Further Regulation for Credit Rating Agencies in the Pipeline

August 13, 2009

Continuing its assessment of the financial crisis, the Obama Administration is closely reviewing ways to improve the effectiveness of rating agencies. A credit rating agency is defined in the Credit Rating Agency Reform Act of 2006 (Rating Agency Act) to be a person “(a) engaged in the business of issuing credit ratings on the Internet or through another readily accessible means, for free or for a reasonable fee, but does not include a commercial credit reporting company; (b) employing either a quantitative or qualitative model, or both, to determine credit ratings; and (c) receiving fees from either issuers, investors, or other market participants, or a combination thereof.” Upon meeting certain requirements under the Rating Agency Act and registering with the U.S. Securities and Exchange Commission (SEC), a credit rating agency is designated a nationally recognized statistical rating organization (NRSRO). On the heels of testimony by the Chairman of the SEC before a U.S. House of Representatives Subcommittee explaining the steps her organization has taken and is considering to further regulate NRSROs, the Administration recently sent its proposed credit rating agency reform legislation to Congress.

SEC Chairman Mary L. Schapiro testified at a July 14, 2009 hearing of the U.S. House Financial Services Committee’s Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises regarding the state of the SEC and its current agenda, including further oversight of NRSROs. Her testimony followed a hearing on May 19, 2009 before the same Subcommittee on approaches to improving credit rating agency regulation that included testimony from industry participants and academics. Prior examinations and a series of actions by the SEC had set the stage for discussion of added oversight.

In August 2007, SEC staff commenced examinations of Fitch Ratings, Ltd., Moody’s Investors Service, Inc., and Standard & Poor’s Ratings Services. The examinations were conducted to review the rating agencies’ activities in connection with rating subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) in connection with RMBS. The SEC staff issued a Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies on July 8, 2008. The Report did not include specific recommendations to regulate the substance of ratings methodologies, as the Commission was prohibited pursuant to 15 U.S.C. § 78o-7(c)(2) from regulating “the substance of the credit ratings or the procedures and methodologies” by which any NRSRO determines credit ratings.

The SEC did, however, take other actions in 2009 relating to NRSROs. Through its February 2, 2009 Amendments to Rules for Nationally Recognized Statistical Rating Organizations, the Commission made several changes to its rules governing NRSROs to increase disclosures to investors, bolster the rating process’ integrity, identify inherent conflicts of interest in the current ratings regime, and enhance the NRSROs’ reporting and recordkeeping requirements to allow the SEC to better execute its oversight functions.

In her testimony, Chairman Schapiro told the Subcommittee that she allocated resources to establish a branch of examiners dedicated specifically to conducting examination oversight of the NRSROs. The branch will conduct routine and special examinations of the NRSROs to review their activities and compliance with the Rating Agency Act and SEC rules.

Chairman Schapiro also indicated in her testimony that she has directed SEC staff to investigate other possible areas for regulation in connection with NRSROs, including limiting the potential for rating shopping. One approach, Ms. Schapiro commented, would be to oblige disclosure by issuers of all preliminary ratings acquired from NRSROs before the selection of the firm to conduct a rating.

A week later, on July 21, 2009, the Obama Administration delivered proposed legislation to Capitol Hill to boost transparency in connection with and intensify oversight of credit rating agencies as part of its proposed Investor Protection Act of 2009. Many of the provisions of the proposed legislation, if adopted, would result in significant changes in the practices and procedures routinely followed by rating agencies.

The draft legislation proposes numerous steps for reducing conflicts of interest. For instance, the legislation would bar rating agencies from consulting with any company that they also rate. Such restrictions will mirror similar restrictions on accountants. Furthermore, the legislation will forbid or compel the management and disclosure of conflicts stemming from the manner in which a rating agency is paid, its business relationships, affiliations or other conflicts. Under the proposal, all rating reports will disclose not only the fees paid by the issuer for a particular rating, but also the total amount of fees paid by the issuer to the rating agency in the prior two years. Additionally, the legislation would target the “revolving door” among issuers and rating agencies. Under the proposal, if a rating agency employee is hired by the issuer and if the employee had worked on ratings for that issuer in the prior year, then a look-back requirement would require a rating agency to review ratings for an issuer to determine if any conflicts of interest influenced the rating and adjust the rating as appropriate. Moreover, rating agencies would each be required to designate a compliance officer to ensure compliance with internal controls and processes, and such officer would submit an annual report to the SEC.

The proposal also includes numerous measures to further disclosure and transparency generally. The Administration’s proposal echoed Chairman Schapiro’s suggestion that an issuer be required to disclose all of the preliminary ratings it had received from various credit rating agencies, allowing investors to gauge the level of “shopping” that occurred and whether there were discrepancies with the final rating. Rating agencies would further be required to present qualitative and quantitative measures of the risks and performance variance inherent in a given security, including an appraisal of data reliability, the chance of default, the estimated loss in the event of default, and the sensitivity of a rating to variations in assumptions. The proposal also includes a proviso that would require rating agencies to use unique symbols to differentiate structured finance products from others to indicate the distinct risks of such products.

SEC authority and supervision would also be increased under the legislation. Currently, a voluntary system of registration exists with respect to rating agencies, but the proposal would make such registration mandatory. The proposed legislation would also establish an office within the SEC to administer rules for NRSROs and to carry out the enhanced regulations required. Documentation on each rating agency’s policies and procedures for the determination of ratings would also be required, and the SEC will examine the agencies’ internal controls, due diligence, and implementation of rating methodologies.

The proposed legislation on credit rating agencies sets forth an ambitious reform effort intended to protect investors. It is difficult to predict with any certainty, however, the exact form of any final legislation and its implementation at the SEC.