Tuesday, June 01, 2010

SRO Envisioned by Senate Bill's Franken Amendment Could Revolutionize Assignment of Credit Ratings

The financial reform legislation passed by the Senate conducts a frontal attack on the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings for asset-backed securities and structured financial products on a rotating basis. This was a provision authored by Senator Al Franken and adopted as an amendment to the Senate bill. Within 180 days of enactment, the SEC must create a Credit Rating Agency Board, a self-regulatory organization, tasked with developing a system in which the Board randomly assigns a credit rating agency to provide a product’s initial rating. There is no comparable provision in the House bill.

Requiring an initial credit rating by an agency not of the issuer’s choosing, but randomly selected by the Board, will put a check on the accuracy of ratings and end forum shopping, in the Senator’s view. The provision does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The provision leaves flexibility to the Board to determine the assignment process. Thus, the new Board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose its initial rating agency. This should eliminate the current incentive for a rating agency to give an inflated rating in the hope of getting repeat business. Cong. Record, May 10, 2010, S3465.

Senator Franken has emphasized that the Credit Rating Agency Board will be a self-regulatory organization that will eliminate the current rating shopping process and the conflict of interest inherent in that process. Since the Board can take past performance into account in handing out rating assignments to agencies, the new process will incentivize accuracy in the market. Cong. Record, May 19, 2010, S3955.

The SRO rating system being created will essentially operate as a clearinghouse to assign credit ratings under an SRO, which will set up its own rules and how the assignments wil work.

The Credit Rating Agency Board would be comprised of industry experts: investors, issuers, raters, and, independents. A majority of its members would be investors, including institutional investors who have experience managing pension funds and university endowments. According to Senator Franken, they would have a vested interest in accurate credit ratings because they depend on them when making investments. Cong Record, May 5. 2010, S3155.

Another key element of the new SRO regime is that the Board will regularly evaluate the performance of the credit rating agencies, and they would have to take that performance into account in coming up with an assignment mechanism. In Senator Franken’s view, there is no better way to get accurate ratings than giving more initial rating jobs to the most accurate raters and fewer jobs to those that repeatedly do a sloppy job. The Board will also be able to prevent raters from charging unreasonable, which strikes at the heart of sweetheart deals in which a rater asks for more money for a better rating. Cong Record, May 5. 2010, S3155.

In addition to randomly assigning credit ratings, the Board will also qualify rating agencies to issue ratings for structured products. The term qualified nationally recognized statistical rating organization with respect to a category of structured finance products means a nationally recognized statistical rating organization that the Board determines, using statutory criteria, to be qualified to issue initial credit ratings with respect to such category.

The term category of structured finance products as used in the legislation must include any asset-backed security and any structured product based on an asset-backed security. The SEC can further define and expand on the definition as necessary, but in issuing such regulations the Commission must consider the types of issuers that issue structured finance products and the types of investors who purchase them, as well as the different categories of structured finance products according to capital flow and legal structure, underlying products, terms used in debt securities, the different values of debt securities, and the different numbers of units of debt securities issued together.

The process of the Board qualifying a rating agency is spelled out in the statute. First, the rating agency submits an application to the Board on a form prescribed by the Board to become a qualified nationally recognized statistical rating organization with respect to a category of structured finance products. The application must contain information regarding the institutional and technical capacity of the NRSRO to issue credit ratings, and information on whether the NRSRO has been exempted by the SEC from any requirements under any other provisions, as well as any additional information the Board may require.


The Board may reject an application if the NRSRO has been exempted by the Commission from any requirements under any other provision of this section. The Board must select qualified rating agencies with respect to each category of structured finance products from among nationally recognized statistical rating organizations that submit applications.

An entity selected as a qualified nationally recognized statistical rating organization must retain its status and obligations under the law as an NRSRO and neither the SEC nor the Board is authorized to exempt qualified nationally recognized statistical rating organizations from obligations or requirements otherwise imposed by federal law on nationally recognized statistical rating organizations.

An issuer seeking an initial credit rating for a structured finance product may not request an initial credit rating from a nationally recognized statistical rating organization. Rather, the issuer must submit a request for an initial credit rating to the Board on a form the Board may prescribe.

Issuer requests for ratings will be given to a rating agency selected by the Board under a system determined by the Board based on statutory selection guidelines.

The Board must evaluate a number of selection methods, including a lottery or rotating assignment system, incorporating factors to reduce the conflicts of interest that exist under the issuer-pays model and prescribe and publish a selection method. In evaluating a selection method, the Board must consider the information submitted by the qualified nationally recognized statistical rating organization regarding its institutional and technical capacity to issue credit ratings; evaluations conducted, formal feedback from institutional investors, and information to implement a mechanism which increases or decreases assignments based on past performance. In choosing a selection method, the Board may not use a method that would allow for the solicitation or consideration of the preferred national recognized statistical rating organizations of the issuer.

The Board must also issue rules describing the process by which it can modify the assignment of ratings process. Also, a rating organization must charge an issuer a reasonable fee, as determined by the Commission, for an initial credit rating on a structured financial product. Fees may be determined by the qualified national recognized statistical rating organizations unless the Board determines it is necessary to issue rules on fees. The Board must issue regulations to define the term reasonable fee.

A rating agency selected by the Board to give an initial rating on a structured product can refuse to accept a selection for a particular request by notifying the Board of such refusal; and submitting to the Board a written explanation for the refusal. Upon receipt of the refusal notification, the Board must select another rating agency. The Board must also annually submit any explanations of refusals it received to the SEC and the explanatory submissions must be published in the required annual inspection reports.

Each initial credit rating issued for a structured financial product must include, in writing, the following disclaimer: ‘This initial rating has not been evaluated, approved, or certified by the Government of the United States or by a Federal agency.’’

The Board is directed to adopt rules by which it will evaluate the performance of each qualified nationally recognized statistical rating organization, including rules that require, at a minimum, an annual evaluation of each NRSRO. The Board, in conducting such an evaluation, must consider the results of the annual examination, surveillance of credit ratings conducted by the rating agency after the credit ratings are issued, including how the rated instruments perform, the accuracy of the ratings provided compared to the other rating agencies, and the effectiveness of the methodologies used to arrive at the rating. The Board must make any evaluations it conducts available to Congress. A rating agency may request a reevaluation not less frequently than once a year.

The SEC will select the initial members of the Board for a four-year term and the SEC has discretion to decide how many members will serve on the Board so long as it is an odd number. A majority of the Board must be investor industry representatives who do not represent issuers. One member must be from the issuer community and one must be from the credit rating agency industry. Finally, one member must be independent. The SEC must adopt rules for the nomination and election of future Board members.

A Board member or employee must not accept any loan of money or securities, or anything above nominal value, from any nationally recognized statistical rating organization, issuer, or investor. However, this prohibition does not apply to a loan made in the context of disclosed, routine banking and brokerage agreements, or a loan that is clearly motivated by a personal or family relationship. Board members or employees must not engage in employment negotiations with any rating agency, issuer, or investor, unless they discloses the negotiations immediately upon initiation and recuse themselves from all proceedings concerning the entity involved in the negotiations until termination of negotiations or until termination of their employment by the Board, if an offer of employment is accepted.

A credit analyst of a qualified NRSRO must not accept any loan of money or securities, or anything above nominal value, from any issuer or investor. Except that this prohibition does not apply to a loan made in the context of disclosed, routine banking and brokerage agreements, or a loan that is clearly motivated by a personal or family relationship.

The SEC must adopt a schedule ensuring that the Board begins assigning rating agencies to provide initial ratings within one year of selection of the members. The schedule must set forth when the Board will conduct a study of the securitization and rating process and provide recommendations to the SEC and when the Board will begin accepting applications to select qualified NRSROs and begin assigning initial ratings. The Board is authorized to levy fees on qualified NRSROS to fund its expenses.

Within five years of the date the Board begins assigning initial ratings on structured financial products, the SEC must report recommendations to Congress on the Board’s continuation and any changes in Board procedures.

1 comment:

Morris Simkin said...

Senator Franken's amendment to create a Credit Rating Agency Board overseen by the SEC has several weaknesses may limit its intended purpose of preventing higher ratings by a credit rating agency to obtain future business, laziness in the rating process or sweetheart deals for a more favorable rating.

This Board would set the criteria for a nationally recognized statisitical rating organziaiton to become a qualified nationally recognized statistical rating agency that can be selected by the Board to assign an initial rating to a structured finance product or an asset backed security.

There are about 12 nrsro's. I would assume that most of them will become qualfied nrsro's. If a lesser recognized rating agency is selelcted, it is probable that the issuer or underwriter will hire a better recognized rating agency to rate its product. If a better recognized rating agency is initially selected it will have an incentive, in the case of repeat issuers or their udnerwriters, to favorably rate the issue in order to get future "second opinion" rating business.