Credit Rating Agency Reform Update
The Financial Crisis Inquiry Commission, which examined the causes of the financial and economic crisis of 2008, concluded that "the failures of credit rating agencies were essential cogs in the wheel of financial destruction" and the "three [dominant] credit rating agencies were key enablers of the financial meltdown."1 Criticism of the conduct and competence of credit rating agencies (CRAs) after 2008 focused on the huge number of write-downs of highly rated residential mortgage-backed securities and collateralized-debt obligations, but critical scrutiny of CRAs had been ongoing since the late 1990s.
In 2006, Congress passed the Credit Rating Agency Reform Act,2 which gave the Securities and Exchange Commission (SEC) limited regulation of CRAs. The Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank)3 mandated much more regulatory oversight. This column will review the provisions of Dodd-Frank applicable to CRAs and the progress of the SEC in implementing those provisions.
Regulation of CRAs
CRAs analyze and evaluate the creditworthiness of corporate and sovereign issuers of debt securities. While CRA ratings are often regarded as a judgment on the worthiness of an investment, CRAs claim that their opinions relate solely to the likelihood that a particular debt security will perform according to its terms. In 1975, the SEC adopted the term "nationally recognized statistical rating organization" (NRSRO) to determine capital charges for broker-dealers for purposes of the SEC's net capital rule. Marketplace and regulatory reliance on credit ratings then gradually increased, and the concept of an NRSRO became embedded in a wide range of U.S. regulations of financial institutions, as well as state, federal, and foreign laws relating to creditworthiness.
The decision to impose government regulation on CRAs in the United States in 2006 was controversial and to some extent remains so. Some argued that the NRSRO designation was a barrier to competition in the rating business. Others argued that the SEC lacked authority to substantively regulate CRAs because the activities of these firms are journalistic and protected by the First Amendment. Even when Congress imposed SEC regulation on CRAs, hesitancy about government control of ratings led to a provision in the 2006 statute that expressly prohibits the SEC from regulating "the substance of credit ratings or the procedures and methodologies by which any [CRA] determines credit ratings."4
For many years, the CRAs sold subscriptions to investors to pay for issuer credit ratings, but in recent years, an issuer pay model has prevailed. Furthermore, CRAs became public companies or subsidiaries of public companies and were motivated to increase their earnings. Then, during the bubble years preceding the 2008 financial meltdown, CRAs were actively engaged in rating securitized financial products and often participated in the structuring of these products in order to give them a high credit rating. More recently, CRAs have been criticized for their sovereign debt ratings.
Dodd-Frank enhanced the regulation and oversight of NRSROs by imposing new reporting, disclosure and examination requirements. Further, Dodd-Frank mandated the creation of the Office of Credit Ratings within the SEC, which was established in June 2012. Since Dodd-Frank was passed, the SEC adopted a number of rules applicable to NRSROs relating to the registration of NRSROs, required business records and public disclosure of ratings history data, audited and other financial reports, the establishment of procedures regarding material non-public information, conflicts of interest, prohibitions against unfair, abusive or coercive practices, and requirements for, including information regarding representations, warranties and enforcement mechanisms available to investors.5
The Credit Rating Agency Reform Act and Dodd-Frank also required that the SEC make certain annual reports to Congress. In December 2013, the SEC staff issued a summary report on the SEC's examination of each NRSRO (examinations report)6 and an annual report on registered CRAs.7 These reports detail the SEC's progress in imposing new regulations on NRSROs and continuing shortcomings in their regulation.
Much of the annual report is devoted to an analysis of competition within the NRSRO industry. The industry remains concentrated, with only 10 NRSROs registered with the SEC, and three of them—S&P, Moody's and Fitch having issued 96.5 percent of all outstanding ratings as of Dec. 31, 2012, only a slight decline from year end 2007.8 Although the examinations report reveals a number of weaknesses in the management of conflicts of interest, implementation of ethics policies and internal supervisory controls, the report does not name names, so it is not possible to discern which of the CRAs has failed to fully reform its practices and procedures.
When Dodd-Frank was under consideration by Congress, two somewhat contradictory ideas were vetted with regard to rating agency reform. Both of these ideas were based on the belief that CRAs were an unacceptable oligopoly because three big NRSROs dominated the field. First, there was a view that all references to ratings should be deleted from SEC regulations and the regulations of other government agencies. A provision to this effect was included in Dodd-Frank as passed.
Second, was a proposal for a self-regulatory or other organization that would assign an offering to NRSROs for a rating. This proposal, contained in the Franken-Wicker amendment to Dodd-Frank, was put into the Senate bill, but was not included in the final statute. However, the SEC was tasked with considering an assigned rating system or proposing some alternative method for dealing with conflicts of interest in the ratings process.
On Dec. 27, 2013, the SEC passed rules removing references to NRSRO rating in several of its rules and forms.9 The use of the term NRSRO was devised in order to provide a method for determining net capital charges by broker-dealers on different grades of debt securities under Rule 15c3-1, the net capital rule, which prescribes a net liquid assets test for purposes of determining whether a firm has sufficient liquid assets for an orderly wind-down of its business in the event of financial failure. The rule prescribes differing haircut amounts for classes of securities, which measure whether there are market or credit risks that prevent the securities from having a ready market. Previously, commercial paper, nonconvertible debt and preferred stock rated in high rating categories by at least two NRSROs were included in the classes of securities that had lower haircuts than other securities.
In the rules removing references to credit ratings in Rule 15c3-1, the SEC substituted an alternative standard of "creditworthiness" as a condition for qualifying for the lower haircut treatment.10 As a conceptual matter, this sounds simple, but as a practical matter broker-dealers will be required to engage in some complicated procedures in order to apply a creditworthiness standard. A broker-dealer will be required to establish, document, maintain, and enforce policies and procedures to assess and monitor the creditworthiness of each security or money market instrument to determine whether an investment has only a minimal amount of risk. In order to guide broker-dealers in developing adequate procedures for determining creditworthiness, the SEC set forth a list of factors to be considered, as follows: credit spreads; securities-related research; internal or external credit risk assessments; default statistics; inclusion in an index; enhancements and priorities; price, yield/and/or volume; and asset class-specific factors.11