Dodd-Frank Wall Street Reform and Consumer Protection
Act: Credit Rating Agency Provisions with Comments on
Application to Public Finance
On July 21, 2010, President Obama signed into law the
Dodd-Frank Wall Street Reform and Consumer Protection
Act.
The legislation covers a wide variety of topics in an
effort to address the causes of the recent financial
crisis. With regard to credit rating agencies, the
legislation covers the following topics: increased
accountability, internal controls to avoid conflicts of
interest and to better ensure the accuracy of ratings,
elimination of reliance on ratings by federal agencies, and
public disclosure of the information on which ratings are
based to allow investors and other users to evaluate accuracy
and to compare the performance of different agencies.
As indicated below, many of the requirements to be imposed
have been left by Congress to regulations to be prescribed by
the SEC and many actions that had been proposed in Congress
have been relegated to studies to be conducted over the next
several years. Generally, the SEC is required to issue
final regulations with regard to credit rating agencies within
one year of the date the legislation is enacted.
This summary describes the provisions of the legislation
relating to rating agency regulation generally, and where the
summary raises issues particularly relevant to public finance,
there are additional comments describing the implications of
the law to public finance.
Accountability
Internal
Controls
Conflicts of
Interest
Corporate
Governance
Regulation of
NRSROs
Disclosure
of Credit Ratings
Methodologies and
Procedures
Removal
of Statutory References to Credit Ratings
Review
and Modification of Federal Agency Reliance on
Ratings
Studies
Accountability
Liability for Information Filed Section 15E of
the Securities Exchange Act of 1934 (the '34 Act) includes
provisions relating to the registration of Nationally
Recognized Statistical Rating Organizations ("NRSROs") with
the SEC. In various parts of Section 15E, there had been
references to information to be "furnished" to the
Commission. NRSROs will now be required to "file" such
information with the Commission, and will therefore be subject
to liability under Section 18 of the '34 Act in the event that
any such filings contain false or misleading statements of
material fact.
"Accuracy" The legislation also empowers the
SEC to temporarily suspend or permanently revoke the
registration of an NRSRO with respect to a particular class of
securities if, among other things, the Commission finds that
the NRSRO "has failed over a sustained period of time . . . to
produce ratings that are accurate for that class or subclass
of securities . . ."
"Expert" Liability Rule 436(g) under the
Securities Act of 1933 (the '33 Act), which provides that
credit ratings assigned by an NRSRO are not considered part of
a registration statement prepared or certified by a person
within the meaning of Sections 7 and 11 of the '33 Act, is
nullified. Written consent of an NRSRO must thus be
obtained by a registrant in order to include a credit rating
in a registration statement, and NRSROs are therefore subject
to liability under Section 11 of the '33 Act for misstatements
or omissions of material facts in connection with credit
rating disclosure.
Rule 436(g), which is rescinded by the legislation, had
provided an exception for ratings from the requirement of Rule
436(a), which provides that any issuer that includes a
report or opinion of an expert quoted in a registration
statement must file with the registration statement a consent
of the expert. Most issues of municipal securities are
not subject to the registration requirements because of the
exemption under Section 3(a)(2) of the '33 Act. The
consent requirement of Rule 436(a) does not apply to exempt
municipal securities and therefore no consent of the rating
agencies is required in order to include ratings in Official
Statements for such exempt municipal securities.
The '33 Act Section 11 civil liability for an expert, who
has consented to the use of a report or opinion in a
registration statement, applies only to issues subject
to the registration requirements. Section 11 has no
application to municipal securities that are exempt from the
registration requirements and, therefore, does not subject a
rating agency to such liability merely by reason of inclusion
of its rating in an Official Statement for exempt municipal
securities.
Internal
Controls
Section 15E has also been amended to require NRSROs to
"establish, maintain and enforce an effective internal control
structure governing the implementation of and adherence to
policies, procedures, and methodologies for determining credit
ratings".
Annual Report Requirement The SEC is required
by the legislation to prescribe rules requiring NRSROs to
submit to the SEC annual internal controls reports describing
the responsibility of the NRSRO's management in establishing
and maintaining internal controls, assessing the effectiveness
of their internal control structures, and containing an
attestation of the CEO.
Conflicts of
Interest
Separation of Ratings from Sales and Marketing
The SEC will also be required to issue rules to prevent sales
and marketing considerations from influencing the production
of ratings. The legislation mandates that exceptions to
the rules be provided for small NRSROs where separation of
sales and marketing is not practical.
Look-back Requirement NRSROs will be required
to put in place procedures reasonably designed to ensure that,
if any employee of an issuer, underwriter, or sponsor of a
security or money market instrument subject to a credit rating
had previously been employed by the NRSRO and participated in
determining a credit rating of that entity during the one-year
period before the rating action, the NRSRO will conduct
reviews to determine whether conflicts of interest influenced
the rating, and will revise the rating as appropriate.
The SEC will be required to periodically review the look-back
procedures and code of ethics policies of each NRSRO.
Employment Transitions NRSROs will be required
to report to the SEC (and the SEC will be required to disclose
to the public) when an individual who had been an employee of
the NRSRO within the previous five years becomes employed by
an obligor, issuer, underwriter, or sponsor of a security or
money market instrument that was rated by the NRSRO during the
twelve months before the employee transitioned to his or her
new position, in cases where the employee was a senior officer
of the NRSRO or participated in or supervised someone
participating in rating the obligor, issuer, underwriter, or
sponsor.
Rule to Prevent Conflicts of Interest The
legislation sets forth the sense of Congress that the SEC
should exercise its rulemaking authority to prevent improper
conflicts of interest arising from NRSRO employees providing
services to issuers, including consulting and advisory
services, in addition to providing credit ratings to those
issuers.
Corporate
Governance
Independent Board Each NRSRO must have a board
of directors, at least half but no fewer than two members of
which are independent. To be independent, a board
member may not, other than in the capacity of member of the
board, accept a fee from the NRSRO, be associated with the
NRSRO or any affiliated company, or be involved in determining
a rating in which it has a financial interest. Some of
the independent members must be users of NRSRO ratings.
Duties of Board The NRSRO board of directors
will be required to oversee the establishment, maintenance,
and enforcement of policies and procedures for determining
credit ratings and addressing and dealing with conflicts of
interest, the effectiveness of the internal control system,
and compensation and promotion policies.
If the SEC determines that compliance with these provisions
is an unreasonable burden for a small NRSRO, the SEC may
permit such NRSRO to delegate these responsibilities to a
committee which includes at least one person who is a user of
NRSRO ratings.
Regulation of
NRSROs
Office of Credit Ratings The SEC will be
required to establish an Office of Credit Ratings within the
SEC to administer rules regarding the practice of determining
ratings, promoting rating accuracy, and ensuring that ratings
are not influenced by conflicts of interest.
- Examinations The Office of Credit Ratings
will be required to conduct examinations of NRSROs at least
annually to review management of conflicts of interest,
internal controls, governance, and implementation of its
policies, procedures, and rating methodologies.
- Inspection Reports The SEC will make
available to the public a summary of its findings with
regard to material regulatory deficiencies, including
whether the NRSRO has appropriately addressed
recommendations of the SEC and any responses by the NRSRO.
- Penalties The SEC will be required to
establish fines and other penalties applicable to NRSROs
violating the provisions of Section 15E.
Private Right of Action
- Statements Made by Credit Rating Agencies
Section 15E(m) of the '34 Act is amended so that the penalty
and enforcement provisions of the '34 Act apply to
statements made by a credit rating agency in the same manner
and to the same extent as they apply to statements made by a
registered public accounting firm or a securities analyst
under the securities laws. These statements are not
deemed to be forward-looking statements for purposes of the
safe harbor pursuant to Section 21E of the '34 Act.
There is no longer a bar against private rights of action as
there previously had been under Section 15E(m). The
potential liability of rating agencies under the new
legislation applies to statements made by rating agencies in
connection with municipal securities as well as to ratings
of other types of securities.
- State of Mind Section 21D(b)(2) of the '34
Act is amended so that, with respect to private securities
fraud actions for money damages against a rating agency or a
controlling person, it is sufficient that a complaint state
with particularity the facts giving rise to a strong
inference that the credit rating agency knowingly or
recklessly failed (i) to conduct a reasonable investigation
of the rated security with respect to the factual elements
relied upon by its own methodology for evaluating credit
risk, or (ii) to obtain reasonable verification of such
factual elements from other sources the credit rating agency
considered competent, and that were independent of the
issuer and underwriter. The specific state of mind
provisions applicable to private actions against rating
agencies would apply in a case brought in connection with
municipal securities.
Duty to Report Tips Alleging Material Violations of
Law
Each NRSRO must report to the appropriate authority any
credible information it receives alleging that an issuer of
securities rated by the NRSRO has committed or is committing a
material violation of law.
Disclosure of Credit
Ratings
SEC Rule as to Disclosure The SEC must issue a
rule requiring NRSROs to publicly disclose information on the
initial credit rating given to each obligor, security, and
money market instrument, and on any subsequent rating
change. The direction to the SEC does not have an
exception for municipal securities. In fact, the legislative
direction to the SEC to adopt transparency rules states that
they are to be made "for each type of obligor". Thus, public
disclosure rules adopted by the SEC are likely to
specifically reference information about municipal ratings as
well as other categories of ratings.
Content and Type of Disclosure The disclosures
made by each NRSRO must (i) be comparable so that users can
compare credit ratings performance across NRSROs, (ii) be
clear and informative, (iii) include performance information
over a range of years and for a variety of types of credit
ratings, including for withdrawn credit ratings, (iv) be
freely available and easily accessible on its website, and (v)
include an attestation that the rating is based solely on an
independent evaluation of the risks and merits of the
instruments being rated.
Form Accompanying Ratings The SEC will require
each NRSRO to prescribe a form to accompany each publication
of a credit rating which is easy to use, comparable across
security type, and readily available to credit rating
users.
- Qualitative Content: The form will be required to
include disclosure of (i) the credit rating, (ii) the main
assumptions and data used in making the rating
determination, (iii) potential limitations of the credit
rating, (iv) information on the reliability, accuracy, or
quality of the data used in making a credit rating
determination, (v) information as to limitations of
essential data such as limits on the scope of historical
data and limits on accessibility to certain documents, (vi)
whether and to what extent third party due diligence
services were used by the NRSRO, a description of the
information that third party reviewed, and a description of
the third party's conclusions, (vii) an assessment of the
quality of information available in making the rating
determination, and (viii) information as to conflicts of
interest.
- Quantitative Content: The form will be required
also to include disclosure of (i) factors that could lead to
a change in the credit rating and the magnitude of change to
be expected under various market conditions, (ii)
information on the content of the rating, including the
historical performance of the rating, and the expected
probability of default and consequent loss, and (iii)
information on the sensitivity of the rating to assumptions
made in the rating process.
Third Party Due Diligence The issuer or
underwriter of any asset-backed security will be required to
make publicly available the findings and conclusions of any
third party due diligence report it obtains. Any third
party due diligence provider employed by an NRSRO, issuer, or
underwriter must provide written certification to the NRSRO
that it conducted a thorough review of the data and
documentation used by an NRSRO to make a rating determination
in a form to be established by the SEC, and the NRSRO will be
required to disclose the certification to the public.
Since the requirements for disclosure of third party due
diligence reports applies to "any asset-backed security", it
would seem not to apply to issues of municipal securities.
However, some public finance issues have the characteristics
of an "asset-backed security". The legislation has no
definition of asset-backed securities and no exception for
issues of municipal securities. The problem has been
compounded by recent proposed regulations of the SEC
applicable to asset-backed securities or structured products
in which the definition of terms do not clearly exclude issues
of municipal securities or tender option bonds based on
municipal securities. This issue is likely to be the subject
of continuing comment letters to the SEC and may require
requests to the staff for "no-action" letters.
Elimination of Regulation FD Exemption Under
Regulation FD, if an issuer or any person acting on behalf of
an issuer discloses material nonpublic information about the
issuer or its securities to certain enumerated entities, the
issuer must make such disclosure public. The current
rule exempts disclosures made to credit rating agencies.
The SEC is required to revise Regulation FD within 90 days of
enactment of the legislation to remove the exemption for
disclosures to credit rating agencies.
The elimination of the Regulation FD exemption is not
likely to significantly impact public finance. Regulation FD
applies to reporting companies under the '34 Act, which
normally include the same companies whose securities are
subject to the registration requirements of the '33 Act and,
therefore, does not apply to municipal issuers. The
primary purpose of Regulation FD is to prevent selective
disclosure of nonpublic information that may be used for
purposes of insider trading. In public finance there is an
insider trading prohibition under section 10 of the '34 Act
and SEC Rule 10b-5. Accordingly, some issuers of municipal
securities use Regulation FD as a general guide to avoid
selective disclosure, but other means of avoiding insider
trading can be equally effective.
If Regulation FD is used as a template for disclosure of
nonpublic information by municipal issuers to rating agencies,
it should be noted that within Regulation FD there are
exceptions in addition to the rating agency exemption that is
to be removed. Regulation FD is not violated if the nonpublic
information disseminated by an issuer will not be obtained by
certain classes of persons listed in Regulation FD (such
as broker-dealers) that are considered likely to
trade on the basis of the nonpublic information. Information
given to rating agencies in the course of an issuer obtaining
a rating is not likely to be leaked to any person in the
listed classes of persons deemed likely to trade. As long as
the nonpublic information is not communicated to any person
(within the defined classes listed), the issuer has no
obligation to disclose the nonpublic information to the public
generally. If it is leaked, and the issuer becomes aware of
the leak, the issuer is to "promptly" disclose the information
to the public. There is a further exception for information
given to a person "who owes a duty of trust or confidence to
the issuer", or to a person "who expressly agrees to maintain
the disclosed information in confidence". An issuer can have a
rating agency sign a confidentiality agreement to evidence
that this exception is being relied upon. Confidentiality
agreements are commonly signed by rating agencies.
The legislation requires the SEC to revise Regulation FD
within 90 days to remove the rating agency exemption. Issuers
of municipal securities should follow the development of this
revision to be sure there is no spillover effect on the
usefulness of Regulation FD as a template in public
finance.
Methodologies and
Procedures
SEC Rules as to Procedures and Methodologies
The SEC must prescribe rules requiring NRSROs to:
- ensure that credit ratings are determined using
procedures and methodologies that are approved by the board
of the NRSRO and in accordance with the NRSRO's policies and
procedures,
- ensure that material changes to credit rating procedures
and methodologies are applied consistently to all credit
ratings, as applicable, within a reasonable period of time,
and that the reasons for the change are publicly disclosed,
and
- notify credit rating users of the version of a procedure
or methodology used to determine a particular rating, when a
material change to a procedure is made, when an error is
identified, and the likelihood that a material change in
procedure will result in a rating change.
Use of Information from Outside Sources NRSROs
must consider information about an issuer that it receives
from a source other than the issuer or underwriter when
producing a rating, if the NRSRO finds the information
credible and potentially significant to the rating
decision.
Qualifications for Credit Rating Analysts The
SEC will be required to issue rules designed to ensure that
persons employed by an NRSRO to perform credit ratings meet
standards of training, experience, and competence necessary to
produce accurate ratings and are tested for knowledge of the
credit rating process.
Universal Rating Symbols The SEC must require
NRSROs to establish, maintain, and enforce written policies
and procedures that (i) assess the likelihood that an issuer
of a security or money market instrument will default or fail
to make payments in a timely manner in accordance with the
terms of the instrument, (ii) clearly define the symbol used
to denote the credit rating, and (iii) apply credit rating
symbols in a consistent manner.
Removal
of Statutory References to Credit Ratings
Removal of Statutory References Certain
statutory references to credit ratings are required to be
removed, effective two years after the date of
enactment. Regulatory bodies will be required to develop
their own standards of credit-worthiness to replace these
references.
Feasibility Study The SEC will be required to
undertake a study on the feasibility and desirability of
standardizing credit rating terminology and meanings.
The SEC must submit a report of its findings and
recommendations to Congress within one year after
enactment.
Review
and Modification of Federal Agency Reliance on
Ratings
Each federal agency is required to review and modify its
regulations to remove references to credit ratings and
substitute its own standard of credit-worthiness. Upon
conclusion of the process, each federal agency must submit a
report to Congress describing the modifications made.
Studies
NRSRO Independence The SEC must conduct a
study of the independence of NRSROs and of how such
independence affects the ratings issued. The SEC must
evaluate management of conflicts of interest raised by an
NRSRO providing services in addition to awarding ratings, and
the potential impact of rules prohibiting an NRSRO from
providing such other services to issuers it rates. A
report on the results must be submitted to Congress within
three years of enactment.
Alternative Business Models The GAO must
conduct a study on alternative means for compensating NRSROs
in order to create incentives for NRSROs to provide more
accurate credit ratings. A report on the results must be
submitted to Congress within 18 months of enactment.
Creation of Independent Professional Analyst
Organization The GAO must conduct a 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 and a code of ethical conduct, and
for overseeing the profession. A report on the results
must be submitted to Congress within one year of
enactment.
Assigned Credit Ratings Study and Rulemaking
- Study The SEC must conduct a study of (i)
the credit rating process for structured finance products
and the conflicts of interest associated with issuer-pay and
subscriber-pay models, (ii) the feasibility of establishing
a system whereby NRSROs are assigned to determine credit
ratings of structured finance products, including an
assessment of potential ways to determine fees, appropriate
methods for paying fees, and the extent to which such a
system could be viewed as the creation of a moral hazard by
the Federal Government, (iii) the range of metrics that
could be used to determine the accuracy of credit ratings,
and (iv) alternative compensation schemes that would
incentivize more accurate credit ratings. A report on
the results must be submitted to Congress within two years
of enactment.
- Establishment of Assignment System After
submission of the report, the SEC must, as it determines is
necessary or appropriate, establish a system for the
assignment of NRSROs to determine initial credit ratings of
structured finance products, such that the issuer, sponsor,
or underwriter of the structured finance product does not
make the assignment.
Section 15E(w) of the '34 Act, as that provision would have
been added by section 939D of H.R. 4173 (111th Congress), as
passed by the Senate on May 20, 2010, would have established a
system pursuant to which a self-regulated Credit Rating Agency
Board would assign NRSROs to determine initial credit ratings
of structured finance products. The SEC will be required
to implement the system described in Section 15E(w) unless the
SEC determines that an alternative system would better serve
the public interest and the protection of investors.
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