SEC proposes series of reforms to rules governing credit rating agencies

By Cydney Posner

In June, the SEC voted to propose a comprehensive series of credit rating agency reforms to bring increased transparency to the ratings process and to curb practices that were viewed to have contributed to the recent turmoil in the credit markets. The major rating agencies, such as Standard & Poor's and Moody's, have been widely categorized among the villains of the crisis for assigning inappropriately high ratings to, and then sharply downgrading, subprime mortgage investments, which triggered the credit market crisis. Some critics have asserted that they succumbed to pressures from investment banks, which were acting as "arrangers" in packaging complex and risky debt under an "originate to distribute" model (i.e., where loans were originated with the intent to securitize them, with large arranger fees associated with originating, structuring, servicing, managing and underwriting). See, for example, the article below from today's NYT, where Moody's effectively admits to problems arising out of conflict issues. Some commentators have accused the SEC of ``outsourcing'' regulation by inappropriately incorporating the use of ratings into its rules and effectively delegating risk decisions by "telling banks or telling broker dealers or money-market mutual funds or insurance companies that they've got to pay attention to some select few group of credit raters....'' The proposals are designed to address concerns about the integrity of the credit rating procedures and methodologies of credit rating agencies and to eliminate the patina of authority from the decisions of these agencies.

The SEC has now posted all of these proposals. The first proposal would add requirements for nationally recognized statistical rating organizations (NRSROs) aimed at reducing conflicts of interests in the credit rating process, fostering competition and comparability among credit rating agencies and increasing the transparency of the credit rating process. The second proposal (issued in the same release as the first proposal) is designed to improve investor understanding of the risk characteristics of structured finance products by requiring credit rating agencies to differentiate (e.g., by using different symbols) the ratings they issue on structured finance products from those they issue on regular bonds. The third proposal is the result of the SEC's review of its rules and forms for references that rely on security ratings by an NRSRO. Essentially, the SEC believes these references to NRSROs may suggest that their credit ratings have the SEC's imprimatur and therefore adversely affect the quality of due diligence and investment analysis conducted by brokers, prospective purchasers and others. The proposal would remove most of the references to credit ratings in the SEC's rules. 

The first two proposals may be of general interest. For example, they propose extensive public disclosure of the information provided by the issuer, sponsor, trustee or underwriter that is used by the credit rating agency in determining the credit rating, but those proposals appear, so far, to apply only to structured finance products. (Also, for anyone interested in a primer on the workings of securitizations, credit enhancements, synthetic CDOs, the "waterfall," credit default swaps and credit rating procedures, the first release might be a good resource.) However, the most relevant proposed modifications from our perspective are contained in the third proposal, which, very generally, would substitute for many references to the now-disdained NRSRO standard the standard for determining status as a "well-known seasoned issuer," or WKSI, applicable to issuers of non-convertible securities. More specifically, if adopted, the proposal would make the following notable changes:

Securities Act Rules

• The proposal would revise the transaction eligibility criteria for registering primary offerings of non-convertible securities on Forms S-3 and F-3. As proposed, the instructions to these forms would no longer include a reference to a security rating by an NRSRO in the transaction requirements for issuers registering primary offerings of non-convertible securities for cash. Instead, these forms would be available to register primary offerings of non-convertible securities if the issuer has issued (as of a date within 60 days prior to the filing of the registration statement) for cash more than $1 billion in non-convertible securities, other than common equity, through registered primary offerings over the prior three years. The proposal would use the same method and threshold used as one of the criteria in determining WKSI status. The SEC expects that the number of eligible issuers would not change significantly under the proposal.
• In determining compliance with this threshold:
  • issuers may aggregate the amount of non-convertible securities, other than common equity, issued in registered primary offerings during the prior three years;
  • issuers may include only those non-convertible securities that were issued in registered primary offerings for cash, not in registered exchange offers; and
  • parent company issuers may include in their calculations only the principal amount of their full and unconditional guarantees, within the meaning of Rule 3-10 of Reg S-X, of non-convertible securities, other than common equity, of their majority-owned subsidiaries issued in registered primary offerings for cash during the three-year period.
• The aggregate principal amount of non-convertible securities that may be counted toward the $1 billion issuance threshold may have been issued in any registered primary offering for cash, on any form (other than Form S-4 or Form F-4). In calculating the $1 billion amount, issuers generally may include the principal amount of any debt and the greater of liquidation preference or par value of any non-convertible preferred stock that were issued in primary registered offerings for cash. Non-convertible securities need not be investment grade securities to be included in the calculation.
• Forms S-4 and F-4 allow registrants that meet the registrant eligibility requirements of Form S-3 or F-3 and are offering investment grade securities to incorporate by reference certain information. Similarly, Schedule 14A permits a registrant to incorporate by reference if the Form S-3 registrant requirements are met and the registrant is offering investment grade securities. The SEC is proposing to make conforming changes in those forms as well.
• Rules 138, 139 and 168 provide safe harbor exceptions from the definitions of offer for sale or offer to sell a security within the meaning of Sections 2(a)(10) and 5(c) of the Securities Act for certain communications that relate to an offering of non-convertible investment grade securities. These communications include the following:
  • under Rule 138, publication by a broker or dealer about securities of a foreign private issuer that meets F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities;
  • under Rule 139, publication or distribution of a research report by a broker or dealer about an issuer or its securities where the issuer meets Form S-3 or F-3 registrant requirements and is or will be offering investment grade securities pursuant to General Instruction I.B.2 of Form S-3 or F-3, or where the issuer meets Form F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities; and
  • under Rule 168, the regular release and dissemination by or on behalf of an issuer of communications containing factual business information or forward-looking information where the issuer meets Form F-3 eligibility requirements (other than the reporting history requirements) and is issuing non-convertible investment grade securities.

  The SEC is proposing conforming changes here as well.

• The SEC's policy on disclosure of security ratings, in Item 10(c) of Reg S-K, permits issuers to disclose in SEC filings security ratings assigned by credit rating agencies to classes of debt securities, convertible debt securities and preferred stock. While the SEC had previously considered mandating this disclosure, the current release would retain the current permissive Item 10(c) policy on security ratings, with minor changes.
• Rule 436(g) provides that a security rating assigned by an NRSRO to a class of debt securities, a class of convertible debt securities or a class of preferred stock is not an expertized part of a registration statement within the meaning of sections 7 and 11 of the Securities Act, which would require filing of a consent by the NRSRO. Under the proposal, the application of Rule 436(g) would be extended beyond NRSROs to include ratings by any credit rating agency. The extension of relief from the expert's consent requirement is intended to foster competition.

The proposal would not make changes to the following rules:

• Rule 134(a)(17) provides a safe harbor from the definitions of prospectus or free writing prospectus for certain communications, including among them the disclosure of security ratings. This reference to security ratings is not being eliminated. However, the proposal would revise the rule to allow disclosure of ratings assigned by any credit rating agency, not just NRSROs. If applicable, the disclosure must also note that the credit rating agency is not an NRSRO.
• Under Rule 100(b)(2) of Reg FD, disclosures to an entity whose primary business is the issuance of security ratings are excluded from coverage, so long as the information is disclosed solely for the purpose of developing a credit rating and the entity’s ratings are publicly available. This exception for disclosures to credit rating agencies is not proposed to be eliminated or revised.

Exchange Act Rules

• Rules 101 and 102 of Reg M specifically prohibit issuers, selling security holders, underwriters, brokers, dealers, other distribution participants and any of their affiliated purchasers from directly or indirectly bidding for or purchasing, or attempting to induce another person to bid for or purchase, a covered security until the applicable restricted period has ended. Both rules currently contain an exception to these prohibitions for investment grade nonconvertible and asset-backed securities. These exceptions apply to nonconvertible debt securities, nonconvertible preferred securities and asset-backed securities that are rated by at least one NRSRO in one of its generic rating categories that signifies investment grade. The proposal would substitute for those NRSRO-based exceptions new exceptions for nonconvertible debt securities and nonconvertible preferred securities based on the WKSI standard. Asset-backed securities would be excepted from Rules 101 and 102 if those securities were registered on Form S-3.

  The proposed exceptions for nonconvertible debt and nonconvertible preferred securities would require that the issuer:

  • meet the requirements of the WKSI definition (regardless of how the issuer attained WKSI status); and
  • meet the requirements for nonconvertible securities other than common equity in paragraph (1)(i)(B)(1) of the definition of WKSI in Securities Act Rule 405, that is, the issuer must have issued at least $1 billion aggregate principal amount of nonconvertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act.

  These requirements are designed to limit the exceptions to securities issued by companies that have an existing public market in nonconvertible securities (other than common equity) that are publicly known and followed and, thus, less likely to be subject to manipulation.

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