Originally published February 10, 2009

Keywords: SEC, nationally recognized statistical rating organizations, NSRO, credit rating procedures, no-advice rule

On February 2, 2009, the US Securities and Exchange Commission (the "Commission") released new final rules imposing additional requirements on the conduct of nationally recognized statistical rating organizations (NRSROs).1 Additional proposed rules for NRSROs were separately issued on the same day.2 Both the final rules, which are effective on April 10, 2009, and the proposed rules are meant to address concerns about the integrity of credit rating procedures and methodologies, which was the first of three subjects addressed by the Commission's rule proposals last summer relating to NRSROs.3 The Commission is adopting a majority of the rule amendments it proposed on this subject, with some revisions that respond to comments received on the proposals.

The Commission has not yet finalized the proposals relating to the other two subjects, which were:

  • A change in the rating symbols or disclosure applied to ratings of structured finance products; and
  • Amendments intended to reduce reliance on NRSRO ratings in the Commission's rules.

Disclosure of Information Used in the Rating Process

One of the earlier proposed rules that the Commission did not adopt would have required NRSROs to publicly disclose information used in arriving at or monitoring the ratings of structured finance products that are paid for by issuers, sponsors or underwriters (collectively referred to below as "arrangers"). However, the Commission has issued a set of related proposals for further comment. Under the newly proposed amendments, when an NRSRO is hired by an arranger to rate a structured finance product, the following rules would all apply:

  • The NRSRO would be required to disclose to other NRSROs that it was providing the rating;
  • The arranger would be required to represent to each hired NRSRO that the arranger will provide the same rating-related information to other NRSROs that it gives to the hired NRSRO; and
  • NRSROs seeking to access information maintained by hired NRSROs and arrangers would be required to certify annually to the Commission the limits on their use of the information.

These proposals, like the original proposal, are meant to facilitate unsolicited ratings, which the Commission expects to act as a counterbalance to the undue influence that the Commission believes arrangers may exercise through their ability to select which NRSROs rate (and therefore are compensated for rating) particular securities.

Adoption of the No-Advice Rule

The Commission adopted a rule that prohibits NRSROs from providing any structuring advice relating to the securities that they rate. The Commission was apparently concerned with NRSROs sometimes making structural recommendations to arrangers and then rating the resulting securities — a process that the Commission describes as the NRSROs "in effect, rating their own work."4 The Commission acknowledged in the proposing release that, "the line between providing feedback during the rating process and making recommendations about how to obtain a desired rating may be hard to draw in some cases."5 However, the Commission believes that this practice creates a conflict that cannot be effectively managed, and so, after considering the comments received, has decided to prohibit the practice outright. The adopting release provides some guidance on the line between permitted feedback and prohibited recommendations, but we expect that it will take some time to work out the distinction in practice.

Other New Rules

The Commission also adopted rules that:

  • Prohibit any one person from both participating in a rating decision and also negotiating the fee for the rating.
  • Prohibit gifts valued over $25 from those who receive ratings to rating personnel.
  • Expand recordkeeping requirements for NRSROs by requiring them to:
    • maintain a record of all of their ratings and subsequent rating actions (which is subject to examination by the Commission), and publish a random sample of this information on a delayed basis;6
    • maintain a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued on a structured finance product, if a quantitative model is a substantial component in the process of determining the credit rating;
    • retain records of third party complaints regarding the performance of a credit analyst in determining credit ratings; and
    • disclose default and rating transition statistics for each class of credit rating used by the NRSRO, broken out over 1-, 3- and 10-year periods.
  • Require NRSROs to disclose:
    • how rating decisions are affected by information about verification performed on underlying assets or assessments of the quality of originators;
    • how frequently ratings are reviewed, and whether different models or criteria are used for ratings surveillance than for initial ratings determinations;
    • whether changes made to models and criteria for determining initial ratings are applied retroactively to existing ratings; and
    • whether changes made to models and criteria for performing ratings surveillance are incorporated into the models and criteria for determining initial ratings.
  • Require NRSROs to report to the Commission annually on the number of ratings actions taken in each ratings class.

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Footnotes

1. Release No. 34-59342 (the "Adopting Release"), available at http://www.sec.gov/rules/final/2009/34-59342.pdf.

2. Release No. 34-59343 available at http://www.sec.gov/rules/proposed/2009/34-59343.pdf.

3. The proposals were set out in (a) Release No. 34-57967, 73 Federal Register 36212 (June 25, 2008), which addressed the first two subject areas and is available at http://edocket.access.gpo.gov/2008/pdf/E8-13887.pdf and (b) the following three releases, which addressed the third subject area from the perspective of rules administered by the Commission's Divisions of Corporation Finance, Investment Management and Trading and Markets, respectively: Release No. 33-8940, available at http://sec.gov/rules/proposed/2008/33-8940.pdf; Release No. IC-28327, available at http://sec.gov/rules/proposed/2008/ic-28327.pdf; and Release No. 34-58070, available at http://sec.gov/rules/proposed/2008/34-58070.pdf.

4. Adopting Release, supra note 1, at 39.

5. Release No. 34-57967, 73 Federal Register at 36227.

6. In the companion proposing release, supra note 2, the Commission has proposed expanding the amount of this information that must be publicly disclosed.

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