The House Financial Services Committee has passed bi-partisan legislation reforming the governance and operations of credit rating agencies. The Accountability and Transparency in Rating Agencies Act, HR 3890, enhances the accountability of credit rating agencies by clarifying the ability of individuals to sue such agencies. The Exchange Act is amended to provide that, in an action for money damages against a rating agency, it is enough for pleading any required state of mind that the complaint state with particularity facts giving rise to a strong inference that the rating agency knowingly or recklessly violated the securities laws. In addition, statements made by rating agencies will not be deemed forward looking statements for purposes of the Exchange Act’s safe harbor.
In any private action against a rating agency, the same pleading standards with respect to knowledge and recklessness must apply to the rating agency as would apply to any other person in the same or similar private right of action against such person. The draft also clarifies that the limitation on the SEC or any State not to regulate the substance of credit ratings or ratings methodologies does not afford a defense against civil antifraud actions.
The draft also adds a new duty to supervise a rating agency’s employees and authorizes the SEC to sanction supervisors for failing to do so.
In an effort to improve the governance of rating agencies, the draft requires each rating agency to have a board with at least one-third independent directors whose term of office must be for a pre-agreed non-renewable fixed period of no more than five years. Moreover, the compensation of the directors cannot be linked to the business performance of the rating agency; and must be arranged to ensure the independence of their judgment.
The board must oversee policies and procedures aimed at preventing conflicts of interest and improving internal controls, among other things. They must establish and enforce policies for determining credit ratings, as well as compensation and promotion policies for the agency.
The legislation also contains numerous new requirements designed to mitigate the conflicts of interest that arise out of the issuer-pays model for compensating rating agencies. In addition to enhanced disclosure, the draft significantly enhances the responsibilities and accountability of rating agency compliance officers to address conflicts of interest issues, as well as other internal control and risk management duties.
The draft requires all rating agencies to designate a compliance officer who would report directly to the board and would review all of the agency’s policies to manage conflicts of interest and, in consultation with the board, resolve any conflicts of interest that arise.
The compliance officer must also asses the risk that compliance or lack of such may compromise the integrity of the rating process. Similarly, the compliance officer must review compliance with internal controls with respect to the procedures and methodologies for determining credit ratings, including quantitative models and qualitative inputs used in the rating process, and assess the risk that such compliance with the internal controls or lack thereof may compromise the integrity and quality of the credit rating process.
The draft also requires the compliance officer to be responsible for administering the policies and procedures required to be established by the legislation and, more broadly, ensure compliance with securities laws and SEC regulations. The compliance officer must annually prepare and sign a report on the compliance of the rating agency with the securities laws and its own internal policies and procedures, including its code of ethics and conflict of interest policies, in accordance with SEC rules. This compliance report must accompany the financial reports of the rating agency that are required to be filed with the Commission and must include a certification that the report is accurate and complete.
The compliance officer must also establish procedures for the receipt, retention, and treatment of complaints regarding credit ratings, models, methodologies, and compliance with the securities laws and the policies and procedures required by the Act, as well as provide for the confidential treatment of anonymous complaints by employees, issuers, and investors.
In addition, the compliance officer must set up procedures for the remediation of non-compliance issues found during compliance office reviews, internal or external audit findings, self-reported errors, or through validated complaints. Overall, the procedures must be designed so that ratings that the agency disseminates reflect consideration of all information that comes to the attention of, and is believed by, the agency to be relevant, in a manner generally consistent with the agency’s published rating methodology, including information which is provided or otherwise obtained from issuer and non-issuer sources, such as investors, the media, and other interested parties
An amendment offered by Rep. Waters provides that, just as with independent directors, the compensation of compliance officers cannot be linked to the business performance of the rating agency and must be arranged so as to ensure the independence of the officer’s judgment.
The legislation prohibits compliance officers from determining credit ratings or participating in the establishment of the procedures and methodologies or the models used to determine credit ratings. Compliance officers are also barred from performing marketing or sales functions or from participating in the setting of compensation levels, other than for employees working for them.
When rating agency employees go to work for an issuer whose securities they helped rate, the draft requires the rating agency to conduct a one year look-back into the ratings in which the employee was involved to make sure that proper procedures were followed and proper ratings were issued. The rating agency must conduct a review to determine if any conflicts of interest of the employee influenced the credit rating and revise the rating if appropriate. The draft also requires rating agencies to report to the SEC, and for the SEC to make such reports public, as well as the names of former rating agency employees who go to work for issuers.
The SEC must conduct periodic reviews of the look-back policies of the rating agency to ensure that they are reasonably designed to most effectively eliminate conflicts of interest. The SEC must also review the code of ethics and conflict of interest policies of rating agencies at least annually and whenever the policies are materially modified.
Rating agencies must establish and enforce policies to manage and disclose any conflicts of interest arising from their business. For its part, the SEC must issue rules prohibiting conflicts of interest or requiring the management and disclosure of conflicts of interest relating to the issuance of credit ratings, including conflicts relating to the compensation of the rating agency or to the provision of consulting or advisory services by the agency.
The SEC rules must also require disclosure of conflicts of interest relating to a business relationship and affiliations of rating agency board members with issuers. The Commission must also adopt rules requiring rating agencies to disclose on their websites a consolidated report at the end of the year showing the percent of net revenue earned by the rating agency for providing services other than credit ratings to each person who paid for a credit rating. There must also be disclosure of the relative standing of each person who paid for a credit rating that was outstanding as of the end of the fiscal year in terms of the amount of net revenue earned by the rating agency organization attributable to each such person and classified by the highest 5, 10, 25, and 50 percentiles and lowest 50 and 25 percentiles.
The SEC rules must also require the establishment of a system of payment for each rating agency requiring the structuring of payments in a manner designed to ensure that the agency conducts accurate and reliable surveillance of ratings over time, as applicable, and that incentives for reliable ratings are in place. The rules must also require that a rating agency disclose with the publication of a credit rating the type and number of credit ratings it has provided to the person being rated or affiliates of such person, the fees it has billed for the credit rating, and the aggregate amount of net revenue earned by the rating agency in the preceding two fiscal years attributable to the person being rated and its affiliates. A catch all provision requires the SEC to require the disclosure of any other potential conflict of interest, in the public interest or for the protection of investors.
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