SEC Adopts Final Rules for the Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations

On May 23, the Securities and Exchange Commission adopted final rules for the oversight of credit rating agencies registered as "nationally recognized statistical rating organizations" ("NRSRO"). As a result of this new regulatory and oversight regime, credit rating agencies must now more than ever carefully design and implement relevant policies and procedures, ensure effective recordkeeping, and appropriately monitor the manner in which they conduct their business. The following briefly describes the final six rules and discusses the more significant changes from the proposed rules to the final rules.

I.          Registration: Rule 17g-1

The registration rule-Rule 17g-1-sets forth the requirements for credit rating agencies to apply with the Commission for registration as an NRSRO.  Pursuant to this rule, when applying for registration, credit rating agencies must do the following:

• Identify one or more of five classes for which it is applying to be registered, including (1) financial institutions or brokers or dealers, (2) insurance companies, (3) corporate issuers, (4) issuers of asset-backed securities, and (5) issuers of government securities, municipal securities, and foreign government securities;
• Provide credit ratings performance measurement statistics;
• Describe the procedures and methodologies used for determining credit ratings;
• Describe policies and procedures adopted and implemented to prevent the misuse of material, nonpublic information;
• Identify conflicts of interest related to the issuance of credit ratings and policies and procedures to address and manage such conflicts of interest; and
• Describe the number and minimum qualifications of credit analysts and their supervisors, as well as provide the name and specified employment and educational history of the designated compliance officer.

Rule 17g-1 also requires NRSROs, if approved by the Commission for registration, to promptly update their registration applications when those applications become materially inaccurate and to file annual certifications on Form NRSRO. 

Approved NRSROs must make much of their registration application public.  But, an applicant need not do so and may request that the Commission keep information in the application confidential pending approval, which the Commission has stated it would do to the extent permitted by law.

II.        Recordkeeping: Rule 17g-2

The recordkeeping rule-Rule 17g-2-requires NRSROs to create and retain specified records, and to retain other specified records made in the normal course of the credit rating agencies’ businesses.  The rule dictates the time periods for, and the general manner in which, NRSROs must maintain required records without requiring a specific recordkeeping system.

Proposed Rule 17g-2(a)(2) would have required the creation and retention of a record identifying the procedures and methodologies used to determine each current credit rating, as well as a record of the method by which that credit rating was made publicly available.  The Commission eliminated this requirement from the final rule to reduce the recordkeeping burden on NRSROs and because the Commission staff will have access to much of this information by virtue of other provisions of the final rules.

III.       Annual Financial Reports: Rule 17g-3 

Pursuant to Rule 17g-3-the annual financial report rule-each NRSRO must furnish to the Commission certain financial reports each year, including a report containing the NRSRO’s audited financial statements.  As to the rationale for this rule, the Commission cited its responsibility to monitor NRSROs’ maintenance of adequate financial and managerial resources to consistently produce credit ratings with integrity.  In addition to the audited financial statements, the rule also requires NRSROs to furnish unaudited financial reports showing, among other things, revenue sources, compensation information for credit analysts, and their 20 largest issuers and subscribers.

Importantly, the Commission modified the proposed rule responding to commenters’ concerns regarding the difficulty and expense of obtaining audits of information other than the financial statements.  Therefore, the final rule applies the audit requirement only to NRSROs’ financial statements.

IV.       Prevention of the Misuse of Material, Nonpublic Information: Rule 17g-4

Rule 17g-4, without prescribing specific procedures, requires an NRSRO to have written policies and procedures reasonably designed to prevent three risks related to the misuse of material, nonpublic information.  These risk are:

• Inappropriate dissemination inside and outside the NRSRO of material, nonpublic information obtained in connection with performing credit rating services;
• Inappropriate dissemination inside and outside the NRSRO of a pending credit rating action before issuing the credit rating; and
• NRSRO personnel purchasing, selling, or otherwise benefiting from any transaction in securities or money market instruments when the personnel are aware of material, nonpublic information obtained in connection with performing credit rating services that affect the securities or money market instruments.

In response to issues identified by commenters, the Commission made three changes to required policies and procedures responding to the last identified risk: that NRSRO personnel will purchase, sell, or benefit from material, nonpublic information.  First, the Commission deleted the inclusion of household members of NRSRO personnel, because their inclusion would make designing effective procedures difficult.  Second, the Commission modified the required procedures to refer to situations where NRSRO personnel are "aware" of
-rather than "possess" or have "access" to-material, nonpublic information, in part based on the formulation of Rule 10b5-1.  Finally, the Commission narrowed the scope of the rule provision to "persons within"-rather than those "associated with"-the NRSRO because the Commission agreed that the proposed wording was otherwise too broad. 

V.         Conflicts of Interest: Rule 17g-5

Largely as proposed, final Rule 17g-5 prohibits NRSROs from having certain conflicts of interest, while requiring NRSROs to disclose-and manage through established policies and procedures-other conflicts of interest that arise while engaging in the normal course of issuing credit ratings.  The conflicts requiring disclosure and management pursuant to the rule include:

• NRSROs receiving compensation from issuers or underwriters to determine credit ratings with respect to securities or money market instruments they issue or underwrite;
• NRSROs receiving compensation from issuers or underwriters for ancillary services when the issuers or underwriters have also paid for a credit rating; and
• Specified NRSRO personnel having an ownership interest in a rated entity. 

The Commission simplified and clarified the rule in response to comments, and restructured portions of the final rule to clarify the types of conflicts that the rule addressed.  The Commission also added one conflict that requires disclosure and management relating to subscribers who also directly own rated securities. 

VI.       Prohibited Acts or Practices: Rule 17g-6

Rule 17g-6 prohibits NRSROs from engaging in certain unfair, coercive, or abusive practices.  For example, an NRSRO may not threaten to issue a credit rating that is not determined in accordance with the NRSRO’s established procedures and methodologies for determining credit ratings, based on whether the rated person purchases another product from the NRSRO.

With respect to structured products, proposed Rule 17g-6(a)(4) would have prohibited an NRSRO from issuing or threatening to issue a lower credit rating, lowering or threatening to lower an existing credit rating, refusing to issue a credit rating, or withdrawing a credit rating unless a portion of the assets underlying the structured product also was rated by that NRSRO.  Based on extensive comments, the Commission amended the final rule to prohibit such practices only if the NRSRO engages in such practices for an anti-competitive purpose.

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If you would like to speak with the professionals at Promontory about these new rules, or for more information regarding the Promontory Securities Practice Group, please contact Kathleen Hamm, Managing Director, at (202) 384-1022 or khamm@promontory.com.