SEC Proposes More Credit Rating Agency Paperwork

The SEC has proposed new rules for Credit Rating Agencies.

Chairman Schapiro introduced debate on the new NRSRO rules:

Specifically, the following six items related to NRSROs are being considered:

A recommendation to adopt rules to provide greater information concerning ratings histories — and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.

A recommendation to propose amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.

A recommendation to adopt amendments to the Commission’s rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.

A recommendation to reopen the comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.

A recommendation to require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any “preliminary ratings” were obtained from other rating agencies — in other words, whether there was “ratings shopping”

A recommendation to seek comment on whether we should amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

There was a statement from Commissioner Kathleen L. Casey:

Second, we must not become so obsessed with conflicts of interest to the point that it detracts from more important policy considerations. We are now at or beyond that point, or at least perilously close. Indeed, an obsessive and myopic focus on conflicts could become a sideshow that diverts our attention from more significant issues, the most important of which are enhanced access to information and the regulatory use of ratings.

If we truly believe that trying to mitigate or eliminate all conflicts, or potential conflicts, should be the overriding concern of our regulatory program, then why don’t we just skip the small stuff and adopt a rule banning the biggest conflict of all, the issuer-pays system of compensation? I am not recommending that we do so, by the way. That would result in a situation where the solution is worse than the problem.

Third — and this is related to the first two points about competition and conflicts of interest rules — before adopting still more regulations that are not market-based, the Commission needs to step back and take stock of all the new rules it has adopted over the past two years. The simple fact is that rating agencies are highly regulated today. That is not to say that they will always issue accurate ratings for investors. Government regulation could never deliver such results. And it does not mean that we can second-guess their rating judgments or seek to regulate their rating methodologies. The Rating Agency Act precludes the Commission from such actions, and properly so, in my view. But what it does mean is that we have adopted comprehensive regulations in many key areas. We should seek to establish regulatory certainty. At some point, we need to be able to see if the rules we have on the books are having their intended effect.

In many cases, particularly in structured finance, rating judgments are more art than science. We need to stop pretending that adopting more rules and regulations will lead to higher quality ratings. Some policymakers want to sanction rating agencies for inaccurate ratings. Absent fraud, that is the wrong approach.

My fourth point. I sincerely believe that exposing NRSROs, which are subject to the antifraud provisions of the securities laws, to additional, costly, and inefficient private litigation from class action lawyers will not serve to protect investors, it will not improve ratings quality, and it absolutely does not reflect in any way the explicit policy goals of Congress as reflected in the statute that we are charged with administering, the Rating Agency Act.

Last, but certainly not least, the issue of government-sanctioned ratings firms. The divisions of Trading and Markets and Investment Management are recommending that we adopt removal of NRSRO references from certain Exchange Act and Investment Company Act rules and forms. I support these recommendations, but as noted earlier, believe that the Commission needs to eliminate the government imprimatur given to certain debt analysts by removing NRSRO references in all of our rules. When we crafted those rules, I think it is fair to say that we did not intend to anoint certain firms with a government seal of approval.

A statement from Commissioner Troy A. Paredes:

rule amendments are before the Commission that would require NRSROs to disclose their ratings track records publicly and that would make information available so that NRSROs can rate structured products on an unsolicited basis.

Regarding track record disclosures, one concern has been the extent to which such disclosures could deprive NRSROs of revenues, in some instances challenging the commercial viability of certain NRSROs. This is a particular concern for the subscriber-pay model. To address this concern, the disclosures are to occur on a delayed basis.

In the future, it will be important for the Commission to monitor the overall impact of track record disclosures to ensure that competition is not inadvertently stiffled.

One proposal would require an NRSRO to disclose the percentage of its net revenue attributable to the 20 largest users of the NRSRO’s credit rating services. How useful is this information if, say, the percentage of an NRSRO’s net revenue attributable to the largest user is considerably more than the percentage attributable to the twentieth largest user of the NRSRO’s credit rating services? If the aggregate net revenue attributable to the 20 largest users is substantial, what should investors infer about the quality of particular ratings?

A second rule amendment would require NRSROs to disclose the relative standing of the person paying the NRSRO to issue a rating — namely, whether the person was in the top 10%, top 25%, top 50%, bottom 50%, or bottom 25% of contributors to the NRSRO’s revenues. Again, to what use will investors put this information? Might the disclosure leave a misimpression that a conflict exists if the NRSRO’s client is in a top tier, even if the client contributes a relatively small portion of the NRSRO’s total revenue? To what extent might the disclosure negatively impact smaller NRSROs if clients prefer to receive ratings from larger NRSROs to avoid being in a top revenue tier?

We also are considering a concept release that explores subjecting NRSROs to section 11 of the Securities Act. I look forward to the considerable comment I expect we will receive. For now, I will simply note that while subjecting NRSROs to section 11 may lead to more legal accountability, it may result in less competition if certain NRSROs are unable to bear the resulting risk of liability. Competition itself is a source of investor protection that may be lost if the risk of legal liability increases. We need to consider this and other tradeoffs in evaluating the proper liability regime for the credit rating industry.

Better disclosure of past performance is always a good thing, but why stop there? Any advisor with discretionary authority over client money should provide composites to his regulator and have these published by the regulator as part of his on-line registration review package. That will do more to protect investors than any fiddling with the CRAs.

The rule on sharing data is a step in the right direction, but only a step. CRAs are entitled to use material non-public information in the course of their business, a fact which makes second-guessing them a risky business. Strike down the Regulation FD Exemption!

One Response to “SEC Proposes More Credit Rating Agency Paperwork”

  1. […] will know what this rule is; those who are not sufficiently assiduous may wish to refer to the PrefBlog post reporting the concept release, with additional commentary on October 7. Basically, the proposed rule change […]

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