Credit rating agencies market themselves as providers of independent research and in-depth credit analysis. But in the financial crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex structures.
Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities and other derivatives, adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.
The Senate draft Restoring American Financial Stability Act mandates that each nationally recognized statistical rating organization must establish, enforce, and document an effective internal control structure governing the implementation of policies and methodologies they use to determine credit ratings. Further, the SEC must adopt rules requiring credit rating agencies to submit to the Commission an annual internal controls report, containing a description of the responsibility of the management of the rating agency in establishing and maintaining effective internal controls. In addition, the rating agency must assess the effectiveness of the internal controls and the attestation of the CEO.
The legislation would authorize the SEC to temporarily suspend or permanently revoke the registration of a credit rating agency with respect to a particular class or subclass of securities if the Commission finds, after notice and an opportunity for a hearing, that the rating agency does not have adequate financial and managerial resources to consistently produce credit ratings with integrity. In making this determination, the SEC must consider whether the rating agency has failed over a sustained period of time to produce accurate ratings for that class or subclass of securities; and whether the performance of the rating agency has been significantly worse than the performance of other rating agencies during the same time period.
The SEC must also adopt rules separating the ratings from sales and marketing. Specifically, the rules must prevent the sales and marketing considerations of
a rating agency from influencing the production of ratings. The SEC rules must provide for exceptions for small rating agencies when the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.
The Credit Rating Agency Reform Act of 2006 ordered rating agencies to name a compliance officer to ensure compliance with the securities laws and regulations. The draft prohibits these compliance officers from working on ratings, methodologies, or sales and marketing, and from establishing compensation levels except for employees working for them. The SEC may exempt a small rating agency from these limitations upon a finding that compliance with such limitations would impose an unreasonable burden on the agency.
The draft mandates that compliance officers must establish procedures for the receipt and treatment of complaints regarding ratings and the methodologies used to set the ratings, as well as a system to deal with confidential, anonymous complaints from employees or users of credit ratings.
Further, compliance officers must submit to the rating agency an annual report on the agency’s compliance with the securities laws and its own policies, including a description of any material changes to its code of ethics and conflict of interest policies and a certification that the report is accurate and complete. Then, the rating agency must file the compliance officer’s report with the SEC, along with the financial report already required to be furnished to the SEC. The Commission may treat as confidential any information contained in a financial statement upon determining that its publication may harm the rating agency.
The legislation creates an Office of Credit Ratings at the SEC with its own compliance staff and the authority to fine agencies. The Director of the Office of Credit Ratings would report directly to the SEC Chair; and the Office must be adequately staffed with persons with expertise in structured debt.
The Office is required to conduct annual examinations of rating agencies and make key findings public. The draft also requires rating agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible. The SEC is authorized to deregister an agency for providing bad ratings over time. The Senate draft would allow investors to bring private rights of action against ratings agencies for a knowing or reckless failure to investigate or to obtain analysis from an independent source.
In an effort to improve transparency, the draft would require rating agencies to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.