Credit rating agencies, and in particular, nationally recognized statistical rating organizations ("NRSRO"), have been thought by many to be at the center of much of what went on with the market crisis, particularly in the area of structured products. The agencies have come under significant criticism for their methodologies, lack of procedures and conflicts of interest.
Dodd-Frank seeks to address these concerns in a series of provisions dealing with oversight and structure which will be discussed in this series. Other provisions significantly impact liability. The Act also requires the SEC to write a number of rules in this area and directs that several studies be prepared, all of which promise further legislation in this area in the future. These provisions will be discussed subsequently. Prior segments of this series have dealt with portions of the legislation concerning SEC ruling making (here), SEC Enforcement (here), executive compensation (here) and corporate governance (here).
Dodd-Frank creates the new SEC Office of Credit Ratings. This Office is charged with administering SEC rules with respect to NRSRO practices in determining ratings. The Office is also required to conduct an annual examination of each NRSRO and issue a public report. The report must summarize the essential findings of the examination, identify material deficiencies, state if previous SEC recommendations have been resolved and record any response by the examined agency. The SEC is also required to establish fines and penalties for any NRSRO violations.
A key part of the new provisions deals with the structure of the rating agencies. This begins with the board of directors and its accountability for critical functions. Each NRSRO is required to have a board of directors, at least half of whom are independent. The board is charged with overseeing the implementation of internal controls regarding policies and procedures for determining ratings, as well as compensation and promotions within the organization. It is also responsible for overseeing the management of conflicts of interest through the implementation of appropriate policies and procedures.
The organization is required under the Act to maintain a documented, effective system of internal controls for determining ratings. The Commission is charged with requiring that each NRSRO prepare an annual report regarding its controls. The report must include an attestation by the CEO that describes the responsibility of management for establishing and maintaining the system.
Each NRSRO is also required to designate a compliance officer. That officer cannot perform credit ratings or participate in marketing or sales activities. Likewise, the compensation of the officer can not be tied to the financial performance of the organization. Rather, it must be arranged to assure independence.
The compliance office is charged with preparing an annual report addressing changes in the internal compliance procedures and code of ethics of the organization. The report must also examine compliance with the securities laws and the organization's policies and procedures. The SEC is required to review the code of ethics and the conflict of interest policy of the organization annually and when there are material changes.
The Act also addresses the "revolving door" issue between NRSROs and their clients. In this regard, Dodd-Frank requires that each NRSRO report to the SEC employment of certain senior officers associated with the rating agency in the prior five years where the agency has issued a rating for an instrument during the twelve month period prior to the employment of that person. The SEC is to make this information available to the public.
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 first part of this post 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:
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:
Finally, Dodd-Frank requires the preparation of studies and reports which may impact the future regulation of credit rating agencies. These include:
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