Published on Aug 27th, 2014 | Posted in Articles
The Securities and Exchange Commission today adopted new requirements for credit rating agencies to enhance governance, protect against conflicts of interest, and increase transparency to improve the quality of credit ratings and increase credit rating agency accountability.  The new rules and amendments, which implement 14 rulemaking requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act, apply to credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (NRSROs). “This expansive package of reforms will strengthen the overall quality of credit ratings, enhance the transparency of credit rating agencies and increase their accountability,” said SEC Chair Mary Jo White. “Today’s reforms will help protect investors and markets against a repeat of the conduct and practices that were central to the financial crisis.” The new requirements for NRSROs address internal controls, conflicts of interest, disclosure of credit rating performance statistics, procedures to protect the integrity and transparency of rating methodologies, disclosures to promote the transparency of credit ratings, and standards for training, experience, and competence of credit analysts.  The requirements provide for an annual certification by the CEO as to the effectiveness of internal controls and additional certifications to accompany credit ratings attesting that the rating was not influenced by other business activities. The Commission also adopted requirements for issuers, underwriters, and third-party due diligence services to promote the transparency of the findings and conclusions of third-party due diligence regarding asset-backed securities. Certain amendments will become effective 60 days after publication in the Federal Register.  The amendments with respect to the annual report on internal controls and the production and disclosure of performance statistics will be effective on Jan. 1, 2015, which means that the first internal controls report to be submitted by an NRSRO would cover the fiscal year that ends on or after Jan. 1, 2015, and the first annual certification on Form NRSRO relating to performance statistics is required for the annual certifications filed after the end of the 2015 calendar year. The following provisions are effective nine months after publication in the Federal Register: prohibiting the sales and marketing conflict; addressing look-back reviews to determine whether the credit analyst’s prospects of future employment influenced a credit rating; requiring the disclosure of rating histories; addressing rating methodologies; requiring the form and certification to accompany credit ratings; addressing issuer and underwriter disclosure of third-party due diligence findings; addressing the certification of a third-party due diligence provider; addressing NRSRO standards of training, experience, and competence; and addressing universal rating symbols.  This period is intended to provide time for NRSROs, issuers, underwriters, and providers of third-party due diligence services to prepare for the changes resulting from the new requirements.

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FACT SHEET

May 2011 Proposals – The Commission proposed for comment amendments to existing rules and new rules in accordance with Title IX, Subtitle C of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The amendments and new rules approved today finalize the May 2011 proposals. The Dodd-Frank Act – Title IX, Subtitle C of the Dodd-Frank Act, among other things, established new self-executing requirements applicable to NRSROs and required that the Commission adopt rules applicable to NRSROs in a number of areas.  The NRSRO provisions in the Dodd-Frank Act augment the Credit Rating Agency Reform Act of 2006, which established a registration and oversight program for NRSROs through self-executing provisions added to the Securities Exchange Act of 1934 and the implementation of rules adopted by the Commission.  Title IX, Subtitle C of the Dodd-Frank Act also established a new requirement for issuers and underwriters of asset-backed securities to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.  In addition, Title IX, Subtitle C of the Dodd-Frank Act provides that the Commission shall prescribe the format of a certification that providers of third-party due diligence services must provide to each NRSRO producing a credit rating for an ABS to which the due diligence services relate. NRSROs – NRSROs are credit rating agencies registered with the Commission under section 15E of the Exchange Act.  An NRSRO can be registered in one or more of five classes of credit ratings: financial institutions, brokers, or dealers; insurance companies; corporate issuers; issuers of ABS; and issuers of government securities, municipal securities, or securities issued by a foreign government.  Currently, 10 credit rating agencies, including the three largest credit rating agencies (Moody’s, Standard & Poor’s and Fitch Group), are registered as NRSROs. Highlights of the Amendments and New Rules Factors an NRSRO must consider when establishing, maintaining, enforcing, and documenting an Internal Control Structure The Dodd-Frank Act amended the Exchange Act to require 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 Commission may prescribe, by rule. The rule amendments require an NRSRO to consider certain identified factors.  In particular, with respect to establishing an internal control structure, the NRSRO must consider:
  • Controls reasonably designed to ensure that a newly developed methodology or proposed update to an in-use methodology for determining credit ratings is subject to an appropriate review process (for example, by persons who are independent from the persons that developed the methodology or methodology update) and to management approval prior to the new or updated methodology being employed by the NRSRO to determine credit ratings.
  • Controls reasonably designed to ensure that a newly developed methodology or update to an in-use methodology for determining credit ratings is disclosed to the public for consultation prior to the new or updated methodology being employed by the NRSRO to determine credit ratings, that the NRSRO makes comments received as part of the consultation publicly available, and that the NRSRO considers the comments before implementing the methodology.
  • Controls reasonably designed to ensure that in-use methodologies for determining credit ratings are periodically reviewed (for example, by persons who are independent from the persons who developed and/or use the methodology) in order to analyze whether the methodology should be updated.
  • Controls reasonably designed to ensure that market participants have an opportunity to provide comment on whether in-use methodologies for determining credit ratings should be updated, that the NRSRO makes any such comments received publicly available, and that the NRSRO considers the comments.
  • Controls reasonably designed to ensure that newly developed or updated quantitative models proposed to be incorporated into a credit rating methodology are evaluated and validated prior to being put into use.
  • Controls reasonably designed to ensure that quantitative models incorporated into in-use credit rating methodologies are periodically reviewed and back-tested.
  • Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of a class of obligors, securities, or money market instruments the NRSRO has not previously rated to determine whether the NRSRO has sufficient competency, access to necessary information, and resources to rate the type of obligor, security, or money market instrument.
  • Controls reasonably designed to ensure that an 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.
  • Controls reasonably designed to ensure that measures (for example, statistics) are used to evaluate the performance of credit ratings as part of the review of in-use methodologies for determining credit ratings to analyze whether the methodologies should be updated or the work of the analysts employing the methodologies should be reviewed.
  • Controls reasonably designed to ensure that, with respect to determining credit ratings, the work and conclusions of the lead credit analyst developing an initial credit rating or conducting surveillance on an existing credit rating is reviewed by other analysts, supervisors, or senior managers before a rating action is formally taken (for example, having the work reviewed through a rating committee process).
  • Controls reasonably designed to ensure that a credit analyst documents the steps taken in developing an initial credit rating or conducting surveillance on an existing credit rating with sufficient detail to permit an after-the-fact review or internal audit of the rating file to analyze whether the analyst adhered to the NRSRO’s procedures and methodologies for determining credit ratings.
  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or internal audits of rating files to analyze whether analysts adhere to the NRSRO’s procedures and methodologies for determining credit ratings.
With respect to maintaining the internal control structure, the NRSRO must consider:
  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews of whether it has devoted sufficient resources to implement and operate the documented internal control structure as designed.
  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or ongoing monitoring to evaluate the effectiveness of the internal control structure and whether it should be updated.
  • Controls reasonably designed to ensure that any identified deficiencies in the internal control structure are assessed and addressed on a timely basis.
When enforcing the internal control structure, the NRSRO must consider:
  • Controls designed to ensure that additional training is provided or discipline taken with respect to employees who fail to adhere to requirements imposed by the internal control structure.
  • Controls designed to ensure that a process is in place for employees to report failures to adhere to the internal control structure.
Report on the Effectiveness of the NRSRO’s Internal Control Structure The Dodd-Frank Act also amended the Exchange Act to provide that the Commission shall prescribe rules requiring an NRSRO to annually submit to the Commission an internal controls report that contains information on management’s responsibilities relating to the internal control structure, the effectiveness of the internal control structure, and an attestation of the CEO or equivalent on the report. The rule amendments require an NRSRO to file an annual report with the Commission regarding the NRSRO’s internal control structure that contains a:
  • Description of the responsibility of management in establishing and maintaining an effective internal control structure.
  • Description of each material weakness in the internal control structure identified during the fiscal year, if any, and a description, if applicable, of how each identified material weakness was addressed.
  • Statement as to whether the internal control structure was effective as of the end of the fiscal year.
The amendments also provide that management is not permitted to conclude that the internal control structure of the NRSRO was effective as of the end of the fiscal year if there were one or more material weaknesses in the internal control structure as of the end of the fiscal year.  The amendments further prescribe when a material weakness exists for purposes of this reporting requirement. NRSRO Conflicts Relating to Sales and Marketing Activities The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall issue rules to prevent an NRSRO’s sales and marketing considerations from influencing the production of credit ratings.  It also specifies that the Commission shall provide for exceptions for small NRSROs and for the suspension or revocation of an NRSRO’s registration for violating a rule addressing conflicts of interest. The rule amendments:
  • Prohibit an NRSRO from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models also: participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or is influenced by sales or marketing considerations.
  • Provide that upon written application by an NRSRO, the Commission may exempt the NRSRO, either unconditionally or on specified terms and conditions, from the sales and marketing prohibition if the Commission finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.
  • Establish an alternative rule-based finding that can be used by the Commission in a proceeding under section 15E(d)(1) of the Exchange Act to suspend or revoke the registration of an NRSRO (namely, if the Commission finds, in lieu of a finding specified under sections 15E(d)(1)(A), (B), (C), (D), (E), or (F) of the Exchange Act, that the NRSRO has violated a rule addressing conflicts of interest and that the violation affected a credit rating).
NRSRO Look-Back Reviews The Dodd-Frank Act amended the Exchange Act to require an NRSRO to have policies and procedures for conducting a “look-back” review to determine whether the prospect of future employment by an issuer or underwriter influenced a credit analyst in determining a credit rating, and, if such influence is discovered, to revise the credit rating in accordance with rules the Commission shall prescribe. New Rule 17g-8 requires that the NRSRO’s look-back review procedures must address instances in which a review determines that a conflict of interest influenced a credit rating by including, at a minimum, procedures that are reasonably designed to ensure that the NRSRO will:
  • Promptly determine whether the current credit rating must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.
  • Promptly publish, based on the determination of whether the current credit rating must be revised, a revised credit rating or an affirmation of the credit rating and with either publication include disclosures about the existence and impact of the conflict of interest.
  • If the credit rating is not revised or affirmed within 15 calendar days of the date of the discovery that the credit rating was influenced by a conflict of interest, publish a rating action placing the credit rating on watch or review and include with the publication an explanation that the reason for the action is the discovery that the credit rating was influenced by a conflict of interest.
Public Disclosure of NRSRO Credit Rating Performance Statistics The Dodd-Frank Act amended the Exchange Act to provide that the Commission, by rule, shall require NRSROs to publicly disclose information about their initial credit ratings and subsequent changes to the credit ratings to allow users of credit ratings to evaluate the accuracy and compare the performance of credit ratings across NRSROs. Before the SEC’s rule amendments approved today, NRSROs were required to disclose the percent of credit ratings in each class for which they are registered that over a one-year, three-year, and 10-year period were downgraded or upgraded (transition rates) or classified as a default (default rates). The rule amendments enhance the disclosures of transition and default rates by, among other things:
  • Standardizing the methodologies used by NRSROs in computing their transition and default rates.
  • Requiring transition and default rates for various subclasses of structured finance products (e.g., residential mortgage-backed securities and commercial mortgage-backed securities).
  • Standardizing the presentation of the transition and default rates in an easy to understand table.
Public Disclosure of NRSRO Credit Rating Histories Before the SEC’s rule amendments, NRSROs were required to disclose in an XBRL format histories of their credit ratings (e.g., the initial credit rating and all subsequent modifications to the credit rating (such as upgrades and downgrades) and the dates of such actions).  The goal of the proposed amendments is to allow users of credit ratings to compare how different NRSROs rated an individual obligor, security, or money market instrument and how and when those ratings were changed over time.  The disclosure of rating histories also is designed to provide “raw data” that can be used by third parties to generate independent performance statistics such as transition and default rates.  The amendments increase the amount of information that must be disclosed by expanding the scope of the credit ratings that must be included in the histories and by adding additional data elements that must be disclosed in the rating history for a particular credit rating. NRSRO Credit Rating Methodologies The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall prescribe rules with respect to the procedures and methodologies, including qualitative and quantitative data and models, used by NRSROs to determine credit ratings that require each NRSRO to ensure that certain objectives are met. Paragraph (a) of new Rule 17g-8 requires an NRSRO to have policies and procedures reasonably designed to ensure that:
  • The procedures and methodologies the NRSRO uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.
  • The procedures and methodologies the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO.
  • Material changes to the procedures and methodologies the NRSRO uses to determine credit ratings are:
  • Applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply.
  • To the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.
  • The NRSRO promptly publishes on an easily accessible portion of its corporate Internet website:
  • Material changes to the procedures and methodologies the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any current credit ratings.
  • Notice of the existence of a significant error identified in a procedure or methodology the NRSRO uses to determine credit ratings that may result in a change to current credit ratings.
  • The NRSRO discloses the version of a credit rating procedure or methodology used with respect to a particular credit rating.
Form and Certifications to Accompany Credit Ratings The Dodd-Frank Act amended the Exchange Act to provide that the Commission shall require, by rule, NRSROs to disclose with the publication of a credit rating a form containing certain qualitative and quantitative information about the credit rating.  It also requires an NRSRO at the time it produces a credit rating to disclose any certifications from providers of third-party due diligence services with respect to ABS. The SEC’s rule amendments require an NRSRO to publish two items when taking certain rating actions: a form containing the quantitative and qualitative information about the credit rating specified in the statute; and any certification of a provider of third-party due diligence services received by the NRSRO that relates to the credit rating.  Under the new amendments, “rating action” includes preliminary credit ratings, initial credit ratings, upgrades and downgrades of credit ratings, and affirmations and withdrawals of credit ratings if they are the result of a review using the NRSRO’s procedures and methodologies for determining credit ratings. The information that must be disclosed in the form includes:
  • The version of the procedure or methodology used to determine the credit rating.
  • The main assumptions and principles used in constructing the procedures and methodologies used to determine the credit rating.
  • The potential limitations of the credit rating, including the types of risks excluded from the credit rating that the NRSRO does not comment on, including, as applicable, liquidity, market, and other risks.
  • Information on the uncertainty of the credit rating, including information on the reliability, accuracy, and quality of the data relied on in determining the credit rating and a statement relating to the extent to which data essential to the determination of the credit rating were reliable or limited.
  • A description of the types of data about any obligor, issuer, security, or money market instrument that were relied upon for the purpose of determining the credit rating.
  • A statement containing an overall assessment of the quality of information available and considered in determining the credit rating for the obligor, security, or money market instrument, in relation to the quality of information available to the NRSRO in rating similar obligors, securities, or money market instruments.
  • Information relating to conflicts of interest, including whether the NRSRO was paid to determine the credit rating by the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated, or by another person.
  • An explanation or measure of the potential volatility of the credit rating.
  • Information on the content of the credit rating, including, if applicable, the historical performance of the credit rating and the expected probability of default and the expected loss in the event of default.
  • Information on the sensitivity of the credit rating to assumptions made by the NRSRO.
  • If the credit rating is assigned to an ABS, information on the representations, warranties, and enforcement mechanisms available to investors.
Issuer/Underwriter Disclosure of ABS Third-Party Due Diligence Report The Dodd-Frank Act amended the Exchange Act to require the issuer or underwriter of an ABS to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.  New Rule 15Ga-2 requires an issuer or underwriter of an ABS that is to be rated by an NRSRO to furnish Form ABS–15G on the EDGAR system containing the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.  The rule applies to both registered and unregistered offerings of ABS. Certification of ABS Third-Party Due Diligence Provider The Dodd-Frank Act amended the Exchange Act to require a provider of third-party due diligence services for ABS to provide a written certification to any NRSRO that produces a credit rating to which the services relate and provides that the Commission shall establish the format and content of the written certification.  New Rule 17g-10 requires third-party due diligence providers to use new Form ABS Due Diligence-15E to make the written certification to be provided to the NRSRO.  The form elicits information about the due diligence including a description of the work performed, a summary of the findings and conclusions of the third party, and the identification of any relevant NRSRO due diligence criteria that the third party intended to meet in performing the due diligence.   The amendments require the NRSRO to disclose a certification (if it receives the certification) with each rating action to which the certification relates. NRSRO Standards of Training, Experience, and Competence The Dodd-Frank Act provides that the Commission shall issue rules reasonably designed to ensure that NRSRO credit analysts meet standards of training, experience, and competence necessary to produce accurate ratings for the categories of issuers whose securities the person rates and are tested for knowledge of the credit rating process. New Rule 17g-9 requires an NRSRO to:
  • Establish, maintain, enforce, and document standards of training, experience, and competence for the individuals it employs to participate in the determination of credit ratings that are reasonably designed to achieve the objective that the NRSRO produces accurate credit ratings in the classes of credit ratings for which the NRSRO is registered.
  • Consider the following when establishing the standards:
  • If the credit rating procedures and methodologies used by the individual involve qualitative analysis, the knowledge necessary to effectively evaluate and process the data relevant to the creditworthiness of the obligor being rated or the issuer of the securities or money market instruments being rated.
  • If the credit rating procedures and methodologies used by the individual involve quantitative analysis, the technical expertise necessary to understand any models and model inputs that are a part of the procedures and methodologies.
  • The classes and subclasses of credit ratings for which the individual participates in determining credit ratings and the factors relevant to such classes and subclasses, including the geographic location, sector, industry, regulatory and legal framework, and underlying assets applicable to the obligors or issuers in the classes and subclasses.
  • The complexity of the obligors, securities, or money market instruments for which the individual participates in determining credit ratings.
  • Include in the standards:
  • A requirement for periodic testing of the individuals employed by the NRSRO to participate in the determination of credit ratings on their knowledge of the procedures and methodologies used by the NRSRO to determine credit ratings in the classes and subclasses of credit ratings for which the individual participates in determining credit ratings.
  • A requirement that at least one individual with an appropriate level of experience in performing credit analysis, but not less than three years, participates in the determination of a credit rating.
Universal NRSRO Rating Symbols The Dodd-Frank Act provides that the Commission shall by rule require each NRSRO to establish, maintain, and enforce written policies and procedures with respect to the use of rating symbols.  Paragraph (b) of new Rule 17g-8 requires an NRSRO to have policies and procedures that are reasonably designed to:
  • Assess the probability that an issuer of a security or money market instrument will default, fail to make timely payments, or otherwise not make payments to investors in accordance with the terms of the security or money market instrument.
  • Clearly define each symbol, number, or score in the rating scale used by the NRSRO to denote a credit rating category and notches within a category for each class of credit ratings for which the NRSRO is registered (including subclasses within each class) and to include such definitions in the performance measurement statistics that must be disclosed in Form NRSRO (the NRSRO registration form, which must be up-to-date and publicly disclosed).
  • Apply any symbol, number, or score in a manner that is consistent for all types of obligors, securities, and money market instruments for which the symbol, number, or score is used.