SEC Adopts Credit Rating Agency Reform; Differentiation for Future Action

The SEC approved a series of measures to increase transparency and accountability at credit rating agencies, and ensure that firms provide more meaningful ratings and greater disclosure to investors. The new rules are designed to deal with conflict of interest issues that came into stark relief as a result of the securitization crisis. The rules reflect a growing skepticism that a rating agency can give an objective rating to a security product if it has advised the issuer or underwriter on how to structure that same product. In an effort to restore trust in the rating process, the SEC has established a framework for rating agencies under which conflicts of interest are properly and more effectively managed. The SEC’s actions were informed by an extensive 10-month examination of three major credit rating agencies that found significant weaknesses in ratings practices. But, the SEC deferred action on the issue of differentiation of structured products.

These comprehensive rules touch every aspect of the credit rating process, said Chairman Cox, from conflicts of interest, to publication of ratings methodologies, to disclosure of ratings track records.

Addressing conflict of interest charges, the SEC added three new prohibited conflicts to its rules. The first would prohibit a rating agency from issuing a credit rating with respect to a security where the agency made recommendations to the issuer or underwriter of the security about the corporate or legal structure, assets, liabilities, or activities of the issuer of the security. The second change would prohibit a person within a rating agency who has responsibility for participating in determining credit ratings or for developing or approving procedures or methodologies used for determining credit ratings from participating in any fee discussions or arrangements. The third change would prohibit a rating agency from allowing a credit analyst who participated in determining or monitoring the credit rating to receive gifts, including entertainment, from the obligor being rated or from the issuer or underwriter of the securities being rated, other than items provided in the context of normal business activities, such as meetings, that have an aggregate value of no more than $25.

The new rules also require rating agencies to provide the Commission with an annual report of the number of credit rating actions that occurred during the fiscal year for each class of security for which they are registered.

The SEC added three new recordkeeping requirements to its rules. First, rating agencies would have to make and retain records of all rating actions related to a current rating from the initial rating to the current rating. Second, if a quantitative model is a substantial component of the credit rating process for a structured finance product, a rating agency must keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. Third, rating agencies would be required to retain records of any complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating.

The SEC rules will also require rating agencies to make publicly available a random sample of 10% of their issuer-paid credit ratings and their histories documented for each class of issuer-paid credit rating for which they are registered and have issued 500 or more ratings. This information would be required to be made public on the rating agency’s corporate Internet website in XBRL format no later than six months after the rating is made.

At the same time it adopted these reform rules, the SEC also reproposed rules that would prohibit rating agencies from issuing a rating for a structured finance product paid for by the product’s issuer or underwriter unless the information about the product provided to the agency to determine the rating and, thereafter, monitor the rating is made available to other rating agencies.

Specifically, the SEC would require rating agencies that are hired by arrangers to perform credit ratings for structured finance products to disclose to other agencies, and only other agencies, the deals for which they were in the process of determining such credit ratings. The arrangers would need to provide the rating agencies they hire to rate structured finance products with a representation that they will provide information given to the hired agency to other rating agencies. In addition, rating agencies seeking to access information maintained by the agencies and the arrangers would need to furnish the Commission an annual certification that they are accessing the information solely to determine credit ratings and will determine a minimum number of credit ratings using the information.

The European Commission proposed reforms embody the principle of differentiation under which rating agencies must either differentiate rating categories for structured finance instruments so that they are not confused with rating categories for other types of financial instruments or produce a comprehensive report attached to each structured finance rating. It is envisioned that such a report would provide a detailed description of the rating methodology used to determine the credit rating and an explanation of how it differs from the determination of ratings for any other type of rated entity or financial instrument, and how the credit risk characteristics associated with a structured finance instrument differ from the risks related to any other type of rated instrument.