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 instruments.
• 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 time.

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 antifraud liability.
• 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 creditworthiness.
• 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 investigation.

Finally, Dodd-Frank requires the preparation of studies and reports which may impact the future regulation of credit rating agencies. These include:

• 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 classes.
• 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.

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