The Securities and Exchange Commission (SEC or Commission) recently published two releases regarding rules for SEC-registered credit rating agencies or Nationally Recognized Statistical Rating Organizations (NRSROs). One release proposes additional, broader disclosure requirements for NRSROs and arrangers of structured finance products. Comments are due to the Commission on March 26, 2009.¹ The other release adopts final rules that specify three new categories of prohibited conflicts of interest and impose additional recordkeeping and disclosure requirements.²

The 2009 Proposal and the Final Rule Release involve rules under the Securities Exchange Act of 1934 (Exchange Act) that impose obligations on NRSROs.³ Because these regulatory initiatives are intended to change certain business practices of the NRSROs, they also affect other market participants that work closely with the NRSROs. This is particularly true for structured finance, where the NRSROs' relationships with the structured products' issuers, sponsors and underwriters (collectively, arrangers) have been under intense public scrutiny. We discuss here the proposed and final rules, focusing on the key considerations for arrangers of structured finance products and the changes that both arrangers and NRSROs will need to make to comply with the new and proposed rules.

I. The Proposed Rules: New Disclosure Requirements for Arrangers and NRSROs

In recent months, SEC Commissioners have pointed repeatedly to credit rating agencies' important role in the credit crisis and have stated their intent to tighten regulation of these entities.⁴ In July 2008, SEC staff completed a report of findings and recommendations regarding the regulation of credit rating agencies, based on examinations of the three largest credit rating agencies.⁵ Among the concerns noted were the conflicts of interest involved in the credit rating process, including those extending from the "issuer pays" model of credit rating. The term "issuer-paid" refers to credit ratings paid for by the obligor being rated or by the issuer, underwriter or sponsor of the security being rated. According to the SEC's Office of Economic Analysis (OEA), the conflicts of interest arising from the "issuer pays" model are exacerbated for structured finance products. OEA pointed to several circumstances that increase the potential for conflicts: (1) the arranger has flexibility to adjust the structure of the transaction to achieve the desired rating; (2) the arranger has substantial choice over which credit rating agency will rate the deal; and (3) the work of arranging such transactions is concentrated with a small number of firms.⁶

The 2009 Proposal contains two new disclosure provisions involving issuer-paid credit ratings that are intended to mitigate the potential conflicts of interest noted by the SEC staff. These new requirements, discussed below, will affect both arrangers and NRSROs.

A. Disclosure Requirement for Issuer-Paid Structured Finance Product Ratings

A re-proposed–though substantially modified–rule would mean significant new disclosure obligations for arrangers of structured finance products. Specifically, the proposed rule would prohibit an NRSRO from issuing or maintaining an issuer-paid rating for a structured finance product, unless it makes available to other NRSROs the information provided to it in connection with issuing or maintaining such credit rating. The key aspects of the proposed rule are:

• The information would have to be made available to other NRSROs through a password-protected website maintained by the product's arranger.
• Each NRSRO would be required to maintain, and make available to other NRSROs, a password-protected website that lists the structured finance products for which it currently is in the process of determining an initial credit rating, along with certain other information including the name of the arranger and a link to the arranger's password-protected site.
• An arranger would certify to the NRSRO it hired to rate the product that it will provide the relevant information on its password-protected website at the same time as it provides it to the hired NRSRO.
• An NRSRO wishing to access the information would gain access after providing the arranger with a copy of its annual certification to the SEC that it will (a) access such information only for the purpose of determining and monitoring credit ratings; (b) maintain the confidentiality of the information and treat it as material non-public information; and (c) determine and maintain credit ratings for at least 10% of the products for which it accesses information pursuant to the certification, if it accesses such information for 10 or more issued products in a calendar year covered by the certification.⁷

Although the proposed rule regulates NRSROs, and not arrangers of structured finance products, it would have the effect of requiring arrangers to agree to certain undertakings with respect to each structured finance product to be rated. An NRSRO would not be permitted to proceed with an issuer-paid rating of a structured finance product absent the arranger's "representation that can reasonably be relied upon" that it will comply with certain requirements.

Specifically, an arranger would need to represent to its hired NRSRO that it will fulfill the following obligations:

• Maintain a password-protected website with the required information, in a way that indicates which information currently should be relied on to determine or monitor the credit rating.
• Provide access to this site during the applicable calendar year to any NRSRO that furnishes it with a copy of its annual certification to the SEC for that year.
• Post on the site all information the arranger provides to the hired NRSRO for the purpose of determining the initial credit rating for the structured finance product, including information about the product's legal structure and the characteristics of the underlying or referenced assets. The arranger must post such information at the same time such information is provided to the hired NRSRO.
• Post on the site all information the arranger provides to the hired NRSRO for the purpose of monitoring the credit rating, including information about the characteristics and performance of the underlying or referenced assets. The arranger must post such information at the same time such information is provided to the hired NRSRO.⁸

The Commission seeks comment on all aspects of the re-proposed rule. In particular, the Commission has asked for comment on whether:

• The rule's application to securities and money market instruments "issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction"–which the Commission intends to include all structured finance products–should be broader or narrower.⁹
• The Commission should require only that final information be posted on the arranger's website, to avoid the potential for an NRSRO to base a credit rating on erroneous information.
• Other entities, such as credit rating agencies not registered with the Commission, should be permitted to access the information.
• The arranger should be required to represent that it will not provide any material information to the hired NRSRO without disclosing the information on the website.
• The Commission should provide a standardized list of the minimum information to be disclosed, and if so, what such a list should include.¹⁰

B. Rating Action Disclosure

The 2009 Proposal also would require an NRSRO to make publicly available rating action information for all current issuer-paid ratings initially rated by the NRSRO on or after the Rating Agency Act first took effect on June 26, 2007. Newly adopted Rule 17g-2(d), which requires disclosure of rating action histories for a 10% sample of issuer-paid ratings and takes effect on August 10, 2009, would remain part of the rule. A six-month time lag for disclosure would continue to apply to the 10% sample, whereas a 12-month disclosure time lag would apply to the broader disclosure requirement.¹¹ The Commission seeks comment on all aspects of the proposed amendment.

As noted above, the comment period for the 2009 Proposal ends March 26, 2009.

II. Conflicts of Interest: New Prohibitions Effective April 10, 2009

The Final Rule Release amends Exchange Act Rule 17g-5(c) to add three new prohibited conflicts of interest. As with the other prohibited conflicts of interest, the presence of one of the prohibited conflicts precludes the NRSRO from issuing or maintaining the relevant credit rating. The text of the final rule amendments is unchanged from the proposed amendments published in June 2008.

A. No Recommendations by NRSRO or Affiliate on How to Achieve Rating

The final amendments add a provision that prohibits an NRSRO from issuing or maintaining a credit rating if the NRSRO or its affiliate has made recommendations to the obligor or the issuer, underwriter or sponsor of the security about the corporate or legal structure, assets, liabilities or activities of the security's obligor or issuer. The Commission describes this provision, located in a new paragraph (5) of Rule 17g-5(c), as preventing an NRSRO from "rating its own work or the work of an affiliate."¹² Though perhaps most applicable to structured finance ratings, the Final Rule Release clarifies that the prohibition applies to all rating classes.¹³

According to the Commission, the rule prohibits an NRSRO from instructing an arranger on how to structure a transaction in order to achieve a particular credit rating. The SEC does not, however, intend for the rule to inhibit communication between the NRSRO and an arranger regarding the rating process and its application to a particular transaction. Nor should it preclude an arranger, upon receiving preliminary results from the NRSRO, from making changes to the proposed transaction and re-submitting it to the NRSRO for a new rating evaluation. The arranger, however, must "decide independently" what changes to make in order to achieve the desired rating.¹⁴ It is acceptable, according to the Final Rule Release, for the NRSRO to inform the arranger that a particular factor (e.g., over-concentration of loans in a particular geographic region, for a proposed residential mortgage-backed security) in the rating model precluded the desired rating. The Commission apparently views this type of information as explanation of the NRSRO's rating methodology, rather than a recommendation of how to change a proposed transaction to achieve the desired rating. In contrast, in the example above for a residential mortgage-backed security, the new rule prohibits an NRSRO analyst from advising an arranger how to change the composition of the loan pool.

Echoing its theme of promoting transparency in the rating process, the Commission advises that NRSROs can reduce their risk of violating the rule by improving their disclosures about their rating methodologies. The new rule gives rise to a number of questions and considerations that arrangers should consider, including the following:

• Even if the rule results in increased transparency through more detailed disclosures, when does discussion or explanation of a rating model's application to a particular transaction become a "recommendation" prohibited by the rule? Does this distinction mean, for instance, that an NRSRO analyst and an arranger may discuss hypothetical changes raised by the sponsor, but not by the arranger? May an analyst generally answer yes-or-no questions regarding possible changes to a proposed transaction, whereas "how-to" questions are off-limits? While such formulations may be too formalistic to serve as useful guidelines for compliance with the rule, both NRSROs and arrangers seeking ratings from them will need to find concrete ways to prepare their personnel to comply with the rule.

Given that there may be some uncertainty regarding what constitutes a "recommendation," and given that the rule imposes a flat prohibition on ratings once a recommendation has been made, other questions may be expected to arise in connection with the rule's operation. For instance, what action should an NRSRO take if internal controls determine that a recommendation may have been provided? If a rating has already been issued, must it be withdrawn pending further investigation? Arrangers will want to consider such questions and prepare their personnel accordingly, in order to minimize the risk of communications that might compel an NRSRO to withdraw or refrain from issuing a rating.

• Arrangers of structured finance products may also want to consider providing in their contracts with NRSROs for the situation in which a violation of this rule prevents the NRSRO from issuing or maintaining a rating.¹⁵
• Significantly, the plain text of the rule prohibits issuing or maintaining a credit rating if a prohibited recommendation has been provided. As such, it appears to require an NRSRO to withdraw its rating if it becomes affiliated with a person that–before the affiliation–has provided a recommendation to the obligor or the issuer, underwriter or sponsor of a security rated by the NRSRO. The Final Rule Release does not address this scenario. The Final Rule Release does note, however, that the SEC opted to implement an absolute ban on this potential conflict of interest, rather than permitting NRSROs to manage it through, for example, information barriers between an NRSRO and its affiliate.¹⁶ The SEC specifically states that the ban seeks to eliminate the NRSRO's objectivity from being compromised by its interest in the financial success of its affiliate.¹⁷
• In light of this stated aim, a related question is whether the ban applies if an NRSRO affiliate provided recommendations within the scope of the rule, but then ceased to be an affiliate of the NRSRO.¹⁸ In this situation, the NRSRO would no longer appear to have an interest in the success of the person that provided recommendations. May the NRSRO issue and maintain a credit rating in this instance? The answer to this question may affect ratings that will be outstanding when the rule amendments take effect on April 10, 2009, as well as securities in the planning and rating stages before that date.

B. No Participation by Certain NRSRO Personnel in Fee Discussions

Another new provision in Rule 17g-5 prohibits an NRSRO from issuing or maintaining a credit rating if the fee paid for the rating was negotiated, discussed or arranged by a person at the NRSRO who is responsible for participating in or determining credit ratings, or for developing or approving credit rating procedures or methodologies, including qualitative and quantitative models. The aim of new paragraph (c)(6) is to minimize the conflict between the objective of producing accurate and objective ratings and the aim of generating revenues for the NRSRO.¹⁹ The Commission clarified in the Final Rule Release that the prohibition also applies to persons responsible for approving credit ratings.²⁰ The Commission indicated that it will consider requests for exemptions by small NRSROs, based on their specific circumstances.

This new rule raises some important considerations for arrangers:

• They should expect analysts' access to information about fees to be more restricted than in the past, even though the rule does not preclude NRSRO personnel that are negotiating fees from obtaining information from analysts regarding expected staffing and resource requirements.
• Because the Commission stopped short of stating more broadly–as several commenters had requested–that the rule does not prohibit an NRSRO's internal communications regarding fees, the rule's scope is somewhat ambiguous.²¹ The Summary Report, however, did raise concerns about analysts' access to fee information and how knowledge of fee arrangements may affect ratings.²² In light of this, firms acting as arrangers for structured finance products may wish to instruct their personnel who interact with NRSRO analysts that they should not discuss fees with analysts or other NRSRO personnel involved in credit rating analytical processes.

C. No Gifts to Analyst or Person Approving Rating

Another new provision in Rule 17g-5 prohibits an NRSRO from issuing or maintaining a credit rating if a credit analyst who participated in determining or monitoring the credit rating, or a person responsible for approving the credit rating, received gifts, including entertainment, from the obligor being rated, or from any of the arrangers. The rule permits the provision of incidental items in the context of normal business activities such as meetings (e.g., note pads, pens, or light refreshments), if their aggregate value does not exceed $25. The Commission cautions, however, that the $25 limit is not an exception and does not permit an analyst to accept any gift that has no use in connection with the meeting. The $25 limit applies to each analyst in connection with each interaction.²³ The rule applies to gifts received on or after April 10, 2009.²⁴

Arrangers should ensure that they have policies and procedures in place to ensure compliance with the new rule.

III. Other Final Rule Amendments: New Requirements for NRSROs and Implications for Arrangers

Other aspects of the final rule amendments do not affect arrangers directly, although their effect on the ratings process may be expected to have an indirect impact on arrangers that pay NRSROs for ratings.

These rule changes include:

• Enhanced Disclosure Requirements on Form NRSRO. Form NRSRO will require additional disclosures, including performance measurement statistics, information about certain verification performed and its effect on credit ratings, how qualitative assessments of the originators of assets underlying structured finance products affect the rating process, the frequency of surveillance efforts, and how changes in the ratings models affect surveillance.
• Records and Public Disclosure of Rating Histories. A new provision will require–for each outstanding credit rating the NRSRO maintains–a record of all rating actions (initial rating, upgrades, downgrades, placements on watch for upgrade or downgrade, and withdrawals).²⁵ Another new provision will require an NRSRO to make publicly available, with a six-month delay, the rating action records for a random sample of 10% of the issuer-paid credit ratings.²⁶
• Record of Material Deviation from Result of Quantitative Model. An amended rule requires that if a quantitative model is a substantial component in the NRSRO's rating process, and if the NRSRO assigns to a structured finance product a rating that deviates materially from the rating implied by the model, the NRSRO must make and retain a record of the rationale for the divergence.²⁷
• Records of Third-Party Complaints Regarding Analysts. A new rule provision requires NRSROs to retain written communications from persons not associated with the NRSRO that contain complaints about the performance of a credit analyst in initiating, determining, maintaining, monitoring, changing or withdrawing a credit rating.²⁸
• Report on Number of Credit Rating Actions. A new rule provision requires an NRSRO to submit to the Commission, on a confidential basis, an annual report of the number of credit rating actions for each class of credit rating for which the NRSRO is registered with the Commission.²⁹

IV. Conclusions

The final and proposed rule changes are expected to affect many market participants by introducing new dynamics in the rating process, such as changes in the NRSROs' rating surveillance practices, their willingness to deviate from implied outputs of their models, and the amount of information publicly available regarding their rating processes. While the market for structured finance has been quiet due to the ongoing turmoil in the credit markets, it is considered an important element in revitalizing our financial system. We believe that arrangers and other interested parties should consider actively participating in the public comment process.

¹ Exchange Act Release No. 59,343 (Feb. 2, 2009), 74 Fed. Reg. 6,485 (Feb. 9, 2009) (2009 Proposal). The 2009 Proposal re-proposes with modifications certain amendments proposed in June 2008. See Exchange Act Release No. 57,967 (June 16, 2008), 73 Fed. Reg. 36,212 (June 25, 2008) (2008 Proposing Release). The 2009 Proposal takes no action on related proposals issued last summer. See Exchange Act Release No. 58,070 (July 1, 2008), 73 Fed. Reg. 40,088 (July 11, 2008) (proposing to remove references to NRSROs in SEC rules); Securities Act Release No. 8,940 (July 1, 2008), 73 Fed. Reg. 40,106 (July 11, 2008) (same); Investment Company Act Release No. 28,327 (July 1, 2008), 73 Fed. Reg. 40,124 (July 11, 2008) (same).

² Exchange Act Release No. 59,342 (Feb. 2, 2009), 74 Fed. Reg. 6,456 (Feb. 9, 2009) (Final Rule Release). These rule amendments were published for comment in the 2008 Proposing Release. The effective date for these final rules is April 10, 2009; however, the compliance date for the required public disclosure of a sample of rating action histories, in Rule 17g-2(d), does not start until August 10, 2009, in order to allow time for necessary technological development. The Commission voted in December to adopt these final rules and to propose other rule amendments. See SEC Press Release No. 2008-284 (Dec. 3, 3008).

³ All rules (final and proposed) referenced here are Exchange Act rules.

⁴See, e.g., Christopher Cox, SEC Chairman, Testimony Concerning Recent Developments in U.S. Financial Markets and Regulatory Responses, Before the U.S. Senate Committee on Banking, Housing and Urban Affairs (July 15, 2008) (calling the credit rating industry "one of the most significant problem areas that led to the spread of the subprime crisis"); Christopher Cox, SEC Chairman, Testimony Concerning the Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation, Before the U.S. House Committee on Oversight and Government Reform (Oct. 23, 2008) (stating that credit rating agencies "notoriously gave AAA ratings to [] structured mortgage-backed securities . . . [and] sometimes helped to design these securities so they could qualify for higher ratings," and stating that the SEC is working "to expose weaknesses in the ratings process and to develop strong new rules"); Christopher Cox, SEC Chairman, Address to Joint Meeting of the Exchequer Club and Women in Housing and Finance, Washington, D.C. (Dec. 4, 2008) (referring to credit rating agencies' conflicts of interest and the SEC's study of and actions with regard to NRSROs); Kathleen L. Casey, SEC Commissioner, Remarks Before the Exchequer Club, Washington, D.C. (Jan. 14, 2009) (stating her belief that the Commission should take further action to impose additional requirements on credit rating agencies); Mary L. Schapiro, SEC Chairman, Address to Practising Law Institute's "SEC Speaks in 2009" Program, Washington, D.C. (Feb. 6, 2009) (stating as one of her priorities "[i]mproving the quality of credit ratings by addressing the inherent conflicts of interest credit rating agencies face as a result of their compensation models and limiting the impact of credit ratings on capital requirements of regulated financial institutions").

Other efforts to improve transparency in the credit markets–particularly with respect to securitized products–are active as well, and they include efforts beyond the U.S. borders. For example, the European Securitisation Forum recently released its RMBS Issuer Principles for Transparency and Disclosure. These voluntary guidelines for European issuers of residential mortgage-backed securities are part of the Ten Industry Initiatives to Increase Transparency in the Securitisation Markets, which ESF has committed to the European Commission. The new guidelines aim to promote consistent disclosure by issuers to investors and other market participants. See European Securitisation News, ESF releases RMBS Issuer Principles for Transparency and Disclosure (Feb. 19, 2009), available here.

⁵ Staff of the Office of Compliance Inspections and Examinations, the Division of Trading and Markets, and the Office of Economic Analysis, SUMMARY REPORT OF ISSUES IDENTIFIED IN THE COMMISSION STAFF'S EXAMINATIONS OF SELECT CREDIT RATING AGENCIES, July 2008 (Summary Report).

⁶ Summary Report, at 31-32.

⁷ Proposed Rule 17g-5(a)(3), (b)(9), (e).

⁸ Proposed Rule 17g-5(a)(3)(iii)(A)-(D). The 2009 Proposal also would amend Regulation FD to create a general exception to allow material nonpublic information to be provided to NRSROs without triggering Regulation FD's public disclosure requirement, regardless of whether the NRSROs' ratings are made publicly available. The aim of this proposed amendment is to accommodate (1) NRSROs that may access information through the password-protected websites, but not issue ratings, and (2) subscriber-paid ratings that are not made public. 2009 Proposal, 74 Fed. Reg. at 6,497.

⁹ The scope of products subject to the re-proposed rule is the same as in the 2008 Proposing Release.

¹⁰ 2009 Proposal, 74 Fed. Reg. at 6,493-97.

¹¹ The recordkeeping requirement would be renumbered as Rule 17g-2(d)(1). The provision requiring disclosure of the 10% sample would be renumbered as 17g-2(d)(2), and 17g-2(d)(3) would state the broader disclosure requirement. Among the Commission's specific questions for comment are whether the proposed disclosure requirement should be extended to subscriber-paid ratings, and whether the proposed 12-month delay for disclosure should be shorter, longer, or eliminated.

¹² Final Rule Release, 74 Fed. Reg. at 6,466.

¹³Id. at 6,467.

¹⁴Id. at 6,466.

¹⁵ According to the Summary Report, at least as to residential mortgage-backed securities, a fee typically is paid only if a rating is issued, although a break-up fee sometimes is paid to the credit rating agency for its analytic work if a rating is not issued. Summary Report, at 9.

¹⁶ Final Rule Release, 74 Fed. Reg. at 6,467.

¹⁷Id.  

¹⁸ The Commission notes in the Final Rule Release that some NRSROs may find it necessary to restructure some of their business models or activities as a result of the new rules. Id. at 6,479.

¹⁹Id. at 6,467.

²⁰Id. at 6,467.

²¹Id. at 6,468.

²² Summary Report, at 24-25.

²³ Final Rule Release, 74 Fed. Reg. at 6,469.

²⁴Id. That is, the rule will not preclude a rating by an analyst based on the analyst's receipt of a gift prior to the rule's effective date.

²⁵ Rule 17g-2(a)(8), as amended by the Final Rule Release.

²⁶ Rule 17g-2(d), as amended by the Final Rule Release. The SEC modified its much broader initial proposal in response to comments it received, limiting its application to issuer-paid ratings, a 10% sample, and classes of credit ratings for which the NRSRO has issued at least 500 issuer-paid ratings, and adding a six-month delay.

²⁷ Rule 17g-2(a)(2), as amended by the Final Rule Release.

²⁸ This requirement is located in a new rule paragraph, Rule 17g-2(b)(8). The express limitation to written communications from persons not associated with the NRSRO was added in response to comments that the proposed rule might be overly broad and burdensome.

²⁹ Rule 17g-3(a)(6).