Skip to Content

Rule

Nationally Recognized Statistical Rating Organizations

Document Details

Information about this document as published in the Federal Register.

Published Document

This document has been published in the Federal Register. Use the PDF linked in the document sidebar for the official electronic format.

Start Preamble Start Printed Page 55078

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rules.

SUMMARY:

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and to enhance oversight, the Securities and Exchange Commission (“Commission”) is: adopting amendments to existing rules and new rules that apply to credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (“NRSROs”); adopting a new rule and form that apply to providers of third-party due diligence services for asset-backed securities; and adopting amendments to existing rules and a new rule that implement a requirement added by the Dodd-Frank Act that issuers and underwriters of asset-backed securities make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. The Commission also is adopting certain technical amendments to existing rules.

DATES:

This rule is effective November 14, 2014; except the amendments to § 240.17g-3(a)(7) and (b)(2) and Form NRSRO, which are effective on January 1, 2015; and the amendments to § 240.17g-2(a)(9), (b)(13) through (15), § 240.17g-5(a)(3)(iii)(E), (c)(6) through (8), § 240.17g-7(a) and (b), and Form ABS-15G, which are effective June 15, 2015. The addition of §§ 240.15Ga-2, 240.17g-8, 240.17g-9, 240.17g-10, and Form ABS Due Diligence-15E are effective June 15, 2015.

Start Further Info

FOR FURTHER INFORMATION CONTACT:

Randall W. Roy, Assistant Director, at (202) 551-5522; Raymond A. Lombardo, Branch Chief, at (202) 551-5755; Rose Russo Wells, Senior Counsel, at (202) 551-5527; Division of Trading and Markets; Harriet Orol, Branch Chief, at (212) 336-0554; Kevin Vasel, Attorney, at (212) 336-0981; Office of Credit Ratings; or, with respect to the rules for issuers and underwriters of asset-backed securities, Michelle M. Stasny, Special Counsel in the Office of Structured Finance, at (202) 551-3674; Division of Corporation Finance; Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

End Further Info End Preamble Start Supplemental Information

SUPPLEMENTARY INFORMATION:

The Commission, with respect to NRSROs, is adopting amendments to rules 17 CFR 232.101 (“Rule 101 of Regulation S-T”), 17 CFR 240.17g-1 (“Rule 17g-1”), 17 CFR 240.17g-2 (“Rule 17g-2”), 17 CFR 240.17g-3 (“Rule 17g-3”), 17 CFR 240.17g-5 (“Rule 17g-5”), 17 CFR 240.17g-6 (“Rule 17g-6”), 17 CFR 240.17g-7 (“Rule 17g-7”), and 17 CFR 249b.300 (“Form NRSRO”); and is adopting new rules 17 CFR 240.17g-8 (“Rule 17g-8”) and 17 CFR 240.17g-9 (“Rule 17g-9”).

In addition, the Commission, with respect to providers of third-party due diligence services for asset-backed securities, is adopting new rules 17 CFR 240.17g-10 (“Rule 17g-10”) and 17 CFR 249b.500 (“Form ABS Due Diligence-15E”).

Finally, the Commission, with respect to issuers and underwriters of asset-backed securities, is adopting amendments to 17 CFR 249.1400 (“Form ABS-15G”) and is adopting new rule 17 CFR 240.15Ga-2 (“Rule 15Ga-2”).

Table Of Contents

I. Introduction

A. Background

B. Economic Analysis

1. Guiding Principles9

2. Baseline

a. NRSROs

b. Asset-Backed Security Issuers, Underwriters, and Third-Party Due Diligence Providers

c. Industry Practices

3. Broad Economic Considerations

a. Amendments and Rules Enhancing NRSRO Governance and Integrity of Credit Ratings

b. Amendments and Rules Enhancing Disclosure and Transparency of Credit Ratings

II. Final Rules and Rule Amendments

A. Internal Control Structure

1. Prescribing Factors

2. Amendment to Rule 17g-2

3. Amendments to Rule 17g-3

4. Economic Analysis

B. Sales And Marketing Conflict of Interest

1. New Prohibited Conflict

2. Exemption for “Small” NRSROs

3. Suspending or Revoking a Registration

4. Economic Analysis

C. “Look-Back” Review

1. Paragraph (c) of New Rule 17g-8

2. Amendment to Rule 17g-2

3. Economic Analysis

D. Fines and Other Penalties

1. Final Rule

2. Economic Analysis

E. Disclosure of Information About the Performance of Credit Ratings

1. Amendments to Instructions for Exhibit 1 to Form NRSRO

a. Proposal

b. Final Rule

2. Amendments to Rule 17g-1

3. Amendments to Rule 17g-2 and Rule 17g-7

a. Proposal

b. Final Rule

4. Economic Analysis

F. Credit Rating Methodologies

1. Paragraph (a) of New Rule 17g-8

2. Amendment to Rule 17g-2

3. Economic Analysis

G. Form And Certifications to Accompany Credit Ratings

1. Paragraph (a) of Rule 17g-7—Prefatory Text

2. Paragraph (a)(1)(i) of Rule 17g-7—Format of the Form

3. Paragraph (a)(1)(ii) of Rule 17g-7—Content of the Form

4. Paragraph (a)(1)(iii) of Rule 17g-7—Attestation

5. Paragraph (a)(2) of Rule 17g-7—Third-Party Due Diligence Certification

6. Economic Analysis

H. Third-Party Due Diligence for Asset-Backed Securities

1. New Rule 15Ga-2 and Amendments to Form ABS-15G

2. New Rule 17g-10

3. New Form ABS Due Diligence-15E

4. Economic Analysis

I. Standards of Training, Experience, and Competence

1. New Rule 17g-9

2. Amendment to Rule 17g-2

3. Economic Analysis

J. Universal Rating Symbols

1. Paragraph (b) of New Rule 17g-8

2. Amendment to Rule 17g-2

3. Economic Analysis

K. Annual Report of Designated Compliance Officer

1. Amendment to Rule 17g-3

2. Economic Analysis

L. Electronic Submission of Form NRSRO and the Rule 17g-3 Annual Reports

1. Amendments to Rule 17g-1, Form NRSRO, Rule 17g-3, and Regulation S-T

2. Economic Analysis

M. Other Amendments

1. Changing “Furnish” to “File”

2. Amended Definition of NRSRO

3. Definition of Asset-Backed Security

4. Other Amendments to Form NRSRO

a. Clarification with Respect to Items 6 and 7

b. Clarification with Respect to Exhibit 8

c. Clarification with Respect to Exhibits 10 through 13

5. Economic Analysis

III. Effective Dates

A. Amendments Effective Sixty Days After Publication in the Federal Register

B. Amendments Effective On January 1, 2015

C. Amendments and New Rules Effective Nine Months After Publication In the Federal Register

IV. Paperwork Reduction Act

A. Summary of the Collection of Information Requirements

1. Amendments to Rule 17g-1

2. Amendments to Instructions for Exhibit 1 to Form NRSRO

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8Start Printed Page 55079

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

B. Use of Information

1. Amendments to Rule 17g-1

2. Amendments to Instructions for Exhibit 1 to Form NRSRO

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

C. Respondents

D. Total Initial and Annual Recordkeeping and Reporting Burdens

1. Amendments to Rule 17g-1

2. Amendments to Form NRSRO Instructions

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

13. Total Paperwork Burdens

E. Collection of Information Is Mandatory

F. Confidentiality

G. Retention Period of Recordkeeping Requirements

V. Implementation and Annual Compliance Considerations

A. Internal Control Structure

B. Conflicts of Interest Relating to Sales and Marketing

C. “Look-Back” Review

D. Fines and Other Penalties

E. Enhancements to Disclosures of Performance Statistics

F. Enhancements to Rating Histories Disclosures

G. Credit Rating Methodologies

H. Form and Certification To Accompany Credit Ratings

I. New Rule 15ga-2 and Amendments to Form Abs-15g

J. New Rule 17g-10 and New Form ABS Due Diligence-15e

K. Standards of Training, Experience, and Competence

L. Universal Rating Symbols

M. Electronic Submission of Form NRSRO and the Rule 17G-3 Annual Reports

VI. Final Regulatory Flexibility Analysis

A. Need for and Objectives of the Amendments and New Rules

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Rules

1. NRSROs and Providers of Third-Party Due Diligence Services

2. Issuers

D. Reporting, Recordkeeping, and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

VII. Statutory Authority

I. Introduction

A. Background

The Dodd-Frank Act,[1] through Title IX, Subtitle C, “Improvements to the Regulation of Credit Rating Agencies,” among other things, establishes new self-executing requirements applicable to NRSROs and requires that the Commission adopt rules applicable to NRSROs in a number of areas.[2] It also requires certain studies relating to NRSROs.[3] The NRSRO provisions in the Dodd-Frank Act augment the Credit Rating Agency Reform Act of 2006 (the “Rating Agency Act of 2006”), which established a registration and oversight program for NRSROs through self-executing provisions added to the Exchange Act and implementing rules adopted by the Commission under the Exchange Act, as amended by the Rating Agency Act of 2006.[4] Title IX, Subtitle C of the Dodd-Frank Act also provides that the Commission shall prescribe the format of a certification that providers of third-party due diligence services must provide to each NRSRO producing a credit rating for an asset-backed security to which the due diligence services relate.[5] Finally, Title IX, Subtitle C of the Dodd-Frank Act establishes a new requirement for issuers and underwriters of asset-backed securities Start Printed Page 55080to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.[6]

On May 18, 2011, the Commission proposed for comment amendments to existing rules and new rules in accordance with Title IX, Subtitle C of the Dodd-Frank Act and to enhance oversight of NRSROs.[7] The Commission received a number of comment letters in response to the proposals.[8] The comments on specific proposals are summarized below in the corresponding sections of this release discussing the proposals and the amendments and new rules being adopted today.

B. Economic Analysis

The Commission has performed an economic analysis in connection with today's adoption of the amendments and new rules discussed in section II. of this release. The economic analysis is reflected in this section I.B. of the release as well as throughout the rest of the release.[9]

1. Guiding Principles

Title IX, Subtitle C of the Dodd-Frank Act mandates that the Commission prescribe rules to improve regulation of NRSROs.[10] Section 931 of the Dodd-Frank Act, “Findings,” introduces Title IX, Subtitle C of the Dodd-Frank Act and provides context to what motivated Congress to enact these provisions with respect to NRSROs.[11] In particular, Congress found:

  • Because of the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators, the activities and performances of credit rating agencies, including NRSROs, are matters of national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the U.S. economy.[12]
  • Credit rating agencies, including NRSROs, play a critical “gatekeeper” role in the debt market that is functionally similar to that of securities analysts, who evaluate the quality of securities in the equity market, and auditors, who review the financial statements of firms. Such role justifies a similar level of public oversight and accountability.[13]
  • Because credit rating agencies perform evaluative and analytical services on behalf of clients, much as Start Printed Page 55081other financial “gatekeepers” do, the activities of credit rating agencies are fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts, and investment bankers.[14]
  • In certain activities, particularly in advising arrangers of structured financial products on potential ratings of such products, credit rating agencies face conflicts of interest that need to be carefully monitored and that therefore should be addressed explicitly in legislation in order to give clearer authority to the Commission.[15]
  • In the recent financial crisis, the ratings on structured financial products have proven to be inaccurate. This inaccuracy contributed significantly to the mismanagement of risks by financial institutions and investors, which in turn adversely impacted the health of the economy in the United States and around the world. Such inaccuracy necessitates increased accountability on the part of credit rating agencies.[16]

The amendments and new rules being adopted today to implement sections 932, 936, and 938 of the Dodd-Frank Act are designed to address these findings of Congress. For example, they are intended to increase the integrity and transparency of credit ratings and promote public oversight and accountability of NRSROs as “gatekeepers” for the primary benefit of the users of credit ratings.[17] The amendments and new rules also prescribe new disclosure requirements relating to structured finance products and, in particular, asset-backed securities.[18] These requirements are designed to address concerns about the role of NRSROs in the financial crisis of 2007-2009 [19] in terms of how they rated certain types of structured finance products and, in particular, the inherent conflicts of interest in rating these products.[20]

In the market for structured finance products, the pool of assets underlying or referenced by the product is often comprised of hundreds of thousands of loans, each requiring time and expense to evaluate. In these markets, the separation between the borrower and the ultimate provider of credit can introduce significant information asymmetries between the parties involved in the securitization process that creates a structured finance product [21] and investors in the product, who may have less information on the credit quality and other relevant characteristics of the asset pool.[22] Further, disclosures to investors regarding the asset pool may not be sufficiently detailed to allow investors to adequately evaluate the quality of the collateral backing the securities and, thereby, assess the credit risk of the securities. Consequently, the market for structured finance products has evolved as a “rated” market in which the credit risk of the products is assessed by credit rating agencies [23] and the valuations of the products depend significantly on credit ratings.[24] To curb their informational disadvantage, certain investors in structured finance products may use credit ratings to inform their investment decisions.[25]

Given that investors may not know the quality of the assets underlying structured finance products, certain originators of these assets may attempt to adversely transfer risks of poor origination decisions to investors by creating complex and opaque structured finance products.[26] This risk is especially pronounced when the originator, sponsor, depositor, or underwriter receives compensation before investors learn about the quality of the assets.[27] Because origination fees Start Printed Page 55082are based on transaction volume and risks are transferred to investors, an originator may have the economic incentive to produce as many assets (for example, mortgage loans) as possible without adequately screening their credit quality.[28]

The rating process for structured finance products differs from the rating process for corporate bonds, whose ratings are largely based on publicly available data such as audited financial statements. The data used in rating structured finance products is primarily provided by the sponsor, depositor, or underwriter.[29] Unlike credit ratings for corporate bonds, credit ratings of structured finance products are “highly sensitive to the assumptions of (1) default probability and recovery value, (2) correlation of defaults, and (3) the relation between payoffs and the economic states that investors care about most.” [30] The rating process for these products may happen in the reverse of how a more traditional product is rated because the sponsor, depositor, arranger, or underwriter often decides before the structure is finalized what credit rating it would like for each tranche of securities to be issued, within the limits of what is possible, and structures the product accordingly (for example, with regard to selecting the underlying assets and establishing the credit enhancements applicable to the different tranches of securities). Concerns have been raised that the inherently iterative nature of the process between the credit rating agency and the sponsor, depositor, arranger, or underwriter may give rise to potential conflicts of interest [31] and that credit rating agencies marketing advisory and consulting services to their clients during this process may accentuate the conflict.[32]

Just prior to the financial crisis, the size of the structured finance market was considerable. New issuances of RMBS, for example, peaked in 2006 for a total of $801.7 billion.[33] Low interest rates drove investor demand for products that had high yields but also were highly rated by the credit rating agencies.[34] Mortgage originators largely exhausted the supply of traditional quality mortgages and, to keep up with investor demand for RMBS, subprime lending became increasingly popular. As the number of delinquencies on subprime mortgages suddenly soared in late 2007, RMBS lost a considerable amount of value,[35] and investors began to question the accuracy of credit ratings assigned to RMBS and CDOs linked to RMBS.[36] Certain academic studies argue that, as the structured finance market boomed between 2004 and 2007, NRSROs might have had an incentive to generate revenue by relaxing rating standards,[37] inflating credit ratings,[38] facilitating the sale of asset-backed securities by a small number of large issuers,[39] and reducing due diligence in Start Printed Page 55083the presence of investors that solely rely on credit ratings.[40] The concerns about the accuracy of credit ratings fueled an emergent reluctance to invest in these products.[41] The new issuances of RMBS totaled $715.3 billion in 2007 and plunged to $34.5 billion in 2008.

In August 2007, the Commission staff initiated examinations of the three largest credit rating agencies to review their role in the turmoil in the subprime mortgage-related securities markets.[42] Among other things, these examinations revealed that the credit rating agencies struggled to adjust the number of staff and resources employed in the rating process to the increasing volume and complexity of RMBS and CDOs.[43] Certain significant aspects of the rating process and methodologies used to rate RMBS and CDOs were not documented or disclosed.[44] The credit rating agencies examined did not have specific written procedures for rating RMBS and CDOs.[45] Also, the credit rating agencies did not appear to have specific written policies and procedures to identify or address errors in their models or methodologies.[46] In certain instances, Commission staff believed that adjustments to models were made without appropriately documenting a rationale for deviations from the model.[47] Processes for performing surveillance and monitoring of outstanding credit ratings on an ongoing basis appeared to be less robust than the processes for determining initial credit ratings.[48] Moreover, in the Commission staff's view, sufficient steps were not taken to prevent considerations of fees, market share, or other business interests from influencing credit ratings or rating criteria.[49] Finally, the examined credit rating agencies appeared to solely rely on the information provided by RMBS sponsors.[50] In particular, they did not appear to verify the integrity and accuracy of such information as, in their view, due diligence duties belonged to other parties and they did not appear to seek representations from sponsors that due diligence was performed.[51]

Following the financial crisis, the Dodd-Frank Act mandated regulatory actions intended to enhance regulation, accountability, and transparency of NRSROs.[52] Generally, the majority of the rulemaking mandated by the Dodd-Frank Act addresses all classes of credit ratings, rather than credit ratings for only structured finance products.[53] In implementing the mandate, the amendments and new rules being adopted today are designed to further enhance the governance of NRSROs in their role as “gatekeepers” [54] and increase the transparency of the credit rating process as a whole. Further, as discussed in section II. of this release, the amendments and new rules being adopted today include new requirements designed to enhance transparency with respect to structured finance products, including requirements for NRSROs to disclose information about the performance and history of credit ratings for subclasses of structured finance products and requirements for NRSROs, issuers, underwriters, and providers of third-party due diligence services to disclose information about due diligence services performed with respect to asset-backed securities.[55]

2. Baseline

The amendments and new rules being adopted today primarily affect NRSROs, issuers, and underwriters of asset-backed securities, and providers of third-party due diligence services for asset-backed securities. To the extent that the new requirements change the business practices of the primarily affected parties, such changes may also affect clients of NRSROs (that is, obligors who pay NRSROs to obtain entity credit ratings, issuers who pay NRSROs to obtain credit ratings for their issued securities, subscribers who pay NRSROs to access credit ratings and research, and persons who pay NRSROs for other services), credit raters or credit rating agencies other than NRSROs, parties involved in asset-backed securities markets (other than issuers, underwriters, third-party due diligence providers, and NRSROs), and users of credit ratings in general.

The baseline against which economic costs and benefits, as well the impact of the amendments and new rules being adopted today on efficiency, competition, and capital formation, are measured is the situation in existence today, prior to the adoption of the amendments and rules. The baseline includes an estimate of the number of entities that will likely be directly affected by the amendments and rules and a description of the relevant features of the regulatory and economic environment in which the affected entities operate. The discussion below identifies the main features of the regulatory and economic baseline, which will be further developed in section II of this release discussing the amendments and rules, including in the Start Printed Page 55084focused economic analyses that follow the discussions of the amendments and rules.

a. NRSROs

As discussed above, the Rating Agency Act of 2006, among other things, amended section 3 of the Exchange Act to add definitions, added section 15E to the Exchange Act to establish self-executing requirements for NRSROs and provide the Commission with the authority to implement a registration and oversight program for NRSROs, amended section 17 of the Exchange Act to provide the Commission with recordkeeping, reporting, and examination authority over NRSROs, and amended section 21B(a) of the Exchange Act to provide the Commission with the authority to assess penalties “against any person” in administrative proceedings instituted under section 15E of the Exchange Act.[56]

To implement the Rating Agency Act of 2006, the Commission adopted Rules 17g-1 through 17g-6 and Form NRSRO.[57] Section 943 of the Dodd-Frank Act mandates that the Commission adopt rules requiring an NRSRO to include in any report accompanying a credit rating of an asset-backed security a description of the representations, warranties, and enforcement mechanisms available to investors and how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities.[58] In January 2011, the Commission adopted Rule 17g-7 to implement section 943.[59] The Exchange Act, Rules 17g-1 through 17g-7, and Form NRSRO represent the baseline for the amendments and new rules being adopted today in terms of requirements applicable to NRSROs.

Pursuant to section 6 of the Rating Agency Act of 2006, the Commission is required to submit an annual report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives that includes the views of the Commission on the state of competition, transparency, and conflicts of interest among NRSROs.[60] In addition, section 15E(b) of the Exchange Act provides that not later than ninety days after the end of each calendar year, each NRSRO shall file with the Commission an amendment to its registration application, in such form as the Commission, by rule, may prescribe: (1) Certifying that the information and documents in the application for registration continue to be accurate; (2) listing any material change that occurred to such information or documents during the previous calendar year; and (3) amending its credit ratings performance statistics.[61] Rule 17g-1 requires these filings (“annual certifications”) to be made on Form NRSRO.[62] Further, each NRSRO is required to furnish the Commission with annual reports containing audited financial statements and information about revenues and other matters.[63] The Commission's annual reports submitted to Congress and the NRSROs' annual certifications and annual reports are an integral part of establishing the baseline for the amendments and new rules being adopted today, as discussed below.

As of today, there are ten credit rating agencies registered with the Commission as NRSROs.[64] Based on the annual reports the NRSROs furnish with the Commission, in their 2013 fiscal years, the ten NRSROs had $5.4 billion of total revenue—an approximate 6% increase over their 2012 fiscal years. In addition, based on their annual certifications, the NRSROs employed a total of 4,218 credit analysts at the end of the 2013 calendar year. Table 1 shows the number of credit analysts employed by each NRSRO at the end of the 2013 calendar year and, of the total number of credit analysts employed by the NRSROs, the percent of credit analysts at S&P, Moody's, and Fitch (90%) and the remaining seven NRSROs (10%).

Table 1—Credit Analysts Employed by NRSROs (as of [—])

NRSROsTotal credit analysts
S&P, Moody's, & Fitch90%
Other NRSROs10%
A.M. Best123
DBRS98
EJR7
Fitch1,102
HR Ratings34
JCR57
Kroll58
Moody's1,244
Morningstar30
S&P1,465
Total4,218
Note: The total number of credit analysts, including credit analyst supervisors, is provided by each NRSRO in Exhibit 8 to Form NRSRO, which is available on each NRSRO's Web site.

Among other things, the operations of the ten NRSROs differ in terms of business model, classes of credit ratings for which they are registered, history of issuing credit ratings, size, and market share. Of the ten NRSROs, seven operate primarily under the issuer-pay model,[65] in which an obligor pays the NRSRO to rate it as an entity or an issuer pays the NRSRO to rate the securities it issues.[66] One NRSRO operates exclusively under the subscriber-pay model,[67] in which Start Printed Page 55085subscribers pay a fee to access the credit ratings issued by the NRSRO.[68] Two NRSROs previously operated primarily under the subscriber-pay model but for several years have been issuing an increasing number of credit ratings paid for by the obligor being rated or the issuer of the securities that are rated.[69]

The ten NRSROs also differ by the scope of their business and, in particular, by whether their operations include products and services other than credit ratings,[70] which can be provided through business lines, segments, groups, or divisions within the NRSROs or through affiliated companies or other businesses not within the NRSRO.[71] For credit ratings, there are five classes of credit ratings for which a credit rating agency can be registered as an NRSRO: (1) Financial institutions, brokers, or dealers; (2) insurance companies; (3) corporate issuers; (4) issuers of asset-backed securities (as that term is defined in section 1101(c) of part 229 of Title 17, Code of Federal Regulations, “as in effect on the date of enactment of this paragraph”); and (5) issuers of government securities, municipal securities, or securities issued by a foreign government.[72] Eight of the NRSROs are registered in multiple classes, while two NRSROs are registered in one class.[73] Table 2 shows the approximate number of outstanding credit ratings as reported by each NRSRO in its annual certification for the 2013 calendar year end, in each of the five categories for which the NRSRO is registered.

Table 2—Approximate Number of NRSRO Credit Ratings Outstanding by Class of Credit Rating (as of [December 31, 2013])

NRSROsFinancial institutionsInsurance companiesCorporate issuersAsset-backed securitiesGovernment securitiesTotal ratings
S&P, Moody's, & Fitch84%74%92%90%99%97%
Other NRSROs16%26%8%10%1%3%
A.M. BestN/R4,4921,65356N/R6,201
DBRS13,6241503,79010,70616,03844,308
EJR10446877N/RN/R1,027
Fitch49,8213,22215,29953,612204,303326,257
HR RatingsN/RN/RN/RN/R189189
JCR15027463N/R56696
Kroll15,982442,7491,4012520,201
Moody's53,3833,41840,00876,464728,627901,900
MorningstarN/RN/RN/R11,567N/R11,567
S&P59,0007,20049,70090,000918,8001,124,700
Total192,06418,599114,539243,8061,868,0382,437,046
Note: The approximate number of NRSRO credit ratings outstanding as of December 31, 2013 is provided by each NRSRO in its annual certification, which is available on each NRSRO's Web site. “N/R” indicates that an NRSRO is not registered for that class of credit rating.

As shown in Table 2, S&P has the greatest number of outstanding credit ratings in each of the five classes. S&P, Moody's, and Fitch are the top three producers of credit ratings in every class of credit ratings except for insurance companies (in this class, A.M. Best has the second highest number of outstanding credit ratings after S&P). Overall, S&P accounts for about 46% of the total NRSRO credit ratings outstanding, followed by Moody's (37%) and Fitch (13%), implying that two NRSROs (S&P and Moody's) account for 83% of all credit ratings outstanding and three NRSROs (S&P, Moody's, and Fitch) account for approximately 97%. Also, as discussed above, Table 1 shows that these three NRSROs employ 90% of the total number of NRSRO credit analysts. Comparing the number of credit ratings outstanding for established NRSROs and newly registered NRSROs may not provide a complete picture of competition in the industry. The incumbent NRSROs (particularly S&P, Moody's, and Fitch) have a longer history of issuing credit ratings, and their credit ratings include those for Start Printed Page 55086debt obligations and obligors that were rated long before the establishment of the newer entrants.[74]

Recent trends in the industry structure are shown in Table 3, which reports the inverse of the Herfindahl-Hirschman Index (HHI) as a measure of industry concentration by rating class.[75] The HHI inverse is calculated from 2007 to 2013 for credit ratings outstanding as reported by the NRSROs in each rating class. Table 3 shows that the NRSRO industry concentration for all rating classes has moderately increased as suggested by the decrease in the HHI inverse since 2010. Despite a monotonic increase in competition in the rating class of asset-backed securities, the NRSRO industry remains concentrated, with the three largest NRSROs accounting for approximately 95% of the NRSROs' 2013 fiscal year total revenue, based on the annual reports the NRSROs furnish to the Commission.

Table 3—Inverse of Herfindahl-Hirschman Index by Class of Credit Rating

YearFinancial institutionsInsurance companiesCorporate issuersAsset-backed securitiesGovernment securitiesTotal ratings
20073.374.023.272.712.352.65
20083.724.053.792.822.832.99
20093.853.843.183.182.652.86
20103.993.373.173.202.692.88
20114.163.763.023.382.472.74
20124.043.723.003.442.502.75
20133.993.683.033.482.462.72
Note: The inverse of HHI is determined using the approximate numbers of NRSRO credit ratings outstanding reported in the Commission staff annual reports on NRSROs published in June 2008, September 2009, January 2011, March 2012, December 2012, and December 2013. For the 2013 calendar year end, the inverse of HHI is calculated using the number of outstanding credit ratings reported by NRSROs in their annual certifications.

In particular, for the asset-backed security class—which includes, among other things, RMBS, commercial mortgage backed securities (“CMBS”), and consumer finance and other asset-backed securities—Table 4 below shows the number of credit ratings outstanding from 2007 to 2013. The total number of outstanding credit ratings has significantly decreased (by 38%) since 2007, mostly due to pay-downs of existing asset-backed securities that have not been replaced by newly issued asset-backed securities that are rated by NRSROs.[76] While the three largest NRSROs accounted for 97% of the outstanding credit ratings for asset-backed securities in 2007, this number decreased to 90% in 2013.

Table 4—Approximate Number of Credit Ratings Outstanding in the Asset-Backed Security Class

NRSROs2007200820092010201120122013
S&P, Moody's, & Fitch97%96%94%94%91%91%90%
Other NRSROs3%4%6%6%9%9%10%
A.M. Best54545454565556
DBRS8407,4708,43010,0919,88910,05410,706
EJR14141313N/RN/R
Fitch72,27877,48069,51564,53558,31556,31153,612
HR RatingsN/RN/R
JCR687164N/RN/RN/RN/R
Kroll246000403521,401
Moody's110,000109,261106,337101,54693,91382,35776,464
Morningstar10,2359,2008,8568,32216,07013,93511,567
R&I214210186N/R
S&P197,700198,200124,600117,900108,40097,50090,000
Total391,635401,960318,056302,461286,696260,564243,806
Note: “N/R” indicates that an NRSRO is not registered for the asset-backed security class of credit ratings and “—” indicates that the credit rating agency was not registered as an NRSRO for the applicable year. Kroll acquired LACE Financial Corp. in August 2010. Morningstar, formerly known as Realpoint LLC, changed its name in 2011. Rating and Investment Information, Inc. (“R&I”) withdrew its registration as an NRSRO with the Commission in October 2011. HR Ratings became registered as an NRSRO in 2012. Statistics come from the Commission staff annual reports on NRSROs published in June 2008, September 2009, January 2011, March 2012, December 2012, and December 2013. For calendar year 2013, the statistics come from the annual certifications of the NRSROs.

In 2013, some of the relatively newer or smaller NRSROs increased their market shares in terms of rating asset-backed securities. Table 5 reports full-year credit rating agency information for 2013, compared to 2007, the year immediately prior to the financial crisis. As the total issuances of asset-backed securities decreased considerably from 2007 to 2013, DBRS has maintained its market share in rating new issuances and has become the most active participant in rating RMBS, while S&P, Moody's and Fitch have lost market shares. DBRS, Kroll, and Morningstar have gained market shares in rating CMBS after the financial crisis and have rated a significant number of newly issued CMBS in 2013. Finally, in the market for rating consumer finance and other asset-backed securities, which has Start Printed Page 55087the largest number of issuances, DBRS and Kroll have increased their market shares, although S&P, Moody's and Fitch continue to play a significant role.

Table 5—Market Shares of Credit Rating Agencies for RMBS, CMBS, and Consumer Finance and Other Asset-Backed Securities, 2013 and 2007

RankNRSROs2013 Issuance ($ mil.)Number of offeringsMarket share (%)2007 Issuance ($ mil.)Number of offeringsMarket share (%)2007-2013 Change (%)
Residential mortgage-backed securities
1DBRS$12,501.905061.4$12,817.60202.9−2.5
2Fitch9,969.602348.9253,721.1031858.2−96.1
3S&P9,597.502347.1409,532.4053494.0−97.7
4Kroll7,908.701738.8N/AN/AN/AN/A
5Moody's3,796.00918.6324,923.5042174.6−98.8
Total20,372.0068100.0435,815.60575100.0−95.3
Commercial mortgage-backed securities
1Moody's$62,802.606772.9$171,787.006174.6−63.4
2Fitch50,447.705658.6159,687.306069.4−68.4
3Kroll45,140.105552.4N/AN/AN/AN/A
4S&P34,255.204939.8202,381.007187.9−83.1
5DBRS18,574.902621.613,295.3065.839.7
6Morningstar17,089.002719.8N/AN/AN/AN/A
Total86,135.80122100.0230,195.8086100.0−62.6
Consumer finance and other asset-backed securities
1S&P$134,860.6024469.3$576,417.9088496.7−76.6
2Moody's114,569.9015558.9563,982.9073594.6−79.7
3Fitch113,213.8015658.2342,140.1041857.4−66.9
4DBRS16,530.60518.543,102.70737.2−61.6
5Kroll3,983.10162.0N/AN/AN/AN/A
Total194,600.70341100.0596,016.20981100.0−67.3
Note: A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. Market shares of individual NRSROs do not add up to 100% since more than one NRSRO may rate a particular offering. “N/A” indicates that statistics are not available for 2007. CMBS data relates to U.S. CMBS, including U.S. conduit/fusion and U.S. single borrower. Data comes from Asset-Backed Alert and Commercial Mortgage Alert Web sites, publicly available at http://www.abalert.com/​ranks.php and http://www.cmalert.com/​ranks.php.

b. Asset-Backed Security Issuers, Underwriters, and Third-Party Due Diligence Providers

The asset-backed security market that existed in the United States as of the end of 2013 differed significantly from the market prior to the crisis. In 2004, issuing entities of non-agency asset-backed securities held $2.6 trillion in assets, which grew to $4.5 trillion in 2007 and declined to $1.6 trillion in 2013.[77] Table 6 presents issuance amounts, number of offerings, and number of unique issuers for non-agency asset-backed securities, categorized by type of offering.[78] While new issuances of registered asset-backed securities represented the majority of offerings and totaled $1.0 trillion in 2004, they drastically dropped to $140.7 billion in 2008. In 2013, the asset-backed security market totaled $393.6 billion, of which $174.1 billion is the new issuance amount of registered asset-backed securities.

Table 6—Issuance Amount, Number of Offerings, and Number of Unique Issuers for Non-Agency Asset-Backed Securities

YearIssuance amount ($ bln)Number of offeringsNumber of unique issuers
Regist'd144APrivateTotalRegist'd144APrivateTotalRegist'd144APrivateTotal
2002617.13122.072.00741.201,074491311,59614322617327
2003790.47149.200.17939.851,27158931,8631392233309
20041,024.16186.530.851,211.531,37067022,0421312182298
20051,450.33322.643.701,776.681,59490732,5041343002376
20061,446.07623.380.502,069.951,5081,55113,0601164061460
20071,048.81518.590.551,567.951,0881,10212,1911113421396
2008140.70130.800.00271.49163240040351960128
Start Printed Page 55088
200985.45120.140.00205.588026603463081097
201051.01163.3014.01228.32654014470291451160
201174.94139.0613.58227.598629115392391636179
2012157.15186.530.00343.681574650622512420270
2013174.06219.470.08393.611825321715612941336
Note: Statistics are calculated by DERA using the Asset-Backed Alert and Commercial Mortgage Alert databases. A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. The offerings are categorized by offering year and offering type (Commission registered, Rule 144A, or traditional private offerings). Non-agency asset-backed securities include RMBS, CMBS, and other asset-backed securities. Non-agency RMBS include residential, Alt-A, subprime RMBS, high loan-to-value (“no-equity”) loans, and non-U.S. residential loans. Auto loan asset-backed securities include asset-backed securities backed by auto loans and auto leases, both prime and subprime, motorcycle loans, recreational vehicle loans, and truck loans. The first set of columns show the total issuance amounts in billions of dollars. The second set of columns show the total number of asset-backed security offerings. The third set of columns show the number of unique issuers of asset-backed securities in each category. The number in the column “Total” may not be the sum of numbers in the columns “Regist'd”, “144A” and “Private” because some issuers may initiate offerings in several categories. Only non-agency asset-backed security offerings sold in the United States and issuers of such offerings are counted.

Issuers of asset-backed securities often include banks, mortgage companies, finance companies, investment banks, and other entities that originate or acquire and package financial assets for resale as asset-backed securities.[79] As reported in Table 6, in 2004 there were 298 unique issuers, while in 2013 there were 336 unique issuers, mostly involved in Rule 144A offerings.[80] The ten most active issuers were responsible for about 30% of the total issuance amounts at the end of 2013.[81]

As noted in Figure 1 below, an analysis of the segments of the asset-backed security market shows that all segments experienced significant downturns during the crisis but only a few of them have experienced a recovery in the aftermath. Figure 1 focuses on non-agency asset-backed security offerings and reports the issuance volume by main asset classes (RMBS, CMBS, auto loans/leases, credit card loans, student loans, and other asset-backed securities).

As shown in Figure 1, new issuances of non-agency RMBS in 2004 totaled $542 billion, with registered offerings representing the majority of non-agency RMBS issued before the crisis. Non-agency RMBS issuance—which totaled $715 billion in 2007—dropped drastically to $35 billion in 2008. As of the end of 2013, the non-agency RMBS Start Printed Page 55089market remains weak and consists almost exclusively of unregistered RMBS offerings. In particular, new issuances of non-agency RMBS totaled $25 billion in 2013, which represents about 5% of the issuance level in 2004. CMBS experienced a similar drop in issuance levels, though it has rebounded to a level that is closer to the 2004 issuance level than RMBS. In particular, CMBS issuance rose from $96 billion in 2004 to $231 billion in 2007. It then dropped to $12 billion in 2008. It was $86 billion in 2013, which is about 90% of the issuance level in 2004. The consumer finance asset-backed security market also declined drastically in terms of number of offerings and issuance volume after the financial crisis. For example, $70 billion of securities backed by auto loans and leases were issued in 2004, but issuance decreased to $38 billion in 2008. The issuances of consumer finance asset-backed securities, especially those securities backed by auto loans and leases, and other asset-backed securities have steadily increased since 2008 to reach pre-crisis levels of about $75 billion in 2013.

Among the asset-backed security segments, the non-agency RMBS segment has experienced a significant decline in the number of issuers with twenty-two issuers arranging non-agency RMBS (and only one issuer arranging non-agency registered RMBS) as of the end of 2013, compared to fifty-eight issuers in 2004. In the RMBS market, issuers arranging non-agency RMBS encounter competitive pressure from government-sponsored enterprises that arrange RMBS that are guaranteed [82] and exempt from registration and reporting requirements.[83] As non-agency RMBS issuance has declined, issuance of agency RMBS has increased. Issuances of RMBS arranged by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association were $1.4 trillion in 2004 and grew to $1.9 trillion in 2013.[84]

Table 7 shows the number of unique underwriters of non-agency asset-backed securities. As of the end of 2013, it is a highly concentrated industry with ninety underwriters (if international securitizations are included in the data) and fifty underwriters (if international securitizations are excluded), with the top ten underwriters by volume underwriting about 70% of the securitizations.[85]

Table 7—Number of Unique Asset-Backed Security Underwriters

YearRegist'd144APrivateTotal excluding internat'lInternat'lTotal including internat'l
20022240154786107
2003294134787109
2004294625699123
20052945350101118
20062857159114137
20072759161109132
2008194204495113
200914260285872
201015451467690
201118445456279
201220460486381
201322470507290
Note: Statistics are calculated by DERA staff using the Asset-Backed Alert and Commercial Mortgage Alert databases. A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. The number of unique underwriters of asset-backed securities is divided into categories by type of offering (registered, 144A, private, or international). The total number in the last column may not be the sum of numbers in the columns labeled “Public”, “144A”, “Private,” and “Internat'l” because some underwriters may market offerings in several categories. Only non-agency asset-backed security offerings and underwriters of such deals are counted.

Finally, providers of third-party due diligence services with respect to asset-backed securities are significantly affected by the amendments and new rules being adopted today. The Commission has little information about these firms and the characteristics of the industry. The Commission estimates that there are approximately fifteen providers of third-party due diligence services.[86] Because there are very few publicly traded firms specializing in due diligence, little is known about these service providers in terms of loan review volume, market share, and revenue.[87]

Asset-backed security issuers and underwriters may use third-party due diligence services to identify issues with loans, to negotiate better prices on pools of loans they are considering for Start Printed Page 55090purchase, and to negotiate expanded representations and warranties in purchase and sale agreements from sellers.[88] The reviews of third-party due diligence providers are performed on an adverse or random sample of loans consistent with the guidelines of clients. Compensation is likely not contingent on due diligence findings or the ultimate performance of the loans reviewed. Instead, third-party due diligence providers may be paid a standard service fee for each loan reviewed.[89]

c. Industry Practices

The Commission staff conducts annual examinations of each NRSRO and publishes a report summarizing the essential findings of the examinations, as required by section 15E(p)(3) of the Exchange Act.[90] The staff's 2013 report noted improvements, relative to prior examinations, among the NRSROs in five general areas that are related to the amendments and new rules being adopted today: Enhanced documentation, disclosure, and board of director oversight of criteria and methodologies; investment in software or computer systems for electronic recordkeeping and monitoring employee securities trading; increased prominence of the role of the designated compliance officer within NRSROs; implementation or enhancement of internal controls over the rating process (for example, use of audits and other testing to verify compliance with federal securities laws, and employee training on compliance matters); and adherence to internal policies and procedures.[91] The report also discussed certain weaknesses or concerns in a number of review areas: Adherence to policies, procedures, and methodologies; [92] management of conflicts of interest; [93] implementation of ethics policies; [94] internal supervisory controls; [95] governance; [96] the activities of the designated compliance officer; [97] the processing of complaints; [98] and the policies governing post-employment activities of former staff of the NRSRO.[99] These essential findings were related to several areas of NRSRO operations and were not limited to activities relating to rating asset-backed securities.

3. Broad Economic Considerations

In this section, the Commission describes the primary economic impacts that may derive from the amendments and new rules being adopted today, relative to the baseline discussed above. A detailed analysis of the particular economic effects—including the costs and benefits and the impact on efficiency, competition, and capital formation—that may result from the amendments and rules is presented in the focused economic analyses in section II of this release.[100]

Section 3(f) of the Exchange Act requires the Commission, when engaging in rulemaking that requires the Commission to consider or determine whether an action is necessary or appropriate in the public interest, to also consider whether the action will promote efficiency, competition, and capital formation.[101] Further, section 23(a)(2) of the Exchange Act requires the Commission, when adopting rules under the Exchange Act, to consider the impact that any new rule would have on competition and to not adopt any rule that would impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.[102] The Commission's analysis of the economic effects, including the likely costs and benefits and the likely impact on efficiency, competition, and capital formation of the amendments and new rules, include those attributable to the rulemaking that the Commission is mandated to undertake in accordance with the Dodd-Frank Act and those attributable to the exercise of the Commission's discretionary authority.

In the proposing release, the Commission solicited comments on all aspects of the costs and benefits associated with the proposed rules. In addition to comments on the economic effects of specific provisions, which will be discussed in section II of this release, the Commission received comments on the overall economic effects of the proposed amendments and new rules. Generally, commenters expressed concerns that the potential cumulative burden and costs associated with the proposed amendments and new rules could be so onerous that they would have negative effects on competition by imposing an excessive burden on smaller NRSROs and raising barriers to entry for credit rating agencies that seek to register as NRSROs.[103] In particular, one commenter suggested that “fostering competition among rating agencies was a primary goal of both the Rating Agency Act of 2006 and the Dodd-Frank Act” but that “the proposed rules will be so costly to implement that additional credit rating agencies are unlikely to register as NRSROs and the existing pool of registrants may contract.” [104]

As discussed in section II of this release, the Commission has considered these comments and has modified the amendments and new rules being adopted today from the proposals in a number of ways that are designed to reduce the cumulative burden and costs associated with complying with the new requirements. Nonetheless, the Commission recognizes—as reflected in the economic analysis—that the amendments and rules establish a substantial package of new requirements applicable to NRSROs and that complying with these requirements will entail significant costs to NRSROs.[105] The amendments and rules also impose burdens on issuers and underwriters of asset-backed securities and providers of third-party due diligence services with respect to asset-backed securities. As discussed throughout the economic analysis, the Commission believes that Start Printed Page 55091the new requirements should result in substantial benefits and should not impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.

In particular, the amendments and new rules being adopted today are designed to implement Title IX, Subtitle C of the Dodd-Frank Act, which, in turn, was designed to address the causes of certain market failures (that is, the principal-agent problem,[106] including conflicts of interest, and asymmetric information) that may impair the integrity and transparency of NRSRO credit ratings and the procedures and methodologies NRSROs use to determine credit ratings. Some of the amendments and new rules are primarily designed to enhance the integrity of how NRSROs determine credit ratings by improving internal governance of NRSROs, managing potential principal-agent problems and conflicts of interest in the credit rating process, and promoting adherence to the procedures and methodologies for determining credit ratings and compliance with laws and regulations.[107] For example, provisions in the amendments and new rules require an NRSRO, among other things, to: (1) Assess and report on the effectiveness of internal controls; (2) address conflicts of interest relating to sales and marketing activities and employment of former analysts; (3) have policies and procedures relating to their procedures and methodologies for determining credit ratings; (4) have standards of training, experience and competence for their credit analysts; and (5) have policies and procedures to promote the consistent use of credit rating symbols.[108]

Other provisions in the amendments and new rules being adopted today are designed mainly to enhance the transparency of NRSRO credit ratings by increasing disclosure and reducing information asymmetries that may adversely affect users of credit ratings. This should facilitate external scrutiny of NRSRO activities. More specifically, provisions in the amendments and new rules require an NRSRO, among other things, to disclose: (1) Standardized performance statistics; (2) increased information about credit rating histories; (3) information about material changes and significant errors in the procedures and methodologies used to determine credit ratings; and (4) information about a specific rating action.[109] The main objective of these requirements is to improve the information provided to users of credit ratings, including investors. The enhanced disclosure may reduce information asymmetries between the NRSRO and the users of its credit ratings, enabling the users to make more informed investment and credit related decisions and allowing them to compare the performance of credit ratings by different NRSROs. Additionally, there are requirements in the amendments and new rules that are designed to reduce information asymmetries among issuers and underwriters of asset-backed securities, NRSROs rating asset-backed securities, and the users of credit ratings for asset-backed securities.[110] These requirements may benefit NRSROs and users of credit ratings, including investors in these securities.

a. Amendments and Rules Enhancing NRSRO Governance and Integrity of Credit Ratings

The requirements in the amendments and new rules being adopted today that are primarily designed to enhance an NRSRO's internal governance should have economic benefits, relative to the existing baseline, in terms of promoting the integrity of how NRSROs determine and monitor credit ratings. In particular, there are new requirements applicable to NRSROs that assign responsibilities to an NRSRO's management and board of directors, which should promote accountability and facilitate internal oversight over the processes governing the determination of credit ratings and the implementation of the procedures and methodologies an NRSRO uses to determine credit ratings. For example, an NRSRO is required to file an annual report containing an assessment by management of the effectiveness during the fiscal year of the internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings.[111] Similarly, an NRSRO is required to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the procedures and methodologies, including qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.[112] The board's oversight may prevent situations in which an NRSRO seeks to implement a procedure or methodology to determine credit ratings that is designed to inappropriately issue favorable credit ratings for existing and prospective clients in order to retain or gain market share.[113]

There are new requirements applicable to NRSROs pursuant to which they must avoid certain conflicts of interest and have policies and procedures to take certain actions to address credit ratings that are influenced by a conflict of interest.[114] These requirements may facilitate the alignment of incentives at both the NRSRO and individual NRSRO employee level to ultimately promote the production of unbiased credit ratings. At the NRSRO level, for example, sales and marketing considerations may influence the NRSRO's production of credit ratings. Consequently, there is a new requirement that prohibits an NRSRO from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also: (1) Participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (2) is influenced by sales or marketing considerations.[115] This absolute prohibition should result in internal policies, procedures, and organizational solutions that isolate the analytical function from sales and marketing considerations within the NRSRO. To the extent that the absolute prohibition prevents credit analysts that participate in the determination of Start Printed Page 55092credit ratings from being influenced by sales and marketing considerations, this should curb potential conflicts of interest related to “rating catering” practices that have been suggested by anecdotal evidence [116] and academic literature.[117] Isolating the production of credit ratings and the development of procedures and methodologies for determining credit ratings from sales and marketing considerations should promote the integrity and quality of credit ratings to the benefit of their users.

At the individual level, an analyst's incentives may be distorted by the prospect of future employment at an issuer or underwriter, which could influence the analyst in determining a credit rating for that issuer or underwriter. Consequently, there is a new requirement that an NRSRO must have policies and procedures that address instances in which this conflict of interest influenced a credit rating that are reasonably designed to ensure that the NRSRO promptly determines whether the current credit rating must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings and to promptly publish a revised credit rating, an affirmation of the credit rating, or potentially place the credit rating on watch or review and in each case include certain disclosures about the existence of the conflict.[118] This provision is designed to require the NRSRO to promptly address a conflicted credit rating, and it will likely limit the potential risk that users of credit ratings may make investment decisions using biased or inaccurate information. The disclosures also should provide information to investors and other users of credit ratings that they can use to scrutinize an NRSRO, thereby promoting accountability to the market for failing to appropriately manage this conflict of interest.

In terms of accountability, the Commission is finalizing a rule amendment pursuant to which an NRSRO could have its registration suspended or revoked for violating a rule governing conflicts of interest.[119] In addition, the Commission is amending Form NRSRO to provide notice to an NRSRO or a credit rating agency applying for registration as an NRSRO that an NRSRO is subject to applicable fines, penalties, and other sanctions under the Exchange Act.[120] This may serve as a reminder to the NRSRO or applicant of the potential consequences of failing to comply with federal laws and regulations. Taken together, these accountability measures may have incremental effects on the integrity of an NRSRO's activities and credit ratings by promoting compliance with the Commission's rules.

There are new requirements applicable to NRSROs pursuant to which they must establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure that: (1) The procedures and methodologies, including qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO; and (2) material changes to the procedures and methodologies, including changes to qualitative and quantitative data and models, that the NRSRO uses to determine credit ratings are applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply and, to the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.[121] To the extent that these policies and procedures are effectively implemented and enforced, their application may enhance the integrity of how NRSROs determine credit ratings.

There are new requirements applicable to NRSROs pursuant to which they must establish, maintain, enforce, and document standards of training, experience, and competence for the individuals they employ to participate in the determination of credit ratings that are reasonably designed to achieve the objective that the NRSRO produces accurate credit ratings in the classes of credit ratings for which the NRSRO is registered. At a minimum, these standards must include: (1) A requirement for periodic testing of the individuals employed by the NRSRO to participate in the determination of credit ratings on their knowledge of the procedures and methodologies used by the NRSRO to determine credit ratings in the classes and subclasses of credit ratings for which the individual participates in determining credit ratings; and (2) a requirement that at least one individual with an appropriate level of experience in performing credit analysis, but not less than three years, participates in the determination of a credit rating.[122] These requirements may increase the level of competence and experience of the credit analysts employed by the NRSRO to participate in the production of credit ratings with possible positive effects on the integrity and quality of credit ratings.[123]

There are new requirements applicable to NRSROs pursuant to which they must have reasonably designed policies and procedures relating to: (1) Assessing the probability that an issuer of a security or money market instrument will default, fail to make timely payments, or otherwise not make payments in accordance with the terms of the security or money market instrument; (2) clearly defining each symbol, number, or score in the rating scale used by the NRSRO and including the definitions in Exhibit 1 to Form NRSRO; and (3) applying any symbol, Start Printed Page 55093number, or score in the rating scale used by the NRSRO in a manner that is consistent for all types of obligors, securities, and money market instruments for which the symbol, number, or score is used.[124] Compliance with these policies and procedures may increase the likelihood that NRSROs apply rating symbols, numbers, or scores consistently across classes of credit ratings to the benefit of the users of credit ratings and obligors and issuers that are subject to credit ratings.

Finally, there are new requirements applicable to NRSROs pursuant to which they must retain records of certain internal controls, policies, procedures and standards they are required to document.[125] These record retention requirements should facilitate Commission oversight of NRSROs to the benefit of users of credit ratings. Similarly, the Exchange Act requires an annual report of the NRSRO's designated compliance officer to be filed on a confidential basis with the Commission.[126] The new requirement should facilitate Commission oversight as well.

There will be costs associated with the amendments and new rules being adopted today related to governance of NRSROs.[127] These costs will be primarily incurred by NRSROs.[128] Initial and ongoing direct costs, including compliance costs, may vary among the NRSROs depending on the size and complexity of their business activities (for example, number of credit ratings outstanding, number of analysts, or number of classes of credit ratings). Among other costs, NRSROs also may incur training costs in order to make their personnel aware of the changes in internal controls, policies, and procedures required by the amendments and new rules. These costs are difficult to quantify because they depend significantly on how the required changes differ from the internal policies and procedures currently in place within each NRSRO. In addition, they depend on factors such as the NRSRO's size and business complexity. For example, an NRSRO may need to train its credit analysts and sales and marketing staff in the updated policies and procedures related to the sales and marketing conflict requirements. Among other factors, this cost will likely vary significantly with the degree of the existing separation between the functions of analytical staff and sales and marketing personnel.[129]

Keeping all other factors constant, the costs associated with establishing, maintaining, enforcing, and documenting internal policies and procedures may be higher for structured finance products because the inherent conflict of interest that credit rating agencies face in rating these products is more acute than it is with respect to rating other types of securities.[130] In addition, keeping all other factors constant, NRSROs operating under a business model that combines the issuer-pay and subscriber-pay models may face greater direct costs, given that the two models may entail different internal policies and procedures to prevent different sources of potential conflicts of interest. A component of these costs may also be fixed, which may have a disproportionate impact on smaller NRSROs that may find it more difficult to bear the costs. If NRSROs are not able to readily pass the overall additional costs to clients, there may be adverse effects, particularly on smaller NRSROs.

As a result of the amendments and new rules being adopted today, the number of credit rating agencies registered with the Commission as NRSROs may decline if current registrants believe that the cost of being registered and being subject to these new requirements outweighs the benefit of registration. The barriers to entry for credit rating agencies to register as NRSROs may rise, discouraging credit rating agencies from registering as NRSROs. Further, historically, successful new entrants have established themselves by first specializing in a particular industry, creating a track record in a particular rating class, and building the necessary reputational capital to achieve marketplace acceptance of their credit ratings.[131] Compliance costs may reduce the incentive for an NRSRO to expand its rating business into new classes of credit ratings, with adverse effects on competition in certain market segments. Also, if compliance costs significantly erode profit margins for NRSROs, the barriers to exit from being registered as an NRSRO in certain or all classes of credit ratings may lower. The risk for deregistration may likely be higher for smaller NRSROs. As mentioned earlier, these costs also should depend on the complexity of operations within the NRSRO. Further, given that the conflict of interest in rating structured finance products is more acute, the competitive effects could be greater within the markets for rating these products. These potential consequences could reduce competition among NRSROs.

An amendment being adopted today provides a mechanism for a small NRSRO to seek an exemption from the sales and marketing prohibition.[132] The exemption based on size may decrease the burden on small NRSROs. However, this amendment could create adverse effects on competition as exempted NRSROs may be able to draw business through rating catering. In particular, exempted NRSROs may be able to more readily produce conflicted and inflated ratings [133] or generate a greater stream of revenue from selling rating and ancillary services than non-exempted NRSROs. Reputation, which is an important disciplinary mechanism in this industry, may mitigate this risk to a certain extent.[134]

A number of credit rating agencies located in the United States have not registered as NRSROs.[135] As U.S. regulatory agencies continue to remove references to NRSRO credit ratings from the regulations they administer, market Start Printed Page 55094participants subject to these regulations may choose to use unregistered credit rating agencies thereby diminishing the incentive to register as an NRSRO.[136] On the other hand, users of credit ratings may choose to use NRSROs over unregistered credit rating agencies because of the NRSRO registration and oversight program, which is being enhanced by the amendments and new rules being adopted today.

To the extent that these amendments and new rules improve the quality of credit-related information, they may have effects related to allocative efficiency and capital formation. As a result of these amendments and new rules, users of credit ratings could make more efficient investment decisions based on higher-quality information. Market efficiency also may improve if credit ratings become more informative and the additional information is reflected in asset prices. To the extent that the amendments and rules will be effective in enhancing the integrity and quality of NRSRO credit ratings, users of these credit ratings may benefit from an enhanced confidence in the quality of the creditworthiness assessments reflected in the credit ratings, which may have positive effects on the willingness of investors to participate in the securities markets and thereby enhance capital formation, as capital efficiently flows to more productive uses. The benefits in terms of efficiency and capital formation arising from the rules enhancing governance and the integrity of credit ratings are likely to be greater for asset-backed securities, where the inherent conflict of interest in the issuer-pay model is more acute, and, as a result of the amendments and new rules, investors may become less reluctant to invest in asset-backed securities.

b. Amendments and Rules Enhancing Disclosure and Transparency of Credit Ratings

The requirements in the amendments and new rules being adopted today that are primarily designed to enhance disclosure should have economic benefits, relative to the baseline that existed before the amendments and rules were adopted, in terms of promoting the transparency of credit ratings and NRSRO activities and, therefore, NRSRO accountability. This should benefit users of credit ratings, including investors. The amendments and rules also should enhance disclosure requirements with respect to asset-backed securities for the benefit of users of credit ratings, including investors in these securities.

The amendments significantly enhance the existing requirements for NRSROs to produce and disclose performance statistics to make the disclosures more comparable across NRSROs and easier for users of credit ratings and others to understand.[137] Similarly, the existing requirements for NRSROs to disclose rating histories are being enhanced to make the histories more complete in terms of the scope of credit ratings that must be included in the histories and more robust in terms of the information that must be disclosed with each rating action.[138] To the extent that the new disclosures facilitate the evaluation of the performance of an NRSRO's credit ratings and the comparison of rating performance across all NRSROs—including direct comparisons of the rating history of the same obligor or instrument across two or more NRSROs—the rules may benefit users of credit ratings, including investors. In particular, the enhanced disclosure may allow them to better assess the reliability of credit ratings from different NRSROs and, in the case of issuer-paid credit ratings or subscriber-paid credit ratings, make more informed decisions regarding whether to hire, or subscribe to the credit ratings of, a particular NRSRO.

There are new requirements applicable to NRSROs pursuant to which they must publish on their Internet Web sites: (1) Material changes to the procedures and methodologies, including to qualitative models or quantitative inputs, the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any current credit ratings; and (2) notice of the existence of a significant error identified in a procedure or methodology, including a qualitative or quantitative model, the NRSRO uses to determine credit ratings that may result in a change to current credit ratings.[139] These requirements may benefit users of NRSRO credit ratings in terms of their ability to evaluate the procedures and methodologies used by an NRSRO to determine credit ratings. In this way, they also may promote the NRSROs' accountability to the market and the issuance of quality credit ratings.

There are new requirements applicable to NRSROs pursuant to which they must publish two items when taking a rating action: (1) A form containing certain quantitative and qualitative information about the credit rating that is the result or subject of the rating action; and (2) any certification of a third-party due diligence provider relating to the credit rating.[140] The required disclosures may be used by investors and other users of credit ratings to better understand credit ratings issued by NRSROs. Specifically, the forms and certifications will provide incremental information about how a credit rating was produced (for example, disclosure about assumptions, limitations, information relied on, version of the procedure or methodology used, potential conflicts of interest) and the information content of the credit rating. The information disclosed in the form, including information about the limitations of the credit rating and information regarding due diligence, may discourage undue reliance on credit ratings by investors and other users of credit ratings in making investment and other credit-based decisions.

There is a new requirement applicable to issuers and underwriters of asset-backed securities pursuant to which they must disclose the findings and conclusions of any third-party due diligence report they obtain.[141] The rule applies to both registered and unregistered offerings of asset-backed securities. Additionally, there is a new requirement applicable to providers of third-party due diligence services with respect to asset-backed securities pursuant to which they must provide a written certification to any NRSRO that is producing a credit rating with respect to the asset-backed security.[142] The certification must disclose information about the due diligence performed, including a summary of the findings and conclusions of the third party, and identification of any relevant NRSRO due diligence criteria that the third party intended to meet in performing the due diligence.

As discussed above, the amendments and new rules are intended to reduce asymmetric information in the asset-backed security market. NRSROs producing credit ratings for asset-backed securities may benefit from receiving the information in the certification. The certification also will be signed by an individual who is duly authorized by the third-party due diligence provider to Start Printed Page 55095make such a certification, promoting confidence in the accuracy of the information disclosed. Importantly, issuers and underwriters can no longer select what part of this information to provide to NRSROs, reducing the possibility of less favorable information being withheld from NRSROs and reducing the risk that the credit ratings will be based on imperfect or incomplete information (to the extent the NRSROs use information about due diligence in producing their credit ratings). Further, making this information available to all NRSROs (rather than just the NRSROs hired to rate the asset-backed security) could promote the issuance of more credit ratings for a given asset-backed security, including credit ratings that provide a more diverse range of views on the creditworthiness of the security. Users of credit ratings, including investors and other participants in the asset-backed securities markets, may benefit both directly and indirectly from the disclosures made by issuers, underwriters, and providers of third-party due diligence services. To the extent that findings and conclusions of all third-party due diligence reports were not previously disclosed to these persons, the amendments and new rules should enhance information available to the public.

Finally, there are new requirements pursuant to which NRSROs must use the Commission's Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system to electronically submit Form NRSRO and required exhibits to the form to the Commission.[143] Having all information available in an electronic format in EDGAR will provide a centralized location and should make the information and the history of that information more easily accessible, comparable, and searchable to users of credit ratings, including investors.

There will be costs associated with the amendments and new rules being adopted today that are related to enhanced disclosure and transparency.[144] These costs will be primarily incurred by NRSROs,[145] issuers and underwriters of asset-backed securities, and third-party due diligence providers. Initial and ongoing direct costs, including compliance costs, may vary among the affected parties depending on their size and the complexity of their business activities (for example, number of credit ratings outstanding, number of analysts, number of classes of credit ratings, number of years issuing credit ratings, and number of historical credit ratings). Keeping all other factors constant, NRSROs operating according to a subscriber-pay model may face greater losses in revenue from the sale of access to historical ratings data, as more of this data becomes publicly available, since they are likely to be more dependent on this source of revenue than NRSROs operating according to the issuer-pay model. A component of these costs may also be fixed, affecting more significantly smaller NRSROs that may find it more difficult to bear the costs. If NRSROs are not able to readily pass the overall additional costs to clients, there may be adverse effects, especially on smaller NRSROs.

Similar to the amendments and new rules relating to governance, the amendments and new rules relating to disclosure and transparency could reduce the number of credit rating agencies registered with the Commission as NRSROs to the extent that current registrants believe the cost of being registered and subject to these new requirements outweighs the benefit of registration. In addition, the barriers to entry for credit rating agencies to register as NRSROs may rise, especially for smaller credit rating agencies. NRSROs may have a reduced incentive to register for a new class of credit ratings with adverse effects on competition in certain market segments. Barriers to exit from registration as an NRSRO may lower due to the possible erosion of profit margins, though an NRSRO's decision to deregister from certain or all classes of credit ratings may depend on whether users of credit ratings will favor NRSROs because of the NRSRO registration and oversight program, which is being enhanced by the amendments and new rules being adopted today. The risk for deregistration will likely be higher for smaller NRSROs, given the fixed component of some compliance costs and the greater difficulty to pass the increase in costs to their clients.

Also, the amendments and new rules may impact competition among third-party due diligence providers. Although the Commission knows little about the characteristics of the market for the services they provide, the certification requirement may increase the liability risk for these providers, particularly for those who do not already bear expert liability under Rule 193.[146] If third-party due diligence providers are not able to charge more for performing the asset review to account for the heightened risk of liability, some providers may exit the market or some entities that otherwise would have entered the market may decide against doing so.

The amendments and new rules also may have positive effects on competition, efficiency and capital formation. The enhanced standardization of the information content may facilitate comparing performance statistics and rating histories across NRSROs. Clients of NRSROs (for example, issuers, subscribers, and others) may use the performance statistics to inform their hiring or subscribing decisions, increasingly promoting competition among NRSROs on the basis of the quality of their credit ratings and the procedures and methodologies used to determine credit ratings. To the extent that the adopted rules facilitate the external monitoring and comparative analysis of NRSROs, they may allow users of credit ratings to develop more refined views of NRSRO performance and thereby indirectly increase accountability and encourage integrity in the production of credit ratings. This, in turn, may facilitate the ability of NRSROs to establish and maintain reputations for issuing quality credit ratings to remain competitive. More comparable performance data may also help relatively smaller and newer NRSROs, including subscriber-paid NRSROs, to attract attention to their rating performance, enhancing their ability to develop a reputation for producing quality credit ratings. This may allow them to better compete with more established competitors. Also, the ability of non-hired NRSROs to obtain the information disclosed in the third-party due diligence certification may provide them with an advantage in producing informative unsolicited credit ratings, relative to unregistered Start Printed Page 55096credit rating agencies that cannot obtain this information.

The new disclosure requirements in the form and certifications that accompany a rating action may reduce information asymmetries about how a credit rating was determined by providing additional information about the rating process, such as assumptions, limitations, version of the procedures or methodologies used, and, in the case of an asset-backed security, a description of the findings and conclusions of a third-party due diligence provider, if such services were employed. To the extent that the required disclosure does not diminish the content and timeliness of the information conveyed with the rating actions, the enhanced information may increase the ability of users of credit ratings to accurately interpret the information, potentially resulting in more efficient investment decisions and higher overall market efficiency to the benefit of those investors that use credit ratings. This, in turn, may increase investors' participation in the securities markets with positive effects on capital formation. Because of the higher degree of information asymmetry in the asset-backed security market, the benefits in efficiency and capital formation resulting from the enhanced disclosure and transparency of credit ratings are likely to be greater for these securities, with the result that investors may become more willing to participate in this market.

II. Final Rules and Rule Amendments

As discussed in detail below, the Commission is adopting new rules and amendments to existing rules to implement Title IX, Subtitle C of the Dodd-Frank Act and to enhance the NRSRO registration and oversight program administered by the Commission. In designing rules to implement Title IX, Subtitle C of the Dodd-Frank Act, the Commission has taken into account section 15E(c)(2) of the Exchange Act.[147] This section provides, in pertinent part, that neither the Commission nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedures and methodologies by which any NRSRO determines credit ratings.[148] One way the Commission has sought to reconcile the rulemaking mandated by the Exchange Act, as amended by the Dodd-Frank Act, with the limitation in section 15E(c)(2) is to model rule text closely on statutory text.

A. Internal Control Structure

Section 932(a)(2)(B) of the Dodd-Frank Act added paragraph (3) to section 15E(c) of the Exchange Act.[149] Section 15E(c)(3)(A) requires an NRSRO to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings (“internal control structure”), taking into consideration such factors as the Commission may prescribe, by rule.[150] While section 15E(c)(3)(A) provides that the Commission “may” prescribe factors an NRSRO would need to take into consideration when establishing, maintaining, enforcing, and documenting the internal control structure, the requirement that an NRSRO “establish, maintain, enforce, and document an effective internal control structure” is self-executing.[151] Consequently, an NRSRO must adhere to this provision irrespective of whether the Commission prescribes factors pursuant to section 15E(c)(3)(A).

Section 15E(c)(3)(B) of the Exchange Act provides that the Commission “shall prescribe” rules requiring each NRSRO to submit an annual internal controls report to the Commission, which shall contain: (1) A description of the responsibility of the management of the NRSRO in establishing and maintaining an effective internal control structure; (2) an assessment of the effectiveness of the internal control structure; and (3) the attestation of the chief executive officer (“CEO”), or equivalent individual, of the NRSRO.[152]

In the proposing release, the Commission: (1) Deferred prescribing factors the NRSRO must take into consideration in establishing, maintaining, enforcing, and documenting an effective internal control structure; (2) proposed amending the NRSRO recordkeeping rule (Rule 17g-2) to require that the documentation of the internal control structure be subject to the rule's record retention requirements; and (3) proposed amending the NRSRO annual reporting rule (Rule 17g-3) to require an NRSRO to file an unaudited annual internal controls report with the Commission.[153]

1. Prescribing Factors

In the proposing release, the Commission stated that it was deferring prescribing factors an NRSRO must take into consideration when establishing, maintaining, enforcing, and documenting an effective internal control structure to provide the Commission with an opportunity—through the NRSRO examination process and the submission of annual reports by the NRSROs on the effectiveness of their internal control structures—to review how NRSROs have complied with the self-executing requirement in section 15E(c)(3)(A) of the Exchange Act to establish, maintain, enforce, and document an effective internal control structure.[154] However, the Commission sought comment on whether it would be appropriate as part of this rulemaking to prescribe factors and on potential factors the Commission could prescribe.[155] In particular, the Commission identified factors relating to: (1) The establishment of an internal control structure; (2) the maintenance of an internal control structure; and (3) the enforcement of an internal control structure.[156]

In terms of establishing an internal control structure, the Commission requested comment on the following factors:

  • Controls reasonably designed to ensure that a newly developed methodology or proposed update to an in-use methodology for determining credit ratings is subject to an appropriate review process (for example, by persons who are independent from the persons that developed the methodology or methodology update) and to management approval prior to the new or updated methodology being employed by the NRSRO to determine credit ratings; [157]
  • Controls reasonably designed to ensure that a newly developed methodology or update to an in-use methodology for determining credit ratings is disclosed to the public for consultation prior to the new or updated Start Printed Page 55097methodology being employed by the NRSRO to determine credit ratings, that the NRSRO makes comments received as part of the consultation publicly available, and that the NRSRO considers the comments before implementing the methodology;
  • Controls reasonably designed to ensure that in-use methodologies for determining credit ratings are periodically reviewed (for example, by persons who are independent from the persons who developed and/or use the methodology) in order to analyze whether the methodology should be updated;
  • Controls reasonably designed to ensure that market participants have an opportunity to provide comment on whether in-use methodologies for determining credit ratings should be updated, that the NRSRO makes any such comments received publicly available, and that the NRSRO considers the comments;
  • Controls reasonably designed to ensure that newly developed or updated quantitative models proposed to be incorporated into a credit rating methodology are evaluated and validated prior to being put into use;
  • Controls reasonably designed to ensure that quantitative models incorporated into in-use credit rating methodologies are periodically reviewed and back-tested;
  • Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of a class of obligors, securities, or money market instruments the NRSRO has not previously rated to determine whether the NRSRO has sufficient competency, access to necessary information, and resources to rate the type of obligor, security, or money market instrument;
  • Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of an “exotic” or “bespoke” type of obligor, security, or money market instrument to review the feasibility of determining a credit rating;
  • Controls reasonably designed to ensure that measures (for example, statistics) are used to evaluate the performance of credit ratings as part of the review of in-use methodologies for determining credit ratings to analyze whether the methodologies should be updated or the work of the analysts employing the methodologies should be reviewed;
  • Controls reasonably designed to ensure that, with respect to determining credit ratings, the work and conclusions of the lead credit analyst developing an initial credit rating or conducting surveillance on an existing credit rating is reviewed by other analysts, supervisors, or senior managers before a rating action is formally taken (for example, having the work reviewed through a rating committee process);
  • Controls reasonably designed to ensure that a credit analyst documents the steps taken in developing an initial credit rating or conducting surveillance on an existing credit rating with sufficient detail to permit an after-the-fact review or internal audit of the rating file to analyze whether the analyst adhered to the NRSRO's procedures and methodologies for determining credit ratings; and
  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or internal audits of rating files to analyze whether analysts adhere to the NRSRO's procedures and methodologies for determining credit ratings.[158]

In terms of maintaining an internal control structure, the Commission requested comment on the following factors:

  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews of whether it has devoted sufficient resources to implement and operate the documented internal control structure as designed;
  • Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or ongoing monitoring to evaluate the effectiveness of the internal control structure and whether it should be updated; and
  • Controls designed to ensure that any identified deficiencies in the internal control structure are assessed and addressed on a timely basis.[159]

In terms of enforcing an internal control structure, the Commission requested comment on the following factors:

  • Controls designed to ensure that additional training is provided or discipline taken with respect to employees who fail to adhere to requirements imposed by the internal control structure; and
  • Controls designed to ensure that a process is in place for employees to report failures to adhere to the internal control structure.[160]

In terms of documenting the internal control structure, the Commission asked for comment on whether there should be a factor relating to the level of written detail about the internal control structure that should be documented.[161]

A number of commenters addressed whether the Commission should prescribe factors as part of this rulemaking and, if so, the type of factors the Commission should prescribe.[162] NRSROs urged the Commission to defer rulemaking and stated that the Commission should not prescribe factors.[163] For example, one NRSRO stated that the Commission should defer rulemaking until it has the opportunity to determine through the examination process and its review of the NRSROs' annual reports the “best practices utilized” by NRSROs to comply with the self-executing requirement in section 15E(c)(3)(A) and that the Commission's “examination feedback regarding best practices related to internal controls will be an important element for the adequate design and monitoring of internal controls.” [164] Another NRSRO stated that it “strongly agrees” with the Commission's proposal to defer rulemaking but that, if the Commission proceeds with rulemaking, it should “exercise caution” because attempting to create a “one-size fits all” rule in “such a short timeframe could result in the creation of an anti-competitive environment and the attendant unintended consequences.” [165] A third NRSRO stated that “NRSROs should have the flexibility to implement whatever control structure suits their size and particular business operations.” [166]

In contrast, several other commenters stated that the Commission should not defer rulemaking.[167] For example, one commenter stated that the Commission “already has significant information about the weak internal controls at the NRSROs and has already identified a number of factors critical to an effective internal control system” and that “[p]ostponing the issuance of any standards will result in the NRSROs developing different internal control Start Printed Page 55098structures, making oversight and the implementation of minimum standards more difficult, time consuming, and expensive down the line.” [168] Another commenter stated that the proposed approach “will be ineffective in reforming credit rating agency practices and will leave the Commission with little if any ability to hold ratings agencies accountable if they adopt weak and ineffective controls.” [169] These commenters and others recommended that the Commission prescribe factors,[170] and one of the commenters recommended that the Commission re-propose the rule to prescribe factors.[171]

One commenter discussed factors that the commenter believed should be included in “a set of mandatory minimum standards for an effective internal control system for credit ratings.” [172] Another commenter stated that “the criteria on which the Commission seeks comment are precisely the sort of controls that ought to be in place if the system is operating effectively.” [173] A third commenter agreed that the rule should “incorporate all of these factors [as described in the proposing release].” [174] Two commenters pointed to the internal control framework developed by the Committee of Sponsoring Organizations of the Treadway Commission in 1992 as a model.[175] Two commenters stated that the rule should require that the documentation of the internal control structure include specific elements, such as how the board of directors conducted its oversight of the internal control structure.[176]

The Commission believes it is critically important to investors and other users of credit ratings that, as required by section 15E(c)(3)(A) of the Exchange Act, NRSROs establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their policies, procedures, and methodologies for determining credit ratings.[177] The Commission agrees that the requirements established by the NRSROs to address the internal control structure should “provide the companies' management the ability to effectively administer their internal compliance measures, and instill confidence in their investors and the public that the companies in fact are achieving the objectives of their internal control rules and, in so doing, promoting ratings that are high-quality, objective, independent, reliable, and free from influence by any conflicts of interest.” [178] This is one of the reasons that the Commission previously has expressed concerns about—and has taken action to address—the integrity of policies, procedures, and methodologies for determining credit ratings used by certain NRSROs in light of the role these NRSROs played in determining credit ratings for securities collateralized by or linked to subprime residential mortgages.[179]

Moreover, the Commission staff conducts annual examinations of each NRSRO and publishes a report summarizing the essential findings of the examinations, as required by section 15E(p)(3) of the Exchange Act.[180] The annual report attributes the essential findings, as applicable, to the “smaller” NRSROs or “larger” NRSROs, and describes for the public the nature and extent of the deficiencies cited. The Commission staff, as part of the annual examination of each NRSRO, reviews whether the internal control structure of the NRSRO is effective as required by section 15E(c)(3)(A) of the Exchange Act.[181]

For example, in the annual report published in December 2013, the Commission staff noted that all NRSROs had “added or improved internal controls over the rating process” since the examinations began in 2010 and generally improved adherence to their rating policies and procedures, which “appear[ed] to be attributable, in part, to improvements in the internal control structure at NRSROs.” [182] However, in several instances the staff found that an NRSRO did not follow its policies and procedures and the staff recommended that the NRSRO improve its internal controls to ensure compliance with the policies and procedures.[183] In particular, the Commission staff cited section 15E(c)(3)(A) of the Exchange Act in its report and stated that many NRSROs relied on a testing or internal audit program as an internal supervisory control.[184] The staff then described certain weaknesses it found in those controls, and recommended that those NRSROs improve and better document their testing and audit programs.[185]

Deficiencies in the internal control structure found by the examination staff are brought to the attention of the NRSRO, and the staff monitors whether and how those deficiencies are addressed. If warranted, the examination staff also can refer an NRSRO to the enforcement staff for potential violations of section 15E(c)(3)(A).

Given the importance of the NRSROs' internal control structures, the Commission believes that an NRSRO should be required to consider the factors identified in the proposing release when establishing, maintaining, enforcing, and documenting an effective internal control structure. The exercise of considering these factors will provide the NRSROs with an opportunity to critically evaluate the effectiveness of their existing internal control structures and new registrants a reference point for designing or modifying existing internal control structures to comply with the statutory requirement. This should improve the overall effectiveness of the internal control structures of the NRSROs.

Consequently, the Commission is adding paragraph (d) to new Rule 17g-8 to provide that an NRSRO must consider certain factors when establishing, maintaining, enforcing, or documenting an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings pursuant to section 15E(c)(3)(A) of the Act.[186] The factors identified in this paragraph are Start Printed Page 55099the same factors the Commission identified in the proposing release.[187] Paragraph (d)(1) identifies the factors relating to establishing an effective internal control structure, paragraph (d)(2) identifies the factors relating to maintaining an effective internal control structure, and paragraph (d)(3) identifies the factors relating to enforcing an effective internal control structure.[188]

In considering a given factor, an NRSRO should determine whether it would be appropriate for the firm's internal control structure. Moreover, paragraphs (d)(1), (d)(2), and (d)(3) contain a “catchall” provision that provides that the NRSRO must consider any other controls necessary to establish, maintain, or enforce an effective internal control structure taking into consideration the nature of the business of the NRSRO, including its size, activities, organizational structure, and business model. The Commission is including the catchall provisions because the factors identified in paragraph (d) of Rule 17g-8 may not be comprehensive or sufficient for the circumstances of a particular NRSRO. An NRSRO should not treat them as a checklist or “safe harbor” that allows the firm to conclude that it has established, maintained, enforced, and documented an effective internal control structure.

Paragraph (d)(4) of Rule 17g-8 addresses the documentation of the internal control structure.[189] In the proposing release, the Commission did not identify a factor relating to this provision of the statute.[190] Consequently, paragraph (d)(4) does not identify a specific factor.[191] Instead, the paragraph provides—consistent with the catchall provisions in paragraphs (d)(1) through (d)(3)—that an NRSRO must take into consideration any controls necessary to document an effective internal control structure taking into consideration the nature of the business of the nationally recognized statistical rating organization, including its size, activities, organizational structure, and business model.[192]

Finally, in adopting the final rule, the Commission has taken into account comments from NRSROs that it should not prescribe factors or “exercise caution” in doing so because “NRSROs should have the flexibility to implement whatever control structure suits their size and particular business operations” [193] and attempting to create a “one-size fits all” rule in “could result in the creation of an anti-competitive environment and the attendant unintended consequences.” [194] In particular, the Commission notes that, while the Commission is prescribing factors an NRSRO must consider, it is not mandating that a specific factor be implemented. Consequently, while NRSROs must consider the factors identified by the Commission, they can tailor their internal control structures to their particular circumstances.

2. Amendment to Rule 17g-2

Section 15E(c)(3)(A) of the Exchange Act contains a self-executing provision that requires an NRSRO, among other things, to document its internal control structure.[195] However, the statute does not prescribe how an NRSRO must maintain this record. For example, the statute does not prescribe how long the record must be retained or the manner in which it must be maintained. Consequently, the Commission proposed adding paragraph (b)(12) to Rule 17g-2 to identify the internal control structure an NRSRO must document pursuant to 15E(c)(3)(A) of the Exchange Act as a record that must be retained.[196] As a result, the various retention and production requirements of paragraphs (c), (d), (e), and (f) of Rule 17g-2 would apply to the record documenting the internal control structure.[197]

Two commenters expressed support for the proposal,[198] whereas three other commenters raised concerns which are discussed below.[199] The Commission is adding paragraph (b)(12) to Rule 17g-2 as proposed.[200] Retention of the record will provide a means for the Commission to monitor the NRSROs' compliance with 15E(c)(3)(A) of the Exchange Act.

In addition, the Commission is amending paragraph (c) of Rule 17g-2. Prior to today's amendments, this paragraph provided that the records required to be retained under paragraphs (a) and (b) of Rule 17g-2 must be retained for three years after the date the record is made or received. The modification clarifies that the records documenting the internal control structure, the policies and procedures discussed in sections II.C., II.F., and II.J. of this release, and the standards discussed in section II.I. of this release must all be retained until three years after the record is replaced with an updated record (that is, when a control, policy, procedure, or standard documented in one of these records is replaced with a new control, policy, procedure, or standard).[201]

The reason for this clarifying amendment is that the text of paragraph (c) of Rule 17g-2 prior to today's amendment was intended to address records that generally contain historical information. For example, the rule requires the retention of records reflecting entries to and balances in all general ledger accounts, records indicating the identity of any credit analyst(s) that participated in determining a credit rating, credit analysis reports, credit assessment reports, and private credit rating reports.[202] The intent of the three-year record retention requirement is to preserve these records documenting historical information for three years after the fact in order to allow Commission examiners the opportunity to review the past activities of the NRSRO as reflected in these records. It also provides the NRSRO with records that can be used in connection with internal or third-party audits and for tracking past activities.

The Commission intended the three-year record retention provision in paragraph (c) of Rule 17g-2 as applied to the documentation of the internal control structure, the policies and Start Printed Page 55100procedures, and the standards to also preserve historical information for three years after the fact to facilitate Commission examinations and NRSRO internal or third party audits of past activities. However, the record reflects current rather than historical information until there is an update of the internal control structure, policies and procedures, or standards documented in the record (that is, the record reflects the internal controls, policies and procedures, or standards, as applicable, that govern the NRSRO's conduct now and in the future). Consequently, because paragraph (c) of Rule 17g-2—prior to today's amendments—required a record “to be retained for three years after the date the record is made or received,” this provision as applied to the documentation of the internal control structure, policies and procedures, and standards would be ambiguous as to whether the record must be retained for three years after the information reflected in the record is no longer current.

For example, section 15E(c)(3)(A) of the Exchange Act requires an NRSRO to document its internal control structure.[203] This means that at all times the NRSRO must document the internal control structure that is in effect and, consequently, if a given version of an internal control structure is in effect for more than three years, the NRSRO must continue to maintain the record documenting the internal control structure even though three years have elapsed since the record was made. The clarifying text being added to paragraph (c) of Rule 17g-2 addresses an ambiguity in the rule text. This ambiguity could be read to establish a three-year retention period that is largely meaningless and is inconsistent with the Commission's intent that these records be retained for three years after the information in the record is no longer current.[204] Specifically, without the clarifying amendment, paragraph (c) of Rule 17g-2 could be read to provide that the three-year retention period begins to run at the time the internal control structure was first documented. Under this reading, the rule would be redundant because it would prescribe a retention period that is already addressed by the self-executing requirement in section 15E(c)(3)(A) of the Exchange Act (that an NRSRO must document its internal control structure). In other words, the statutory requirement to document the internal control structure acts as a retention requirement for as long as the current version of the internal control structure is in effect. Further, under this reading of the rule, if an internal control structure was in effect for three or more years, an NRSRO could discard the record documenting the previous internal control structure as soon as it is replaced with an updated record documenting the revised internal control structure (as it would have retained the previous record of the internal control structure for three or more years). This could prevent the Commission from reviewing whether the NRSRO adhered to its previous internal control structure, as examinations generally review past activities. The appropriate and intended retention period is until three years after the internal control structure is updated. As a result, the documentation recording the current internal control structure and the documentation recording any prior versions of the internal control structure that were updated within three years will be available to Commission examiners. This will create an audit trail between prior versions of the internal control structure and the existing internal control structure. For these reasons, the Commission is amending paragraph (c) of Rule 17g-2 to make clear that the records documenting the internal control structure, the policies and procedures, and the standards must be retained until three years after the date the record is replaced with an updated record.[205]

One commenter stated that a three-year retention period is “insufficient,” since “the effects of a credit rating decision may not arise until after that retention period expires.” [206] The Commission believes the three year retention period is sufficient. First, as noted above, an NRSRO must maintain a record documenting its existing internal control structure for as long as the internal control structure is in effect and for an additional three years after the record is replaced with an updated record documenting the internal control structure. Second, the Commission staff performs an annual examination of each NRSRO. Consequently, the record documenting an internal control structure that is no longer in effect will be available for several exam cycles.

Another commenter suggested requiring that documentation be made available to the Commission “regardless of where the credit rating is produced.” [207] The Commission notes that under the rules, regardless of where a credit rating is produced, an NRSRO must document its internal control structure and produce to Commission staff the records documenting both its current internal control structure and any prior versions of the internal control structure that are within the three-year retention period.[208]

A third commenter stated that the requirement to document internal controls is burdensome, particularly for smaller NRSROs, and argued that documenting policies and procedures “naturally coincide with the establishment of a properly functioning internal controls structure,” which the NRSRO should be allowed to establish on its own, and the commenter urged the Commission to exclude “extensive or overly-inclusive documentation requirements” should it adopt new paragraph (b)(12) of Rule 17g-2.[209] In response, the Commission notes that section 15E(c)(3)(A)—not Rule 17g-2—requires an NRSRO to document its internal control structure.[210] The amendment to Rule 17g-2 establishes retention requirements for this documentation.

3. Amendments to Rule 17g-3

Section 15E(c)(3)(B) of the Exchange Act provides that the Commission shall prescribe rules requiring an NRSRO to submit an annual internal controls report to the Commission, which must contain: (1) A description of the responsibility of management in establishing and maintaining an effective internal control structure; (2) an assessment of the effectiveness of the internal control structure; and (3) the attestation of the CEO or equivalent individual.[211]

The Commission proposed amending Rule 17g-3 to implement the rulemaking mandated by section 15E(c)(3)(B) of the Exchange Act.[212] Start Printed Page 55101Rule 17g-3 requires an NRSRO to furnish annual reports to the Commission.[213] In particular, before today's amendments, paragraph (a) of Rule 17g-3 required an NRSRO to furnish five or, in some cases, six separate reports within ninety days after the end of the NRSRO's fiscal year and identified the reports that must be furnished.[214] The first report containing the NRSRO's financial statements must be audited; the remaining reports on revenues and other matters may be unaudited.[215] Before today's amendments, paragraph (b) of Rule 17g-3 provided that the NRSRO must attach to the reports a signed statement by a duly authorized person that the person has responsibility for the reports and, to the best knowledge of the person, the reports fairly present, in all material respects, the information contained in the reports.[216]

The proposed amendments would add paragraph (a)(7) to Rule 17g-3 to require an NRSRO to file an additional report—which would be unaudited—with its annual submission of reports pursuant to Rule 17g-3.[217] The proposed rule text describing the report that would need to be filed closely mirrored the statutory text.[218] In particular, proposed paragraph (a)(7) would have required that the internal controls report contain: (1) A description of the responsibility of management in establishing and maintaining an effective internal control structure; and (2) an assessment by management of the effectiveness of the internal control structure.[219]

Section 15E(c)(3)(B)(iii) of the Exchange Act provides that the annual internal controls report must contain an attestation of the NRSRO's CEO or equivalent individual.[220] Accordingly, the Commission proposed amending paragraph (b) of Rule 17g-3 to require that the NRSRO attach to the report a signed statement by the CEO or, if the firm does not have a CEO, an individual performing similar functions.[221]

The Commission is adding paragraphs (a)(7) and (b)(2) to Rule 17g-3 with modifications from the proposal in response to comments.[222] As discussed below, the modifications to the text of paragraph (a)(7) are designed to provide more guidance to NRSROs on the information that must be included in the report compared to the proposed rule text, which—as noted above—closely mirrored the statutory text.

Paragraph (a)(7)—as proposed and adopted—requires an NRSRO to include in the report a description of the responsibility of management in establishing and maintaining an effective internal control structure.[223] This rule text largely mirrors the statutory text.[224] A number of commenters addressed the level of management that should have primary responsibility for establishing and maintaining an effective internal control structure and for assessing its effectiveness.[225] An NRSRO stated that the CEO (or equivalent) and other management, supervisory, and compliance personnel affiliated with the NRSRO should be responsible for designing the structure, and that the board of directors should oversee the structure.[226] Two other commenters stated that the board of directors should oversee the structure.[227] An NRSRO stated that the wording in the proposed rule was reasonable, but that the Commission should refrain from specifying which level of management should be responsible for establishing and maintaining the system and that this determination “is best left to each NRSRO based upon its business needs and organization.” [228] Similarly, another NRSRO stated that management and board oversight of the internal control structure will vary greatly between each NRSRO and, therefore, such determinations should be left to each NRSRO.[229] On the other hand, a commenter suggested that management should have no part in the establishment or maintenance of an internal control structure, and that a committee of analysts should assess the effectiveness of the NRSRO's internal control structure.[230]

In response to these comments, the Commission notes that section 15E(t)(3)(C) of the Exchange Act prescribes a self-executing requirement that the board of directors of the NRSRO shall “oversee” the “effectiveness of the internal control system with respect to the policies and procedures for determining credit ratings. ” [231] Moreover, as discussed above, the self-executing provision in section 15E(c)(3)(A) requires an NRSRO to establish, maintain, enforce, and document an effective internal control structure.[232] Further, section 15E(c)(3)(B) of the Exchange Act refers, in pertinent part, to “a description of the responsibility of the management of the [NRSRO] in establishing and maintaining an effective internal control Start Printed Page 55102structure.” [233] Moreover, this section of the statute also provides that the annual internal controls report—which must include an assessment of the effectiveness of the internal control structure—must contain an attestation of the NRSRO's CEO or equivalent individual.[234] Consequently, a reasonable interpretation of these statutory provisions is that they allocate responsibility to the NRSRO's board to “oversee” the effectiveness of the internal control structure and responsibility to the NRSRO's management to establish, maintain, enforce, and document the internal control structure and to report annually on its effectiveness. This interpretation also is consistent with the Commission's understanding of how the responsibilities of a firm's board and management generally are allocated.

While it is the responsibility of management to establish, maintain, enforce, and document the internal control structure, in carrying out this responsibility management could, as a matter of good practice, consider the extent to which other persons within the NRSRO should be involved.[235] For example, management could seek input from persons within the NRSRO that carry out the day-to-day functions related to governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings. This could include input from persons responsible for determining credit ratings, developing rating methodologies, and reviewing and monitoring the NRSRO's compliance with its policies, procedures, and methodologies. In addition, establishing a mechanism for persons within the NRSRO to report, on a confidential basis if they choose, directly to the board of directors any material weaknesses in the NRSRO's internal control structure could be a useful check on management's annual assessment of the effectiveness of the internal control structure and could assist the board in its responsibility to oversee the effectiveness of the internal control structure. Finally, an NRSRO could consider developing procedures to identify and address internal conflicts of interest that potentially could prevent an independent, impartial, and unbiased assessment of the effectiveness of the internal control structure. This could promote more accurate reporting by the NRSRO on the internal control structure.

In addition to the description of the responsibility of management in establishing and maintaining an effective internal control structure, the proposal required that the internal controls report include “an assessment by management of the effectiveness of the internal control structure.” [236] As discussed in more detail below, several commenters stated that the Commission should strengthen the reporting requirement in the rule relating to the assessment of the effectiveness of the internal control structure.[237]

The Commission is persuaded that the proposal should be modified to provide more clarity on the information that must be reported in the internal controls report. In particular, paragraph (a)(7) of Rule 17g-3, as adopted, requires that the internal controls report include (in addition to a description of the responsibility of management in establishing and maintaining an effective internal control structure): (1) A description of each material weakness in the internal control structure identified during the fiscal year, if any, and a description, if applicable, of how each identified material weakness was addressed; and (2) a statement as to whether the internal control structure was effective as of the end of the fiscal year.[238] Consequently, the final amendment provides more specificity as to the information that must be included in the internal controls report in terms of assessing the effectiveness of the NRSRO's internal control structure.[239]

Further, in response to comments that the rule should specify that the assessment covers the entire year, the Commission has made several modifications to the proposal.[240] Specifically, the prefatory text of paragraph (a)(7)(i) of Rule 17g-3, as amended, provides that the internal controls report must contain an assessment by management of the effectiveness during the fiscal year of the internal control structure.[241] The amendment further requires that the report must include a description of each material weakness in the internal control structure identified during the fiscal year, if any, and a description, if applicable, of how each identified material weakness was addressed.[242] Consequently, the reporting relating to material weaknesses must cover the entire fiscal year. The amendment also requires that the internal controls report contain a statement as to whether the internal control structure was effective as of the end of the fiscal year.[243] Thus, this statement in the report relates to a point in time: The fiscal year end. However, the assessment of whether the internal control structure is effective as of the fiscal year end will depend on how the NRSRO addressed any material weaknesses identified during the fiscal year.[244]

Commenters also addressed how to assess the internal control structure. One commenter pointed to the internal control framework developed by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in 1992 as a model.[245] Another commenter stated that the Commission should establish a framework against which the internal controls of an NRSRO can be measured that would identify the objectives of the controls, set forth mandatory minimum components, and specify how a material weakness would be handled.[246] Some commenters suggested that the Commission clarify how an NRSRO should assess whether its internal Start Printed Page 55103control structure is effective.[247] One of these commenters suggested the Commission lay out a basic definition of internal control and the objectives the internal controls are designed to achieve but did not provide a suggested definition.[248] An NRSRO suggested that the Commission clarify that “an `effective' internal control structure is one that is `reasonably designed' to achieve its purposes.” [249] In contrast, another NRSRO stated that the proposed reporting requirement is “sufficiently explicit” and that “additional guidance is not needed.”[250] This commenter added that each NRSRO operates in its own unique way and that prescribing more detailed rules “may not be appropriate for every NRSRO in every situation.”[251]

The Commission agrees that providing more clarity as to when management of the NRSRO is not permitted to conclude that its internal control structure is effective would strengthen the requirement and provide greater certainty to NRSROs in terms of how to assess the effectiveness of the internal control structure.[252] The Commission therefore is modifying the proposal to add a provision specifying when the NRSRO is not permitted to conclude that its internal control structure is effective.[253] In particular, the final amendment provides that management of the NRSRO is not permitted to conclude that the internal control structure of the NRSRO was effective as of the end of the fiscal year if there were one or more material weaknesses in the internal control structure as of the end of the fiscal year.[254]

Commenters suggested several definitions of the term material weakness. For example, one commenter suggested that material weakness be defined as a “serious deficiency that would prevent or in fact did prevent the internal controls from achieving their objective.” [255] Another commenter described a material weakness as “a serious deficiency in an internal control that would prevent it from achieving its objective.” [256] Similarly, a third commenter stated that a definition of material weakness should be one “which clearly sets out what would be a serious deficiency in internal controls that would prevent the internal controls from achieving their objective.” [257] An NRSRO requested that the Commission provide guidance as to what constitutes a material weakness and suggested that a material weakness be defined as a “deficiency, or combination of deficiencies, in internal controls where it is more likely than not that the integrity of the rating process will be compromised by the failure to follow the NRSRO's policies, procedures, and methodologies.” [258] This commenter also stated that it believed that one of the objectives of the internal control structure is to “provide reasonable assurance regarding the prevention or timely detection of actions that could have a material effect on the integrity of credit ratings.” [259] On the other hand, another NRSRO stated that the Commission should allow NRSROs to define material weakness and other terms.[260]

The Commission is persuaded that including a description of a material weakness in paragraph (a)(7) of Rule 17g-3 will strengthen the reporting requirement and provide greater certainty to NRSROs in terms of how to assess the effectiveness of the internal control structure. Consequently, the paragraph, as adopted, includes a description of when a material weakness exists.[261] This description is based, in part, on suggestions by commenters and on recent amendments to the broker-dealer reporting rule.[262] The description of material weakness in the rule incorporates the concept of a deficiency in the internal control structure of the NRSRO.[263] Consequently, paragraph (a)(7) of Rule 17g-3 also includes a description of when a deficiency in the internal control structure exists.[264] Under the requirements of the paragraph, the first step is to determine whether there are deficiencies in the internal control structure. If so, the second step is to determine whether a material weakness exists in light of the identified deficiencies.

The description in paragraph (a)(7) of Rule 17g-3 of when a deficiency exists is based on the control objectives set forth in section 15E(c)(3)(A) of the Exchange Act.[265] This self-executing provision specifies that the internal control structure must effectively govern the implementation of and adherence to the NRSRO's policies, procedures, and methodologies for determining credit ratings. In other words, the controls must be designed to achieve the following objectives: (1) That the NRSRO implements policies, procedures, and methodologies for determining credit ratings in accordance with its policies and procedures; and (2) that the NRSRO determines credit ratings in accordance with its policies, procedures, and methodologies for determining credit ratings. Given these control objectives, the paragraph provides that a deficiency in the internal control structure exists when the design or operation of a control does not allow management or employees of the NRSRO, in the normal course of performing their assigned functions, to prevent or detect a failure of the NRSRO to: (1) Implement a policy, procedure, or methodology for determining credit ratings in accordance with its policies and procedures; or (2) adhere to an implemented policy, procedure, or methodology for determining credit ratings.[266]

The existence of a deficiency in the internal control structure, however, does not necessarily mean that a material weakness exists. Even a well-designed internal control structure cannot guarantee that a deficiency will never occur. Therefore, paragraph (a)(7) of Rule 17g-3 provides that a material weakness exists if a deficiency, or a combination of deficiencies, in the design or operation of the internal control structure creates a reasonable possibility that a failure identified in the description of deficiency (that is, a failure of the NRSRO to implement a policy, procedure, or methodology for Start Printed Page 55104determining credit ratings in accordance with its policies and procedures or to adhere to a policy, procedure, or methodology for determining credit ratings) that is material will not be prevented or detected on a timely basis.[267]

In the proposing release, the Commission asked whether the internal controls report should be made public.[268] One commenter stated that the internal controls report should be made publicly available.[269] The commenter stated that making the report public would enable users of credit ratings “to evaluate the effectiveness of [the] rating agency's internal control structure and consider what impact, if any, it may have on the quality of the credit ratings the NRSRO produces.” [270] On the other hand, three commenters—all NRSROs—stated that the report should be kept confidential (as are the other reports submitted to the Commission under Rule 17g-3).[271] One NRSRO stated that publicizing the reports could make them less informative and more defensive in nature, limiting their effectiveness.[272] A second NRSRO stated that “[m]anagement reports to the board (including an annual report, which would also be filed with the Commission) are likely to be key elements of the board's ability to oversee the effectiveness of the internal control structure” and “[s]ince board oversight will be promoted by open and free dialogue with management, the Commission should not impede such communication when imposing requirements that make some or all parts of such management reports publicly available.” [273] A third NRSRO stated that the reports may contain proprietary or confidential information pertaining to the activities of the NRSRO.[274]

The Commission is adopting the amendment as proposed and, therefore, is not requiring that the internal controls report be made public. The final amendment is intended to assist the Commission in examining and monitoring the effectiveness of the internal control structures of NRSROs and how the structures evolve and improve over time.[275] Making the reports public—as suggested by one commenter—could cause NRSROs to make them less detailed and candid.[276] In appropriate cases, if an NRSRO fails to establish, maintain, enforce, and document an effective internal control structure, the Commission could institute enforcement proceedings, at which point the allegations related to the internal control structure would be a matter of public record.

One commenter suggested the report be subjected to a third-party audit attesting to the report's reliability.[277] As stated above, the final amendment does not require that the internal controls report be made public. Consequently, the report is not a public document that will be relied upon by investors and other users of credit ratings. Rather, it is a non-public report that will be used by Commission examiners as part of their monitoring of NRSROs' compliance with the requirement in section 15E(c)(3)(A) of the Exchange Act to establish, maintain, enforce, and document an effective internal control structure. The Commission has taken these factors into consideration in balancing the benefits of having the internal controls report audited by a third party and the costs of such a requirement. The Commission examines each of the ten NRSROs currently registered with the Commission annually. At this time, the Commission believes that the annual examinations by the Commission staff will provide a sufficient means for reviewing the accuracy of the internal controls reports filed by the NRSROs.

In order to implement section 15E(c)(3)(B)(iii) of the Exchange Act, the Commission is adopting the amendment to paragraph (b) of Rule 17g-3 with modifications to correspond to the modifications to paragraph (a)(7) discussed above.[278] Specifically, as proposed, paragraph (b)(2) of Rule 17g-3 would require that the NRSRO attach to the internal controls report filed pursuant to paragraph (a)(7) a signed statement by the CEO of the NRSRO or, if the NRSRO does not have a CEO, an individual performing similar functions, stating, in pertinent part, that the report fairly presents, in all material respects, a description of the responsibility of management in establishing and maintaining an effective internal control structure and an assessment of the effectiveness of the internal control structure.[279] As discussed above, under the final amendments, paragraph (a)(7) of Rule 17g-3 provides that the report must contain a description of each material weakness in the internal control structure identified during the fiscal year, if any, and a description, if applicable, of how each material weakness was addressed, and an assessment by management of the effectiveness of the internal control structure as of the end of the fiscal year.[280] Consequently, under the final amendments, paragraph (b)(2) of Rule 17g-3 provides that the CEO or individual performing similar functions must state, in pertinent part, that the internal controls report fairly presents, in all material respects: An assessment by management of the effectiveness of the internal control structure during the fiscal year that includes a description of the responsibility of management in establishing and maintaining an effective internal control structure; a description of each material weakness in the internal control structure identified during the fiscal year, if any; a description, if applicable, of how each identified material weakness was addressed; and an assessment by management of the effectiveness of the internal control structure as of the end of the fiscal year.[281]

4. Economic Analysis

This section builds on the economic analysis in section I.B. of this release by presenting a focused analysis of the potential economic effects that may derive from the specific amendments relating to reporting on internal control structures.[282] The baseline that existed before today's amendments was one in which NRSROs must establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their methodologies for determining credit ratings.[283] In Start Printed Page 55105addition, section 15E(t)(3)(C) of the Exchange Act requires the board of directors of the NRSRO to “oversee” the “effectiveness of the internal control system with respect to policies and procedures for determining credit ratings.” [284] However, before today's amendments, there were no requirements addressing: (1) The factors an NRSRO must consider when establishing, maintaining, enforcing, and documenting an internal control structure; and (2) the retention of the records documenting the NRSRO's internal control structure. In addition, there were no requirements to file an annual internal controls report with the Commission attested to by the NRSRO's CEO or equivalent individual describing the responsibility of the management of the NRSRO in establishing and maintaining an effective internal control structure and containing an assessment of the effectiveness of the internal control structure.

Relative to the baseline, paragraph (d) of Rule 17g-8 requiring an NRSRO to consider certain factors when establishing, maintaining, enforcing, and documenting an internal control should result in benefits. As noted above, the exercise of considering these factors will provide the NRSROs with an opportunity to critically evaluate the effectiveness of their existing internal control structures and new registrants a reference point for designing or modifying existing internal control structures to comply with the statutory requirement to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their methodologies for determining credit ratings.[285] This should improve the overall effectiveness of the internal control structures of the NRSROs.

Relative to this baseline, the amendments to Rule 17g-2 requiring an NRSRO to retain a record documenting its internal control structure should result in benefits. Recordkeeping rules such as Rule 17g-2 are integral to the Commission's investor protection function because the preserved records are the primary means of monitoring compliance with applicable securities laws.[286] Rule 17g-2 is designed to ensure that an NRSRO makes and retains records that will assist the Commission's staff in monitoring, through its examination program, whether an NRSRO is complying with applicable securities laws, including the provisions of section 15E of the Exchange Act and the rules adopted under section 15E. The amendments to Rule 17g-2 are designed to assist the Commission staff in monitoring an NRSRO's compliance with the requirement in section 15E(c)(3)(A) of the Exchange Act to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to its policies, procedures, and methodologies for determining credit ratings.

Relative to the baseline, the amendments to Rule 17g-3 requiring NRSROs to file an internal controls report with the Commission should result in benefits. First, the annual report will facilitate the Commission's oversight of NRSROs by assisting the Commission in monitoring an NRSRO's compliance with the requirement in section 15E(c)(3)(A) of the Exchange Act to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings. Compliance with the requirement to file the internal controls report may enhance the integrity of credit ratings by increasing the likelihood that NRSROs will adhere to their procedures and methodologies for determining credit ratings.

Second, the requirement that an NRSRO describe in the report any material weaknesses identified during the fiscal year and how any identified material weakness was addressed may incentivize an NRSRO to more closely monitor and make appropriate improvements to its internal control structure, which could improve the integrity and quality of its credit ratings. The requirements also could provide accountability for effective governance by the NRSRO's board and management, which also may improve the integrity of credit ratings.

Third, the requirement that the CEO or a person performing similar functions attest to the report should help to ensure that the report fairly presents the assessment by management of the effectiveness of the internal control structure. It also should promote greater focus within an NRSRO on establishing, maintaining, enforcing, and documenting an effective internal control structure, given the involvement of senior level management in attesting to the reported information. Further, because the person attesting to the report must represent that the person has responsibility for the report, there will be senior level accountability for the accuracy and completeness of the report, which also should promote greater focus within an NRSRO on establishing, maintaining, enforcing, and documenting an effective internal control structure.

Paragraph (d) of Rule 17g-8 and the amendments to Rules 17g-3 and 17g-2 should promote the objective of ensuring that NRSROs comply with section 15E(c)(3)(A) of the Exchange Act (that is, establish, maintain, enforce, and document an effective internal control structure).[287] This should mitigate the risk that an NRSRO may use a rating methodology that has not been implemented in accordance with its policies and procedures or that it issues a credit rating that was not determined in accordance with its policies, procedures, and methodologies for determining credit ratings. Again, the integrity and quality of credit ratings could increase as a result.

With respect to prescribing factors, commenters stated, in response to a question in the proposing release, that the Commission should not prescribe factors for an internal control structure because this would place a heavy burden on small NRSROs.[288] The Commission believes the manner in which it has prescribed factors will address these concerns and, relative to the baseline, paragraph (d) of Rule 17g-8 should not result in costs. NRSROs already are required to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their methodologies for determining credit ratings.[289] In doing so, an NRSRO already must consider the types of controls that would be necessary to meet this statutory requirement. Paragraph (d) of Rule 17g-8 provides reference points for engaging in this exercise and may facilitate and focus the process. Moreover, while the Commission is prescribing factors an NRSRO must consider, it is not mandating that a specific factor be implemented. Consequently, while NRSROs must consider the factors identified by the Commission, they can tailor and scale their internal control structures to their size and business activities.

Relative to the baseline, the amendments to Rule 17g-2 prescribing retention requirements for the documentation of the internal control structure will result in costs to NRSROs. NRSROs already have recordkeeping systems in place to comply with the recordkeeping requirements in Rule Start Printed Page 5510617g-2 before today's amendments. Therefore, the recordkeeping costs of this rule will be incremental to the costs associated with these existing requirements. Specifically, the incremental costs will consist largely of updating their record retention policies and procedures and retaining and producing the additional record. Based on analysis for purposes of the Paperwork Reduction Act (“PRA”),[290] the Commission estimates that paragraph (b)(12) of Rule 17g-2 and the amendment to paragraph (c) of Rule 17g-2 will result in total industry-wide one-time costs to NRSROs of approximately $12,000 and total industry-wide annual costs to NRSROs of approximately $3,000.[291]

Relative to the baseline, the amendments to Rule 17g-3 requiring that NRSROs file an annual internal controls report with the Commission will result in costs to NRSROs. An NRSRO will likely incur costs to engage outside counsel to analyze the requirements for the report and to assist in drafting and reviewing the report. These legal costs are expected to be greater for the filing of the first report and are expected to depend on the size and complexity of the operations of the NRSRO. NRSROs also will need to establish and maintain internal processes to gather and retain evidentiary information to support the report. However, NRSROs already have processes and controls for preparing and submitting the annual reports required by Rule 17g-3 before today's amendments. Therefore, the reporting costs of this rule will be incremental to the costs associated with these existing requirements. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (a)(7) of Rule 17g-3 and the amendment to paragraph (b) of Rule 17g-3 will result in total industry-wide one-time costs to NRSROs of approximately $400,000 and total industry-wide annual costs to NRSROs of approximately $667,000.[292]

The amendments to Rule 17g-2 and Rule 17g-3 may result in other costs. For example, these requirements may affect the timeliness of credit ratings if they result in an NRSRO implementing internal controls that increase the time required to produce a credit rating. For example, an NRSRO may choose to implement controls which require the work of a lead credit analyst to be reviewed by other analysts. As a result, users of credit ratings may incur costs associated with having credit ratings that are less timely.

Paragraph (d) of Rule 17g-8 and the amendments to Rule 17g-3 and Rule 17g-2 could have a number of effects related to efficiency, competition, and capital formation.[293] As stated above, these amendments could improve the integrity and quality of credit ratings. Consequently, users of credit ratings could make more efficient investment decisions based on this higher-quality information. Market efficiency could also improve if this information is reflected in asset prices. Consequently, capital formation could improve as capital may flow to more efficient uses with the benefit of this enhanced information. Alternatively, the timeliness of credit-related information may be diminished as discussed above. In this case, users of credit ratings may have access to less timely credit-related information which could decrease the efficiency of their investment decisions and the efficiency of markets as it could delay the updating of asset prices to reflect available information. The amendments to Rule 17g-3 and Rule 17g-2 also will impose costs, some of which may have a component that is fixed in magnitude across NRSROs and does not vary with the size of the NRSRO. Therefore, the operating costs per rating of smaller NRSROs may increase relative to that of larger NRSROs, which could create adverse effects on competition. As a result of these amendments, the barriers to entry for credit rating agencies to register as NRSROs might be higher for credit rating agencies, while some NRSROs, particularly smaller firms, may decide to withdraw from registration as an NRSRO.

There are a number of reasonable alternatives to the amendments. First, the Commission could have deferred prescribing factors to be taken into consideration when establishing, maintaining, enforcing, and documenting an effective internal control structure. As explained above, the exercise of considering these factors will provide the NRSROs with an opportunity to critically evaluate the effectiveness of their existing internal control structures and new registrants a reference point for designing or modifying existing internal control structures to comply with the statutory requirement to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their methodologies for determining credit ratings.[294] This should improve the overall effectiveness of the internal control structures of the NRSROs. Moreover, the “catchall” provisions in the rule will mitigate the risk that an NRSRO treats the factors as a checklist or “safe harbor.” Moreover, as discussed above, the Commission does not believe that prescribing factors will result in additional costs to NRSROs.

Second, the Commission could require that the annual internal controls report be made public, as suggested by one commenter.[295] This alternative could improve the quality of credit ratings by providing additional information to issuers, subscribers, investors, and other users of credit ratings to assess the quality of an NRSRO's internal control structure and, thereby, promote the NRSROs' accountability to the market and the issuance of quality credit ratings by the NRSRO. However, as stated above, publicly disclosing the internal controls reports could cause NRSROs to be less detailed and candid. This could diminish the utility of the reports as a means for the Commission to monitor compliance with the requirements of section 15E(c)(3)(A) of the Exchange Act and for the boards of the NRSROs to meet their obligations under section 15E(t)(3)(C) of the Exchange Act to “oversee” the “effectiveness of the internal control system with respect to the policies and procedures for determining credit ratings.”

Third, the Commission could require that the internal controls report be audited by a third party, as suggested by a commenter.[296] As stated above, the final amendment does not require that the internal controls report be made public. Consequently, the report is not a public document that will be relied upon by investors and other users of credit ratings. Rather, it is a non-public report that will be used by Commission examiners. The Commission has taken these factors into consideration in balancing the benefits of having the internal controls report audited by a third party and the costs of such a requirement. The Commission examines each of the ten NRSROs currently Start Printed Page 55107registered with the Commission annually. At this time, the Commission believes that the annual examinations by the Commission staff will provide a sufficient means for reviewing the accuracy of the internal controls reports filed by the NRSROs.

B. Sales and Marketing Conflict of Interest

Section 932(a)(4) of the Dodd-Frank Act added paragraph (3) to section 15E(h) of the Exchange Act.[297] Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of credit ratings by the NRSRO.[298] Section 15E(h)(3)(B)(i) of the Exchange Act requires that the Commission's rules shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of credit ratings and sales and marketing activities is not appropriate.[299] Section 15E(h)(3)(B)(ii) of the Exchange Act requires that the Commission's rules shall provide for the suspension or revocation of the registration of an NRSRO if the Commission finds, on the record, after notice and opportunity for a hearing, that: (1) The NRSRO has committed a violation of a rule issued under section 15E(h) of the Exchange Act; and (2) the violation affected a rating.[300]

The Commission proposed to implement sections 15E(h)(3)(A), 15E(h)(3)(B)(i), and 15E(h)(3)(B)(ii) of the Exchange Act by amending the NRSRO conflict of interest rule (Rule 17g-5).[301] The proposal would amend Rule 17g-5 by: (1) Identifying a new prohibited conflict in paragraph (c) of the rule relating to sales and marketing activities; (2) adding paragraph (f) to the rule to set forth the finding the Commission would need to make in order to grant a small NRSRO an exemption from the prohibition; and (3) adding paragraph (g) to the rule to set forth the standard for suspending or revoking an NRSRO's registration for violating a rule adopted under section 15E(h) of the Exchange Act.[302]

1. New Prohibited Conflict

Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of credit ratings by the NRSRO.[303] The Commission proposed to implement this provision by identifying a new conflict of interest in paragraph (c) of Rule 17g-5.[304] Paragraph (c) prohibits an NRSRO and a person within an NRSRO from having a conflict of interest identified in the paragraph under all circumstances (an “absolute prohibition”).[305] As proposed, paragraph (c)(8) of Rule 17g-5 would identify an additional absolute prohibition: Issuing or maintaining a credit rating where a person within the NRSRO who participates in sales or marketing of a product or service of the NRSRO or a product or service of a person associated with the NRSRO also participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative or quantitative models.[306] In effect, this would prohibit persons who participate in sales and marketing activities from participating in determining or monitoring credit ratings or developing or approving rating procedures or methodologies.

Several commenters suggested that the requirements in the proposed amendment should be stronger.[307] Commenters raised concerns that the amendment as proposed would not prohibit managers from seeking to inappropriately influence credit analysts and the personnel who develop and approve rating procedures and methodologies.[308] For example, one commenter stated that the proposal could “be strengthened by barring NRSRO management from taking negative actions against analysts due to client complaints seeking better ratings, more lenient treatment of their products, or relief from providing information about a product being rated” and that such actions “inevitably lead to inaccurate and inflated ratings.” [309] A second commenter stated that the requirement needs to apply “more broadly to any action by any rating agency employee that has the intent or effect of allowing sales and marketing considerations, including concern over building market share, to inappropriately influence the rating process or undermine ratings accuracy.” [310] The commenter stated that this was necessary to address practices such as “basing analysts' performance evaluations or compensation on their success in building market share, allowing investment bankers to influence the selection of analysts involved in rating their deals, and delaying revisions to rating models because of concerns about their impact on market share.” [311] A third commenter stated that motivations by management to increase profits and market share can lead to top-down policies and practices that emphasize higher credit ratings over improved accuracy and reliability.[312]

Other commenters suggested that the proposed requirement be less restrictive.[313] These commenters recommended, among other things, that the proposed amendment require procedures to manage the conflict,[314] or apply only when sales and marketing considerations “influenced” the production of the credit rating.[315]

Start Printed Page 55108

After considering these comments, the Commission is revising the rule text to incorporate into the rule language that is both consistent with the statutory language and with the requirement in paragraph (a)(1)(iii) of Rule 17g-7 [316] (discussed in section II.G.4. of the release), which would address sources of influence with respect to sales and marketing considerations in addition to persons involved in sales and marketing activities. Accordingly, the final amendment modifies the proposal to provide that an NRSRO is prohibited from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also: (1) Participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (2) is influenced by sales or marketing considerations.[317]

Under the first prong of the final amendment, an NRSRO is prohibited from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO.[318] As with the proposal, this prong of the absolute prohibition is designed to address situations in which, for example, individuals within the NRSRO who engage in activities to sell products and services (both ratings-related and non-ratings-related) of the NRSRO or its affiliates could seek to influence a specific credit rating to favor an existing or prospective client or the development of a credit rating procedure or methodology to favor a class of existing or prospective clients. In practice, the Commission believes the amendment will require an NRSRO to prohibit personnel that have any role in the determination of credit ratings or the development or modification of rating procedures or methodologies from having any role in sales and marketing activities. It also will require an NRSRO to prohibit personnel that have any role in sales and marketing activities from having any role in the determination of credit ratings or the development or modification of rating procedures or methodologies. Consequently, these functions will need to be separate.

Commenters suggested that the proposed requirement be less restrictive.[319] These commenters recommended, among other things, that the proposed amendment require procedures to manage the conflict,[320] or apply only when sales and marketing considerations “influenced” the production of the credit rating.[321] In response, the Commission notes that section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of ratings by the NRSRO.[322] Moreover, section 15E(h)(3)(B)(i) of the Exchange Act requires that the Commission's rules under section 15E(h)(3)(A) shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of credit ratings and sales and marketing activities is not appropriate.[323] The Commission therefore believes that it is a reasonable interpretation of the statute to adopt a rule that requires the separation of the two functions. As stated above, in practice, the final amendment will require an NRSRO to prohibit the personnel that have any role in sales and marketing activities from having any role in the determination of credit ratings or the development or modification of rating procedures and methodologies. In addition, this approach establishes a particularly strong measure to address the sales and marketing conflict because, as discussed above, the final amendment establishes an absolute prohibition. Moreover, depending on the facts and circumstances, it would also violate the first prong of the rule as amended for an individual who participates in sales and marketing activities to seek to influence the determination of a credit rating or the rating procedures and methodologies used to determine a credit rating, even if the individual's conduct did not influence the credit rating or rating procedures or methodologies.

Further, Commission staff found as part of the examination of the activities of the three largest NRSROs in rating RMBS and CDOs linked to subprime mortgages that it appeared “employees responsible for obtaining ratings business would notify other employees, including those responsible for criteria development, about business concerns they had related to the criteria.” [324] As the Commission stated in the proposing release, the absolute prohibition was designed to insulate individuals within the NRSRO responsible for the analytic function from such sales and marketing concerns and pressures.[325]

The Commission shares the concerns raised by commenters about the potential inappropriate influence that managers may have over employees involved in the determination of credit ratings or the development or modification of rating procedures and methodologies.[326] In response, the Commission notes that a manager who participates in sales and marketing activities and who seeks to influence a credit rating or the rating procedures and methodologies used to determine the credit rating would be “participating” in determining or monitoring the credit rating or in developing or approving the rating procedures or methodologies used to determine the credit rating under paragraph (a)(8) of Rule 17g-5, as adopted.[327] Consequently, depending Start Printed Page 55109on the facts and circumstances, the rule as amended would be violated if it was established that an NRSRO issued or maintained a credit rating in a case in which managers involved in sales and marketing activities pressured or otherwise offered incentives to analysts working on the credit rating to take commercial concerns into account in determining the credit rating. Similarly, depending on the facts and circumstances, it would violate the rule as amended for an NRSRO to issue or maintain a credit rating that managers involved in sales and marketing activities sought to influence by pressuring or offering incentives to personnel who developed or approved the rating procedures or methodologies used to determine the credit rating to take commercial concerns into account in developing or approving the procedures or methodologies. Moreover, depending on the facts and circumstances, because the rule is an absolute prohibition, this conduct would violate the rule, even if a manager did not successfully influence any credit rating or the rating procedures or methodologies used to determine the credit rating.

Commenters stated that the requirements of proposed paragraph (c)(8) of Rule 17g-5 are ambiguous and requested that the Commission clarify various aspects of the proposal.[328] Five commenters raised concerns as to what it means to participate in sales and marketing activities under the proposed rule.[329] Four of those commenters requested that the Commission provide additional guidance on this question.[330] On the other hand, an NRSRO suggested that the Commission should not provide additional guidance and should allow the NRSRO to define participate.[331] Similarly, five commenters (including NRSROs) requested the Commission clarify what constitutes a sales and marketing activity,[332] while an NRSRO suggested that the Commission not provide additional guidance and allow the NRSRO to determine what constitutes a sales and marketing activity.[333] One NRSRO stated that the rule should not contain definitions that “compel large size” by mandating, explicitly or implicitly, minimum numbers of employees or layers of management.[334]

In response to these comments requesting clarification of terms used in the amendment, the Commission notes that sales and marketing activities involve efforts by an NRSRO to sell or in any manner market its products and services to prospective customers.[335] Participating in sales and marketing activities would clearly include certain actions. For example, a person within an NRSRO would participate in a sales and marketing activity if: (1) The individual contacted a company that was about to issue debt and solicited the business of rating the issuance or met with company officials for business development purposes (for example, to “pitch” the NRSRO's services); (2) the individual contacted an institutional investor and offered subscriptions to the NRSRO's credit ratings or credit analyses; (3) the individual was contacted by an issuer about the cost of rating its issuance or by an institutional investor about the cost of a subscription to the NRSRO's credit ratings or analyses and the individual provided information about these costs.

The Commission recognizes that certain scenarios posed by commenters may not be as clear-cut as these examples in terms of whether the activities would be considered participating in sales and marketing activities; each scenario will have to be evaluated based on the particular facts and circumstances.[336] For example, if rating personnel engage in analytical discussions with persons outside the NRSRO, including with obligors and issuers who purchase credit rating services from the NRSRO or with investors and others who purchase subscriptions to the NRSRO's credit ratings, that would not constitute participating in a sales and marketing activity as long as the discussions do not involve commercial matters related to selling or marketing the NRSRO's services; however, if the discussions with ratings analysts involved such commercial matters, the analysts may be considered to be participating in sales and marketing activities.[337] Similarly, if an issuer agrees to have only one meeting with an NRSRO to discuss both analytical matters relating to, and fees for, obtaining credit ratings for the securities it issues, the NRSRO could bring a team of analysts and a team of sales and marketing personnel to the meeting.[338] If the sales and marketing team does not attend the portion of the meeting in which analytical matters are discussed, they would not have participated in the determination of a credit rating. Similarly, if the analytical team does not attend the portion of the meeting in which commercial matters are discussed, they would not have participated in a sales and marketing activity. Further, an analyst would not necessarily participate in a sales or marketing activity if the analyst gives a presentation at a conference attended by persons who could be prospective purchasers of the NRSRO's services.[339] For example, the analyst would generally not be considered to be participating in a sales or marketing activity if the presentation avoided marketing the services offered by the NRSRO and focused solely on topics involving credit analysis (for example, the analytical process used by the NRSRO to determine credit ratings, an analysis of the creditworthiness of one or more obligors or issuers, or a credit forecast for a particular industry sector).[340] Similarly, the analyst would not participate in a sales or marketing activity if the analyst gave this type of presentation in the context of an interview with a news outlet. In each case, the determination whether the analytical team is participating in sales and marketing activity would turn on the facts and circumstances.

As noted above, the first prong of the absolute prohibition requires an NRSRO to separate its analytical functions from its sales and marketing functions. While Start Printed Page 55110this is a strong measure to address the sales and marketing conflict, the Commission also believes that it is appropriate to revise the rule text to incorporate language about persons participating in production of a credit rating being “influenced” by sales and marketing considerations.[341] Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of credit ratings by the NRSRO.[342] Given the concerns raised by commenters, this statutory language, the language in section 15E(q)(2)(F) of the Exchange Act,[343] and Rule 17 g-7, the Commission is modifying the proposal to add a second prong to the absolute prohibition. Under the second prong, an NRSRO is prohibited from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also is influenced by sales or marketing considerations.[344] Thus, this prong of the absolute prohibition is consistent with the provision of Rule 17g-7 that specifically requires a statement that no part of the rating was “influenced” by business activities.

In connection with making the evaluation necessary for the second prong of the absolute prohibition, the Commission believes there are a number of possible channels of influence that should be considered, such as compensation arrangements that may incentivize analysts to produce inflated credit ratings to increase or retain the NRSRO's market share, performance evaluation systems that reward analysts who produce inflated credit ratings to increase or retain the NRSRO's market share, compliance personnel who unduly influence credit analysts to inflate credit ratings in response to complaints by clients, clients such as rated entities who pressure analysts to produce inflated credit ratings to retain their business, or managers who are not involved in sales and marketing activities but may seek to pressure analysts to produce inflated credit ratings to increase or retain the NRSRO's market share.

In addition, the Commission notes that the sales and marketing prohibition is being added to a comprehensive set of existing requirements that address NRSRO conflicts and, as discussed below, the Commission is adopting additional measures to address conflicts.[345] Consequently, the sales and marketing prohibition should not be viewed in isolation but rather as part of a set of requirements (both statutory and regulatory) pursuant to which NRSROs must disclose and manage conflicts of interest and, in some cases, avoid them altogether. For example, paragraph (b)(1) of Rule 17g-5 identifies the conflict of being paid by issuers or underwriters to determine credit ratings (the issuer-pay conflict), and under paragraph (a)(2) of Rule 17g-5 and section 15E(h)(1) of the Exchange Act, an NRSRO with this conflict must establish, maintain and enforce written policies and procedures reasonably designed to address and manage the conflict.[346] An NRSRO that permits a corporate culture in which managers seek to inappropriately influence analysts and the personnel who develop and approve rating procedures and methodologies could not be viewed as having or enforcing policies and procedures reasonably designed to address the issuer-pay conflict and, consequently, this type of conduct would violate section 15E(h)(1) of the Exchange Act and Rule 17g-5.

Further, as discussed below in section II.G.4. of this release, the Commission is adopting a requirement that an NRSRO must attach to the form to accompany certain credit rating actions a signed statement by a person within the NRSRO stating that the person has responsibility for the rating action and, to the best knowledge of the person: (1) No part of the credit rating was influenced by any other business activities; (2) the credit rating was based solely upon the merits of the obligor, security, or money market instrument being rated; and (3) the credit rating was an independent evaluation of the credit risk of the obligor, security, or money market instrument.[347] If any of these requirements are not satisfied, such person would not be able to truthfully make this attestation.

The Commission made another modification to the proposal in response to a comment suggesting that the text of the amendment be revised to reference the “products or services of the NRSRO's affiliated entities” in place of the proposed reference to a “product or service of a person associated with the [NRSRO].” [348] A “person associated” with the NRSRO includes natural persons.[349] The commenter stated that, as proposed, the amendment could preclude a natural person from participating in the credit rating process “if he or she operates a completely different business (such as a photography studio on the side).” [350] This would be an overly broad application of the amendment, as it is designed to prevent sales and marketing of products and services of the NRSRO or its affiliated companies from influencing the credit rating process. Consequently, the final amendment has been modified from the proposal to apply to products and services of the affiliates of the NRSRO (rather than persons associated with the NRSRO).[351] However, the Commission notes that outside businesses of employees can raise potential conflicts.[352] Consequently, pursuant to section 15E(h)(1) of the Exchange Act and Rule 17g-5, an NRSRO must have policies, procedures, and controls to address employees engaging in outside businesses if the NRSRO permits employees to operate outside businesses.[353]

Two commenters stated that paragraph (c)(8) of Rule 17g-5 may be redundant, given the existing absolute prohibition in paragraph (c)(6) of Rule 17g-5.[354] In response, the Commission Start Printed Page 55111believes it is appropriate to retain paragraph (c)(6) because it complements paragraph (c)(8) of Rule 17g-5, as adopted. In particular, paragraph (c)(6) of Rule 17g-5 addresses the conflict that arises when persons within an NRSRO involved in determining credit ratings or developing or approving rating methodologies also negotiate, discuss, or arrange the fees paid for determining credit ratings.[355] Thus, it focuses on preventing persons within the NRSRO responsible for credit analysis from being influenced by business considerations (for example, issuing ratings favorable to a client with whom they negotiated a substantial fee). Paragraph (c)(8) of Rule 17g-5, as adopted, addresses the conflict that arises when persons within an NRSRO involved in sales and marketing activities also participate in determining credit ratings or developing or approving rating procedures and methodologies. Thus, it focuses on preventing the persons within the NRSRO responsible for generating business for the NRSRO from influencing the work of the persons responsible for credit analysis (for example, pressuring them to develop rating procedures and methodologies that favor the NRSRO's clients or prospective clients).

Finally, several commenters stated that the proposed amendment would negatively impact smaller NRSROs.[356] As discussed below, the final amendments to Rule 17g-5 provide a mechanism for small NRSROs to apply for an exemption from the absolute prohibition.[357] Under the final amendment, the Commission may grant an exemption if it finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.[358]

For all of the reasons discussed above, the Commission is adopting the amendment with the modifications discussed above. Moreover, for those reasons, the Commission is not persuaded that it is necessary to re-propose the rule as suggested by one commenter.[359] However, the Commission may consider further rulemaking to address conflicts of interest inherent in the NRSRO industry as appropriate and as circumstances warrant.

2. Exemption for “Small” NRSROs

Section 15E(h)(3)(B)(i) of the Exchange Act requires that the Commission's rules under section 15E(h)(3)(A) shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of credit ratings and sales and marketing activities is not appropriate.[360] To implement this provision, the Commission proposed to amend Rule 17g-5 by adding paragraph (f).[361] As proposed, paragraph (f) would provide a mechanism for a small NRSRO to apply in writing for an exemption from the absolute prohibition that would be established by adding paragraph (c)(8) to Rule 17g-5.[362] In particular, the proposed amendment provided that upon written application by an NRSRO, the Commission may exempt, either conditionally or unconditionally or on specified terms and conditions, such NRSRO from the provisions of paragraph (c)(8) of Rule 17g-5 if the Commission finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.[363]

The Commission stated in the proposing release that in some cases the small size of an NRSRO could make a complete separation of the sales and marketing function from the credit rating analytical function inappropriate.[364] For example, the NRSRO may not have enough staff (or the resources to hire additional staff) to establish separate functions.[365] In this case, the Commission stated that it would entertain requests for relief, although it may impose conditions designed to preserve as much of the separation between these two functions as possible.[366]

The Commission is adding paragraph (f) to Rule 17g-5 substantially as proposed, but with a technical modification to the rule text in response to comments.[367] In particular, the final amendment provides that, upon written application by an NRSRO, the Commission may exempt, either unconditionally or on specified terms and conditions, such NRSRO from the provisions of paragraph (c)(8) of Rule 17g-5 if the Commission finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.[368]

Several commenters expressed support for the objective of the proposed amendment.[369] Supporters argued that it could be difficult for smaller NRSROs to maintain the strict separation of sales and marketing activities from the production of credit ratings, as would be required under paragraph (c)(8) of Rule 17g-5, as proposed.[370] In contrast, several commenters expressed concerns with the proposed amendment, generally arguing that the proposed amendment should be narrowed or eliminated altogether because the size of an NRSRO does not affect whether the potential conflict could influence a Start Printed Page 55112credit rating.[371] For example, one of these commenters stated that “if a credit rating agency is too small to separate its rating process from its marketing process, it should not qualify as an NRSRO.”[372]

In response to concerns about providing for exemptions for small NRSROs, the Commission notes that section 15E(h)(3)(B)(i) of the Exchange Act provides that the Commission's rules issued under section 15E(h)(3)(A) shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of credit ratings and sales and marketing activities is not appropriate.[373] The final amendment implements this statutory requirement but in a manner that will require the Commission to make a specific finding before granting an exemption; namely, that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.[374]

The Commission considered the concerns expressed by commenters about granting any relief to small NRSROs in considering whether to adopt a self-executing exemption, which was suggested by a commenter.[375] Under the final amendment, exemptions will be granted on a case-by-case basis, after analyzing the facts and circumstances the applying NRSRO presents in its request for relief and any other relevant facts and circumstances. Any exemptive relief granted can be tailored to the specific circumstances of the NRSRO and can include specific terms and conditions designed to mitigate the sales and marketing conflict and help ensure that any relief that may be provided to a small NRSRO does not undermine the overarching purpose of section of 15E(h)(3)(A) of the Exchange Act. The ability to tailor exemptive relief on a case-by-case basis will allow the Commission the flexibility to specify conditions that address the conflict in a way that takes into account the specific circumstances of the NRSRO requesting the relief (including its size, business model, and the steps it has taken to mitigate sales and marketing conflicts). For these reasons, the Commission does not believe it would be appropriate to establish a self-executing exemption.

Commenters addressed various aspects of potential exemption orders the Commission might grant under the proposed amendment. For example, several NRSROs commented on how the Commission should determine “small” for purposes of granting exemptions.[376] Two commenters stated that all NRSROs that are smaller than the three largest NRSROs should be considered small.[377] Three commenters suggested that annual revenue should be the metric for determining if an NRSRO is small.[378] Two commenters stated that the Commission should make the size determination on a case-by-case basis,[379] while one commenter suggested a self-executing exemption under which an NRSRO would be automatically exempt if its total revenue falls below a certain threshold.[380] On the other hand, one opponent of the proposal stated that revenue is not an appropriate measure for granting an exemption and suggested, if the Commission proceeds with an exemption, that it be based on other metrics.[381]

Commenters also addressed the duration of an exemption.[382] One supporter of granting exemptions under the proposal suggested that the Commission periodically re-evaluate whether the NRSRO continued to be small and provide it with a transition period in the event the Commission determines it is no longer small.[383] Another commenter, opposing the proposal, suggested that if the Commission does grant an exemption, it should be very limited, and that if the Commission later determines the NRSRO is not small, it should have only a short transition period.[384] This commenter added that an exempted NRSRO should have to publicly disclose the rules from which it is exempt.[385]

Several commenters addressed the conditions that should be part of an exemption order under the proposal.[386] Some stated that even if an NRSRO is exempt, the amendments to Rule 17g-5 should make clear that NRSROs remain subject to the overarching prohibition against allowing sales and marketing considerations to influence credit ratings.[387] Two commenters suggested that any exemption should be contingent upon the NRSRO adhering to certain requirements.[388] Another commenter suggested that any NRSRO that is granted an exemption under the proposal should be required to indicate on the homepage of its Web site that it is a recipient of the exemption.[389] One commenter that opposed the proposed exemption identified additional conditions the Commission should consider if it adopts the proposal.[390]

In making its finding for purposes of determining whether to grant an exemption, the Commission will evaluate the particular facts and circumstances of the application. In addition, the Commission may specify conditions designed to mitigate the sales and marketing conflict without imposing an absolute prohibition. Although the Commission is not modifying the exemption process from the proposal, suggestions by commenters may be helpful to the Commission in undertaking the analysis of whether a particular NRSRO should be considered “small” and in considering how to tailor the exemptive relief to mitigate the sales and marketing conflict.

3. Suspending or Revoking a Registration

Section 15E(h)(3)(B)(ii) of the Exchange Act provides that the Commission's rules under section 15E(h) of the Exchange Act shall provide for suspension or revocation of the registration of an NRSRO if the Commission finds, on the record, after notice and opportunity for a hearing, that the NRSRO has committed a violation of “a rule issued under this Start Printed Page 55113subsection” and the violation of the rule affected a credit rating.[391] While section 15E(h)(3)(A) relates only to the conflict arising from sales and marketing activities, section 15E(h)(3)(B)(ii)—by using the term “subsection”—has a broader scope in that it refers to all rules issued under section 15E(h) of the Exchange Act. Consequently, the proposed amendment implementing section 15E(h)(3)(B)(ii) addressed violations of any rule adopted under section 15E(h). Section 15E(h)(3)(B)(ii) does not require that the violation of the rule under section 15E(h) be “willful.”

Currently, the Commission can seek to suspend or revoke the registration of an NRSRO, in addition to other potential sanctions, under section 15E(d) of the Exchange Act.[392] In particular, section 15E(d) provides that the Commission shall, by order, censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding twelve months, or revoke the registration of an NRSRO if the Commission finds, “on the record after notice and opportunity for a hearing,” that such sanction is “necessary for the protection of investors and in the public interest” and the NRSRO, or a person associated with the NRSRO (whether prior to or subsequent to becoming so associated), has engaged in one or more of six categories of conduct specified in sections 15E(d)(1)(A) through (F) of the Exchange Act.[393] Section 15E(d)(1)(A) specifies the first category of conduct: That the NRSRO or an associated person has committed or omitted any act, or has been subject to an order or finding, enumerated in subparagraphs (A), (D), (E), (G), or (H) of section 15(b)(4) of the Exchange Act; has been convicted of any offense identified in section 15(b)(4)(B) of the Exchange Act; or has been enjoined from any action, conduct, or practice identified in section 15(b)(4)(C) of the Exchange Act.[394] The acts enumerated in section 15(b)(4)(D) of the Exchange Act include that the person has willfully violated any provision of the Exchange Act or the rules or regulations under the Exchange Act.[395] Therefore, the Commission has the authority, if it makes the finding under section 15E(d)(1)(A), to suspend or revoke the registration of an NRSRO for a willful violation of Rule 17g-5, but does not have the authority to do so under section 15E(d)(1)(A) for violations of Rule 17g-5 that are not willful.[396]

In addition to proceedings under section 15E(d)(1) of the Exchange Act, the Commission can take action under section 15E(d)(2).[397] This section provides that the Commission may temporarily suspend or permanently revoke the registration of an NRSRO with respect to a particular class or subclass of securities, if the Commission finds, on the record after notice and opportunity for a hearing, that the NRSRO does not have adequate financial and managerial resources to consistently produce credit ratings with integrity.[398] Furthermore, section 21C of the Exchange Act provides the Commission with authority, among other things, to enter an order requiring, among other things, that a person cease and desist from continuing to violate, or future violations of, a provision of the Exchange Act or any rule or regulation thereunder.[399]

In the proposing release, the Commission stated its preliminary belief that a rule implementing section 15E(h)(3)(B)(ii) of the Exchange Act should work in conjunction with sections 15E(d) and 21C of the Exchange Act.[400] Consequently, the Commission proposed adding paragraph (g) to Rule 17g-5.[401] This paragraph provided that in a proceeding pursuant to section 15E(d) or section 21C of the Exchange Act, the Commission shall suspend or revoke the registration of an NRSRO if the Commission finds in such proceeding that the NRSRO has violated a rule issued under section 15E(h) of the Exchange Act, the violation affected a credit rating, and that suspension or revocation is necessary for the protection of investors and in the public interest.[402] This provision was proposed to be placed in Rule 17g-5, given that it is the predominant rule issued under section 15E(h) of the Exchange Act.[403]

The first two findings in the proposed amendment mirrored the text of section 15E(h)(3)(B)(ii) of the Exchange Act.[404] The final finding—that the suspension or revocation is necessary for the protection of investors and in the public interest—is a common finding that the Commission must make to take disciplinary action against a registered person or entity.[405] It is not, however, a finding that the Commission must make in a proceeding under section 21C.[406] Further, unlike section 15E(d) of the Exchange Act, the Commission can take action under section 21C for violations of the securities laws even if the violations are not willful.[407] Moreover, section 15E(h)(3)(B)(ii) of the Exchange Act does not prescribe the maximum amount of time for which an NRSRO could be suspended, whereas section 15E(d) provides that a suspension shall not exceed twelve Start Printed Page 55114months.[408] Consequently, a proceeding pursuant to paragraph (g) of Rule 17g-5 brought under section 21C could result in a suspension that exceeds twelve months. Given that section 21C of the Exchange Act has a lower threshold for intent to establish a violation, and given the substantial consequences of suspending or revoking a registration, the Commission stated a preliminarily belief in the proposing release that the public interest finding would be an appropriate predicate to a suspension or revocation of an NRSRO's registration under section 21C of the Exchange Act.[409]

Two commenters addressed whether the Commission should adopt, pursuant to section 15E(h)(3)(B)(ii) of the Exchange Act, an independent and alternative process for suspending or revoking an NRSRO's registration beyond the processes set forth in sections 15E(d) and 21C of the Exchange Act.[410] Both commenters agreed with the Commission's proposal that the processes for suspension or revocation currently available under the Exchange Act are sufficient.[411] One commenter stated that section 15E(h)(3)(B)(iii) of the Exchange Act should work in conjunction with proceedings already available under sections 15E(d) and 21C of the Exchange Act.[412] Similarly, a second commenter stated that proceedings currently available under the Exchange Act are adequate and that no alternative process is necessary, but stated that if the Commission does implement a separate process, there should be certain prerequisites to its decision to suspend or revoke a registration.[413]

The Commission is persuaded that it is appropriate to adopt an amendment to Rule 17g-5 that incorporates the statutory provisions governing the suspension or revocation of an NRSRO's registration (rather than a stand-alone rule). Consequently, the Commission is incorporating the statutory provisions into paragraph (g) of Rule 17g-5, as proposed, but with modifications from the proposal.[414] Two commenters stated that the proposed rule should incorporate only section 15E(d) of the Exchange Act in response to the Commission's requests for comment on whether the amendment should incorporate section 15E(d) and section 21C.[415] One of these commenters added that the section 21C standard is “too low and its consequences too high” and is therefore inappropriate to use in considering suspension or revocation of an NRSRO's registration.[416] The other commenter stated that authority under section 15E(d) is “adequate,” making it unnecessary for the Commission to incorporate section 21C into the rule, and that not all of the provisions of section 21C are applicable to NRSROs.[417]

The Commission believes that it is not necessary to incorporate section 21C of the Exchange Act into the provision governing the suspension or revocation of an NRSRO's registration for violating a rule issued under section 15E(h) of the Exchange Act, but not for the reasons stated by the commenters. The Commission believes the rule can be modified in a way that achieves one objective of the proposal—providing for the suspension or revocation of the registration of an NRSRO for violations that are not willful—without incorporating section 21C. Instead, the rule can be modified from the proposal so that it includes a finding that the Commission must make in the context of a proceeding under section 15E(d)(1) of the Exchange Act that is in lieu of the findings specified in sections 15E(d)(1)(A) through (F) of the Exchange Act. As discussed above, the finding specified in section 15E(d)(1)(A) is that the NRSRO or an associated person committed or omitted any act, or has been subject to an order or finding, enumerated in section 15(b)(4)(D) of the Exchange Act, among other sections.[418] The acts enumerated in section 15(b)(4)(D) of the Exchange Act include that the person has willfully violated any provision of the Exchange Act or the rules or regulations under the Exchange Act.[419] Therefore, the Commission has the authority, if it makes a finding under section 15E(d)(1)(A) of the Exchange Act, to suspend or revoke the registration of an NRSRO for a violation of Rule 17g-5, but only if the violation is willful.[420] The alternative finding does not require a finding that the violation was willful, and the Commission can therefore suspend or revoke the registration of an NRSRO using this alternative without a finding of willfulness and without the need to institute the proceeding under section 21C.

For these reasons, the Commission is modifying the rule from the proposal to establish a finding that must be made in the context of a proceeding under section 15E(d)(1) of the Exchange Act that is in lieu of the findings specified in sections 15E(d)(1)(A) through (F).[421] In particular, paragraph (g) of Rule 17g-5, as adopted, provides that in a proceeding pursuant to section 15E(d)(1) of the Exchange Act, the Commission shall suspend or revoke the registration of an NRSRO if the Commission finds, in lieu of a finding required under sections 15E(d)(1)(A), (B), (C), (D), (E), or (F) of the Exchange Act, that the NRSRO has violated a rule issued under section 15E(h) of the Exchange Act (for example, Rule 17g-5) and that the violation affected a credit rating.[422]

The alternative finding includes the first two prongs of the proposed finding: (1) That the NRSRO has violated a rule issued under section 15E(h) of the Exchange Act; and (2) that the violation affected a credit rating. As discussed above and in the proposing release, these two prongs of the finding mirror the text of section 15E(h)(3)(B)(ii) of the Exchange Act.[423] In addition, the alternative finding must be made in the context of a proceeding under section 15E(d)(1). Consequently, the Commission must find, “on the record after notice and opportunity for a hearing,” that suspension or revocation is “necessary for the protection of investors and in the public interest.” [424] In this way, the alternative finding also incorporates the public interest finding that was part of the proposed finding, which the Commission continues to Start Printed Page 55115believe is appropriate given the severity of the sanction of suspending or revoking an NRSRO's registration.[425]

The final amendment—because it incorporates section 15E(d) only—is different from the proposed amendment in that the Commission is limited to suspending a registration for a period not exceeding twelve months.[426] The Commission does not view this as a significant difference. To the extent the Commission believes a credit rating agency should stop operating as an NRSRO for a period longer than twelve months, the Commission can seek to revoke its registration.[427]

Finally, three commenters addressed the factual predicate necessary to support a finding that the violation affected a credit rating.[428] The commenters generally stated that a finding that a rule violation affected a credit rating is only part of the appropriate analysis and is not, by itself, enough to suspend or revoke an NRSRO's registration.[429] One commenter added that any suspension or revocation proceeding must “take into account all relevant factors of the particular circumstance at issue.” [430] The other two commenters recommended additional findings that should be considered in making a determination that a violation of a rule affected a credit rating.[431] In response, the Commission notes that to suspend or revoke an NRSRO's registration under section 15E(d)(1) of the Exchange Act the Commission must find, among other things, that doing so is necessary for the protection of investors and in the public interest.[432] This will entail consideration of the particular facts and circumstances of each case in crafting an appropriate remedy.

4. Economic Analysis

This section builds on the economic analysis in section I.B. of this release by presenting a focused analysis of the potential economic effects that may derive from the amendments relating to the sales and marketing conflict of interest.[433] The baseline that existed before today's amendments was one in which an NRSRO was not explicitly prohibited from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also: (1) Participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (2) is influenced by sales or marketing considerations. However, section 15E(h)(1) of the Exchange Act and Rule 17g-5, thereunder, require NRSROs to establish, maintain, and enforce written policies and procedures reasonably designed to address and manage any conflicts of interest that can arise from the business of the NRSRO.[434] In addition, paragraph (c)(6) of Rule 17g-5 prohibits an NRSRO from issuing or maintaining a credit rating 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. Rule 17g-6 prohibits an NRSRO from engaging in certain unfair, coercive, or abusive practices such as conditioning the issuance of a credit rating on the purchase of other services or products of the NRSRO.[435]

Relative to this baseline, paragraph (c)(8) of Rule 17g-5, as amended, should result in benefits. For example, the amendment should decrease the probability that undue influences on credit analysts based on sales and marketing considerations could impact the objectivity of an NRSRO's credit rating process.[436] Certain academic studies suggest that NRSROs may have engaged in “ratings catering” in which an NRSRO will deliberately inflate a Start Printed Page 55116credit rating in order to induce the purchase of the credit rating by the issuer, sponsor, or underwriter of the rated security.[437] Involving credit analysts in sales and marketing activities (which are designed to obtain business) could potentially influence them to inappropriately take business considerations into account when determining credit ratings. Such influence may also arise from other channels, such as compensation arrangements that may incentivize analysts to produce inflated credit ratings to increase or retain the NRSRO's market share, performance evaluation systems that reward analysts who produce inflated credit ratings to increase or retain the NRSRO's market share, clients such as rated entities who pressure analysts to produce inflated credit ratings to retain their business, or managers that are not involved in sales and marketing activities but may seek to pressure analysts to produce inflated credit ratings to increase or retain the NRSRO's market share. The two-pronged absolute prohibition is designed to insulate credit analysts from sales and marketing concerns and pressures that may arise through any channel. This could enhance the integrity and quality of credit ratings.

Relative to the baseline, paragraph (c)(8) of Rule 17g-5 will result in costs to NRSROs. For example, some NRSROs may incur costs for hiring additional personnel, given the need to separate the analytical and sales and marketing functions. Commenters did not provide data for this specific cost. However, some NRSROs may choose to reallocate responsibilities among existing staff in order to meet the requirement. This cost of hiring additional personnel will likely vary significantly with the size of the NRSRO and the degree of existing separation between analytical staff and sales and marketing personnel.[438] NRSROs may also incur costs to make other operational changes, such as changes to communication policies, to ensure that credit analysts are not influenced by sales or marketing considerations from other channels. These incremental costs may vary based on the current operational structure of NRSROs. It is also possible that NRSROs may incur costs related to changes in the compensation arrangements of credit analysts.[439]

An NRSRO also will incur costs for updating its written policies and procedures to address and manage conflicts of interest required under section 15E(h) of the Exchange Act and Rule 17g-5 and to file with the Commission an update of its registration on Form NRSRO to account for the updated policies and procedures. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (c)(8) of Rule 17g-5 will result in total industry-wide one-time costs to NRSROs of approximately $354,000.[440]

Relative to the baseline, paragraph (f) of Rule 17g-5 will result in costs to NRSROs to the extent they expend resources to draft and submit a written request for an exemption under paragraph (f) of Rule 17g-5. The Commission believes that an NRSRO would likely engage outside counsel to assist in drafting the request. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (f) of Rule 17g-5 will result in costs to NRSROs of approximately $62,000 per request.[441] However, if a small NRSRO is granted an exemption from the absolute prohibition, it could avoid having to hire additional personnel to undertake sales and marketing activities that were otherwise undertaken by individuals involved in the production of credit ratings.

Relative to the baseline, paragraph (g) of Rule 17g-5 should not result in additional costs to NRSROs. NRSROs already are subject to the remedy of suspension or revocation under section 15E(d) the Exchange Act.

The amendments to Rule 17g-5 also may result in other costs. For example, prohibiting persons within an NRSRO who participate in determining or monitoring the credit ratings, or developing or approving rating procedures or methodologies from participating in sales and marketing activities may diminish the effectiveness of an NRSRO's sales and marketing efforts. For example, the revenues of an NRSRO may decrease if existing sales and marketing staff lack the expertise to communicate technical information about the NRSRO's rating procedures and methodologies to clients and potential clients. However, as discussed above, the final amendment does not preclude credit analysts from having these discussions with clients as long as the analysts do not discuss commercial matters and are not influenced by, for example, any pressure imposed by clients to produce inflated credit ratings.

The amendments to Rule 17g-5 should have a number of effects related to efficiency, competition, and capital formation.[442] First, these amendments could improve the quality of credit-related information. As a result, users of credit ratings could make more efficient investment decisions based on this better-quality information. Market efficiency also could improve if this information is reflected in asset prices. Consequently, capital formation could improve as capital may flow to more efficient uses with the benefit of this enhanced information. These amendments also provide for an exemption based on size, which may decrease the burden of these requirements on small NRSROs. However, these amendments could still create adverse effects on competition as exempted NRSROs potentially may be more prone to engage in “ratings catering” and, thereby, obtain more business as a result.[443] More specifically, exempted NRSROs may be more likely to produce credit ratings that favor their clients as a result of allowing persons involved in sales and marketing activities to participate in analytical processes.

As explained above, commenters suggested a number of alternatives to Start Printed Page 55117the proposed amendments to Rule 17g-5. Several commenters suggested that the amendments be less restrictive. One reasonable alternative suggested by commenters would be for the Commission not to adopt an absolute prohibition but rather to require an NRSRO to disclose and have procedures to manage the conflict.[444] This alternative might reduce costs for NRSROs related to, for example, hiring additional personnel. However, as explained above, the absolute prohibition was designed to insulate individuals within the NRSRO responsible for the analytic function from any sales and marketing concerns and pressures. Another less restrictive alternative would be, as proposed, to adopt only the first prong of the prohibition. This alternative may reduce the scope of policies and procedures that an NRSRO may need to revise to ensure compliance with the amendments. However, as discussed above, there are several potential channels through which sales and marketing considerations could influence credit analysts that would not be addressed by the first prong of the prohibition. Any less restrictive alternative may reduce the benefit of improved credit ratings quality if this alternative fails to mitigate conflicts of interest as effectively as the requirements of the final amendment.

One commenter suggested a self-executing exemption where an NRSRO would be automatically exempt if its total revenue falls below a certain threshold.[445] This alternative would eliminate the need and associated cost for certain NRSROs to apply to the Commission for exemptive relief. However, this alternative would eliminate the flexibility of the Commission to tailor exemptive relief. Under the final amendment, exemptions will be granted on a case-by-case basis, after analyzing the facts and circumstances concerning the NRSRO seeking the relief. Any exemptive relief granted can be tailored to the specific circumstances of the NRSRO requesting the relief and include specific terms and conditions designed to mitigate the sales and marketing conflict. The ability to tailor exemptive relief on a case-by-case basis will allow the Commission the flexibility to specify conditions that address the conflict in a way that takes into account the specific circumstances of the NRSRO requesting the relief (including its size and business model). For this reason, the Commission does not believe it would be appropriate to establish an automatic self-executing exemption.

Commenters also suggested that the rule not require that the Commission make a public interest finding to suspend or revoke an NRSRO's registration for violating a rule issued under section 15E(h) of the Exchange Act, as this would weaken the enforcement remedy.[446] This alternative might benefit users of credit ratings by improving the quality of credit ratings. In particular, NRSROs may have higher incentives to conform to these requirements as a result of a lower threshold for revoking or suspending their registration. However, this alternative may result in costs for NRSROs by subjecting them to more frequent suspensions and revocations, which could reduce the number of NRSROs producing credit ratings. In addition, as stated above, among other things, the Commission believes that the public interest finding is appropriate given the severity of the sanctions.

C. “Look-Back” Review

Section 932(a)(4) of the Dodd-Frank Act amended section 15E(h) of the Exchange Act to add a paragraph (4).[447] Section 15E(h)(4)(A) provides that an NRSRO must establish, maintain, and enforce policies and procedures reasonably designed to ensure that, in any case in which an employee of a person subject to a credit rating of the NRSRO, or the issuer, underwriter, or sponsor of a security or money market instrument subject to a credit rating of the NRSRO, was employed by the NRSRO and participated in any capacity in determining credit ratings for the person or the securities or money market instruments during the 1-year period preceding the date an action was taken with respect to the credit rating, the NRSRO shall: (1) Conduct a review (a “look-back review”) to determine whether any conflicts of interest of the employee influenced the credit rating [448] ; and (2) take action to revise the credit rating, if appropriate, in accordance with such rules as the Commission shall prescribe.[449]

Section 15E(h)(4)(A) of the Exchange Act contains a self-executing provision requiring an NRSRO to establish, maintain, and enforce policies and procedures reasonably designed to ensure that the NRSRO will conduct look-back reviews.[450] The Commission proposed paragraph (c) of new Rule 17g-8 and proposed adding paragraph (a)(9) to Rule 17g-2 to implement rulemaking required in section 15E(h)(4)(A)(ii) of the Exchange Act.[451] The Commission is adopting paragraph (c) of Rule 17g-8, with modifications, and adding paragraph (a)(9) to Rule 17g-2 as proposed.[452]

1. Paragraph (c) of New Rule 17g-8

As proposed, paragraph (c) of Rule 17g-8 provided that the policies and procedures an NRSRO establishes, maintains, and enforces pursuant to section 15E(h)(4)(A) of the Exchange Act must address instances in which a look-back review conducted pursuant to those policies and procedures determines that a conflict of interest influenced a credit rating assigned to an obligor, security, or money market instrument.[453]

Specifically, paragraph (c)(1) of Rule 17g-8, as proposed, provided that an NRSRO must have procedures reasonably designed to ensure that, upon the NRSRO's discovery that a former employee's conflict influenced a credit rating, it immediately publishes a rating action placing the applicable credit ratings of the obligor, security, or money market instrument on credit watch or review.[454] Proposed paragraph (c)(1) also provided that the policies and procedures must be reasonably designed to ensure the NRSRO includes the information required by proposed paragraph (a)(1)(ii)(J)(3)(i) of Rule 17g-7 in the form to accompany a credit rating with the publication of the rating action placing the credit rating on credit watch.[455] Specifically, paragraph (a)(1)(ii)(J)(3)(i) of Rule 17g-7, as proposed, would have required the NRSRO to provide in the form published with the rating action an Start Printed Page 55118explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest and the date and associated credit rating of each prior rating action the NRSRO currently has determined was influenced by the conflict.[456]

Paragraph (c)(2) of Rule 17g-8, as proposed, provided that the NRSRO must have procedures reasonably designed to ensure that it promptly determines whether the current credit rating assigned to the obligor, security, or money market instrument must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.[457] The proposed approach was intended to ensure that, as soon as possible, the assigned credit rating will become solely a product of the NRSRO's procedures and methodologies for determining credit ratings (that is, no longer influenced by the conflict).[458]

Paragraph (c)(3) of Rule 17g-8, as proposed, provided that the NRSRO must have procedures reasonably designed to ensure it promptly publishes a revised credit rating, if appropriate, or an affirmation of the credit rating, if appropriate, based on the determination of whether the current credit rating assigned to the obligor, security, or money market instrument must be revised.[459] Paragraph (c)(3), as proposed, also provided that the NRSRO's procedures must be reasonably designed to ensure that information required pursuant to paragraphs (a)(1)(ii)(J)(3)(ii) and (iii) of Rule 17g-7, as proposed, is included in the form to accompany the publication of a revised credit rating or a credit rating affirmation.[460] In the case of a revised credit rating, paragraph (a)(1)(ii)(J)(3)(ii) of Rule 17g-7, as proposed, would require the NRSRO to provide in the form an explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest, the date and associated credit rating of each prior rating action the NRSRO has determined was influenced by the conflict, and an estimate of the impact the conflict had on each such prior rating action.[461] Similarly, in the case of an affirmed credit rating, paragraph (a)(1)(ii)(J)(3)(iii) of Rule 17g-7, as proposed, would require the NRSRO to provide an explanation of why no rating action was taken to revise the credit rating notwithstanding the conflict, the date and associated credit rating of each prior rating action the NRSRO has determined was influenced by the conflict, and an estimate of the impact the conflict had on each such prior rating action.[462]

As discussed in more detail below, the Commission is adopting paragraph (c) of Rule 17g-8, with modifications from the proposal in response to comments.[463] The modifications eliminate the requirement to immediately place the credit rating on credit watch or review and make certain technical changes. The Commission is adopting paragraph (a)(1)(ii)(J)(3) of Rule 17g-7 with modifications from the proposal in response to comments.[464] The modifications eliminate the required disclosure that would have accompanied the placement of the credit rating on credit watch, revise the disclosure requirement with respect to estimating the impact of the conflict, and make certain technical changes.[465]

The Commission is adopting the prefatory language to paragraph (c) of Rule 17g-8 as proposed.[466] Consequently, the final rule provides, in pertinent part, that the policies and procedures an NRSRO is required to establish, maintain, and enforce pursuant to section 15E(h)(4)(A) of the Exchange Act must address instances in which a review conducted pursuant to those policies and procedures determines that a conflict of interest influenced a credit rating assigned to an obligor, security, or money market instrument by including, at a minimum, procedures that are reasonably designed to ensure that the NRSRO will take the steps discussed below.[467]

Two commenters stated that the Commission should define what it means for a conflict of interest to influence a credit rating.[468] One of these commenters stated that any definition should not require “proof of subjective intent or motivation on the part of the NRSRO employee” since it would be difficult to discern.[469] On the other hand, two NRSROs stated that the Commission should not provide a definition.[470] One stated that a finding of influence should only be required “where the NRSRO determines that, absent the conflict, the NRSRO would have issued a different rating” because this is the only “influence” that has “practical consequences for the users of the affected credit rating.” [471] The other NRSRO stated that any definition should “include situations where a primary analyst or voting member of a credit rating committee succeeded in persuading other committee members to agree to a ratings determination that was inconsistent with the NRSRO's ratings criteria, procedures and methodologies.” [472]

The Commission does not believe it is necessary at this time to define in the rule what it means to influence a credit rating because the provisions of the rule provide sufficient guidance in this respect. In particular, the rule provides that the NRSRO must determine whether a conflicted credit rating must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.[473] Thus, the rule contains a standard that can be used for purposes of making the influence determination required by section 15E(h)(4)(A) of the Exchange Act: Namely, whether the credit rating is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings. As one commenter stated, a finding of influence should only be required “where the NRSRO determines that, absent the conflict, the NRSRO would have issued a different rating.” [474] The Commission believes that this is an appropriate framework for assessing whether a conflict influenced a credit rating under Start Printed Page 55119section 15E(h)(4)(A). Moreover, it is consistent with the standard to be used in paragraph (c) of Rule 17g-8, as adopted, for determining whether the credit rating must be revised.[475]

One commenter stated that the rule should require the NRSRO to review whether a conflict influenced the determination of its rating methodologies or procedures.[476] This suggestion is outside the scope of the proposal. However, section 15E(h)(1) of the Exchange Act requires an NRSRO to establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of the business of such NRSRO and affiliated persons and affiliated companies thereof, to address and manage any conflicts of interest that can arise from such business.[477] Further, Rule 17g-5, among other things, prohibits an NRSRO from having conflicts of interest unless they are disclosed and managed through policies and procedures.[478] Thus, the statute and rule cover the conflict that arises when the prospective employment of an NRSRO's employee influenced a credit rating methodology (as opposed to a credit rating). For these reasons, an NRSRO would need to address the conflict pursuant to section 15E(h)(1) and Rule 17g-5 if it concluded in connection with a look-back review conducted pursuant to section 15E(h)(4)(A) of the Exchange Act that the prospect of future employment inappropriately influenced a credit rating procedure or methodology of the NRSRO.

One commenter stated that the Commission should specify minimum steps that the NRSRO must follow to determine if a former employee's conflict of interest influenced a credit rating because an “NRSRO's initial review” to determine whether a conflict influenced a rating is “at least as important as the process for revising a rating.” [479] One NRSRO stated that the NRSRO should review credit ratings “upon a discovery that they may have been influenced by a conflict” but that convening a new rating committee each time a potential conflict is discovered should not be required because it could impact the timeliness of ratings determinations.[480]

These comments address the self-executing provisions of section 15E(h)(4)(A)(i) of the Exchange Act.[481] The Commission did not propose rules to implement this part of the statute as the statute itself directly prescribes specific requirements for NRSROs.[482] However, the Commission notes that the statute requires the look-back review policies and procedures to be reasonably designed. Consequently, while the Commission is not prescribing by rule how an NRSRO must conduct a look-back review, an NRSRO must establish, maintain, and enforce policies and procedures that are reasonably designed to achieve the objectives set forth in the statute.

A number of commenters addressed proposed paragraph (c)(1) of Rule 17g-8, which would have required NRSROs to immediately publish a rating action placing applicable credit ratings on credit watch or review based on the discovery that a former employee's conflict influenced a credit rating.[483] Several commenters, including NRSROs, stated that the proposed requirements may cause volatility, confusion, or disruption in the market,[484] and one NRSRO stated that the placement of credit ratings on credit watch may force investment managers to sell securities, pursuant to investment guidelines.[485] Two NRSROs stated that the NRSRO should be allowed to determine whether and when to place a credit rating on credit watch, in accordance with its analytical criteria and procedures.[486] One of these NRSROs stated that mandating that the NRSRO place a credit rating on credit watch may impact the timeliness of credit rating determinations and may constitute regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings in violation of section 15E(c)(2) of the Exchange Act.[487] Another NRSRO suggested that the Commission “provide a timeframe for the NRSRO to revise and affirm the rating when a conflict arises” before requiring it to place the credit rating on credit watch.[488] Several commenters stated that a credit rating should be placed on credit watch only after the NRSRO determines that a conflict of interest has influenced the credit rating.[489]

The Commission is persuaded that the proposed requirement to immediately place the credit rating on watch or review could lead to potential market disruption and confusion, possibly harming investors and issuers, at a time when it is not clear that the credit rating will be changed. However, the Commission also believes that investors and other users of an NRSRO's credit ratings should be notified that a prior credit rating was influenced by a conflict of interest within a reasonable period of time. As discussed below, an NRSRO must promptly determine whether the credit rating must be revised or affirmed and promptly revise or affirm the credit rating and include with the publication of the rating action revising or affirming the credit rating information about the existence of the conflict. In most cases, this process should provide investors and other users of the NRSRO's credit ratings with notice of the existence of the conflict in a timely manner.

However, if there is a delay in publishing the revised or affirmed credit rating, the Commission believes the NRSRO should provide notice of the existence of the conflict of interest through another means. Accordingly, paragraph (c) of Rule 17g-8, as adopted, has been modified to eliminate the requirement to immediately place credit ratings on credit watch or review based on the discovery of the conflict.[490] Instead, the rule provides that the NRSRO must place the credit rating on Start Printed Page 55120watch or review if the credit rating is not revised or affirmed in accordance with the rule within fifteen calendar days of the date of the discovery that the credit rating was influenced by a conflict of interest.[491] This is designed to provide notice to users of the NRSRO's credit ratings of the existence of the conflict in a case where the NRSRO delays publishing a revision or affirmation of the credit rating. However, by prescribing a deadline of fifteen calendar days, the Commission is not suggesting that an NRSRO can meet its obligation to promptly revise or affirm a credit rating by waiting fifteen calendar days. As discussed below, an NRSRO must promptly revise or affirm the credit rating. The question of whether an NRSRO has met this standard will depend on the facts and circumstances.

Consistent with modifications to Rule 17g-7 discussed below in section II.G.1. of this release, the Commission is eliminating the related disclosure requirement in proposed paragraph (a)(1)(ii)(J)(3)(i) of Rule 17g-7 that would need to have been made when the credit rating is put on watch or review.[492] Instead, paragraph (c)(2)(ii) of Rule 17g-8 provides that, if an NRSRO is required to place the credit rating on watch or review because it did not revise or affirm the credit rating within fifteen calendar days, the NRSRO must include with the publication an explanation that the reason for the action is the discovery that the credit rating was influenced by a conflict of interest.

The Commission is adopting the requirement in proposed paragraph (c)(2) of Rule 17g-8 substantially as proposed, but is redesignating it as paragraph (c)(1) of Rule 17g-8.[493] As adopted, the final rule requires that the NRSRO's policies and procedures under section 15E(h)(4)(A) of the Exchange Act be reasonably designed to ensure that the NRSRO will promptly determine whether the current credit rating assigned to the obligor, security, or money market instrument must be revised so that it is no longer influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.[494]

In the proposing release, the Commission asked whether the rule should be more prescriptive in terms of how an NRSRO would be required to determine whether to revise a credit rating by, for example, requiring an NRSRO to apply a de novo review of the rated obligor, security, or money market instrument using its rating procedures and methodologies.[495] Three NRSROs stated that the Commission should not prescribe more requirements for how NRSROs must determine whether a rating must be revised.[496] Two of these NRSROs stated that doing so may constitute regulating the substance of the credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings in contravention of section 15E(c)(2) of the Exchange Act,[497] and one of these NRSROs stated that the NRSRO “should retain the flexibility to conduct whatever analysis a particular situation calls for.” [498] On the other hand, one commenter stated that the Commission should be “more prescriptive in this area” and “require the NRSRO to apply de novo its procedures and methodologies” to determine whether a credit rating must be revised.[499] Another commenter stated that it is “essential” to require the NRSRO to “conduct a de novo analysis of the credit rating using its methodologies and procedures.” [500] In implementing section 15E(h)(4)(A)(i) of the Exchange Act through Rules 17g-8 and 17g-7, the Commission has sought to strike an appropriate balance between adopting a measure designed to address the employment conflict with the prohibition in section 15E(c)(2) of the Exchange Act under which the Commission may not regulate the substance of credit ratings or the procedures and methodologies by which any NRSRO determines credit ratings.[501] To strike this balance, the Commission believes that the rule should provide flexibility for the NRSRO to make this determination by applying procedures and methodologies that it designs to ensure that the credit rating is no longer influenced by the conflict of interest. Such procedures and methodologies could but may not necessarily require a de novo review of the rated obligor or obligation.

Two NRSROs stated that a conflict of interest may impact a number of other credit ratings, which would need to be revised and published.[502] Accordingly, one of these NRSROs suggested that the words “immediately” and “promptly” in the proposed requirements be replaced with “as soon as practicable” given that certain procedures may have to be followed.[503] The other NRSRO suggested that paragraph (c)(2) of proposed Rule 17g-8 include a “reasonableness standard” for the term “promptly.” [504] A third NRSRO suggested that a “reasonable amount of time” be given to the NRSRO to “investigate the conflict and determine whether the rating must be revised.” [505]

In response, the Commission believes it is important that the NRSRO not delay completing the process that it will use to determine whether the credit rating must be revised to ensure that it is solely a product of the NRSRO's procedures and methodologies for determining credit ratings (that is, not influenced by the conflict of interest). The longer the determination takes the longer that investors and other users of credit ratings will remain unaware of the important fact that the credit rating was influenced by a conflict. Consequently, the final rule retains the requirement that the NRSRO must “promptly determine” whether a credit rating must be revised.[506] The Commission recognizes that the amount of time necessary to complete the determination will depend on facts and circumstances, including the number of credit ratings impacted, the degree to which the conflict influenced the credit ratings, and the complexity of the rating procedures and methodologies used to determine the credit ratings.[507] However, the Commission expects that in each instance, the NRSRO will complete the process promptly in order to satisfy the “promptly determine” requirement and that the process, in many cases, will be expedited by the fact that much of the work to determine the impact, if any, and, if necessary, revise the credit rating would already be accomplished at the time an NRSRO determines that the credit rating was in Start Printed Page 55121fact influenced by a conflict. In such cases, the Commission would expect the revision or affirmation, as appropriate, to be issued promptly after the existence of the conflict was determined. The Commission notes that, as part of the annual examinations of each NRSRO, Commission staff reviews the policies of the NRSRO governing the post-employment activities of former staff of the NRSRO.

The Commission is adopting the requirements in proposed paragraph (c)(3) of Rule 17g-8 substantially as proposed, with technical modifications, and is redesignating it as paragraph (c)(2)(i) of Rule 17g-8.[508] As adopted, the final rule provides that the NRSRO must promptly publish, based on the determination of whether a current credit rating referred to in paragraph (c)(1) of Rule 17g-8 must be revised: (1) A revised credit rating, if appropriate, and include with the publication of the revised credit rating the information required by paragraph (a)(1)(ii)(J)(3)(i) of Rule 17g-7; or (2) an affirmation of the credit rating, if appropriate, and include with the publication of the affirmation the information required by paragraph (a)(1)(ii)(J)(3)(ii) of Rule 17g-7.[509] As discussed below, the Commission also is adopting the corresponding disclosure requirements to accompany the publication of a revised credit rating and an affirmation of a credit rating in paragraphs (a)(1)(ii)(J)(3)(i) and (ii) of Rule 17g-7, respectively, with modifications in response to comments.

One commenter stated that the NRSRO should publish a revised credit rating or affirmation, as appropriate, “as soon as practicable” instead of “promptly.” [510] As discussed above, paragraph (c)(1) of Rule 17g-8, as adopted, requires the NRSRO to promptly determine whether a credit rating discovered through a look-back review to have been influenced by a conflict of interest must be revised so that it is no longer influenced by the conflict and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings. Having made the determination, paragraph (c)(2) of Rule 17g-8, as adopted, sets forth the next steps the NRSRO must take: Promptly publish a revised credit rating or an affirmation of the credit rating and provide users of the NRSRO's credit ratings information about the reasons for taking either action. These steps are an important component of the look-back review process. They are designed to ensure that the NRSRO promptly addresses any impact the conflict had on the credit rating and alerts the users of its credit ratings about the existence of the conflict and its resolution. As stated above, failing to act when a conflict has influenced a credit rating creates the risk that investors and other users of credit ratings will use a conflicted credit rating when making an investment or other credit-related decision. Thus, paragraph (c)(2) of Rule 17g-8, as adopted, retains the requirement that the NRSRO must act promptly.

Commenters addressed whether the NRSRO should be required to publish a rating affirmation,[511] including whether such a requirement would constitute regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings in contravention of section 15E(c)(2) of the Exchange Act.[512] The Commission does not expect (and the final rule does not require) an NRSRO to revise a credit rating in every circumstance in which an earlier rating action was influenced by a conflict of interest. Section 15E(h)(4)(A)(ii) of the Exchange Act provides that the NRSRO's policies and procedures shall be reasonably designed to, among other things, ensure that the NRSRO takes action to revise the credit rating “if appropriate.” [513] It is possible, for example, that in the period since the NRSRO published the conflicted credit rating, events unrelated to the conflict occurred that, when taken into account by the NRSRO's procedures and methodologies for determining credit ratings, would produce a credit rating at the same notch in the rating scale of the NRSRO as the credit rating that was influenced by the conflict.[514] A requirement that the NRSRO nonetheless revise the credit rating could interfere with the NRSRO's procedures and methodologies for determining credit ratings in that it would force the NRSRO to change the credit rating assigned to the obligor, security, or money market instrument to a different notch in the rating scale than would be the case if the credit rating were solely a product of the NRSRO's procedures and methodologies. Consequently, a mandatory revision requirement could, in effect, require the NRSRO to publish a credit rating that was not consistent with those procedures and methodologies. Accordingly, the final rule permits the NRSRO to publish an affirmation of the credit rating as an alternative to revising the credit rating, if appropriate. As discussed below, the Commission is requiring that an NRSRO publish an affirmation if the credit rating is not going to be revised because this will be the mechanism for disclosing the fact that a conflict at one time influenced the credit rating.

Commenters suggested that if the credit rating is not going to be revised there should not be a requirement to publish an affirmation.[515] One commenter stated that such a requirement constitutes regulating the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings in contravention of section 15E(c)(2) of the Exchange Act.[516] The Commission is not persuaded that the rule should require only the publication of a revised credit rating. If the rule did not require publication of an affirmation, the users of the NRSRO's credit ratings would not learn of the existence of the conflict. One of the goals of the registration and oversight program for NRSROs is to increase the transparency of their activities so that users of credit ratings can understand how they operate and can compare NRSROs. Disclosing the Start Printed Page 55122existence of the conflict with the publication of the revised credit rating or affirmation of the credit rating will provide users of the NRSRO's credit ratings with information to assess the adequacy of the NRSRO's policies, procedures, and controls designed to manage conflicts of interest and, more generally, the integrity of the NRSRO's credit rating process. Moreover, the required disclosures could be useful to users of the NRSRO's credit ratings in considering the potential risk of using the NRSRO's credit ratings to make investment or other credit-based decisions. Furthermore, in light of the prohibition against regulating the substance of credit ratings and rating procedures and methodologies in section 15E(c)(2) of the Exchange Act, the final rule has been carefully tailored to avoid interfering with the NRSRO's analytical process.[517] It is the NRSRO that will determine—using its own procedures and methodologies—whether the credit rating should be revised or affirmed. For these reasons, the Commission is adopting the requirement to publish an affirmation of the credit rating if the credit rating does not need to be revised.

The Commission is adopting the disclosure requirements in proposed paragraphs (a)(1)(ii)(J)(3)(ii) and (iii) of Rule 17g-7 with modifications and is redesignating them as paragraphs (a)(1)(ii)(J)(3)(i) and (ii).[518] Commenters raised concerns about the proposed requirement to disclose an estimate of the impact of the conflict on each applicable prior credit rating.[519] One commenter stated that estimating the impact of a conflict on a credit rating may “create inefficiencies.” [520] A second NRSRO stated that it may be “unduly burdensome,” delaying publication of a corrective rating.[521] A third NRSRO stated that it would be “practically impossible” to estimate the impact of a conflict on a prior rating and that the Commission should not require disclosure of the reasons for revising or affirming a credit rating.[522]

The Commission is persuaded by commenters that precisely quantifying the impact of the conflict could be difficult and that a more narrative disclosure would be appropriate. Consequently, the final amendments to Rule 17g-7 require the NRSRO to provide a description of the impact the conflict had on the prior rating action or actions.[523] The Commission expects the description to be sufficient to provide investors and users of credit ratings with insight into the nature of the impact the conflict had on the credit rating. The Commission recognizes that this may entail a degree of judgment on the part of the NRSRO in terms of estimating the degree of the impact.

In addition, the text of paragraph (a)(1)(ii)(J)(3)(iii) of Rule 17g-7, as proposed, has been modified to reflect that the requirement to place the credit rating on watch and make a corresponding disclosure has been eliminated.[524] As proposed, this paragraph would govern the disclosure to be made with an affirmation of the credit rating. The disclosure requirement was intended to follow the initial disclosure that would have been made when the credit rating was placed on watch. The initial disclosure would have included an explanation that the credit rating was placed on watch because of the discovery that the credit rating was influenced by a conflict of interest. Because this disclosure will not be required, the disclosure that accompanies an affirmation of a credit rating will need to include an explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest.[525] This will provide context for why the NRSRO is issuing the affirmation.[526]

One commenter stated that the rule should require disclosure about the nature of the conflict.[527] In response, the Commission notes that the rule requires the NRSRO to include with a revised credit rating an explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest.[528] Similarly, the rule requires an NRSRO to include with an affirmation of a credit rating an explanation that the credit rating was influenced by a conflict of interest.[529] The Commission agrees with the commenter that the disclosure should provide some context for these explanations. Consequently, the Commission is modifying the rule text from the proposal to provide that the explanation of the conflict to be made with a revision of a credit rating or an affirmation of a credit rating must include a description of the nature of the conflict.[530] For example, the description could disclose that a former employee was unduly influenced by the prospect of working for the issuer of the rated security and, as a consequence, did not adhere to the NRSRO's rating methodology in order to make the credit rating more favorable to the issuer.

Finally, two commenters stated that information regarding a credit rating influenced by a conflict of interest should be provided to former subscribers.[531] As discussed above, the disclosures are required to be made in the form to accompany a rating action under paragraph (a) of Rule 17g-7, as amended.[532] This form—as discussed below in section II.G.1. of this release—must be published in the same manner as the credit rating that is the result or subject of the rating action and made available to the same persons who can receive or access the credit rating that is the result or subject of the rating action.[533] This provision thereby accommodates both the issuer-pay business model in which rating actions generally are made publicly available and the subscriber-pay business model in which rating actions generally are made available to current subscribers only.[534] Consequently, if the NRSRO makes its rating actions available only to current subscribers, former subscribers will not have access to the form and the Start Printed Page 55123disclosure it contains about the conflict of interest. In considering the comments about disclosing the information to former subscribers, the Commission balanced the interest in providing users of credit ratings with information about a given NRSRO's credit ratings with the interest in promulgating rules that accommodate and integrate with the two predominant NRSRO business models. For example, since the final amendments to Rule 17g-7 require the disclosure to be made in the same manner as the disclosure of the credit rating that is the result or subject of the rating action, a requirement that the disclosure must be made to former subscribers (who normally would not have access to a rating action that was published after their subscription expired) would necessarily require a different process for the disclosure. For example, the disclosure could be made through publication on the NRSRO's Web site, but this method of disclosure may not be effective if former subscribers no longer view the Web site. Alternatively, the NRSRO could send the disclosure to former subscribers, but this could be burdensome and present practical difficulties. Because former subscribers are no longer using the NRSRO's credit ratings, the Commission believes at this time that it is not necessary to add a requirement that an NRSRO operating under the subscriber-pay model must make this disclosure to former subscribers.

2. Amendment to Rule 17g-2

The Commission proposed adding paragraph (a)(9) to Rule 17g-2 to require NRSROs to make and retain a record documenting the policies and procedures an NRSRO is required to establish, maintain, and enforce pursuant to section 15E(h)(4)(A) of the Exchange Act and paragraph (c) of proposed Rule 17g-8.[535] As a result, the policies and procedures would need to be documented and the record documenting them would be subject to the record retention and production requirements in paragraphs (c) through (f) of Rule 17g-2.[536] One NRSRO stated that it “supports the Commission's proposal to include look-back policies and procedures as records that an NRSRO must retain under Rule 17g-2(a)(9).” [537] The Commission is adding paragraph (a)(9) to Rule 17g-2 as proposed.[538] This will provide a means for the Commission to monitor the NRSROs' compliance with section 15E(h)(4)(A) of the Exchange Act and paragraph (c) of Rule 17g-8. The record must be retained until three years after the date the record is replaced with an updated record in accordance with the amendment to paragraph (c) of Rule 17g-2 discussed above in section II.A.2. of this release.[539]

3. Economic Analysis

This section builds on the economic analysis in section I.B. of this release by presenting a focused analysis of the potential economic effects that may derive from the amendments and new rule with respect to look-back reviews.[540] The baseline that existed before today's amendments and new rule was one in which section 15E(h)(4)(A)(i) of the Exchange Act, added by the Dodd-Frank Act, required NRSROs to establish, maintain, and enforce policies and procedures reasonably designed to ensure that the NRSRO conducts look-back reviews in any case in which an employee of a person subject to a credit rating of the NRSRO or the issuer, underwriter, or sponsor of a security or money market instrument subject to a credit rating of the NRSRO, was employed by the NRSRO and participated in any capacity in determining credit ratings for the person or the securities or money market instruments during the one-year period preceding the date an action was taken with respect to the credit rating.[541] The Commission staff found during its 2013 examinations of NRSROs that all NRSROs had established written policies and procedures to address the look-back requirement.[542] However, the staff found that two larger and six smaller NRSROs did not consistently, in the staff's view, conduct adequate look-back searches or did not have adequate policies governing the searches.[543]

Section 15E(h)(4)(A)(ii) provides that an NRSRO must establish, maintain, and enforce policies and procedures reasonably designed to ensure that the NRSRO will take action to revise the credit rating if appropriate, in accordance with such rules as the Commission shall prescribe.[544] Before today's amendments and new rule, if the NRSRO found, after conducting the look-back review, that the credit rating was influenced by a conflict, the NRSRO would have needed to ensure that the credit rating was determined in accordance with the procedures and methodologies the NRSRO uses to determine credit ratings. However, the NRSRO was not required to “promptly” determine whether the current credit rating must be revised or “promptly” publish a revised credit rating or an affirmation of the credit rating, as appropriate. Further, there was no requirement that the NRSRO disclose information about the existence of the conflict with the publication of a revised credit rating, affirmation of the existing credit rating, or placement of the credit rating on watch or review if the credit rating is not revised or affirmed within fifteen calendar days of the discovery that the credit rating was influenced by a conflict. Finally, an NRSRO was not required to make and retain a record documenting the policies and procedures required under section 15E(h)(4)(A).

The baseline that existed before today's amendments and new rule was one in which, pursuant to paragraph (c)(4) of Rule 17g-5, an NRSRO is prohibited from issuing or maintaining a credit rating where a credit analyst who participated in determining the credit rating is an officer or director of the person that is subject to the credit rating.[545] Also, section 15E(h)(1) of the Exchange Act and Rule 17g-5 require NRSROs to establish, maintain, and enforce written policies and procedures reasonably designed to address and manage any conflicts of interest that can arise from the business of the NRSRO.[546]

In addition, section 15E(h)(5)(A) of the Exchange Act requires NRSROs to report to the Commission any case in which a person associated with the NRSRO within the previous five years obtains employment with a rated entity or the issuer, underwriter, or sponsor of a rated instrument for which the NRSRO issued a credit rating during the twelve-month period prior to the employment if the employee was a senior officer of the NRSRO or participated, or supervised an employee that participated, in determining credit Start Printed Page 55124ratings for the new employer.[547] Section 15E(h)(5)(B) requires that the Commission make the reports publicly available.[548] The Commission received 244 of these reports between January 24, 2006 and December 31, 2013.[549] One academic study examined these transition reports for three NRSROs (Fitch, Moody's, and S&P), which submitted 167 of these reports during that period.[550] The study suggests that the credit ratings assigned to the future employer by the NRSRO employing the transitioning employee were more likely to be upgraded and less likely to be downgraded than the ratings assigned to that future employer by other NRSROs in the year prior to the transition.[551]

Relative to this baseline, the amendments and new rule should result in benefits. They are designed to require the NRSRO to evaluate whether a credit rating has been influenced by a conflict of interest and, if so, promptly address the conflicted credit rating. This could limit the potential risk that users of credit ratings might make investment or other credit-based decisions using incomplete, biased, or inaccurate information. As stated above, the disclosures also will increase transparency and provide users of NRSRO credit ratings with information to assess an NRSRO's ability to address conflicts and to compare NRSROs with respect to their ability to manage the conflicts. Further, the amendments and new rule—because they are designed to integrate with an NRSRO's existing policies and procedures for taking rating actions—could mitigate potential inefficiencies associated with the requirements. For example, the amendments and new rule are designed to work within the existing framework of an NRSRO's policies and procedures for taking rating actions but not to regulate the substance of the credit rating or the procedures and methodologies for determining credit ratings.

The records NRSROs must make and keep under the amendment to Rule 17g-2 will be used by Commission examiners to assess whether a given NRSRO's policies and procedures are reasonably designed and whether it appears that the NRSRO is complying with them. Recordkeeping requirements are integral to the Commission's investor protection function because the preserved records are the primary means of monitoring compliance with applicable securities laws.[552] Compliance by an NRSRO with its policies and procedures for look-back reviews and the oversight exercised by the Commission may benefit users of credit ratings by mitigating conflicts of interest, which may increase the integrity and quality of credit ratings.

Relative to the baseline, the amendments and new rule relating to look-back reviews will result in costs for NRSROs. NRSROs will need to expend resources to establish, make a record of, enforce, and periodically review and update (if necessary) the procedures they establish pursuant to section 15E(h)(4)(A) of the Exchange Act to ensure they comply with paragraph (c) of Rule 17g-8. They also will need to develop and periodically modify processes and systems for ensuring that, if the look-back review determines that a conflict of interest influenced the credit rating, a revised credit rating or an affirmation of the credit rating is promptly published (as appropriate) along with the corresponding disclosures required under paragraph (a)(1)(ii)(J)(3) of Rule 17g-7, or that the credit rating is placed on watch or review if the credit rating is not revised or affirmed within fifteen calendar days of the discovery that the credit rating was influenced by a conflict of interest. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (c) of Rule 17g-8 will result in total industry-wide one-time costs to NRSROs of approximately $295,000 and total industry-wide annual costs to NRSROs of approximately $71,000.[553]

Relative to the baseline, the amendments to Rule 17g-2 prescribing retention requirements for the documentation of the policies and procedures will result in costs to NRSROs. NRSROs already have recordkeeping systems in place to comply with the recordkeeping requirements in Rule 17g-2 before today's amendments. Therefore, the recordkeeping costs of this rule will be incremental to the costs associated with these existing requirements. Specifically, the incremental costs will consist largely of updating their record retention policies and procedures and retaining and producing the additional record. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (a)(9) of Rule 17g-2 and the amendment to paragraph (c) of Rule 17g-2 will result in total industry-wide one-time costs to NRSROs of approximately $12,000 and total industry-wide annual costs to NRSROs of approximately $3,000.[554]

The amendments and new rule by increasing the scrutiny of the work of former analysts could potentially decrease the quality of credit ratings in circumstances where the subjective judgment of participants in the rating process can improve the quality of ratings. In particular, an NRSRO may establish credit rating methodologies that diminish the ability of analysts to exercise subjective judgment in order to minimize the chance that in exercising judgment an analyst may be influenced by this conflict, which, in turn, will trigger the requirements in the amendments and new rule, including the requirement to disclose the existence of the conflict. If the ability to apply subjective analysis is diminished, the credit ratings issued by an NRSRO may not benefit fully from the expertise of the analysts.

The amendments and new rule should have a number of effects related to efficiency, competition, and capital formation.[555] First, they could improve the quality of credit-related information. As a result, users of credit ratings may make more efficient investment decisions based on this higher-quality information. Market efficiency also could improve if this information is reflected in asset prices. Consequently, capital formation could improve as capital may flow to more efficient uses with the benefit of this enhanced information. Alternatively, the quality of credit ratings may decrease in certain circumstances if an NRSRO establishes credit rating methodologies that diminish the ability of participants in the rating process to exercise subjective judgment. In this case, the efficiency of investment decisions, market efficiency, Start Printed Page 55125and capital formation may also be adversely impacted if lower quality information is reflected in asset prices, which may impede the flow of capital to efficient uses. These amendments also will result in costs, some of which may have a component that is fixed in magnitude across NRSROs and does not vary with the size of the NRSRO. Therefore, the operating costs per rating of smaller NRSROs may increase relative to that of larger NRSROs, which could create adverse effects on competition. As a result of these amendments, the barriers to entry for credit rating agencies to register as NRSROs might be higher for credit rating agencies, while some NRSROs, particularly smaller firms, may decide to withdraw from registration as an NRSRO.

There are a number of reasonable alternatives to the amendments and new rule, as adopted. First, the Commission could require that NRSROs immediately place on credit watch or review credit ratings that are determined by a look-back review to have been influenced by a conflict of interest (as was proposed). This alternative might further benefit users of credit ratings by alerting them sooner of conflicted credit ratings, limiting the potential risk that investors and users of credit ratings might make credit-based decisions using incomplete, biased, or inaccurate information, and thereby reduce the risk of mispricing due to the use of such incomplete, biased, or inaccurate information. It also might increase the incentives of NRSROs to develop and adhere to rating policies and procedures that further decrease the chance that conflicts of interest may influence credit ratings. The quality of credit ratings could increase as a result. This alternative also might decrease the quality of credit ratings in certain circumstances if it causes NRSROs to further reduce the use of subjective judgment in rating methodologies relative to the amendments and new rule. This alternative might also result in additional costs for NRSROs and users of credit ratings. First, the NRSRO would need to expend resources to develop, modify, and enforce policies and procedures ensuring that it immediately places such conflicted ratings on credit watch or review in addition to documenting and retaining these policies and procedures pursuant to the amendments to Rule 17g-2. Second, if a look-back review determined that a conflict influenced a credit rating, the NRSRO would need to expend resources to place the credit rating on watch or review. In addition, a number of academic studies indicate that both stock and bond prices of an issuer react adversely when credit ratings are placed on negative credit watch.[556] Therefore, this alternative might also create mispricing and confusion in the market. In particular, a placement of a credit rating on credit watch creates uncertainty in the credit rating that is resolved when the credit rating is either revised or affirmed. As a result of unfamiliarity, users of credit ratings might not react rationally in the short term to the uncertainty introduced by placements of credit ratings on credit watch resulting from look-back reviews. Consequently, this alternative might result in costs for issuers and on market participants who may make non-optimal investment decisions as a result of mispricing and confusion. Several comment letters discussed these potential adverse consequences.[557] However, these costs could arise if the NRSRO is required to place the credit rating on credit watch or review because it does not revise or affirm the credit rating within fifteen calendar days of the discovery of the conflict.

Other alternatives include those that would apply standards other than acting “promptly” with respect to the required timing of review and rating actions after a rating is determined to have been conflicted in a look-back review. For example, an NRSRO could be required to take these actions “as soon as practicable” rather than “promptly,” as suggested by one commenter.[558] However, the Commission believes it is important that the NRSRO not delay completing the process that it will use to determine whether the credit rating must be revised to ensure that it is solely a product of the NRSRO's procedures and methodologies for determining credit ratings and to publish a revised credit rating or an affirmation of the credit rating with the required disclosure of information about the existence of the conflict. The longer the NRSRO takes to complete these steps the greater the risk that investors and other users of credit ratings will rely on a conflicted credit rating when making an investment or credit-related decision. Consequently, the final amendment retains the requirement that the NRSRO must “promptly determine” whether a credit rating must be revised. At the same time, the Commission recognizes that the amount of time necessary to complete the determination will depend on the facts and circumstances, including the number of credit ratings impacted, the degree to which the conflict influenced the credit ratings, and the complexity of the rating methodologies used to determine the credit ratings.[559]

There are a number of other alternatives that would impose additional requirements for addressing a credit rating that is found through a look-back review to be influenced by a conflict of interest. One alternative suggested by commenters would be to require a de novo review of a credit rating that was determined through a look-back review to have been influenced by a conflict of interest.[560] This alternative could produce higher-quality credit ratings because a de novo review may provide a higher level of assurance that the credit rating is no longer influenced by the conflict as the entire rating process would be undertaken (this time without the conflicted analyst participating). In other words, de novo reviews may be more likely to result in credit ratings that are in accordance with the NRSRO's procedures and methodologies for determining credit ratings.

On the other hand, this alternative might impose further costs as NRSROs may be able to conduct a sufficient review without taking all the steps necessary to perform a de novo review (for example, some of the prior work could have been undertaken by a credit analyst that was not influenced by the conflict). Requiring a de novo review also may implicate the prohibition in section 15E(c)(2) of the Exchange Act under which the Commission may not regulate the substance of credit ratings or the procedures and methodologies by which any NRSRO determines credit ratings.[561] Further, this alternative might decrease the quality of credit ratings in certain circumstances if it caused NRSROs to eliminate or reduce the use of subjective judgment in rating procedures or methodologies as Start Printed Page 55126discussed earlier. In addition, the amendments and new rule provide flexibility for the NRSRO to make this determination by applying procedures and methodologies that it designs to ensure that the credit rating is no longer influenced by the conflict of interest, which could include procedures and methodologies that require a de novo review of the rated obligor or obligation in all or certain cases.

Commenters also proposed alternatives which would make the amendments and new rule less restrictive. One alternative suggested by commenters would be to not require publication of an affirmation after a credit rating has been determined to have been conflicted in a look-back review if, for example, in the period since the NRSRO published the credit rating, events unrelated to the conflict occurred that, when taken into account by the NRSRO's procedures and methodologies for determining credit ratings, would produce a credit rating at the same notch in the rating scale as the credit rating that was influenced by the conflict.[562] This alternative could benefit NRSROs by reducing the potential costs associated with publishing affirmations such as the cost of composing text to appear in the NRSRO's publications and press releases. This alternative also might increase the quality of credit ratings in certain circumstances if not having to disclose the existence of the conflict caused NRSROs to allow greater use of subjective judgment in rating methodologies as discussed earlier.

However, as discussed above, if the rule did not require publication of an affirmation, it would result in costs as users of the NRSRO's credit ratings would not learn of the existence of the conflict. Disclosing the existence of the conflict with the publication of the revised credit rating or affirmation of the credit rating will provide users of the NRSRO's credit ratings with information to assess the adequacy of the NRSRO's policies, procedures, and controls designed to manage conflicts of interest and, more generally, the integrity of the NRSRO's credit rating process. Moreover, the required disclosures could be useful to users of the NRSRO's credit ratings in considering the potential risk of using the NRSRO's credit ratings to make investment or other credit-based decisions in comparison to other NRSROs.

D. Fines and Other Penalties

1. Final Rule

Section 932(a)(8) of the Dodd-Frank Act amended section 15E of the Exchange Act to add subsection (p), which contains four paragraphs: (1), (2), (3), and (4).[563] Section 15E(p)(4)(A) provides that the Commission shall establish, by rule, fines and other penalties applicable to any NRSRO that violates the requirements of section 15E of the Exchange Act and the rules under the Exchange Act.[564]

The Exchange Act already provides a wide range of fines, penalties, and other sanctions applicable to NRSROs for violations of any section of the Exchange Act (including section 15E) and the rules under the Exchange Act (including the rules under section 15E).[565] For example, section 15E(d)(1) of the Exchange Act provides that the Commission shall censure an NRSRO, place limitations on the activities, functions, or operations of an NRSRO, suspend an NRSRO for a period not exceeding twelve months, or revoke the registration of an NRSRO if, among other reasons, the NRSRO violates section 15E of the Exchange Act or the Commission's rules under the Exchange Act.[566] In addition, section 932(a)(3) of the Dodd-Frank Act amended section 15E(d) to explicitly provide additional potential sanctions.[567] First, it provided the Commission with the authority to seek sanctions against persons associated with, or seeking to become associated with, an NRSRO.[568] The Commission can censure such persons, place limitations on the activities or functions of such persons, suspend such persons for a period not exceeding one year, or bar such persons from being associated with an NRSRO.[569] Second, section 932(a)(3) of Dodd-Frank Act amended section 15E(d) to provide the Commission with explicit authority to temporarily suspend or permanently revoke the registration of an NRSRO in a particular class or subclass of credit ratings if the NRSRO does not have adequate financial and managerial resources to consistently produce credit ratings with integrity.[570] Furthermore, sections 21, 21A, 21B, 21C, and 32 of the Exchange Act provide additional sanctions if an NRSRO violates the Exchange Act, including the self-executing provisions in section 15E of the Exchange Act, or rules under the Exchange Act.[571]

In the proposing release, the Commission stated its preliminarily belief that these provisions of the Exchange Act, as amended by the Dodd-Frank Act, provide a sufficiently broad range of means to impose fines, penalties, and other sanctions on an NRSRO for violations of section 15E of the Exchange Act and the rules under the Exchange Act.[572] For example, the fines, penalties, and sanctions applicable to NRSROs are similar in scope to the fines, penalties, and sanctions applicable to other registrants under the Exchange Act, such as broker-dealers. Moreover, since enactment of the Rating Agency Act of 2006, the Commission has not identified a specific need for a fine or penalty applicable to NRSROs not otherwise provided for in the Exchange Act. Consequently, in the proposing release, the Commission stated its preliminary belief that it would be appropriate at that time to defer establishing new fines or penalties in addition to those provided for in the Exchange Act.[573] However, the Commission stated that, in the future, it may use the authority in section 15E(p)(4)(A) of the Exchange Act if a specific need to do so is identified.[574]

For the foregoing reasons, to implement section 15E(p)(4)(A) of the Exchange Act, the Commission proposed to amend the instructions to Form NRSRO by adding Instruction Start Printed Page 55127A.10.[575] This instruction would provide notice to credit rating agencies applying for registration as an NRSRO and to NRSROs that an NRSRO is subject to applicable fines, penalties, and other available sanctions set forth in sections 15E, 21, 21A, 21B, 21C, and 32 of the Exchange Act (15 U.S.C. 78o-7, 78u, 78u-1, 78u-2, 78u-3, and 78ff, respectively) for violations of the securities laws.[576]

Several comment letters addressed the proposal.[577] Most commenters generally supported the Commission's proposal to defer establishing new fines or penalties in addition to those currently provided for in the Exchange Act,[578] with one commenter specifically noting that it supports the Commission's proposal to add the new instruction to Form NRSRO.[579] Commenters stated that the fines, penalties, and other sanctions currently applicable to NRSROs under the Exchange Act are “sufficient,” [580] and that no other additional fines or penalties are necessary or warranted.[581] However, one commenter suggested that, while other sections of the Exchange Act provide for appropriate penalties and sanctions, it is not appropriate to consider suspension or revocation of an NRSRO's registration under section 21C of the Exchange Act.[582]

The Commission is adopting Instruction A.10 to Form NRSRO [583] as proposed. As stated above, certain commenters agreed that the fines, penalties, and other sanctions currently applicable to NRSROs under the Exchange Act are sufficient and that additional fines, penalties, or other sanctions are not necessary or appropriate. Consequently, commenters supported the Commission's proposal to add Instruction A.10 to Form NRSRO. While the Commission is adopting Instruction A.10 to Form NRSRO, it is deferring establishing new fines or penalties in addition to those provided for in the Exchange Act. The Commission may choose to use the authority to establish new fines or penalties in the future.[584]

2. Economic Analysis

The final amendments should not create any costs for NRSROs and may provide some benefits. It could benefit credit rating agencies applying for registration as NRSROs and NRSROs because it should notify them of the potential consequences of violating provisions of the Exchange Act and Commission rules.

E. Disclosure of Information About the Performance of Credit Ratings

Section 932(a)(8) of the Dodd-Frank Act added subsection (q) to section 15E of the Exchange Act.[585] Section 15E(q)(1) provides that the Commission shall, by rule, require NRSROs to publicly disclose information on the initial credit ratings determined by the NRSRO for each type of obligor, security, and money market instrument, and any subsequent changes to such credit ratings, for the purpose of allowing users of credit ratings to evaluate the accuracy of credit ratings and compare the performance of credit ratings by different NRSROs.[586] Section 15E(q)(2) provides that the Commission's rules shall require, at a minimum, disclosures that:

  • are comparable among NRSROs, to allow users of credit ratings to compare the performance of credit ratings across NRSROs; [587]
  • are clear and informative for investors having a wide range of sophistication who use or might use credit ratings; [588]
  • include performance information over a range of years and for a variety of types of credit ratings, including for credit ratings withdrawn by the NRSRO; [589]
  • are published and made freely available by the NRSRO, on an easily accessible portion of its Web site, and in writing, when requested; [590]
  • are appropriate to the business model of an NRSRO; [591] and
  • require an NRSRO to include an attestation with any credit rating it issues affirming that no part of the credit rating was influenced by any other business activities, that the credit rating was based solely on the merits of the instruments being rated, and that such credit rating was an independent evaluation of the risks and merits of the instrument.[592]

The rules in existence before today's amendments require NRSROs to publish two types of information about the performance of their credit ratings: (1) Performance statistics [593] and (2) rating histories.[594] The Commission proposed to implement the rulemaking mandated in section 15E(q) of the Exchange Act, in substantial part, by significantly enhancing the requirements for generating and disclosing this information by amending the instructions to Form NRSRO as they relate to Exhibit 1 and the disclosure of transition and default statistics, and by amending Rule 17g-1, Rule 17g-2, and Rule 17g-7 with respect to the disclosure of rating histories.[595] The Commission is adopting the amendments substantially as proposed, with modifications, in part, in response to comments received.

Start Printed Page 55128

1. Amendments to Instructions for Exhibit 1 to Form NRSRO

a. Proposal

Exhibit 1 is part of the registration application a credit rating agency seeking to be registered as an NRSRO must submit to the Commission and that an NRSRO must file with the Commission, keep up-to-date, and publicly disclose.[596] Section 15E(a)(1)(B)(i) of the Exchange Act requires that an application f or registration as an NRSRO include performance measurement statistics over short-term, mid-term, and long-term periods (as applicable).[597] The Commission implemented this requirement, in large part, through Exhibit 1 to Form NRSRO and the instructions for Exhibit 1.[598] Section 15E(b)(1)(A) of the Exchange Act provides that the performance measurement statistics must be updated annually in the annual certification required by section 15E(b)(2).[599] Paragraph (i) of Rule 17g-1 provides, among other things, that the NRSRO must make the annual certification publicly available within ten business days of furnishing the annual certification to the Commission.[600]

Before today's amendments, the instructions for Exhibit 1 required the applicant or NRSRO to provide performance statistics for the credit ratings of the applicant or NRSRO, including performance statistics for each class of credit ratings for which the applicant is seeking registration or the NRSRO is registered.[601] The classes of credit ratings for which an NRSRO can be registered are enumerated in the definition of nationally recognized statistical rating organization in section 3(a)(62) of the Exchange Act: (1) Financial institutions, brokers, or dealers; [602] (2) insurance companies; [603] (3) corporate issuers; [604] (4) issuers of asset-backed securities (as that term is defined in section 1101(c) of part 229 of Title 17, Code of Federal Regulations, “as in effect on the date of enactment of this paragraph”); [605] and (5) issuers of government securities, municipal securities, or securities issued by a foreign government.[606]

In addition, the instructions required that the performance statistics “must at a minimum show the performance of credit ratings in each class over 1-year, 3-year, and 10-year periods (as applicable) through the most recent calendar year-end, including, as applicable: Historical ratings transition and default rates within each of the credit rating categories,[607] notches, grades, or rankings used by the applicant or NRSRO as an indicator of the assessment of the creditworthiness of an obligor, security, or money market instrument in each class of credit rating.”

Before today's amendments, the instructions for Exhibit 1 did not prescribe the methodology an applicant or NRSRO must use to calculate the performance statistics or the format by which they must be disclosed; nor did the instructions limit the type of information that can be disclosed in Exhibit 1.[608] Consequently, as stated in Start Printed Page 55129a 2010 report of the GAO, NRSROs at that time used different techniques to produce performance statistics, which limited the ability of investors and other users of credit ratings to compare the performance of credit ratings across NRSROs.[609] In addition, several NRSROs included substantial amounts of information in Exhibit 1 about performance statistics, in addition to transition and default rates.

As noted above, NRSROs have produced and presented performance statistics in various ways. For example, for the calendar year 2009 performance statistics published by the NRSROs, some NRSROs used a “single cohort approach” to determine transition rates for their credit ratings.[610] Under this approach, an NRSRO would calculate transition rates for the most recent 1-year, 3-year, or 10-year period. For example, for its 2009 3-year transition rates for corporate issuers using the single cohort approach, an NRSRO would calculate transition rates for the class of corporate issuers for the period December 31, 2006 through December 31, 2009. Other NRSROs used an “average cohort approach.” [611] Under this approach, an NRSRO would calculate transition rates for multiple 1-year, 3-year, or 10-year periods and then average them. For example, for its 2009 3-year transition rates for corporate issuers using the average cohort approach, an NRSRO would calculate 3-year transition rates for the class of corporate issuers for multiple 3-year periods (for example, 3-year periods from 1981 to 2009) and then average them. Two NRSROs also published “Lorenz curves,” which are “visual tools for assessing the accuracy of the rank ordering of creditworthiness that a set of ratings provides.” [612] The GAO found that the variability in how NRSROs produce performance statistics limited the ability of investors and other users of credit ratings to compare the performance of credit ratings across NRSROs.[613]

As described by the GAO, the single cohort approach uses information from the most recent time periods, while the average cohort approach uses information from multiple time periods. The GAO stated that the single cohort approach may be useful to predict the performance of credit ratings under similar circumstances, while the average cohort approach may be useful to predict future transition rates under different economic and other conditions.[614] The GAO also found that “[b]oth approaches are valid, depending on the needs of the user, but they do not yield comparable information.” [615]

As indicated above, before today's amendments, the instructions for Exhibit 1 permitted NRSROs to use differing methods to calculate performance statistics and to include additional information in Exhibit 1. This created the potential that the presentation of information in the exhibits would be inconsistent across NRSROs. To address this issue and to implement section 15E(q) of the Exchange Act, the Commission proposed significant amendments to the instructions for Exhibit 1.[616] The proposed amendments would standardize the calculation of the performance statistics by requiring the applicant or NRSRO to calculate 1-year, 3-year, and 10-year transition and default rates for each applicable class and subclass of credit rating using a single cohort approach.[617] Further, the results would need to be presented in tabular form using a standardized format (a “Transition/Default Matrix”).[618] Finally, the proposed amendments would specify that an applicant or NRSRO must not disclose information in the Exhibit that is not required to be disclosed.[619]

Under the proposal, the “issuers of asset-backed securities” class of credit ratings would be divided into the following subclasses: RMBS; CMBS; collateralized loan obligations (“CLOs”); CDOs; asset-backed commercial paper (“ABCP”); other asset-backed securities (“other ABS”); and other structured finance products (“other SFPs”).[620]

As stated above, under the proposal the applicant or NRSRO would be required to use the single cohort approach to calculate transition and default rates in order to determine the percent of credit ratings at each notch in the rating scale for a given class or subclass and for the applicable time period (one, three, or ten years) that were rated at the same notch or transitioned to another notch as of the end of the period, and the percent of credit ratings at each notch that were classified as a default or paid off, or had been withdrawn for reasons other than being classified as a default or paid off during the period.[621] For example, a matrix containing 3-year transition and default rates for the class of corporate issuers would disclose the number of credit ratings of corporate issuers the applicant or NRSRO had outstanding as of the period start date that is three years prior to the most recent calendar year end at each notch in the rating scale used by the applicant or NRSRO, the percent of those credit ratings that were rated at the same notch and the percent that transitioned to each other notch in the rating scale as of the end of the 3-year period, and the percent that were classified as a default or paid off, or had been withdrawn at any time during the 3-year period.[622]

The Commission proposed that an applicant or NRSRO must classify the credit rating assigned to an obligor, security, or money market instrument as a default if, during the applicable period, either: (1) The obligor failed to timely pay principal or interest due according to the terms of an obligation or the issuer of the security or money market instrument failed to timely pay principal or interest due according to the terms of the security or money market instrument; or (2) the applicant or NRSRO classified the obligor, security, or money market instrument as having gone into default using its own Start Printed Page 55130definition of default.[623] The applicant or NRSRO would need to classify an obligor, security, or money market instrument as having gone into default even if the applicant or NRSRO assigned a credit rating to the obligor, security, or money market instrument at a notch above default in its rating scale on or after the event of default or withdrew the credit rating on or after the event of default.[624]

As proposed, an applicant or NRSRO would classify a credit rating assigned to an obligor, security, or money market instrument as paid off if, during the applicable period: (1) An obligor extinguished the obligation by paying in full all outstanding principal and interest due on the obligation according to the terms of the obligation (for example, because the obligation matured, was called, or was prepaid) and the applicant or NRSRO withdrew the credit rating because the obligation was extinguished; or (2) the issuer of a security or money market instrument extinguished its obligation with respect to the security or money market instrument by paying in full all outstanding principal and interest due according to the terms of the security or money market instrument (for example, because the security or money market instrument matured, was called, or was prepaid) and the applicant or NRSRO withdrew the credit rating for the security or money market instrument because the obligation was extinguished.[625]

The proposal would require the applicant or NRSRO to determine and disclose the number of obligors, securities, and money market instruments assigned a credit rating as of the period start date for which the applicant or NRSRO withdrew a credit rating at any time during the applicable time period for a reason other than that the credit rating assigned to the obligor, security, or money market instrument was classified as a default or paid-off.[626] The applicant or NRSRO would have to classify the credit rating assigned to the obligor, security, or money market instrument as withdrawn even if the applicant or NRSRO assigned a credit rating to the obligor, security, or money market instrument after withdrawing the credit rating.[627]

Finally, the performance statistics would need to be presented in a “Transition/Default Matrix” in a format specified in the instructions, which included a sample matrix.[628]

b. Final Rule

Paragraph (1) of the instructions for Exhibit 1. The Commission is adopting paragraph (1) of the instructions for Exhibit 1 with two technical modifications from the proposal.[629] This paragraph requires the applicant or NRSRO to provide performance statistics for each class of credit ratings for which the applicant is seeking registration as an NRSRO or the NRSRO is registered and for the applicable subclasses of credit ratings listed in the paragraph.[630] Specifically, it requires the applicant or NRSRO to provide transition and default rates for 1-year, 3-year, and 10-year periods for each applicable class or subclass of credit rating.[631] It further requires the applicant or NRSRO to produce and present three separate transition and default statistics for each applicable class or subclass of credit rating; namely, for 1-year, 3-year, and 10-year time periods through the most recent calendar year end. In addition, the applicant or NRSRO must present the transition and default rates for each time period together in tabular form using a standard format (a “Transition/Default Matrix”).[632]

Paragraph (1) of the instructions for Exhibit 1 specifies the classes and subclasses of credit ratings for which the applicant or NRSRO must produce Transition/Default Matrices, as applicable.[633] The identified classes reference the classes of credit ratings for which an NRSRO can be registered as enumerated in the definition of nationally recognized statistical rating organization in section 3(a)(62)(A) of the Exchange Act.[634] As was the case prior to today's amendments, the class of credit ratings enumerated in section 3(a)(62)(A)(iv) of the Exchange Act (issuers of certain asset-backed securities) is expanded to include a broader range of structured finance products than are within the scope of the definition in section 3(a)(62)(A)(iv).[635] Moreover, this class has been divided into the following subclasses: RMBS; [636] CMBS; [637] CLOs; [638] CDOs; [639] ABCP; [640] other Start Printed Page 55131ABS; [641] and other structured finance products.[642]

Regarding the proposed seven subclasses of asset-backed securities, one commenter stated that the proposed degree of granularity “would lead to the creation of sparse Transition/Default Matrices because many NRSROs do not have enough ratings for each proposed subclass to produce statistically significant results” and that the class of ABS ratings should be divided into three classes: RMBS, CMBS, and “Other ABS.” [643] Another NRSRO stated that dividing the class of credit ratings for structured finance products as proposed “would tend to further increase market transparency” and that the proposed subclasses are “suitable,” but that “greater stratification may in some cases produce subclasses that are too small to generate meaningful statistics.” [644]

In response, the Commission notes that the reason for dividing the broad class of structured finance products into these subclasses is to provide investors and other users of credit ratings with more useful information about the performance of an NRSRO's structured finance credit ratings.[645] Each subclass has characteristics that distinguish it from the other subclasses. Consequently, the separation of performance statistics into these subclasses will provide users of credit ratings with additional information and allow them to compare the performance of the credit ratings in each subclass among the NRSROs. Further, the NRSRO must disclose the number of credit ratings outstanding in each subclass at the beginning of the period, so users of credit ratings will be aware of the number of credit ratings the statistics are based upon.

Paragraph (2) of the instructions for Exhibit 1. The Commission is adopting paragraph (2) of the instructions for Exhibit 1 with modifications.[646] This paragraph prescribes how the applicant or NRSRO must present the performance statistics and other required information in the Exhibit.[647] Specifically, it requires that the Transition/Default Matrices for each applicable class and subclass of credit ratings be presented in the order that the classes and subclasses are identified in paragraphs (1)(A) through (E) of the instructions for Exhibit 1.[648] In addition, the order of the Transition/Default Matrices for a given class or subclass must be: The 1-year matrix, the 3-year matrix, and then the 10-year matrix.[649] Further, if the applicant or NRSRO did not issue credit ratings in a particular class or subclass for the length of time necessary to produce a Transition/Default Matrix for a 1-year, 3-year, or 10-year period, it must explain that fact in the location where the Transition/Default Matrix would have been presented in the Exhibit.[650]

The instructions require the applicant or NRSRO to clearly define in Exhibit 1, after the presentation of all applicable Transition/Default Matrices, each symbol, number, or score in the rating scale used by the applicant or NRSRO to denote a credit rating category and notches within a category for each class and subclass of credit ratings in any Transition/Default Matrix presented in the Exhibit.[651] The instructions also require the applicant or NRSRO to clearly explain the conditions under which it classifies obligors, securities, or money market instruments as being in default.[652] Further, the instructions require that the applicant or NRSRO provide in Exhibit 1 the uniform resource locator (“URL”) of its corporate Internet Web site where the credit rating histories required to be disclosed pursuant to paragraph (b) of Rule 17g-7 would be located (in the case of an applicant) or are located (in the case of an NRSRO).[653]

Finally, as proposed, the instructions provided that the Exhibit must contain no performance statistics or information other than as described in, and required by, the instructions for Exhibit 1; except that the applicant or NRSRO would be permitted to provide, after the presentation of all required Transition/Default Matrices and other required disclosures, Internet Web site URLs where other information relating to performance statistics of the applicant or NRSRO is located.[654] This provision was intended to address the fact that some NRSROs included substantial amounts of information in Exhibit 1 about performance statistics, in addition to transition and default rates.[655] As discussed in more detail below, some commenters stated that there are advantages and limitations to using the single cohort approach as compared to the average cohort approach to calculate the performance statistics.[656] While the instructions for Exhibit 1 mandate the use of the single cohort approach, the Commission believes that, if an NRSRO also calculates performance statistics using the average cohort approach, it would be appropriate to disclose that fact in Exhibit 1 and provide an Internet URL where the performance statistics are located. This will provide additional information to evaluate the performance of the NRSRO's credit ratings. For these reasons, paragraph (2) of the instructions for Exhibit 1 has been modified to provide that Exhibit 1 must contain no performance measurement statistics or information other than as described in, and required by, the Instructions for Exhibit 1; except that Start Printed Page 55132the NRSRO may provide after the presentation of all required Transition/Default Matrices and other disclosures:

  • A short statement describing the required method of calculating the performance measurement statistics in Exhibit 1 (the single cohort approach) and any advantages or limitations to the single cohort approach the NRSRO believes would be appropriate to disclose;
  • A short statement that the NRSRO has calculated and published on an Internet Web site performance measurement statistics using the average cohort approach (if applicable), a description of the differences between the single cohort approach and the average cohort approach used to calculate the performance measurement statistics, and the Internet Web site URL where the performance measurements statistics calculated using the average cohort approach are located; and
  • The Internet Web site URLs where any other information relating to performance measurement statistics of the NRSRO is located.[657]

Paragraph (3) of the instructions for Exhibit 1. The Commission is adopting paragraph (3) of the instructions for Exhibit 1 with modifications to make the disclosures more understandable to users of credit ratings.[658] This paragraph prescribes the format for a Transition/Default Matrix and includes a sample matrix.[659] Specifically, the prescribed format is designed to allow the applicant or NRSRO to show in the matrix the number of outstanding credit ratings in the class or subclass at each notch in the applicable rating scale at the period start-date, and the percent of those credit ratings that were rated at the same notch at the end of the period, the percent of those credit ratings that were rated at each different notch in the rating scale at the end of the period, and the percent of those credit ratings that were classified as a default or paid off or were withdrawn at any time during the period.[660] The prescribed format also is designed so that this information will be displayed in Exhibit 1 in a standard manner across the NRSROs to make it easier for users of NRSRO credit ratings and others to understand and compare the statistics.

One commenter suggested adding the heading “Status of those ratings at the end of the time period” to the Transition/Default Matrix because “less sophisticated investors” may not understand the term “transition,” and also suggested that it may be useful to highlight the box on the chart that corresponds with the credit rating being at the same notch at the end of the period as it was at the beginning.[661] The Commission agrees that these types of modifications could assist users to better understand the information disclosed in the Transition/Default Matrices. Consequently, the narrative instructions in paragraph (3) and the illustration of the sample Transition/Default Matrix have been modified to require highlighting of the cell in the matrix that corresponds with the credit rating being at the same notch at the end of the period as it was at the beginning and to require that the legends at the top of the matrix reflect that the first two columns represent the status of the credit ratings as of the period start date, the subsequent rating category columns represent the status of the credit ratings as of the period end date, and the Default, Paid Off, and Withdrawn (other) columns represent other outcomes that occurred during the period.[662]

As adopted, the sample Transition/Default Matrix in Figure 2 is the sample matrix provided in the instructions that the applicant or NRSRO must use as a model for its Transition/Default Matrices.

Paragraph (4) of the instructions for Exhibit 1. The Commission is adopting paragraph (4) of the instructions for Exhibit 1 with the modifications discussed below.[663] This paragraph prescribes how the applicant or NRSRO must calculate the performance statistics and enter information into the Transition/Default Matrices.[664]

Start Printed Page 55133

Determining Start Date Cohorts

The final amendments (as was proposed) require the applicant or NRSRO to use the single cohort approach to calculate the transition and default rates.[665] One NRSRO stated that the single cohort approach is a “reasonable approach” and “is the best approach as it is, in our opinion, the clearest way to calculate a meaningful default rate.” [666] Another NRSRO requested that the Commission provide “fuller background” on decisions such as the determination to use the single cohort approach rather than an average cohort approach, with a description of potential benefits and limitations of those decisions.[667] Some commenters suggested that the Commission use an average cohort approach in lieu of or in addition to the single cohort approach.[668]

The Commission recognizes that different methods of measuring the performance of credit ratings may have unique advantages in terms of the information provided. As the GAO noted in comparing the single cohort approach and the average cohort approach, “[b]oth approaches are valid, depending on the needs of the user, but they do not yield comparable information.” [669] For example, the average cohort approach may provide better information about how credit ratings perform on average across a wider variety of economic conditions when compared to the single cohort approach.[670] However, the single cohort approach, because it does not average out performance over multiple cohorts, may more readily highlight how a given NRSRO's credit ratings have performed in more recent economic cycles.

Moreover, the single cohort approach is a simpler approach than the other methods noted by the GAO and, therefore, it may be easier for less sophisticated investors and other users of credit ratings to understand how the performance statistics were produced. As stated above, section (q)(2)(B) of the Exchange Act provides that the Commission's rules shall require that the performance measurement disclosures be clear and informative for investors having a wide range of sophistication.[671] The Commission notes that one commenter stated that the single cohort approach “is the clearest way to calculate a meaningful default rate.” [672] In addition, it will be easier for NRSROs to produce performance statistics using this approach as it requires simpler calculations and, consequently, will be less burdensome than the other approaches.

One commenter stated that the single cohort approach could lead to results that are “significantly more volatile within the shorter time period, which will make interpreting those results more difficult.” [673] This commenter stated further that “the volatility impact will be amplified for NRSROs with fewer ratings, which could lead to bias against smaller NRSROs.” [674] The Commission has balanced this concern with the need to prescribe an easy to understand method for calculating the performance statistics. As discussed below, the requirements in the instructions for Exhibit 1 provide for very transparent disclosures about the number of credit ratings in the start date cohort and in the cohort for each notch in the credit rating scale of a given class or subclass.[675] This transparency will provide persons reviewing the performance statistics with information to assess how the small number of credit ratings in a given cohort may have impacted the results.[676] Moreover, as discussed above, the Commission has modified paragraph (2) of the instructions for Exhibit 1 to permit an NRSRO to include a statement about any advantages or limitations to the single cohort approach the firm believes would be appropriate to disclose and, if applicable, a statement disclosing that the NRSRO has calculated performance statistics using the average cohort approach and identifying the Internet Web site URL where those statistics are located.

One commenter suggested that NRSROs should be required to calculate performance statistics using both the single cohort approach and the average cohort approach.[677] One of the objectives of the amendments is to make the disclosures in Exhibit 1 to Form NRSRO shorter and easier to understand. Mandating two sets of 1-year, 3-year, and 10-year performance statistics (one based on the single cohort approach and one based on the average cohort approach) for each class or subclass of credit ratings would substantially increase the length and complexity of the disclosure in Exhibit 1. In addition, it would increase the compliance burden. However, as discussed above, NRSROs that also calculate performance statistics using the average cohort approach can disclose that fact in Exhibit 1.

Finally, one commenter stated that NRSROs should be required to use the single cohort approach for credit ratings of corporate and sovereign debt and a “static pool approach” for credit ratings of structured finance products.[678] The Commission believes that doing so would make the disclosure unnecessarily complex and undermine the objective of making the performance statistics clear and informative for investors having a wide range of sophistication.[679]

For all the reasons discussed above, the final amendments require NRSROs to produce the performance statistics using the single cohort approach.[680] However, in response to comments, the Commission is modifying the requirement with respect to identifying the credit ratings that must be included in a start-date cohort. Several commenters addressed the proposed requirement that a start-date cohort consist of the obligors, securities, and money market instruments in the applicable class or subclass of credit ratings that were assigned a credit rating as of the beginning of the period. One NRSRO stated that “mixing units of study,” consisting of obligors, securities, and money-market instruments “can create mismatched data and potentially double counting.” [681] Similarly, another NRSRO recommended that, except for the structured finance class of credit Start Printed Page 55134ratings, the rule should require calculating a senior credit rating for a given issuer and using that rating in the construction of the cohort, as a single issuer can have many issuances, and including each one in the cohort may skew the performance statistics.[682] A third NRSRO stated that for the structured finance category of credit ratings, “the obligations/issues should be included in the start-date cohorts” because “those transactions do not have obligors in a traditional sense . . .” [683] A fourth NRSRO agreed, stating that “the start-date cohorts should be comprised of obligors for corporate ratings and securities lines for the various subclasses of structured finance ratings.” [684]

The Commission agrees with these comments and has modified the instructions. The final amendments provide that, to determine the number of credit ratings outstanding as of the period start date for all classes of credit ratings other than the class of issuers of asset-backed securities, the applicant or NRSRO must: (1) Identify each obligor that the applicant or NRSRO assigned a credit rating to as an entity where the credit rating was outstanding as of the period start date; (2) identify each additional obligor that issued securities or money market instruments that the applicant or NRSRO assigned credit ratings to where the credit ratings were outstanding as of the period start date; and (3) include in the start-date cohort only credit ratings assigned to an obligor as an entity, or, if the obligor is not assigned a credit rating as an entity, the credit rating of the obligor's senior unsecured debt.[685] All other credit ratings outstanding as of the period start date assigned to securities or money market instruments issued by the obligor must be excluded from the start-date cohort.[686] For the class of issuers of asset-backed securities, the start-date cohort (as was proposed) must consist of credit ratings that the applicant or NRSRO assigned to all securities or money market instruments in the class where the credit ratings were outstanding as of the period start date, excluding expected or preliminary credit ratings.[687]

Finally, as proposed, the start date cohort for all classes of credit ratings must exclude credit ratings that the applicant or NRSRO classified as in default (using its own definition of default) as of the period start-date (and, as discussed above, expected or preliminary credit ratings).[688] As explained in the proposing release, the Transition/Default Matrices should not include credit ratings of obligors, securities, and money market instruments the applicant or NRSRO has classified as in default because the firm is no longer assessing the relative likelihood that the obligor, security, or money market will continue to meet its obligations to make timely payments of principal and interest as they come due (that is, not default on its obligations).[689] Consequently, as long as the obligor, security, or money market instrument continues to be classified as in default there is no credit rating performance to measure. However, if the credit rating is upgraded from the default category because, for example, the obligor emerges from a bankruptcy proceeding, the obligor's credit rating will need to be included in a Transition/Default Matrix that has a start date after the upgrade.[690]

After determining the credit ratings in the start-date cohort, the applicant or NRSRO must determine the number of credit ratings in the start-date cohort for each notch in the rating scale used for the class or subclass as of the period start date.[691] The final step is to enter Start Printed Page 55135these amounts, as well as the total number of credit ratings in the start-date cohort, in the second column of the Transition/Default Matrix.[692]

Calculating Transition and Default Statistics

Paragraph (4)(B) of the instructions for Exhibit 1 prescribes how the applicant or NRSRO must calculate the performance statistics and enter the results into the Transition/Default Matrices.[693] More specifically, the instructions provide that each row representing a credit rating notch in the Transition/Default Matrix must contain percentages indicating the credit rating outcomes as of the period end date for all the credit ratings in the start-date cohort at that notch as of the period start date.[694] The instructions also provide that the percentages in a row must add up to 100%.[695] The final amendments (as was proposed) identify five potential outcomes for a credit rating in the start-date cohort: (1) It is assigned the same credit rating as of the period end date; (2) it is assigned a different credit rating as of the period end date; (3) it was classified as a default at any time during the period; (4) it was classified as paid off at any time during the period; or (5) the applicant or NRSRO withdrew the credit rating at any time during the period for a reason other than that the credit rating assigned to the obligor, security, or money market instrument was classified as a default or paid off.[696] Because the percentages in a row must add up to 100%, each credit rating in a start-date cohort must be assigned one and only one outcome.[697]

The final amendments (as was proposed) require the applicant or NRSRO to determine the number of credit ratings in a given notch as of the period start date that were assigned the same credit rating as of the period end date.[698] The instructions require that: (1) This number must be expressed as a percent of the total number of credit ratings at that notch as of the period start date; (2) the percent must be entered in the column representing the same notch; and (3) the cell must be highlighted.[699] An obligor, security, or money market instrument could have the same credit rating as of the period end date because the credit rating did not change between the start date and the end date or the credit rating transitioned to one or more other notches in the rating scale during the relevant period but transitioned back to the start-date notch where it remained as of the period end date. Consequently, the instructions provide that, to determine this number, the applicant or NRSRO must use the credit rating at the notch assigned to the obligor, security, or money market instrument as of the period end date and not a credit rating at any other notch assigned to the obligor, security, or money market instrument between the period start date and the period end date.[700]

The final amendments (as was proposed) require the applicant or NRSRO to determine the number of credit ratings in a given notch at the period start date that were assigned a credit rating at each other notch in the rating scale as of the period end date.[701] The instructions require that: (1) These numbers must be expressed as percentages of the total number of credit ratings at that notch as of the period start date; and (2) the percentages must be entered in the columns representing each notch.[702] The instructions in the paragraph clarify that, to determine these numbers, the applicant or NRSRO would need to use the credit rating at the notch assigned to the obligor, security, or money market instrument as of the period end date and not a credit rating at any other notch assigned to the obligor, security, or money market instrument between the period start date and the period end date.[703]

The final amendments (as was proposed) require the applicant or NRSRO to determine the total number of credit ratings in a given notch at the period start date that were classified as a default at any time during the applicable time period.[704] The instructions require that: (1) This number must be expressed as a percent of the total number of credit ratings at that notch as of the period start date; Start Printed Page 55136and (2) the percent must be entered in the Default column.[705]

As indicated, the applicant or NRSRO must treat the credit rating as a default if the credit rating was classified as a default at any time during the applicable period.[706] This is different from the calculations of the percent of credit ratings that stayed at the same notch or transitioned to a different notch in the rating scale that are based on the end-date status of the credit rating.[707] This period-long approach is designed to address concerns that an applicant or NRSRO might withdraw a credit rating that was classified as a default during the period in order to improve the default rates presented in the matrix.[708]

The Commission proposed a standard definition of default to be used to classify credit ratings as defaults for the purposes of calculating the default rates.[709] The Commission's goal in proposing a standard definition was to make the default rates calculated and disclosed by the NRSROs more readily comparable.[710] The Commission was concerned that if applicants or NRSROs use their own definitions of default, differences in those definitions could result in applicants and NRSROs inconsistently classifying credit ratings as in default.[711]

A number of commenters addressed the proposed standardized definition of default. One NRSRO stated that it agreed “in principle that there may be value in having” a standard definition “so long as allowance is made for ratings that use a term such as `default' in a non-standard way.” [712] Another NRSRO stated that the proposed definition of default would fail to classify as defaults non-payment events on all instruments that legally constitute equity, including all securitization instruments that use “pass-through” trusts.[713] One NRSRO stated that requiring an NRSRO to classify a security as having gone into default when the NRSRO would not choose that classification under its definition “comes dangerously close to the prohibition against regulating the substance of credit ratings.” [714] This NRSRO also suggested that the proposed language be modified to clarify that the “terms of an obligation” include any grace periods within which an obligor or issuer might cure the default. Another commenter objected to the proposed definition of default, because by incorporating the definition used by the NRSRO it “defeats the aim of promoting uniformity in the performance data for credit ratings.” [715]

The Commission is adopting a standard definition of default with a modification from the proposal to broaden the definition to capture certain events identified by one commenter. As adopted, the final amendments provide that the applicant or NRSRO must classify a credit rating as a default if any of the following conditions are met:

  • The obligor failed to timely pay principal or interest due according to the terms of an obligation during the applicable period or the issuer of the security or money market instrument failed to timely pay principal or interest due according to the terms of the security or money market instrument during the applicable period;
  • The security or money market instrument was subject to a write-down, applied loss, or other realized deficiency of the outstanding principal amount during the applicable period; or
  • The applicant or NRSRO classified the obligor, security, or money market instrument as having gone into default using its own definition of default during the applicable period.[716]

The first and second prongs of the definition comprise the standard definition of default that must be used by the applicant or NRSRO.[717] The second prong was added to the definition in response to a comment that the standard definition of default did not incorporate certain events generally viewed as defaults but that do not involve failure to timely pay principal or interest, such as events relating to securitization instruments that use pass-through trusts.[718] The legal terms of securitizations using pass-through trusts generally do not entitle the certificate holders to receive a greater amount than is collected by the trust. Therefore, failure to make payments to certificate holders in excess of the amounts collected would not constitute a payment default as contemplated under the first prong of the definition.

The second prong is meant to capture events—such as principal write-downs—that are generally viewed to be defaults on this type of security even though such events do not involve failure to timely pay principal or interest. For example, a securitization that uses a pass through trust may experience a write-down of its principal due to losses on underlying collateral backing the security, if those losses cause the security to become under-collateralized (i.e., the principal balance of the collateral is less than the principal balance owed to the holders of the security). Such a write-down results in an immediate loss to the certificate holders since the principal balance against which interest is calculated has been reduced. This is usually considered a situation of default for this type of security. The second prong would also capture distressed exchanges of preferred stock and other hybrid instruments where the principal amount due to preferred security holders is reduced, resulting in a loss to the security holders.

In response to the comment questioning whether the Commission should prescribe a standard definition of default,[719] the Commission notes that one objective of a standard definition is Start Printed Page 55137to avoid a situation in which NRSROs use differing definitions of default, which, as stated above, could result in some NRSROs using materially narrower definitions in order to produce more favorable default rates. Moreover, consistent with paragraph (q)(2)(A) of section 15E of the Exchange Act, the Commission sought to establish a rule that requires disclosures that are comparable among NRSROs and allows users of credit ratings to compare the performance of credit ratings across NRSROs.[720] Further, the final amendments do not require that NRSROs use the standard definition of default in determining and monitoring credit ratings. The amendments only require that the standard definition be used in calculating credit rating default statistics. Consequently, the amendments do not regulate the substance of credit ratings or the procedures or methodologies an NRSRO uses to determine credit ratings.[721]

The third prong of the definition applies if the applicant or NRSRO classified the obligor, security, or money market instrument as having gone into default using its own definition of default.[722] In response to the comment questioning whether the rule should incorporate the applicant's or NRSRO's internal definition,[723] the objective is to supplement the standard definition to address a situation in which the applicant's or NRSRO's definition of default is broader than the standard definition. In this case, the NRSRO potentially could classify a rated obligor, security, or money market instrument as having gone into default during the time period even though, under the standard definition, the applicant or NRSRO would not need to make a default classification. As stated above, each credit rating in the start date cohort must be assigned one of five potential outcomes: (1) It is assigned the same credit rating as of the period end date; (2) it is assigned a different credit rating as of the period end date; (3) it was classified as a default at any time during the period; (4) it was classified as paid off at any time during the period; or (5) the applicant or NRSRO withdrew the credit rating at any time during the period for a reason other than the credit rating assigned to the obligor, security, or money market instrument was classified as a default or paid off. If the NRSRO has classified the credit rating as a default, there is no other outcome other than default that would be appropriate. It would make the Transition/Default Matrices unnecessarily complex to specify a sixth outcome: That the NRSRO has classified the credit rating as a default but the standard definition did not. The standard definition is broad (particularly with the modification discussed above) and should apply to most cases commonly understood as a default. Consequently, it should rarely happen that an applicant or NRSRO classifies a credit rating as a default and the standard definition does not.[724] For these reasons, the definition incorporates the applicant's or NRSRO's definition of default.

The Commission agrees with the comment suggesting that the “terms of an obligation” as used in the standard definition of default would include any grace period provided in those terms within which an obligor or issuer may cure the default.[725] Consequently, an applicant or NRSRO need not classify a credit rating as a default under the standard definition if the obligor is within a grace period specifically provided for under the terms and conditions of the obligation and subsequently “cures the default.”

Finally, as proposed, the final amendments provide that a credit rating must be classified as a default even if the applicant or NRSRO assigned a credit rating to the obligor, security, or money market instrument at a notch above default in its rating scale on or after the event of default or withdrew the credit rating on or after the event of default.[726] This is designed to make clear that the requirement that a credit rating classified as a default at any time during the period covered by the Transition/Default Matrix must be included in the default rate irrespective of any post-default rating actions taken by the NRSRO.

As discussed above, the Transition/Default Matrix must provide statistics on the number of credit ratings in the start-date cohort at a given rating notch that were classified as paid off at any time during the relevant period.[727] The instructions require that: (1) This amount be expressed as a percent of the total number of a credit ratings in the start date cohort as of the period start date; and (2) the percent be entered in the Paid Off column.[728] This classification must be made if the credit rating is classified as paid off at any time during the period.[729]

The proposed rule prescribed a standard definition of paid off with two prongs: (1) One applicable to obligors; and (2) one applicable to securities and money market instruments.[730] One commenter stated that the paid off classification as applied to obligors “is not practicable” because some obligors do not have rated debt outstanding and it would be difficult to track whether all obligations of an obligor are paid off.[731] Further, as discussed above, the determination of the start-date cohorts for classes of credit ratings other than the issuer of asset-backed securities class will require—under the modifications to the proposal—that the applicant or NRSRO use the credit ratings of obligors as entities and exclude the credit ratings of securities issued by the obligor unless the obligor does not have an entity credit rating (in which case only the credit rating of the obligor's senior unsecured debt must be included). A credit rating of an obligor as an entity does not relate to a single obligation with a maturity date but rather to the obligor's overall ability to meet any obligations as they come due. Therefore, an obligor credit rating normally cannot be classified as paid off since it does not reference a specific obligation that will mature.

For these reasons, the Commission has modified the standard definition of paid off to eliminate the prong that applied to entity ratings of obligors. The final amendments provide that the applicant or NRSRO must classify the credit rating as paid off only if the issuer of the security or money market instrument extinguished its obligation with respect to the security or money market instrument during the applicable time period by paying in full all outstanding principal and interest due Start Printed Page 55138according to the terms of the security or money market instrument (for example, because the security or money market instrument matured, was called, or was prepaid); and the applicant or NRSRO withdrew the credit rating for the security or money market instrument because the obligation was extinguished.[732]

As discussed above, the Transition/Default Matrix must provide statistics on the number of credit ratings in the start-date cohort at a given rating notch that were withdrawn for a reason other than they were classified as a default or paid-off.[733] The instructions require that: (1) This amount be expressed as a percent of the total number of credit ratings at a given notch in the rating scale as of the period start date; and (2) the percent be entered in the Withdrawn (other) column.[734] The instructions provide that the applicant or NRSRO must classify the credit rating as withdrawn even if the applicant or NRSRO assigned a credit rating to the obligor, security, or money market instrument after withdrawing the credit rating.[735]

There are legitimate reasons to withdraw a credit rating assigned to an obligor, security, or money market instrument. For example, an NRSRO might withdraw a credit rating because the rated obligor or issuer of the rated security or money market instrument stopped paying for the surveillance of the credit rating or because the NRSRO issued and was monitoring the credit rating on an unsolicited basis and no longer wanted to devote resources to monitoring it. However, an applicant or NRSRO could withdraw a credit rating to make its transition or default rates appear more favorable.[736] The Commission believes that the instructions with respect to withdrawn credit ratings permit NRSROs the flexibility to withdraw credit ratings for legitimate reasons, including those stated above, while helping to prevent manipulation that would make their transition or default rates appear more favorable.

The Commission did not propose that NRSROs be required to track obligors, securities, or money market instruments after they had withdrawn credit ratings assigned to them, but the Commission did seek comment on whether this should be required.[737] Two NRSROs stated that NRSROs should not be required to track withdrawn ratings after withdrawal.[738] The amendments, as adopted, do not require NRSROs to track the outcomes of obligors, securities, or money market instruments after the credit ratings assigned to them are withdrawn.

2. Amendments to Rule 17g-1

As discussed above, section 932(a)(8) of the Dodd-Frank Act added subsection (q) to section 15E of the Exchange Act.[739] Section 15E(q)(2)(D) of the Exchange Act provides that the Commission's rules must require an NRSRO to publish the information about the performance of its credit ratings and make it freely available on an easily accessible portion of its Internet Web site, and in writing when requested.[740] The Commission proposed to implement section 15E(q)(2)(D) by amending paragraph (i) of Rule 17g-1.[741]

Before today's amendments, paragraph (i) of Rule 17g-1 required an NRSRO to make its current Form NRSRO and information and documents submitted in Exhibits 1 through 9 publicly available on its Internet Web site or through another comparable, readily accessible means within ten business days of being granted an initial registration or a registration in an additional class of credit ratings, and within ten business days of furnishing a Form NRSRO to update information on the Form, to provide the annual certification, and to withdraw a registration.[742] These requirements implemented section 15E(a)(3) of the Exchange Act, which provides, among other things, that the Commission shall, by rule, require an NRSRO, upon the granting of a registration, to make the information and documents submitted to the Commission in its completed application for registration, or in any amendment, publicly available on its Internet Web site, or through another comparable, readily accessible means.[743]

Although section 15E(q)(2)(D) addresses the disclosure of information about the performance of credit ratings (which NRSROs disclose in Exhibit 1 to Form NRSRO), the Commission proposed amending paragraph (i) of Rule 17g-1 to require an NRSRO to “make its current Form NRSRO and Exhibits 1 through 9 to Form NRSRO publicly and freely available on an easily accessible portion of its corporate Internet Web site” to avoid having separate requirements for the Exhibit 1 performance statistics and the rest of Form NRSRO and the other public exhibits.[744] In this regard, the Commission stated that it believed that a Form NRSRO would be on an “easily accessible” portion of an Internet Web site if it could be accessed through a clearly and prominently labeled hyperlink to the form on the homepage of the NRSRO's corporate Internet Web site.[745]

In addition, to implement section 15E(q)(2)(D) of the Exchange Act, the Commission proposed to amend paragraph (i) to provide that an NRSRO “must make its up-to-date Exhibit 1 to Form NRSRO freely available in writing to any individual who requests a copy of the Exhibit.”[746]

Because there were references in Form NRSRO and the Instructions for Form NRSRO to make Form NRSRO and information and documents submitted in Exhibits 1 through 9 “publicly available on [the NRSRO's] Web site or through another comparable, readily accessible means,” the Commission proposed amending these references to mirror the text of the proposed amendment to paragraph (i).[747]

Start Printed Page 55139

Several comment letters addressed the proposal.[748] One NRSRO supported the proposal as long as it does not require the disclosure of confidential information.[749] Three NRSROs stated that, as NRSROs are required to make public disclosures in addition to Form NRSRO, a link on the homepage of their corporate Internet Web site labeled “Regulatory Disclosures” (or similar language) to a section of the site that included Form NRSRO would be appropriate and would still provide easy access to Form NRSRO and Exhibits 1 through 9.[750] Two NRSROs stated that there would be costs but no benefits in requiring that Exhibit 1 be made freely available in writing to any individual who requests a copy of the Exhibit, and these NRSROs suggested that NRSROs be able to charge reasonable postage and handling fees.[751]

The Commission is adopting the proposed amendments to paragraph (i) of Rule 17g-1 substantially as proposed. In conformity with the modification (in response to comment) to the proposed instructions for Exhibit 1 to Form NRSRO,[752] the Commission is modifying the proposal to replace the phrase “up-to-date Exhibit 1” with the phrase “most recently filed Exhibit 1.” The Commission also is replacing the phrase “Web site” with the word “Web site,” consistent with the usage in other NRSRO rules.

The Commission agrees with the comments suggesting that NRSROs may charge reasonable postage and handling fees for sending a written copy of Exhibit 1 to individuals who request it in written form.[753] This should reduce the costs of the requirement and incentivize individuals to access the information using the NRSRO's Internet Web site, which is a more efficient method of obtaining the information.

The Commission also is making conforming amendments to Form NRSRO and the Instructions to Form NRSRO (as was proposed).[754] Finally, the Commission agrees with commenters[755] that a Form NRSRO and Exhibits 1 through 9 to Form NRSRO would be on an “easily accessible” portion of an NRSRO's corporate Internet Web site if it could be accessed through a clearly and prominently labeled hyperlink labeled “Regulatory Disclosures” on the homepage of the Web site.

3. Amendments to Rule 17g-2 and Rule 17g-7

a. Proposal

Paragraph (a)(8) of Rule 17g-2 requires an NRSRO to make and retain a record that, “for each outstanding credit rating, shows all rating actions and the date of such actions from the initial credit rating to the current credit rating identified by the name of the rated security or obligor and, if applicable, the CUSIP of the rated security or the Central Index Key (“CIK”) number of the rated obligor.”[756] An NRSRO is required to retain this record for three years under paragraph (c) of Rule 17g-2.[757]

Before today's amendments, paragraph (d)(2) of Rule 17g-2 (the “10% Rule”) required an NRSRO to “make and keep publicly available on its corporate Internet Web site in an eXtensible Business Reporting Language (“XBRL”) format” the information required to be documented pursuant to paragraph (a)(8) of Rule 17g-2 for 10% of the outstanding credit ratings, selected on a random basis, in each class of credit rating for which the NRSRO is registered if the credit rating was paid for by the obligor being rated or by the issuer, underwriter, or sponsor of the security being rated (“issuer-paid” credit ratings) and the NRSRO has 500 or more such issuer-paid credit ratings outstanding in that class.[758] Paragraph (d)(2) further provided that any ratings action required to be disclosed need not be made public less than six months from the date the action is taken; that if a credit rating made public pursuant to the rule is withdrawn or the rated instrument matures, the NRSRO must randomly select a new outstanding credit rating from that class of credit ratings in order to maintain the 10% disclosure threshold; and that in making the information available on its corporate Internet Web site, the NRSRO must use the List of XBRL Tags for NRSROs as specified on the Commission's Internet Web site.

Before today's amendments, paragraph (d)(3) of Rule 17g-2 (the “100% Rule”) required an NRSRO to make publicly available on its corporate Internet Web site information required to be documented pursuant to paragraph (a)(8) of the rule for any credit rating initially determined by the NRSRO on or after June 26, 2007, the effective date of the Rating Agency Act of 2006.[759] The 100% Rule applied to all types of credit ratings (as opposed to the 10% Rule, which was limited to issuer-paid credit ratings). However, the 100% Rule prescribed different grace periods for when an NRSRO must disclose a rating action depending on whether or not it involved an issuer-paid credit rating. For issuer-paid credit ratings, the grace period was twelve months after the date the rating action was taken, and for non-issuer paid credit ratings, the grace period was twenty-four months after the date the rating action was taken. The NRSRO was required to disclose the rating history information on its corporate Internet Web site in an XBRL format using the List of XBRL Tags for NRSROs as published by the Commission on its Internet Web site.[760]

The Commission proposed repealing the 10% Rule, significantly amending the 100% Rule, and codifying the revised 100% Rule in paragraph (b) of Rule 17g-7.[761] As discussed below in section II.E.3.b. of this release, these proposals took into account findings by the GAO.[762] As proposed to be amended, the 100% Rule would incorporate requirements in place before the proposed amendments and, in addition, would require that an NRSRO disclose rating history information on an “easily accessible” portion of its Internet Web site, add more rating histories to its disclosures, provide more information about each rating action, and not remove a rating history from the Start Printed Page 55140disclosure until twenty years after the NRSRO withdraws the credit rating.[763]

To add more rating histories to the disclosures, the 100% Rule, as proposed, would no longer be limited to the disclosure of histories for credit ratings that were initially determined on or after June 26, 2007.[764] Instead, as proposed, the rule would apply to any credit rating that was outstanding as of June 26, 2007, but the rating histories disclosed for these credit ratings would not need to include information about actions taken before June 26, 2007. Moreover, in order to immediately include these credit ratings in the disclosure, the proposals would require the NRSRO to disclose the credit rating assigned to the obligor, security, or money market instrument and associated information as of June 26, 2007. The proposals provided that the rating actions that would need to be included in the history are the initial credit rating or the credit rating as of June 26, 2007 (if the initial credit rating was prior to that date) and any subsequent upgrades or downgrades of the credit rating (including a downgrade to, or assignment of, default), any placements of the credit rating on credit watch or review, any affirmation of the credit rating, and a withdrawal of the credit rating.

To provide more information about each rating action in a rating history, the proposals would increase the number and scope of the required data fields.[765] Specifically, the 100% Rule, as proposed, would identify seven categories of data that would need to be disclosed when a credit rating action is published. The categories of information were:

  • The identity of the NRSRO disclosing the rating action;
  • The date of the rating action;
  • If the rating action is taken with respect to a credit rating of an obligor as an entity, the following identifying information about the obligor, as applicable: (1) The CIK number of the rated obligor; and (2) the legal name of the obligor;
  • If the rating action is taken with respect to a credit rating of a security or money market instrument, as applicable: (1) CIK number of the issuer of the security or money market instrument; (2) the legal name of the issuer of the security or money market instrument; and (3) the CUSIP of the security or money market instrument;
  • A classification of the rating action as either: (1) A disclosure of a credit rating that was outstanding as of June 26, 2007 for purposes of the rule; (2) an initial credit rating; (3) an upgrade of an existing credit rating; (4) a downgrade of an existing credit rating, which would include classifying the obligor, security, or money market instrument as in default, if applicable; (5) a placement of an existing credit rating on credit watch or review; (6) an affirmation of an existing credit rating; or (7) a withdrawal of an existing credit rating and, if the classification is withdrawal, the reason for the withdrawal as either a default, the obligation was paid off, or the withdrawal was for other reasons;
  • The classification of the class or subclass that applies to the credit rating as either: (1) Financial institutions, brokers, or dealers; (2) insurance companies; (3) corporate issuers; (4) RMBS, CMBS, CLO, CDO, ABCP, other ABS, or another structured finance product (in the issuers of structured finance products class); or (5) sovereign issuer, U.S. public finance, or international public finance (in the issuers of government securities, municipal securities, or securities issued by a foreign government class); and
  • The credit rating symbol, number, or score the NRSRO assigned to the obligor, security, or money market instrument as a result of the rating action or, if the credit rating remained unchanged as a result of the rating action, the credit rating symbol, number, or score the NRSRO assigned to the obligor, security, or money market instrument as of the date of the rating action.[766]

The proposed amendments specified when a rating action and its related data would need to be disclosed by establishing two distinct grace periods: Twelve months and twenty-four months.[767] In particular, a rating action would need to be disclosed: (1) Within twelve months from the date the action is taken, if the credit rating subject to the action was issuer-paid; [768] or (2) within twenty-four months from the date the action is taken, if the credit rating subject to the action was not issuer-paid.[769] These proposed separate grace periods for issuer-paid and non-issuer-paid credit ratings were consistent with the requirements of the 100% Rule prior to today's amendments.[770]

Finally, the proposed amendments provided that an NRSRO may cease disclosing a rating history of an obligor, security, or money market instrument no earlier than twenty years after the date a rating action with respect to the obligor, security, or money market instrument is classified as a withdrawal.[771]

b. Final Rule

As proposed, the Commission is eliminating the 10% Rule.[772] The 10% Rule did not permit comparability across NRSROs because it captured only issuer-paid credit ratings in a class of credit ratings where there are 500 or more such ratings and only if two or more NRSROs randomly select the same rated obligor, issuer, or money instrument to be included in the sample.[773] Moreover, the 10% Rule did not produce sufficient “raw data” to allow third parties to generate independent performance statistics.[774] The goal of the rule was to provide some information about how an NRSRO's credit ratings performed, particularly ratings assigned to obligors, securities and money market instruments that had been rated for ten or twenty years. In light of the enhancements to the instructions for Exhibit 1 to Form NRSRO (discussed above in section II.E.1. of this release) and the 100% Rule, retaining the 10% Rule would provide little, if any, incremental benefit to investors and other users of credit ratings in terms of providing information about the performance of a given NRSRO's credit ratings. Several commenters addressed the proposal to eliminate the 10% Rule.[775] All of these commenters supported its elimination.

The Commission is adopting the amendments to the 100% Rule (including moving its provisions from Rule 17g-2 to Rule 17g-7) with Start Printed Page 55141modifications, in part, in response to comments.[776] Two commenters generally supported the proposed amendments to the 100% Rule.[777] On the other hand, one NRSRO objected to the Commission's proposal to expand the 100% Rule “until a more thorough cost-benefit analysis” has been conducted.[778] This NRSRO stated that on average only one person per month is accessing its rating history disclosures, but that it incurs substantial costs to make the information available. Further, it stated that constantly updating the database for the 100% Rule “would impose an unwarranted burden on NRSROs” and that the Commission has “substantially underestimated the costs” of the proposal. Another NRSRO also did not support the proposal, stating that it would impose significant costs on NRSROs, that lost subscription revenue due to the requirement to provide historical data for free will limit NRSROs' ability to innovate, and that industry competition will be undermined, particularly for smaller NRSROs who may be more dependent on subscription fees.[779] Among other benefits, the modification to the proposal—as discussed below—should address some of the practical and burden concerns raised by NRSROs.

The final amendments (as was proposed) require that the NRSRO publicly disclose the rating histories for free on an easily accessible portion of its corporate Internet Web site.[780] It also broadens the scope of credit ratings that will be subject to the disclosure requirements (as was proposed).[781] The objective is to require the disclosure of information about all outstanding credit ratings in each class and subclass of credit ratings for which the NRSRO is registered but within certain prescribed timeframes.

In addition to general burden concerns noted above, commenters raised significant concerns about the proposal to include all credit ratings that were outstanding as of June 26, 2007 and information about credit ratings that is more than three years old (that is, outside the record retention requirements of Rule 17g-2).[782] For example, one NRSRO stated that it may not have, or may find it difficult to obtain, the additional information required by the amendments.[783] A second NRSRO that generally supported the amendments also stated that NRSROs may not be able to provide XBRL information as of June 26, 2007, since those rating actions are beyond the scope of the 3-year record retention requirement.[784] A third NRSRO stated that—because it does not consider affirmations, confirmations, placement of credit ratings on watch or review, and assignment of default status to be credit rating actions and does not subdivide withdrawn ratings into the subcategories of withdrawn due to default, withdrawn because the obligation was paid in full, and withdrawn for “other” reasons—it does not capture that information in a format that is readily retrievable.[785] Consequently, the commenter recommended that the amendment exempt an NRSRO from providing historical data to the extent it does not already capture the data in a readily retrievable format.

The Commission is persuaded that the proposal raises legitimate practical concerns (for example, the additional information may not be available) and would impose a substantial burden. Accordingly, the final amendments have been modified from the proposal so that an NRSRO need only retrieve information that is no more than three years old.[786] In particular, under the final amendments, for a class of credit rating in which the NRSRO is registered with the Commission as of the effective date of the rule, the disclosure requirement applies to a credit rating in the class that was outstanding as of, or initially determined on or after, the date three years prior to the effective date of the rule.[787] Further, for a class of credit rating in which the NRSRO is registered with the Commission after the effective date of the rule, the disclosure requirement applies to a credit rating in the class that was outstanding as of, or initially determined on or after, the date three years prior to the date the NRSRO is registered in the class.[788] Consequently, an NRSRO that is registered in a particular class of credit ratings as of the rule's effective date will need to begin complying with the rule by disclosing information about all credit ratings in that class that were outstanding as of the date three years prior to the effective date or that were initially determined on or after that date, subject to the grace periods discussed below. After the effective date of the rule, a credit rating agency that becomes registered with the Commission as an NRSRO or an NRSRO that adds a class of credit ratings to its NRSRO registration will need to begin complying with the rule by disclosing information about all credit ratings in the classes for which it is registered that were outstanding as of the date three years prior to the registration date or that were initially determined on or after that date, subject to the grace periods. This aligns the retrieval requirement for all NRSROs regardless of when they are registered in a class of credit ratings.[789] It also substantially reduces the burden of adding past rating actions to the rating histories because the NRSRO will need to provide only Start Printed Page 55142three years of historical information initially, which should mitigate, to some degree, concerns about having to retrieve information that was not retained by the NRSRO.[790]

Under the proposal, if a credit rating was added to the rating histories disclosure either because it was outstanding as of June 26, 2007 or was initially determined on or after that date, the rating history for the credit rating needed to include every subsequent upgrade or downgrade of the credit rating (including a downgrade to, or assignment of, default), any placements of the credit rating on credit watch or review, any affirmation of the credit rating, and a withdrawal of the credit rating.[791] Several commenters raised concerns about the proposed types of rating actions that would trigger the disclosure requirements, including rating affirmations.[792] One NRSRO suggested that the disclosure rules apply only to initial ratings because subscription-based NRSROs will likely have significantly more rating actions, and the proposed rule may encourage these NRSROs to provide less frequent surveillance.[793] Another commenter stated that a rating affirmation should not be included in rating actions as the required disclosures may make NRSROs less likely to provide confirmations of credit ratings, which may make it impossible to amend transaction documents.[794] An NRSRO stated that including affirmations in rating actions would significantly increase the burden on NRSROs.[795] The commenter recommended that if affirmations were included, the Commission should state that the term affirmation refers only to a published announcement, or written communication in the case of a private or confidential credit rating, by an NRSRO that it is maintaining the credit rating at its current level, and that the term should not include any purely internal discussions by an NRSRO about a credit rating.

The Commission is persuaded by the comments that the types of rating actions triggering the disclosure requirement can be reduced and the 100% Rule can still meet the objective of allowing users of credit ratings and others to compare the performance of credit ratings among NRSROs and generate their own performance statistics. Consequently, to focus the disclosure on the rating actions that are most relevant to evaluating performance, the final amendments provide that the history of a credit rating must include, in addition to the initial credit rating or the initial entry of the credit rating into the history, any subsequent upgrade or downgrade of the credit rating (including a downgrade to, or assignment of, default) and a withdrawal of the credit rating.[796] These are the rating actions necessary to calculate transition and default rates. With this modification, the final amendments eliminate the requirement to include placements on watch and affirmations (and the required data associated with those actions) in the rating histories. In addition to reducing the burden of the rule, this may alleviate concerns that requiring NRSROs to disclose rating histories (even with the grace periods) may cause subscribers to stop paying for access to credit ratings or for downloads of credit rating actions and instead to use the disclosures of rating histories as a substitute for these types of subscriptions. For example, information about placements of credit ratings on watch and credit rating affirmations may be information that subscribers value as part of their subscriptions.

The final amendments (as was proposed) increase the information that must be disclosed about a rating action.[797] Specifically, paragraph (b)(2) of Rule 17g-7 specifies seven categories of data that must be disclosed with a rating action.[798] The objective of these enhancements is to make the disclosures more useful in terms of the amount of information provided, the ability to search and sort the information, and the ability to compare historical rating information across NRSROs.[799] As discussed below, the Commission has made some modifications to the required data categories in response to suggestions by commenters and to correspond to the modifications discussed above that change the scope of the credit ratings and rating actions covered by the disclosure requirement.

Paragraphs (b)(2)(i) and (ii) of Rule 17g-7 are being adopted as proposed.[800] Paragraph (b)(2)(i) identifies the first category of data that must be disclosed with each rating action: The identity of the NRSRO disclosing the rating action.[801] Because the NRSRO must assign an XBRL Tag to each item of information, including and tagging the identity of the NRSRO will assist users who download and combine data files of multiple NRSROs to sort credit ratings by a given NRSRO. Paragraph (b)(2)(ii) identifies the second category of data: The date of the rating action.[802] This will allow a person reviewing the credit rating histories of the NRSROs to reach conclusions about their relative capabilities in making appropriate and timely adjustments to their credit ratings.[803]

Paragraph (b)(2)(iii) of Rule 17g-7, as proposed, would identify the third category of data that must be disclosed: (1) The CIK number of the rated obligor; and (2) the name of the obligor.[804] Under the proposal, the information in this category would need to be disclosed only if the rating action is taken with respect to a credit rating of an obligor as an entity (as opposed to a credit rating of a security or money market instrument).[805]

Commenters raised concerns about requiring disclosure of the CIK number.[806] One NRSRO questioned the cost-effectiveness of the requirement and recommended that the requirement to provide CIK numbers be eliminated.[807] Another NRSRO stated that it was “unnecessarily burdensome” to require the use of identifiers that may become obsolete, that require NRSROs to pay a fee, or that may not be used outside the United States, as long as NRSROs “use some kind of identifier Start Printed Page 55143system sufficient to identify the rated obligor and obligation,” for example, “an internationally recognized LEI [Legal Entity Identifier] system.” [808]

The Commission believes that the use of an LEI can promote accuracy and standardization of NRSRO data, and therefore can further the purpose of allowing users of credit ratings to compare the performance of credit ratings by different NRSROs.[809] The effort to standardize a universal LEI has progressed significantly over the last few years, and an international standard was published by the International Organization for Standardization (“ISO”) in June 2012, which set out the elements of a working system.[810]

The Commission is modifying the proposal to require, with respect to a rating action involving a credit rating of an obligor as an entity, the disclosure of the obligor's LEI issued by a utility endorsed or otherwise governed by the Global LEI Regulatory Oversight Committee [811] or the Global LEI Foundation, if available, or, if the LEI is not available, the disclosure of the obligor's CIK, if available.[812] The Commission believes that having some method of identifying the obligor—in addition to its name—is appropriate as it will make the data searchable and comparable across NRSROs. Coded identifiers like the LEI and CIK will add a level of standardization to the credit rating history data, making for easier electronic querying and processing.

An NRSRO recommended not requiring inclusion of the legal name of the issuer because inconsistent use of abbreviations has made this problematic.[813] The Commission believes that the name of the obligor provides a more intuitive means of searching for a specific credit rating history in comparison to the LEI or CIK number. The Commission does not, however, view the LEI or CIK as a replacement for a name. For example, the user of the data can search for the name if the user does not know the LEI or CIK number. The Commission agrees with the commenter that requiring the specific legal name can be problematic. Consequently, the proposal has been modified to require the NRSRO to provide the obligor's “name” rather than “legal name.” [814] An NRSRO must disclose a name that clearly identifies the obligor and use that name consistently.[815] For these reasons, the final amendments require the disclosure of the obligor's name.[816]

Paragraph (b)(2)(iv) of Rule 17g-7, as proposed, would identify the fourth category of data to be disclosed with a rating action: (1) The CIK number of the issuer of the security or money market instrument; (2) the name of the issuer of the security or money market instrument; and (3) the CUSIP of the security or money market instrument.[817] The information in this category would need to be disclosed when the rating action is taken with respect to a security or money market instrument. The Commission is adopting paragraph (b)(2)(iv) of Rule 17g-7 with modifications from the proposal.

First, the paragraph requires an NRSRO to disclose the LEI of the issuer, if available, or, if an LEI is not available, the CIK number of the issuer, if available.[818] This will make paragraph (b)(2)(iv) consistent with paragraph (b)(2)(iii), which, as discussed above, requires the disclosure of the LEI of the obligor, if available, or, if an LEI is not available, the CIK number of the issuer, if available. Second, as adopted, the paragraph requires the NRSRO to disclose the “name” of the issuer, rather than the “legal name” as was proposed.[819] This also will make paragraph (b)(2)(iv) consistent with paragraph (b)(2)(iii).

The Commission is adopting the requirement to disclose the CUSIP of the security or money market instrument as was proposed.[820] One NRSRO stated that the cost of adding CUSIP data should be included in the Commission's cost-benefit analysis.[821] In response, the Commission notes that the requirement to disclose the CUSIP of the security or money market instrument was required by the 100% Rule before today's amendments.[822] When adopting the 10% Rule and the 100% Rule, the Commission considered the costs associated with the CUSIP requirement.[823] The Commission recognizes that the continued requirement to disclose the CUSIP number of the security or money market instrument subject to the rating action imposes licensing costs. However, without the CUSIP requirement, the disclosures could be of little utility as there would be no standard identifier with which to search for a specific security or money market instrument. This would make it difficult for users of the rating history disclosures to locate and compare the rating history for a given security or money market instrument. The Commission has balanced the cost of the requirement with the benefit of making the disclosures readily searchable and, therefore, enhancing their utility. For these reasons, the final amendments retain the CUSIP disclosure requirements.[824]

Paragraph (b)(2)(v) of Rule 17g-7, as proposed, would identify the fifth Start Printed Page 55144category of data to be disclosed with a rating action: A classification of the type of rating action.[825] Under the proposal, the NRSRO would be required to select one of seven classifications to identify the type of rating action.[826] In particular, the seven possible classifications were:

  • A disclosure of a credit rating that was outstanding as of June 26, 2007; [827]
  • An initial credit rating; [828]
  • An upgrade of an existing credit rating; [829]
  • A downgrade of an existing credit rating, which would include classifying the obligor, security, or money market instrument as in default, if applicable; [830]
  • A placement of an existing credit rating on credit watch or review; [831]
  • An affirmation of an existing credit rating; [832] or
  • A withdrawal of an existing credit rating and, if the classification is withdrawal, the reason for the withdrawal as: (1) The obligor defaulted, or the security or money market instrument went into default; (2) the obligation subject to the credit rating was extinguished by payment in full of all outstanding principal and interest due on the obligation according to the terms of the obligation; or (3) the credit rating was withdrawn for reasons other than those set forth in items (1) or (2) above.[833]

The Commission is adopting paragraph (b)(2)(v) of Rule 17g-7 with modifications. First, the final amendments eliminate the rating action classifications with respect to placing a credit rating on watch or review and with respect to affirming a credit rating.[834] As discussed above, the amendments do not require the rating histories disclosure to include these types of rating actions.

Second, paragraph (b)(2)(v)(A) of Rule 17g-7 has been modified.[835] As discussed above, this provision was designed to alert a user of the rating histories disclosure that the credit rating and related information about the credit rating was added to the history because of the requirement in the proposal to add all credit ratings outstanding as of June 26, 2007. The final amendments—as discussed above—modify this requirement from the proposal so that an NRSRO must include with each credit rating disclosed under paragraph (b)(1) of Rule 17g-7 a classification of the rating action, if applicable, as an addition to the rating history disclosure: (1) Because the credit rating was outstanding as of the date three years prior to the effective date of the requirements in paragraph (b) of Rule 17g-7; or (2) because the credit rating was outstanding as of the date three years prior to the date the NRSRO became registered in the class of credit ratings.[836] Consequently, paragraph (b)(2)(v)(A) of Rule 17a-7, as adopted, is modified to conform to this change.[837]

Paragraph (b)(2)(v)(E) of Rule 17g-7, as adopted, requires the NRSRO, in the case of a withdrawal, to classify the reason for the withdrawal as either: (1) The obligor defaulted, or the security or money market instrument went into default; (2) the obligation subject to the credit rating was extinguished by payment in full of all outstanding principal and interest due on the obligation according to the terms of the obligation; or (3) the credit rating was withdrawn for reasons other than those set forth in (1) and (2) above.[838] These sub-classifications parallel, in many respects, the outcomes identified in paragraphs (4)(B)(iii), (iv), and (v) of the instructions for Exhibit 1 to Form NRSRO discussed above in section II.E.1.b. of this release. However, unlike the instructions for Exhibit 1, the final amendments do not prescribe standard definitions of default and paid-off for the purposes of making these classifications in the rating histories disclosure. The rating histories disclosure requirement is designed to allow investors and other users of credit ratings to compare how each NRSRO treats a commonly rated obligor, security, or money market instrument. In other words, unlike the production of performance statistics where standard definitions are necessary to promote comparability of aggregate statistics, the historical rating information should indicate on a granular level the differences among the NRSROs with respect to the rating actions they take for a commonly rated obligor, security, or money market instrument, including their differing definitions of default. This will allow investors and other users of credit ratings to review, for example, when one NRSRO downgraded an obligor to the default category as compared to another NRSRO or group of NRSROs. Among other things, investors and other users of credit ratings could review the data to identify NRSROs that are either quick or slow to downgrade obligors, securities, or money market instruments to default. In addition, an NRSRO with a very narrow definition of default might continue to maintain a security at a notch in its rating scale above the default category when other NRSROs, using broader definitions, had classified the security as having gone into default. Creating a mechanism to identify these types of variances is a goal of the enhancements to the 100% Rule.

The Commission believes a default and the extinguishment of an obligation because it was paid in full are the most frequently occurring reasons for an NRSRO to withdraw a credit rating. As discussed above in section II.E.1. of this release, there are other reasons an NRSRO might withdraw a credit rating, including that the rated obligor or issuer Start Printed Page 55145of the rated security or money market instrument stopped paying for the surveillance of the credit rating or the NRSRO decided not to devote resources to continue to perform surveillance on the credit rating on an unsolicited basis. However, the withdrawal of credit ratings could be used to make performance statistics appear more favorable. Consequently, as with the Transition/Default Matrices in Exhibit 1 to Form NRSRO, an NRSRO would be required to identify when a credit rating was withdrawn for reasons other than default or the extinguishment of the obligation upon which the credit rating is based. Similar to the Transition/Default Matrices, persons using the rating history information could analyze how often an NRSRO withdraws a credit rating for other reasons in a class or subclass of credit ratings.

One NRSRO stated that it does not subdivide withdrawn ratings into the subcategories of: (1) Withdrawn due to default; (2) Withdrawn because the obligation paid in full; and (3) withdrawn for “other” reasons.[839] This NRSRO also stated that since it does not monitor withdrawn ratings, it could not certify with confidence that its performance statistics include all defaults with respect to withdrawn ratings, and requiring such monitoring might constitute regulation of the substance of an NRSRO's rating procedures. However, section 15E(q)(2)(C) of the Exchange Act requires that the Commission's rules require the disclosure of performance information for a variety of credit ratings, including for credit ratings withdrawn by an NRSRO.[840] As discussed above, the reason an NRSRO withdraws a credit rating is important information in terms of assessing the performance of an NRSRO's credit ratings. For these reasons, the final amendments retain the requirement to classify the reason for the withdrawal. In response to comment,[841] as stated above with respect to the amendments to the instructions for Exhibit 1 to Form NRSRO, the Commission is clarifying that the amendments as adopted do not require NRSROs to monitor withdrawn credit ratings for a period of time after withdrawal. A withdrawn credit rating is categorized at the time of withdrawal. There is no requirement to update the rating history thereafter.

Paragraph (b)(2)(vi) of Rule 17g-7, as proposed, would identify the sixth category of data that must be disclosed with a rating action: A classification of the class or subclass of the credit rating.[842] The Commission is adopting this paragraph as proposed.[843] The classifications for the classes of credit ratings are based on the definition of nationally recognized statistical rating organization in section 3(a)(62) of the Exchange Act.[844] Consequently, the first classification is financial institutions, brokers, or dealers.[845] The second classification is insurance companies.[846] The third classification is corporate issuers.[847]

The fourth classification is issuers of structured finance products.[848] If the credit rating falls into this class, the NRSRO must disclose which of the following sub-classifications it falls into: RMBS; [849] CMBS; [850] CLOs; [851] CDOs; [852] ABCP; [853] other asset-backed securities; [854] or other structured finance products.[855] The sub-classifications are the same subclasses for structured finance credit ratings an applicant and NRSRO must use for the purposes of the Transition/Default Matrices to be disclosed in Exhibit 1 to Form NRSRO.[856]

The fifth classification is issuers of government securities, municipal securities, or securities issued by a foreign government.[857] If the credit rating falls into this class, the final amendments require the NRSRO to identify a sub-classification as well.[858] The sub-classifications are the same as the sub-classifications for this class in the instructions for Exhibit 1 to Form NRSRO: (1) Sovereign issuers; (2) U.S. public finance; or (3) international public finance.[859]

Paragraph (b)(2)(vii) of Rule 17g-7, as proposed, would identify the seventh category of data that must be disclosed with a rating action: The credit rating symbol, number, or score in the applicable rating scale of the NRSRO assigned to the obligor, security, or money market instrument as a result of the rating action or, if the credit rating remained unchanged as a result of the action, the credit rating symbol, number, or score in the applicable rating scale of the NRSRO assigned to the obligor, security, or money market instrument as of the date of the rating action.[860] The NRSRO also would have to indicate whether the credit rating is in a default category. The Commission is adopting this paragraph as proposed.[861] The rating symbol, number, or score is a key component of the data that must be disclosed as it reflects the NRSRO's view of the relative creditworthiness of the obligor, security, or money market instrument subject to the rating as of the date the action is taken.

Paragraph (b)(3) of Rule 17g-7, as proposed, would provide that the information identified in paragraph Start Printed Page 55146(b)(2) of Rule 17g-7 must be disclosed in an interactive data file that uses an XBRL format and the List of XBRL Tags for NRSROs as published on the Internet Web site of the Commission.[862] One commenter stated that constantly updating the database for the 100% Rule “would impose an unwarranted burden on NRSROs” and requested that the Commission confirm that it may update the database monthly.[863] The Commission agrees that the rule should prescribe a standard timeframe within which the XBRL data file must be updated and that the standard should take into account the burden of updating the file. Consequently, the final amendments provide that the XBRL data file must be updated no less frequently than monthly consistent with the commenter's proposal.[864]

Paragraph (b)(4) of Rule 17g-7, as proposed, would specify when a rating action would need to be disclosed by establishing two distinct grace periods: Twelve months and twenty-four months.[865] In particular, a rating action would need to be disclosed: (1) Within twelve months from the date the action is taken, if the credit rating subject to the action was paid for by the obligor being rated or by the issuer, underwriter, depositor, or sponsor of the security being rated; [866] or (2) within twenty-four months from the date the action is taken, if the credit rating subject to the action is not a rating described above.[867] These separate grace periods are consistent with the requirements of the 100% Rule before today's amendments.[868] Commenters expressed opposing views on the appropriate length of the grace periods and whether there should be one grace period for all NRSROs.[869] One NRSRO stated that the grace periods are “appropriate.” [870] Another NRSRO stated that the Commission should consider a three-year grace period for rating histories of subscriber-paid credit ratings.[871] Two NRSROs were opposed to having two grace periods,[872] and one of these NRSROs stated that there should be an eighteen month grace period for all NRSROs “if the goal is to foster comparability among NRSROs.” [873] Another commenter was “disappointed” that the Commission was retaining the twelve and twenty-four month grace periods, because “such delay is excessive and severely diminishes the usefulness of the information.” [874]

The Commission believes that the twelve and twenty-four month grace periods strike an appropriate balance between the interests of users of credit ratings and the interests of NRSROs with various business models.[875] In particular, the longer grace period for NRSROs operating under the subscriber-paid business model is premised on the fact that the revenues earned by these NRSROs for their credit rating activities are derived largely from subscriptions to access their credit ratings and related analyses. NRSROs operating under the issuer-pay business model earn revenues largely from the fees paid by obligors and issuers to determine credit ratings for the obligor as an entity or for the issuer's securities or money market instruments. These issuer-paid credit ratings typically are publicly disclosed. For these reasons, subscriber-paid NRSROs would be disproportionately impacted if the rating histories disclosure requirement resulted in subscribers canceling subscriptions. Consequently, the Commission continues to believe the longer twenty-four month grace period is appropriate to limit the disproportionate impact on subscriber-paid NRSROs.

Finally, paragraph (b)(5) of Rule 17g-7, as proposed, would provide that an NRSRO may cease disclosing a rating history of an obligor, security, or money market instrument no earlier than twenty years after the date a rating action with respect to the obligor, security, or money market instrument is classified as a withdrawal of the credit rating, provided no subsequent credit ratings are assigned to the obligor, security, or money market instrument after the withdrawal classification.[876] This proposed requirement was designed to ensure that information about credit ratings that are withdrawn for any reason would remain a part of the disclosure for a significant period of time. Two NRSROs commented on this aspect of the proposal.[877] One NRSRO stated that ten years is sufficient, consistent with the Transition/Default Matrices in Exhibit 1 to Form NRSRO, and that the Commission should perform a cost/benefit analysis of the requirement periodically to confirm that the benefits outweigh the costs.[878] The other NRSRO stated that the information would become less useful to investors as the volume of information on withdrawn ratings increases.[879] The Commission agrees at this time that a shorter retention period is appropriate considering the costs and benefits of retaining rating histories with respect to withdrawn ratings. Consequently, the final amendments provide that the NRSRO may cease disclosing a rating history of an obligor, security, or money market instrument if at least fifteen years has elapsed since a rating action classified as a withdrawal of a credit rating pursuant to paragraph (b)(2)(v)(E) of Rule 17g-7 was disclosed in the rating history of the obligor, security, or money market instrument.[880]

4. Economic Analysis

This section builds on the economic analysis in section I.B. of this release by presenting a focused analysis of the potential economic effects that may derive from the specific amendments relating to the disclosure of information about the performance of credit ratings.[881] The baseline that existed before today's amendments was one in which NRSROs were required to make publicly available two types of information about the performance of their credit ratings: (1) Transition and default statistics; and (2) rating histories for certain subsets of the obligors, securities, and money-market instruments that they have rated.[882]

Before today's amendments, the instructions for Exhibit 1 required the applicant or NRSRO to provide performance statistics for the credit ratings of the applicant or NRSRO, Start Printed Page 55147including performance statistics for each class of credit ratings for which the applicant is seeking registration or the NRSRO is registered. In addition, the instructions required that the performance statistics must, at a minimum, show the performance of credit ratings in each class over one-year, three-year, and ten-year periods (as applicable) through the most recent calendar year-end, including transition and default rates within each of the credit rating categories, notches, grades, or rankings used by the applicant or NRSRO. Before today's amendments, the instructions for Exhibit 1 did not prescribe the methodology to be used to calculate the performance statistics or the format in which they must be disclosed; nor did the instructions limit the type of information that can be disclosed in the Exhibit. The instructions did, however, require an applicant or NRSRO to define the credit rating categories, notches, grades, or rankings it used and to explain the performance measurement statistics, including the inputs, time horizons, and metrics used to determine the statistics. Disclosures provided in Exhibit 2, which require a “general description of the procedures and methodologies used” by the NRSRO in determining credit ratings, may have provided additional context for comparing the performance statistics of different NRSROs. NRSROs made their most recent Forms NRSRO and Exhibits 1 through 9 to the forms available on their corporate Internet Web sites, though they were also permitted to make the disclosures publicly available through another comparable, readily accessible means. They were not required to provide Exhibit 1 in writing when requested.

NRSROs also voluntarily provided additional performance statistics in Exhibit 1 or elsewhere on their public Internet Web sites, such as transition and default statistics for particular asset sub-classes, geographies, or industries, or alternative analyses such as Lorenz curves. The voluntary disclosures of such statistics have varied, and some NRSROs, particularly larger ones, may have been able to provide more supplementary statistics at a granular level because they had more credit ratings, over a longer historical period, to analyze.[883]

In characterizing the baseline, it is useful to consider the performance statistics disclosed in NRSROs' annual certifications for the 2009 calendar year, as reviewed by the GAO in its 2010 report. While the disclosures from that year may not be representative of current NRSRO practices, they provide insight into NRSRO practices in 2009 under the rules governing the disclosure of performance statistics before today's amendments. Reviewing the 2009 disclosures of the ten NRSROs then registered, the GAO found significant differences across NRSROs in the computation of performance statistics, which limited their comparability.[884] These differences included, among other things: (1) Whether a single cohort approach or an average cohort approach was used; (2) whether or not statistics were adjusted to exclude withdrawn credit ratings; (3) whether default rates were indicated relative to initial credit ratings or credit ratings as of the beginning of a given period, and (4) whether default statistics were adjusted based on the time to default.[885] The GAO found that five NRSROs did not provide the number of credit ratings in each rating category, which made it impossible either to re-calculate more comparable statistics or to judge the reliability of the performance statistics.[886] The GAO also found that the asset-backed security class of credit ratings may have been too broad for performance statistics for this class as a whole to be meaningful.[887] The GAO concluded that “the disclosure of these statistics has not had the intended effect of increasing transparency for users.” [888]

Before today's amendments, the requirements for NRSROs to make certain rating histories publicly available (the 10% Rule and the 100% Rule) were contained in paragraphs (d)(2) and (d)(3) of Rule 17g-2, respectively. The 10% Rule applied only to NRSROs operating under the issuer-pays model, and required the disclosure of rating actions for a random 10% sample of outstanding credit ratings in each class in which an NRSRO was registered and for which the NRSRO had more than 500 issuer-paid credit ratings outstanding. The 100% Rule applied to all NRSROs, and required the disclosure of rating actions for any credit ratings initially determined by the NRSRO on or after June 26, 2007. Under both rules, the rating action information required to be disclosed was consistent with the information required to be retained pursuant to paragraph (a)(8) of Rule 17g-2. The rating actions that were required to be included in the histories were initial ratings, upgrades, downgrades, placements on credit watch, and withdrawals, and the information required to be disclosed for each such rating action was the rating action, date of the action, the name of the security or obligor, and, if applicable, the CUSIP of the security or CIK number of the obligor. The 10% Rule included a six-month grace period after ratings actions were taken before disclosure was required, while the 100% Rule included a twelve-month grace period for issuer-paid credit ratings and a twenty-four-month grace period for all other credit ratings. NRSROs made the required rating histories publicly available on their corporate Internet Web sites.

In characterizing the baseline, it is useful to consider, as in the case of performance statistics, the conclusions of the GAO in its 2010 report with respect to the disclosure of rating histories by NRSROs. While the disclosures from that period may not be representative of current NRSRO practices, the GAO study provides insight into NRSRO practices at the time of the report and into the limitations of the 10% Rule and 100% Rule before today's amendments. The GAO stated its view that the rating histories provided at that time could not be used to generate reliable performance statistics because, among other things: (1) The 10% samples were being generated in ways that did not make them representative of the total population of credit ratings produced by the NRSROs; (2) the 100% samples were also unrepresentative, because, for example, they were missing the issuer credit ratings of many major American corporations because these credit ratings were initiated before 2007; (3) the data fields provided were insufficient; and (4) not all NRSROs disclosed defaults in these histories.[889] The GAO also stated, Start Printed Page 55148in explaining why the 10% and 100% samples were unrepresentative of the universe of credit ratings, that these samples were not required to include credit ratings that had been withdrawn in prior periods, leading to a sample in which cases of defaults would be underrepresented.[890] The GAO concluded that it was unlikely that the required rating histories could be used to generate performance measures and studies to evaluate and compare NRSRO performance.[891]

Relative to the baseline, the amendments to the instructions for Exhibit 1 to Form NRSRO, Rule 17g-1, Rule 17g-2, and Rule 17g-7 with respect to the disclosure of performance statistics and rating histories should result in benefits for users of credit ratings. The amendments, which implement the provisions of section 15E(q) of the Exchange Act and, as discussed in sections II.E.1. and II.E.3. of this release, took into account findings by the GAO, should result in performance statistics that are more directly comparable across NRSROs and ratings histories that are more useful for performance analyses than those provided under the baseline requirements.[892] To the extent that the new disclosures therefore facilitate the evaluation of the performance of an NRSRO's credit ratings and comparisons of rating performance across NRSROs—including direct comparisons of different NRSROs' treatment of the same obligor or instrument—the amendments may benefit users of credit ratings by allowing them to better assess the reliability and information content of credit ratings from different NRSROs and, in the case of subscriber-paid credit ratings, make more informed decisions regarding whether to subscribe to the credit ratings of particular NRSROs.

Specifically, the amendments to the instructions for Exhibit 1 requiring a standardized calculation of performance statistics—using specified definitions and the single cohort approach—to be presented in a standardized format and specifying that an applicant or NRSRO must not disclose information in the Exhibit that is not required to be disclosed are expected to result in simpler, more standardized disclosures relative to the disclosures produced under the baseline requirements. Moreover, the single cohort approach involves simpler computations than other approaches, so it may be easier for users of credit ratings to understand how the statistics were produced. Also, requiring all NRSROs to use the single cohort approach ensures that the cohorts being analyzed will be aligned across NRSROs, increasing the comparability of the statistics versus other computation methods (such as the average cohort approach). The amendments therefore may allow users of credit ratings, including users with a wide range of sophistication, to more readily compare the performance of credit ratings of different NRSROs than they could previously. The new requirement to divide the class of issuers of asset-backed securities into subclasses and the requirement to separately disclose the number of credit ratings that are withdrawn because the obligation has been paid in full, because the obligor defaulted, and for other reasons, as well as to report the total number of credit ratings in the start-date cohort in each category, should provide users of credit ratings with additional information that may help them better interpret the transition and default rates for the purpose of evaluating and comparing performance.[893]

In addition, the new requirements that expand the scope of credit ratings that must be included in the rating histories should, over time, generate databases that will include a comprehensive sample of rating actions (in contrast to the data disclosed under the baseline requirements). The databases also will include information about cohorts of credit ratings beyond those reflected in the performance statistics disclosed in Exhibit 1. Thus, the enhanced rating histories can be used to generate alternative statistics for evaluating and comparing NRSRO performance, including certain transition and default statistics using average cohort approaches (though, as discussed below, these statistics will likely be based on fewer cohorts than were used by NRSROs that disclosed performance statistics in Exhibit 1 using the average cohort approach before today's amendments). Because the data will be more comprehensive than that disclosed in the baseline, it should also be more likely, relative to the baseline, that rating histories of different NRSROs with respect to the same obligor or instrument will be available. Therefore, users of credit ratings should have more opportunities to directly compare and analyze different NRSROs' treatment of the same obligor or instrument over time. The requirements regarding the enhanced data fields to be included with a rating action should make any analyses using the rating histories more practicable than was the case with the more limited data fields produced under the baseline requirements.[894]

However, the benefits of the amendments in facilitating the evaluation and comparisons of NRSROs may be constrained by limits on the information required by the final rules, which, as discussed in this section, are intended to reduce the burdens on NRSROs resulting from the amendments and, with respect to the performance statistics, make them easier for users of credit ratings to understand how the statistics were produced. For example, Start Printed Page 55149while mandating that only single cohort statistics be presented fosters comparability, the resulting disclosures will present the performance of only three particular cohorts of credit ratings (beginning one, three, and ten years prior to the end of the fiscal year). These statistics therefore may be subject to substantial volatility, particularly for NRSROs with fewer credit ratings.[895] The fact that the credit ratings of particular NRSROs may be more heavily weighted towards particular industries, geographies, or other sectors that might experience more defaults or other changes in creditworthiness over a particular measurement period also may exacerbate volatility in their performance statistics and make it difficult to separate differences in NRSRO performance from the effects of recent conditions.[896] NRSROs are only required to provide their current Form NRSRO on their Web sites, so users of credit ratings may not have access to previous Forms NRSRO in order to consider the cohorts analyzed in these other years.[897]

The rating histories may be helpful to users of credit ratings in addressing the limitations of the performance statistics both in that information about many additional cohorts may be available and also through the ability to directly compare NRSRO performance with respect to the same obligor or instrument. Such direct comparisons should not be skewed by the industry or sector focus of a given NRSRO. However, the final rules require only one or two years of history to be disclosed initially, depending on the applicable grace periods, so the benefits of these histories will be delayed until the histories grow to a length suitable for analysis. Also, as discussed below, even as data for additional years becomes available, the ability of NRSROs to remove a rating history from the data file fifteen years after the credit rating is withdrawn will limit the amount of historical information in the data file and, therefore, limit analyses by users of credit ratings that require a representative sample of credit ratings over an extended period of time. On the other hand, users of credit ratings that are interested in comparing NRSRO performance over time with respect to the same obligor or instrument should not face the same limitation and, therefore, should be able to take advantage of the full length of histories provided under the amendments.

A potential consequence of selecting one approach to be used for purposes of the Exhibit 1 disclosures is that it may impact the disclosures NRSROs make using other approaches. For example, even though the amendments require NRSROs to use the single cohort approach, NRSROs may continue on a voluntary basis to provide, not directly in Exhibit 1 but by reference to an Internet Web site address in this exhibit, disclosures of additional performance statistics such as statistics using the average cohort approach. These supplementary statistics may address some of the aforementioned limitations of statistics using the single cohort approach in that they may provide users of credit ratings with information about many more cohorts of credit ratings. However, NRSROs that previously disclosed average cohort statistics to fulfill their Exhibit 1 requirements might not continue to report these statistics voluntarily or might report them in an even less standardized fashion than previously (for example, for performance periods different from the one-year, three-year, and ten-year periods required in Exhibit 1). Importantly, NRSROs might be less likely to voluntarily disclose such additional statistics when they do not compare favorably to the performance of competitors.

The amendments may result in other benefits to users of credit ratings and NRSROs by enhancing accountability, competition, and efficiency. As has been widely documented, the most common NRSRO business model—the issuer-pay revenue model—creates an inherent conflict of interest.[898] Given this conflict, and because the demand for an NRSRO's credit ratings depends on its reputation for producing credit ratings of high quality, reputation is thought to play a particularly important disciplinary role in this industry.[899] To the extent that the amendments facilitate the external monitoring and comparative analysis of NRSROs, they may allow users of credit ratings to develop more refined views of NRSRO performance and thereby indirectly increase accountability and encourage integrity in the production of credit ratings, since NRSROs should have the incentive to maintain reputations for producing credit ratings of high quality in order to remain competitive. More comparable performance data also may help smaller NRSROs and new and recent entrants into the industry, including subscriber-paid NRSROs, to attract attention to their track records of issuing and monitoring credit ratings. If they produce track records comparable or superior to those of other NRSROs, this could enhance their ability to develop a reputation for producing high quality credit ratings. Such a reputation may allow them to better compete with more established competitors. The enhanced ability of users of credit ratings to evaluate the performance of NRSROs also may increase their ability to accurately interpret the information conveyed by credit ratings, potentially resulting in more efficient investment decisions. Market efficiency could also improve if this information is reflected in asset prices.[900]

The amendments to Rule 17g-1 and Rule 17g-7 requiring that these disclosures be published on an “easily accessible” portion of the NRSRO's Internet Web site could result in incremental benefits relative to the baseline. As mentioned above, the Commission agrees with commenters Start Printed Page 55150that the disclosures would be on an “easily accessible” portion of an NRSRO's Internet Web site if they could be accessed through a clearly and prominently labeled hyperlink labeled “Regulatory Disclosures” on the homepage of the Web site. Some NRSROs may already provide Form NRSRO, Exhibits 1 through 9 to the form, and rating histories in such a location. However, to the extent that these amendments result in NRSROs moving the disclosures to a more prominent location on their Internet Web sites to fulfill the requirement that they be “easily accessible,” they may incrementally assist users of credit ratings in locating these disclosures. Requiring that Exhibit 1 be made available in writing when requested may benefit any users of credit ratings who do not have access to the Internet.

Relative to the baseline, the amendments with respect to the disclosure of performance statistics and rating histories will impose costs on applicants and NRSROs. In particular, while all NRSROs currently disclose transition and default rates, the content and presentation of these performance statistics differ, to varying degrees, from the information required and the format prescribed by the rules. The revised requirements therefore will require the initial collection and analysis of certain additional historical data (for example, whether issuers or instruments defaulted under the standard definition) as well as changes in systems and procedures to collect and present this information according to the amendments going forward. The Commission's estimates of these costs—which are based on analyses for purposes of the PRA—are provided below.

Two NRSROs have commented that, in some cases, collecting certain historical information would require substantial cost or could be impossible.[901] The historical information required for the transition and default statistics which NRSROs may not have stored (or stored in a readily retrievable format) consists of, over a ten year history, the more detailed categorization of any withdrawn credit ratings and the assignment of credit ratings in the asset-backed securities class into sub-classes. As discussed above, the Commission has modified the amendments to reduce the amount of historical information that may need to be retrieved with respect to withdrawn credit ratings. In particular, the amendments provide that, except in the case of the asset-backed securities class of credit ratings, the transition and default statistics must include only credit ratings assigned to an obligor as an entity or, if there is no such credit rating, the credit rating of the obligor's senior unsecured debt, instead of all credit ratings of securities or money-market instruments in the respective class or subclass. The Commission has also revised the standard definition of paid off to eliminate the prong that applied to credit ratings of obligors as entities. Because the Commission has narrowed the scope of the credit ratings that must be included in the performance statistics for four of the five classes of credit ratings, and has revised the standard definition of paid off so that it does not apply to entity credit ratings, the cost of categorizing historical withdrawals based on the standard definitions of default and paid off and withdrawals for other reasons should be substantially reduced. The modifications from the proposal should therefore mitigate concerns to some degree about having to obtain information that was not traditionally retained by the NRSRO because it will significantly narrow the scope of such information that will need to be collected in order to calculate the performance statistics. While the Commission believes that these modifications may substantially reduce the amount of historical data to be collected, an NRSRO can seek exemptive relief from the Commission under section 36 of the Exchange Act.

The costs of the compliance efforts described above should vary across NRSROs due to: (1) Differences in the quantity of credit ratings they issue and the number of classes of credit ratings for which they issue credit ratings; (2) differences in terms of how their disclosures under the baseline requirements compare to the disclosures required under the amendments; (3) differences with respect to the historical information they currently store in a readily-retrievable format; (4) differences in the number of past years and number of historical credit ratings for which additional historical information will need to be collected; and (5) differences in the design and flexibility of their information systems. However, based on analysis for purposes of the PRA, the Commission estimates that the amendments to Exhibit 1 to Form NRSRO will result in total industry-wide one-time costs to NRSROs of approximately $737,000 and total industry-wide annual costs to NRSROs of approximately $295,000.[902]

Under the amendments to paragraph (i) of Rule 17g-1, NRSROs are required to make Form NRSRO and Exhibits 1 through 9 freely available on an easily accessible portion of their corporate Internet Web site and to provide a paper copy of Exhibit 1 to individuals who request a paper copy. NRSROs may need to re-configure their corporate Internet Web sites to comply with the amendments and will need to establish procedures and protocols for processing requests for a paper copy. Based on analysis for purposes of the PRA, the Commission estimates that the amendments to paragraph (i) of Rule 17g-1 will result in total industry-wide one-time costs to NRSROs of approximately $150,000 and total industry-wide annual costs to NRSROs of approximately $121,000.[903]

The amendments to the instructions for Exhibit 1 also may result in other costs to NRSROs. For some NRSROs, it is possible that using only the single cohort approach to produce the performance statistics in Exhibit 1 may lead users of credit ratings to misinterpret their performance, negatively impacting competition in the industry. Specifically, as discussed above, the single cohort approach will produce statistics about three particular cohorts of credit ratings and may thus be subject to volatility. Further, the statistics may be particularly volatile for certain NRSROs, such as those that have a small number of credit ratings in a given start date cohort or those that focus on particular industries, geographies, or other sectors within a class of credit ratings. The requirements of the final amendments (that is, showing the number of credit ratings in the start date cohort) are designed to provide persons reviewing the statistics with sufficient information to readily assess the impact that a small number of credit ratings can have on the statistics. Also, the disclosure of ratings histories should permit more refined comparisons of performance in cases where differences in performance statistics may reflect differences in the universe of obligors or instruments rated Start Printed Page 55151by NRSROs. However, some persons reviewing the transition and default rates could inappropriately view the volatility resulting from such factors unfavorably, potentially disadvantaging these NRSROs relative to the baseline to the extent that their reputation for producing quality credit ratings is negatively affected. The competitive position of small NRSROs may be further disadvantaged by the burden associated with establishing systems to produce the statistics, since this cost may not depend on the number of credit ratings in the start-date cohorts and thus may result in a higher relative burden for small NRSROs.[904]

Under the baseline requirements, NRSROs publicly disclosed certain rating histories data to fulfill the requirements of the 10% Rule and the 100% Rule, but the sample of credit ratings subject to the disclosure, the rating actions disclosed, the extent of the histories, and the included data fields differ, to varying degrees, from those required by the amendments. The amendments may thus require NRSROs to add more rating histories to their disclosures because in contrast to the baseline requirements the amendments: (1) Apply to all credit ratings outstanding as of the specified date or initiated thereafter rather than a random sample of credit ratings; (2) do not exclude credit ratings that were outstanding as of the specified date but initiated before June 26, 2007; and (3) require the rating histories of withdrawn ratings to be retained in the file for fifteen years. Also, the amendments will require NRSROs to revise which rating actions are included and to provide more information about each rating action in the rating histories. NRSROs initially will have to collect additional historical data and edit the history files to meet these requirements. Some of the required information which might not have been collected previously—such as the categorization of credit ratings in the asset-backed securities class into sub-classes—will be retrieved in the process of complying with the amended instructions for Exhibit 1 to Form NRSRO discussed above. NRSROs also will have to reprogram existing systems and make changes in procedures to collect and upload the information according to the amendments going forward. NRSROs may have to make changes to their corporate Internet Web sites to disclose the information on an “easily accessible” portion of their Web sites, though the incremental changes required beyond the Web site changes to disclose Form NRSRO discussed above may be minimal. On an ongoing basis, the cost of the procedures required to update the rating histories files at least monthly may exceed the annual burden previously imposed by the 10% Rule (which is being repealed) and the 100% Rule before today's amendments, given the comprehensive nature of the data required. The Commission's estimates of these costs—which are based on analyses for purposes of the PRA—are provided below.

One commenter stated that the Commission “substantially underestimated the costs” of the proposed amendments to the 100% Rule in the proposing release.[905] Two other commenters raised concerns that retrieving the required historical data would require substantial cost or could be impossible.[906] The Commission acknowledges that the amendments will impose significant costs on NRSROs, and has modified the proposal in a number of ways to mitigate costs. First, the final amendments eliminate the requirement to include information for all credit ratings outstanding on June 26, 2007, and replace it with a standard three-year backward-looking requirement that applies irrespective of when the NRSRO is registered in a class of credit ratings. This should significantly reduce the costs of retrieving and analyzing historical information for the purposes of making the rating histories disclosures. Further, the final amendments eliminate two types of rating actions that would trigger a requirement to add information to a credit rating's history: Placements of the credit rating on watch or review and affirmations of the credit rating. This may further reduce the cost of retrieving the historical information that must be disclosed in the rating histories, since a record of an affirmation of the credit rating may not previously have been stored (or stored in a readily retrievable format) by NRSROs. Consequently, because of these modifications, NRSROs should not need to perform analyses to identify historical affirmations and reconstruct the information that would need to have been disclosed under the proposal in connection with each affirmation of the credit rating (for example, the date of the action). The remaining information that is required to be disclosed, but may not have been systematically stored by NRSROs previously (such as the required categorization of the reason for a withdrawal), generally will need to be collected only once for each rating history rather than for multiple rating actions within a history, as each rating history should, for example, have only one withdrawal (whereas a history could have multiple affirmations of the credit rating). The narrowing of the scope of the types of rating actions that are required to be included in the rating histories also should reduce the burden of updating the XBRL data file with new information in the future. While the Commission believes the modifications discussed above may substantially reduce the costs of retrieving historical data, an NRSRO can seek exemptive relief from the Commission under section 36 of the Exchange Act. The amendments also specify a standard for updating the file—no less frequently than monthly. This should mitigate concerns that the file would need to be updated more frequently. Finally, the final amendments modify the proposal to reduce the time period a credit rating history must be retained after the credit rating is withdrawn from twenty years to fifteen years. This should reduce the data retention and maintenance costs associated with the amendments compared to the proposal.

The costs of the compliance efforts described above with respect to the amended requirements for disclosing rating histories should vary across NRSROs due to: (1) Differences in the quantity of credit ratings they issue and have issued in the historical years subject to disclosure; (2) differences in the data fields that they currently include in their rating histories; (3) differences with respect to the historical information they currently store in a readily-retrievable format; and (4) differences in the design and flexibility of their information systems. However, based on analysis for purposes of the PRA, the Commission estimates that the amendments to Rule 17g-2 and paragraph (b) of Rule 17g-7 will result in total industry-wide one-time costs to NRSROs of approximately $393,000, and total industry-wide annual costs to NRSROs of approximately $131,000.[907]

One commenter stated that the proposed amendments “may force NRSROs to incur increased licensing Start Printed Page 55152costs to add new CUSIP data.” [908] The CUSIP Global Services' license fees may vary based on the level of usage (that is, the number of CUSIPs databased and the licensees' business lines and regions of operation where the data will be used) and the form of usage (such as the internal databasing of CUSIP data or the distribution of CUSIP data).[909] The Commission believes that most NRSROs already have licensing agreements in place for their current usage of CUSIP data, but it is possible that these baseline licensing agreements may need to be expanded given the additional CUSIP data that may have to be stored and disclosed to comply with the amendments. The comment letter that highlighted these potential costs did not provide an estimate of these costs and did not provide data or analysis that would allow the Commission to estimate how NRSROs' CUSIP licenses would need to be changed to account for the new requirements.[910] Without information about the scope of the NRSROs' current licenses and the cost of obtaining updated licenses, it is not feasible for the Commission to develop an estimate of any such costs.[911]

Another potential cost to NRSROs is the potential loss of revenue from the sale of access to historical ratings data, as more of this data becomes publicly available. The Commission understands that revenue from this source may be significant for certain NRSROs, though commenters did not provide data or analysis that would allow the Commission to estimate the amount of revenue that could be lost.[912] The Commission is unable to estimate the revenue attributable to the sale of access to historical ratings data from other sources because the information about NRSRO revenues available to the Commission is not broken down at this level of granularity and, in practice, access to such historical data may be bundled with access to analytical tools and other services. This potential loss of revenue may be mitigated by the grace periods before disclosure, the fact that historical information before the three-year look-back period is not required to be disclosed, the exclusion of placements on credit watch and affirmations from the rating actions that must be disclosed in the public rating histories,[913] and the ability to remove a rating history from the public data file fifteen years after the credit rating is withdrawn. However, it is difficult to predict how subscribers will react to the change in the extent of publicly available data.

Because any such losses in revenue likely would disproportionately affect NRSROs that are more dependent on revenue from selling access to historical ratings data, and particularly NRSROs that operate on the subscriber-pay model, the disclosure requirement may disadvantage these NRSROs to the detriment of competition in the industry. Additional impacts on competition may result from the disproportionate burden on small NRSROs, given that some of the compliance costs are not likely to vary with size, and on NRSROs that have systems and data collection procedures that vary the most from the requirements of the amendments.

In addition to these effects, the amendments may affect capital formation. Some academic research indicates that credit rating agencies should not focus exclusively on ratings accuracy, but also should consider the feedback effects of their credit ratings on the probability of survival of an issuer.[914] Specifically, these theories suggest that if credit ratings can directly affect the default probability of an issuer, such as when a ratings downgrade itself makes it harder or more costly for a company to raise funds, then it may be optimal for credit rating agencies to delay credit rating downgrades in order to lessen the impact of such feedback on the company's prospects. If the adopted rules drive increased transparency with respect to performance, and this leads to pressures on NRSROs to assign more accurate credit ratings by making earlier downgrades, the amplified feedback effects could increase the default frequencies of issuers and other obligors.[915]

The Commission has considered the costs and benefits of reasonable alternatives relative to today's amendments, including certain alternatives that have been raised by commenters and discussed above. One NRSRO requested that the Commission provide “fuller background” on decisions such as the determination to require the single cohort approach rather than an average cohort approach for performance statistics, with a description of potential benefits and limitations of those decisions.[916] As an alternative to the single cohort approach, the Commission could have required NRSROs to use the average cohort approach, or to present two sets of statistics using the average and single cohort approaches respectively, as suggested by commenters.[917] Statistics generated using the average cohort approach would provide information to users of credit ratings that is not available from statistics generated using the single cohort approach, specifically with regard to how credit ratings perform on average across a wider variety of economic conditions. Such information may be of use to users of credit ratings in evaluating and comparing the performance of NRSROs. However, variation in the length of histories available at the different NRSROs makes it difficult to produce a standardized methodology for computing average cohort statistics that would be comparable across NRSROs. Also, because the single cohort approach requires simpler calculations, it may be less burdensome for NRSROs to produce such statistics and easier for less sophisticated investors to understand how such performance measurement statistics were produced. As discussed above, NRSROs will continue to be permitted to present alternative statistics on a voluntary basis on their public Web sites, and by reference to a URL in Exhibit 1.

A second alternative with respect to the performance statistics would be to require the disclosure of withdrawn credit ratings, without requiring that this category be separated into credit ratings that were withdrawn because the related obligation was paid off, because the obligor defaulted, or for other reasons. This alternative would be less burdensome than the approach in the amendments, because, as discussed by Start Printed Page 55153two commenters,[918] NRSROs that have not tracked this information historically likely would incur costs to collect the required information retroactively and change their systems to collect and report this information going forward. However, given that an applicant or NRSRO could withdraw a credit rating to make its transition or default rates appear more favorable, information about the reasons for withdrawal is likely to be useful to users of credit ratings in interpreting the performance statistics.

An alternative approach to the amendments regarding rating histories would be to require the inclusion of placements on credit watch in the rating histories, while still excluding ratings affirmations, which would be consistent with the rating actions subject to disclosure in histories under the baseline requirements. Among the three commenters that recommended that the scope of rating actions included in public rating histories be narrowed, two did not raise concerns about the inclusion of placements on credit watch.[919] Academic research has found that credit watch announcements are associated with abnormal stock and bond returns, indicating that placing a rating on credit watch is a significant information event.[920] Including these announcements in rating histories would thus allow persons to, for example, judge which NRSROs have historically been more likely to provide, and more timely at providing, this information to the users of credit ratings, and thus may increase the accountability, time sensitivity, and judiciousness of NRSROs in placing credit ratings on credit watch. However, while making information about placements on credit watch publicly available in the rating histories may benefit users of credit ratings that value this information, the fact that some users of credit ratings may value this information also means that excluding such information from rating histories may make subscribers to NRSRO services that include access to historical ratings data (including placements on credit watch) somewhat less likely to stop subscribing as an increasing amount of historical ratings data becomes publicly available. The Commission therefore believes that excluding placements on credit watch from the rating histories may reduce potential losses in NRSRO revenues from services that include access to their credit ratings and/or rating histories while still permitting users of credit ratings to use the public rating histories to conduct certain analyses (such as calculating alternative transition and default statistics) to evaluate and compare NRSRO performance.

Additional alternatives with respect to rating history disclosure would be to not permit a rating history for a credit rating to be removed from the data file fifteen years after the credit rating is withdrawn, or to shorten the retention period to ten years as suggested by a commenter.[921] Under the first alternative, the retention period could be substantially increased or a history could be required to be retained permanently. In particular, because the amendments allow credit ratings to be removed from the histories fifteen years after they are withdrawn, any data that becomes available for periods over fifteen years in the past will not reflect a representative sample of the credit ratings of the NRSRO, since withdrawn credit ratings, including credit ratings withdrawn because of default, will be underrepresented in the sample of outstanding credit ratings in the rating histories for a period that is more than fifteen years in the past.[922] Thus, the data files disclosed pursuant to the amendments will over time result in no more than fifteen years (and likely no more than thirteen or fourteen years, given the permitted grace periods) of data that is fully comprehensive and can therefore be used to calculate performance statistics or perform other analyses that require a representative sample of credit ratings. The data will, over time, become sufficient to produce, for example, five-year and twelve-year performance statistics using the single cohort approach or, for example, three-year performance statistics using the average cohort approach applied to the eleven annual cohorts beginning thirteen years ago. However, performance statistics using the data from ratings histories will be limited to cohorts of credit ratings over these thirteen or fourteen years of history and thus may not reflect as wide as a variety of economic conditions as may be desired.

Increasing the retention period would therefore benefit users of credit ratings interested in using the rating histories to perform analyses that require a representative sample of the credit ratings of the NRSRO outstanding as of a date or a series of dates that are more than thirteen or fourteen years in the past. However, as in the case of excluding data with respect to placements on credit watch, applying a shorter retention period may reduce potential losses to NRSROs of revenue from selling access to historical ratings data. Also, one NRSRO stated that “the amount of data storage required” to comply with a twenty-year retention requirement for the public rating histories “would be considerable.” [923] The Commission therefore believes that a fifteen-year retention requirement may reduce the burden on NRSROs, while still permitting users of credit ratings to use the public rating histories to conduct certain analyses (such as transition and default statistics that require up to thirteen or fourteen years of data, or comparisons over longer horizons of NRSRO performance with respect to the same obligor or instrument) to evaluate and compare NRSRO performance.

For these reasons, the Commission also does not believe it would be appropriate to shorten the retention period to ten years as suggested by one commenter.[924] A ten year retention period (rather than a fifteen year retention period) would further limit the utility of the rating histories in terms of being able to use the data to generate performance statistics that are different than the performance statistics that must be disclosed in Exhibit 1 to Form NRSRO.

A further alternative for rating history disclosure would be to increase or decrease the grace periods relative to the twelve- and twenty-four-month grace periods that are permitted for issuer-paid and other credit ratings respectively under the amendments. Longer permitted grace periods likely would reduce potential losses experienced by NRSROs in revenues Start Printed Page 55154from services that include access to their credit ratings and/or rating histories. However, shorter grace periods would increase the benefits from the disclosure by making more, and more timely, information available to users of credit ratings for the purpose of evaluating and comparing the performance of NRSROs. The Commission believes it has appropriately balanced the costs and benefits of increasing or decreasing the grace periods in setting the grace periods permitted under the amendments.

F. Credit Rating Methodologies

Section 932(a)(8) of the Dodd-Frank Act amended section 15E of the Exchange Act to add subsection (r).[925] Section 15E(r) of the Exchange Act provides that the Commission shall prescribe rules, for the protection of investors and in the public interest, with respect to the procedures and methodologies, including qualitative and quantitative data and models, used by NRSROs that require each NRSRO to ensure that objectives identified in section 15E(r) are met.[926] The Commission proposed to implement section 15E(r) in large part, through paragraph (a) of Rule 17g-8, which would require an NRSRO to establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure it meets the objectives identified in section 15E(r).[927] The intent was to provide flexibility for an NRSRO to establish policies and procedures that can be integrated with its procedures and methodologies for determining credit ratings, which vary across NRSROs.[928] The proposed approach also was sensitive to the limitation in section 15E(c)(2) of the Exchange Act, given that the objectives set forth in section 15E(r) of the Exchange Act relate to the procedures and methodologies an NRSRO uses to determine credit ratings.[929] The Commission also proposed an amendment to Rule 17g-2 to apply the record retention and production requirements of that rule to the documentation of the policies and procedures that would be required under proposed paragraph (a) of Rule 17g-8.[930]

1. Paragraph (a) of New Rule 17g-8

As proposed, paragraph (a) of Rule 17g-8 would require an NRSRO to establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure that it achieves the objectives identified in section 15E(r) of the Exchange Act.[931] In particular, the prefatory text of paragraph (a) would require an NRSRO to establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure that it meets the objectives identified in paragraphs (a)(1), (2), (3), (4), and (5).[932] The rule text in proposed paragraphs (a)(1), (2), (3), (4), and (5) of Rule 17g-8 largely mirrored the statutory text of section 15E(r) of the Exchange Act.[933]

The Commission is adopting the prefatory text of paragraph (a) of Rule 17g-8 as proposed.[934] The final rule requires an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that it meets the objectives identified in paragraphs (a)(1), (2), (3), (4), and (5) of the rule.

One commenter stated that the proposal appropriately recognizes that procedures and methodologies vary across NRSROs and thus there is a need for flexibility to establish policies and procedures that can be integrated with the NRSRO's existing credit rating methodologies.[935] Some commenters expressed general opposition to the proposal on the basis of cost.[936] One of these commenters stated that certain aspects of the proposals, including those regarding credit rating methodologies, would compound barriers to entry, and that many of the rules would be expensive and burdensome to implement.[937] More specifically, this commenter stated that the Commission should take into account the dominance of very large players and expand exemptions for small NRSROs designed to level the competitive field.[938]

In response, the Commission notes that the final rule is designed to meet the rulemaking mandate of section 15E(r) of the Exchange Act in a manner that provides flexibility to NRSROs to design the required policies and procedures. Consequently, an NRSRO can tailor and scale its policies and procedures to its business model, size, and the scope of its activities as well as to its procedures and methodologies for determining credit ratings, which should mitigate concerns to some degree about the costs of the final rule and its potential to create barriers to entry for small credit rating agencies. The Commission also believes that the policies and procedures required under section 15E(r), as implemented by the Commission in paragraph (a) of Rule 17g-8, will promote the integrity and transparency of the procedures and methodologies NRSROs use to determine credit ratings by, for example, Start Printed Page 55155promoting board oversight of these procedures and methodologies and requiring disclosure when material changes are made to them. Nonetheless, as discussed below in the economic analysis, the Commission acknowledges that these requirements will result in costs and that those costs could create competitive barriers.

As proposed, paragraph (a)(1) of Rule 17g-8 would implement section 15E(r)(1)(A) of the Exchange Act.[939] This section identifies the objective of ensuring that credit ratings are determined using procedures and methodologies, including qualitative and quantitative data and models, that are approved by the board of the NRSRO, or a body performing a function similar to that of a board.[940] Paragraph (a)(1), as proposed, would require an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that credit ratings are determined using procedures and methodologies, including qualitative and quantitative data and models, that are approved by the board of the NRSRO, or a body performing a function similar to that of a board.[941] The Commission intended this requirement to operate in conjunction with section 15E(t)(3)(A) of the Exchange Act, which establishes a statutory requirement that the board of an NRSRO “shall oversee” the establishment, maintenance, and enforcement of the policies and procedures for determining credit ratings.[942]

The Commission is adopting paragraph (a)(1) of Rule 17g-8, as proposed.[943] The final rule requires an NRSRO to have policies and procedures that are reasonably designed to ensure that the procedures and methodologies it uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.[944] In relation to this requirement in paragraph (a)(1), section 15E(t)(3)(A) of the Exchange Act (as discussed above) contains a self-executing requirement that the board of an NRSRO “shall oversee” the “establishment, maintenance, and enforcement of the policies and procedures for determining credit ratings.” [945] Consequently, as discussed in the proposing release, the policies and procedures required pursuant to paragraph (a)(1) of Rule 17g-8, as adopted, must be reasonably designed to ensure that the NRSRO's board carries out this statutorily mandated responsibility.[946] In addition, section 15E(t)(5) of the Exchange Act provides that the Commission may permit an NRSRO to delegate responsibilities required in section 15E(t) to a committee if the Commission finds that compliance with the provisions of that section present an unreasonable burden on a small NRSRO.[947] In this case, the policies and procedures required pursuant to paragraph (a)(1) of Rule 17g-8, as adopted, must be reasonably designed to ensure the NRSRO's committee carries out the responsibility to oversee the establishment, maintenance, and enforcement of the NRSRO's procedures and methodologies for determining credit ratings.[948]

One commenter stated that the proposal appropriately meets the Exchange Act mandate.[949] Another commenter cited the high costs associated with having an independent board and stated that given those high costs the scope of board functions should not be inadvertently expanded.[950] This commenter also stated that it would have been helpful for the final rule to provide greater guidance to confirm that the board is not required to approve or pass judgment on, for example, “qualitative and quantitative data and models.” [951] A second commenter stated that a periodic approval process is more consistent with the board of directors' oversight role and provides the board of directors a better opportunity to provide well-planned and meaningful guidance that would be better at creating consistency in best practices across the NRSRO.[952] A third commenter stated that responsibility for the development of ratings criteria, methodologies, and models “should be in the hands of experienced ratings professionals” and that the board should be responsible for approving the policies and procedures that are used to develop the NRSROs' criteria, methodologies, and models.[953] The commenter did not interpret the proposal to require the board to approve the criteria, methodologies, or models themselves, stating that any such requirement would not be feasible given the vast amounts of continually developing criteria used by NRSROs.[954]

In response to the comments, the Commission notes that section 15E(t)(3)(A) of the Exchange Act provides that the board of an NRSRO shall oversee the establishment, maintenance, and enforcement of policies and procedures for determining credit ratings.[955] Consequently, the self-executing requirement in the statute governs the responsibility of the board. Paragraph (a)(1) of Rule 17g-8 governs the responsibility of the NRSRO to have policies and procedures reasonably designed to ensure that the board carries out this responsibility. In terms of complying with the statutory requirement to oversee rating policies and procedures, the Commission recognizes that the board cannot be involved in managing the day-to-day affairs of the NRSRO. There must be an appropriate balance between the board's responsibilities as a governing body and the responsibilities of the NRSRO's managers as supervisors of the daily activities of the NRSRO. As a practical matter, an NRSRO will need to appropriately allocate responsibilities to the NRSRO's board and to the NRSRO's managers with respect to the implementation of rating procedures and methodologies, with the board exercising its statutory responsibility to oversee the establishment, maintenance, and enforcement of the NRSRO's policies and procedures for determining credit ratings. Consequently, the Commission does not expect board members to undertake the detailed work of developing rating procedures and methodologies.

Further, as discussed above, section 15E(t)(5) of the Exchange Act provides exception authority under which the Commission may permit an NRSRO to delegate responsibilities of the board required in section 15E(t) to a committee if the Commission finds that compliance with the provisions of that section present an unreasonable burden on a small NRSRO.[956] The ability to request an exception under section 15E(t)(5) provides a means for a small NRSRO to seek relief to delegate Start Printed Page 55156responsibilities to a committee if the potential costs and burdens associated with the requirements of section 15E(t) of the Exchange Act—including the requirement that the board oversee the establishment, maintenance, and enforcement of the policies and procedures for determining credit ratings—are an unreasonable burden.[957]

Commenters also questioned whether the board of directors would need to have members with expertise in rating methodologies.[958] One of these commenters stated that the rule should require the NRSRO to appoint at least one board member with quantitative financial analysis expertise.[959] Section 15E(t)(3)(A) of the Exchange Act, while mandating that the NRSRO's board must “oversee” the establishment, maintenance, and enforcement of the NRSRO's policies and procedures for determining credit ratings, does not address whether the board must include a member with specific expertise in this area.[960] Similarly, section 15E(r)(1)(A) of the Exchange also does not address board expertise and, consequently, neither does paragraph (a)(1) of Rule 17g-8.[961] In complying with the statute and rule, an NRSRO and its shareholders will need to strike an appropriate balance between board members who have generalized experience and those who have more specific experience with aspects of the NRSRO's business activities, including with rating methodologies.

Paragraph (a)(2) of Rule 17g-8, as proposed, would implement section 15E(r)(1)(B) of the Exchange Act.[962] This section identifies the objective of ensuring that credit ratings are determined using procedures and methodologies, including qualitative and quantitative data and models, that are in accordance with the policies and procedures of the NRSRO for the development and modification of credit rating procedures and methodologies.[963] As proposed, paragraph (a)(2) would require an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the procedures and methodologies, including qualitative and quantitative data and models, that the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO.[964]

The Commission is adopting paragraph (a)(2) of Rule 17g-8 as proposed.[965] Section 15E(c)(3)(A) of the Exchange Act requires an NRSRO to “establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings.” [966] Consequently, section 15E(c)(3)(A) establishes a statutory requirement that an NRSRO have an internal control structure that governs the implementation of rating procedures and methodologies.[967] In addition, paragraph (a)(2) of Rule 17g-8 establishes a complementary requirement that an NRSRO have policies and procedures reasonably designed to ensure that rating procedures and methodologies are developed and modified in accordance with the NRSRO's procedures for developing and modifying rating procedures and methodologies.[968]

Two commenters supported the proposal.[969] In contrast, one commenter suggested the Commission take a different approach than was proposed in paragraph (a)(2) of Rule 17g-8.[970] Specifically, this commenter recommended that the rule establish a “committee assessment function” devoted to analyzing the performance of rating committees.[971] In response, the Commission notes that the rulemaking mandate in section 15E(r)(1)(B) of the Exchange Act addresses ensuring that the NRSRO uses rating procedures and methodologies that are in accordance with the NRSRO's procedures and methodologies for developing and modifying such procedures and methodologies.[972] In other words, the statute is concerned with ensuring that the NRSRO follows its processes for developing and modifying rating procedures and methodologies. The commenter's suggestion for a committee assessment function addresses the performance of rating committees in determining credit ratings (that is, in applying the rating procedures and methodologies). Consequently, the Commission considers the commenter's proposal outside the scope of this rulemaking.

Paragraph (a)(3)(i) of Rule 17g-8, as proposed, would implement section 15E(r)(2)(A) of the Exchange Act.[973] This section identifies the objective of ensuring that, when material changes are made to rating procedures and methodologies (including changes to qualitative and quantitative data and models), the changes are applied consistently to all credit ratings to which the changed procedures and methodologies apply.[974] As proposed, paragraph (a)(3)(i) would require an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that material changes to the procedures and methodologies, including changes to qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are applied consistently to all credit ratings to which the changed procedures and methodologies apply.[975]

Paragraph (a)(3)(ii) of Rule 17g-8, as proposed, would implement section 15E(r)(2)(B) of the Exchange Act.[976] This section identifies the objective of ensuring that when material changes are made to rating procedures and methodologies (including changes to qualitative and quantitative data and models), to the extent that changes are made to credit rating surveillance procedures and methodologies, the changes are applied to then-current credit ratings by the NRSRO within a reasonable time period determined by the Commission, by rule.[977] As proposed, paragraph (a)(3)(ii) would require an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that material changes to the procedures and methodologies, including changes to qualitative and Start Printed Page 55157quantitative data and models, the NRSRO uses to determine credit ratings are, to the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to then-current credit ratings within a reasonable period of time taking into consideration the number of ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.[978] The proposed rule text differed from the text of section 15E(r)(2)(B) of the Exchange Act because it provided that the changes must be applied to then-current credit ratings within a reasonable period of time taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.[979]

The Commission is adopting paragraphs (a)(3)(i) and (ii) of Rule 17g-8 with modifications to paragraph (a)(3)(i) to clarify the requirements of the rule in response to comment.[980] Specifically, one commenter stated that the provision appropriately meets the requirements of the Exchange Act but asked the Commission to clarify that paragraph (a)(3)(i) is applicable only to changes to procedures and methodologies that may impact new credit ratings, and that the implementation of changes affecting existing ratings are addressed separately in paragraph (a)(3)(ii).[981] The commenter's interpretation of paragraph (a)(3)(i) is incorrect. The Commission intended this paragraph to address the procedures and methodologies an NRSRO uses to determine new credit ratings and to make adjustments to current credit ratings. Otherwise, the policies and procedures required under paragraph (a)(3)(i) would not address the consistent treatment of current credit ratings. However, to remove any ambiguity, the text of paragraph (a)(3)(i) has been modified to clarify that the paragraph applies to “current and future credit ratings.” [982]

Another commenter questioned whether the provision was appropriate given the commenter's view that an NRSRO cannot ensure that changes are applied consistently to all credit ratings to which the changed procedures and methodologies apply because qualitative assessments differ from credit rating committee to credit rating committee.[983] The Commission acknowledges that rating procedures and methodologies commonly incorporate qualitative analysis that introduces a degree of subjectivity to the rating process. The final rule is not intended to interfere with the qualitative process that is part of determining a credit rating. Rather, it is designed to ensure that an NRSRO does not apply different rating procedures and methodologies when determining credit ratings with respect to types of obligors or obligations that are intended to be subject to the same rating procedures and methodologies. If, for example, an NRSRO changes a rating procedure or methodology for determining initial credit ratings for RMBS, the policies and procedures of the NRSRO must be reasonably designed to ensure that the NRSRO does not continue to use the old procedure or methodology to determine initial credit ratings for some RMBS and the new procedure or methodology to determine initial credit ratings for other RMBS.[984]

The Commission is making modifications to paragraph (a)(3)(ii) of Rule 17g-8 from the rule text as proposed.[985] As stated above, one commenter asked the Commission to clarify that paragraph (a)(3)(i) is applicable only to changes to procedures and methodologies that may impact new credit ratings, and that the implementation of changes affecting current ratings are addressed separately in paragraph (a)(3)(ii).[986] As discussed above, the commenter's interpretation of paragraph (a)(3)(i) was not correct and the paragraph has been modified to clarify that it applies to current and future credit ratings. However, the commenter is correct that paragraph (a)(3)(ii) was intended to apply to current credit ratings. Specifically, the Commission intended paragraph (a)(3)(ii) to address the timeframe in which an NRSRO must apply an updated procedure or methodology for performing surveillance or monitoring of credit ratings to current credit ratings to which the changed procedure or methodology applies. For example, if the NRSRO changes the methodology for monitoring credit ratings of RMBS, paragraph (a)(3)(i) of the final rule requires the firm to have policies and procedures that are reasonably designed to ensure that it uses the updated methodology to monitor all RMBS credit ratings going forward.[987] The change in methodology, however, may require the NRSRO to adjust the current credit ratings assigned to RMBS. Paragraph (a)(3)(ii), as proposed, was intended to address the timeframe in which an NRSRO must apply the updated methodology to current credit ratings to determine whether they should be adjusted. The Commission has modified the text of paragraph (a)(3)(ii) to make this more clear. Specifically, the final rule requires an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that material changes to the procedures and methodologies, including changes to qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are, to the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.[988]

One commenter asked for clarification as to what time period constitutes a “reasonable period” for applying changed surveillance or monitoring procedures and methodologies to current credit ratings.[989] Two commenters supported the decision not to prescribe a timeframe given the variables surrounding such a change (for example, number of impacted credit ratings).[990] Another commenter acknowledged the need for flexibility with respect to the timeframe but expressed the concern that absent any guidance there would continue to be insufficient resources made available for surveillance and monitoring of credit Start Printed Page 55158ratings.[991] Two commenters argued that the Commission must establish a firm deadline for the application of revised rating methodologies or surveillance procedures to current credit ratings to ensure NRSROs act promptly.[992] Another commenter, more generally, urged the Commission to require prompt re-testing after the NRSRO makes any such material changes.[993]

In response to the comments that the rule should prescribe a specific timeframe in which the review must take place or prescribe what constitutes a reasonable period of time, the Commission is not persuaded that doing so would be feasible or appropriate. For example, some NRSROs have hundreds of thousands of credit ratings outstanding in certain classes of credit ratings, whereas others have fewer than one thousand.[994] Consequently, if the specified timeframe was too short, an NRSRO with a large number of credit ratings might need to rush to meet the deadline. This could negatively impact the quality of the review of the credit ratings subject to the changed surveillance or monitoring procedures and methodologies and could result in adjustments to those credit ratings that were not the result of thorough analysis. If the specified timeframe was too long, an NRSRO with relatively few credit ratings would have a “safe harbor” that allowed the firm to act more slowly to apply the changed surveillance procedures and methodologies to current credit ratings than was necessary.[995] Consequently, the final rule retains the proposed requirement that the updated surveillance or monitoring procedure or methodology must be applied to the current credit ratings to which the changed procedure or methodology applies within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated. The question of whether the NRSRO has acted within a reasonable period of time will depend on factors such as the number of credit ratings an NRSRO has outstanding that would be impacted by the change.

Another commenter stated that the Commission should clarify the manner in which changes in rating procedures and methodologies would apply to current credit ratings.[996] More specifically, the commenter explained that proposed paragraph (a)(3)(i) of Rule 17g-8 did not address whether an NRSRO applying changed procedures or methodologies to outstanding credit ratings must re-rate the transaction based upon the information available at the time of the initial rating or whether the process should include performance information received after that time.[997] The commenter also stated that the NRSRO should not apply changes in procedures or methodologies to current credit ratings without a change in the performance of the credit rating.[998] In response, the Commission notes that the final rule does not require the NRSRO to adjust the outstanding credit ratings impacted by the changed rating procedure or methodology; nor does it specify on what basis an NRSRO should adjust an outstanding credit rating.[999] Rather, it requires the NRSRO to have policies and procedures reasonably designed to ensure that changes to surveillance or monitoring procedures and methodologies are applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable timeframe. The question of whether an outstanding credit rating must be adjusted after the application of the changed procedures or methodologies will depend solely on the NRSRO's procedures and methodologies. Based on those procedures and methodologies, the NRSRO may adjust an existing credit rating because of the change in the procedure or methodology, because of a change in circumstances that impacts the creditworthiness of the obligor or issuer that is subject to the credit rating, or a combination of these factors. This decision, however, will be based solely on the NRSRO's procedures and methodologies.[1000]

Paragraph (a)(4)(i) of Rule 17g-8, as proposed, would implement sections 15E(r)(2)(C), 15E(r)(3)(B), and 15E(r)(3)(D) of the Exchange Act.[1001] Section 15E(r)(2)(C) identifies the objective of ensuring that when material changes are made to rating procedures and methodologies (including changes to qualitative and quantitative data and models), the NRSRO publicly discloses the reason for the change.[1002] Section 15E(r)(3)(B) identifies the objective of ensuring that an NRSRO notifies users of credit ratings when a material change is made to a procedure or methodology, including to a qualitative model or quantitative input.[1003] Section 15E(r)(3)(D) identifies the objective of ensuring that the NRSRO notifies users of credit ratings when a material change is made to a procedure or methodology, including to a qualitative model or quantitative input, of the likelihood the change will result in a change in current credit ratings.[1004] The Commission proposed to implement these sections in paragraph (a)(4)(i) of Rule 17g-8, which would require an NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the NRSRO promptly publishes on an easily accessible portion of its corporate Internet Web site material changes to the procedures and methodologies, including to qualitative models or quantitative inputs, the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any “current ratings.” [1005]

The Commission is adopting paragraph (a)(4)(i) of Rule 17g-8 with a minor modification to make terminology throughout the rule consistent.[1006] As adopted, paragraph (a)(4)(i) requires the NRSRO to have policies and procedures that are reasonably designed to ensure that the NRSRO promptly publishes on an easily accessible portion of its corporate Internet Web site material changes to the procedures and methodologies, including to qualitative models or quantitative inputs, the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any current credit ratings.[1007]

Paragraph (a)(4)(ii) of Rule 17g-8, as proposed, would implement section Start Printed Page 5515915E(r)(3)(C) of the Exchange Act.[1008] This section provides that the Commission's rules shall require an NRSRO to notify users of credit ratings when a significant error is identified in a procedure or methodology, including a qualitative or quantitative model, that may result in credit rating actions.[1009] As proposed, paragraph (a)(4)(ii) would require the NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the NRSRO promptly publishes on an easily accessible portion of its corporate Internet Web site significant errors identified in a procedure or methodology, including a qualitative or quantitative model, the NRSRO uses to determine credit ratings that may result in a change in the current ratings.[1010]

The Commission is adopting paragraph (a)(4)(ii) of Rule 17g-8 with a minor modification. As proposed, the rule provided, in pertinent part, that the NRSRO must publish “significant errors” identified in a rating procedure or methodology. The proposal was intended to notify users of the NRSRO's credit ratings when a significant error is identified.[1011] One potential reading of the text, however, was that it required publication of the actual error. This was not intended. Further, publication of the error without context—rather than notification that an error was identified—could diminish the value of the disclosure. For example, if the error was in the code of a quantitative model, the disclosure of the code containing the error without identifying that it contained an error likely would not inform users of the NRSRO's credit ratings that there was an error. Consequently, the final rule is modified to provide for the prompt publication of notice of the existence of a significant error. More specifically, the final rule requires an NRSRO to have policies and procedures that are reasonably designed to ensure that the NRSRO promptly publishes on an easily accessible portion of its corporate Internet Web site notice of the existence of a significant error identified in a procedure or methodology, including a qualitative or quantitative model, the NRSRO uses to determine credit ratings that may result in a change to current credit ratings.[1012]

A number of commenters addressed paragraph (a)(4) of Rule 17g-8, as proposed.[1013] Some commenters stated that Internet Web site publication would help ensure that NRSROs communicate information pertaining to material changes in procedures and methodologies, as well as significant errors in the procedures and methodologies, to investors and other users of credit ratings in a timely manner.[1014] One commenter opposed the provision in paragraph (a)(4) of Rule 17g-8 requiring NRSROs to publish material changes and significant errors on an easily accessible portion of the NRSRO's corporate Internet Web site.[1015] The commenter argued that the statute requires more direct notification than Internet Web site publication, which could include allowing users to sign up for alerts.[1016] The Commission believes that specifying publication on an easily accessible portion of the NRSRO's Internet Web site is the most direct and cost effective way to provide an opportunity for all potentially interested parties to have access to the required disclosures.[1017] This does not preclude an NRSRO from offering additional disclosure services such as alerts or third parties from offering alert services based on the disclosures an NRSRO publishes.

One NRSRO stated that it would be helpful for the Commission to provide guidance as to when either a material change or significant error would trigger the disclosures.[1018] This commenter stated that significant errors should be disclosed if there is a reasonable likelihood that correction of the error will result in a change to current credit ratings. In contrast, another commenter stated that the Commission should not attempt to define the phrase significant error as any imposition of an arbitrary definition could result in situations where an NRSRO must identify errors that are minor and a correction does not result in a rating action.[1019]

The question of whether a change is material or an error is significant will depend on the facts and circumstances and, most importantly, on the impacted rating procedure or methodology (which vary across NRSROs). In general, the Commission believes that a change to a rating procedure or methodology would be material if there is a substantial likelihood that reasonable users of the NRSRO's credit ratings would find notice of the change important information in terms of assessing the rating procedure or methodology.[1020] The Commission believes that an error in a rating procedure or methodology would be significant if there is a substantial likelihood that reasonable users of the NRSRO's credit ratings would find notice of the error important information in terms of assessing the impact the error had on credit ratings determined using the rating procedure or methodology that contained the error.[1021]

Finally, paragraph (a)(5) of Rule 17g-8, as proposed, would implement section 15E(r)(3)(A) of the Exchange Act.[1022] This section provides that the Commission's rules shall require an NRSRO to notify users of credit ratings of the version of a procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating.[1023] As proposed, paragraph (a)(5) would require the NRSRO to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the NRSRO discloses the version of a credit rating procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating.[1024]

Start Printed Page 55160

The Commission is adopting paragraph (a)(5) of Rule 17g-8 as proposed.[1025] Specifically, the final rule requires an NRSRO to have policies and procedures that are reasonably designed to ensure that it discloses the version of a credit rating procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating.[1026]

One commenter requested clarification that the requirement to publish the version of the criteria used for a particular credit rating applies only when there is an action on the credit rating, such as an upgrade, downgrade, or withdrawal.[1027] A second commenter stated that the rule should require the NRSRO to publicly provide, along with the publication of the credit rating, disclosure about the credit rating and the methodology used to determine it.[1028]

The Commission is implementing section 15E(r)(3)(A) of the Exchange Act through paragraph (a)(5) of Rule 17g-8 and paragraph (a)(1)(ii)(B) of Rule 17g-7. Paragraph (a)(1)(ii)(B) of Rule 17g-7, as discussed below in section II.G.3. of this release, requires that the form to be included with the publication of certain rating actions include a disclosure of the version of the credit rating procedure or methodology used to determine the credit rating.[1029] The policies and procedures required by paragraph (a)(5) of Rule 17g-8 must address the NRSRO's compliance with the disclosure requirement in Rule 17g-7. In response to the comments about when the version of the credit rating procedure or methodology used to determine the credit rating must be disclosed, Rule 17g-7 specifies when the form containing the disclosure of the version of the credit rating procedure or methodology used to determine the credit rating must be published by the NRSRO: Upon the taking of one of the rating actions identified in the rule (for example, an initial credit rating or an upgrade or a downgrade of an outstanding credit rating).[1030]

A third commenter expressed concern that the proposal would provide NRSROs with a defense for developing poor opinions on creditworthiness.[1031] More specifically, the commenter stated that, based on his experience, reference to published methodologies has given at least one NRSRO a defense for having formed poor opinions on CDOs and RMBS.[1032] The commenter also questioned the underlying rationale of the rule insofar as NRSRO methodologies are already freely accessible and transparent.[1033] In response, the Commission notes that the statutory directive is clear: The rule must require each NRSRO to notify users of credit ratings of the version of a procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating.[1034] To address the commenter's concern, the Commission would need to do the opposite and prohibit an NRSRO from notifying users of credit ratings of the version of a procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating. This would be inconsistent with the statutory requirement that the rule provide for notification.

2. Amendment to Rule 17g-2

The Commission proposed adding paragraph (b)(13) to Rule 17g-2 to identify the policies and procedures an NRSRO is required to establish, maintain, enforce, and document pursuant to paragraph (a) of Rule 17g-8 as a record that must be retained.[1035] The one comment letter that addressed the proposal supported it.[1036] The Commission is adding paragraph (b)(13) to Rule 17g-2 as proposed.[1037] This will provide a means for the Commission to monitor the NRSROs' compliance with paragraph (a) of Rule 17g-8. The record must be retained until three years after the date the record is replaced with an updated record in accordance with the amendment to paragraph (c) of Rule 17g-2 discussed above in section II.A.2. of this release.[1038]

3. Economic Analysis

This section builds on the economic analysis in section I.B. of this release by presenting a focused analysis of the potential economic effects that may derive from the specific amendments and new rule relating to credit rating methodologies.[1039] The economic baseline that existed before today's amendments was one in which an NRSRO's board of directors must oversee the establishment, maintenance, and enforcement of the NRSRO's policies and procedures for determining credit ratings pursuant to Exchange Act section 15E(t)(3)(A).[1040] The baseline that existed before today's amendments and new rule also was one in which NRSROs must establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to their methodologies for determining credit ratings.[1041] NRSROs—under the baseline requirements—were not explicitly required to establish, maintain, enforce, document, and retain a record of policies and procedures relating to: (1) Board approval of the procedures and methodologies for determining credit ratings;[1042] (2) the development and modification of the procedures and methodologies for determining credit ratings;[1043] (3) applying material changes to the procedures and methodologies for determining credit ratings;[1044] (4) publishing material changes to and notices of significant errors in the procedures and methodologies for determining credit ratings;[1045] and (5) disclosing the version a procedure or methodology for determining credit ratings used with respect to a particular credit rating.[1046]

Relative to this baseline, the Commission believes that the amendments and new rule may result in a number of benefits. For example, implementing policies and procedures designed to ensure that the NRSRO's board of directors (or a body performing a similar function) oversees the establishment, maintenance, and enforcement of the NRSRO's policies and procedures for determining credit ratings in accordance with 15E(t)(3)(A) of the Exchange Act should promote the quality and consistency of the Start Printed Page 55161procedures and methodologies. Similarly, taking steps to ensure that the procedures and methodologies for determining credit ratings are developed and modified pursuant to the NRSRO's policies and procedures also should promote the quality and consistency of the procedures and methodologies.

Taking steps to ensure that material changes to the procedures and methodologies the NRSRO uses to determine credit ratings are applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply should help ensure consistent and timely application of such changes and promote the integrity of the credit rating process. This should benefit users of credit ratings. In addition, taking steps to ensure that an NRSRO promptly publishes on an easily accessible portion of its Internet Web site information about material changes to the procedures and methodologies the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any current credit ratings should benefit investors and other users of credit ratings by increasing the transparency of the NRSROs' credit rating activities and providing additional information with which to assess the quality of a given NRSRO's credit rating processes. Similarly, taking steps to ensure that an NRSRO promptly publishes on an easily accessible portion of its corporate Internet Web site notice of the existence of a significant error identified in a procedure or methodology used to determine credit ratings also should benefit investors and other users of credit ratings by increasing the transparency of the NRSROs' credit rating activities and providing additional information with which to assess the quality of a given NRSRO's credit rating processes.

The records NRSROs must keep pursuant to Rule 17g-2 will be used by Commission examiners to evaluate whether a given NRSRO's policies and procedures are reasonably designed and the NRSRO is complying with them. Compliance with these policies and procedures may increase the likelihood that NRSROs apply sound procedures and methodologies consistently to all applicable credit ratings and inform investors of these procedures and methodologies.

Relative to the baseline, the Commission anticipates that the final rule will result in costs. NRSROs will need to expend resources to develop, document, enforce, and periodically modify the policies and procedures they establish pursuant to paragraph (a) of Rule 17g-8.

As stated above, some commenters opposed the proposed rule on the basis of cost.[1047] One of these commenters stated that certain aspects of the proposals, including those regarding credit rating methodologies, would compound barriers to entry, and that many of the rules would be expensive and burdensome to implement.[1048] More specifically, this commenter stated that the Commission should take into account the dominance of very large players and expand small NRSRO exemptions designed to level the competitive field.[1049]

In response, the Commission acknowledges that these requirements will result in costs, which could create competitive barriers. However, the Commission reiterates that the final rule is designed to meet the rulemaking mandate in section 15E(r) of the Exchange Act in a manner that provides flexibility to NRSROs in terms of designing the required policies and procedures. Consequently, an NRSRO can tailor its policies and procedures to its business model, size, and the scope of its activities as well as to its methodologies and procedures for determining credit ratings, which, to some degree, may mitigate concerns about the costs of the final rule and its potential to create barriers to entry for small credit rating agencies. These costs would likely be higher for NRSROs with more complex operations in terms of the quantity of credit ratings they issue, the different types of credit ratings they issue, and the number of locations from which they determine and issue credit ratings. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (a) of Rule 17g-8 will result in total industry-wide one-time costs to NRSROs of approximately $566,000 and total industry-wide annual costs to NRSROs of approximately $142,000.[1050]

Relative to the baseline, the amendments to Rule 17g-2 prescribing retention requirements for the documentation of the policies and procedures will result in costs to NRSROs. NRSROs already have recordkeeping systems in place to comply with the recordkeeping requirements in Rule 17g-2 before today's amendments. Therefore, the recordkeeping costs of this rule will be incremental to the costs associated with these existing requirements. Specifically, the incremental costs will consist largely of updating their record retention policies and procedures and retaining and producing the additional record. Based on analysis for purposes of the PRA, the Commission estimates that paragraph (b)(13) of Rule 17g-2 and the amendment to paragraph (c) of Rule 17g-2 will result in total industry-wide one-time costs to NRSROs of approximately $12,000 and total industry-wide annual costs to NRSROs of approximately $3,000.[1051]

The Commission believes that NRSROs will incur costs to apply material changes to ratings procedures and methodologies consistently to all current credit ratings to which the changed procedures or methodologies apply. This cost will likely vary significantly per occurrence depending on the number of credit ratings and the type of instruments affected by the change as well as the nature and extent of the change. In addition, the Commission believes that an NRSRO will incur costs when promptly publishing on an easily accessible portion of its Internet Web site information about material changes to procedures and methodologies, the likelihood such changes will result in changes to any current ratings, and notice of significant errors identified in a procedure or methodology in accordance with paragraphs (a)(4)(i) and (ii) of Rule 17g-8. Based on analysis for purposes of the PRA, the Commission estimates that paragraphs (a)(4)(i) and (ii) of Rule 17g-8 will result in costs to NRSROs of approximately $5,700 per publication on their Web site.[1052]

A possible additional cost is that the final rule potentially could decrease the quality of credit ratings in circumstances where the subjective judgment of participants in the rating process could improve the quality of ratings. In order to ensure that material changes to ratings procedures and methodologies are applied consistently to all current credit ratings to which the changed procedures or methodologies apply “within a reasonable timeframe” Start Printed Page 55162in accordance with the new rule, an NRSRO may establish credit rating procedures and methodologies that diminish the ability of participants in the rating process to exercise subjective judgment, which could lengthen the rating process. As a result, the credit ratings may not benefit fully from the expertise of the analysts in the rating process, which could negatively impact the quality of the credit rating. This concern may be mitigated by the fact that the new rule does not require that the policies and procedures specify a specific timeframe to apply the changed procedure or methodology but rather requires that the change to be applied within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.

The amendments and new rule should have a number of effects related to efficiency, competition, and capital formation.[1053] First, these amendments could improve the quality and consistency of credit ratings as well as increasing the information available to users of credit ratings regarding rating procedures and methodologies. As a result, users of credit ratings could make more efficient investment decisions based on this higher-quality information. Market efficiency also could improve if this information is reflected in asset prices. Consequently, capital formation could improve as capital may flow to more efficient uses with the benefit of this enhanced information. Alternatively, the quality of credit ratings may decrease in certain circumstances if an NRSRO establishes credit rating procedures and methodologies that diminish the ability of participants in the rating process to exercise subjective judgment. In this case, the quality of credit ratings may decrease, which could decrease the efficiency of investment decisions made by users of credit ratings. Market efficiency and capital formation may also be adversely impacted if lower quality information is reflected in asset prices, which may impede the flow of capital to efficient uses. These amendments also will result in costs, some of which may have a component that is fixed in magnitude and does not vary with the size of the NRSRO. Therefore, the operating costs per credit rating of smaller NRSROs may increase relative to that of larger NRSROs. Consequently, the costs associated with these amendments may have a disproportionate impact on smaller NRSROs as suggested by commenters,[1054] creating adverse effects on competition. For example, one commenter suggested that these requirements would require an NRSRO to review credit rating methodologies, which would place an undue burden on smaller NRSROs.[1055] As a result of these amendments, the barriers to entry for credit rating agencies to register as an NRSRO might be higher for credit rating agencies, while some NRSROs, particularly smaller firms, may decide to withdraw from registration as an NRSRO. As discussed earlier, these costs also will depend on the complexity of operations within the NRSRO.

Commenters have proposed a number of alternatives to the final rule. One alternative would be to require that NRSROs permit users of an NRSRO's credit ratings to sign up for alerts regarding material changes and significant errors in an NRSRO's procedures and methodologies, which, according to the commenter, “would significantly improve communication.” [1056] As stated above, the Commission believes that publication on an easily accessible portion of the NRSRO's Internet Web site is the most direct and cost effective way to ensure that all potentially interested parties have access to the required disclosures. Therefore, this alternative without a requirement to also disclose the information on the NRSRO's Internet Web site could potentially have the result that fewer users of credit ratings are informed of changes and errors. For example, certain users of credit ratings may opt not to sign up for email notification in order to avoid receiving unwanted communications.

Another alternative would be for the Commission to establish a firm deadline for the application of revised rating methodologies or surveillance or monitoring procedures to current credit ratings to ensure that NRSROs act promptly, as suggested by commenters.[1057] As stated above, the Commission is not persuaded that prescribing a specific timeframe in which the review must take place is feasible or appropriate. For example, some NRSROs have hundreds of thousands of credit ratings outstanding in certain classes of credit ratings, while others have fewer than one thousand.[1058] In addition, there is variation across NRSROs in the level of resources available to apply these changes. For example, the number of credit analysts employed by each NRSRO ranges from fewer than ten to more than a thousand.[1059] Consequently, mandating a timeframe that is too short could negatively impact the quality of the review of the credit ratings subject to the changed surveillance or monitoring procedures and methodologies and could result in adjustments to those credit ratings that are not the result of thorough analysis. In this case, this alternative could result in costs for users of credit ratings who may make credit-based decisions using incomplete or inaccurate information. In addition, an NRSRO with relatively fewer resources to make the required changes might need to incur costs such as hiring more staff to meet the deadline. If the mandated timeframe were too long, an NRSRO with relatively greater resources could take longer than necessary to apply the changed surveillance procedures and methodologies to impacted credit ratings.[1060] In this case, this alternative could result in costs for users of credit ratings as information would be updated in a less timely fashion than will be the case under the new rule.

G. Form and Certifications to Accompany Credit Ratings

Section 932(a)(8) of the Dodd-Frank Act amended section 15E of the Exchange Act to add paragraphs (q) and (s).[1061] Section 15E(q)(2)(F) of the Exchange Act provides that the Commission's rules must require an NRSRO to include an attestation with any credit rating it issues affirming that no part of the rating was influenced by any other business activities, that the rating was based solely on the merits of the instruments being rated, and that such rating was an independent evaluation of the risks and merits of the instrument.[1062] Sections 15E(s)(1) through (4), among other things, contain provisions requiring Commission rulemaking with respect to disclosures an NRSRO must make with the publication of a credit rating.[1063] The Start Printed Page 55163Commission proposed paragraph (a) to Rule 17g-7, in large part, to implement sections 15E(q) and 15E(s) of the Exchange Act.[1064]

Under the proposal, an NRSRO would be required to publish two items when taking a rating action: (1) A form containing information about the credit rating resulting from or subject to the rating action; and (2) any certification of a provider of third-party due diligence services received by the NRSRO that relates to the credit rating.[1065] The proposal also included provisions prescribing the format of the form; the content of the form; and an attestation requirement for the form.[1066] The Commission is adopting paragraph (a) to Rule 17g-7 with modifications in response to comments.[1067]

1. Paragraph (a) of Rule 17g-7—Prefatory Text

Section 15E(s)(1) of the Exchange Act provides that the Commission shall require, by rule, an NRSRO to prescribe a form to accompany the publication of each credit rating that discloses: (1) Information relating to the assumptions underlying the credit rating procedures and methodologies; the data that was relied on to determine the credit rating; and if applicable, how the NRSRO used servicer or remittance reports, and with what frequency, to conduct surveillance of the credit rating; and (2) information that can be used by investors and other users of credit ratings to better understand credit ratings in each class of credit rating issued by the NRSRO.[1068] Section 15E(s)(2)(C) of the Exchange Act provides that the form shall be made readily available to users of credit ratings, in electronic or paper form, as the Commission may, by rule, determine.[1069] Section 15E(s)(4)(D) of the Exchange Act provides that the Commission shall adopt rules requiring an NRSRO at the time it produces a credit rating to disclose any certifications from providers of third-party due diligence services to the public in a manner that allows the public to determine the adequacy and level of due diligence services provided by the third party.[1070]

The Commission proposed to implement sections 15E(s)(1), 15E(s)(2)(C), and 15E(s)(4)(D) of the Exchange Act, in large part, through the prefatory text of proposed paragraph (a) of Rule 17g-7.[1071] As proposed, the prefatory text provided that an NRSRO must publish two items when taking a rating action: (1) A form containing information about the credit rating resulting from or subject to the rating action;[1072] and (2) any certification of a provider of third-party due diligence services received by the NRSRO that relates to the credit rating.[1073] The first sentence of the prefatory text further provided that an NRSRO must publish the form and certification, as applicable, when taking a rating action with respect to a credit rating assigned to an obligor, security, or money market instrument in a class of credit ratings for which the NRSRO is registered.[1074] The second sentence of the prefatory text defined the term rating action for purposes of the rule to mean any of the following: The publication of an expected or preliminary credit rating assigned to an obligor, security, or money market instrument before the publication of an initial credit rating; an initial credit rating; an upgrade or downgrade of an existing credit rating (including a downgrade to, or assignment of, default); a placement of an existing credit rating on credit watch or review; an affirmation of an existing credit rating; and a withdrawal of an existing credit rating.[1075] The third sentence of the prefatory text provided that the form and any applicable certifications must be published in the same medium and made available to the same persons who can receive or access the credit rating that is the result of the rating action or the subject of rating action.[1076]

The Commission is adopting the first sentence of the prefatory text of paragraph (a) of Rule 17g-7 with a modification in response to comment.[1077] As adopted, this sentence provides that except as provided in paragraph (a)(3), an NRSRO must publish the items described in paragraphs (a)(1) (the form) and (a)(2) (third-party due diligence certifications), as applicable, when taking a rating action with respect to a credit rating assigned to an obligor, security, or money market instrument in a class of credit ratings for which the NRSRO is registered.[1078]

The Commission is adopting the second sentence of the prefatory text of paragraph (a) of Rule 17g-7 with modifications to narrow the definition of rating action in response to comments.[1079] Several commenters stated generally that the proposed definition is overly broad.[1080] One NRSRO stated that a broad definition of rating action could limit disclosure by “creating incentives for NRSROs to publish commentary about their credit ratings less frequently.”[1081] Commenters stated that the proposed definition of rating action would make it difficult for NRSROs to release their credit ratings in a timely fashion.[1082] One commenter stated that rating actions involving transaction documents that were finalized before the effective date of the rules should not be subject to the disclosure requirements.[1083] An NRSRO stated that the amount of preparation time needed to comply with the rule will likely delay the issuance of ratings, “particularly with respect to preliminary ratings.”[1084] In contrast, Start Printed Page 55164another commenter stated that including preliminary ratings on asset-backed securities ratings will ensure that investors receive the information at a time when it is “likely to be most useful to them in making an investment decision.” [1085]

As explained below, commenters urged the Commission to eliminate from the definition of rating action: Preliminary credit ratings; placements of credit ratings on watch or review; affirmations and confirmations of credit ratings; and withdrawals of credit ratings.[1086]

One NRSRO commented that placing a credit rating on review should not be considered a rating action because a review is simply an indication of the potential for a future rating action, and is not itself a rating action.[1087] Several commenters stated that some or all rating affirmations should not be included in the definition of a rating action.[1088] One NRSRO stated that including rating affirmations would “significantly” increase the reporting burden on NRSROs, and would produce only a record that there was no change to the rating in question.[1089] The NRSRO also suggested that if affirmations are included, they should refer only to a published announcement or written confirmation that the rating is being maintained at its current level. Another commenter stated that affirmations should be excluded unless they represent “a comprehensive review of a transaction.” [1090] A different commenter stated that a “confirmation,” which is a type of affirmation that simply indicates that a particular action will not change a credit rating, should not constitute a rating action because disclosures associated with confirmations would only cover very minor document changes and add “little value.”[1091]

Two commenters stated that some or all withdrawals should not be included in the definition of a rating action.[1092] One NRSRO stated that publishing the forms for withdrawals that are “mechanical in nature and not based on a credit assessment or analysis” could make it more difficult for market participants to locate significant information.[1093]

The Commission is sensitive to the burdens imposed by its rules, and in considering the comments discussed above has sought to balance the need for timely and robust disclosure with concerns about the costs that would result from the proposal. As discussed below, the Commission believes it is appropriate to narrow the definition of rating action from the proposed definition to include those actions that are made at a time when there is limited information about the rated obligor, security, or money market instrument and to other rating actions if they are linked to the performance of credit analysis. This will reduce the burden of complying with the rule. Nonetheless, the Commission recognizes that preparing the form in response to those rating actions that trigger the disclosure requirement will take time and that this could impact how quickly an NRSRO is able to publish the credit rating that results from or is the subject of the rating action. However, the Commission has balanced this concern with the directive of the statute (that the Commission adopt a rule requiring the form to be published with a credit rating) and the benefits of the increased transparency the disclosures in the form will provide to users of the NRSRO's credit ratings.[1094] Moreover, an NRSRO should be able to draft significant portions of the form largely in tandem with the credit rating process and, therefore, the form and the final decision on the rating action generally should be completed simultaneously.

In response to the comment to eliminate preliminary credit ratings from the definition of rating action, the Commission notes that this type of rating action and certain initial credit ratings (that is, those assigned to a newly formed obligor or newly issued security or money market instrument) are made at a time when there is little information available about the rated obligor, security, or money market instrument. Given the timing of these rating actions, the Commission agrees with comments that it is critical that investors and other users of credit ratings have access to the information that is required to be disclosed in the form and any applicable certifications on Form ABS Due Diligence-15E.[1095] Consequently, the Commission is adopting the requirement that the form and certifications be published when the NRSRO publishes a preliminary or expected credit rating or an initial credit rating.[1096]

Some of the types of rating actions included in the proposed definition are not necessarily linked to the performance of credit analysis. In particular, placements of credit ratings on watch or review, certain types of affirmations of credit ratings, and certain types of withdrawals of credit ratings are not based on the NRSRO applying its rating procedures or methodologies and making a credit rating determination. In the case of a watch or review, the rating action precedes the application of the rating procedure or methodology, which, once completed, may result in an affirmation or an adjustment (upgrade or downgrade) to the credit rating. However, not all credit rating Start Printed Page 55165affirmations are based on the NRSRO applying its rating procedures and methodologies.[1097] Similarly, NRSROs withdraw credit ratings for a number of reasons that are unrelated to the performance of credit analysis, including that the obligation was paid off or the obligor stopped paying to be rated.[1098]

In balancing the concerns of commenters about the burden of the rule against the need for timely and robust disclosure, the Commission, as stated above, believes it is appropriate to focus the disclosure requirement on rating actions that are based on the application of the NRSRO's procedures and methodologies for determining credit ratings. In this regard, much of the information required to be disclosed in the form under section 15E(s)(3) of the Exchange Act relates to the procedures, methodologies, and information used to determine the credit rating.[1099] For these reasons, placements of credit ratings on watch or review have been removed from the definition of rating action.[1100] In addition, the definition provides that an affirmation or withdrawal is a rating action if the affirmation or withdrawal is the result of a review of the credit rating assigned to the obligor, security, or money market instrument by the NRSRO using its procedures and methodologies for determining credit ratings.[1101]

For the foregoing reasons, the amendments have been modified from the proposal to eliminate placements of credit ratings on watch or review from the definition of rating action and to eliminate from the definition affirmations and withdrawals that are not based on the NRSRO applying its procedures and methodologies for determining credit ratings. Consequently, the second sentence—as adopted—provides that the term rating action “means any of the following: The publication of an expected or preliminary credit rating assigned to an obligor, security, or money market instrument before the publication of an initial credit rating; an initial credit rating; an upgrade or downgrade of an existing credit rating (including a downgrade to, or assignment of, default); and an affirmation or withdrawal of an existing credit rating if the affirmation or withdrawal is the result of a review of the credit rating assigned to the obligor, security, or money market instrument by the NRSRO using applicable procedures and methodologies for determining credit ratings.” [1102]

The Commission is making another modification to the proposed amendments that will reduce the burden of the adopted rule. Specifically, one NRSRO recommended that the temporary conditional exemption for foreign transactions from the requirements in paragraph (a)(3) of Rule 17g-5 be applied to the disclosure requirements in paragraph (a) of Rule 17g-7, as proposed.[1103] The commenter stated that many foreign issuers lack the infrastructure to comply with the level of disclosure required by paragraphs (a)(1) and (a)(2) of Rule 17g-7, as proposed.[1104] The commenter stated further that, without an exemption, “NRSROs either might be unable to issue a credit rating on non-U.S. securities or must withdraw as an NRSRO in order to continue rating certain non-U.S. securities.” [1105]

The Commission is persuaded that at this time the disclosure requirement should not apply to rating actions involving credit ratings of obligors or issuers whose securities or money market instruments will be offered or sold in transactions that occur exclusively outside the United States. As noted above, one commenter suggested that local laws could impede the ability of the NRSRO to obtain or disclose information about the issuer in accordance with the requirements of the proposed amendments. To address these types of concerns, the Commission is adding paragraph (a)(3) to Rule 17g-7 to provide an exemption from the requirements of paragraphs (a)(1) and (a)(2) for rating actions in which: (1) The rated obligor or issuer of the rated security or money market instrument is not a U.S. person (as defined under Securities Act Rule 902(k)); [1106] and (2) the NRSRO has a reasonable basis to conclude that a security or money market instrument issued by the rated obligor or the issuer will be offered and sold upon issuance, and that any underwriter or arranger linked to the security or money market instrument will effect transactions in the security or money market instrument after issuance, only in transactions that occur outside the United States.[1107] The wording of the exemption is modeled closely on the temporary conditional exemption from the requirements in paragraph (a)(3) of Rule 17g-5 the Commission has granted by order.[1108] Start Printed Page 55166As stated above, the Commission is making a corresponding modification to the first sentence of the prefatory text of paragraph (a) of Rule 17g-7, to add that an NRSRO must publish the items described in paragraphs (a)(1) and (a)(2) of Rule 17g-7 “except as provided in paragraph (a)(3)” of Rule 17g-7.[1109]

The Commission is adopting the third sentence of the prefatory text of paragraph (a) of Rule 17g-7 with technical modifications to improve its clarity.[1110] This sentence provides that the items described in paragraphs (a)(1) and (a)(2) must be published in the same manner as the credit rating that is the result or subject of the rating action and made available to the same persons who can receive or access the credit rating that is the result or subject of the rating action.[1111] In response to comments, the Commission agrees that an NRSRO may satisfy this requirement by publishing the form and any applicable certifications on its public Internet Web site if the credit rating is disseminated through the Web site as well.[1112] In addition, if the NRSRO publishes the credit rating in a press release announcing the relevant rating action in addition to publishing the credit rating on its corporate Internet Web site, the NRSRO may make the form available through a clearly and prominently labeled hyperlink on the press release to the page on its corporate Internet Web site that contains the form and any applicable certifications.[1113]

In addition, the final amendments, as proposed, require that the form and any applicable certifications on Form ABS Due Diligence-15E must be made available to the same persons who can receive or access the credit rating that is the result of the rating action.[1114] Consequently, if the NRSRO publishes credit ratings for free on its corporate Internet Web site, it must make the form and certifications similarly available.[1115] Alternatively, if the NRSRO operates under the subscriber-pay business model, it must make the form and certifications available to its subscribers.[1116]

Finally, one commenter suggested the assessment of financial penalties for each day that NRSROs do not post the form when taking a rating action.[1117] The Commission has authority to take appropriate action against an NRSRO that fails to comply with the requirements of paragraph (a) of Rule 17g-7. Further, as discussed above in section II.D.1. of this release, the Exchange Act provides a wide range of fines, penalties, and other sanctions applicable to NRSROs for violations of any section of the Exchange Act (including section 15E) and the rules under the Exchange Act (including the rules under section 15E).[1118] The Commission therefore does not believe that providing for additional penalties is necessary.

2. Paragraph (a)(1)(i) of Rule 17g-7—Format of the Form

To implement sections 15E(s)(2)(A) and (B) of the Exchange Act, the Commission proposed paragraph (a)(1)(i) of Rule 17g-7, which would describe the required format of the form to accompany the publication of a rating action.[1119] In particular, section 15E(s)(2)(A) of the Exchange Act provides that the form developed by the NRSRO shall be easy to use and helpful for users of credit ratings to understand the information contained in the report.[1120] The Commission proposed paragraph (a)(1)(i)(A) of Rule 17g-7 to implement this section of the statute.[1121] This paragraph—as proposed—mirrored the statutory text by providing that the form generated by the NRSRO would need to be easy to use and helpful for users of credit ratings to understand the information contained in the form.[1122]

Section 15E(s)(2)(B) of the Exchange Act provides that the quantitative content required to be disclosed in the form and identified in section 15E(s)(3)(B) must be directly comparable across types of securities.[1123] As discussed below, section 15E(s)(3) of the Exchange Act identifies qualitative and quantitative information that must be included in the form.[1124] The Commission proposed that the quantitative content specified in section 15E(s)(3)(B) of the Exchange Act must be disclosed in the form pursuant to paragraphs (a)(1)(ii)(K), (L), and (M) of Rule 17g-7, as proposed.[1125] Consequently, paragraph (a)(1)(i)(B) of Rule 17g-7, as proposed, required the form generated by the NRSRO to be in a format that provides the content described in paragraphs (a)(1)(ii)(K), (L), and (M) of Rule 17g-7 in a manner that is directly comparable across types of obligors, securities, and money market instruments.[1126]

The Commission is adopting the proposal with modifications in response to comments.[1127] The modifications are Start Printed Page 55167designed to respond to comments recommending that the rule prescribe a standard format for presenting the information in the form.[1128]

In particular, as proposed, the rule would require that the form, among other things, must be in a format that is easy to use and helpful for users of credit ratings to understand.[1129] However, the proposal did not prescribe a form into which NRSROs would input information or provide more specificity as to how the information in the form must be presented. Two commenters recommended that the format of the form should be more standardized.[1130] One commenter stated that standardization would simplify oversight and make the information in the form easier for investors to analyze.[1131] The other commenter suggested standard headings and prescribing an order for the presentation of the information in the form.[1132] The Commission agrees with the commenters that requiring the NRSROs to adhere to a more standardized format will assist users of the form in locating and analyzing items of information disclosed in the form. It also will facilitate the Commission's oversight of the disclosure requirements, as noted by the commenter. Consequently, paragraph (a)(1)(i) of Rule 17g-7 provides that the form must be in a format that organizes the information required to be disclosed into numbered items that are identified by the type of information being disclosed and by a reference to the paragraph in Rule 17g-7 that specifies the information required to be disclosed, and are in the order that the paragraphs specifying the information to be disclosed are codified in Rule 17g-7.[1133] In addition, as adopted, paragraph (a)(1)(i) of Rule 17g-7 contains a note providing details about this requirement—in particular, stating that a given item in the form should be identified by a title that identifies the type of information and references paragraph (a)(1)(ii)(A), (B), (C), (D), (E), (F), (G), (H), (I), (J), (K), (L), (M), (N), or (a)(2) of Rule 17g-7, based on the information being disclosed in the item.[1134] The note provides the example that the item on the form containing the information specified in paragraph (a)(1)(ii)(C) of Rule 17g-7 should be captioned: “Main Assumptions and Principles Used to Construct the Rating Methodology used to Determine the Credit Rating as required by Paragraph (a)(1)(ii)(C) of Rule 17g-7.” [1135] The note also explains that the form must organize the items of information in the following order: Items 1 through 14 must contain the information specified in paragraphs (a)(1)(ii)(A) through (N) of Rule 17g-7, respectively, and item 15 must contain the certifications specified in paragraph (a)(2) of Rule 17g-7.[1136]

Several NRSROs stated that a standardized form may discourage NRSROs from providing more transparency.[1137] Another NRSRO stated that if formatted disclosure is ultimately required, “the Commission should provide sufficient flexibility to allow for disclosure that is meaningful in the context provided.” [1138] The Commission believes the approach it has taken in prescribing a standardized format for presenting the information in the form without, for example, requiring that a prescribed form be filled out, strikes an appropriate balance in implementing section 15E(s)(2) of the Exchange Act between the comparability of the information provided across NRSROs and the flexibility to allow for meaningful disclosure. For example, the final amendments—while prescribing certain formatting requirements—generally permit an NRSRO to design the form that will be used to make the disclosure. Thus, an NRSRO can tailor the form to specific classes or subclasses of credit ratings to provide more targeted information.

The proposed amendments required that the form must be in a format that is easy to use and helpful for users of credit ratings to understand the information contained in the form.[1139] The proposed rule text closely mirrored section 15E(s)(2)(A) of the Exchange Act.[1140] The modifications discussed above prescribing a standard for presenting the information in the form are specifically designed to achieve the objective set forth in section 15E(s)(2)(A) and the proposed rule. However, the final amendments, as proposed, include the more general requirement that the form must be in a format that is “easy to use and helpful for users of credit ratings to understand the information contained in the form.” [1141] Because the presentation of the information has been prescribed, this format-related requirement will be more relevant to the narrative disclosures that are made in the items of the form. In particular, NRSROs must provide narrative disclosures that help users of credit ratings to understand the information. Several commenters stated that the form will result in boilerplate disclosure rather than more transparency.[1142] Pursuant to the final amendments, NRSROs will need to make the disclosures as specific to the particular rating action, and as relevant to investors, as possible, and strike a reasonable balance between standardizing the disclosures and tailoring them to specific rating actions. While the Commission recognizes that some of the information to be disclosed in the form may be standardized for classes or subclasses of credit ratings, NRSROs must disclose information in the form in a manner that promotes greater understanding of how a credit rating was determined. Accordingly, the form must contain plainly worded and succinct disclosures that are easy to understand and not lengthy boilerplate disclaimers.

Finally, paragraph (a)(1)(i)(C) of Rule 17g-7, as proposed, provides that the form must be in a format that provides the content described in paragraphs (a)(1)(ii)(K), (L), and (M) of Rule 17g-7 in a manner that is directly comparable across types of obligors, securities, and money market instruments.[1143] As discussed below in section II.G.3. of this release, these paragraphs of Rule 17g-7 require the disclosure of certain types of quantitative information as mandated by section 15E(s)(3)(B) of the Exchange Start Printed Page 55168Act.[1144] One commenter stated that it would be difficult, if not impossible, to make this information “directly comparable” across all NRSROs.[1145] In response, the Commission notes that the final amendments require certain types of quantitative information to be comparable across types of obligors, securities, and money market instruments rated by the NRSRO (rather than across NRSROs).[1146]

3. Paragraph (a)(1)(ii) of Rule 17g-7—Content of the Form

Section 15E(s)(3) of the Exchange Act provides that the Commission shall require, by rule, that the form accompanying the publication of a credit rating contain specifically identified items of information.[1147] In particular, section 15E(s)(3)(A) identifies eight items of “qualitative content” [1148] and section 15E(s)(3)(B) identifies four items of “quantitative content.” [1149] Because the statute specified the type of information to be included in the form, the Commission proposed rule text prescribing the required contents of the form that largely mirrored the statutory text.[1150] In particular, the prefatory text of paragraph (a)(1)(ii) of Rule 17g-7, as proposed, provided that the form generated by the NRSRO must contain the information about the credit rating that is identified in paragraphs (a)(1)(ii)(A) through (N) of the rule.[1151] The order of, and information required in, these paragraphs largely mirrored the provisions of section 15E(s)(3) of the Exchange Act.[1152]

The Commission is adopting the prefatory text of paragraph (a)(1)(ii) of Rule 17g-7 without modification.[1153] The paragraph provides that the form generated by the NRSRO must contain information about the credit rating identified in paragraphs (a)(1)(ii)(A) through (N).[1154] Consequently, NRSROs are required to generate a form containing the prescribed information and publish it when taking a rating action (as defined in the prefatory text of paragraph (a) of Rule 17g-7).

Several commenters raised concerns that the proposed rule could require the disclosure of confidential or proprietary information regarding the NRSRO or an issuer.[1155] The Commission does not intend that the rule require an NRSRO to disclose confidential or proprietary information in the form. As discussed above, the format of the form must be easy to use and helpful for users of credit ratings to understand the information contained in the form about the rating action.[1156] NRSROs must provide narrative disclosures that are helpful for users of credit ratings to understand the information and, therefore, the form must contain plainly worded and succinct disclosures that are not overly detailed. An NRSRO must meet this standard through disclosures that are informative but at the same time the Commission does not expect an NRSRO to disclose confidential or proprietary information.

As noted above, commenters suggested expanding the information required to be disclosed in the form. In particular, one commenter stated that the Commission should encourage NRSROs to provide additional information if they deem it appropriate,[1157] another stated that NRSROs should provide further information that would enable investors to understand the significance of the disclosures,[1158] and a third stated that NRSROs should be required to indicate the “projected time period during which the given rating was expected to be valid.” [1159] One commenter stated that some disclosure requirements should be expanded to provide in greater detail information that can be used by investors and other users of credit ratings.[1160] Another commenter suggested further rulemaking to require NRSROs to disclose and explain the rationale behind proposed credit ratings to the rated entity prior to publication, provide a rated entity with the right to appeal a proposed credit rating, and give reasonable consideration to an appeal.[1161]

In contrast, other commenters raised burden concerns with respect to the breadth of the information that the proposed rule required to be included in the form. One NRSRO urged the Commission not to extend the rule beyond what the statute requires.[1162] Another NRSRO stated that although the form may be useful to investors, it must not be “so lengthy and overburdened with detail that it loses its utility,” and expressed a concern that the level of detail “far surpasses what most users of credit ratings would find of practical use, while imposing unnecessary burdens on NRSROs.” [1163] A third NRSRO stated that disclosure should be limited to asset-backed securities ratings, indicating that expanding requirements to other ratings is “extremely overburdensome” and provides little information that is not already publicly available.[1164]

The Commission acknowledges that section 15E(s)(3) of the Exchange Act identifies a significant amount of information that the Commission's rule must require to be disclosed in the form.[1165] This information will be helpful in providing transparency as to how an NRSRO determines credit ratings across all classes of credit ratings. This transparency should benefit users of credit ratings and could mitigate the risk of undue reliance on credit ratings by providing information about the limits of credit ratings. Further, because the statute was very specific regarding the information to be disclosed, the Commission has sought to model its rule closely on the statutory text. Accordingly, the Commission does not believe it would be appropriate to limit the disclosure requirements to rating actions involving asset-backed securities. Moreover, given the significant amount of information required to be disclosed, the Commission also does not believe it to be necessary at this time to expand the disclosure requirements as suggested by some commenters.

The Commission also wants to emphasize that the information that must be disclosed in the form must relate to the rating action that is being taken. The NRSRO need not include in the disclosure information about the credit rating that is no longer up-to-date. For example, consistent with the statutory text, the rule text sometimes Start Printed Page 55169uses the phrase “to determine the credit rating.” The Commission intended this to relate to the credit rating that is determined as a consequence of the rating action that triggers the disclosure requirement (a preliminary credit rating, an initial credit rating, an upgrade or downgrade of the credit rating, or certain affirmations or withdrawals of the credit rating). The objective is to provide investors and other users of credit ratings with helpful information about the rating action being taken with respect to the credit rating of the obligor, security, or money market instrument.

Paragraph (a)(1)(ii)(A). Section 15E(s)(3)(A)(i) of the Exchange Act provides that, as required by Commission rule, an NRSRO shall disclose on the form the credit ratings produced by the NRSRO.[1166] The Commission proposed to implement this section in paragraph (a)(1)(ii)(A) of Rule 17g-7.[1167] This paragraph, as proposed, would require the NRSRO to include in the form the symbol, number, or score in the rating scale used by the NRSRO to denote the credit rating categories and notches within categories assigned to the obligor, security, or money market instrument that is the subject of the credit rating and the identity of the obligor, security, or money market instrument.[1168]

The Commission is adopting paragraph (a)(1)(ii)(A) of Rule 17g-7 with one modification from the proposal.[1169] The paragraph provides that the form must contain the symbol, number, or score in the rating scale used by the NRSRO to denote credit rating categories and notches within categories assigned to the obligor, security, or money market instrument that is the subject of the credit rating and, as applicable, the identity of the obligor or the identity of the security or money market instrument and, in a modification from the proposal, must also contain, a description of the security or money market instrument.[1170]

The Commission stated in the proposing release that the identity of a security or money market instrument must be the name of the security or money market instrument, if applicable, and a description of the security or money market instrument.[1171] In the proposing release, the Commission provided an example of how an NRSRO could identify a bond: “senior unsecured debt issued by Company XYZ maturing in 2015.” [1172] Consistent with the discussion in the proposing release, the Commission has modified the rule text from the proposal to add that, in the case of a credit rating of a security or money market instrument, the NRSRO must include in the form “the identity and a description of the security or money market instrument.” [1173]

Two NRSROs commented on the requirement to identify the relevant obligor.[1174] In the proposing release, the Commission stated its preliminary belief that the obligor's identity would be its legal name and any other name used in its business.[1175] One NRSRO stated that it could be “enormously burdensome” for an NRSRO to learn and disclose all the business names that an obligor may use, and the additional information would add “little benefit” to those who use the form.” [1176] The other NRSRO stated that entry of legal names in its database has been problematic due to the inconsistent use of abbreviations.[1177] Both NRSROs suggested that NRSROs should be permitted to determine the clearest way to identify obligors.[1178] The Commission agrees with the commenters that an NRSRO should be permitted to determine the clearest way to identify an obligor. An NRSRO must disclose a name that clearly identifies the obligor.[1179]

Paragraph (a)(1)(ii)(B). Section 15E(r)(3)(A) of the Exchange Act provides that the Commission shall prescribe rules with respect to the procedures and methodologies used by NRSROs that require NRSROs to notify users of credit ratings of the version of a procedure or methodology, including the qualitative methodology or quantitative inputs, used with respect to a particular credit rating.[1180] As discussed above in section II.F.1. of this release, the Commission proposed to implement this provision in Rules 17g-8 and 17g-7.[1181] With respect to Rule 17g-7, proposed paragraph (a)(1)(ii)(B) would require an NRSRO to disclose on the form the version of the procedure or methodology used to determine the credit rating.[1182]

The Commission is adopting paragraph (a)(1)(ii)(B) of Rule 17g-7 as proposed.[1183] The paragraph provides that the NRSRO must include in the form the version of the procedure or methodology used to determine the credit rating.[1184]

Two NRSROs commented on paragraph (a)(1)(ii)(B) of Rule 17g-7, as proposed.[1185] One NRSRO stated that disclosing the version of the procedure or methodology used to determine a credit rating could be accomplished by identifying the name of the procedure or methodology, the date the procedure was implemented, and a hyperlink to further information about the procedure or methodology.[1186] The Commission agrees.[1187]

A second NRSRO stated that the actual benefit to investors is slight because the required content can be accessed through the NRSRO's public Internet Web site.[1188] As the Commission stated in the proposing release, section 15E(s)(1)(B) of the Exchange Act provides that the Commission shall require, by rule, each NRSRO to prescribe a form to accompany the publication of a credit rating that discloses information that can be used by investors and other users of credit ratings to better understand credit ratings in each class of credit rating issued by the NRSRO.[1189] Start Printed Page 55170Disclosing in the form the version of the procedure or methodology used to determine the credit rating will promote this goal. For example, credit rating methodologies that are predominantly quantitative may rely on models to produce credit ratings. These models are periodically updated and released as newer or different versions of the previous model. Disclosing in the form the version of a model used to produce a credit rating with the credit rating is expected to help investors and other users of credit ratings better understand the credit rating and how the determination of the credit rating may differ from the determination of credit ratings of similar products using an earlier version of the model.

Paragraph (a)(1)(ii)(C). Section 15E(s)(3)(A)(ii) of the Exchange Act provides that, as required by Commission rule, an NRSRO shall disclose on the form the main assumptions and principles used in constructing procedures and methodologies, including qualitative methodologies and quantitative inputs and assumptions about the correlation of defaults across underlying assets used in rating structured products.[1190] The Commission proposed to implement this section through paragraph (a)(1)(ii)(C) of Rule 17g-7, which mirrored the statutory text.[1191] The Commission is adopting paragraph (a)(1)(ii)(C) of Rule 17g-7 as proposed.[1192] The paragraph provides that the NRSRO must include in the form the main assumptions and principles used in constructing the procedures and methodologies used to determine the credit rating, including qualitative methodologies and quantitative inputs, and, if the credit rating is for a structured finance product, assumptions about the correlation of defaults across the underlying assets.[1193]

Three commenters addressed paragraph (a)(1)(ii)(C) of Rule 17g-7, as proposed.[1194] One NRSRO stated that the Commission should harmonize this requirement with those of similar disclosures required in other jurisdictions, including the European Union.[1195] The commenter, however, did not provide explicit suggestions as to how the rule text could be modified to provide for such harmonization. Consequently, the Commission is not modifying the text on this basis. Two commenters stated that the Commission should not require the disclosure of confidential or proprietary information belonging to either the NRSRO or the issuer, such as non-public financial information of an issuer.[1196] The Commission does not intend that NRSROs will be required to disclose confidential or proprietary information to meet the requirements of paragraph (a)(1)(ii)(C) of Rule 17g-7. As discussed earlier with respect to the format of the form, NRSROs must provide narrative disclosures that are helpful for users of credit ratings to understand the information. Accordingly, the form must contain plainly worded and succinct disclosures. However, the Commission does not expect the disclosures to include confidential or proprietary information.

Paragraph (a)(1)(ii)(D). Section 15E(s)(3)(A)(iii) of the Exchange Act provides that, as required by Commission rule, an NRSRO shall disclose on the form the potential limitations of the credit ratings and the types of risks excluded from the credit ratings that the NRSRO does not comment on, including liquidity, market, and other risks.[1197] The Commission proposed to implement this section through paragraph (a)(1)(ii)(D) of Rule 17g-7, which mirrored the statutory text.[1198]

The Commission is adopting paragraph (a)(1)(ii)(D) of Rule 17g-7 as proposed.[1199] The paragraph provides that the NRSRO must include in the form the potential limitations of the credit rating, including the types of risks excluded from the credit rating that the NRSRO does not comment on, including, as applicable, liquidity, market, and other risks.[1200]

Two commenters addressed paragraph (a)(1)(ii)(D) of Rule 17g-7, as proposed.[1201] One NRSRO supported the rule text as proposed,[1202] and another commenter stated that the disclosure should include more than a listing of the risks that are not assessed as part of the rating.[1203] The Commission agrees with both commenters and notes that the rule as proposed and adopted requires the NRSRO to disclose the potential limitations of the credit rating, including the types of risks excluded from the credit rating that the NRSRO does not comment on, including, as applicable, liquidity, market, and other risks. Consequently, the risks excluded from the credit rating are only a part of the required disclosure. For example, the NRSRO also must disclose the limitations of the credit rating with respect to the risks the NRSRO does comment on, including credit risk.

Paragraph (a)(1)(ii)(E). Section 15E(s)(3)(A)(iv) of the Exchange provides that, as required by Commission rule, an NRSRO shall disclose on the form information on the uncertainty of the credit rating, including: (1) Information on the reliability, accuracy, and quality of the data relied on in determining the credit rating; and (2) a statement relating to the extent to which data essential to the determination of the credit rating were reliable or limited, including any limits on the scope of historical data and any limits in accessibility to certain documents or other types of information that would have better informed the credit rating.[1204] The Commission proposed to implement this section through paragraph (a)(1)(ii)(E) of Rule 17g-7, which mirrored the statutory text.[1205]

The Commission is adopting paragraph (a)(1)(ii)(E) of Rule 17g-7 as proposed.[1206] The paragraph provides that the form must contain information on the uncertainty of the credit rating, including: (1) Information on the reliability, accuracy, and quality of the data relied on in determining the credit rating; and (2) a statement relating to the extent to which data essential to the determination of the credit rating were reliable or limited, including any limits on the scope of historical data and any limits on accessibility to certain documents or other types of information that would have better informed the credit rating.[1207]

Start Printed Page 55171

Two commenters addressed paragraph (a)(1)(ii)(E) of Rule 17g-7, as proposed.[1208] One commenter stated that the Commission should require an NRSRO to address specifically the heightened uncertainty associated with ratings of offerings that do not have an extensive track record, complex or customized securities, or areas where the credit rating agency has limited data on which to base a rating.[1209] The Commission agrees and believes the rule as proposed and adopted requires disclosure on the matters identified by the commenter in that it requires disclosures regarding limits on the scope of historical data and limits on the accessibility to certain documents or other types of information that would have better informed the credit rating.

One NRSRO stated that requiring NRSROs to provide overly detailed information regarding “`reliability,' `accuracy' and `quality'” of data, could result in extremely lengthy disclosures due to the number of types of data.[1210] The NRSRO further stated that the Commission should harmonize this requirement with other jurisdictions' requirements by requiring only a statement about “(i) whether essential data was available; (ii) whether such data was believed to be reliable; and (iii) any limitations on access to data for that transaction that differed from typical circumstances.” [1211] As discussed above, NRSROs must provide narrative disclosures that are helpful for users of credit ratings to understand the information and, therefore, the form must contain plainly worded and succinct disclosures that are not unnecessarily detailed. As for the suggestion to harmonize the rule with other jurisdictions' requirements, the text suggested by the commenter generally seems consistent with the proposed rule. Consequently, the Commission is not persuaded that it is necessary to modify the proposed rule in response to this comment.[1212]

Paragraph (a)(1)(ii)(F). Section 15E(s)(3)(A)(v) of the Exchange Act provides that, as required by Commission rule, an NRSRO shall disclose on the form whether and to what extent third-party due diligence services have been used by the NRSRO, a description of the information that such third party reviewed in conducting due diligence services, and a description of the findings or conclusions of such third party.[1213] The Commission proposed to implement this section through paragraph (a)(1)(ii)(F), which largely mirrored the statutory text.[1214]

Several commenters addressed paragraph (a)(1)(ii)(F) of Rule 17g-7, as proposed.[1215] The Commission is adopting paragraph (a)(1)(ii)(F) of Rule 17g-7 with modifications in response to comments.[1216]

Two commenters stated that the rule should be confined in scope to credit ratings on asset-backed securities.[1217] Two NRSROs stated that unless the person providing third-party due diligence services was engaged by the NRSRO, disclosure would be more appropriately made by the party that hired the due diligence provider.[1218] One NRSRO stated that “[i]ssuers and underwriters, not NRSROs, should pass through the third party's description of the information reviewed and the third party's findings and conclusions,” but, if the NRSROs must disclose the information, the Commission should clarify that the disclosure requirement can be met by the NRSRO “passing through the certification that the third party provides to the NRSRO.” [1219] In addition, one commenter stated that the final amendments should require that NRSROs “expressly restate” specific findings and conclusions from third-party due diligence reports to prevent them from being “mischaracterized or taken out of context.” [1220] Another commenter suggested that the words “a description of the findings or conclusions” should be revised to “a summary of the findings and conclusions,” because a “summary” better aligns with the requirement in proposed Form ABS Due Diligence-15E.[1221] The commenter further stated that what should be provided is a summary of the findings and conclusions, not the findings and conclusions themselves, and “there is no reason why the summary would not be substantially similar in each context.” [1222] One NRSRO stated that publishing the certification of the third-party due diligence provider with the form as required by paragraph (a)(2) of Rule 17g-7, as proposed, makes its use by the NRSRO “self-evident.” [1223]

The Commission is adopting the requirement that the form must contain information relating to due diligence services performed by a third party to implement section 15E(s)(3)(A)(v) of the Exchange Act.[1224] This information will help investors and other users of credit ratings to understand how the NRSRO determined the credit rating. In response to the comments that paragraph (a)(1)(ii)(F) should be limited to rating actions involving asset-backed securities, the Commission interprets the text of the rule referring to “due diligence services of a third party” as meaning the type of due diligence services that are within the scope of Rule 17g-10, as adopted, and Form ABS Due Diligence-15E (which apply to third-party due diligence services only in connection with asset-backed securities).[1225] Consequently, paragraph (a)(1)(ii)(F) is limited to rating actions involving Exchange Act-ABS.[1226]

In response to comments, the Commission is modifying the rule from the proposal to permit the NRSRO to provide a cross-reference to a Form ABS Due Diligence-15E that is published with the form to meet part of the disclosure requirement in paragraph (a)(1)(ii)(F).[1227] The Commission is persuaded by commenters that if an NRSRO used due diligence services of a third party it would be redundant, and potentially confusing, for the NRSRO to provide a description of the information that the third party reviewed in Start Printed Page 55172conducting the due diligence services and a description of the findings or conclusions of the third party if that information is in a Form ABS Due Diligence-15E published with the form.[1228]

In addition, as noted above, a commenter proposed modifying the rule to replace the phrase “a description of the findings or conclusions” to “a summary of the findings and conclusions,” because the commenter believed that a “summary” better aligns with the requirement in proposed Form ABS Due Diligence-15E and that, in each case, the rules should require a summary of the findings and conclusions (as opposed to the findings and conclusions themselves).[1229] Item 5 of Form ABS Due Diligence-15E requires the third party to provide a “summary of the findings and conclusions that resulted from the due diligence services.” [1230] The Commission agrees with the commenter and has therefore modified the proposal to replace the words “description of the findings or conclusions of such third party” with the words “summary of the findings and conclusions of the third party.” [1231] However, if an NRSRO chooses to provide a summary of the findings and conclusions, the level of detail in the summary should be comparable to the level of detail a provider of third-party due diligence services provides in Form ABS Due Diligence-15E, as the summary in the form can be a substitute for the NRSRO providing a summary.[1232]

For these reasons, the final amendments provide that the form must contain whether and to what extent the NRSRO used due diligence services of a third party in taking the rating action, and, if the NRSRO used such services, either: (1) A description of the information that the third party reviewed in conducting the due diligence services and a summary of the findings and conclusions of the third party; or (2) a cross-reference to a Form ABS Due Diligence-15E executed by the third party that is published with the form, provided the cross-referenced Form ABS Due Diligence-15E contains a description of the information that the third party reviewed in conducting the due diligence services and a summary of the findings and conclusions of the third party.[1233]

The Commission is not persuaded by the comment that publishing the certification of the third-party due diligence provider with the form as required by paragraph (a)(2) of Rule 17g-7, as proposed, makes its use by the NRSRO “self-evident.” [1234] As discussed below in section II.G.5. of this release, section 15E(s)(4)(B) of the Exchange Act requires a third party providing due diligence services to an NRSRO, issuer, or underwriter with respect to an asset-backed security to provide a written certification to any NRSRO that produces a credit rating to which the due diligence services relate.[1235] Section 15E(s)(4)(D) of the Exchange Act provides that the Commission shall adopt rules requiring an NRSRO that receives a certification to disclose the certification to the public at the time at which the NRSRO produces a rating.[1236] Paragraph (a)(2) of Rule 17g-7, as amended, implements section 15E(s)(4)(D) by requiring the NRSRO to publish with the form any certifications it receives. However, the NRSRO's receipt of the certification pursuant to section 15E(s)(4)(B) and publication of the certification pursuant to paragraph (a)(2) of Rule 17g-7, as amended, is not predicated on the NRSRO having used the due diligence services in determining the credit rating. Consequently, the final amendments retain the requirement for the NRSRO to include in the form whether and to what extent the NRSRO used due diligence services of a third party in taking the rating action.[1237]

Paragraph (a)(1)(ii)(G). Section 15E(s)(1)(A)(iii) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form information relating to, if applicable, how the NRSRO used servicer or remittance reports, and with what frequency, to conduct surveillance of the credit rating.[1238] The Commission proposed to implement this section through paragraph (a)(1)(ii)(G) of Rule 17g-7, which mirrored the statutory text.[1239]

One commenter addressed paragraph (a)(1)(ii)(G) of Rule 17g-7, as proposed, by noting its support of the rule text as proposed.[1240] The Commission is adopting paragraph (a)(1)(ii)(E) of Rule 17g-7 as proposed.[1241] The paragraph provides that the NRSRO must include in the form, if applicable, how servicer or remittance reports were used, and with what frequency, to conduct surveillance of the credit rating.[1242]

Paragraph (a)(1)(ii)(H). Section 15E(s)(3)(A)(vi) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form a description of the data about any obligor, issuer, security, or money market instrument that were relied upon for the purpose of determining the credit rating.[1243] The Commission proposed to implement this section through paragraph (a)(1)(ii)(H) of Rule 17g-7, which mirrored the statutory text.[1244] The Commission is adopting paragraph (a)(1)(ii)(H) of Rule 17g-7 with a modification in response to comments.[1245]

One NRSRO stated that the requirement may result in “effectively overloading” investors with information and essentially “reducing rather than enhancing” the disclosure's value.[1246] This commenter and another commenter expressed concerns that some data may be confidential or provided to the NRSRO under terms restricting public disclosure.[1247] One commenter suggested that the Commission clarify that the requirement for a “description of the data relied upon” requires only a description of the general type of data and not of specific data, since specific data can be obtained Start Printed Page 55173from the relevant offering documents.[1248]

In response to these comments, the Commission notes, as stated above, that section 15E(s)(3)(A)(vi) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form a description of the data about any obligor, issuer, security, or money market instrument that were relied upon for the purpose of determining the credit rating.[1249] Paragraph (a)(1)(ii)(H) of Rule 17g-7, as proposed, was designed to implement the statute. Moreover, as discussed above, the form must disclose information that can be used by investors and other users of credit ratings to better understand credit ratings [1250] and, therefore, the form must contain plainly worded and succinct disclosures that are not overly detailed. In this regard, the Commission did not intend to require that the form repeat verbatim all the data that were relied upon to determine the credit rating. Instead, it intended the form to include a “description” to help users of the credit rating to understand the types of data the NRSRO relied on. To make this more clear and address the commenter's concern, the Commission has modified the final amendments to require the NRSRO to include in the form a description of the types of data about any obligor, issuer, security, or money market instrument that were relied upon for the purpose of determining the credit rating.[1251]

Paragraph (a)(1)(ii)(I). Section 15E(s)(3)(A)(vii) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form a statement containing an overall assessment of the quality of information available and considered in producing a rating for the obligor, security, or money market instrument, in relation to the quality of information available to the NRSRO in rating similar issuances.[1252] The Commission proposed to implement this section through paragraph (a)(1)(ii)(I) of Rule 17g-7, which largely mirrored the statutory text.[1253]

The Commission is adopting paragraph (a)(1)(ii)(I) of Rule 17g-7 as proposed.[1254] The paragraph provides that the NRSRO must include in the form a statement containing an overall assessment of the quality of information available and considered in determining the credit rating for the obligor, security, or money market instrument, in relation to the quality of information available to the NRSRO in rating similar obligors, securities, or money market instruments.[1255]

One NRSRO stated that the requirement to disclose an overall assessment of the quality of information used in its rating “would present practical, and possibly contractual difficulties,” and that the Commission should harmonize this requirement with other jurisdictions' requirements by requiring a statement about “(i) whether essential data was available; (ii) whether such data was believed to be reliable; and (iii) any limitations on access to data for that transaction that differed from typical circumstances.” [1256] The commenter did not explain how the proposed requirement would present contractual difficulties but, as discussed above, the Commission does not intend the disclosure provisions in the rule to require NRSROs to disclose confidential or proprietary information. In terms of practical issues, as discussed above, the NRSROs must provide narrative disclosures in the form that are helpful for users of credit ratings to understand the information and, therefore, the form must contain plainly worded and succinct disclosures that are not overly detailed. Thus, the practical issue of having to make highly detailed disclosures is not implicated by the rule as proposed and adopted. As for the suggestion to harmonize the rule with other jurisdictions, the text suggested by the commenter generally seems aimed at requiring relatively similar disclosures though it does not explicitly require an assessment of the overall quality of information available to the NRSRO in rating similar obligors, securities, or money market instruments. Consequently, the Commission is not persuaded that it is necessary to implement the statute in a manner that deviates from the proposed rule.[1257]

Paragraph (a)(1)(ii)(J). Proposed paragraph (a)(1)(ii)(J) of Rule 17g-7 [1258] would implement, in part, section 15E(s)(3)(A)(viii) of the Exchange Act, which provides that the Commission shall require, by rule, that the NRSRO disclose on the form information relating to conflicts of interest of the NRSRO.[1259] The Commission proposed to identify three specific items of information that, at a minimum, an NRSRO would need to disclose in the form relating to conflicts of interest.[1260]

First, proposed paragraph (a)(1)(ii)(J)(1) would require the NRSRO to include a classification of the credit rating as either solicited sell-side, solicited buy-side, or unsolicited.[1261] The proposal defined solicited sell-side to mean that the credit rating was paid for by the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated.[1262] The proposal defined solicited buy-side to mean that the credit rating was paid for by a person other than the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated.[1263] The proposal defined an unsolicited credit rating to mean the NRSRO was not paid to determine the credit rating.[1264] The Commission is Start Printed Page 55174adopting paragraph (a)(1)(ii)(J)(1) of Rule 17g-7 with modifications in response to comments about these definitions.[1265]

One NRSRO stated that equating the concept of solicitation with payment would result in confusion in the market, and that the definition should be harmonized with that of other jurisdictions, where an unsolicited credit rating is defined as one that is initiated by the credit rating agency and not requested by the issuer.[1266] The Commission is persuaded that requiring the NRSRO to classify the credit rating using one of these terms could be confusing given other views as to what constitutes a solicited or unsolicited credit rating. Further, disclosing the conflict through a classification may not be as helpful as simply having the NRSRO include a statement in the form as to whether another person paid for the credit rating. For these reasons, the final amendments have been modified to exclude the specific terms proposed and instead require the NRSRO to include in the form, as applicable, a statement that the NRSRO was: (1) Paid to determine the credit rating by the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated; (2) paid to determine the credit rating by a person other than the obligor being rated or the issuer, underwriter, depositor, or sponsor of the security or money market instrument being rated; or (3) not paid to determine the credit rating.[1267]

The second type of conflict disclosure was specified in proposed paragraph (a)(1)(ii)(J)(2) of Rule 17g-7.[1268] Pursuant to this paragraph, if the credit rating was classified as either solicited sell-side or solicited buy-side, the NRSRO would be required to disclose whether the NRSRO provided services other than determining credit ratings to the person that paid for the credit rating during the most recently ended fiscal year.[1269] The Commission is adopting paragraph (a)(1)(ii)(J)(2) of Rule 17g-7 with modifications in response to comments.[1270]

A commenter stated that the disclosure about other services provided by an NRSRO does not provide any basis to conclude that a rating may be compromised.[1271] Another commenter strongly opposed the requirement due to the difficulty of shielding analysts from such information so as to promote independence in the credit rating process.[1272] A third commenter supported the proposed requirement and added that the Commission should also require NRSROs to disclose the revenue they received from a particular issuer.[1273]

The Commission does not agree with the commenter that being paid for other services does not present a potential conflict. As the Commission stated in the proposing release, clients paying an NRSRO for services in addition to determining credit ratings may pose an increased risk of exerting undue influence on the NRSRO with respect to its determination of credit ratings.[1274] The Commission has adopted rules that address this conflict.[1275] The proposed disclosure requirement about paying for other services was intended to complement these requirements.[1276]

The Commission acknowledges the concern raised by the commenter about the objective of shielding analysts from information that could compromise their independence.[1277] Nonetheless, the Commission believes that the proposed disclosure that the NRSRO was paid for other services is appropriate because it will provide users of credit ratings with relevant information about this conflict even when balanced against the concern that an analyst reading the report will learn that the NRSRO was paid for other services. If the NRSRO was required to disclose the amount of revenue received (as suggested by the third commenter), this concern that the analyst might be influenced by the disclosure would be increased.[1278]

For all of these reasons, the Commission is adopting the requirement that the NRSRO must include a disclosure in the form if it was paid for other services.[1279] The Commission modified the final amendments to correspond to the modifications discussed above with respect to eliminating the proposed classification of the credit rating as either solicited or unsolicited. Specifically, the final amendments require the NRSRO, if applicable, to include in the form a statement that the NRSRO also was paid for services other than determining credit ratings during the most recently ended fiscal year by the person that paid the NRSRO to determine the credit rating.[1280]

The third type of conflict disclosure was specified in (a)(1)(ii)(J)(3) and related to rating actions resulting from look-back reviews.[1281] As discussed above in section II.C.1. of this release, the proposal would require the disclosure of information about a conflict of interest influencing a credit rating action discovered as a result of a look-back review conducted pursuant to section 15E(h)(4)(A) of the Exchange Act and proposed paragraph (c) of Rule 17g-8. Also, as discussed above in section II.C.1. of this release, the Commission is adopting paragraph (a)(1)(ii)(J)(3) of Rule 17g-7 with modifications in response to comments that eliminate the required disclosure that would have accompanied the placement of the credit rating on credit watch, modify the required disclosure with respect to estimating the impact of the conflict, and make certain related and technical modifications.[1282]

Paragraph (a)(1)(ii)(K). Section 15E(s)(3)(B)(i) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form an explanation or measure of the potential volatility of the credit rating, including: (1) Any factors that might lead to a change in the credit rating; and (2) the magnitude of the Start Printed Page 55175change that a user can expect under different market conditions.[1283] The Commission proposed to implement this section through paragraph (a)(1)(ii)(K) of Rule 17g-7, which largely mirrored the statutory text.[1284] The Commission is adopting paragraph (a)(1)(ii)(K) of Rule 17g-7 with modifications in response to comment.[1285]

Three commenters addressed paragraph (a)(1)(ii)(K) of Rule 17g-7, as proposed.[1286] An NRSRO suggested that the Commission modify the rule to require the disclosure of any factors that are “reasonably likely to” (rather than “might”) lead to a change in the credit rating.[1287] A second NRSRO stated that “each NRSRO should decide for itself what conditions merit discussion in light of the characteristics of the rated instrument and whatever other information the NRSRO believes it is appropriate to take into account.” [1288] A third commenter stated that the Commission should require the NRSROs to be very specific about the events and the magnitude of those events that would cause ratings to be in “error” and provided a five percent drop in housing prices as an example.[1289]

The Commission agrees with the modifications suggested by the first commenter. The word “might” as used in the proposed rule text is imprecise and could lead to disclosures that seek to identify any conceivable factor that could lead to the change in the credit rating no matter how remote the possibility. This could diminish the usefulness of the disclosure by including information that is not highly relevant to understanding the credit rating and generally making the disclosure too long.

Regarding the second comment, the magnitude of the change that could occur under different market conditions will depend on an NRSRO's procedures and methodologies for determining credit ratings that apply to the credit rating that is subject to the rating action.[1290] Consequently, the required disclosure—as proposed and adopted—will be based on those procedures and methodologies and how they account for different market conditions. In other words, the NRSRO will need to “decide for itself” the potential market conditions that could cause a change in the credit rating given its rating procedures and methodologies. However, to make this clear, the Commission is modifying the rule to specify that the different market conditions are those that are determined by the NRSRO to be relevant to the rating.[1291]

Finally, the Commission generally agrees with the third commenter that the disclosure by the NRSRO must specify the factors (for example, market conditions) that would lead to a change in the credit rating. As discussed above, the NRSRO must disclose factors that might lead to a change in the credit rating. In doing so, the NRSRO must explain the factors.

For these reasons, the final amendments require the NRSRO to include in the form an explanation or measure of the potential volatility of the credit rating, including: (1) Any factors that are reasonably likely to lead to a change in the credit rating; and (2) the magnitude of the change that could occur under different market conditions determined by the NRSRO to be relevant to the rating.[1292]

Paragraph (a)(1)(ii)(L). Section 15E(s)(3)(B)(ii) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form information on the content of the credit rating, including: (1) The historical performance of the credit rating; and (2) the expected probability of default and the expected loss in the event of default.[1293] The Commission proposed to implement this section through paragraph (a)(1)(ii)(L) of Rule 17g-7, which mirrored the statutory text.[1294]

The Commission is adopting paragraph (a)(1)(ii)(L) of Rule 17g-7 as proposed.[1295] The paragraph provides that the NRSRO must include in the form information on the content of the credit rating, including: (1) If applicable, the historical performance of the credit rating; and (2) the expected probability of default and the expected loss in the event of default.[1296]

Two NRSROs addressed paragraph (a)(1)(ii)(L) of Rule 17g-7, as proposed.[1297] One stated that it supports the disclosure elements specified in this paragraph.[1298] The other commenter stated that the proposal is sufficiently explicit, but indicated that its credit ratings do not connote a “particular” expectation of the probability of default.[1299] The Commission recognizes that credit ratings generally are intended to indicate the relative degree of credit risk of an obligor or debt instrument rather than reflect a measure of a specific default probability or loss expectation.[1300] The Commission does not expect NRSROs to alter the meanings of their credit ratings or rating procedures and methodologies to conform to the disclosure requirement. Rather, the Commission expects NRSROs to provide “information” to the extent it is consistent with their procedures and methodologies for determining credit ratings, on the expected probability of default and expected loss in the event of default. This information could consist of, for example, historical default and loss statistics, respectively, for the class or subclass of the credit rating.

Paragraph (a)(1)(ii)(M). Section 15E(s)(3)(B)(iii) of the Exchange Act provides that the Commission shall require, by rule, that the NRSRO disclose on the form information on the sensitivity of the credit rating to assumptions made by the NRSRO, including: (1) Five assumptions made in the ratings process that, without accounting for any other factor, would have the greatest impact on a rating if the assumptions were proven false or inaccurate; and (2) an analysis, using specific examples, of how each of the five assumptions identified impacts a credit rating.[1301] The Commission proposed to implement this section through paragraph (a)(1)(ii)(M) of Rule 17g-7, which mirrored the statutory Start Printed Page 55176text.[1302] The Commission is adopting paragraph (a)(1)(ii)(M) of Rule 17g-7 with modifications in response to comments.[1303]

Several commenters addressed paragraph (a)(1)(ii)(M) of Rule 17g-7, as proposed.[1304] An NRSRO stated that the disclosure of assumptions will tend to become a “mechanical exercise” where disclosure is “sufficiently vague so as to be unimpeachable,” but will not be useful.[1305] Another NRSRO stated that it should be permissible to disclose fewer than five assumptions if fewer than five significant assumptions exist.[1306] Two other NRSROs stated that it may be difficult to identify five single assumptions[1307] because, according to one NRSRO, many assumptions are “cross-dependent,” and different assumptions may “play out differently in various economic scenarios.” [1308] Another commenter stated that the Commission should also require NRSROs to disclose the sensitivity of the credit rating to several assumptions changing at the same time and the dependencies assumed between the assumptions.[1309]

The Commission agrees with the commenter that an NRSRO should not disclose five assumptions if there are fewer than five assumptions that would have an impact on the credit rating if proven false or inaccurate. Otherwise, the disclosure could contain information that is potentially misleading by, for example, creating the impression the assumption is important when it is not. Consequently, the final amendments are modified to include a provision that the NRSRO need only disclose information on the assumptions that would have an impact on the credit rating if there are fewer than five such assumptions.[1310] Specifically, the final amendments require the NRSRO to include in the form information on the sensitivity of the credit rating to assumptions made by the NRSRO, including: (1) Five assumptions made in the ratings process that, without accounting for any other factor, would have the greatest impact on the credit rating if the assumptions were proven false or inaccurate, provided that, if the NRSRO has made fewer than five such assumptions, it need only disclose information on the assumptions that would have an impact on the credit rating; and (2) an analysis, using specific examples, of how each of the assumptions impacts the credit rating.[1311]

In response to the comment that this disclosure will become “mechanical” and not useful, the Commission—as stated above—expects NRSROs to make the disclosures as specific to the particular rating action, and as relevant to investors, as possible, and to strike a reasonable balance between standardizing the disclosures and tailoring them to specific rating actions. With respect to the comments on isolating the assumptions and the co-dependencies between assumptions, the Commission understands that certain assumptions may be co-dependent. The NRSRO should provide an explanation of this co-dependency in the disclosure of the assumptions to the extent it is relevant to understanding how they would impact the credit rating.

Paragraph (a)(1)(ii)(N). Paragraph (a)(1)(ii)(N) of Rule 17g-7, as proposed, would contain the disclosure requirements in paragraphs (a) and (b) of Rule 17g-7 before today's amendments.[1312] Specifically, this paragraph would provide that if the credit rating is issued with respect to an asset-backed security, as that term is defined in section 3(a)(79) of the Exchange Act, the NRSRO must include in the form a description of: (1) The representations, warranties, and enforcement mechanisms available to investors; and (2) how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities, each time there was a rating action with respect to an asset-backed security.[1313] The Commission is adopting paragraph (a)(1)(ii)(N) of Rule 17g-7 with modifications in response to comments.[1314]

Several commenters addressed paragraph (a)(1)(ii)(N) of Rule 17g-7, as proposed.[1315] Two NRSROs objected to the frequency of the required disclosures under the proposed paragraph.[1316] One NRSRO stated that, while the disclosures are relevant at the time an initial credit rating is published, the disclosures may not be relevant at later times because the representations, warranties, and enforcement mechanisms likely will not change in the course of a rated security's existence.[1317] Another NRSRO stated that requiring the disclosures with each rating action “unacceptably” expands the disclosure requirement in Rule 17g-7 before today's amendments, which required the disclosures when a rating report is published, noting that some rating actions “would not necessarily be accompanied by the issuance of a credit rating report.” [1318]

One NRSRO stated that the disclosures required by Rule 17g-7 before today's amendments are “enormously costly to the NRSROs” and are “of very little value to investors” according to feedback from institutional clients and an analysis of the NRSRO's Internet Web site usage data.[1319] This NRSRO suggested that the rule be modified to require disclosures that “relate to the asset pool underlying the ABS transaction” and which “the issuer has disclosed in the prospectus, private placement memorandum or other offering document for that transaction.” [1320] Similarly, one commenter stated that the required disclosures should be limited to representations, warranties, and enforcement mechanisms that “appear in the prospectus or other offering document for [the applicable] security” because otherwise the information Start Printed Page 55177would not be material to an investor's ability to make an informed decision.[1321] Finally, an NRSRO suggested that the benchmarks for the representations, warranties, and enforcement mechanisms should be displayed in “a dedicated area of the NRSROs' Web sites” instead of in the form.[1322]

The Commission has modified the final amendments in response to some of these comments and consistent with the Commission's objective of making the information in the form disclosed with a credit rating helpful to investors and other users of credit ratings in understanding how the credit rating was determined. The first significant modification is to narrow the disclosure requirement so that it addresses the representations, warranties, and enforcement mechanisms available to investors which were disclosed in the prospectus, private placement memorandum, or other offering documents for the asset-backed security and that relate to the asset pool underlying the asset-backed security. The Commission agrees with commenters that this is highly relevant information for investors. Therefore, focusing the disclosure requirement in this way may make the required disclosure more relevant and useful to investors and other users of credit ratings than the disclosures required under Rule 17g-7 before today's amendments. Specifically, paragraph (a)(1)(ii)(N) of Rule 17g-7 requires an NRSRO, if the credit rating is assigned to an asset-backed security as defined in section 3(a)(79) of the Exchange Act, to disclose in the form information on: (1) The representations, warranties, and enforcement mechanisms available to investors which were disclosed in the prospectus, private placement memorandum, or other offering documents for the asset-backed security and that relate to the asset pool underlying the asset-backed security; and (2) how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities.[1323]

The second significant modification is to reduce the frequency of the disclosure. As commenters stated, the proposal—by incorporating the requirements of Rule 17g-7 before today's amendments into the new form disclosure requirements—would increase the number of times an NRSRO would need to disclose the information about representations, warranties, and enforcement mechanisms. The Commission believes that the critical time for disclosing this information is when investors are making investment decisions about a new issuance, which would have no performance history. The Commission also believes the disclosure would be useful if there is a material change in the representations, warranties, or enforcement mechanisms after issuance because the change could be relevant to investment decisions made in the secondary market for the security. Finally, because Rule 17g-7 became effective on September 26, 2011, the final amendments provide that the requirement to make the disclosure after a material change is triggered only if the rating action involves an asset-backed security that was initially rated by the NRSRO on or after September 26, 2011. This will further limit the burden associated with the rule. It also will address the practical issue of an NRSRO having to make a disclosure involving historical information that it may not have collected and retained because it was not required to make the disclosure about the representations, warranties, or enforcement mechanisms when it initially rated the asset-backed security. For these reasons, the final amendments require the information to be disclosed if the rating action is a preliminary credit rating or an initial credit rating or if the rating action is the first one taken after a material change in the representations, warranties, or enforcement mechanisms and the rating action involves an asset-backed security that was initially rated by the NRSRO on or after September 26, 2011.[1324]

4. Paragraph (a)(1)(iii) of Rule 17g-7—Attestation

Section 15E(q)(2)(F) of the Exchange Act provides that the Commission's rules must require an NRSRO to include an attestation with any credit rating it issues affirming that no part of the rating was influenced by any other business activities, that the rating was based solely on the merits of the instruments being rated, and that such rating was an independent evaluation of the risks and merits of the instrument.[1325] While section 15E(q) relates to the disclosure of information about the performance of credit ratings, the Commission proposed that this attestation provision would more appropriately be implemented with respect to all disclosures that must be made when a specific rating action is published.[1326] Accordingly, the Commission proposed that the attestation be included in the form accompanying a credit rating.[1327]

As proposed, an NRSRO would be required to attach to the form with each rating action a signed statement by a person within the NRSRO stating that the person has responsibility for the credit rating and, to the best knowledge of the person: (1) No part of the credit rating was influenced by any other business activities; (2) the credit rating was based solely upon the merits of the obligor, security, or money market instrument being rated; and (3) the credit rating was an independent evaluation of the risks and merits of the obligor, security, or money market instrument.[1328] Thus, the proposed rule text mirrored the statutory text in terms of the representations that would be included in the attestation.[1329]

The Commission received several comments that addressed the proposal.[1330] One commenter stated that the “strong” attestation requirement is a “valuable enhancement” because it promotes increased accountability and “more meaningful disclosures.” [1331] One NRSRO endorsed the attestation requirement substantially as proposed.[1332] Two NRSROs were concerned that the attestation requirement would result in an employee or officer being personally liable for a rating action.[1333] One Start Printed Page 55178NRSRO stated that a ratings committee already attests to the rating's independence by signing its internal rating forms and stated “[t]hus, such an attestation is already part and parcel of the ratings package that is . . . available to Commission staff during their annual exams, or at any other time.” [1334] One NRSRO suggested that rather than an attestation, the NRSRO should be required to disclose the name of the chair of the rating committee because doing so is an implicit attestation that the credit rating was determined in accordance with the NRSRO's rating procedures and methodologies.[1335]

The Commission is adopting paragraph (a)(1)(iii) of Rule 17g-7 with one modification in response to comments. Specifically, one NRSRO suggested that the wording of the proposed attestation—because it used the phrase “risks and merits”—could inadvertently lead users of credit ratings to believe that credit ratings address other types of risk, such as liquidity risk, market value risk, or price volatility.[1336] The commenter suggested the phrase “credit risk” be used instead.

The Commission agrees. Credit ratings are assessments of creditworthiness.[1337] Consequently, the attestation should reference credit risk so as not to be misleading. In addition, the NRSRO should have the flexibility to designate the individual who will execute the certification, as more than one individual within the NRSRO may have responsibility for the rating action.[1338] For these reasons, the final amendments provide that the NRSRO must attach to the form a signed statement by a person within the NRSRO stating that the person has responsibility for the rating action and, to the best knowledge of the person: (1) No part of the credit rating was influenced by any other business activities; (2) the credit rating was based solely upon the merits of the obligor, security, or money market instrument being rated; and (3) the credit rating was an independent evaluation of the credit risk of the obligor, security, or money market instrument.[1339]

The Commission does not believe the alternatives suggested by commenters—relying on internal records or disclosure of the identity of the rating committee chair—would adequately implement the statute. As discussed above, section 15E(q)(2)(F) of the Exchange Act provides that the Commission's rules must require an NRSRO to include an attestation with any credit rating it issues affirming that no part of the rating was influenced by any other business activities, that the rating was based solely on the merits of the instruments being rated, and that such rating was an independent evaluation of the risks and merits of the instrument.[1340] Consequently, the attestation must be included with the credit rating the NRSRO issues rather than being documented in an internal record. Further, the Commission believes that having an individual attest to t