Credit Rating Industry (§§ 932, 933, 935 & 939)
In the wake of the financial crisis, the systemic importance of credit rating agencies (CRAs) and their role in capital formation and as gatekeepers in the debt markets have become the subject of extended debate among government and market participants alike. Under the legislation, the credit rating industry will be subject to heightened oversight, regulation, and expanded liability. To administer these reforms, Congress has directed the SEC to establish an Office of Credit Ratings, discussed below. Like many other components of the legislation, Congress has delegated significant details regarding these reforms to the SEC’s rulemaking discretion.
Office of Credit Ratings (§ 932)
The legislation establishes an independent office within the SEC called the Office of Credit Ratings (OCR), with a mandate to promote accuracy of credit ratings and prevent conflicts of interest. The OCR will conduct a review of each CRA at least annually to evaluate each CRA’s compliance with the legislation’s governance, management, and operational requirements. In addition, each CRA will be required to maintain an internal system to ensure compliance with various accountability and ethics requirements, including controls with respect to conflicts of interest and post-employment activities of former CRA employees.
Civil Liability (§§ 933 & 939G)
The legislation subjects CRAs to significant private litigation and will not allow CRAs to rely on the safe harbor provided for forward-looking statements under the Securities Act. Consequently, it will be easier for private litigants to sue CRAs. In addition, the legislation nullifies Rule 436(g) of the Securities Act, which exempted credit ratings provided by nationally recognized statistical rating organizations (NRSROs) from being considered part of a registration statement prepared or certified by an “expert” and thereby under the “expert liability” regime of section 7 and section 11 of the Securities Act. Given the small number of CRAs and the very substantial liability CRAs potentially may incur, one may expect the industry to approach ratings differently than in the past.
In addition, the SEC may fine CRAs or their associated persons for certain violations of the securities laws. If a violation affects the integrity of a rating, then the violation may eventually lead to the suspension or revocation of a CRA’s registration with the SEC.
Internal Controls and Other Restrictions (§§ 932, 935, & 939B)
The legislation imposes new restrictions and requirements on a CRA’s corporate governance, internal controls, transparency, conflicts of interest, and liability exposure under the securities laws. At least half of a CRA’s board of directors must qualify as independent directors. Each CRA’s board of directors and senior credit officer will be responsible for the procedures and methodologies applied to the credit ratings it issues. Similar to the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act), the legislation requires a CRA’s CEO to attest to the effectiveness of the firm’s internal controls in the form of a certification submitted to the SEC. The legislation also establishes new professional standards for ratings analysts, including qualifying exams and continuing education.
In addition, the legislation directs the SEC to promulgate new rules that require an internal separation of the credit rating activity from sales and marketing activity within individual CRAs, although the SEC has been directed to provide an exception for smaller CRAs under certain circumstances. Furthermore, CRAs will be required to report to the SEC when a former CRA employee becomes employed by an underwriter or obligor of a security or money market instrument subject to a rating by that CRA and undertake a one-year look-back review to evaluate whether any conflicts of interest relating to the employee influenced the rating.
The legislation also requires material changes to rating procedures and methodologies to be applied consistently and publicly disclosed. Users of credit ratings must be notified of material changes to any procedures and methodologies or upon the identification of a significant error in those procedures or methodologies. CRAs must also consider in their ratings any information they find credible and potentially significant about an issuer that is received from a third-party source, although CRAs are not required to initiate a search for that kind of information. The intended aim of Congress in mandating these disclosures of rating procedures and methodologies is to make ratings performance data more transparent and easily evaluated and enable investors to compare credit ratings among CRAs.
Initial Ratings of Structured Finance Products (§ 939F)
The CRAs’ issuer-pays business model has been the subject of recurring criticism and often is used to highlight the conflicts of interest seen as pervasive in the credit rating industry, particularly with respect to structured finance products. Accordingly, Congress has directed the SEC to carry out a study that analyzes the credit rating process for structured finance products and the associated conflicts of interest. Following submission of the study’s reported findings, which is to occur within two years of the enactment of the legislation, the SEC is required to establish a system to prevent a structured finance product issuer, sponsor, or underwriter from selecting the CRA determining and monitoring the initial credit ratings of structured finance products. Unless the SEC concludes that a different approach would better protect investors and serve the public interest, the SEC is required to create a new SRO that will assign CRAs, on a random or rotating basis, to provide initial ratings of structured finance products. Structured finance products covered by the rule include ABS and any structured product based on one or more ABS.
Removal of Credit Rating Entities from Federal Laws (§ 939)
Historically, the Federal Deposit Insurance Act, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, the Investment Company Act, the National Bank Act, the Securities Exchange Act of 1934 (Exchange Act), and certain other federal statutes have relied on NRSROs and minimum credit ratings issued thereby as a proxy for the riskiness of debt instruments in a variety of regulatory contexts. The legislation generally eliminates statutory references to NRSROs and minimum credit ratings, and these references will be replaced with a concept of credit-worthiness, which will be defined by the relevant regulator.