SEC Credit Agency Regulations Roil Investment Firms, Securitizers

Issuers of asset-backed securities—banks and other financial firms whose ABS offerings keep the flow of capital coursing through the public markets—find themselves on the horns of a disclosure dilemma these days.

It's a dilemma that has equally snarled the Securities and Exchange Commission. The heart of the problem is how to implement various sections of the Dodd-Frank Act that try to divorce ABS offerings from their reliance on stamps of approval from credit rating agencies. To do that, issuers would need to calculate and disclose a battalion of risks in those ABS offerings, which they've never done before to this extent. Worse, the SEC is finding that new rules to outline those obligations aren't easy to pin down either.

As the SEC continues to implement rules aimed at regulating credit rating agencies, issuers are scrambling to prepare for strict new disclosure requirements in the ABS market, and for new rating responsibilities. The new rules could affect the market for ABS and make it more difficult for companies to securitize certain cash streams, such as leases, receivables, and real estate.

The most recent development is the SEC's proposed rule on credit risk retention, which requires issuers of asset-backed securities to maintain at least 5 percent economic interest in the securities that they trade.

Two other rules—one was proposed on March 2 that would do away with all references to rating agencies in SEC filings and replace them with companies' own assessments of securities, and another approved on Jan. 20 that will require ABS issuers and credit rating agencies to file a new annual report with the SEC at the beginning of next year—have caught the attention of companies wary of more burdensome requirements.

These are only some of the latest rules in a barrage of mandates that Dodd-Frank has foisted upon the Commission to protect investors from relying too heavily on faulty credit ratings—seen as a major culprit in the financial crisis

Cutting out references to the rating agencies leaved a “big, gaping hole” in the money markets system, says Scott Talbot, senior vice president for government affairs at the Financial Services Roundtable. “It's fine to say, ‘We're not going to use the credit rating agencies,' but you've got to put something in its place—because now you've actually made the system weaker,” he says. “Now there's no requirement to evaluate the basis of the investment.”

While the SEC's hands are tied by the mandates from Congress, the Commission has still found creative solutions to difficult problems, says Frank Polverino, partner at the law firm Cadwalader, Wickersham & Taft, referring to the no-action relief issued in the summer to prevent the entire ABS market from grinding to a halt.

On March 2, the Commission proposed rule required under Dodd-Frank to remove references to credit rating agencies from the Investment Company Act rules. Under this proposal, funds that invest in such securities would no longer have to rely on ratings to justify investment decisions: instead, the fund's board would judge the issuer's capacity to meet its short-term financial obligations or would judge whether the security has minimal credit risk, said chairman Mary Schapiro when she announced the proposal.

“The SEC had to come up with some creative way to avoid having the rating agencies be considered ‘experts' in public deals.”

—Frank Polverino,

Partner,

Cadwalader, Wickersham & Taft

Companies will need to consider carefully how to take on this extra responsibility. “The investment board would have to take on more oversight and more investigation, because that's the only line of defense,” says Polverino. “In the current regime, the boards still have to make the decision that this is the right investment, but by removing the ratings requirement, you remove a level of objectivity. Some people could say that it might actually weaken the rule in terms of what has to be done now for investing in money market funds.”

“We would urge that the SEC consider providing flexibility until the credit rating agencies have been strengthened,” says Talbot.

Since it seems that the SEC has little choice in the matter, companies will still need to think up solutions to make the new system work. “I think smaller companies can devise scoring systems that use ratings as part of their decision process,” says Daniel Curry, president of the rating agency DBRS, Inc. “Ratings should only be one consideration in an investment decision.  I don't think it is realistic to think that any investor other than the largest firms can replicate what the rating agencies are doing.”

NRSRO RULES

Below find key details regarding the regulation of credit rating agencies as mandated by the Dodd-Frank Act:

A. The Act requires nationally recognized statistical rating organizations (NRSROs) to establish and document internal controls concerning the methodologies and policies for determining credit ratings, and to submit an annual internal controls report to the SEC. This report must be attested to by the CEO of the NRSRO, must describe the management's role in implementing the internal controls, and must evaluate the effectiveness of the control structure.

B. The Act gives the SEC the ability to sanction individuals associated with an NRSRO for failure to reasonably supervise an individual who violates the securities laws.

C. The SEC will have the authority to temporarily suspend or permanently revoke the registration of an NRSRO, with respect to a particular class of securities, if it finds that the NRSRO does not have the resources to consistently produce credit ratings with integrity.

D. The Act requires the SEC to adopt rules to prevent sales and marketing practices of NRSROs from influencing credit ratings. The SEC may suspend or revoke the registration of an organization for violating these rules.

E. NRSROs will be required to implement policies and procedures to limit potential conflicts of interest when an employee of the NRSRO has previously worked with an issuer, underwriter, or sponsor of a money market instrument.

F. The Act imposes limitations on the role of the designated compliance officer within each NRSRO. The designated compliance officer may not perform credit ratings, participate in the development of ratings, engage in marketing or sales functions, or assist in establishing compensation levels for employees not working directly for the compliance officer. The compensation for this position may not be linked to the financial performance of the NRSRO. The compliance officer must submit an annual report to the NRSRO, and file the report with the SEC, detailing the compliance of the NRSRO with securities laws and with its own internal procedure and policies, and detailing any changes in ethical and conflict of interest policies.

G. The Act establishes an Office of Credit Ratings (Office) within the SEC to oversee NRSROs. The Office will conduct annual examinations of each NRSRO, reviewing the organization's adherence to internal policies and procedures; its management of conflicts of interest; its implementation of ethics policies; its internal governance; the activities of its compliance officer; the processing of complaints; and the its policies for governing post-employment activities of former staff. A summary of this report will be made public.

H. The SEC must adopt rules regarding the procedures and methodologies used to produce credit ratings to ensure that these methods are approved by the board of an NRSRO, are applied consistently, and adhere to the internal policies and procedures of the NRSRO. If changes are made to methodologies and procedures, the NRSRO must notify users of the credit rating, must disclose the reason for the changes, must specify the version of the method used for a particular credit rating, and must identify whether the change in methodology will affect current credit ratings. NRSROs also must notify users if significant errors in procedures or methodologies are identified.

I. At least half of the board of directors of each NRSRO, but not fewer than two members of the board, must be independent directors who are uninvolved in the credit rating process, and whose compensation is not linked to the business performance of the NRSRO. Independent directors may serve for a pre-fixed, non-renewable period of time, not exceeding five years. The board is required to oversee the procedures for determining ratings, the policies and procedures for addressing conflicts of interest, the effectiveness of the internal control system, and the compensation and promotion policies.

J. Statements made by credit rating agencies will be subject to the same enforcement and penalty provisions as statements made by public accounting firms and securities analysts, and will not be considered forward-looking statements for purposes of the safe harbor provision of Section 21E of the 1934 Act.

K. The Act repeals SEC Rule 439(g), which exempted credit ratings by NRSROs from the requirements applying to experts under Sections 7 and 11 of the Securities Act of 1933 (1933 Act) when the ratings were part of a registration statement.

L. If an action for money damages is brought against an NRSRO for purposes of pleading, it is sufficient that the complaint describe facts giving rise to a strong inference that the NRSRO failed to conduct a reasonable investigation of the rated security with respect to the factual elements on which it relied, or failed to obtain reasonable verification of these factual elements.

Source: Foley & Lardner's Legal News Alert, July 19, 2010.

Last summer, after the SEC implemented the Dodd-Frank mandate to repeal the rule that exempts credit rating agencies from “expert” designation—making them liable for material misstatements or omissions in their securities ratings under—the agencies said they wouldn't issue any ratings for the ABS markets. The only problem is that since issuers were required to include ratings in new public offerings, the market would've shut down, making it nearly impossible for companies to make an initial public offering. “The SEC had to come up with some creative way to avoid having the rating agencies be considered ‘experts' in public deals,” says Polverino. “They said, ‘We won't pursue you, we'll take no action against you guys in this market, if you file your prospectuses without identifying the ratings of the securities.'” That no-action measure was extended indefinitely on Nov. 24.

New Disclosures

Now, the new rule affecting the ABS market that was passed in January requires securitizers of ABS to “disclose fulfilled and unfulfilled repurchase requests.” Congress' intent here was to identify the asset originators with clear underwriting deficiencies, says Polverino. The rule went into effect on March 28. Initial filings must come in by February 2012, after which there will be quarterly filings.

Everyone who wants to participate in the ABS market—from Ford to Goldman Sachs to Wells Fargo—will be required to have repurchase covenants in their deal documents.

“This is a completely brand-new form, a new disclosure that's never been out there before, so obviously it creates an additional burden on securitization participants for tracking this data, compiling it, putting it in the forms, getting comfort that the information in those forms is correct, and then doing the actual filings themselves,” says Polverino.

Issuers with public disclosures filed with the SEC must name the originator's report. “If you're an issuer that aggregates loans from the secondary market and you buy loans from various originators, you have to keep track of who those originators are and then, if there's a breech of rep or warranty with respect to loans in that particular pool, you have to attribute that there's a breech with respect to each loan and each originator,” Polverino says.

Under the rule, nationally recognized statistical rating organizations (NRSROs) must also put information in all rating reports that regards “the representations, warranties and enforcement mechanisms available to investors in an asset-backed securities offering.”

In other words, agencies now have to list each person that paid them to issue or maintain a credit rating, the percent of the net revenue earned from providing services, and products other than credit rating services, and the relative standing of the person in terms of the person's contribution to revenue, in an annual report, also available on their Website, said A.M. Best in a letter submitted to the SEC. A.M objected to the requirement “due to the anti-competitive nature of the rule, particularly on smaller NRSROs” and since “such disclosures could be misleading to users of ratings.”

The SEC is accepting comments on the proposal to remove references to credit ratings from SEC filings until April 25. The comment period on the proposal to require ABS securitizers to retain at least 5 percent of the risk will run through June 10.