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July 8, 2011
Credit Rating Agencies SEC Proposes a Broad Range of Amendments to Implement Dodd-Frank Act Provisions
SUMMARY
The SEC has proposed a number of rules with respect to its oversight of registered credit rating agencies
(nationally recognized statistical rating organizations, or “NRSROs”) to implement certain provisions of
Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).
While most of the requirements contemplated by these proposals would apply directly to NRSROs,
certain requirements would apply to issuers and underwriters of rated asset-backed securities who use
third-party due diligence services, and other requirements would apply to the providers of those services.
The SEC’s proposals address, among other things:
disclosures made by NRSROs, including disclosures required for each credit rating action, disclosures regarding ratings performance and the use of rating symbols, and the electronic submission of certain forms and reports on EDGAR;
disclosures required of issuers and underwriters of rated asset-backed securities who use third-party due diligence services, and certifications required from the providers of such services;
the separation of NRSRO sales and marketing activities from rating activities;
NRSRO “look-back” review and disclosure requirements;
an expansion of the SEC’s enforcement powers with respect to NRSROs;
the consistent use and disclosure of appropriate rating methodologies by NRSROs;
standards of training, experience and competence for NRSRO rating analysts; and
NRSRO internal control structures.
Comments on the SEC’s proposals are due by August 8, 2011.
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I. NRSRO DISCLOSURE REQUIREMENTS
The proposed rules would require an NRSRO to publish a number of disclosures with each credit rating
action, revise certain disclosures regarding the performance of its credit ratings and rating histories,
disclose and consistently apply its credit rating symbols, and submit certain forms and reports to the SEC
electronically on the EDGAR system.
A. FORM AND CERTIFICATIONS TO ACCOMPANY CREDIT RATINGS
New Section 15E(s) of the Exchange Act, as added by the Dodd-Frank Act, requires the SEC to prescribe
rules requiring an NRSRO to make certain disclosures with the publication of each credit rating. To
implement this requirement, the SEC has proposed to amend paragraph (a) of Rule 17g-7 to require an
NRSRO to publish with each “rating action”: (i) a form containing specified information about the rating
action, and (ii) if the rating action relates to an asset-backed security, any certification relating to the
rating provided to the NRSRO by a third-party due diligence provider1. The term “rating action” is defined
broadly to include the publication of an expected or preliminary credit rating; an initial credit rating; an
upgrade, downgrade, affirmation or withdrawal of a rating; or the placement of an existing rating on credit
watch or review.2
The SEC has requested comment on all aspects of this general approach, including whether multiple
rating actions related to the same entity should trigger multiple publication requirements, how disclosures
should be disseminated, and how the “preliminary credit rating” trigger can be practically implemented. In
addition, with respect to rating actions for asset-backed securities issued in a registered shelf offering, the
SEC has requested comment on whether the deadline for disclosures should be no later than the
deadline for filing the preliminary prospectus proposed separately under Rule 424(h), which would be at
least five business days prior to the first sale in the offering.3
1 The statutory text of Section 15E(s)(4)(B)-(C) does not specify that this certification requirement is
limited to asset-backed securities; however, Section 15E(s)(4) is titled “Due diligence services for asset-backed securities,” and the SEC has interpreted the certification requirement to apply only to those securities. See Proposed Rule, Nationally Recognized Statistical Rating Organizations (“Release”), Exchange Act Release No. 64514 (May 18, 2011), 76 FR 33420, 33465 (June 8, 2011).
2 For these purposes, a “preliminary rating” would include any credit rating, range of ratings, or other indications of a credit rating published prior to the assignment of an initial credit rating for a new issuance. In particular, the proposing release notes that the definition of “credit rating” is designed to cover pre-sale reports typically issued by an NRSRO at the commencement of an offering of an asset-backed security. Such reports often include an expected or preliminary rating and a summary of transaction highlights.
3 Proposed Rule 424(h) would require an issuer of registered asset-backed securities using a shelf registration statement on proposed Form SF-3 to file a preliminary prospectus containing transaction-specific information at least five business days prior to the first sale of securities in the offering. See Asset-Backed Securities, Securities Act Release No. 9117 (April 7, 2010), 75 FR 23328 (May 3, 2010).
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1. Format of the Form
Section 15E(s)(2) of the Exchange Act requires that the disclosure form be in a format that (i) is easy to
use and helpful for users of credit ratings, (ii) presents any quantitative content in a manner that facilitates
direct comparison across types of securities, and (iii) is readily available in a medium determined by the
SEC. Proposed Rule 17g-7(a) largely mirrors the statutory requirements of the first two clauses and
would require an NRSRO to make the form and certification available in the same medium as the
applicable credit rating and to the same persons who can receive or access the rating. The SEC has
requested comment on whether it should provide additional guidance on the form’s format (for example,
to make the form more easily comparable across NRSROs).
2. Content of the Form
Section 15E(s)(3) of the Exchange Act specifies extensive qualitative and quantitative content for the
disclosure form to accompany each rating action. Proposed Rule 17g-7(a)(1)(ii) largely mirrors these
statutory requirements and would require the form to include:
the symbol, number, or score that the NRSRO uses to denote the credit rating categories and notches within categories;
the identity of the obligor, security or money market instrument that is the subject of the rating action, in a manner that clearly notifies users of the form;
the version of the procedure or methodology used to determine the credit rating;
the main assumptions and principles used in constructing procedures and methodologies, including qualitative methodologies, quantitative inputs, and (for structured finance products) assumptions about the correlation of defaults across underlying assets;
potential limitations of the credit rating and risks excluded from the credit rating that the NRSRO does not comment on, including liquidity, market, and other risks;
information on the uncertainty of the credit rating, including information on the reliability, accuracy, and quality of data relied upon to determine the rating, and a statement disclosing the extent to which data essential to the credit rating determination was reliable or limited (for example, any limits on the scope of historical data or accessibility to certain deal documents);
whether and the extent to which the NRSRO used third-party due diligence services, as well as a description of the information reviewed by the third party and of its ultimate findings or conclusions;4
a description of how the NRSRO used servicer or remittance reports, if at all;
a description of the data about any obligor, issuer, security, or money market instrument that was relied upon for the rating;
4 The SEC preliminarily believes that this disclosure also would include (among other things) a
description of how the NRSRO used the findings or conclusions of any third-party diligence report made publicly available by an issuer or underwriter of an asset-backed security pursuant to the requirements of Section 15E(s)(4)(A) of the Exchange Act, discussed in Section II.A of this memorandum.
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an overall assessment of the quality of information available and considered in producing a rating for an obligor, issuer, security or money market instrument, in relation to the quality of information available when rating similar entities;
disclosures related to conflicts of interest, including: (i) whether the rating was unsolicited (e.g., subscriber-paid), solicited sell-side (e.g., issuer-paid) or solicited buy-side (e.g., investor-paid); (ii) for a solicited rating, whether the NRSRO provided non-rating services to the person that paid for the rating during the most recent fiscal year; and (iii) whether the rating action resulted from a look-back review;5
an explanation or measure of the potential volatility of the rating, including factors that might lead to a change in the rating, and the expected magnitude of changes under different market conditions;
information on the content of the rating, including the historical performance of the rating (if applicable) and the expected probability of default and loss given default;
information about the sensitivity of the rating to assumptions made by the NRSRO, including the five assumptions that would have the greatest impact on the rating if proven false or inaccurate, as well as an example-driven analysis of how each of these assumptions impacts the rating; and
for ratings of asset-backed securities, a description of the representations, warranties, and enforcement mechanisms available to investors and how they differ from those in similar securities.6
The SEC has requested comment on these proposed disclosure requirements, with emphasis on the
clarity and usefulness of the requirements. Among other things, the SEC also has requested input on
whether certain requirements (e.g., the requirement to disclose certain assumptions underlying the rating)
would require the disclosure of proprietary information, and whether the conflict-related disclosure
requirements are appropriate.
3. Attestation Requirement
Pursuant to Section 15E(q)(2)(F) of the Exchange Act, the SEC must require an NRSRO to provide an
attestation “with any credit rating it issues” affirming that no other business activities influenced the rating,
the rating is based solely on the merits of the instrument being rated, and the rating rests solely on an
independent evaluation of the risks and merits of the instrument. The SEC has proposed to require an
NRSRO to attach the attestation to the disclosure form accompanying each “rating action,” which includes
(among other things) the issuance of a preliminary rating, as described above. The attestation must be
signed by a person within the NRSRO with responsibility for the rating. The SEC has requested comment
on this attestation requirement, including who may qualify to make the attestation and whether the
attestation alternatively may be implemented in the proposed provisions requiring disclosure of the
performance of an NRSRO’s credit ratings (discussed in Section I.B of this memorandum).
5 Although the statute does not provide details on the types of conflict-related disclosures that the SEC
must require in the form, the SEC has proposed these three disclosure elements. For a more detailed discussion of the look-back review disclosure requirements, see Section III.B of this memorandum.
6 This requirement is carried over from the current disclosure requirement in Rule 17g-7.
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4. Certification of Third-Party Due Diligence Providers for Asset-Backed Securities
As described in Section II.B of this memorandum, Section 15E(s)(4)(B) of the Exchange Act requires a
third party that provides due diligence services to an NRSRO, issuer or underwriter to provide a written
certification to any NRSRO that renders a credit rating to which those due diligence services relate. In
turn, Section 15E(s)(4)(D) compels the SEC to require an NRSRO that receives such a certification to
disclose it to the public. To implement this requirement, new paragraph (a)(2) of Rule 17g-7 would
require an NRSRO to disclose with each rating action any such certification it has received.
B. PUBLIC DISCLOSURES REGARDING THE PERFORMANCE OF CREDIT RATINGS AND RATING HISTORIES
New Section 15E(q) of the Exchange Act, as added by the Dodd-Frank Act, requires the SEC to prescribe
rules requiring an NRSRO to publicly disclose information on initial credit ratings and subsequent
changes to those ratings, so that users of credit ratings may evaluate their accuracy and compare
performance across NRSROs. To implement this statutory provision, the SEC has proposed to revise the
disclosures currently required of an NRSRO with respect to performance statistics and rating histories.
1. Disclosures of Performance Measurement Statistics
The instructions to Exhibit 1 to Form NRSRO currently require an NRSRO to provide performance
measurement statistics with respect to each class of credit ratings for which it is registered.7 At a
minimum, these statistics must show the performance of ratings in each class over 1-year, 3-year, and
10-year periods, including historical ratings transition and default rates within each rating category. The
SEC notes that since the current instructions do not prescribe the methodology for calculating and
presenting these statistics and do not limit the information that may be published, disclosures in response
to this requirement have varied widely among NRSROs.
To make these disclosures of performance statistics more consistent across NRSROs, facilitate
comparisons, and implement Section 15E(q) of the Exchange Act, the SEC has proposed a revised set of
requirements that are more prescriptive and limiting with respect to the information that may be disclosed
on Exhibit 1.8 Under proposed amendments to Rule 17g-1(f), these statistics must be updated yearly with
the NRSRO’s annual certification of Form NRSRO and must be made publicly and freely available (i) on
an easily accessible portion of the NRSRO’s website and (ii) in writing upon request.
7 These requirements also apply to persons seeking to apply for NRSRO registration. 8 An NRSRO would be free to include in Exhibit 1 a website address at which additional performance
measurement statistics may be obtained. The proposed rules would not limit the amount or types of such statistics that an NRSRO may disclose on its website.
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Specifically, for each class and subclass9 of credit ratings, an NRSRO would be required to publish
matrices disclosing rating transition and default rates over the prior 1-year, 3-year and 10-year periods, as
shown in the example below from the proposing release:
The cohort used for each matrix would consist of all obligors, securities and money market instruments
that were assigned a credit rating that was outstanding as of the start date for the applicable time period
(i.e., the date 1, 3, or 10 years prior to the most recently ended calendar year). For each credit rating
category or notch used by the NRSRO, the matrix would show the ratings distribution as of the period end
date for the obligors, securities and money market instruments that were assigned a rating at that
particular category or notch as of the period start date. The matrix would also show the percentage of
ratings initially assigned a rating at each category or notch that were in “default,” “paid off,” or “withdrawn
[for other reasons]” as of the period end date.
“Default.” For these purposes, an obligor, security or money market instrument would be classified in
the “default” category if, at any time during the applicable time period (and regardless of whether the
NRSRO later withdrew the rating), (i) the obligor or issuer failed to timely pay principal or interest due
according to the terms of the obligation, security or instrument, or (ii) the NRSRO otherwise classified the
obligor, security or money market instrument as having gone into default using its own (broader)
definition.10
“Paid Off.” A security or money market instrument would be classified as “paid off” if (i) the issuer
extinguished its obligation during the applicable time period by paying in full all outstanding principal and
9 In contrast with the current instructions to Form NRSRO, the SEC has proposed to divide the class of
credit ratings representing structured finance products into separate subclasses for residential mortgage-backed securities, commercial mortgage-backed securities, collateralized loan obligations, collateralized debt obligations, issuances of asset-backed commercial paper conduits, other asset-backed securities, and other structured finance products. A separate matrix would be required for each subclass.
10 The SEC preliminarily believes that the first prong of the definition of “default” would apply to most cases commonly understood as a default, and that a classification of default under the second prong would be rare.
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interest due (e.g., because the security or money market instrument matured, was called, or was
prepaid), and (ii) the NRSRO withdrew the credit rating because the obligation was extinguished.
An obligor would be classified as “paid off” if the same two criteria were met and the relevant rating was
assigned with respect to a single specifically-identified obligation of the obligor (e.g., the rating must not
relate to the obligor’s overall ability to meet any obligations as they come due).
“Withdrawn (other).” A rating would be classified in the “withdrawn (other)” category if it was withdrawn
by the NRSRO during the applicable time period for reasons other than those specified in the definitions
of “default” or “paid off.” For example, this might occur if the issuer stopped paying for the surveillance of
a rating or because the NRSRO decided to reallocate resources devoted to monitoring an unsolicited
rating.
The SEC has requested comment on all aspects of these proposed disclosure requirements, including
whether the single cohort approach is appropriate, whether the proposals would have an impact on
competition (for example, by causing certain NRSROs to stop determining a particular type of rating),
whether the proposed subclasses of structured finance products are appropriate, and whether the
definitions of “default,” “paid off” and “withdrawn (other)” should be modified (including, for example,
whether the definition of “default” should include cross-defaults or distinguish between degrees of
severity).
2. Disclosures of Rating Histories
Currently, Rule 17g-2 requires an NRSRO to disclose complete rating histories (dating back to the initial
credit rating and including all subsequent rating actions) for 10% of outstanding issuer-paid credit ratings,
selected on a random basis, in each class for which the NRSRO has 500 or more such issuer-paid
ratings (the “10% Rule”). A rating action subject to this requirement must be publicly disclosed no later
than 6 months after the date the action was taken.
Separately, Rule 17g-2 requires an NRSRO to disclose complete rating histories for all credit ratings
initially determined by the NRSRO after June 26, 2007 (the “100% Rule”). If such a rating is issuer-paid,
the disclosure may be made up to 12 months after the date the action was taken; for all non-issuer paid
ratings, this grace period is 24 months.
In order to enhance the usefulness of rating history disclosures, the SEC has proposed to expand the
scope of ratings that would be subject to the 100% Rule. In light of its disclosure-related proposals, the
SEC also has proposed to repeal the 10% Rule.
Specifically, the 100% Rule would be modified (through new paragraph (b) of Rule 17g-7) to require an
NRSRO to disclose complete rating histories for all credit ratings that were outstanding (rather than
initially determined) as of June 26, 2007, provided that these rating histories would not need to include
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information about rating actions taken before that date. For each such credit rating, the NRSRO would be
required to disclose the credit rating assigned to the obligor, security or money market instrument as of
June 26, 2007, as well as any subsequent rating action taken. In each case, the disclosure of the June
26, 2007 rating and each subsequent rating action must include, in XBRL format:
the identity of the NRSRO disclosing the rating action;
the date of the rating action;
the CIK number and legal name of the obligor or issuer;
the CUSIP (with respect to a security or money market instrument);
a classification of the type of rating action as: (i) a rating outstanding as of June 26, 2007, (ii) an initial credit rating, (iii) an upgrade, (iv) a downgrade (including to default status), (v) placement of the rating on credit watch or review; (vi) an affirmation of an existing rating; or (vii) a withdrawal of an existing rating;11
the relevant class or subclass of the credit rating (e.g., corporate issuers or insurance companies, or various subclasses of structured finance products); and
the credit rating symbol, number or score resulting from the rating action.
The 12-month and 24-month grace periods for issuer-paid and non-issuer paid ratings, respectively,
would continue to apply under the revised 100% Rule. In addition, the revised rule would provide that an
NRSRO may cease disclosing a rating history no earlier than 20 years after the date the rating is
withdrawn, provided that no subsequent ratings are assigned to the obligor, security or money market
instrument after the withdrawal classification.
The SEC has requested comment on all aspects of these proposals, including whether the 10% Rule
should be retained, whether the 12-month and 24-month grace periods are appropriate, and whether the
proposals raise practical issues (including, for example, with respect to classifying ratings into separate
classes and subclasses).
C. UNIVERSAL RATING SYMBOLS
Largely mirroring the statutory requirements of Section 938(a) of the Dodd-Frank Act, paragraph (b) of
new Rule 17g-8 would require an NRSRO to implement policies and procedures reasonably designed to:
assess the probability that an issuer will default or otherwise fail to make payment in accordance with the terms of the security or money market instrument;
clearly define each symbol, number or score used to denote a credit rating category and notches within a category, and include such definitions in Exhibit 1 of Form NRSRO so that investors have clear access to them; and
apply any credit rating symbol, number or score consistently for all types of obligors, securities and money market instruments for which it is used.
11 With respect to a withdrawal, the disclosure also must include whether the rating was withdrawn
because (1) a default occurred, (2) the rated obligation was extinguished by payment in full according to its terms, or (3) another reason.
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Proposed new paragraph (b)(14) to Rule 17g-2 would subject these policies and procedures to that rule’s
recordkeeping requirements. In accordance with those requirements, the NRSRO must retain
documentation for three years, make documentation easily accessible to its principal office, follow specific
requirements when using a third-party records custodian, and furnish the SEC promptly with legible,
complete, and current copies of records (in English if requested).12
D. WEBSITE DISCLOSURE OF FORM NRSRO
Rule 17g-1(i) currently requires an NRSRO to make its current Form NRSRO and certain exhibits publicly
available on its website or through another comparable, readily accessible means. Proposed
amendments to this rule and form would instead require an NRSRO to make these documents “publicly
freely available on an easily accessible portion” of its website in all cases, removing the option to make
them available through alternative means. The SEC preliminarily believes that Form NRSRO would be
on an “easily accessible” portion of a website if it could be accessed through a clearly and prominently
labeled hyperlink to the form on the NRSRO’s home page.13
E. ELECTRONIC SUBMISSION OF FORM NRSRO AND RULE 17G-3 ANNUAL REPORTS
The SEC has proposed to amend Rule 17g-1, Rule 17g-3, Regulation S-T, and the instructions to Form
NRSRO to require an NRSRO to file or furnish electronically on the EDGAR system: (i) Form NRSRO
and Exhibits 1-9 thereto, if the submission is an update of registration, annual certification, or withdrawal
from registration, and (ii) the annual reports required by Rule 17g-3.14 An NRSRO would continue to
submit in paper format a Form NRSRO required as part of an initial application for registration, an
application to register for an additional class of credit ratings, or a withdrawal of an initial application. The
stated purpose of these amendments is to facilitate the rapid dissemination of financial and business
information contained in SEC filings to investors and other users of ratings, and to increase efficiency in
the filing process. The SEC has emphasized that, as in the past, annual reports filed pursuant to Rule
17g-3 would not be made public.
12 The SEC’s proposed amendments to Rule 17g-2 also would extend these recordkeeping
requirements to certain substantive policies, procedures and documentation required by other parts of this rulemaking and discussed in this memorandum. These include policies and procedures related to rating methodologies; credit analyst standards for training, experience and competence; “look-back” reviews for potential conflicts of interest; and the NRSRO’s internal control structure.
13 The SEC notes that all NRSROs currently make their Form NRSROs available on their websites. 14 The reports that must be filed with the SEC pursuant to Rule 17g-3 require information on revenues
from rating services and other sources; the compensation of credit analysts; certain large users of the NRSRO’s rating services; credit rating actions taken during the year; and the NRSRO’s internal control structure. These required reports also include certain financial statements and the annual report of the NRSRO’s designated compliance officer.
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II. THIRD-PARTY DUE DILIGENCE SERVICES FOR ASSET-BACKED SECURITIES15
New Section 15E(s)(4) of the Exchange Act, as added by the Dodd-Frank Act, establishes certain public
disclosure requirements for issuers and underwriters of asset-backed securities who obtain third-party
due diligence reports. In addition, Section 15E(s)(4) requires certain third-party due diligence providers to
provide an SEC-prescribed certification to any NRSRO that produces a rating to which those services
relate, and it provides for the public disclosure of those certifications by NRSROs.
The SEC has proposed to implement these requirements through various amendments to Rule 314 of
Regulation S-T, Form ABS-15G and Rule 17g-7, and by proposing new Rules 15Ga-2 and 17g-10 and
new Form ABS-Due Diligence 15E.
As described below, the SEC has requested comments on all aspects of its proposals, but it has posed
two primary questions for general comment. First, how will a provider of third-party due diligence services
know the identities of the NRSROs that produce credit ratings to which the third party’s services relate?
The SEC suggests resolving this through a lenient reasonableness standard or through a centralized
database to which an NRSRO or a third party could provide notice of its credit rating or certification,
respectively. Second, when must a certification be provided to an NRSRO by a third party, and should
the requirement sunset?
A. PUBLIC DISCLOSURES REQUIRED OF CERTAIN ISSUERS AND UNDERWRITERS OF RATED ASSET-BACKED SECURITIES
Subject to a potentially significant exemption, proposed Rule 15Ga-2 would require the issuer or
underwriter of a registered or unregistered16 offering of an asset-backed security that is to be rated by an
NRSRO to disclose on Form ABS-15G the findings and conclusions of any third-party due diligence
report it has obtained.17 The form must be furnished18 through EDGAR19 at least five business days prior
15 For purposes of the statutory provisions and proposed rules discussed in this section, the definition
used for the term “asset-backed security” is the definition provided at Section 3(a)(77) of the Exchange Act.
16 The SEC is taking the view that issuers and underwriters of unregistered offerings of asset-backed securities may disclose the information required by Rule 15Ga-2 without jeopardizing reliance on the private offering exemptions and safe harbors under the Securities Act, provided that the information disclosed is limited to that required by the proposed rule, and the issuer does not otherwise use Form ABS-15G to offer or sell securities in a manner that conditions the market. See Release, 76 FR at 33469.
17 Section 15E(s)(4)(A) of the Exchange Act, which this proposed rule implements, requires an issuer or underwriter of an asset-backed security to make publicly available the findings and conclusions of any third-party due diligence report it obtains. The SEC believes that this requirement should be interpreted narrowly in the context of the other provisions of Section 15E(s)(4), such that it should apply only to an asset-backed security that is to be rated by an NRSRO.
18 Information that is “furnished” to the SEC is not subject to the liability provisions of Section 18 of the Exchange Act. See Section III.D of this memorandum.
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to the first sale in the offering, and it must be signed by the senior officer in charge of securitization of the
depositor (if furnished by the issuer) or a duly authorized officer (if furnished by the underwriter).20
In the proposing release, the SEC notes that an NRSRO separately would be required to disclose in the
form accompanying a rating action (discussed in Section I.A of this memorandum) whether and to what
extent it used third-party due diligence services, a description of the information reviewed by the third-
party provider, and a description of the findings or conclusions of the third-party provider. To eliminate
redundant disclosures, the SEC has proposed to exempt the issuer or underwriter from furnishing Form
ABS-15G if it obtains a representation from an NRSRO21 that can be reasonably relied upon that the
disclosures required by Rule 15Ga-2 will be publicly disclosed22 by the NRSRO five business days prior to
the first sale in the offering.23 Notwithstanding an issuer’s or underwriter’s reasonable reliance on such
an assurance, if an NRSRO fails to make public the required information five business days prior to the
first sale in the offering, the issuer or underwriter would be required to furnish Form ABS-15G at least two
business days prior to the first sale. Thus, under the proposal, issuers and underwriters might still need
to monitor the compliance of the NRSRO with Rule 15Ga-2.
The SEC notes that an issuer of a registered asset-backed security separately may engage third parties
to assist in conducting the review of pool assets required by Securities Act Rule 193. The utilization of
third-party reports in such circumstances would not necessarily trigger the disclosure requirements of
Rule 15Ga-2. Similarly, and contrary to an earlier proposal by the SEC, an issuer of a registered asset-
backed security would not necessarily be required to disclose the information required by Rule 15Ga-2 in
19 A municipal entity that sponsors or issues an asset-backed security, or an underwriter of such an
offering, could instead furnish the information required by Form ABS-15G through the Electronic Municipal Market Access (“EMMA”) system, pursuant to a proposed amendment to Rule 314 of Regulation S-T.
20 This proposal represents a modification to an earlier proposal by the SEC to implement Section 15E(s)(4)(A) as part of a larger rulemaking initiative to implement Section 945 of the Dodd-Frank Act. See Issuer Review of Assets in Offerings of Asset-Backed Securities, Securities Act Release No. 9150 (Oct. 13, 2010), 75 FR 64182 (Oct. 19, 2010).
21 The text of proposed Rule 15Ga-2 only requires this representation to be received from “a [NRSRO];” however, the SEC’s proposing release describes this provision as requiring a representation from “each NRSRO engaged to produce a credit rating for the [asset-backed security]” (emphasis added). See Release, 76 FR at 33467.
22 The SEC preliminarily interprets the term “publicly disclose” to require the NRSRO to make the findings and conclusions readily available to any users of credit ratings, not merely to the NRSRO’s subscribers or prospective investors in the security. See Release, 76 FR at 33468, n. 534.
23 According to the proposing release, whether reliance on the NRSRO’s representation is reasonable would depend on the facts and circumstances, including whether there are ongoing or prior failures by the NRSRO to adhere to its representations, or whether there is a pattern of conduct by the NRSRO where it fails to promptly correct breaches of its representations. In addition, the issuer or underwriter would be required to provide to the SEC, upon request, information regarding the manner in which it obtained the representation.
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its prospectus, unless the third party’s findings are part of the Rule 193 review and disclosure separately
is required by that rule and Item 1111 of Regulation AB.
The SEC has requested comment on all aspects of the proposed rule and form. Among other specific
issues for comment, the SEC seeks input on:
whether Rule 15Ga-2 should apply to both registered and unregistered offerings;
whether the rule should apply only if an asset-backed security is to be rated by an NRSRO;
whether the exemption relating to an issuer’s or underwriter’s reasonable reliance on an NRSRO’s representation is appropriate;
whether more effective alternatives exist for making third-party due diligence reports publicly available;
whether issuers of registered offerings should be required to furnish the information required by Rule 15Ga-2 on Form ABS-15G and not in a prospectus; and
whether certain issuers or underwriters (e.g., issuers or underwriters of “exempted securities” as defined in Section 3(a)(12) of the Exchange Act, including government securities and municipal securities) or other parties should be exempt altogether.
B. CERTIFICATIONS FROM THIRD-PARTY PROVIDERS OF DUE DILIGENCE SERVICES
New Section 15E(s)(4)(B) of the Exchange Act, as added by the Dodd-Frank Act, requires a third-party
provider of “due diligence services” that is hired by an NRSRO, issuer24 or underwriter to provide a written
certification to any NRSRO that produces a rating to which those services relate. Proposed new Rule
17g-10 would provide a definition of “due diligence services” for purposes of triggering this requirement,
and proposed new Form ABS Due Diligence-15E would prescribe the contents of the required
certification.
1. Trigger for Certifications Required from Third-Party Providers of Due Diligence Services – Proposed New Rule 17g-10
Rule 17g-10 would define “due diligence services” to mean a review of the assets underlying an asset-
backed security for the purpose of making findings with respect to:
the quality or integrity of the information or data about the assets provided, directly or indirectly, by the securitizer or originator25 (for example, the proposing release notes that this may include comparing data in an electronic “loan tape” database with the data in the
24 In implementing the statute, the SEC has interpreted the term “issuer” to include a “sponsor” or
“depositor,” each as defined at 17 C.F.R. § 229.1101, that participates in the issuance of an asset-backed security. See proposed Rule 17g-10(c)(2).
25 The terms “securitizer” and “originator” would have the meanings ascribed to them in Section 15G(a) of the Exchange Act, which was added by the Dodd-Frank Act. Specifically, a “securitizer” would be defined as “(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.” An “originator” would be defined as “a person who (A) through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security; and (B) sells an asset directly or indirectly to a securitizer.”
-13- Credit Rating Agencies July 8, 2011
underlying hard-copy loan documentation for accuracy, or verifying that the loan tape contains all the information required by the NRSRO to determine a rating);
whether the origination of the assets conformed to stated underwriting or credit extension standards (for example, this may include reviewing whether a sampled loan meets the originator’s underwriting guidelines, or how the originator verified information such as income or employment status);
the value of collateral securing the assets (for example, this may include analyzing how the originator verified asset values and analyzing the quality of any appraisers and appraisals used);
whether the originator complied with federal, state or local laws or regulations (for example, this may include analyzing a sampled loan file to verify that the loan was made in conformance with truth-in-lending regulations); or
any other factor material to the likelihood that the issuer will pay interest and principal according to the stated terms and conditions.
Although the final catch-all component of the definition of “due diligence services” appears broad, the
SEC notes in the proposing release that the definition should not cover asset reviews designed to
generate findings that would not be relevant to determining a credit rating. The SEC believes that the
scope of the statutory certification requirement is intended only to address third-party diligence reports
obtained from specialized providers of due diligence services that are relevant to the determination of a
credit rating by an NRSRO for an asset-backed security; consequently, the proposed definition is not
intended to cover “every type of person that might perform some type of diligence in the offering process.”
The SEC has requested comment on proposed new Rule 17g-10, including with respect to the five-part
definition of “due diligence services;” whether the rule should apply to other structured finance products in
addition to asset-backed securities; and whether the definitions of “issuer,” “originator,” and “securitizer”
identify the types of entities that should trigger the rule’s requirements.
2. Form for Certifications Required from Third-Party Providers of Due Diligence Services – Proposed Form ABS Due Diligence-15E
As noted above, the certification required by a third-party provider of due diligence services would be
submitted to an NRSRO on proposed Form ABS Due Diligence-15E. This form, which would in turn be
disclosed by the NRSRO in the form accompanying the relevant rating action, contains the following five
items:
the identity and address of the provider of the due diligence services;
the identity and address of the issuer, underwriter or NRSRO that paid for the due diligence services;
if the services provided by the third party satisfied specific due diligence criteria published by an NRSRO, the identity of each such NRSRO and the title and date of the published criteria;
a description of the scope and manner of the review sufficiently detailed to convey an understanding of the individual steps taken in performing due diligence (including, for example, a description of the types and sample sizes of assets reviewed and the specific types of reviews conducted); and
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a summary of the findings and conclusions sufficiently detailed to convey an understanding of what was provided to the hiring issuer, underwriter or NRSRO.
In addition, the individual executing the form would be required to represent that: (i) he or she has
executed the form on behalf of, and on the authority of, the third party, (ii) the third party conducted a
thorough review in performing the due diligence described on the form, and (iii) the form is accurate in all
significant respects.
The SEC has requested comment on all aspects of Form ABS Due Diligence-15E. In particular, the SEC
has asked whether the form should be more prescriptive with respect to the steps that a third party must
take in providing due diligence services (for example, whether the form should specify minimum sample
sizes), and whether the form would provide useful information for NRSROs, investors, and other users of
credit ratings.
III. AMENDMENTS TO NRSRO CONFLICT OF INTEREST AND ENFORCEMENT PROVISIONS
The SEC’s proposals would create a prohibited conflict of interest with respect to sales and marketing
considerations influencing the rating process, and they would require an NRSRO to conduct a “look-back”
in certain cases if a rating employee becomes employed by a rated entity or an issuer, underwriter, or
sponsor of a rated security. In addition, the proposals implement statutory provisions for suspending or
revoking an NRSRO’s registration and for deeming certain reports to be “filed” with the SEC, rather than
“furnished.” The SEC has deferred implementing additional penalty provisions at this time.
A. PROPOSED NEW PROHIBITED SALES AND MARKETING CONFLICT
New Section 15E(h)(3) of the Exchange Act, as added by the Dodd-Frank Act, requires the SEC to
prescribe rules to prevent sales and marketing considerations from influencing the credit ratings of an
NRSRO, with exceptions for small NRSROs as the SEC determines appropriate. To implement this
requirement, new paragraph (c)(8) of Rule 17g-5 would prohibit an NRSRO from issuing or maintaining a
rating if a person within the NRSRO who participates in the sales and marketing of a service or product of
the NRSRO (or of an affiliate) also participates in either the determination or monitoring of a credit rating
or the development or approval of procedures to determine the credit rating, including qualitative or
quantitative models.26 The stated purpose of this rule is to insulate employees responsible for the
analytic functions of an NRSRO from sales and marketing concerns.
The SEC has requested comment on several issues, including whether it should provide guidance on (i)
the definition of “sales and marketing” activities, (ii) what it means to “participate” in sales and marketing
26 Rule 17g-5 contains two broad categories of conflicts. Certain conflicts are permissible as long as
they are appropriately disclosed and managed, such as being paid by an issuer to determine a credit rating. Other conflicts, including this proposed conflict related to sales and marketing, are prohibited entirely.
-15- Credit Rating Agencies July 8, 2011
activities, and (iii) what it means to “participate in developing or approving procedures and methodologies
used for determining credit ratings.” In addition, the SEC has requested comment on how the proposal
would impact existing governance structures, reporting lines and internal organizations of NRSROs, and
whether there are certain sales and marketing activities that should be exempt from the prohibition.
Exemption for Small NRSROs. The new conflict prohibition would provide for an exemption or
conditional exemption for a small NRSRO if, upon application, the SEC finds that the small size of the
NRSRO would make it inappropriate to require the separation of sales and marketing activities from rating
activities, and that the exemption is in the public interest. The SEC preliminarily believes that the rule’s
prohibition would apply to all NRSROs, but it notes that certain NRSROs may not have the resources or
staff to fully effect the required separation. In granting any relief from the prohibition, the SEC may
impose conditions designed to preserve as much of the separation as possible.
The SEC has requested comment on how it should implement this exemption, including how it should
determine which NRSROs are “small” NRSROs, which factors it should consider in granting an exemption
(including whether the exemption should be automatic in certain cases), and whether the exemption
should be conditional in all or certain cases.
B. “LOOK-BACK” REVIEW REQUIREMENTS
New Section 15E(h)(4) of the Exchange Act, as added by the Dodd-Frank Act, requires an NRSRO to
implement policies and procedures for conducting a “look-back” review of conflicts of interest in respect of
any case in which an employee of a person subject to an NRSRO credit rating, or of any issuer,
underwriter or sponsor of a rated security or money market instrument, was employed by the NRSRO and
participated in determining the relevant credit rating during the one-year period prior to a rating action.
Section 15E(h)(4) further requires the SEC to prescribe rules requiring an NRSRO to revise a rating, if
appropriate, after such a look-back review.
To implement this requirement, paragraph (c) of new Rule 17g-8 would require an NRSRO to have
policies and procedures reasonably designed to ensure that the NRSRO does the following three things
in the event that a look-back review indicates that a conflict of interest influenced a credit rating:27
Placement of the Rating on Credit Watch. First, the NRSRO must place the rating on credit
watch “immediately” upon discovering that the rating was influenced by a conflict, even if the
NRSRO is in the process of determining whether other ratings were influenced as well. The
27 These policies and procedures would be subject to the general recordkeeping requirements of Rule
17g-2.
-16- Credit Rating Agencies July 8, 2011
disclosure form accompanying the credit watch rating action must indicate that the rating had
been placed on credit watch because it was influenced by a conflict of interest.28
Reassessment of the Rating. Second, the NRSRO must promptly determine whether it should
revise the rating to ensure that the rating is no longer influenced by the conflict. The SEC
preliminarily believes that one way for an NRSRO to make this determination would be to apply
its rating procedures and methodologies de novo to the rated obligor, security or money market
instrument and revise the current rating if the de novo application produces a different result.
Revision or Affirmation of the Rating. Third, based on this determination, the NRSRO must
either revise or affirm the rating in a new rating action. In the case of a revised rating, the
accompanying disclosure form must explain that the rating is being revised because prior rating
actions were influenced by a conflict of interest; similarly, in the case of an affirmation, the
disclosure form must explain why no rating action is being taken notwithstanding the conflict. In
either case, the disclosure form must also provide the date and rating of each prior rating action
influenced by the conflict, and an estimate of the impact the conflict had on each such prior
action. The SEC preliminarily believes that one way for the NRSRO to estimate this impact would
be to reconstruct each such prior rating action through a “conflict-free” application of its rating
procedures and methodologies, and then disclose the difference between that reconstructed
rating action and the rating action actually taken.
The SEC has requested comment on all aspects of these proposals, including how they would impact an
obligor or issuer subject to a credit rating that has been determined to have been influenced by a conflict.
The SEC also has requested comment on whether it should be more prescriptive regarding what it means
for a conflict to “influence” a credit rating, whether the requirement to estimate the impact of a conflict
would substantially prolong the time it would take an NRSRO to revise a rating, and whether additional or
alternative information about a conflict should be disclosed.
C. SUSPENSION OR REVOCATION OF AN NRSRO’S REGISTRATION
New Section 15E(h)(3)(B)(ii) of the Exchange Act, as added by the Dodd-Frank Act, requires the SEC to
provide for the suspension or revocation of an NRSRO’s registration if the SEC finds, on the record after
notice and opportunity for a hearing, that the NRSRO has violated any rule issued under Section 15E(h)
and that the violation affected a credit rating. Although Section 15E(h)(3) generally appears to focus only
on conflicts of interest relating to sales and marketing, one particular provision (Section 15E(h)(3)(B)(ii))
requires the SEC to provide for the suspension or revocation of an NRSRO’s registration upon “a violation
of a rule issued under this subsection,” which the SEC has interpreted more broadly to mean any rule
issued under Section 15E(h). The rules issued under Section 15E(h) consist primarily of the SEC’s 28 The Dodd-Frank Act requires an NRSRO to publish a disclosure form with credit rating action; the
SEC’s proposals to implement this requirement are discussed at Section I.A of this memorandum.
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conflict of interest regulations at Rule 17g-5. In the proposing release, the SEC notes that an NRSRO’s
rule violation need not be “willful” for the SEC to take action under the statute.
The SEC has proposed to implement this suspension and revocation authority in conjunction with
enforcement proceedings under Sections 15E(d) and 21C of the Exchange Act, as those statutory
provisions already provide the SEC with the authority to take action against an NRSRO for violations (or,
in the case of Section 15E(d), willful violations) of rules issued under Section 15E(h) of the Exchange
Act.29
Specifically, new paragraph (g) of Rule 17g-5 would provide that, in a proceeding pursuant to Section
15E(d) or Section 21C, the SEC will suspend or revoke an NRSRO’s registration if it finds that: (i) the
NRSRO has violated a rule issued under Section 15E(h), (ii) the violation affected a rating, and (iii) the
suspension or revocation is necessary for the protection of investors and in the public interest. Although
the public interest finding is not required by Section 15E(h), such a finding already is required for the
imposition of sanctions under Section 15E(d). The SEC preliminarily believes that such a finding also
should be applicable to suspensions and revocations issued under Section 21C, due to the lesser intent
required to establish a violation and the substantial consequences of suspending or revoking a
registration.
The SEC has requested comment on all aspects of this proposal, including whether this new suspension
and revocation authority should be implemented and enforced independently of proceedings under
Sections 15E(d) and 21C. Among other things, the SEC also has requested comment on how to
determine whether a violation “affected a rating,” and whether the requirement of a public interest finding
(or some other finding) is appropriate.
D. ADDITIONAL SEC “FILING” REQUIREMENTS
Section 932(a) of the Dodd-Frank Act amended Section 15E of the Exchange Act to designate certain
submissions by an NRSRO to the SEC as “filings” rather than “furnishings.” The primary significance of
this change is that under Section 18 of the Exchange Act, any person who makes or causes to be made a
statement that is “false or misleading with respect to any material fact” in a report or document filed with
the SEC may be liable for damages caused to a person who traded the security in reliance on the
information contained in the statement. Section 18 does not provide for similar liability for misstatements
contained in “furnishings.”
29 Under Section 15E(d) of the Exchange Act, the SEC can take enforcement actions against an
NRSRO – including revoking or suspending for up to 12 months the NRSRO’s registration – for certain enumerated violations, including a willful violation of any provision of the Exchange Act or the SEC’s rules issued thereunder. A sanction under Section 15E(d) requires notice and opportunity for a hearing, as well as a finding that the sanction is “necessary for the protection of investors and in the public interest.” Separately, Section 21C of the Exchange Act permits the SEC to take certain actions for violations of the securities laws, even if the violations are not willful.
-18- Credit Rating Agencies July 8, 2011
Proposed amendments to Rule 17g-1, Rule 17g-3 and the instructions to Form NRSRO would reflect this
change. Specifically, submissions that now would be considered “filings” include initial applications on
and updates to Form NRSRO, annual certifications to Form NRSRO, and the annual financial reports
required pursuant to Rule 17g-3, with the exception of the report that lists all credit rating actions taken
during the prior year.30
E. FINES AND OTHER PENALTIES
New Section 15E(p)(4)(A) of the Exchange Act, as added by the Dodd-Frank Act, requires the SEC to
establish, by rule, fines and other penalties applicable to an NRSRO that violates the requirements of
Section 15E and the rules issued thereunder. Noting that the Exchange Act already provides the SEC
with broad authority to impose sanctions upon an NRSRO, and that the SEC has not identified a specific
need for a fine or penalty not otherwise provided for, the SEC has deferred establishing new fines or
penalties at this time. Instead, the SEC has proposed to add an instruction to Form NRSRO providing
notice that NRSROs are subject to fines, penalties and other sanctions under Sections 15E, 21, 21A,
21B, 21C and 32 of the Exchange Act for violating the securities laws. The SEC may establish new fines
and penalties in the future, if a specific need is identified.
The SEC has requested comment on whether existing sanctions are sufficient, or whether additional fines
or penalties should be established by rule.
IV. CREDIT RATING METHODOLOGIES
New Section 15E(r) of the Exchange Act, as added by the Dodd-Frank Act, requires an NRSRO to ensure
that it meets certain specified objectives with respect to its credit rating procedures and methodologies.
The SEC has proposed to implement these requirements in new Rule 17g-8(a), which largely mirrors the
statutory text. Specifically, the SEC’s proposal would require an NRSRO to implement policies and
procedures reasonably designed to ensure that:
credit ratings are determined using procedures and methodologies that are (i) approved by the NRSRO’s board of directors and (ii) in accordance with the NRSRO’s internal policies for the development and modification of rating procedures and methodologies;
the NRSRO applies material changes to credit rating methodologies consistently to all applicable credit ratings – to the extent that changes are made to surveillance procedures and methodologies, such changes must be applied to then-current ratings within a “reasonable” time;31
30 Even though Section 932 of the Dodd-Frank Act did not replace the word “furnish” with “file” in
Section 15E(a), which governs the submission of initial applications for registration as an NRSRO, the SEC has stated that it believes this omission was in error, and the SEC would therefore apply the change to initial applications as well.
31 The SEC has requested comment on whether it should prescribe specific time frames in this context. Although the SEC has not defined “reasonable” for these purposes, the proposed rule provides that
-19- Credit Rating Agencies July 8, 2011
the NRSRO promptly publishes on an easily accessible portion of its website: (i) material changes to rating procedures and methodologies, the reason for the changes, and the likelihood the changes will result in changes to any current ratings, and (ii) “significant errors” identified in a rating procedure or methodology that may result in a change to current ratings;32 and
the NRSRO discloses the version of a rating procedure or methodology used with respect to a particular credit rating.
These policies and procedures would be subject to the general recordkeeping requirements of Rule
17g-2. The SEC has requested comment on whether its proposal appropriately meets the mandates of
Section 15E(r) of the Exchange Act.
V. STANDARDS OF TRAINING, EXPERIENCE, AND COMPETENCE FOR NRSRO CREDIT RATING ANALYSTS
Section 936 of the Dodd-Frank Act requires the SEC to prescribe rules reasonably designed to ensure
that an NRSRO employee who performs credit ratings (i) meets standards of training, experience, and
competence necessary to produce accurate ratings, and (ii) is tested for knowledge of the credit rating
process. To implement this requirement, the SEC has proposed new Rule 17g-9, which would require an
NRSRO to establish and maintain standards for training, experience, and competence that are
reasonably designed to ensure that its ratings employees produce accurate credit ratings. Although this
proposed rule grants NRSROs some discretion in designing these standards, it requires NRSROs to
consider several factors, including:
for employees engaging in qualitative analysis, the knowledge necessary to evaluate and process the data relevant to the creditworthiness of the obligor or issuer;
for employees engaged in quantitative analysis, the technical expertise necessary to understand relevant models and model inputs;
factors relevant to the particular classes and subclasses of ratings covered by the employee, including the geography, sector, industry, regulatory and legal framework, and underlying assets with respect to the applicable obligors or issuers; and
the complexity of the obligors, securities or money market instruments rated by the employee.
Specific Testing and Experience Requirements. In addition, proposed Rule 17g-9(c) would require an
NRSRO’s standards to incorporate specific testing and experience requirements, including (i) periodic
testing of employees who determine credit ratings on their knowledge of the NRSRO’s procedures and
an NRSRO may take into consideration the number of ratings impacted, the complexity of the applicable rating procedures and methodologies, and the type of rated obligor, security or money market instrument. The SEC has requested comment on whether it should prescribe specific time frames in this context.
32 The SEC has requested comment on whether it should define “significant error.”
-20- Credit Rating Agencies July 8, 2011
methodologies, and (ii) a requirement that at least one individual with at least three years of credit
analysis experience participates in each credit rating determination.33
The standards established by an NRSRO pursuant to new Rule 17g-9 would be subject to the general
recordkeeping provisions of Rule 17g-2.
The SEC has requested comment on all aspects of this proposal, including:
whether requiring NRSROs to design their own standards appropriately serves the objectives of the Dodd-Frank Act, or whether the SEC should prescribe specific, industry-wide standards;
whether the SEC should clarify or omit any of the proposed factors, or whether additional factors should be considered;
whether the SEC should establish a standardized review process for assessing an NRSRO’s standards;
how the accuracy of credit ratings should be measured;
whether the requirement for “periodic” testing of analysts is sufficient, or whether the SEC should prescribe the frequency of such testing; and
whether the three-year experience requirement would be an effective benchmark for ensuring accurate credit ratings, or whether the experience requirement should be adjusted.
VI. NRSRO INTERNAL CONTROL STRUCTURE AND COMPLIANCE REPORTING REQUIREMENTS
As amended by the Dodd-Frank Act, Section 15E(c) of the Exchange Act requires an NRSRO to
implement an effective internal control structure to govern the implementation of and adherence to
policies, procedures and methodologies for determining credit ratings, taking into consideration factors
that the SEC may prescribe. In addition, Sections 15E(c) and 15E(j) require the SEC to prescribe rules
requiring an NRSRO to submit annually an internal controls report and a report of the NRSRO’s
designated compliance officer, respectively.
The SEC’s proposals to implement these requirements largely mirror the statutory requirements.
A. INTERNAL CONTROL STRUCTURE IMPLEMENTATION REQUIREMENTS
New Section 15(c)(3)(A) of the Exchange Act, as added by the Dodd-Frank Act, requires an NRSRO to
“establish, maintain, enforce, and document an effective internal control structure governing the
implementation of and adherence to policies, procedures, and methodologies for determining credit
ratings, taking into consideration such factors as the [SEC] may prescribe, by rule.” The SEC has
proposed to defer prescribing factors for an NRSRO to consider in implementing such an internal control
structure, noting that the statutory requirement is self-executing and that the rulemaking process may be
33 The proposing release notes that this requirement may be met, for example, by having the
experienced individual serve on the rating committee or review and approve a rating action proposed by a junior analyst. See Release, 76 FR at 33479.
-21- Credit Rating Agencies July 8, 2011
better informed by permitting the SEC to first observe (through the examination and annual reporting
process) how NRSROs achieve compliance. However, the SEC has requested comment on this
approach generally, and whether the SEC should instead prescribe rules specifying factors as part of this
rulemaking initiative.
The SEC also has requested comment on which individual elements of the internal control structure
requirement – establishment, maintenance, enforcement, and documentation – would benefit from
prescriptive factors. In addition, although no factors are formally included as part of the proposed
rulemaking, the SEC has invited comment on several suggestions. For example, the SEC has requested
comment on whether an NRSRO’s establishment of an internal control structure should incorporate
controls reasonably designed to ensure that, among other things:
newly-developed methodologies or proposed updates to methodologies are appropriately reviewed and/or disclosed to the public prior to being employed by the NRSRO;
persons independent of the development and use of in-use methodologies periodically review the methodologies, and market participants have an opportunity to provide comment, in each case to determine whether methodologies should be updated;34
the NRSRO engages in analysis before commencing the rating of an “exotic” or “bespoke” type of obligor, security or money market instrument to review the feasibility of determining a credit rating; and/or
analysts document the steps taken in developing rating actions in sufficient detail to permit after-the-fact review or internal audit of the rating file for adherence to the NRSRO’s rating procedures and methodologies, and that such reviews or audits are conducted periodically.
The SEC has requested comment on whether an NRSRO’s maintenance of an internal control structure
should incorporate controls reasonably designed to ensure that:
the NRSRO conducts periodic reviews of whether it has devoted sufficient resources to implement and operate the internal control structure, and whether the internal control structure is effective; and/or
any identified deficiencies are timely assessed and addressed.
The SEC has requested comment on whether an NRSRO’s enforcement of an internal control structure
should incorporate controls reasonably designed to ensure that:
the NRSRO provides additional training or takes discipline with respect to employees who fail to adhere to the internal control structure’s requirements; and/or
a process is in place for employees to report failures to adhere to the internal control structure.
Finally, the SEC has requested comment on whether factors for an NRSRO’s documentation of the
internal control structure should describe the level of written detail that should be documented. Proposed
34 The SEC also requests comment on whether to require the NRSRO to make such comments from
market participants publicly available and to consider those comments before implementing a methodology.
-22- Credit Rating Agencies July 8, 2011
new paragraph (b)(12) to Rule 17g-2 would subject the documentation of an NRSRO’s internal control
structure to the rule’s recordkeeping requirements. However, the SEC’s proposed amendment does not
specify the form or content that such documentation would take.
B. ANNUAL INTERNAL CONTROLS REPORT
Proposed new paragraphs (a)(7) and (b)(2) to Rule 17g-3 would require an NRSRO to file an annual
internal controls report with the SEC within 90 days of the end of the NRSRO’s fiscal year. The report
must describe management’s responsibility in establishing and maintaining an effective internal control
structure, assess the effectiveness of the structure, and provide an attestation of the chief executive
officer. Although the rule as proposed would closely mirror the statutory requirements, the SEC has
requested extensive comment on whether and how it should make these requirements more explicit
and/or provide additional guidance to NRSROs. Among other things, the SEC has requested comment
on the appropriate level of board involvement in the internal controls system, and whether the internal
controls report should be made public on EDGAR.
C. ANNUAL REPORT OF DESIGNATED COMPLIANCE OFFICER
New Section 15E(j)(5) of the Exchange Act, as added by the Dodd-Frank Act, requires an NRSRO’s
designated compliance officer to submit to the NRSRO—and the NRSRO to subsequently file with the
SEC—an annual report assessing the NRSRO’s compliance with its policies and procedures and with the
securities laws. The report must include a description of any material changes to the NRSRO’s code of
ethics and conflict of interest policies and a certification that the report is accurate and complete.
The SEC has proposed adding paragraph (a)(8) to Rule 17g-3 to clarify that the designated compliance
officer’s unaudited report is one of the reports that must be filed with the SEC within 90 days of the end of
the NRSRO’s fiscal year.
VII. OTHER AMENDMENTS
A. CLARIFICATION TO THE DESCRIPTION OF STRUCTURED FINANCE PRODUCTS
Section 941(a) of the Dodd-Frank Act amended Section 3 of the Exchange Act to establish a definition of
the term “asset-backed security” that includes (among other things) collateralized mortgage obligations.
A number of existing provisions in the SEC’s NRSRO regulations currently refer broadly to a structured
finance product as “any security or money market instrument issued by an asset pool or as part of an
asset-backed or mortgage-backed securities transaction” (emphasis added). To eliminate any
redundancy, the SEC has proposed striking the term “or mortgage-backed” from the applicable rules
(specifically Rules 17g-2, 17g-3, 17g-5 and 17g-6). The SEC has requested comment on whether this
change would narrow any rule to exclude any security or transaction that previously had been covered.
-23- Credit Rating Agencies July 8, 2011
B. CLARIFYING AMENDMENTS TO THE INSTRUCTIONS TO FORM NRSRO
The SEC has proposed a number of clarifying amendments to the instructions to Form NRSRO to
eliminate confusion and address interpretive questions raised by NRSROs concerning the disclosures
required by the form. These amendments relate to:
calculating the number of credit ratings outstanding in a given class of ratings and classifying ratings appropriately;
calculating the number of credit analysts employed;
clarifying that Exhibits 10-13 of Form NRSRO are not required to be made publicly available and should not be updated with the annual certification; and
clarifying that a new NRSRO applicant no longer must have been in business as a credit rating agency for the three years immediately preceding the date of application.35
* * *
35 Section 932(b) of the Dodd-Frank Act eliminated this requirement from the definition of NRSRO. See
Section 3(a)(62) of the Exchange Act.
Copyright © Sullivan & Cromwell LLP 2011
-24- Credit Rating Agencies July 8, 2011
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