and informative for
investors having a wide range of sophistication
who use or might use credit ratings.”
•
Any credit rating issued by an NRSRO must be
accompanied by an attestation “affirming that
no part of the rating was influenced by any
other business activities, that the rating was
based solely on the merits of the instruments
being rated, and that such rating was
independent of the risks and merits of the
instrument.”
•
In keeping with rules to be prescribed by the
SEC regarding “the procedures and
methodologies, including qualitative and
quantitative data and models,” NRSROs will be
required to disclose to the users of credit
ratings: (i) the version of a procedure or
methodology used with respect to a particular
rating; (ii) when a material change is made to a
procedure or methodology, and the likelihood
that such change will result in a change to
current credit ratings; and (iii) any significant
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Financial Services Reform Alert
error identified in a procedure or methodology
that may result in credit rating actions.
•
•
Following a form to be established by the SEC,
NRSROs must publish with the issuance of each
credit rating detailed information, including:
(i) the main assumptions and principles
underlying the procedures and methodologies
used to determine the credit rating; (ii) the data
upon which the credit rating is based, and the
reliability of that data; (iii) the existence of
conflicts of interest; potential limitations, and
risks related to the credit rating; and (iv) the use,
if any, of third party research and due diligence.
This disclosure is intended to help investors and
other users of credit ratings “better understand
credit ratings in each class of credit rating
issued” by the NRSRO, and must be presented
in a format that is “easy to use and helpful for
users of credit ratings.”
With respect to their unique credit rating
symbols, NRSROs must establish, maintain, and
enforce written policies and procedures
(i) clearly defining and disclosing the meaning
of all symbols, and (ii) mandating the consistent
application of a symbol across all types of
securities and money market instruments for
which the symbol is used.
Impact on Existing Federal Securities
Laws
Notably, Subtitle C removes a wide variety of
statutory references to credit ratings, credit rating
agencies, and NRSROs and, in many cases, requires
the development of new standards of criteria to
evaluate creditworthiness. These amendments affect
the Federal Deposit Insurance Act, the National
Bank Act, the Federal Housing Enterprises Financial
Safety and Soundness Act, certain World Bank
statutory provisions, the Securities Exchange Act,
and the Investment Company Act.
The amendments to the Securities Exchange Act
strike the ratings requirement included in the
definitions of “mortgage related security” and “small
business related security,” and require that these
securities meet creditworthiness standards to be
established by the SEC. Similarly, the provision
affecting Section 6(a)(5) of the Investment Company
Act, which provided certain exemptions for stateregulated companies that do not issue redeemable
securities, replaces references to NRSROs with
references to standards of creditworthiness to be
adopted by the SEC. These provisions of DoddFrank are paralleled by similar regulatory
developments, such as the SEC’s April 7, 2010
proposal to remove references to credit ratings from
Rule 144A under the Securities Act.
It remains to be seen how the SEC will frame a new
creditworthiness standard under the directives of
Dodd-Frank, which gives the SEC ample discretion.
The SEC could replace the current NRSRO ratings
standard with a nebulous standard of
reasonableness: the creditworthiness of a particular
security would be based on what a reasonable
person would deem creditworthy under the
circumstances regulated by the given law. The SEC
might, however, pursue a variety of alternative
paths, such as incorporating the creditworthiness
standards articulated in (i) the July 1, 2008 proposal
to strike references to NRSROs in Rules 2a-7, 3a-7,
5b-3 and 10f-3 under the Investment Company Act,
and (ii) the rule amendments it adopted in
November 2009 that eliminate certain references to
credit ratings issued by NRSROs in (a) rules and
forms under the Securities Exchange Act “related to
the regulation of self-regulatory organizations and
alternative trading systems,” and (b) rules under the
Investment Company Act affecting an investment
company’s ability to purchase refunded securities
and securities in underwritings with affiliated
participants.2
Not unlike the goals of Congress with Subtitle C,
the SEC’s July 2008 proposal and November 2009
amendments were “designed to address concerns
that references to NRSRO ratings in [SEC] rules
may have contributed to an undue reliance on those
ratings by market participants.” In both the July
2008 and November 2009 rule releases, the SEC
endorsed the substitution of NRSRO references with
“alternative provisions that require the assessment
2
In November 2009, the SEC also re-opened the comment
period for the July 1, 2008 proposal. The SEC proposal to
eliminate references to ratings of NRSROs was the subject of
our Investment Management Updates in July 2008 and
August 2008. See also our October 2009 Investment
Management Alert regarding the status of reforms of credit
rating agency practices.
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Financial Services Reform Alert
of liquidity and credit risk” by giving fund boards
the duty of determining whether a security is
(i) “sufficiently liquid that it can be sold at or near
its carrying value within a reasonable period of
time,” and (ii) subject to no greater than moderate or
minimal credit risk, depending on the type of fund
making the investment and certain other factors.
Subtitle C does not explicitly impact the
amendments to the rules governing money market
funds under the Investment Company Act that the
SEC adopted on February 23 of this year in response
to the extreme turbulence experienced by the money
fund sector in 2007 and 2008. In those amendments,
in the face of strong opposition to its proposal to
require money funds to invest only in the highestquality, “first-tier” securities – a definition based on
credit agency ratings3 – the SEC elected to limit the
type and amount of assets of second-tier securities in
which money funds can invest and to: (i) require
money funds’ boards to designate four or more
NRSROs, any one or more of whose short-term
credit ratings the fund uses to determine whether a
security is an eligible security, and determine at least
annually that the designated NRSROs issue credit
ratings that are sufficiently reliable; and (ii) require
money funds to identify the designated NRSROs in
the statement of additional information.4
Asset-Backed Securities (Structured
Finance Products)
Among other measures in Dodd-Frank aimed at the
ABS market, Subtitle D of Title IX of Dodd-Frank –
“Improvements to the Asset-Backed Securitization
Process” – tasks the SEC with creating new
disclosure rules as well as “a new mechanism to
prevent issuers of asset-backed securities from
picking the agency they think will give the highest
credit rating, after conducting a study and after
submission of the report to Congress.” Within 180
days of the enactment of Dodd-Frank, the SEC will
3
A “first-tier security” is: (i) a rated security that has received
the highest short-term rating from the requisite NRSRO(s); (ii)
a comparable unrated security, as determined by a fund’s
board; (iii) a money market fund; or (iv) a Government security.
4
The SEC’s proposal to amend the money market fund rules
was the subject of our Investment Management Alert in July
2009 and our Early Fall 2009 Investment Management
Update. The amendments, as adopted, were the subject of
our Investment Management Alert in March 2010.
release, among many others, rules requiring that
credit rating agencies include with each ABS ratings
issuance a report describing (i) the representations,
warranties, and enforcement mechanisms related to
the rating, and (ii) how the representations,
warranties, and enforcement mechanisms may differ
from those related to the credit ratings of similar
securities.
Additionally, Section 939F of Subtitle C gives the
SEC the responsibility of carrying out a two-year
study of (i) the credit rating process for structured
finance products (i.e., asset-backed securities), “and
the conflicts of interest associated with the issuerpay and the subscriber-pay models,” and (ii) “the
feasibility of establishing a system in which a public
or private utility or a self-regulatory organization
assigns [NRSROs] to determine the credit ratings of
structured finance products.” The SEC study
required by Section 939F represents the
compromise struck between the sponsors of DoddFrank and the proposed Franken Amendment,
which would have amended the Securities Exchange
Act to require that initial structured finance product
credit ratings be determined by a centralized “Credit
Rating Agency Board” that would prevent seekers
of credit ratings from choosing the ratings issuer by
assigning pre-qualified NRSROs on a rotating basis.
In assessing the appropriate system for the
generation of structured finance product credit
ratings, the SEC must consider, among other
factors, the extent to which the creation of a new
system “would be viewed as the creation of a moral
hazard by the Federal Government,” as well as “any
constitutional or other issues concerning the
establishment of such a system.” Section 939F also
mandates that upon completion of the study, the
SEC must adopt rules to establish the system of
assigning initial credit ratings to structured finance
products,” and that the system proposed by the
Franken Amendment should be implemented
“unless the Commission determines that an
alternative system would better serve the public
interest and the protection of investors.” The
effectiveness of the board contemplated by the
Franken Amendment has been a matter of great
debate in Congress, as it raises certain logistical
impracticalities and potential conflicts of interest
related to the rating of debt securities issued by the
U.S. government.
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Financial Services Reform Alert
Looking Forward
In addition to rule and regulation changes, Subtitle C
requires initiation of the following studies, each of
which may result in further rulemaking and other
developments affecting the function and role of
credit ratings:
•
To the extent applicable, each federal agency
must conduct a one-year review of agency
regulations requiring “the use of an assessment
of the creditworthiness of a security or money
market instrument and any references to or
requirements…regarding credit ratings,” and
modify those regulations by removing any
reference to reliance on credit ratings and
putting in its place a standard of
creditworthiness deemed appropriate by the
agency issuing the regulation. Under this
provision of Subtitle C, it seems that the SEC
may be free to implement in full its July 1, 2008
proposal – which was re-opened for public
comment in November 2009 – to replace
references to NRSROs in rules under the
Investment Company Act. It is not yet clear
what the SEC and other federal agencies
covered by Subtitle C will establish as the
appropriate measure of creditworthiness for their
rules and regulations. It is of course possible
that a broad standard of “reasonableness under
the circumstances,” or another similarly
malleable standard, could be adopted across the
federal government. But pursuant to the
language of Subtitle C, which only offers the
guidance that each federal agency “shall seek to
establish, to the extent feasible, uniform
standards of creditworthiness for use by such
agency, taking into account the entities regulated
by such agency and the purposes for which such
entities would rely on such standards of
creditworthiness,” it is also possible that the new
agency standards could vary significantly.
Congress will oversee any amendments to the
federal laws, as each federal agency will provide
Congress with a report “containing a
description of any modification of any
regulation...made pursuant to
[Section 939A of Subtitle C].”
•
The SEC will conduct a three-year study of the
independence of NRSROs and how
independence affects their issuance of credit
ratings. The study is intended to strengthen the
independence of credit rating agencies, and will
evaluate the management of conflicts of interest
created by the other services, such as risk
management or advisory services, that an
NRSRO may offer. The SEC study will also
consider the potential impact of rules that would
prohibit NRSROs from providing such services.
•
The GAO will conduct an 18-month study “on
alternative means for compensating [NRSROs]
in order to create incentives…to provide more
accurate credit ratings, including any statutory
changes that would be required to facilitate the
use of an alternative means of compensation.”
Similar to the SEC study on assigned credit
ratings, the purpose of this GAO study is to
analyze ways to reduce the conflicts of interest
intrinsic to the issuer-pays and subscriber-pays
models of obtaining credit ratings for structured
finance products, including asset-backed
securities.
•
The GAO also will conduct a one-year study
“on the feasibility and merits of creating an
independent professional organization for rating
analysts employed by [NRSROs] that would be
responsible for establishing independent
standards for governing the profession of rating
analysts; establishing a code of ethics; conduct;
and overseeing the profession of rating
analysts.”
This client alert is part of a series of alerts focused on
monitoring financial regulatory reform
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Financial Services Reform Alert
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