Davis Polk & Wardwell Newsflash

SEC Approves Measures to Strengthen Oversight of Credit Rating Agencies

December 4, 2008

At a public meeting yesterday, the Securities and Exchange Commission adopted final rules designed to address perceived conflicts of interest in the credit rating industry, while deferring action on other related proposals originally put forth in June and July 2008 as part of the SEC’s response to the ongoing credit crisis.  The SEC also announced that it would re-propose two rules in modified form.  The new rules apply to each rating agency registered with the SEC as a “nationally recognized statistical rating organization” (NRSRO), including Standard & Poor’s Ratings Services, Moody’s Investors Service and Fitch Ratings.  The SEC actions occur amid efforts in the European Union to create a uniform registration and surveillance regime for rating agencies – which ultimately may differ from the SEC and International Organization of Securities Commissions (IOSCO) approaches.

The SEC has not yet published the text of the new rules, but they are expected to include the following:

  • Ban on recommendations.  An NRSRO may not make “recommendations” to the issuer about how to obtain a desired credit rating.  During the comment period, a number of observers pointed out that this rule could inappropriately chill critical discussions between issuers and rating agencies.  Addressing this concern during the meeting, the SEC staff stated that this rule is not intended to prohibit “useful feedback” from the NRSRO during the ratings process, and indicated that the final rule release would provide guidance on this point.
  • Ban on fee discussions.  NRSRO personnel who participate in determining a rating may not discuss or arrange the fees paid to the NRSRO.
  • Ban on gifts.  NRSRO personnel may not receive gifts or entertainment from a rated issuer valued in excess of $25.
  • Internet disclosure of rating actions.  Each NRSRO operating on the “issuer-pays” business model must publish a 10% sample of its rating actions on its website in XBRL format.
  • Model deviations.  Each NRSRO must document the rationale for any material deviation in the rating assigned to a structured finance product from the rating implied by the NRSRO’s quantitative model.  This requirement is intended to assist SEC examiners during inspections of the NRSRO, although observers have suggested that it could cause NRSROs to become unduly reliant upon their models.
  • Complaints about analysts.  NRSROs must retain any communications that contain complaints about the performance of a credit analyst relating to a rating.
  • Enhanced disclosure.  Each NRSRO must publicly disclose (i) performance measurement statistics broken out over 1, 3 and 10-year periods, (ii) information on what verification it performs on assets underlying structured finance products, (iii) how its assessment of the quality of asset originators affects its rating of structured finance products and (iv) information about its ongoing credit surveillance policies.

The SEC also re-proposed two rules in modified form:

  • Disclosure of data underlying structured finance ratings.  In June, the SEC proposed sweeping rules which would have required an NRSRO to publicly disclose most of the data provided to the NRSRO by the arranger of a structured finance product.  The SEC’s goal was to encourage other rating agencies (including those not registered with the SEC) to publish competing ratings.  Several observers questioned the breadth of the SEC’s proposal, and the SEC has scaled the proposal back to put the disclosure burden on the arranger, and to provide that the disclosure be made only to other NRSROs that agree to use the data for ratings purposes.
  • Additional Internet disclosure by “issuer-pays” NRSROs.  As noted above, an NRSRO operating on the “issuer-pays” business model must publish a 10% sample of its rating actions on its website in XBRL format.  The SEC has proposed making “issuer-pays” NRSROs publish 100% of their rating actions on that basis, subject to a 12-month lag.  The SEC is seeking comment on whether this proposal should be broadened to cover “subscriber-pays” NRSROs as well.  NRSROs are likely to resist any requirement to relinquish their rating histories into the public domain on an unlicensed basis.

The SEC deferred action on other related proposals:

  • Structured finance rating symbols.  In June 2008, the SEC proposed rules that would effectively require NRSROs to change their rating symbols for structured finance products.  A number of observers questioned the benefits and practicality of such a requirement, as well as the SEC’s authority to impose it.
  • SEC reliance on credit ratings. NRSRO ratings are currently deeply embedded in the SEC rulebook. Today, NRSRO ratings are used to determine such matters as eligibility for Form S-3, the types of investments that a money-market fund can make, and whether or not a broker-dealer is adequately capitalized to conduct business. In July 2008, the SEC proposed to substantially eliminate references to NRSRO credit ratings in its rules and forms.  For example, rather than using an investment grade rating as a bright-line rule to determine the assets in which a money-market fund can invest, the fund’s board of directors would be tasked with making a determination about whether an asset “presents minimal credit risks.”  The subsequent intensifying of the credit crisis and the widely-publicized “breaking of the buck” by the Reserve Fund may have played a role in causing the SEC to rethink these proposals.

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If you have any questions about the matters covered in this newsflash, please contact any of the lawyers listed below or your regular Davis Polk contact:

Annette Nazareth*, Partner
212-450-4804 | annette.nazareth@dpw.com

Joseph Hall, Partner
212-450-4565 | joseph.hall@dpw.com

Margaret Tahyar, Partner
212-450-4379 | margaret.tahyar@dpw.com

Michael Kaplan, Partner
212-450-4111 | michael.kaplan@dpw.com


Davis Polk & Wardwell

*Admission pending in DC; practicing in DC under the supervision of partners of the firm.