SEC REGULATION OF RATING AGENCIES NRSROs
Generally, a credit rating agency is defined in the Rating Agency Act of 2006 to be a person (a) engaged in the business of issuing credit rating on the Internet or through another readily accessible means, for free or for a reasonable fee, but does not include a commercial credit reporting company; (b) employing either a quantitative or qualitative model, or both, to determine credit ratings; and (c) receiving fees from either issuers, investors, or other market participants, or a combination thereof. The 2006 Act further identified that “the oversight of such credit rating agencies serves the compelling interest of investor protection.” Credit rating agencies are companies, contracted by corporations, nations, states, and banks to ascribe an appropriate risk of default to a financial instrument (typically bonds and mortgage-backed securities) which issuers intend to sell. Once given a designation, an entity typically markets the instrument and touts its designations to potential buyers. The designation of a higher rating indicates a lower risk of default within the underlying obligation, making it more likely an investor will purchase the instrument, and the borrower will recieve a lower interest rate. More directly and aptly stated, credit rating agencies are companies relied upon by institutional and individual investors to provide expert guidance in purchasing bonds or securities. They are the de facto gatekeepers for corporate borrowing and marketing of asset backed derivatives.
Since the early 1900’s CRA’s have been rating securities and publishing ratings. In 1975, with the SEC’s designation of “nationally recognized statistical rating agency,” (NRSRO) CRA’s became prominently regulated under the federal government. The SEC began allowing rating agencies to register with it and to base its net capital rules for broker-dealers with respect to different grades of debt securities on NRSRO ratings. In time, the SEC and others incorporated the NRSRO concept into many other rules and regulations. In 2006, Congress replaced the SEC's largely informal approach to NRSRO regulation by enacting the Credit Rating Agency Reform Act of 2006, which defined NRSRO and authorized the SEC to implement registration, recordkeeping, financial reporting, and oversight rules with respect to registered credit rating agencies.
NRSRO activities are regulated primarily under 1934 Act Section 15E and the rules adopted there under (SEC Rules 17g-1 through 17g-7), which prescribes the registration requirements and regulations governing NRSROs. These rules generally address disclosure, recordkeeping on ratings procedures and methodologies, and annual reports of credit rating actions to be filed with the SEC. These regulations expressly deal with conflicts of interest, some of which are prohibited and others that are to be managed, specifies prohibited acts and practices, and mandates disclosures in reports accompanying an asset backed-security's credit rating of the representations, warranties, and enforcement mechanisms applicable to the securitization.
Credit rating agencies may register with the SEC to be NRSROs for up to five classes of credit ratings: (1) financial institutions, brokers, or dealers; (2) insurance companies; (3) corporate issuers; (4) issuers of asset-backed securities; and (5) issuers of government securities, municipal securities, or securities issued by a foreign government. There are 10 firms registered with the SEC as NRSROs: A.M. Best Company, Inc.; DBRS Ltd.; Egan-Jones Rating Company; Fitch, Inc.; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.; Moody's Investors Service, Inc.; Rating and Investment Information, Inc.; Realpoint LLC; and Standard & Poor's Ratings Services.
SEC Rule 17g-1 prescribes the application process for registration as an NRSRO. It requires a credit rating agency to submit an initial NRSRO application on Form NRSRO, which is generally available publicly and which is also used for updates and annual certifications. Form NRSRO contains eight line items and requires 13 exhibits that the applicant/NRSRO must submit in varying detail documenting its credit ratings performance measurement statistics; a description of its credit rating procedures and methodologies; copies of policies and procedures with regard to nonpublic information and ethics and conflicts of interest; information on its organizational structure, rating analysts, credit supervisors, compliance officer; the applicant's/NRSRO's audited financial statements as well as a list of the largest users of the rating agencies services during the prior year.
An NRSRO must report credit ratings performance measurement statistics on Exhibit 1 to Form NRSRO. At a minimum, Exhibit 1 must show default and transition statistics for one-, three-, and 10-year periods (as applicable) for each asset class of credit ratings for which the firm is registered or is seeking registration. The default statistics must include defaults relative to the initial ratings. Transition statistics are to include all rating transitions, upgrades, and downgrades. These statistics are to provide for any security or money market instrument issued by an asset pool or as part of any asset-backed security (ABS) or mortgage-backed security (MBS) transaction.
Exhibit 2 to Form NRSRO requires the applicant/NRSRO to set forth a general description of the procedures and methodologies used to determine credit ratings, in sufficient detail to provide users of credit ratings with an understanding of the processes employed and should address (if applicable), matters such as the following:
• Initiating a rating—Policies for determining whether to initiate a credit rating.
• Information sources—Public and nonpublic sources of information used in determining credit ratings, including information and analysis provided by third-party vendors.
• Verification information—Whether and, if so, how information on verification performed on assets underlying or referenced by the security or money market instrument issued by an asset pool or as part of any ABS or MBS transaction is relied on in determining credit ratings.
• Models and metrics used—Qualitative and quantitative models and metrics used, procedures for interacting with management of a rated obligor or issuer and the structure and voting process of the committees that review and approve the ratings.
• Monitoring, updating, and withdrawing ratings—Procedures for notifying rated obligors and issuers of rating decisions and for monitoring, updating, and withdrawing previously assigned ratings.
• Interaction with management—The procedures for interacting with the management of a rated obligor or issuer of rated securities or money market instruments.
• Credit committee processes—The structure and voting process of committees that review or approve credit ratings.
Once designated as an NRSRO, a credit rating agency must comply with SEC Rule 17g-2, which imposes a number of recordkeeping and public disclosure requirements. An NRSRO must make and retain complete and accurate records for each of their outstanding credit ratings, from the initial rating to the current rating, dates of such actions along with the name of the security or obligor rated and, if applicable, the CUSIP for the rated security or the Central Index Key (CIK) number of the rated obligor. Under this rule, a NRSRO must post on its Web site, in XBRL format, the complete ratings histories for a random sample of 10% of its issuer-paid credit ratings in each class of credit ratings for which the NRSRO is registered and has issued 500 or more issuer-paid credit ratings. When an NRSRO's sample falls below 10%, either because the rating agency withdraws a rating or a rated instrument matures, the NRSRO must replace this rating with a new randomly selected rating from the class.
If a quantitative model is a substantive component of a rating process, an NRSRO is required to make a record of the rationale for its credit ratings when a final credit rating on a security or money market instrument issued by an asset pool or as part of any ABS or MBS transaction materially deviates from the rating implied by the model. Further, Rule 17g-2 requires an NRSRO to retain written communication that contains complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating, marketing materials, and internal and external communications that relate to all aspects of the credit rating surveillance process.
SEC Rule 17g-3 requires an NRSRO to file six financial reports annually, including an audited balance sheet, income statement, statement of cash flows, and a statement of changes in ownership equity as well as an unaudited annual report of the number of credit rating actions that occurred during the prior fiscal year for each class of security for which the NRSRO is registered with information on upgrades, downgrades, placements on credit watch, and withdrawals. The credit rating action report is required on any security or money market instrument issued by an asset pool or as part of any ABS or MBS transaction. An NRSRO must attach to its financial reports a signed statement by a duly authorized person associated with the NRSRO stating that the person has responsibility for the financial reports and, to the best of his or her knowledge, the financial reports fairly present, in all material respects, the financial condition, results of operations, cash flows, revenues, analyst compensation, and credit rating actions of the NRSRO for the period presented.
SEC Rule 17g-4 requires an NRSRO to establish written policies and procedures to prevent misuse of material nonpublic information obtained in connection with the performance of credit rating services. SEC Rule 17g-5 addresses conflicts of interest by persons within an NRSRO and generally requires the NRSRO to have written policies and procedures to address and manage such conflicts of interest. Conflicts of interest fall into two categories: those to be managed and those that are prohibited. Conflicts that are to be managed include when the NRSRO:
• Paid by issuer/underwriter—Is paid by issuers or underwriters or obligors to determine credit ratings with respect to securities or money market instruments they issue or underwrite or with respect to the obligors (this practice is commonly referred to as the “issuer paid” or “issuer pays” model).
• Paid for additional services—Is paid for services, that are in addition to determining credit ratings, by issuers, underwriters, or obligors that have paid the NRSRO to determine a credit rating.
• Paid by interested subscribers—Is paid by persons for subscriptions to receive or access the credit ratings of the NRSRO and/or for other services offered by the NRSRO where such persons may use the NRSRO's credit ratings to comply with, and obtain benefits or relief under, statutes and regulations using the term NRSRO or where such persons also may own investments or have entered into transactions that could be favorably or adversely impacted by a credit rating issued by the NRSRO.
• Investments by NRSRO personnel—Allows persons within the NRSRO to directly own securities or money market instruments of, or have other direct ownership interests in, issuers or obligors subject to a credit rating determined by the NRSRO.
• Business relationships—Allows persons within the NRSRO to have a business relationship that is more than an arm’s length ordinary course of business relationship with rated entities.
• Underwriters—Having an associated person who is a broker-dealer engaged in underwriting securities or money market instruments.
• Rating paid for by pool issuer—Issues or maintains a credit rating for a security or money market instrument issued by an asset pool or as part of any ABS or MBS transaction that was paid for by the issuer, sponsor, or underwriter of the security or money market instrument.
• Other conflict—Any other type of conflict of interest relating to the issuance of credit ratings that is material to the NRSRO and identified in Form NRSRO.
Paragraph (c) of SEC Rule 17g-5 identifies conflicts of interests that an NRSRO is prohibited from having, including issuing or maintaining a credit rating:
• 10% contributor—Solicited by a person that, in the most recently ended fiscal year, provided 10% or more of the total net revenue of the NRSRO (as defined in SEC Rule 17g-3) for the prior fiscal year, or is a person associated with the NRSRO.
• Direct ownership interest—With respect to a person (excluding a sovereign nation or an agency of a sovereign nation) where the NRSRO, a credit analyst that participated in determining the credit rating, or a person responsible for approving the credit rating, directly owns securities of, or has any other direct ownership interest in, the person that is subject to the credit rating.
• Officer or director—Where a credit analyst who participated in determining the credit rating, or a person responsible for approving the credit rating, is an officer or director of the person that is subject to the credit rating.
• Recommendation to issuer—With respect to an obligor or security where the NRSRO or a person associated with the NRSRO 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 obligor or issuer of the security.
• Fee arrangements—Where the fee paid for the rating was negotiated, discussed, or arranged by a person within the NRSRO who has responsibility for participating in determining credit ratings or for developing or approving procedures or methodologies used for determining credit ratings, including qualitative and quantitative models.
• Gifts and entertainment—Where 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 the issuer, underwriter, or sponsor of the securities being rated, other than items provided in the context of normal business activities, such as meetings, that have an aggregate value of no more than $25.
SEC Rule 17g-6 prohibits an NRSRO from engaging in any of the following unfair, coercive, or abusive practices:
• Purchase of services—Conditioning or threatening to condition the issuance of a credit rating on the purchase by an obligor or issuer or affiliate of other NRSRO products or services.
• Depart from established procedures—Issuing, or offering or threatening 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 the purchase of other NRSRO services or products.
• Modifying a rating—Modifying, or offering or threatening to modify, a credit rating in a manner that is contrary to the NRSRO's established procedures and methodologies for modifying credit ratings based on the purchase of other NRSRO services or products.
• Anticompetitive activities—For securities or money market instruments issued by an asset pool or as part of any ABS or MBS transaction, 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 or threatening to withdraw a credit rating unless all or a portion of the assets also are rated by the NRSRO.
 2006 S. 3850 sec. 3(a)(61).
 See id. at sec. 2(4).
 Definition of a Nationally Recognized Statistical Ratings Organization, Securities Exchange Release nos. 33-8570, 34-51572 (April 19, 2005).
 See Rule 15c3-1 of the Securities Exchange Act of 1934 (1934 Act).
 In re Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws, Securities Exchange Release nos. 33- 8236, 34-47972 (June 4, 2003).
 Registration of nationally recognized statistical rating organizations, 15 U.S.C.A. § 78o-7 (2011).
 Definitions and Applications, 15 U.S.C.A. § 78c(a)(62).
 17 C.F.R. Pt. 240.17g-1
 Oversight Of Credit Rating Agencies Registered As Nationally Recognized Statistical Rating Organizations, Securities Exchange Act Release No. 34-55857 (June 5, 2007).
 Proposed Rules for Nationally Recognized Statistical Rating Organizations , Securities Exchange Act Release No. 34-64514 (May 18, 2011).
 Oversight Of Credit Rating Agencies Registered As Nationally Recognized Statistical Rating Organizations, Securities Exchange Release No.34-55857 (June 5, 2007).
 See id.
 17 C.F.R. Pt. 240. 17g-2
 17 C.F.R. Pt. 240. 17g-2(a)(8)
 17 C.F.R. Pt. 240. 17g-2(c)(2)
 17 C.F.R. Pt. 240. 17g-2(a)(2)(iii)
 17 C.F.R. Pt. 240. 17g-2(b)(8)
 17 C.F.R. Pt. 240. 17g-2(b)(6)
 17 C.F.R. Pt. 240. 17g-2(b)(7)
 17 C.F.R. Pt. 240. 17g-2(b)(1),(2)
 17 C.F.R. Pt. 240. 17g-5(b)(1)
 17 C.F.R. Pt. 240. 17g-5(b)(3)
 17 C.F.R. Pt. 240. 17g-5(b)(4)(5)
 17 C.F.R. Pt. 240. 17g-5(b)(6)
 17 C.F.R. Pt. 240. 17g-5(b)(7)
 17 C.F.R. Pt. 240. 17g-5(b)(8)
 17 C.F.R. Pt. 240. 17g-5(b)(9)
 17 C.F.R. Pt. 240. 17g-5(b)(10)
 17 C.F.R. Pt. 240. 17g-5(c)(1)
 17 C.F.R. Pt. 240. 17g-5(c)(2)
 17 C.F.R. Pt. 240. 17g-5(c)(4)
 17 C.F.R. Pt. 240. 17g-5(c)(5)
 17 C.F.R. Pt. 240. 17g-5(c)(6)
 17 C.F.R. Pt. 240. 17g-5(c)(7)
 17 C.F.R. Pt. 240. 17g-6(a)(1)
 17 C.F.R. Pt. 240. 17g-6(a)(2)
 17 C.F.R. Pt. 240. 17g-6(a)(3)
 17 C.F.R. Pt. 240. 17g-6(a)(4)
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