08/25/2010 10:42:00 AM EST
Dodd – Frank: Credit Rating Agencies, Part II
Dodd-Frank focuses on the structure of credit rating
agencies, requiring revisions and imposing other requirements in an effort to
resolve the conflicts of interest and other difficulties many believe were at
the center of the market crisis. The article on Monday focused on the new SEC office which will
deal with NRSROs and the structural issues.
One key aspect of the new requirements deals with the
revolving door issue and imposes certain disclosure requirements to try and
solve this problem as described in Part I. Those provisions will be
supplemented by SEC rules. The Commission is required to establish rules with a
look back requirement focused on when an employee of an entity subject to an
NRSRO rating was employed by the agency when that person participated in
determining ratings for the entity within one year.
While the Act deals with certain specific structure and
operations issues of NRSROs, the SEC is required to write rules addressing
others. These include:
- Influences on ratings: Rules to preclude ratings from
being influenced by sales and marketing. The penalties must be registration
suspension or revocation.
- Rating symbols: Rules defining the meaning of rating
symbols and requiring that they be used consistently. The NRSRO is required to
use distinct symbols to denote credit ratings for different types of
- Probability of default: Rules requiring that each NRSRO
assess and disclose the probability that an issuer will default or otherwise
not make payments in accord with the terms of the instrument.
- Qualifications: Rules regarding the qualifications,
knowledge, experience and training of persons who perform ratings.
- Performance information: Rules requiring the disclosure
of information which will allow an evaluation of the accuracy of ratings and
foster comparability among the agencies.
- Basis of ratings: Rules requiring each NRSRO to
disclose information about the underlying assumptions, procedures and
methodologies employed as well as the data used on a form which will accompany
each rating issued.
The Commission is authorized by the Act to suspend or
revoke the registration of any NRSRO with respect to a particular class of
securities if it determines that the organization lacks adequate financial or
managerial resources to consistently produce ratings with integrity. In making
this determination, after notice and a hearing, the Commission must consider if
the rating agency failed to produce accurate ratings over a sustained period of
Several sections of the Act address the potential
liability or litigation defenses of NRSROs. These include:
- No antifraud defense: The Exchange Act provisions which
prohibit the regulation of the substance of a rating are not a defense to
- Expert liability: NRSROs may now be liable under
Section 11 of the Securities Act. Dodd-Frank overrides Rule 436 which exempted
the organizations from being considered as part of a registration statement.
Accordingly, to include a report in a registration statement, consent from the
NRSRO will have to be obtained.
- Regulation FD: The Commission is required to remove the
exemption for credit rating agencies under Regulation FD. The Act also requires
all federal agencies to review and modify regulations to remove references or
reliance on credit ratings and substitute an alternative standard of
- Statements: The Act specifies that statements made by
credit rating agencies are subject to liability in the same manner as those of
accounting firms and securities analysts under the federal securities laws.
Statements by the rating agencies are also not forward looking statements.
- State of mind: To establish liability it is sufficient
to state facts with particularity which give rise to a strong inference that
the agency acted knowingly or recklessly failed to conduct a reasonable
Finally, Dodd-Frank requires the preparation of studies
and reports which may impact the future regulation of credit rating agencies.
- Structured finance ratings: The SEC is to prepare a
report to Congress within twenty-four months on the credit rating process for
these products. It must include a study regarding the feasibility of
establishing an independent organization to assign NRSROs to determine credit
rating agencies. After the report is submitted the SEC is, as it determines to
be appropriate, to establish a system for the assignment of NRSROs to determine
ratings for these products.
- Independence: The SEC is required within three years to
complete a report on the independence of NRSROs and how this impacts ratings.
- Standardization of ratings: The SEC is required within
one year to furnish a study on the feasibility and desirability of
standardizing credit rating terminology across credit rating agencies and asset
- Compensation: The GAO is directed to prepare a study of
alternative means for compensating NRSROs to create incentives for more
accurate ratings. This study is to be completed within eighteen months.
- Professional organization. The GAO must prepare within
one year a study on the feasibility of creating an independent professional
organization for NRSRO rating analysts. The organization would establish
standards, a code of ethics and oversee the profession.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.