Proposed Rules for Nationally Recognized Statistical Rating Organizations, 36212-36252 [E8-13887]
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Federal Register / Vol. 73, No. 123 / Wednesday, June 25, 2008 / Proposed Rules
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Parts 240 and 249b
[Release No. 34–57967; File No. S7–13–08]
RIN 3235–AK14
Proposed Rules for Nationally
Recognized Statistical Rating
Organizations
Securities and Exchange
Commission (‘‘Commission’’).
ACTION: Proposed rule.
AGENCY:
SUMMARY: In the first of three related
actions the Commission is proposing
rule amendments that would impose
additional requirements on nationally
recognized statistical rating
organizations (‘‘NRSROs’’) in order to
address concerns about the integrity of
their credit rating procedures and
methodologies in the light of the role
they played in determining credit
ratings for securities collateralized by or
linked to subprime residential
mortgages. Second, the Commission also
makes a proposal related to structured
finance products rating symbology. And
third, in the near future, the
Commission intends to propose rule
amendments that would be intended to
reduce undue reliance in the
Commission’s rules on NRSRO ratings.
DATES: Comments should be received on
or before July 25, 2008.
ADDRESSES: Comments may be
submitted by any of the following
methods:
Electronic Comments
• Use the Commission’s Internet
comment form (https://www.sec.gov/
rules/proposed.shtml); or
• Send an e-mail to rulecomments@sec.gov. Please include File
Number S7–13–08 on the subject line;
or
• Use the Federal eRulemaking Portal
(https://www.regulations.gov). Follow the
instructions for submitting comments.
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Paper Comments
• Send paper comments in triplicate
to Secretary, Securities and Exchange
Commission, 100 F Street, NE.,
Washington, DC 20549–1090.
All submissions should refer to File
Number S7–13–08. This file number
should be included on the subject line
if e-mail is used. To help us process and
review your comments more efficiently,
please use only one method. The
Commission will post all comments on
the Commission’s Internet Web site
(https://www.sec.gov/rules/
proposed.shtml). Comments are also
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available for public inspection and
copying in the Commission’s Public
Reference Room, 100 F Street, NE.,
Washington, DC 20549, on official
business days between the hours of 10
a.m. and 3 p.m. All comments received
will be posted without change; we do
not edit personal identifying
information from submissions. You
should submit only information that
you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT:
Michael A. Macchiaroli, Associate
Director, at (202) 551–5525; Thomas K.
McGowan, Assistant Director, at (202)
551–5521; Randall W. Roy, Branch
Chief, at (202) 551–5522; Joseph I.
Levinson, Attorney, at (202) 551–5598;
Carrie A. O’Brien, Attorney, at (202)
551–5640; Sheila D. Swartz, Special
Counsel, at (202) 551–5545; Rose Russo
Wells, Special Counsel, at (202) 551–
5527; Division of Trading and Markets,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–6628 or, with respect to
questions involving the proposed
amendments as they implicate the
Securities Act of 1933, Kathy Hsu,
Special Counsel, at (202) 551–3306 or
Eduardo Aleman, Special Counsel, at
(202) 551–3646; Division of Corporation
Finance, Securities and Exchange
Commission, 100 F Street, NE,
Washington, DC 20549–3628.
SUPPLEMENTARY INFORMATION:
increase in subprime loan delinquencies
and, ultimately, in defaults has had
substantial adverse effects on the
markets for, and market values and
liquidity of, residential mortgage-backed
securities (‘‘RMBS’’) backed by
subprime loans and on collateralized
debt obligations (‘‘CDOs’’) linked to
such loans (collectively ‘‘subprime
RMBS and CDOs’’).3
Moreover, the impacts from the
troubles experienced by subprime loans
extended beyond subprime RMBS and
CDOs to the broader credit markets and
the economy as a whole.4 As a result,
the parties that participated in various
parts of the process of making subprime
loans, packaging them into subprime
RMBS and CDOs, and selling these debt
instruments, including mortgage
brokers, loan originators, securities
sponsors and underwriters, and
NRSROs have come under intense
scrutiny. Today, the Commission is
proposing a series of new requirements
that are designed to address concerns
that have been raised about NRSROs in
light of the role they played in this
process. Additionally, two weeks from
today, the Commission will complete its
proposal of this series of rule changes.
These changes would be intended to
reduce undue reliance in the
Commission’s rules on NRSRO ratings,
thereby promoting increased investor
due diligence.
I. Background
B. The Credit Rating Agency Reform Act
of 2006
The purpose of the Credit Rating
Agency Reform Act of 2006 (the ‘‘Rating
Agency Act’’), enacted on September 29,
2006, is to ‘‘improve ratings quality for
the protection of investors and in the
public interest by fostering
accountability, transparency, and
competition in the credit rating
industry.’’ 5 The operative provisions of
the Rating Agency Act became
applicable upon the Commission’s
A. Introduction
Beginning in the early 2000s,
originators started to increasingly make
residential mortgage loans based on
lower underwriting standards
(‘‘subprime loans’’).1 For the first few
years there did not appear to be any
negative repercussions from this lending
practice. However, beginning in mid2006, home values leveled off and soon
began to decline, which, in turn, led to
a corresponding increase in
delinquencies and, ultimately, defaults
in subprime loans.2 This marked
1 There is no standard definition of a subprime
loan. However, such a loan can broadly be
described as a mortgage loan that does not conform
to the underwriting standards required for sale to
the government sponsored enterprises (nonconforming loans) and are made to borrowers who:
(1) Have weakened credit histories such as payment
delinquencies, charge-offs, judgments, and
bankruptcies; (2) have reduced repayment capacity
as measured by credit scores (e.g., FICO), debt-toincome ratios, loan-to-value rations, or other
criteria; (3) have not provided documentation to
verify all or some of the information, particularly
financial information, in their loan applications; or
(4) have any combination of these factors. Nonconforming loans made to less risky borrowers fall
into two other classifications: jumbo and Alt-A.
2 See e.g., Testimony of John C. Dugan,
Comptroller of the Currency, before the U.S. Senate
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Committee on Banking, Housing, and Urban Affairs
(March 4, 2008) (‘‘Dugan March 4, 2008 Senate
Testimony’’), pp. 8–12; Statement of Sheila C. Bair,
Chairman, Federal Deposit Insurance Corporation,
before U.S. Senate Committee on Banking, Housing,
and Urban Affairs (March 4, 2008) (‘‘Bair March 4,
2008 Senate Statement’’), pp. 5–6.
3 See e.g., Dugan March 4, 2008 Senate
Testimony, pp. 12–14; Bair March 4, 2008 Senate
Statement, pp. 6–7.
4 See e.g., Statement of Ben S. Bernanke,
Chairman, Board of Governors of the Federal
Reserve System, before the U.S. Senate Committee
on Banking, Housing, and Urban Affairs (February
28, 2008) (‘‘Bernanke February 28, 2008 Senate
Statement’’), pp. 1–3; Dugan March 4, 2008 Senate
Testimony, pp. 12–15.
5 Report of the Senate Committee on Banking,
Housing, and Urban Affairs to Accompany S. 3850,
Credit Rating Agency Reform Act of 2006, S. Report
No. 109–326, 109th Cong., 2d Sess. (Sept. 6, 2006)
(‘‘Senate Report’’), p. 1.
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adoption in June 2007 of a series of
rules implementing a registration and
oversight program for credit rating
agencies that register as NRSROs.6
To date, a total of nine credit rating
agencies have been granted registration
with the Commission as NRSROs
pursuant to the Rating Agency Act and
the rules thereunder.7 These registrants
include the credit rating agencies most
active in rating subprime RMBS and
CDOs: Fitch Ratings, Inc. (‘‘Fitch’’),
Moody’s Investors Service (‘‘Moody’s’’),
and Standard and Poor’s Rating Services
(‘‘S&P’’).8 In the fall of 2007, the
Commission, exercising the new
authority conferred by the Rating
Agency Act, began a staff examination
of the NRSROs’ activities in rating
subprime RMBS and CDOs in order to
review whether they adhered to their
stated and documented procedures and
methodologies for rating these debt
instruments and the extent, if any, to
6 See Oversight of Credit Rating Agencies
Registered as Nationally Recognized Statistical
Rating Organizations, Securities Exchange Act of
1934 (‘‘Exchange Act’’) Release No. 55857 (June 5,
2007), 72 FR 33564 (June 18, 2007) (‘‘Adopting
Release’’). The rules adopted by the Commission
prescribe: how a credit rating agency must apply to
the Commission for registration as an NRSRO (Rule
17g–1 (17 CFR 240.17g–1)); the form of the
application and the information that must be
provided in the application (Form NRSRO and the
Instructions to Form NRSRO (17 CFR
240.249b.300)); the records an NRSRO must make
and maintain (Rule 17g–2 (17 CFR 240.17g–2)); the
reports an NRSRO must furnish to the Commission
annually (Rule 17g–3 (17 CFR 240.17g–3)); the areas
that must be addressed in an NRSRO’s procedures
to prevent the misuse of material nonpublic
information (Rule 17g–4 (17 CFR 240.17g–4)); the
types of conflicts of interest an NRSRO must
disclose and manage or is prohibited from having
(Rule 17g–5 (17 CFR 240.17g–5)); and certain
unfair, coercive, or abusive practices an NRSRO is
prohibited from engaging in (Rule 17g–6 (17 CFR
240.17g–6)).
7 See Commission Orders granting registration of
A.M. Best Company, Inc. (34–56507, September 24,
2007), DBRS Ltd. (34–56508, September 24, 2007),
Fitch, Inc. (34–56509, September 24, 2007), Japan
Credit Rating Agency, Ltd, (34–56510, September
24, 2007), Moody’s Investor Services, Inc. (34–
56511, September 24, 2007), Rating and Investment
Information, Inc. (34–56512, September 24, 2007),
Standard & Poor’s Rating Services (34–56513,
September 24, 2007), Egan-Jones Rating Company
(34–57031, December 21, 2007) and LACE Financial
Corp. (34–57300, February 11, 2008).
8 According to their most recent Annual
Certifications on Form NRSRO, S&P rates 197,700
issuers of asset-backed securities, the category that
includes RMBS, Moody’s rates 110,000 such
issuers, and Fitch rates 75,278 such issuers. No
other registered NRSRO reports rating more than
1,000 issuers of asset-backed securities. See
Standard & Poor’s 2007 Annual Certification on
Form NRSRO, available at https://
www.standardandpoors.com; Moody’s Investor
Services 2007 Annual Certification on Form
NRSRO, available at https://www.moodys.com;
Fitch, Inc. 2007 Annual Certification on Form
NRSRO, available at https://www.fitchratings.com.
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which their ratings may have been
impaired by conflicts of interest.9
In addition to the examination, the
Commission has worked closely with
other regulators and supervisors of the
financial markets in analyzing the credit
market turmoil and in developing
recommendations and principles for
market participants, including
NRSROs.10 For example, the President’s
Working Group on Financial Markets
issued a Policy Statement on Financial
Market Developments in March 2008.11
Further, as a member of the
International Organization of Securities
Commissions (‘‘IOSCO’’), the
Commission played a substantial role in
drafting The Role of Credit Rating
Agencies in Structured Finance Markets,
which was issued for consultation by
IOSCO in March 2008.12 Also, the
Commission, as part of its participation
in the Financial Stability Forum,
worked with its counterparts in the U.S.
and abroad on The Report of the
Financial Stability Forum on Enhancing
Market and Institutional Resilience
released in April 2008, which discussed
credit rating agencies.13
These and other efforts have assisted
the Commission in identifying a number
of areas in which its current NRSRO
rules could be augmented to address
concerns about the role NRSROs played
in the credit market turmoil.14 As a
result, the Commission is proposing
amendments to its existing NRSRO rules
and a new rule with the goal of
improving the quality of credit ratings
determined by NRSROs generally and,
in particular, for structured finance
products such as RMBS and CDOs.15
These proposals and the proposals to be
considered in two weeks are designed
to:
• Enhance the disclosure and
comparability of credit ratings
performance statistics;
9 See Testimony of Christopher Cox, Chairman,
Commission, before the U.S. Senate Committee on
Banking, Housing, and Urban Affairs (April 22,
2008) (‘‘Cox April 22, 2008 Senate Testimony’’), pp.
2–3.
10 See Id, p. 4.
11 A copy of the policy statement is available at:
https://www.ustreas.gov.
12 A copy of the report is available at: https://
www.iosco.org.
13 A copy of the report is available at: https://
www.fsforum.org.
14 See Cox April 22, 2008 Senate Testimony, pp.
6–8.
15 The term ‘‘structured finance product’’ as used
throughout this release refers broadly to any
security or money market instrument issued by an
asset pool or as part of any asset-backed or
mortgage-backed securities transaction. This broad
category of financial instrument includes, but is not
limited to, asset-backed securities (‘‘ABS’’) such as
RMBS and to other types of structured debt
instruments such as CDOs, including synthetic and
hybrid CDOs.
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• Increase the disclosure of
information about structured finance
products;
• Require more information about the
procedures and methodologies used to
determine credit ratings for structured
finance products;
• Strengthen internal control
processes through reporting
requirements; and
• Address conflicts of interest arising
from the process of rating structured
finance products; and
• Reduce undue reliance in the
Commission’s rules on NRSRO ratings,
thereby promoting increased investor
due diligence.
The Commission believes these
proposals would further the purpose of
the Rating Agency Act to improve the
quality of NRSRO credit ratings by
fostering accountability, transparency,
and competition in the credit rating
industry.16
C. The Role of Credit Ratings in the
Credit Market Turmoil
The growth in the origination of
subprime loans began in the early
2000s.17 For example, Moody’s reports
that subprime loans amounted to $421
billion of the $3.038 trillion in
mortgages originated in 2002 (14%) and
$640 billion of the $2.886 trillion in
mortgages originated in 2006 (22%).18
This growth was facilitated by steadily
rising home values and a low interest
rate environment.19 In addition,
increases in the breadth of the credit
risk transfer markets as a result of new
investors willing to purchase credit
based structured finance products
provided an opportunity for lenders to
originate subprime loans and then move
them off their balance sheets by
packaging and selling them through the
securitization process to investors as
subprime RMBS and CDOs.20 The
investors in subprime RMBS and CDOs
included domestic and foreign mutual
funds, pension funds, hedge funds,
banks, insurance companies, special
investment vehicles, and state
government operated funds.
This ‘‘originate to distribute’’ business
model created demand for residential
16 See
Senate Report, p. 2.
e.g., Statement of Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation, before U.S.
Senate Committee on Banking, Housing, and Urban
Affairs (January 31, 2008) (‘‘Bair January 31, 2008
Senate Statement’’), p. 4.
18 According to Moody’s, subprime mortgage
loans represented $421 billion of $3.038 trillion
total mortgage origination in 2002 and $640 billion
of $2.886 trillion total mortgage origination in 2006.
See A Short Guide to Subprime, Moody’s, March
25, 2008, p. 1.
19 See e.g., Dugan March 4, 2008 Senate
Testimony, pp. 8–11.
20 Id.
17 See
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mortgage loans, including subprime
loans. For example, according to
Moody’s, of the approximately $2.5
trillion worth of mortgage loans
originated in 2006, $1.9 trillion were
securitized into RMBS and
approximately 25%, or $520 billion
worth, of these loans were categorized
as subprime.21 The demands of the loan
securitization markets encouraged
lenders to lower underwriting standards
to maintain a steady volume of loans
and to use less traditional products such
as adjustable rate, negative amortization,
and closed-end second lien mortgages.22
1. The Creation of Subprime RMBS and
CDOs
The creation of an RMBS begins by
packaging a pool of mortgage loans,
usually numbering in the thousands,
and transferring them to a bankruptcy
remote trust. The trust purchases the
loan pool and becomes entitled to the
interest and principal payments made
by the borrowers. The trust finances the
purchase of the loan pool through the
issuance of RMBS. The monthly interest
and principal payments from the loan
pool are used to make monthly interest
and principal payments to the investors
in the RMBS.
The trust typically issues different
classes of RMBS (known as ‘‘tranches’’)
offering a sliding scale of coupon rates
based on the level of credit protection
afforded to the security. Credit
protection is designed to shield the
tranche securities from loss of interest
and principal arising from defaults of
the loans backing the RMBS. The degree
of credit protection afforded a tranche
security is known as its ‘‘credit
enhancement’’ and is provided through
several means. The primary source of
credit enhancement is subordination,
which creates a hierarchy of loss
absorption among the tranche securities.
For example, if a trust issued securities
in 10 different tranches of securities, the
first (or senior) tranche would have nine
subordinate tranches, the next highest
tranche would have eight subordinate
tranches and so on down the capital
structure. Losses of interest and
principal experienced by the trust from
delinquencies and defaults among loans
in the pool are allocated first to the
lowest tranche until its principal
amount is exhausted and then to the
next lowest tranche and so on up the
capital structure. Consequently, the
senior tranche would not incur any loss
21 Subprime Residential Mortgage Securitizations:
Frequently Asked Questions, Moody’s, April 19,
2007, p. 1.
22 See e.g., Bernanke February 28, 2008 Senate
Testimony, p. 1; Dugan March 4, 2008 Senate
Testimony, pp. 8–10.
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until the principal amounts from all the
lower tranches have been exhausted
through the absorption of losses from
the underlying loans.
A second form of credit enhancement
is over-collateralization, which is the
amount that the principal balance of the
mortgage pool underlying the trust
exceeds the principal balance of the
tranche securities issued by the trust.
This excess principal creates an
additional ‘‘equity’’ tranche below the
lowest tranche security to absorb losses.
In the example above, the equity tranche
would sit below the 10th tranche
security and protect it from the first
losses experienced as a result of
defaulting loans.
A third form of credit enhancement is
excess spread, which consists of the
amount by which the interest derived
from the underlying loans in the
aggregate exceeds interest payments due
to investors in the tranche securities in
the aggregate plus the administrative
expenses of the trust such as fees due
the loan servicer as well as premiums
due on derivatives contracts and bond
insurance. In other words, the excess
spread is the amount that the monthly
interest income from the pool of loans
exceeds the weighted average interest
due to the RMBS bondholders. This
excess spread can be used to build up
loss reserves or pay off delinquent
interest payments due to a tranche
security.
A fourth form of credit enhancement
sometimes employed is bond insurance.
When used, bond insurance is typically
purchased only for the senior RMBS
tranche.
The creation of a typical CDO is
similar to that of an RMBS. A
bankruptcy remote trust is created to
hold the CDO’s assets and issue its
securities. The underlying assets,
however, are generally debt securities
rather than mortgage loans. The CDO
trust uses the interest and principal
payments from the approximately 200
underlying debt securities to make
interest and principal payments to
investors in the securities issued by the
trust. The trust is structured to provide
differing levels of credit enhancement to
the securities it issues. Similar to RMBS,
credit enhancement is provided through
subordination, over-collateralization,
excess spread, and bond insurance. In
addition to the underlying assets, one
significant difference between a CDO
and an RMBS is that the CDO may be
actively managed such that its
underlying assets change over time,
whereas the mortgage loan pool
underlying an RMBS remains static for
the most part.
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In recent years, CDOs have been some
of the largest purchasers of subprime
RMBS and the drivers of demand for
those securities. For example, according
to Fitch, the average percentage of
subprime RMBS in the collateral pools
of CDOs it rated grew from 43.3% in
2003 to 71.3% in 2006.23 Generally, the
CDOs holding subprime RMBS issued
fell into one of two categories: High
grade and mezzanine. High grade CDOs
are generally defined as those that hold
RMBS tranches with AAA, AA, or A
credit ratings, whereas mezzanine CDOs
are those that hold RMBS tranches rated
predominantly BBB. Securities issued
by mezzanine CDOs pay higher yields
than those issued by high grade CDOs
since the BBB-rated RMBS underlying
the mezzanine CDOs pay higher yields
than the AAA to A rated RMBS
underlying high grade CDOs. In
addition to CDOs holding subprime
RMBS, a market for CDOs holding other
CDOs that held subprime RMBS
developed in recent years. These debt
instruments are known as ‘‘CDOssquared.’’
As the market for mortgage related
CDOs grew, CDO issuers began to use
credit default swaps to replicate the
performance of subprime RMBS and
CDOs. In this case, rather than
purchasing subprime RMBS or CDOs,
the CDO entered into credit default
swaps referencing subprime RMBS or
CDOs, or indexes on RMBS. These
CDOs, in some cases, are composed
entirely of credit default swaps
(‘‘synthetic CDOs’’) or a combination of
credit default swaps and cash RMBS
(‘‘hybrid CDOs’’). The use of credit
default swaps allowed the CDO
securities to be issued more quickly,
since the issuer did not have to wait to
accumulate actual RMBS for the
underlying collateral pool.
2. Determining Credit Ratings for
Subprime RMBS and CDOs
A key step in the process of creating
and ultimately selling a subprime RMBS
and CDO is the issuance of a credit
rating for each of the tranches issued by
the trust (with the exception of the most
junior ‘‘equity’’ tranche). The credit
rating for each rated tranche indicated
the credit rating agency’s view as to the
creditworthiness of the debt instrument
in terms of the likelihood that the issuer
would default on its obligations to make
interest and principal payments on the
debt instrument.24 To varying degrees,
23 Rating Stability of Fitch-Rated Global Cash
Mezzanine Structured Finance CDOs with Exposure
to U.S. Subprime RMBS, Fitch, April 2, 2007, p. 1.
24 See, e.g., Inside the Ratings: What Credit
Ratings Mean, Fitch, August 2007 (‘‘Inside the
Ratings’’), p. 2; Testimony of Michael Kanef, Group
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many investors rely on credit ratings in
making the decision to purchase
subprime RMBS or CDOs, particularly
with respect to the senior AAA rated
tranches. Some investors use the credit
ratings to assess the risk of the debt
instruments. In part, this may be due to
the large number of debt instruments in
the market and their complexity. Other
investors use credit ratings to satisfy
client investment mandates regarding
the types of securities they can invest in
or to satisfy regulatory requirements
based on certain levels of credit ratings,
or a combination of these conditions.
Moreover, investors typically only have
looked to ratings issued by Fitch,
Moody’s, and S&P, which causes the
arrangers 25 of the subprime RMBS and
CDOs to use these three NRSROs to
obtain credit ratings for the tranche
securities they brought to market.
The procedures followed by these
three NRSROs in developing ratings for
subprime RMBS are generally similar.
The arranger of the RMBS initiates the
rating process by sending the credit
rating agency a range of data on each of
the subprime loans to be held by the
trust (e.g., principal amount, geographic
location of the property, credit history
and FICO score of the borrower, ratio of
the loan amount to the value of the
property, and type of loan: First lien,
second lien, primary residence,
secondary residence), the proposed
capital structure of the trust, and the
proposed levels of credit enhancement
to be provided to each RMBS tranche
issued by the trust. Upon receipt of the
information, the NRSRO assigns a lead
analyst who is responsible for analyzing
the loan pool, proposed capital
structure, and proposed credit
enhancement levels and, ultimately, for
formulating a ratings recommendation
for a rating committee composed of
analysts and/or senior-level personnel
not involved in the analytic process.
The next step in the ratings process is
the development of predictions, based
Managing Director, Moody’s Investors Service,
Before the United States Senate Committee on
Banking, Housing, and Urban Affairs (September
26, 2007) (‘‘Kanef September 26, 2007 Senate
Testimony’’), p. 2; Principles-Based Rating
Methodology For Global Structured Finance
Securities, S&P, May 29, 2007, p. 3. Since credit
ratings are issued for tranches of RMBS and CDOs
individually, rather than for the issuers of those
tranches, the NRSRO credit ratings are estimates of
the probability of default of each RMBS or CDO
tranche as an independent instrument.
25 As bankruptcy remote stand-alone legal
entities, RMBS and CDO trusts had no employees.
Consequently, they relied on third-parties to create
and manage them. The term ‘‘arranger’’ is used
herein to refer to the party that oversees the creation
of the RMBS and CDO, which would include the
process of obtaining credit ratings for the various
tranches. Frequently, the arranger also served as the
underwriter of the securities.
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on a quantitative expected loss model
and other qualitative factors, as to how
many of the loans in the collateral pool
would default under stresses of varying
severity. This analysis also includes
assumptions as to how much principal
would be recovered after a defaulted
loan is foreclosed. Each NRSRO
generally uses between 40 and 60
specific credit characteristics to analyze
each loan in the collateral pool of an
RMBS in order to assess the potential
future performance of the loan under
various possible scenarios. These
characteristics include the loan
information described above as well as
the amount of equity that the borrowers
have in their homes, the amount of
documentation provided by borrowers
to verify their assets and/or income
levels, and whether the borrowers
intend to rent or occupy the homes.26
The purpose of this loss analysis is to
determine how much credit
enhancement a given tranche security
would need for a particular category of
credit rating. The severest stress test
(i.e., the one that would result in the
greatest number of defaults among the
underlying loans) is run to determine
the amount of credit enhancement
required for an RMBS tranche issued by
the trust to receive an AAA rating. For
example, this test might result in an
output that predicted that under the
‘‘worst case’’ scenario, 40 percent of the
loans in the underlying pool would
default and that after default the trust
would recover only 50 percent of the
principal amount of each loan in
foreclosure. Consequently, to get an
AAA rating, an RMBS tranche security
issued by the trust would need credit
enhancement sufficient to cover at least
20 percent of the principal amount of all
the RMBS tranches issued by the trust.
In other words, absent other forms of
credit enhancement such as excess
spread, at least 20 percent of the
principal amount of the RMBS tranches
issued by the trust, including the equity
tranche, would have to be subordinate
to the senior tranche and, therefore,
obligated to absorb the losses resulting
from 40% of the underlying loans
defaulting.27 The next severest stress
test is run to determine the amount of
credit enhancement required of the AA
tranche and so on down the capital
structure. The lowest rated tranche
(typically BB or B) is analyzed under a
more benign market scenario.
26 See, e.g., Kanef September 26, 2007, Senate
Testimony, p. 7.
27 To the extent that the RMBS included other
forms of credit enhancement besides the
subordination and over-collateralization provided
in this example, e.g., excess spread, this 20 percent
subordination figure would be reduced accordingly.
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Consequently, its required level of
credit enhancement—typically provided
primarily or exclusively by a
subordinate equity tranche—is based on
the number of loans expected to default
in the normal course given the lowest
possible level of macroeconomic stress.
Following the determination of the
level of credit enhancement required for
each credit rating category, the next step
in the ratings process is to check the
proposed capital structure of the RMBS
against these requirements. For
example, if the proposed structure
would create a senior RMBS tranche
that had 18 percent of the capital
structure subordinate to it (the other
RMBS tranches, including, as
applicable, an equity tranche), the
analyst reviewing the transaction might
conclude that based on the output of the
loss model the senior tranche should be
rated AA since it would need 20 percent
subordination to receive an AAA credit
rating. Additionally, the analyst could
take other factors into consideration
such as the quality of the loan servicer
or the actual performance of similar
pools of loans underlying other RMBS
trusts to determine that in this case 18
percent subordination would be
sufficient to support an AAA rating (to
the extent these factors were not
covered by the model).
Typically, if the analyst concludes
that the capital structure of the RMBS
did not support the desired ratings—in
the example above, if it determined that
18 percent credit enhancement is
insufficient for the desired AAA
rating—this preliminary conclusion
would be conveyed to the arranger. The
arranger could accept that
determination and have the trust issue
the securities with the proposed capital
structure and the lower rating or adjust
the structure to provide the requisite
credit enhancement for the senior
tranche to get the desired AAA rating
(e.g., shift 2 percent of the principal
amount of the senior tranche to a lower
tranche or add or remove certain
mortgages from the proposed asset
pool). Generally, arrangers aim for the
largest possible senior tranche, i.e., to
provide the least amount of credit
enhancement possible, since the senior
tranche—as the highest rated tranche—
pays the lowest coupon rate of the
RMBS’ tranches and, therefore, costs the
arranger the least to fund.
The next step in the process is a cash
flow analysis on the interest and
principal expected to be received by the
trust from the pool of subprime loans to
determine whether it will be sufficient
to pay the interest and principal due on
each RMBS tranche issued by the trust.
The NRSROs use quantitative cash flow
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models that analyze the amount of
principal and interest payments
expected to be generated from the loan
pool each month over the terms of the
RMBS tranche securities under various
stress scenarios. The outputs of this
model are compared against the priority
of payments (the ‘‘waterfall’’) to the
RMBS tranches specified in the trust
legal documents. The waterfall
documentation could specify overcollateralization and excess spread
triggers that, if breached, would
reallocate principal and interest
payments from lower tranches to higher
tranches until the minimum levels of
over-collateralization and excess spread
were reestablished. Ultimately, the
monthly principal and interest
payments derived from the loan pool
need to be enough to satisfy the monthly
payments of principal and interest due
by the trust to the investors in the RMBS
tranches as well as to cover the
administrative expenses of the trust.
In addition to expected loss and cash
flow analysis, the analysts review the
legal documentation of the trust to
evaluate whether it is bankruptcy
remote, i.e., isolated from the effects of
any potential bankruptcy or insolvency
of the arranger. They also review
operational and administrative risk
associated with the trust, using the
results of periodic examinations of the
principal parties involved in the
issuance of the security, including the
mortgage originators, the issuer of the
security, the servicer of the mortgages in
the loan pool, and the trustee.28 In
assessing the servicer, for example, an
NRSRO might review its past
performance with respect to loan
collection, billing, recordkeeping, and
the treatment of delinquent loans.
Following these steps, the analyst
develops a rating recommendation for
each RMBS tranche, which then is
presented to a rating committee
composed of analysts and/or seniorlevel personnel not involved in the
analytic process. The rating committee
votes on the ratings for each tranche and
usually approaches the arranger
privately to notify it of the ratings
decisions. In most cases, an arranger can
appeal a rating decision, although the
appeal is not always granted (and, if
granted, may not necessarily result in
any change in the rating decision). Final
ratings decisions are published and
subsequently monitored through
surveillance processes. The NRSRO
28 Principal parties are not rated de novo in each
RMBS transaction; rather, each NRSRO has its own
procedures and schedules for reviewing those
parties on a periodic basis in order to incorporate
its assessment of those entities into the rating
process.
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typically is paid only if the credit rating
is issued, though sometimes it receives
a breakup fee for the analytic work
undertaken even if the credit rating is
not issued.
The process for assigning ratings to
subprime CDOs also involves a review
of the creditworthiness of each tranche
of the CDO. As with RMBS, the process
centers on an examination of the pool of
assets held by the trust and analysis of
how they would perform individually
and in correlation during various stress
scenarios. However, this analysis is
based primarily on the credit rating of
each RMBS or CDO in the underlying
pool or referenced through a credit
default swap entered into by the CDO.
In other words, the credit rating is the
primary characteristic of the underlying
debt instruments that the NRSROs take
into consideration when performing
their loss analysis. Hence, this review of
the debt instruments in the collateral
pool and the potential correlations
among those securities does not ‘‘look
through’’ those securities to their
underlying asset pools. The analysis,
consequently, generally only goes one
level down to the credit ratings of the
underlying instruments or reference
securities.
CDOs collateralized by RMBS or by
other CDOs often are actively managed.
Consequently, there can be frequent
changes to the composition of the cash
assets (RMBS or CDOs), synthetic assets
(credit default swaps), or combinations
of cash and synthetic assets in the
underlying pool. As a result, NRSRO
ratings for managed CDOs are based not
on the closing date composition of the
pool but instead on covenanted limits
for each potential type of asset that
could be put in the pool. Typically,
following a post-closing period in which
no adjustments can be made to a CDO’s
collateral pool, the CDO’s manager has
a predetermined period of several years
in which to adjust that asset pool
through various sales and purchases
pursuant to covenants set forth in the
CDO’s indenture. These covenants set
limitations and requirements for the
collateral pools of CDOs, often by
establishing minimum and maximum
concentrations for certain types of
securities or certain ratings.
NRSROs use a CDO’s indenture
guidelines to run ‘‘worst-case’’ scenarios
based on the various permutations of
collateral permitted under the
indenture. For example, an indenture
might specify that a CDO’s collateral
pool must include between 10 and 20
percent AAA-rated subprime RMBS,
with the remaining 80 to 90 percent
composed of investment-grade, but not
AAA, subprime RMBS. In preparing a
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rating for that CDO, an NRSRO will run
its models based on all possible
collateral pools permissible under the
indenture guidelines, placing the most
weight on the results from the weakest
potential pools (i.e., the minimum
permissible amount, 10 percent, of
AAA-rated securities and the lowestrated investment grade securities for the
remaining 90 percent). As with RMBS
ratings, the model results are then
compared against the capital structure
of the proposed CDO to confirm that the
level of subordination, overcollateralization and excess spread
available to each tranche provides the
necessary amount of credit
enhancement to sustain a particular
rating.
3. The Downgrades in Credit Ratings of
Subprime RMBS and CDOs
As noted above, the development of
the credit risk transfer markets gave rise
to an ‘‘originate to distribute’’ model
whereby mortgage loans are originated
with the intent to securitize them.
Under this model, arrangers earn fees
from originating, structuring, and
underwriting RMBS and servicing the
loans underlying the RMBS, as well as
frequently a third set of fees from
structuring, underwriting, and managing
CDOs composed of RMBS. Moreover,
the yields offered by subprime RMBS
and CDO tranches (as compared to other
types of similarly rated debt
instruments) led to increased investor
demand for these debt instruments. The
originate to distribute model creates
incentives for originating high volumes
of mortgage loans while simultaneously
reducing the incentives to maintain high
underwriting standards for making such
loans. The continued growth of the
housing market through 2006, which led
to increased competition among lenders,
also contributed to looser subprime loan
underwriting standards.29
By mid-2006, however, the steady rise
in home prices that had fueled this
growth in subprime lending came to an
end as prices began to decline.30
Moreover, widespread areas of the
country began to experience declines
whereas, in the past, poor housing
markets generally had been confined to
distinct geographic areas.31 The
downturn in the housing market has
been accompanied by a marked increase
29 See e.g., Dugan March 4, 2008 Senate
Testimony, p. 10; Bernanke February 28, 2008
Senate Testimony, p. 1.
30 See e.g., Id; Bair March 4, 2008 Senate
Statement, pp. 5–8; Bair January 31, 2008 Senate
Statement, p. 3.
31 See e.g., Bair January 31, 2008 Senate
Statement, p. 3.
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in delinquencies and defaults of
subprime loans.32
The increases in delinquency and
default rates have been concentrated in
loans made in 2006 and 2007, which
indicates that borrowers have been
falling behind within months of the
loans being made.33 For example, by the
fourth quarter of 2006, the percentage of
subprime loans underlying RMBS rated
by Moody’s that were in default within
six months of the loans being made
stood at 3.54 percent, nearly four times
the average six month default rate of
0.90 percent between the first quarter of
2002 and the second quarter of 2005.
Similarly, default rates for subprime
loans within 12 months of the loans
being made rose to 7.39 percent as
compared to 2.00 percent for the period
from the first quarter of 2002 through
the second quarter of 2005.34 Figures
released by S&P show similar
deterioration in the performance of
recent subprime loans.35 According to
S&P, the serious delinquency rate 36 for
subprime loans underlying RMBS rated
by S&P within twelve months of the
initial rating was 4.97 percent of the
current aggregate pool balance for
subprime RMBS issued in 2005, 10.55
percent for subprime RMBS issued in
2006, and 15.19 percent for subprime
RMBS issued in 2007.37
Along with the deterioration in the
performance of subprime loans, there
has been an increase in the losses
incurred after the loans are foreclosed.
According to S&P, the actual realized
losses on loans underlying 2007
subprime RMBS after 12 months of
seasoning were 65 percent higher than
the losses recorded for RMBS issued in
2006 at the same level of seasoning.38
The rising delinquencies and defaults
in subprime loans backing the RMBS
rated by the NRSROs has exceeded the
projections on which they based their
initial ratings. Furthermore, the defaults
and foreclosures on subprime loans
have resulted in realizable losses to the
lower RMBS tranches backed by the
loans and, correspondingly, to the lower
CDO tranches backed by those RMBS.
hsrobinson on PROD1PC76 with PROPOSALS2
32 Id.
33 See e.g., Bair March 24, 2008 Senate Statement,
p. 6 (‘‘Serious delinquency rates on subprime
mortgages securitized in 2006 are significantly
higher than those for any of the previous three
years.’’).
34 Early Defaults Rise in Mortgage Securitizations:
Updated Data Show Continued Deterioration,
Moody’s, September 19, 2007, pp. 3–4.
35 U.S. Subprime RMBS Performance Update:
January 2008 Distribution Date, S&P, February 25,
2008, p. 1.
36 Defined as 90-plus day delinquencies,
foreclosures, and real estate owned. Id.
37 Id.
38 Id.
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As discussed above, the reduction in the
amount of monthly principal and
interest payments coming from the
underlying pool of subprime loans or, in
the case of a CDO, RMBS tranches or
other CDO tranches is allocated to the
tranches in ascending order. In addition
to directly impairing the affected
tranche, the losses—by reducing the
principal amount of these tranches—
decreased the level of subordination
protecting the more senior tranches. In
other words, losses suffered by the
junior tranches of an RMBS or CDO
directly reduced the level of credit
enhancement—the primary factor
considered by NRSROs in rating
tranched securities—protecting the
senior tranches of the instrument. These
factors have caused the NRSROs to
reevaluate, and in many cases
downgrade, their ratings for these
instruments.
• As of February 2008, Moody’s had
downgraded at least one tranche of 94.2
percent of the subprime RMBS deals it
rated in 2006 (including 100 percent of
2006 RMBS deals backed by subprime
second-lien mortgage loans) and 76.9
percent of all subprime RMBS deals it
rated in 2007. Overall, 53.7 percent and
39.2 percent of 2006 and 2007 tranches,
respectively, had been downgraded by
that time. RMBS tranches backed by
first lien loans issued in 2006 were
downgraded an average of 6.0 notches
from their original ratings, while RMBS
tranches backed by second-lien loans
issued that year were downgraded 9.7
notches on average. The respective
figures for 2007 first- and second-lien
backed tranches were 5.6 and 7.8
notches.39
• As of March 2008, S&P had
downgraded 44.3 percent of the
subprime RMBS tranches it had rated
between the first quarter of 2005 and the
third quarter of 2007, including 87.2
percent of second-lien backed securities.
Downgrades to subprime RMBS issued
in 2005 averaged four to six notches,
while the average for those issued in
2006 and 2007 was 6.0 to 11 notches.40
• As of December 7, 2007, Fitch had
issued downgrades to 1,229 of the 3,666
tranches of subprime RMBS issued in
2006 and the first quarter of 2007,
representing a par value of $23.8 billion
out of a total of $193 billion.41
Subsequently, on February 1, 2008,
Fitch placed all subprime first-lien
39 U.S. Subprime RMBS 2005–2007 Vintage
Rating Actions Update: January 2008, Moody’s,
February 1, 2008, pp. 2–4.
40 Transition Study: Structured Finance Rating
Transition And Default Update as of March 21,
2008, S&P, March 28, 2008, pp. 2–3.
41 U.S. RMBS Update, Fitch, February 20, 2008 p.
5.
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36217
RMBS issued in 2006 and the first half
of 2007, representing a total outstanding
balance of approximately $139 billion,
on Rating Watch Negative.42
The extensive use of subprime RMBS
in the collateral pools of CDOs has led
to similar levels of downgrade rates for
those securities as well. Moreover, the
use of subprime RMBS as reference
securities for synthetic CDOs magnified
the effect of RMBS downgrades on CDO
ratings. Surveillance of CDO credit
ratings has been complicated by the fact
that the methodologies used by the
NRSROs to rate them relied heavily on
the credit rating of the underlying
RMBS or CDOs. Consequently, to adjust
the CDO rating, the NRSROs first have
needed to complete their reviews of the
ratings for the underlying RMBS or
adjust their methodologies to
sufficiently account for the anticipated
poor performance of the RMBS.43
Ultimately, the NRSROs have
downgraded a substantial number of
CDO ratings.
• Over the course of 2007, Moody’s
issued 1,655 discrete downgrade actions
(including multiple rating actions on the
same tranche), which constituted
roughly ten times the number of
downgrade actions in 2006 and twice as
many as in 2002, previously the most
volatile year for CDOs. Further, the
magnitude of the downgrades (number
of notches) was striking. The average
downgrade was roughly seven notches
as compared to a previous average of
three to four notches prior to 2007. In
the words of a March 2008 report by
Moody’s, ‘‘[T]he scope and degree of
CDO downgrades in 2007 was
unprecedented.’’ 44
• As of April 1, 2008, S&P had
downgraded 3,068 tranches from 705
CDO transactions, totaling $321.9
billion in issuance, and placed 443
ratings from 119 transactions, with a
value of $33.8 billion, on CreditWatch
negative, ‘‘as a result of stress in the
42 Update on U.S. Subprime and Alt-A:
Performance And Rating Reviews, Fitch, March 20,
2008, p. 13.
43 For example, in November 2007, Fitch
announced that in rating CDOs with asset pools
which included subprime RMBS, it would adjust all
subprime RMBS securities on Rating Watch
Negative downwards by three categories—or
notches—(six in the case of 2007 subprime RMBS
rated BBB+ or lower) before factoring them into a
re-assessment of the CDO’s rating. See Global
Criteria for the Review of Structured Finance CDOs
With Exposure to U.S. Subprime RMBS, Fitch,
November 15, 2007, p. 4.
44 2008 U.S. CDO Outlook and 2007 Review,
Moody’s, March 3, 2008, p. 6.
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hsrobinson on PROD1PC76 with PROPOSALS2
U.S. residential mortgage market and
credit deterioration of U.S. RMBS.’’ 45
• By mid-December, 2007, Fitch had
issued downgrades to 158 of the 431
CDOs it had rated with exposure to
RMBS.46 Among the 30 CDOs with
exposure to the subprime RMBS which
‘‘suffered the greatest extent and
magnitude of negative rating migration,’’
all but $82.7 million of the $20.7 billion
in balance was downgraded.47
The scope and magnitude of these
downgrades has caused a loss of
confidence among investors in the
reliability of RMBS and CDO credit
ratings issued by the NRSROs.48 This
lack of confidence in the accuracy of
NRSRO ratings has been a factor in the
broader dislocation in the credit
markets.49 For example, the complexity
of assessing the risk of structured
finance products and the lack of
commonly accepted methods for
measuring the risk has caused investors
to leave the market, including the
market for AAA instruments,
particularly investors that had relied
primarily on NRSRO credit ratings in
assessing whether to purchase these
instruments.50 This has had a significant
impact on the liquidity of the market for
these instruments.51
In the wake of these events, the
NRSROs that rated subprime RMBS and
CDOs have come under intense
criticism and scrutiny. It has been
suggested that changes may be needed
to address the conflicts of interest
inherent in the process of rating RMBS
and CDOs.52 The NRSROs that have
been the primary ratings providers for
subprime RMBS and related CDOs each
operate under an ‘‘issuer-pays’’ model
in which they are paid by the arranger
to rate a proposed RMBS or CDO. The
arranger has an economic interest in
obtaining the highest credit rating
possible for each security issued by the
trust and the NRSRO has an economic
interest in having the arranger select it
to rate the next RMBS or CDO brought
by the arranger to market. Observers
45 86 Ratings Lowered On 20 U.S. CDOs Of ABS
Deals; $9.107 Billion In Issuance Affected, S&P,
April 1, 2008, p. 1.
46 Summary of Global Structured Finance CDO
Rating Actions, Fitch, December 14, 2007, p. 1.
47 Id., p. 6.
48 See, e.g., Dugan March 4, 2008 Senate
Testimony, p. 13.
49 Id., Bair March 4, 2008 Senate Statement, p. 7.
50 Id., Bernanke February 28, 2008 Senate
Testimony, p. 3.
51 See, e.g., Dugan March 4, 2008 Senate
Testimony, p. 13; Bair January 31, 2008 Senate
Testimony, pp. 3–4.
52 See, e.g., Opening Statement of Senator Richard
C. Shelby for the Hearing of the U.S. Senate
Committee on Banking, Housing, and Urban Affairs
(September 26, 2007), pp. 1–2.
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have questioned whether, given the
incentives created by this arrangement,
the NRSROs are able to issue unbiased
ratings, particularly as the volume of
deals brought by certain arrangers
increased in the mid-2000s.53 The above
concerns are compounded by the
arrangers’ ability to ‘‘ratings shop.’’
Ratings shopping is the process by
which an arranger will bring its
proposed RMBS and CDO transaction to
multiple NRSROs and choose, on a dealwide or tranche-by-tranche basis, which
two (or in some cases one) to use based
on the preliminary ratings of the
NRSROs.
In addition, the interaction between
the NRSRO and the arranger during the
RMBS and CDO rating process has
raised concerns that the NRSROs are
rating products they designed (i.e.,
evaluating their own work).54 A
corporate issuer is more constrained in
how it can adjust in response to an
NRSRO to improve its creditworthiness
in order to obtain a higher rating. In the
context of structured finance products,
the arranger has much more flexibility
to make adjustments to obtain a desired
credit rating by, for example, changing
the composition of the assets in the pool
held by the trust or the subordination
levels of the tranche securities issued by
the trust. In fact, an arranger frequently
will inform the NRSRO of the rating it
wishes to obtain for each tranche and
will choose an asset pool, trust
structure, and credit enhancement
levels based on its understanding of the
NRSRO’s quantitative and qualitative
models. The credit analyst will use the
expected loss and cash flow models to,
in effect, check whether the proposed
assets, trust structure and credit
enhancement levels are sufficient to
support the credit ratings desired by the
arranger.
The NRSRO rules adopted by the
Commission in June of 2007 preceded
the full emergence of the credit market
turmoil. The Commission, in light of its
experience since the final rules became
effective, is proposing amendments to
those rules and a new rule with the goal
of further enhancing the utility of
NRSRO disclosure to investors,
strengthening the integrity of the ratings
process, and more effectively addressing
the potential for conflicts of interest
53 See, e.g., Testimony of Professor John C. Coffee,
Jr., Adolf A. Berle Professor of Law, Columbia
University Law School, before the U.S. Senate
Committee on Banking, Housing, and Urban Affairs
(September 26, 2007), pp. 4–5.
54 See, e.g., Opening Statement of Senator Jack
Reed for the Hearing of the U.S. Senate Committee
on Banking, Housing, and Urban Affairs (September
26, 2007), pp. 1–2.
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inherent in the ratings process for
structured finance products.
II. Proposed Amendments
A. Amendments to Rule 17g–5
The Commission adopted Rule 17g–5,
in part, pursuant to authority ‘‘to
prohibit, or require the management and
disclosure of, any conflicts of interest
relating to the issuance of credit ratings
by an [NRSRO].’’ 55 The rule identifies a
series of conflicts arising from the
business of determining credit ratings.
Under the rule, some of these conflicts
must be disclosed and managed, while
other specified conflicts are prohibited
outright.
Paragraph (a) of Rule 17g–5 prohibits
an NRSRO from having a conflict
identified in paragraph (b) of the rule
unless the NRSRO discloses the type of
conflict on Form NRSRO and
establishes, maintains, and enforces
procedures to manage it.56 Paragraph (b)
identifies eight types of conflicts, which
include being paid by issuers or
underwriters to determine credit ratings
with respect to securities or money
market instruments they issue or
underwrite 57 or being paid by persons
for subscriptions to receive or access
credit ratings where such persons also
may own investments or have entered
into transactions that could be favorably
or adversely impacted by a credit
rating.58
Paragraph (c) of Rule 17g–5 prohibits
outright four types of conflicts of
interest. Consequently, an NRSRO
would violate the rule if it has the type
of conflict described in paragraph (c)
even if it disclosed the conflict and
established procedures to manage it. In
the Adopting Release, the Commission
explained that these conflicts were
prohibited because they would be
difficult to manage given their potential
to cause undue influence.59
The Commission is proposing to
amend Rule 17g–5 to require the
disclosure and establishment of
procedures to manage an additional
conflict and to prohibit certain other
conflicts outright, as described below.
55 See Section 15E(h)(2) of the Exchange Act (15
U.S.C. 78o–7(h)(2)).
56 17 CFR 240.17g–5(a).
57 17 CFR 240.17g–5(b)(1).
58 17 CFR 240.17g–5(b)(5).
59 Adopting Release, 72 FR at 33598.
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1. Addressing the Particular Conflict
Arising From Rating Structured Finance
Products by Enhancing the Disclosure of
Information Used in the Rating Process
a. The Proposed Amendment
The Commission is proposing to
amend Rule 17g–5 60 to add to the list
of conflicts that must be disclosed and
managed the additional conflict of
repeatedly being paid by certain
arrangers to rate structured finance
products. This conflict is a subset of the
broader conflict already identified in
paragraph (b)(1) of Rule 17g–5; namely,
‘‘being paid by issuers and underwriters
to determine credit ratings with respect
to securities or money market
instruments they issue or
underwrite.’’ 61 In the case of structured
finance products, the Commission
preliminarily believes this ‘‘issuer/
underwriter-pay’’ conflict is particularly
acute because certain arrangers of
structured finance products repeatedly
bring ratings business to the NRSROs.62
As sources of constant deal based
revenue, some arrangers have the
potential to exert greater undue
influence on an NRSRO than, for
example, a corporate issuer that may
bring far less ratings business to the
NRSRO.63 Consequently, the
Commission is proposing amendments
to Rule 17g–5 that would require
additional measures to address this
particular type of ‘‘issuer/underwriterpay’’ conflict.
Specifically, the proposed
amendment would re-designate
paragraph (b)(9) of Rule 17g–5 as
paragraph (b)(10) and in new paragraph
(b)(9) identify the following conflict:
issuing or maintaining a credit rating for
a security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction that was paid for
by the issuer, sponsor, or underwriter of
the security or money market
instrument. To address this conflict,
proposed new paragraph (a)(3) would
require that as a condition to the
NRSRO rating a structured finance
product the information provided to the
60 17
CFR 240.17g–5.
CFR 240.17g–5(b)(1). As the Commission
noted when adopting Rule 17g–5, the concern with
conflict identified in paragraph (b)(1) ‘‘is that an
NRSRO may be influenced to issue a more favorable
credit rating than warranted in order to obtain or
retain the business of the issuer or underwriter.’’
Adopting Release, 72 FR at 33595.
62 See e.g., Testimony of Professor John C. Coffee,
Jr., Adolf A. Berle Professor of Law, Columbia
University Law School, before the U.S. Senate
Committee on Banking, Housing, and Urban Affairs
(April 22, 2008) (‘‘Coffee April 22, 2008 Senate
Testimony’’), pp. 4–6.
63 Id.
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NRSRO and used by the NRSRO in
determining the credit rating would
need to be disclosed through a means
designed to provide reasonably broad
dissemination of the information.64 The
intent behind this disclosure is to create
the opportunity for other NRSROs to use
the information to rate the instrument as
well. Any resulting ‘‘unsolicited
ratings’’ could be used by market
participants to evaluate the ratings
issued by the NRSRO hired to rate the
product and, in turn, potentially expose
an NRSRO whose ratings were
influenced by the desire to gain favor
with the arranger in order to obtain
more business.65
The proposed amendment would
require the disclosure of information
provided to an NRSRO by the ‘‘issuer,
underwriter, sponsor, depositor, or
trustee.’’ The Commission preliminarily
believes that, taken together, these are
the parties that provide all relevant
information to the NRSRO to be used in
the initial rating and rating monitoring
processes. The Commission is not
proposing to specify the party—NRSRO,
arranger, issuer, depositor, or trustee—
that would need to disclose the
information. It may be that the issuer
through the arranger and trustee would
be in the best positions to disclose the
information. In this case, in contracting
with these parties to provide a rating for
a structured finance product, the
NRSRO could require a representation
from them that the necessary
information would be disclosed as
required by the proposed rule. The
Commission notes, however, that the
proposed rule does not provide a safe
harbor for an NRSRO arising from such
a representation. Consequently, an
NRSRO would violate the proposed rule
if it issued a credit rating for a
structured finance product where the
information is not disclosed
notwithstanding any representations
from the arranger.
The goal of this proposed amendment
is to promote the effective management
of this conflict of interest, increase the
transparency of the process for rating
structured finance products, and foster
competition by making it feasible for
more market participants, in particular
NRSROs that are not contracted by the
64 This proposed requirement would be in
addition to the current requirements of paragraph
(a) that an NRSRO disclose the type of conflict of
interest in Exhibit 6 to Form NRSRO; and establish,
maintain and enforce written policies and
procedures to address and manage the conflict of
interest. 17 CFR 240 17g–5(a)(1) and (2).
65 As used herein, an ‘‘unsolicited rating’’ is one
that is determined without the consent and/or
payment of the obligor being rated or issuer,
underwriter, or arranger of the securities being
rated.
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arranger to issue a rating but still wish
to do so, to perform credit analysis on
the instrument and to monitor the
instrument’s creditworthiness. As noted
above, by providing the opportunity for
more NRSROs to determine credit
ratings for structured finance products,
this proposal is designed to increase the
number of ratings extant for a given
instrument and, in particular, promote
the issuance of ratings by NRSROs that
are not hired by the arranger. The goal
would be to expose an NRSRO that was
unduly influenced by the ‘‘arrangerpay’’ conflict into issuing higher than
warranted ratings.66 An ancillary benefit
would be that the proposal could make
it easier for users of credit ratings to
identify potentially inaccurate credit
ratings and incompetent NRSROs. The
proposal also is designed to make it
more difficult for arrangers to exert
influence on the NRSROs that they hire
to determine ratings for structured
finance products. Specifically, by
opening up the rating process to greater
scrutiny, the proposal is designed to
make it easier for the hired NRSRO to
resist pressure from the arranger by
increasing the likelihood that any steps
taken to inappropriately favor the
arranger could be exposed to the market.
Further, as noted above, an ancillary
benefit of the proposal is that it could
operate as a check on inaccuracy and
incompetence.
To further these goals, the proposal
would require the disclosure of the
following information:
• All information provided to the
nationally recognized statistical rating
organization by the issuer, underwriter,
sponsor, depositor, or trustee that is
used in determining the initial credit
rating for the security or money market
instrument, including information about
the characteristics of the assets
underlying or referenced by the security
or money market instrument, and the
legal structure of the security or money
market instrument; 67
• All information provided to the
nationally recognized statistical rating
organization by the issuer, underwriter,
sponsor, depositor, or trustee that is
used by the nationally recognized
statistical rating organization in
undertaking credit rating surveillance
on the security or money market
66 The Commission notes that ‘‘unsolicited’’
ratings could be used to obtain business with
arrangers by creating a track record of favorable
ratings. The Commission believes the potential to
expose such conduct would be equal to that of
exposing an NRSRO influenced by the ‘‘arrangerpay’’ conflict insomuch as the paid for ratings
(usually at least two) would be consistently lower
than the ‘‘unsolicited’’ ratings.
67 See proposed paragraph (a)(3)(i)(A) and (B) of
Rule 17g–5.
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instrument, including information about
the characteristics and performance of
the assets underlying or referenced by
the security or money market
instrument.68
For the purposes of the proposed
amendment, the Commission would
consider only information that is taken
into account in generating the credit
rating or in performing surveillance to
be ‘‘used’’ by the NRSRO in those
contexts. This would exclude
information about collateral pools (i.e.,
‘‘loan tapes’’) provided by the arranger
containing a mix of assets that is
different than the composition of the
final collateral pool upon which the
credit rating is based. The proposed rule
also would exclude from disclosure
most, if not all, communications
between the NRSRO and the issuer,
underwriter, sponsor, depositor, or
trustee to the extent the
communications do not contain
information necessary for the NRSRO to
determine an initial credit rating or
perform surveillance on an existing
credit rating.
The Commission recognizes that the
NRSRO would define the information
that it uses for purposes of generating
credit ratings and, likely, would obtain
representations from the arranger that
the information is being disclosed as
required under the rule. There is a
potential that an NRSRO that uses
relatively little information to generate
credit ratings would be favored by
arrangers to minimize the amount of
information subject to the disclosure
requirement. The Commission
preliminarily believes that there is some
degree of standardization as to the
information used by NRSROs to rate
structured finance products (e.g., loan
level information, payment priorities
among the issued tranched securities,
and legal structure of the issuer). An
NRSRO that requires less than the
standard level of information would
need to convince users of credit ratings,
most notably investors, that its ratings
process was credible. Otherwise,
arrangers ultimately would not use the
NRSRO since it would be more difficult
to sell the structured finance products if
they carried ratings that were not
accepted by the marketplace.
Nonetheless, the Commission, if this
proposal is adopted, intends to monitor
whether it results in a significant
reduction in the information provided
to NRSROs.
The timing and scope of the
disclosures of the first set information
described above—information used in
68 See
proposed paragraph (a)(3)(ii) of Rule 17g–
5.
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determining the initial credit rating—
would depend on the nature of the
offering: public, private, or offshore. 69
In an offering registered under the
Securities Act of 1933 (15 U.S.C. 77a et
seq.), the information would need to be
disclosed on the date the underwriter
and the issuer or depositor set the
offering price of the securities being
rated (the ‘‘pricing date’’). 70 In offerings
that are not registered under the
Securities Act of 1933 (15 U.S.C. 77a et
seq.), the information would need to be
disclosed to investors in the offering
and entities meeting the definition of
‘‘credit rating agency’’ in Section
3(a)(61) of the Exchange Act (which
would include credit rating agencies
registered, and not registered, as
NRSROs) 71 and on the pricing date and
disclosed publicly on the first business
day after the transaction closes.
The Commission is proposing the
pricing date as the time of the first
disclosures because it preliminarily
believes that this is the earliest date
upon which the asset pool and legal
structure of the trust are settled on.
Thus, the information that would be
disclosed would reflect the actual
characteristics of the securities to be
issued and not, for example,
preliminary assets pools with different
compositions of loans. At the same time,
the disclosure of the information before
the securities are sold is designed to
provide the opportunity for other credit
rating agencies to use the information to
develop ‘‘unsolicited ratings’’ for the
tranche securities before they are
purchased by investors. To the extent
unsolicited ratings are issued, they
would provide investors with a greater
range of credit assessments and, in
particular, assessments from credit
rating agencies that are not subject to
the ‘‘arranger-pay’’ conflict.
The Commission anticipates that the
information that would need to be
disclosed (i.e., the information used by
the hired NRSRO to determine the
initial rating) generally would include
the characteristics of the assets in the
pool underlying the structured finance
product and the legal documentation
setting forth the capital structure of the
trust, payment priorities with respect to
the tranche securities issued by the trust
(the waterfall), and all applicable
covenants regarding the activities of the
trust. For example, for an initial rating
for an RMBS, this information generally
69 See Sections II.A.1.b.i—iii below for a broader
discussion of the scope of the disclosures that
would be required under the proposed
amendments.
70 See proposed paragraph (a)(3)(i)(A) of Rule
17g–5.
71 15 U.S.C. 78c(a)(61).
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would include the ‘‘loan tape’’
(frequently a spreadsheet) that identifies
each loan in the pool and its
characteristics such as type of loan,
principal amount, loan-to-value ratio,
borrower’s FICO score, and geographic
location of the property. In addition, the
disclosed information also would
include a description of the structure of
the trust, the credit enhancement levels
for the tranche securities to be issued by
the trust, and the waterfall cash flow
priorities. With respect to the loan pool
information, the Commission does not
intend that the proposed disclosure
would include any personal identifying
information on individual borrowers or
properties (such as names, phone
numbers, addresses or tax identification
numbers).
After the disclosure of the information
used by the NRSRO to perform the
initial rating, the proposed amendment
would require the disclosure of
information about the underlying assets
that is provided to, and used by, the
NRSRO to perform any ratings
surveillance.72 The Commission
anticipates that generally this
information would consist of reports
from the trustee describing how the
assets in the pool underlying the
structured finance product are
performing. For an RMBS credit rating,
this information likely would include
the ‘‘trustee report’’ customarily
generated to reflect the performance of
the loans constituting the collateral
pool. For example, an RMBS trustee
may generate reports describing the
percentage of loans that are 30, 60, and
90 days in arrears, the percentage that
have defaulted, the recovery of principal
from defaulted loans, and information
regarding any modifications to the loans
in the asset pool. The disclosure of this
information would allow NRSROs that
were not hired to rate the deal,
including ones that determined
unsolicited initial ratings, to monitor on
a continuing basis the creditworthiness
of the tranche securities issued by the
trust. The proposed amendment
provides that this information would
need to be disclosed at the time it is
provided to the NRSRO. This is
designed to put other NRSROs and other
interested parties on an equal footing
with the NRSRO hired by the arranger
insomuch as they would all obtain the
information at the same time.
Consequently, they all could begin any
surveillance processes simultaneously.
The goal of this aspect of the proposal
again would be to expose an NRSRO
that was allowing business
considerations to impact its judgment.
72 Proposed
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For example, in order to maintain favor
with a particular arranger, an NRSRO
may be reluctant to downgrade a credit
rating for a structured finance product
to its appropriate category even where a
downgrade is implied by its
surveillance procedures and
methodologies. Increasing the number
of credit ratings extant for the
instrument, including ratings not paid
for by the arranger, would make it more
difficult to conceal the fact that a
particular NRSRO was being unduly
influenced by an arranger as to its
surveillance process.
As discussed below, the manner and
breadth of the disclosures, including
how widely the information could be
disseminated, would depend on the
nature of the offering for the rated
structured finance product: public,
private, or offshore. The proposed
amendment’s requirement that the
information be ‘‘disclosed through a
means designed to provide reasonably
broad dissemination’’ would be
interpreted by the Commission to mean
in the manner described in sections
II.A.1.b.i—iii below that discuss the
proposed amendment in the context of
public, private, and offshore offerings.
The Commission is proposing these
amendments to Rule 17g–5, in part,
pursuant to the authority in Section
15E(h)(2) of the Exchange Act.73 The
provisions in this section of the statute
provide the Commission with authority
to prohibit, or require the management
and disclosure of, any potential conflict
of interest relating to the issuance of
credit ratings by an NRSRO.74 The
Commission preliminarily believes the
proposed amendments are necessary
and appropriate in the public interest
and for the protection of investors
because they are designed to address
conflicts of interest and improve the
quality of credit ratings for structured
finance products by: (1) Increasing the
transparency of the ratings process and
thereby making it more apparent when
an NRSRO may be allowing business
considerations to impair its objectivity
and (2) enhancing competition by
creating the opportunity for NRSROs
that are not hired to rate structured
products to nonetheless determine
credit ratings and establish track records
for rating these products.
The Commission preliminarily
believes that it is appropriate to require
an NRSRO to address and manage the
conflict of interest raised by the
NRSRO’s recurring relationships with
structured finance product arrangers by
making the rating process more
73 15
U.S.C. 78o–7(h)(2).
74 Id.
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transparent in terms of the information
used to determine the ratings. This
would create an opportunity for other
NRSROs (including subscriber based
NRSROs), unregistered credit rating
agencies, and other interested parties to
assess the creditworthiness of these
products and issue their own credit
ratings or credit assessments.75 Market
participants and observers would be
able to compare the ratings of the
NRSROs hired by the arrangers against
the ratings of NRSROs and others not
hired by the arrangers. As discussed
above, the Commission preliminarily
believes that this would enhance the
integrity of the ratings process by
making it easier for users of credit
ratings to compare NRSROs and
evaluate whether an NRSRO’s
objectivity had been compromised by
the undue influence of an arranger. It
also could make it easier for the
NRSROs hired to determine credit
ratings for structured finance products
to resist pressure from arrangers
insomuch as the parties would be aware
that the potential for exposing a
compromised NRSRO had been
increased through the proposed
amendment’s disclosure requirements.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• Would the information proposed to
be required to be disclosed sufficient to
permit the determination of an
unsolicited credit rating? Conversely,
would the proposed amendment require
the disclosure of more information than
would be necessary to permit the
determination of an unsolicited credit
rating? Commenters believing more
information should be disclosed should
specifically describe the additional
information and the practicality of
requiring its disclosure, while
commenters believing that less
information should be disclosed should
specifically describe what information
would be unnecessary and explain why
it would be unnecessary to disclose.
• The proposed amendment would
require the disclosure of information
provided to an NRSRO by the ‘‘issuer,
underwriter, sponsor, depositor, or
trustee’’ based on the Commission’s
75 As discussed below, for private offerings and
offshore offerings, this information would not be
disclosed publicly before the offering closes but
instead would be provided via a passwordprotected Internet Web site to credit rating agencies
and accredited investors. After the offering closes,
the information would be required to be disclosed
publicly and, therefore, made available to market
observers such as academics.
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preliminary belief that these would be
the parties relevant to an NRSRO’s
performance of the ratings process, i.e.,
that taken together, these are the parties
that would provide all relevant
information to the NRSRO. Are there
other entities that should be included in
this category?
• Should the Commission provide a
‘‘safe harbor’’ so that an NRSRO that
obtained a representation from one or
more parties to a transaction to disclose
the required information would not be
held in violation of the rule if the party
did not fulfill its disclosure obligations
under the representation?
• Should the Commission also
require the disclosure of information
about the steps, if any, that were taken
by the NRSRO, issuer, underwriter,
sponsor, depositor, or trustee to verify
information about the assets underlying
or referenced by the security or money
market instrument, or, if no such steps
were taken, a disclosure of that fact?
• Would the disclosure of the initial
information on the pricing date provide
enough time for other NRSROs to
determine unsolicited ratings before the
securities were sold to investors? If not,
would it be appropriate to require that
this information be disclosed prior to
the pricing date? Alternatively, would it
be more appropriate to require NRSROs
hired by the arranger to wait a period of
calendar or business days (e.g., 2, 4, 10
days) after the asset pool is settled upon
by the arranger before issuing the initial
credit rating in order to provide other
NRSROs with sufficient time to
determine an unsolicited rating?
• Should the Commission also
require the disclosure of the results of
any steps taken by the NRSRO, issuer,
underwriter, sponsor, depositor, or
trustee to verify information about the
assets underlying or referenced by a
structured finance product?
Alternatively, should the Commission
require a general disclosure of whether
any steps were taken to verify the
information and, if so, a description of
those steps?
• Do NRSROs obtain information
about the underlying assets of
structured products—particularly in the
surveillance process—from third-parties
such as vendors rather than from
issuers, underwriters, sponsors, or
trustees? If so, would it be necessary to
require the disclosure of this
information as proposed or can the goals
of the proposed amendments in
promoting unsolicited ratings be
achieved under current practices
insomuch as the information necessary
for surveillance can be obtained from
third-party vendors, albeit for a fee?
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• Does the information provided to
NRSROs by issuers, underwriters,
sponsors, depositors, or trustees about
assets underlying structured products
(e.g., mortgage loans, home equity loans,
consumer loans, credit card receivables)
commonly include personal identifying
information about individuals such as
names, social security numbers,
addresses, and telephone numbers? If
so, are there practical ways to ensure
that this information is not disclosed?
• Does any of the information
provided to NRSROs by issuers,
underwriters, sponsors, depositors, or
trustees about assets underlying
structured products contain proprietary
information? Commenters that believe
this is the case should specifically
identify any such information.
b. Proposed Guidance for Compliance
With Provisions of the Securities Act of
1933
As noted above, the proposed
amendments to Rule 17g–5 that would
require the disclosure of information
about the underlying assets of a
structured finance product implicate the
Securities Act.76 As explained below,
the means by which information would
be disclosed for the purposes of the
proposed amendments to Rule 17g–5
would be governed by the nature of the
offering. The Securities Act restricts the
types of offering communications that
issuers or other parties subject to the
Securities Act’s provisions (such as
underwriters) may use during a
registered public offering and, for
private offerings, restricts the methods
by which communications may be made
so as to avoid general solicitation or
general advertising of the private
offering to potential purchasers.
Communications that may be
considered offers 77 are subject to these
restrictions.78 Likewise, with respect to
76 15
U.S.C. 77a et seq.
Act Section 2(a)(3) (15 U.S.C.
77b(a)(3)) defines an ‘‘offer’’ as any attempt to offer
to dispose of, or solicitation of any offer to buy, a
security or interest in a security for value. The term
‘‘offer’’ has been interpreted broadly and goes
beyond the common law concept of an offer. See
Diskin v. Lomasney & Co., 452 F. 2d 871 (2d Cir.
1971); SEC v. Cavanaugh, 1 F. Supp. 2d 337
(S.D.N.Y. 1998). The Commission has explained
that ‘‘the publication of information and publicity
efforts, made in advance of a proposed financing
which have the effect of conditioning the public
mind or arousing public interest in the issuer in its
securities constitutes an offer * * *.’’ Guidelines
for the Release of Information by Issuers Whose
Securities are in Registration, Securities Act Release
No. 5180 (August 16, 1971), 36 FR 16506.
78 Before the registration statement is filed, all
offers, in whatever form, are prohibited. See
Securities Act Section 5(c) (15 U.S.C. 77e(c)).
Between the filing of the registration statement and
its effectiveness, offers made in writing (including
by e-mail or Internet), by radio, or by television are
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unregistered offshore offerings that are
intended to comply with the safe harbor
provisions of Regulation S,
communications that are deemed to be
offers in the United States or directed
selling efforts in the United States are
prohibited. Information about securities
that are the subject of an offering that
has been provided to NRSROs and is
required to be disclosed pursuant to the
proposed rules would be considered
offers or directed selling efforts and
therefore subject to these restrictions
relating to offering communications.79
In the following three sections, the
Commission provides guidance on how
the information that would be required
to be disclosed under proposed new
paragraph (a)(3) of Rule 17g–5
(‘‘Paragraph (a)(3) Information’’) would
need to be disclosed under the proposed
amendment and consistent with the
Securities Act. As discussed below, the
manner and breadth of the disclosures
under the proposed amendment would
depend on whether the structured
finance product was issued under a
public, private, or offshore offering.
i. Public Offerings
With respect to registered offerings at
the time the Paragraph (a)(3)
Information would be required to be
disclosed (the pricing date), the
information would be written
communications and the issuer,
underwriter, or other offering
participant also would have to comply
with the Securities Act with regard to
the disclosure of such written
communications.80 In addition, such
written communications would be
limited to a ‘‘statutory prospectus’’ that conforms to
the information requirements of Securities Act
Section 10. See Securities Act Section 5(b)(1) (15
U.S.C. 77e(b)(1)) and Securities Act Section 10 (15
U.S.C. 77j). After the registration statement is
declared effective, offering participants may make
written offers only through a statutory prospectus,
except that they may use additional offering
materials if a final prospectus that meets the
requirements of Securities Act Section 10(a) is sent
or given prior to or with those materials. See
Securities Act Section 2(a)(10) (15 U.S.C.
77b(a)(10)) and Section 5(b)(1).
79 This may be the case even if the information
relates to pools backing prior issuances. In an
offering of securities backed by the same class of
assets, the information provided for surveillance
and required to be disclosed pursuant to proposed
Rule 17g–5(a)(3)(iii) may be static pool data as
described in Item 1105 of Regulation AB (17 CFR
229.1105).
80 See Securities Offering Reform, Securities Act
Release 33–8591 (July 19, 2005), 70 FR 44722
(August 3, 2005) (the ‘‘Securities Offering Reform
Release’’) for a discussion of the definition of
written communications and rules relating to
permitted communications in registered offerings.
See also Asset-Backed Securities, Securities Act
Release No. 8518 (December 22, 2004) 70 FR 1506
(January 7, 2005) (the ‘‘Asset-Backed Securities
Release’’) for rules applicable to offerings of assetbacked securities.
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subject to the civil liability and
antifraud provisions of the Securities
Act.81
As discussed in the Commission’s
Securities Offering Reform Release
adopting several reforms to the
securities offering process,82 issuers of
structured finance products have
potentially two sets of rules under the
Securities Act on which they may rely
in using written offering materials. If the
offering is registered on Securities Act
Form S–3,83 then the written materials
may constitute ABS informational and
computational materials, as defined in
Item 1101 of Regulation AB,84 and
81 Under the Securities Act, purchasers of an
issuer’s securities in a registered offering have
private rights of action for materially deficient
disclosure in registration statements under Section
11 and in prospectuses and oral communications
under Section 12(a)(2). Under Securities Act
Section 12(a)(2) and Securities Act Rule 159, the
liability determination as to an oral communication,
prospectus, or statement, as the case may be, does
not take into account information conveyed to a
purchaser only after the time of sale (including the
contract of sale), including information contained
in a final prospectus, prospectus supplement, or
Exchange Act filing that is filed or delivered
subsequent to the time of sale (including the
contract of sale) where the information is not
otherwise conveyed at or prior to that time. The
time of sale under the Securities Act includes the
time of the contract of sale—the time at which an
investor has taken the action the investor must take
to become committed to purchase the securities and
therefore entered into a contract of sale.
82 See Section III.D.3.b.iii(C)(3)(a)(iii) of the
Securities Offering Reform Release, 70 FR 44722,
44751.
83 17 CFR 239.13. An ABS issuer is eligible to use
Form S–3 if the conditions of General Instruction
V are met.
84 17 CFR 229.1101. Item 1101 of Regulation AB
provides the following definition:
(a) ABS informational and computational
material means a written communication consisting
solely of one or some combination of the following:
(1) Factual information regarding the asset-backed
securities being offered and the structure and basic
parameters of the securities, such as the number of
classes, seniority, payment priorities, terms of
payment, the tax, Employment Retirement Income
Security Act of 1974, as amended, (29 U.S.C. 1001
et seq.) (‘‘ERISA’’) or other legal conclusions of
counsel, and descriptive information relating to
each class ( e.g., principal amount, coupon,
minimum denomination, anticipated price, yield,
weighted average life, credit enhancements,
anticipated ratings, and other similar information
relating to the proposed structure of the offering);
(2) Factual information regarding the pool assets
underlying the asset-backed securities, including
origination, acquisition and pool selection criteria,
information regarding any prefunding or revolving
period applicable to the offering, information
regarding significant obligors, data regarding the
contractual and related characteristics of the
underlying pool assets ( e.g., weighted average
coupon, weighted average maturity, delinquency
and loss information and geographic distribution)
and other factual information concerning the
parameters of the asset pool appropriate to the
nature of the underlying assets, such as the type of
assets comprising the pool and the programs under
which the loans were originated;
(3) Identification of key parties to the transaction,
such as servicers, trustees, depositors, sponsors,
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should be filed on Exchange Act Form
8–K 85 in accordance with Rules 167 and
426 of the Securities Act.86 The written
materials may constitute a free writing
prospectus, as defined in Rule 405 of
the Securities Act.87 In that case, the
information that is disclosed must be
filed in accordance with Rules 164 and
433 of the Securities Act.88 Given that
the Paragraph (a)(3) Information could
constitute offering materials, the
Commission believes it is important to
explain how the rules under the
Securities Act may be relied upon when
Paragraph (a)(3) Information is made
publicly available.89
originators and providers of credit enhancement or
other support, including a brief description of each
such party’s roles, responsibilities, background and
experience;
(4) Static pool data, as referenced in Item 1105
of this Regulation AB, such as for the sponsor’s
and/or servicer’s portfolio, prior transactions or the
asset pool itself;
(5) Statistical information displaying for a
particular class of asset-backed securities the yield,
average life, expected maturity, interest rate
sensitivity, cash flow characteristics, total rate of
return, option adjusted spread or other financial or
statistical information relating to the class or classes
under specified prepayment, interest rate, loss or
other hypothetical scenarios. Examples of such
information under the definition include:
(i) Statistical results of interest rate sensitivity
analyses regarding the impact on yield or other
financial characteristics of a class of securities from
changes in interest rates at one or more assumed
prepayment speeds;
(ii) Statistical information showing the cash flows
that would be associated with a particular class of
asset-backed securities at a specified prepayment
speed; and
(iii) Statistical information reflecting the financial
impact of losses based on a variety of loss or default
experience, prepayment, interest rate and related
assumptions.
(6) The names of underwriters participating in the
offering of the securities, and their additional roles,
if any, within the underwriting syndicate;
(7) The anticipated schedule for the offering
(including the approximate date upon which the
proposed sale to the public will begin) and a
description of marketing events (including the
dates, times, locations, and procedures for attending
or otherwise accessing them); and
(8) A description of the procedures by which the
underwriters will conduct the offering and the
procedures for transactions in connection with the
offering with an underwriter or participating dealer
(including procedures regarding account-opening
and submitting indications of interest and
conditional offers to buy). The Commission
confirmed in the Asset-Backed Securities Release
that loan level information could be included in
ABS information and computational materials.
85 17 CFR 249.308.
86 17 CFR 230.167 and 17 CFR 230.426.
87 17 CFR 230.405. The contents of free writing
prospectuses are not limited to ABS informational
and computational materials.
88 17 CFR 230.164 and 17 CFR 230.433. Rule 433
also provides that a free writing prospectus or
portion thereof required to be filed under Rule 433
containing only ABS informational and
computational materials may be filed under Rule
433 but within the time frame required for
satisfaction of the conditions of Rule 426, and that
such filing will satisfy the conditions of Rule 433.
89 Depending on whether the materials constitute
a free writing prospectus or ABS informational and
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Most elements of the Paragraph (a)(3)
Information would need to be filed in
accordance with the rules governing free
writing prospectuses or ABS
informational and computational
materials pursuant to Rules 433 and
426.90 Currently, the timing or filing
requirements under these rules is tied to
when the information is provided to
specific investors. However, unlike
other free writing prospectuses and ABS
informational and computational
materials that may be provided to
specific investors, in a public offering,
the Paragraph (a)(3) Information would
be required to be disclosed publicly.
Therefore, the Commission believes that
it is appropriate to clarify when the
materials should be filed with the
Commission.
Under Rule 426, ABS informational
and computational materials are
required to be filed by the later of the
due date for filing the final prospectus
under Rule 424(b) or two days after the
date of first use. Under Rule 433, a free
writing prospectus must be filed with
the Commission no later than the date
of first use. However, in order to
conform certain asset-backed free
writing prospectuses with the filing
requirements for ABS informational and
computational materials in Rule 426,
Rule 433(d)(6) provides that a free
writing prospectus containing only ABS
information and computational
materials may be filed in the time
provided by Rule 426(b). Thus, under
both rules the information must be filed
by the later of the due date for filing the
final prospectus under Rule 424(b) or
two days after the date of first use.
In addition, Rule 433 requires filing
by issuers of free writing prospectuses
prepared by or on behalf of, or used or
referred to by, issuers or, depositors,
sponsors, servicers, or affiliated
depositors, whether or not the issuer,
but not by underwriters or dealers,
unless they contain issuer information
or are distributed in a manner
reasonably designed to lead to its broad
dissemination. The Paragraph (a)(3)
Information that would be required to
computational materials, the liability provisions
governing the disclosure may differ. Free writing
prospectuses are subject to liability under Section
12(a)(2) and Section 17(a) of the Securities Act. 15
U.S.C. 77l(a)(2) and 15 U.S.C. 77q(a). A free writing
prospectus will not be part of a registration
statement subject to liability under Securities Act
Section 11 unless the issuer elects to file it as part
of the registration statement. See also Asset-Backed
Securities Release at footnote 335. On the other
hand, ABS informational and computational
materials also are subject to Section 12(a)(2) and
Section 17(a) liability, but they must be filed on
Form 8–K and therefore, by virtue of incorporation
by reference into a registration statement, are
subject to Section 11 liability.
90 17 CFR 230.433 and 17 CFR 230.426.
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be disclosed would not be considered
underwriter or dealer information, even
if prepared by the underwriter or dealer,
given the broad dissemination and thus
would need to be filed.
Rules 164 and 167 provide the
exemption from Section 5(b)(1) of the
Securities Act for the use of free writing
prospectuses and ABS informational
and computational materials,
respectively. For the most part, Rule 164
should be available for the use of the
Paragraph (a)(3) Information, even
where the issuer is an ineligible
issuer,91 given that the rule provides
that ineligible issuers that are assetbacked issuers may use a free writing
prospectus as long as the free writing
prospectus contains only specified
information.92 Much of the Paragraph
91 An ‘‘ineligible issuer,’’ as the term is defined
in Rule 405 of the Securities Act, includes, in the
case of asset-backed issuers, the depositor or any
issuing entities previously established, directly or
indirectly by the depositor, who are not current in
their Exchange Act reports and other materials
required to be filed during the prior 12 months (or
such shorter period that the issuer was required to
file such reports and materials), other than reports
on Form 8–K required solely pursuant to an item
specified in General Instruction I.A.4 of Form S–3.
92 In asset-backed offerings by ineligible issuers,
free writing prospectuses used by ineligible issuers
are limited to the following information:
(1) Factual information regarding the asset-backed
securities being offered and the structure and basic
parameters of the securities, such as the number of
classes, seniority, payment priorities, terms of
payment, the tax, ERISA or other legal conclusions
of counsel, and descriptive information relating to
each class (e.g., principal amount, coupon,
minimum denomination, anticipated price, yield,
weighted average life, credit enhancements,
anticipated ratings, and other similar information
relating to the proposed structure of the offering);
(2) factual information regarding the pool assets
underlying the asset-backed securities, including
origination, acquisition and pool selection criteria,
information regarding any prefunding or revolving
period applicable to the offering, information
regarding significant obligors, data regarding the
contractual and related characteristics of the
underlying pool assets (e.g., weighted average
coupon, weighted average maturity, delinquency
and loss information and geographic distribution)
and other factual information concerning the
parameters of the asset pool appropriate to the
nature of the underlying assets, such as the type of
assets comprising the pool and the programs under
which the loans were originated;
(3) identification of key parties to the transaction,
such as servicers, trustees, depositors, sponsors,
originators and providers of credit enhancement or
other support, including a brief description of each
such party’s roles, responsibilities, background and
experience;
(4) static pool data;
(5) the names of underwriters participating in the
offering of the securities, and their additional roles,
if any, within the underwriting syndicate;
(6) the anticipated schedule for the offering
(including the approximate date upon which the
proposed sale to the public will begin) and a
description of marketing events (including the
dates, times, locations, and procedures for attending
or otherwise accessing them); and
(7) a description of the procedures by which the
underwriters will conduct the offering and the
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(a)(3) Information should contain
information that can be included in a
free writing prospectus used by an assetbacked issuer pursuant to Rule 164. To
the extent that Rule 167 is not available
because the offering is registered on
Form S–1 rather than Form S–3, and
Rule 164 is not available, the
information should be filed in an
amendment to the registration
statement.
In addition, the Commission
understands that currently at least some
of the information that would constitute
Paragraph (a)(3) Information, if not
included in a free writing prospectus, is
often included as a schedule to pooling
and servicing agreements. Those
agreements, along with their schedules
and exhibits, should be filed by the time
of the offering of securities. Therefore
they should be filed at the time of the
takedown as exhibits to a Form 8–K
incorporating them by reference into the
Form S–3 registration statement.93
The Commission generally requests
comment on all aspects of this proposed
guidance. In addition, the Commission
requests comment on the following
questions related to the proposal.
• Do we need to give more guidance
on the relationship between the
proposed disclosure requirements
regarding information about the
underlying assets provided to, and used
by, the NRSRO to perform ratings
surveillance and the requirements of
Regulation FD? 94 If commenters believe
that the proposed requirements are not
consistent with Regulation FD, they
should provide a detailed explanation
as to why not.
• The proposed disclosure
requirements regarding information
about the underlying assets provided to,
and used by, the NRSRO to perform
ratings surveillance may be the same as
the information required to be disclosed
on Form 10–D for so long as the issuer
has an Exchange Act reporting
obligation. Given that the Form 10–D
reporting obligation is typically
suspended for most asset-backed issuers
after the first year of reporting, does the
proposed disclosure requirement raise
any issues regarding Exchange Act
reporting?
• ABS informational and
computation materials, as defined in
Item 1101 of Regulation AB, can
include, among other things, factual
information regarding the pool assets
underlying the asset-backed securities,
including origination, acquisition and
pool selection criteria, information
regarding any prefunding or revolving
period applicable to the offering,
information regarding significant
obligors, data regarding the contractual
and related characteristics of the
underlying pool assets (e.g., weighted
average coupon, weighted average
maturity, delinquency and loss
information and geographic
distribution) and other factual
information concerning the parameters
of the asset pool appropriate to the
nature of the underlying assets, such as
the type of assets comprising the pool
and the programs under which the loans
were originated.95 As noted above, the
Commission believes that at least some
of the proposed Paragraph (a)(3)
Information could fall within this
category and therefore constitute ABS
informational and computational
materials. Since there may be a wide
variety of information that is provided
to an NRSRO, it is not clear that all
information provided would fit within
the definition of ABS informational and
computation materials, or in the various
categories of free writing prospectus.
Should the Commission provide
additional interpretation regarding what
types of material that could be provided
and would be required to be disclosed
to fit within this category? Is there
information that is likely to be provided
and disclosed that does not appear to fit
within these definitions? Should the
Commission instead revise the
definitions to specifically include the
information required to be disclosed?
• Is there any need for the
Commission to revise Securities Act
Rules 426 or 433 to clarify when the
materials need to be filed?
• Are there any additional
requirements in Regulation AB or under
the Securities Act that are implicated by
the proposed amendments? Is there any
information that would typically need
to be disclosed under this proposed
amendment that is not already generally
disclosed in filings with the
Commission?
• Should the Commission amend
Regulation AB to require that the
Paragraph (a)(3) Information be
disclosed?
procedures for transactions in connection with the
offering with an underwriter or participating dealer
(including procedures regarding account opening
and submitting indications of interest and
conditional offers to buy).
93 See Form S–3 (17 CFR 239.13), Form 8–K (17
CFR 249.308) and Item 601(b)(4) of Regulation S–
K (17 CFR 229.601).
94 17 CFR 243.100 to 103.
ii. Private Offerings
The proposed amendments also
would implicate the Securities Act
restrictions affecting private offerings.
Offerings of securities made in reliance
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95 See
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on an exemption from registration
contained in Securities Act Section
4(2),96 the rules promulgated thereunder
or pursuant to Regulation D,97 are
offerings that are not made to the public.
As a result, general solicitation or
advertising is prohibited in these
offerings under Securities Act Section
4(2) and the applicable Securities Act
rules.98 As a result of the application of
the general solicitation and advertising
restrictions, public disclosure of offering
or security information pursuant to the
proposed rules could cause the private
offering exemptions to be unavailable to
securities offerings to which the
proposed rules apply.
As discussed above, the Commission
believes it is likely that much of the
information that would need to be
disclosed under the proposed
amendment would contain extensive
loan level data, and thus anticipates that
a common medium for disclosure of this
information would be an Internet Web
site. The Commission has indicated that
the placement of private offering
materials on an Internet Web site,
without sufficient procedures to limit
access only to accredited investors, is
inconsistent with the prohibition
against general solicitation or
advertising in Securities Act Rule
502(c).99 However, as discussed above,
the Commission also believes that to
address the conflict of interest inherent
in the structured finance product
arranger-pay business model it would be
beneficial to make this information
available to investors and entities
meeting the definition of ‘‘credit rating
agency’’ in Section 3(a)(61) of the
Exchange Act (which would include
NRSROs) 100 on the date the placement
agent and the issuer or depositor set the
offering price of the securities being
96 15
U.S.C. 77d(2).
CFR 230.501 through 230.508.
98 See Securities Act Section 4(2) (15 U.S.C.
77d(2)) and Securities Act Rules 504, 505 and 506
of Regulation D (17 CFR 230.504, 230.505 and
230.506). An exception to the prohibition against
general solicitation applies to some limited
offerings under Rule 504(b)(1) (17 CFR
230.504(b)(1)) when an issuer has satisfied state
securities laws of specified types. See Revision of
Rule 504 of Regulation D, the ‘‘Seed Capital’’
Exemption, Securities Act Release No. 7644
(February 25, 1999), 64 FR 11090. The restriction
on general solicitation or advertising applies to all
methods by which the communication can be made,
including electronic, paper, mail, radio, television,
or in newspapers or magazines.
99 See Use of Electronic Media, Securities Act
Release No. 7856 (April 28, 2000), 65 FR 25843 (the
‘‘Electronic Media Release’’). The Commission
noted in the Electronic Media Release that the
federal securities laws apply equally to information
contained on an issuer’s Web site as they do to
other communications made by or attributed to the
issuer.
100 15 U.S.C. 78c(a)(61).
97 17
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rated, and to the general public on the
first business day after the offering
closes.
The Commission believes, therefore,
that in a private offering, Paragraph
(a)(3) Information would need to be
provided to investors, NRSROs, and
credit rating agencies by posting the
information on a password-protected
Internet Web site.101 On the first
business day after the offering closes,
however, the Paragraph (a)(3)
Information would need to be disclosed
publicly. The Commission believes that
removing the password protection from
the Internet Web site where the
Paragraph (a)(3) Information is posted
after the offering closes is consistent
with the Securities Act restrictions on
private offerings while satisfying the
requirements of proposed Rule 17g–
5(a)(3).
As discussed above, the Commission
believes it would be appropriate to
allow early access to credit rating
agencies other than those hired to issue
a rating to provide them with an
opportunity to perform independent
assessments of the validity of ratings
and identify flaws, opportunities for
improvement, or compromised
procedures in the hired NRSRO’s
approach. While permitting access to
this information to credit rating agencies
in addition to accredited investors
extends beyond the Commission’s
previous interpretations on what
constitutes a general solicitation or
advertising, the Commission believes it
balances those issues with the benefits
of having other credit rating agencies
able to assess the quality of, or provide
additional, ratings.102 This approach is
designed to promote competition among
NRSROs by providing credit rating
agencies that were not paid by the issuer
to rate the issuer’s products with
information they need to issue
unsolicited ratings and allowing other
market participants to also have access
to the information to allow them to
evaluate the ratings. In a private
offering, disclosure of this information
is undertaken in two steps in order to
avoid issues of general solicitation. The
Commission is providing the above
guidance only in the context of the
proposed amendments. Moreover, the
guidance expressed in this release is
101 A password-protected Web site would meet
the requirements of an amended Rule 17g–5 in the
context of private offerings.
102 The Commission noted in Interpretative
Release on Regulation D, Securities Act Release No.
6455 (March 3, 1983), 17 CFR 231, that Rule 502(c)
relates to the nature of the offering, not the nature
of the offerees.
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Jkt 214001
applicable only if the proposed
amendments are adopted.
The Commission generally requests
comment on all aspects of this proposed
guidance. In addition, the Commission
requests comment on the following
questions related to the proposal.
• Are there other parties besides
credit rating agencies and investors that
should be eligible to access Paragraph
(a)(3) Information in the context of a
private offering without raising issues of
general solicitation?
• Should any of the foregoing
guidance regarding the use of Paragraph
(a)(3) Information be codified?
• Is expanding the categories of
parties who can access the information
that would be contained in the proposed
Paragraph (a)(3) Information consistent
with the purposes of the Securities Act?
• Is there any Paragraph (a)(3)
Information that should remain
accessible only to credit rating agencies
and investors, rather than, as proposed,
disclosed to the public on the business
day after the offering has closed?
• Should the requirement to publicly
disclose the Paragraph (a)(3)
Information on the first business day
after the offering has closed also permit
the NRSRO, depositor, etc. to omit dealspecific information relating to the
transaction such that only ‘‘generic’’
information is provided to the public?
• Does disclosure of information
provided for purposes of credit rating
surveillance raise issues of general
solicitation in the context of subsequent
offerings of the same asset class? If so,
does this vary by asset class?
iii. Offshore Offerings
Similar to private offerings, the
proposed amendments would implicate
restrictions under Regulation S. Under
the General Statement of Regulation
S,103 the provisions of Section 5 of the
Securities Act apply to offers and sales
of securities that occur in the United
States and do not apply to those that
occur outside the United States.
Regulation S contains various safe
harbor procedures that issuers, offering
participants and others can follow for
unregistered offerings outside the
United States. These procedures include
restrictions against offers being made to
persons in the United States104 and
restrictions against directed selling
efforts in the United States by the issuer,
distributor, any of their respective
affiliates, or persons acting on their
behalf.105
103 Rule
901 of Regulation S, 17 CFR 230.901.
903(a)(1).
105 Rule 903(a)(2).
104 Rule
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36225
As noted above, the Commission
believes that it is likely that much of the
information that would be required to
be disclosed would contain extensive
loan level data and thus anticipates that
a common medium for disclosure of this
information would be an Internet Web
site. The Commission has provided
guidance with respect to the use of
Internet Web sites for securities
offerings outside the United States.106
This guidance sets out a general
approach that when adequate measures
are implemented to prevent U.S.
persons from participating in an
offshore offer, the Commission would
not view the offer as occurring in the
United States for registration purposes.
The Commission believes that this
guidance can be equally applied to the
proposed disclosure of the proposed
Paragraph (a)(3) Information.
Under this guidance, what constitutes
adequate measures would depend on all
of the facts and circumstances of a
particular transaction. As the
Commission noted previously:
‘‘We generally would not consider an
offshore Internet offer made by a non-U.S.
offeror as targeted at the United States,
however, if: (1) the Web site contains a
prominent disclaimer making it clear that the
offer is directed only to countries other than
the United States; * * * and (2) the Web site
offeror implements procedures that are
reasonably designed to guard against sales to
U.S. persons in the offshore offering.’’ 107
These procedures are not exclusive.
The Commission’s prior guidance
distinguishes among foreign issuers and
U.S. issuers each conducting offshore
offerings under Regulation S and U.S.
offerings conducted on an exempt basis.
The Commission believes it is
appropriate to continue this treatment
with respect to the proposed disclosure
of the Paragraph (a)(3) Information.
Under this guidance, a foreign issuer
making an offshore offering with no
concurrent U.S. private offering is not
required to password-protect Internetbased offering communications so long
as adequate measures are put in place.
Thus, credit rating agencies and other
market participants should be able to
have ready access to any Paragraph
(a)(3) Information that is posted by a
foreign issuer. A foreign issuer making
an offshore offering concurrently with
private offerings in the United States
could implement additional other
procedures to prevent its offshore
Internet communications from being
106 See Statement of the Commission Regarding
Use of Internet Web Sites to Offer Securities, Solicit
Securities Transactions or Advertise Investment
Services Offshore, Securities Act Release No. 7516
(March 23, 1998).
107 Id.
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used to solicit participants for its U.S.based exempt offering, and U.S. issuers
conducting an offshore offering should
implement procedures similar to those
for private placements, such as
password-type procedures, under which
only non-U.S. persons can obtain access
to the materials. Consistent with the
procedures for private offerings, there
could be pricing date disclosure to
credit rating agencies that are not
purchasers in the offering through a
password-protected Internet Web site.
As a result, when a foreign issuer is
conducting a U.S. private offering under
Section 4(2), and when a U.S. issuer is
conducting an offshore offering under
Regulation S or a private offering under
Section 4(2), it would follow the
procedures outlined in Section
II.A.1.b.ii above with respect to private
offerings, including procedures calling
for public disclosure of Paragraph (a)(3)
Information on the business day after
the closing date.
The Commission generally requests
comment on all aspects of this proposed
guidance. In addition, the Commission
requests comment on the following
questions related to the proposal.
• Are there other parties besides
credit rating agencies that should be
eligible to access Paragraph (a)(3)
Information in the context of an offshore
offering without raising issues of
directed selling efforts or offers of
securities in the Unites States?
• Should any of the foregoing
guidance regarding the use of Paragraph
(a)(3) Information be codified?
• Is expanding the categories of
parties who can access the information
that would be contained in the proposed
Paragraph (a)(3) Information consistent
with the purposes of the Securities Act?
• Is there any Paragraph (a)(3)
Information that should remain
accessible only to credit rating agencies
and investors, rather than, as proposed,
be disclosed to the public on the
business day after the offering has
closed?
• Should the requirement to publicly
disclose the Paragraph (a)(3)
Information on the first business day
after the offering has closed also permit
the NRSRO, depositor, etc. to omit dealspecific information relating to the
transaction such that only ‘‘generic’’
information is provided to the public?
2. Rule 17g–5 Prohibition on Conflict of
Interest Related to Rating an Obligor or
Debt Security Where Obligor or Issuer
Received Ratings Recommendations
From the NRSRO or Person Associated
With the NRSRO
The Commission is proposing to
amend Rule 17g–5(c) to add a new
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paragraph (5) that would prohibit an
NRSRO from issuing a credit rating with
respect to an obligor or security where
the NRSRO or a person associated with
the NRSRO, as defined in Section
3(a)(63) of the Exchange Act,108 made
recommendations to the obligor or the
issuer, underwriter, or sponsor of the
security (that is, the parties responsible
for structuring the security) about the
corporate or legal structure, assets,
liabilities, or activities of the obligor or
issuer of the security. This proposal
would prohibit the NRSRO and, in
particular, its credit analysts from
making recommendations to obligors,
issuers, underwriters, and sponsors
such as arrangers of structured finance
products about how to obtain a desired
credit rating during the rating process.
It also would prohibit an NRSRO from
issuing a credit rating where a person
associated with the NRSRO, such as an
affiliate, made such recommendations.
The Commission is proposing this
amendment to Rule 17g–5, in part,
pursuant to the authority in Section
15E(h)(2) of the Exchange Act.109 The
provisions of this section of the statute
provide the Commission with authority
to prohibit, or require the management
and disclosure of, any potential conflict
of interest relating to the issuance of
credit ratings by an NRSRO.110 The
Commission preliminarily believes the
proposed amendment is necessary and
appropriate in the public interest and
for the protection of investors because it
would address a potential practice that
could impair the objectivity, and,
correspondingly, the quality, of a credit
rating. It has been suggested that during
the process of rating structured finance
products the NRSROs have
recommended to arrangers how to
structure a trust or complete an asset
pool to receive a desired credit rating
and then rated the securities issued by
the trust—in effect, rating their own
work.111 This proposal would prohibit
this conduct based on the Commission’s
preliminary belief that it creates a
conflict that cannot be effectively
managed insomuch as it would be very
difficult for an NRSRO to remain
objective when assessing the
creditworthiness of an obligor or debt
security where the NRSRO or person
associated with the NRSRO made
recommendations about steps the
obligor or issuer of the security could
take to obtain a desired credit rating.
108 15
109 15
U.S.C. 78c(a)(63).
U.S.C. 78o–7(h)(2).
110 Id.
111 See e.g., Coffee April 22, 2008 Senate
Testimony, pp. 2–3.
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The proposal is not intended to
prohibit all interaction between the
NRSRO and the obligor, issuer,
underwriter, or sponsor during the
rating process. The Commission
preliminarily believes that the
transparency of an NRSRO’s procedures
and methodologies for determining
credit ratings is enhanced when the
NRSRO explains to obligors and issuers
the bases, assumptions, and rationales
behind rating decisions. For example,
the Commission understands that in the
structured finance area, NRSROs may
provide information to arrangers about
the output of expected loss and cash
flow models. The information provided
by the NRSRO during the rating process
allows the arranger to better understand
the relationship between model outputs
and the NRSRO’s decisions with respect
to necessary credit enhancement levels
to support a particular rating. The
arranger then can consider the feedback
and determine independently the steps
it will take, if any, to adjust the
structure, credit enhancement levels, or
asset pool. However, if the feedback
process turns into recommendations by
the NRSRO about changes the arranger
could make to the structure or asset pool
that would result in a desired credit
rating, the NRSRO’s role would
transition from an objective credit
analyst to subjective consultant. In this
case, the Commission believes it would
be difficult for the NRSRO to remain
impartial since the expectation would
be that the changes suggested by the
NRSRO would result in the credit
ratings sought by the arranger.
The prohibition would extend to
recommendations by persons associated
with the NRSRO to address affiliates.
For example, an NRSRO’s holding
company could establish an affiliate to
provide consulting services to issuers
about how to obtain desired credit
ratings from the NRSRO subsidiary. The
Commission believes it would be
difficult for the NRSRO to remain
objective in this situation since the
financial success of the affiliate would
depend on issuers getting the ratings
they desired after taking any steps
recommended by the affiliate. This
would create undue pressure on the
NRSRO’s credit analysts to determine
credit ratings that favored the affiliate.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• Is this type of conflict one that
could be addressed through disclosure
and procedures to manage it instead of
prohibiting it? Should the Commission,
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rather than prohibiting it, add this type
of conflict to the list of conflicts in
paragraph (b) of Rule 17g–5, which,
under paragraph (a) of the rule, must be
addressed through disclosure and
procedures to manage them?
• Would there be practical difficulties
for an NRSRO that is part of a large
conglomerate in monitoring the
business activities of persons associated
with the NRSRO such as affiliates
located in other countries to comply
with the proposed requirement? If so,
given the greater separation between the
NRSRO and these types of persons
associated with the NRSRO, should the
Commission require instead that, for
these types of persons associated with
the NRSRO only, the NRSRO disclose
this conflict and manage it through
information barriers rather than prohibit
it?
• The Commission recognizes that the
line between providing feedback during
the rating process and making
recommendations about how to obtain a
desired rating may be hard to draw in
some cases. Consequently, should the
Commission specify the type of
interactions between an NRSRO and the
person seeking the rating that would
and would not constitute
recommendations for the purposes of
this rule? Commenters that believe the
Commission should provide more
guidance on this issue should provide
suggested definitions.
3. Rule 17g–5 Prohibition on Conflict of
Interest Related to the Participation of
Certain Personnel in Fee Discussions
The Commission is proposing to
amend Rule 17g–5 112 by adding a new
paragraph (c)(6) of Rule 17g–5 to
address the conflict of interest that
arises when a fee paid for a rating is
discussed or arranged by a person
within the NRSRO who has
responsibility for participating in
determining credit ratings (including
analysts and rating committee members)
or for developing or approving
procedures or methodologies used for
determining credit ratings, including
qualitative and quantitative models.
The Commission is proposing this
amendment to Rule 17g–5, in part,
pursuant to the authority in Section
15E(h)(2) of the Exchange Act.113 The
provisions of this section of the statute
provide the Commission with authority
to prohibit, or require the management
and disclosure of, any potential conflict
of interest relating to the issuance of
credit ratings by an NRSRO.114 The
112 17
113 15
CFR 240.17g–5.
U.S.C. 78o–7(h)(2).
114 Id.
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Commission preliminarily believes the
proposed amendment is necessary and
appropriate in the public interest or for
the protection of investors because it
would address a potential practice that
could impair the objectivity, and,
correspondingly, the quality, of a credit
rating. This amendment is designed to
effectuate the separation within the
NRSRO of persons involved in fee
discussions from persons involved in
the credit rating analytical process.
While the incentives of the persons
discussing fees could be based primarily
on generating revenues for the NRSRO;
the incentives of the persons involved
in the analytical process should be
based on determining accurate credit
ratings. There is a significant potential
for these distinct incentive structures to
conflict with one another where persons
within the NRSRO are engaged in both
activities.
The potential consequences are that a
credit analyst or person responsible for
approving credit ratings or credit rating
methodologies could, in the context of
negotiating fees, let business
considerations undermine the
objectivity of rating process. For
example, an individual involved in a fee
negotiation with an issuer might not be
impartial when it comes to rating the
issuer’s securities. In addition, persons
involved in approving the
methodologies and processes used to
determine credit ratings could be
reluctant to adjust a model to make it
more conservative if doing so would
make it more difficult to negotiate fees
with issuers. For these reasons, the
Commission preliminarily believes that
this conflict should be prohibited.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following items related to the proposal.
• Should the proposed prohibition
also be extended to cover participation
in fee negotiations by NRSRO personnel
with supervisory authority over the
NRSRO personnel participating in
determining credit ratings or developing
or approving procedures or
methodologies used for determining
credit ratings?
• Instead of prohibiting this conflict
outright, would disclosure and
procedures to manage the conflict
adequately address the conflict? If so,
what specific disclosures should be
required? What other measures should
be required in addition to disclosures?
• Would there be practical difficulties
in separating analytic and fee
discussions for a small NRSRO,
including one that has limited staff, that
are significant enough that the
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Commission should consider a different
mechanism to address the conflict? If so,
what sort of mechanism and with what
conditions? Should the Commission
adopt an exemption from the
prohibition for small NRSROs and,
instead, require them to disclose the
conflict and establish procedures to
manage it? For example, the exemption
could apply to NRSROs that have less
than 10, 20, or 50 associated persons.
Commenters that endorse an exemption
for small NRSROs should provide
specific details as to how the
Commission should define an NRSRO
as ‘‘small’’ for purposes of the
exemption. For example, for purposes of
the Final Regulatory Flexibility Analysis
for the Adopting Release the
Commission concluded that an NRSRO
with total assets of $5 million or less
was a ‘‘small’’ entity for purposes of the
Regulatory Flexibility Act.115 Would
that be an appropriate way to define a
small NRSRO for purposes of this
exemption?
4. Rule 17g–5 Prohibition of Conflict of
Interest Related to Receipt of Gifts
The Commission is proposing to
amend Rule 17g–5 116 by adding a new
paragraph (c)(7) that would prohibit an
NRSRO from having a conflict of
interest relating to the issuance or
maintenance of a credit rating where a
credit analyst who participated in
determining or monitoring the credit
rating, or a person responsible for
approving the credit rating, received
gifts, including entertainment, from the
obligor being rated, or from the issuer,
underwriter, or sponsor of the securities
being rated, other than items provided
in the context of normal business
activities such as meetings that have an
aggregate value of no more than $25.
Thus, this proposed prohibition would
prohibit any gifts to credit analysts and
persons on credit rating committees
from the obligors, issuers, underwriters,
or sponsors with respect to whom they
had determined, monitored or approved
credit ratings. It also would create an
exception for items provided during
normal business activities such as
meetings to the extent they do not in the
aggregate exceed $25 per meeting. For
example, the provision of pens,
notepads, or minor refreshments, such
as soft drinks or coffee, generally are
incidental to meetings and other normal
course business interactions and not
treated as gifts per se. The proposed $25
exception is designed to be high enough
115 See
116 17
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to permit these types of exchanges
without implicating the prohibition.
The Commission is proposing these
amendments to Rule 17g–5, in part,
pursuant to the authority in Section
15E(h)(2) of the Exchange Act.117 The
provisions in this section of the statute
provide the Commission with authority
to prohibit, or require the management
and disclosure of, any potential conflict
of interest relating to the issuance of
credit ratings by an NRSRO as the
Commission deems necessary or
appropriate in the public interest or for
the protection of investors.118 The
Commission preliminarily believes the
proposed amendment is necessary and
appropriate in the public interest or for
the protection of investors because it
would address a potential practice that
could impair the objectivity, and,
correspondingly, the quality, of a credit
rating.
Persons seeking credit ratings for an
obligor or debt security could use gifts
to gain favor with the analyst
responsible for determining the credit
ratings and cause the analyst to be less
objective during the rating process. In
the case of a substantial gift, the
potential to impact the analyst’s
objectivity could be immediate. With
smaller gifts, the danger is that over
time the cumulative effect of repeated
gifts can impact the analyst’s objectivity.
Therefore, the proposal would establish
an absolute prohibition on gifts with the
exception of minor incidentals provided
in business meetings.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission request comment on the
following questions related to the
proposal.
• Instead of prohibiting this conflict
outright, should the Commission require
that NRSROs disclose it and establish
procedures to manage it? If so, what
specific disclosures should be required?
• Instead of prohibiting gifts outright,
should the Commission establish a
yearly limit on the aggregate value of
gifts that would be permitted under the
prohibition? For example, the
Commission could provide in the rule
that the prohibition would not be
triggered until the aggregate value of all
gifts received from a particular person
in a twelve month period exceeded
$100, $500 or $1,000 or some other
amount.
• Is the proposed $25 aggregate value
an appropriate threshold for incidentals
provided at meetings, or should a higher
or lower threshold be applied?
117 15
118 Id.
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B. Amendments to Rule 17g–2
The Commission adopted Rule 17g–2,
in part, pursuant to authority in Section
17(a)(1) of the Exchange Act requiring
NRSROs to make and keep such records,
and make and disseminate such reports,
as the Commission prescribes by rule as
necessary or appropriate in the public
interest, for the protection of investors,
or otherwise in furtherance of the
Exchange Act.119 Rule 17g–2 requires an
NRSRO to make and retain certain
records relating to its business and to
retain certain other business records
made in the normal course of business
operations. The rule also prescribes the
time periods and manner in which all
these records are required to be
retained. The Commission is proposing
to amend this rule to require NRSROs to
make and retain certain additional
records and to require that some of these
proposed new records be made publicly
available.
1. A Record of Rating Actions and the
Requirement That They Be Made
Publicly Available
The Commission is proposing to
amend Exchange Act Rule 17g–2 120 to
add a new paragraph (8) to Rule 17g–2
that would require a registered NRSRO
to make and retain a record showing all
rating actions (initial rating, upgrades,
downgrades, and placements on watch
for upgrade or downgrade) and the date
of such actions identified by the name
of the security or obligor and, if
applicable, the CUSIP for the rated
security or the Central Index Key (CIK)
number for the rated obligor.
Furthermore, the Commission is
proposing to amend Rule 17g–2(d) to
require that this record be made
publicly available on the NRSRO’s
corporate Internet Web site in an
interactive data file that uses a machinereadable computer code that presents
information in eXtensible Business
Reporting Language (‘‘XBRL’’) in
electronic format (‘‘XBRL Interactive
Data File’’). The purpose of this
disclosure is to provide users of credit
ratings, investors, and other market
119 See Section 5 of the Rating Agency Act and
15 U.S.C. 78q(a)(1).
120 17 CFR 240.17g–2.
U.S.C. 78o–7(h)(2).
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• Should the Commission adopt a
recordkeeping requirement with respect
to the receipt of gifts by analysts and
persons responsible for approving credit
ratings in addition to the prohibition?
For example, the Commission could
require an NRSRO to document for each
gift the identity of the person providing
the gift, the recipient, and the nature of
the gift.
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participants and observers the raw data
with which to compare how the
NRSROs initially rated an obligor or
security and, subsequently, adjusted
those ratings, including the timing of
the adjustments. In order to expedite the
establishment of a pool of data sufficient
to provide a useful basis of comparison,
this requirement would apply to all
currently rated securities or obligors as
well as to all future credit ratings.
The goal of this proposal is to foster
greater accountability of the NRSROs
with respect to their credit ratings as
well as competition among the NRSROs
by making it easier for persons to
analyze the actual performance of the
credit ratings the NRSROs issue in terms
of accuracy in assessing
creditworthiness. The disclosure of this
information on the history of each credit
rating would create the opportunity for
the marketplace to use the information
to develop performance measurement
statistics that would supplement those
required to be published by the NRSROs
themselves in Exhibit 1 to Form
NRSRO. The intent is to tap into the
expertise and flexibility of credit market
observers and participants to create
better and more useful means to
compare credit ratings. This goal is to
make NRSROs more accountable for
their ratings by enhancing the
transparency of the results of their
rating processes for particular securities
and obligors and classes of securities
and obligors and encourage competition
within the industry by making it easier
for users of credit ratings to judge the
output of the NRSROs.
As noted above, the proposed
amendments would require that the
record be made publicly available on
the NRSRO’s corporate Internet Web site
in an XBRL Interactive Data File that
uses a machine-readable computer code
that presents information in XBRL. The
Commission is proposing to require that
an NRSRO use this format to publicly
disclose the ratings action data because
it would allow users to dynamically
search and analyze the information,
thereby facilitating the comparison of
information across different NRSROs. In
addition, an XBRL Interactive Data File
would enable investors, analysts, and
the Commission staff to capture and
analyze the ratings action data more
quickly and at less of a cost than is
possible using another format. The
Commission further believes that the
XBRL Interactive Data File would be
compatible with a wide range of open
source and proprietary XBRL software
applications and that as the ratings
action data becomes more widely
available, advances in interactive data
software, online viewers, search
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engines, and other Web-based tools may
further enhance the accessibility and
usability of the data.
The Commission’s experience in
having certain issuers use XBRL for
EDGAR filings has demonstrated the
benefits of this format to investors,
filers, and Commission staff.121
Expanding its use to NRSRO ratings
history data would be consistent with
Commission policy to utilize this format
where practical.
The proposed amendment to Rule
17g–2(d) also would provide that the
records be made publicly available no
later than six months after the date of
the rating action. The Commission
anticipates that the record required
under this amendment would need to be
updated frequently as new credit ratings
are issued and existing credit ratings are
upgraded, downgraded and put on
ratings watch. For purposes of the
internal record, the NRSRO would need
to keep the record current to reflect the
complete ratings history of each extant
credit rating. However, for purposes of
the requirement to make the record
publicly available, the NRSRO would be
permitted to disclose the record on its
Internet Web site six months after the
record is updated to reflect a new
ratings action. The proposed six-month
time lag for publicly disclosing the
updated record is designed to
accommodate NRSROs that operate
using the subscriber-pay model because
they are paid for access to their current
credit ratings. It also is designed to
preserve the revenues that NRSROs
operating using the issuer-pay model
derive from selling download access to
their current credit ratings.122 The
Commission preliminarily believes the
six-month time lag would not have any
negative effect on the goal of this
proposed amendment because the
information on credit ratings actions
that would be disclosed—perhaps many
years’ worth for some credit ratings—
should be sufficient to develop
meaningful performance metrics for
comparing NRSROs.
Finally, the proposed amendments
also would amend the instructions to
Exhibit 1 to Form NRSRO to require the
disclosure of the Web address where the
XBRL Interactive Data File could be
accessed. This is designed to inform
121 See Extension of Interactive Data Voluntarily
Reporting Program in the EDGAR System to Include
Mutual Fund Risk/Return Summary Information.
Securities Act Release No. 8823 (August 20, 2007).
122 The accommodation of subscriber-pay models
acknowledges the Rating Agency Act’s intent to
encourage the subscriber-pays model (see Senate
Report, p. 7) while simultaneously ensuring equal
treatment for NRSROs operating under an issuerpays model.
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persons who use credit ratings where
the ratings histories can be obtained.
The Commission is proposing these
amendments, in part, under authority to
require NRSROs to make and keep for
prescribed periods such records as the
Commission prescribes as necessary or
appropriate in the public interest, for
the protection of investors, or otherwise
in furtherance of the purposes of the
Exchange Act.123 The Commission
preliminarily believes the proposed new
recordkeeping and disclosure
requirements are necessary and
appropriate in the public interest and
for the protection of investors, or
otherwise in furtherance of the purposes
of the Exchange Act. Specifically, by
proposing to require NRSROs to make
ratings actions publicly available in an
XBRL Interactive Data File, market
participants would be able to create
their own performance measurement
metrics, including default and transition
matrices, by which to judge the
accuracy of NRSRO ratings. In addition,
users of credit ratings would be able to
compare side-by-side how each NRSRO
initially rated a particular security,
when the NRSRO took actions to adjust
the rating upward or downward, and the
degree of those adjustments.
Furthermore, users of credit ratings,
academics and information venders
could use the raw data to perform
analyses comparing how the NRSROs
differ in their initial ratings and their
monitoring for different types of asset
classes. This could identify an NRSRO
that is an outlier in terms of issuing high
or low credit ratings or consistently
reassesses ratings on a delayed basis for
some or all asset classes when compared
to other NRSROs. It also could help
identify NRSROs that are consistently
more or less accurate than others. This
information also may identify NRSROs
whose objectivity may be impaired
because of conflicts of interest.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• Is the six-month delay before
publicly disclosing a rating action
sufficiently long to address the business
concerns of the subscriber-based
NRSROs and the issuer-paid NRSROs?
Should the delay be for a longer period
such as one or two years or even longer?
Alternatively, is six months too long
and should it be a shorter period of time
such as three months or even shorter?
123 See Section 17(a)(1) of the Exchange Act (15
U.S.C. 78q(a)(1)).
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• Should the rule require that a notice
be published along with the XBRL
Interactive Data File warning that
because of the permitted delay in
updating the record some of the credit
ratings in the record may no longer
reflect the NRSRO’s current assessment
of the creditworthiness of the obligor or
debt security? For example, the notice
could explain that the information in
the record is sixth months old and state
that the credit ratings contained in
record may not be up-to-date.
• Are there ways in which the
NRSROs should be required to sort the
credit ratings contained on the record
such as by asset class or type of ratings?
• What mechanisms are appropriate
for identifying rated securities? Are
there other identifiers in addition, or as
an alternative, to CUSIP or CIK number
that could be used in the rule?
• Should the Commission allow the
ratings action data to be provided in a
format other than XBRL, such as pipe
delimited text data (‘‘PDTD’’) or
eXtensible Markup Language (‘‘XML’’)?
Is there another format that is more
widely used or would be more
appropriate than XBRL for NRSRO data?
What are the advantages/disadvantages
of requiring the XBRL format?
• Should the Commission require that
the information on the assets underlying
a structured finance products discussed
in Section II.A.1.a above be provided in
a specific format such as PDTD, XML,
or XBRL? Again, is there another format
that is more widely used or would be
more appropriate for such data? What
are the advantages/disadvantages of
requiring a specific format?
• Should the Commission take the
lead in creating the new tags that are
needed for the XBRL format or should
it allow the tags to be created by another
group and then review the tags? How
long would it take to create new tags?
• The Commission anticipates that
the data provided by NRSROs would be
simple and repetitive (i.e., the data
would be name, CUSIP, date, rating,
date, rating, etc.). Is there a need for
more detailed categories of data?
• What would be the costs to an
NRSRO to provide data in the XBRL
format? Would there be a cost burden on
smaller NRSROs? Is there another
format that would cost less but still
allow investors and analysts to easily
download and analyze the data?
• Should the Commission institute a
test phase for providing this information
in an XBRL format (such as a voluntary
pilot program, similar to what it is
currently doing for EDGAR filings)?
How long should this test phase last?
• Where is the best place to store the
data provided by NRSROs? Currently,
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information that needs to be made
publicly available is stored on each
NRSRO’s Web site. Should the
Commission create a central database to
store the information? If so, should it
use the EDGAR database or should it
create a new database?
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2. A Record of Material Deviation From
Model Output
The Commission is proposing to
amend paragraph (a)(2) of Rule 17g–2 to
add an additional record that would be
required to be made for each current
credit rating, namely, if a quantitative
model is a substantial component in the
process of determining the credit rating,
a record of the rationale for any material
difference between the credit rating
implied by the model and the final
credit rating issued. The NRSRO issuing
the rating would be responsible for
making the determination of what
constituted a ‘‘substantial component’’
of the rating process as well as what
constituted a ‘‘material’’ difference
between the rating issued and the rating
implied by the model.124 This proposal
is designed to enhance the
recordkeeping processes of the NRSROs
so that Commission examiners (and any
internal auditors of the NRSRO) could
reconstruct the analytical process by
which a credit rating was determined.
This would facilitate their review of
whether the NRSRO followed its
disclosed and internally documented
procedures for determining credit
ratings.
The requirement to make the record
would be triggered in cases where a
quantitative model is a substantial
component of the credit ratings process
for the type of obligor or security being
rated and the output of the model would
result in a materially different
conclusion if the NRSRO relied on it
without making an out-of-model
adjustment. For example, the
Commission preliminarily believes the
expected loss and cash flow models
used by the NRSROs to rate RMBS and
CDOs are substantial components of the
rating process. The following
hypothetical scenario is intended as an
illustrative example of an instance when
an out-of-model adjustment would be
material to the RMBS rating process
thereby triggering the requirement to
document the rationale for the
adjustment under the proposed rule. A
credit analyst uses the NRSRO’s
expected loss model to analyze a $1
billion (aggregate principal amount)
124 The Commission notes that it would consider
the RMBS and CDO rating process described above
in Section I.C.2 as using a quantitative model as a
substantial component in the ratings process.
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loan pool received from an arranger that
is proposed to collateralize an RMBS.
The results of the model imply that the
senior RMBS tranche would need to
have at least 20% subordination in
order to receive an AAA rating.
However, the NRSRO’s methodologies
and procedures for rating RMBS allow
for the subordination level suggested by
the model output to be adjusted based
on certain qualitative factors such as the
experience and competence of the loan
servicer or the recent performance of
similar loan pools. Based on the
superior competence of the loan
servicer, the analyst concludes that the
senior tranche only needs 19%
subordination and, ultimately, the
ratings committee agrees. Consequently,
the RMBS is issued with a senior
tranche having 19% subordination and
receiving an AAA rating from the
NRSRO. In this case, under the
proposed amendment, the NRSRO
would be required to make a record that
identified the rationale—the servicer’s
superior competence—for determining a
credit rating that was different from the
rating implied by the model.
As the above scenario demonstrates,
the failure to make such a record could
hamper the ability of the Commission to
review whether an NRSRO was
following its stated procedures for
determining credit ratings. In the above
scenario, the analyst could adjust the
rating requirements implied by the
model by applying qualitative factors
with respect to the loan servicer or the
performance of similar pools. A record
indicating which rationale was applied
would make it easier for the
Commission to review whether the
procedures were followed.
The Commission is proposing this
amendment, in part, under authority to
require NRSROs to make and keep for
prescribed periods such records as the
Commission prescribes as necessary or
appropriate in the public interest, for
the protection of investors, or otherwise
in furtherance of the purposes of the
Exchange Act.125 The Commission
preliminarily believes this proposed
new recordkeeping requirement is
necessary and appropriate in the public
interest and for the protection of
investors, or otherwise in furtherance of
the purposes of the Exchange Act.
Specifically, as explained above, the
Commission preliminarily believes that
maintaining records identifying the
rationale for material divergences from
the ratings implied by qualitative
models used as a substantial component
in the ratings process would assist the
125 See Section 17(a)(1) of the Exchange Act (15
U.S.C. 78q(a)(1)).
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Commission in evaluating whether an
NRSRO is adhering to its disclosed
procedures for determining ratings.
Further, as the Commission noted in the
Adopting Release, ‘‘books and records
rules have proven integral to the
Commission’s investor protection
function because the preserved records
are the primary means of monitoring
compliance with applicable securities
laws.’’ In the absence of such a
recordkeeping requirement, there may
be no way to determine whether an
analyst modified the requirements for
obtaining a certain category of credit
rating (e.g. AAA) as indicated by the
model results by applying appropriate
qualitative factors permitted under the
NRSRO’s documented procedures or
because of undue influence from the
person seeking the credit rating or other
inappropriate reasons such as those
prohibited by Rule 17g–6.126
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• Would this proposal have the
impermissible effect of regulating the
substance of credit ratings in any way?
• Should the Commission define in
the rule when the use of a model would
be a ‘‘substantial component’’ in the
process of determining a credit rating?
Commenters endorsing the adoption of
such a definition should provide
specific proposals.
• Are there certain types of rated
products (e.g., corporate debt, municipal
bonds) which generally employ a
quantitative model as a substantial
component of the ratings process?
Commenters should identify the types
of bonds and a general description of
the models used to rate them.
• Should the Commission define in
the rule when the divergence from a
model would be ‘‘material’’?
Commenters endorsing the adoption of
such a definition should provide
specific proposals.
• Is the hypothetical scenario of the
RMBS rating process used to illustrate
when a divergence would be material
for purposes of the proposed
amendment reasonable? For example, is
the adjustment of the subordination
level from 20% to 19% for a $1 billion
loan pool a material divergence? Would
126 17 CFR 240.17g–6. Rule 17g–6 prohibits an
NRSRO from engaging in certain unfair, abusive or
coercive practices such as issuing a credit rating
that is not determined in accordance with the
NRSRO’s established procedures and
methodologies for determining credit ratings based
on whether the rated person will purchase the
credit rating. See 17 CFR 240.17g–6(a)(2).
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a lesser adjustment of the subordination
level (e.g., 20% to 19.5%) also be
material?
• Are there alternative types of
records that may be created or retained
by an NRSRO that would allow the
Commission to understand when and
why an NRSRO’s final rating differed
materially from the rating implied by
the model?
• Should the Commission require that
the information about material
deviations from the rating implied by
the model be publicly disclosed by the
NRSRO in the presale report or when
the rating is issued?
3. Records Concerning Third-Party
Analyst Complaints
The Commission is proposing an
amendment to Exchange Act Rule 17g–
2 127 to add a requirement that an
NRSRO retain records of any complaints
regarding the performance of a credit
analyst in determining credit ratings.
Specifically, the proposed amendment
would add a new paragraph (b)(8) to
Rule 17g–2 to require an NRSRO to
retain any communications that contain
complaints about the performance of a
credit analyst in initiating, determining,
maintaining, monitoring, changing, or
withdrawing a credit rating.
The Commission is proposing these
amendments, in part, under authority to
require NRSROs to make and keep for
prescribed periods such records as the
Commission prescribes as necessary or
appropriate in the public interest, for
the protection of investors, or otherwise
in the furtherance of the Exchange
Act.128 The Commission preliminarily
believes the proposed new
recordkeeping requirements are
necessary and appropriate in the public
interest and for the protection of
investors, or otherwise in furtherance of
the Exchange Act, because they would
assist the Commission in reviewing how
NRSROs address conflicts interest that
could impair the integrity of their credit
rating processes. For example, an
NRSRO might respond to complaints
from issuers that an analyst is too
conservative by removing the analyst
from the responsibility of rating the
securities of those issuers and assigning
a new analyst that is more willing to
determine credit ratings desired by the
issuers. As discussed above with respect
to the proposed amendments to Rule
17g–5, the potential for this type of
response to complaints about analysts is
particularly acute in the structured
finance area given that certain arrangers
CFR 240.17g–2.
Section 17(a)(1) of the Exchange Act (15
U.S.C. 78q(a)(1)).
of structured finance products
repeatedly bring ratings business to the
NRSROs.129 The pressure to maintain
the business relationship with these
arrangers could cause an NRSRO to
remove an analyst responsible for rating
the structured finance products these
arrangers bring to market if they
complained about how the analyst was
determining credit ratings and implied
that they might take their business to
other NRSROs.
The records proposed under these
amendments would allow the
Commission, in evaluating the integrity
of the NRSRO’s ratings process, to better
assess whether analyst reassignments or
terminations were for reasons
unconnected to a conflict of interest
(e.g., the analyst’s poor performance) or
as a result of the ‘‘arranger-pay’’ conflict
of interest described above. For
example, the examiners could review
the complaint file that would be
established by this proposed
amendment and follow-up with the
relevant persons within the NRSRO as
to how the complaint was addressed.
The potential for such a review by
Commission examiners could reduce
the willingness of an NRSRO to reassign or terminate a credit analyst for
inappropriate business considerations.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• In addition to the proposed
recordkeeping requirement, should the
Commission require the NRSROs to
publicly disclose when an analyst has
been re-assigned from the responsibility
to rate an obligor or the securities of an
issuer, underwriter, or sponsor?
• Should the Commission require
NRSROs to retain any communications
containing a request from an obligor,
issuer, underwriter, or sponsor that the
NRSRO assign a specific analyst to a
transaction in addition to the proposed
requirement to retain complaints about
analysts?
4. Clarifying Amendment to Rule 17g–
2(b)(7)
Paragraph (b)(7) of Rule 17g–2
currently requires an NRSRO to retain
all internal and external
communications that relate to
‘‘initiating, determining, maintaining,
changing, or withdrawing a credit
rating.’’ The Commission is proposing to
add the word ‘‘monitoring’’ to this list.
The intent is to clarify that NRSRO
recordkeeping rules extend to all
aspects of the credit rating surveillance
process as well as the initial rating
process. This was the intent when the
Commission originally adopted the rule
as indicated by the use of the term
‘‘maintaining.’’ The Commission
believes that adding the term
‘‘monitoring’’—a term of art in the credit
rating industry—would better clarify
this requirement.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following question related to the
proposal.
• Should the Commission delete the
term ‘‘maintaining’’ from paragraph
(b)(7) and proposed new paragraph
(b)(8) of Rule 17g–2 as it has the same
meaning as ‘‘monitoring?’’
C. Amendments to the Instructions for
Form NRSRO
Form NRSRO is the means by which
credit rating agencies apply to be
registered with the Commission and
registered NRSROs update information
they must publicly disclose. Much of
the information elicited in Form NRSRO
is required to be submitted to the
Commission pursuant to the statutory
requirements of Section 15E(a)(1)(B) of
the Exchange Act.130 The Commission
added certain additional information to
be submitted in the Form.131 As
discussed below, the Commission, in
part, under its authority pursuant to
Section 15E(a)(1)(B)(x), is now
proposing to amend Form NRSRO to
further enhance the quality and
usefulness of the information to be
furnished and disclosed by registered
NRSROs by requiring specified
information in addition to that which is
statutorily defined in the Section 15E of
the Exchange Act.
1. Enhanced Ratings Performance
Measurement Statistics on Form NRSRO
As discussed above, the Commission
is proposing to require the disclosure of
the historical rating actions relating to
each current credit rating of an NRSRO
through amendments to Rule 17g–2. The
intent is to make available the raw data
necessary for the marketplace to
develop and apply credit ratings
performance metrics. At the same time,
the Commission is proposing to amend
the instructions to Exhibit 1 to Form
NRSRO to enhance the comparability of
the performance measurement statistics
the NRSROs are required to publicly
disclose in the Form. Currently, the
127 17
128 See
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131 15
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instructions require the disclosure of
‘‘performance measurement statistics of
the credit ratings of the Applicant/
NRSRO over short-term, mid-term, and
long-term periods (as applicable)
through the most recent calendar yearend.’’ The Commission, in adopting this
requirement, did not require disclosure
of performance statistics in Form
NRSRO beyond those specified in
Section 15E(a)(1)(B)(i) of the Exchange
Act.132 In the Adopting Release, the
Commission explained that it was not
prepared to prescribe standard metrics
at that time in light of the varying
approaches suggested by some
commenters and the opposition of other
commenters to having the Commission
impose any standards.133 The
Commission also stated that it would
continue to consider the issue to
determine the feasibility, as well as the
potential benefits and limitations, of
devising measurements that would
allow reliable comparisons of the
accuracy of the NRSROs’ credit
ratings.134
The Commission, with the benefit of
further consideration of the issue, now
preliminarily believes that the
instructions to Exhibit 1 can prescribe
greater specificity about how the
performance statistics must be generated
without intruding into the processes
and methodologies by which NRSROs
determine credit ratings. For example,
through the examination process, the
Commission has become more familiar
with the procedures and methodologies
used by the NRSROs to determine credit
ratings. Through this experience, the
Commission preliminarily believes it
can prescribe generic requirements for
the performance statistics that would
accommodate the different procedures
and methodologies used by the
NRSROs.
The first proposed amendment would
augment the instructions to Exhibit 1 by
requiring the disclosure of separate sets
of default and transition statistics for
each asset class of credit rating for
which an applicant is seeking
registration as an NRSRO or an NRSRO
is registered and any other broad class
of credit ratings issued by the NRSRO.
This would result in the generation of
performance statistics that are specific
to each class of credit ratings for which
the NRSRO is registered (or an applicant
is seeking registration). This proposal is
designed to make it easier for users of
credit ratings to compare the accuracy of
NRSRO credit ratings on a class-by-class
basis.
The proposed amendment also would
require an NRSRO registered in the class
of credit ratings described in Section
3(a)(62)(B)(iv) of the Rating Agency
Act135 (or an applicant seeking
registration in that class) when
generating the performance statistics for
that class to include credit ratings of any
security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction. This is designed
to ensure the inclusion of ratings actions
for credit ratings of structured finance
products that do not meet the narrower
statutory definition of ‘‘issuers of assetbacked securities (as that term is
defined is section 1101(c) of part 229 of
title 17, Code of Federal
Regulations).’’136
The second proposed amendment
would require that these class-by-class
disclosures be broken out over 1, 3 and
10-year periods. Section 15E(a)(1)(B)(i)
of the Exchange Act requires that the
performance statistics be over short,
mid, and long-term periods.137 The
proposed amendment would define
those statutorily prescribed periods in
specific years so that the performance
statistics generated by the NRSROs
cover comparable time periods. The
Commission preliminarily believes that
1, 3, and 10 year periods are reasonable
definitions of the terms ‘‘short-term,
mid-term, and long-term periods’’ as
used in Section 15E(a)(1)(B)(i) of the
Exchange Act.138 For example, the 1
year period would provide users with
information about how the credit ratings
are currently performing. In effect, it
could serve as an early warning
mechanism if a problem developed in
an NRSRO’s rating processes due to
flaws or conflicts. Similarly, the 3 year
period would provide information about
the how the ratings were currently
performing but, by including more
historical data, smooth out spikes in the
1 year statistics to give a better sense of
how the ratings perform over time. The
3 year statistics also would serve as a
bridge to the longer term 10 year
statistics. The 10 year statistics would
show users how the ratings in a
particular class of securities perform
over the long range.
The third proposed amendment
would modify what ratings actions are
required to be included in these
performance measurement statistics by
replacing the term ‘‘down-grade and
default rates’’ with ‘‘ratings transition
and default rates.’’ The proposed switch
135 15
132 See
15 U.S.C. 78o–7(a)(1)(B)(i).
133 See Adopting Release, 72 FR at 33574.
134 Id.
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U.S.C. 78c(a)(62)(B)(iv).
Id.
137 15 U.S.C. 78o–7(a)(1)(B)(i).
138 15 U.S.C. 78o–7(a)(1)(B)(i).
to ‘‘ratings transition’’ rates from
‘‘downgrade’’ rates is designed to clarify
that upgrades (as well as downgrades)
should be included in the statistics. The
fact that an NRSRO upgrades a
substantial amount of credit ratings may
be just as indicative of a flaw in the
initial rating as a large number of
downgrades. For example, an NRSRO
could try to manipulate its performance
statistics by issuing overly conservative
ratings.
The final proposed amendment would
specify that the default statistics
required under the exhibit must show
defaults relative to the initial rating and
incorporate defaults that occur after a
credit rating is withdrawn. This
amendment is designed to prevent an
NRSRO from manipulating the
performance statistics by not including
defaults when generating statistics for a
category of credit ratings (e.g., AA)
because the defaults occur after the
rating is downgraded to a lower category
(e.g., CC) or withdrawn.
The Commission is proposing these
amendments, in part, under authority to
require such additional information in
the application as it finds necessary or
appropriate in the public interest or for
the protection of investors.139 The
Commission preliminarily believes the
proposed new disclosure requirements
for Exhibit 1 are necessary and
appropriate and in the public interest or
for the protection of investors.
Specifically, the information that would
be required under the proposed
amendments would aid investors by
allowing them to evaluate how the
credit ratings of an NRSRO perform (i.e.,
the percentage of credit ratings that
migrate to another category of credit
rating and the percentage of rated
obligors and securities that default) on
a class-by-class basis. This would
provide better information on how an
NRSRO’s ratings have performed within
the field of financial products relevant
to any given user of credit ratings and
investor. For example, an investor
contemplating the purchase of a highlyrated subprime RMBS would be able to
consider the performance of an
NRSRO’s ratings of structured finance
products, which would be more useful
than the NRSRO’s general performance
statistics across all classes of credit
ratings. Specifically, an NRSRO may be
much better at assessing the
creditworthiness of corporate debt
securities than of structured finance
products. Consequently, performance
statistics of such an NRSRO that
incorporate all classes of credit ratings
136 See
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139 See Section 15E(a)(1)(B)(x) of the Exchange
Act (15 U.S.C. 78o–7(a)(1)(B)(x)).
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(e.g., corporate debt and structured
finance products) would be less precise
in terms of evaluating the performance
of the NRSRO’s credit ratings for
structured finance products.
Furthermore, by defining ‘‘short-term,
mid-term, and long-term’’ periods as 1,
3, and 10-year timeframes, the proposed
amendment would provide a better
basis for comparing the performance of
different NRSROs as the statistics for
each NRSRO would cover the same
periods. Finally, the replacement of the
‘‘down-grade’’ requirement with a
‘‘ratings transition’’ requirement and the
clarification of what default statistics
would need to be incorporated into the
ratings performance statistics would
further enhance investor understanding
of NRSRO performance by requiring that
similar information be captured in the
NRSROs’ performance rating statistics
and eliminating certain ways that could
be used to ‘‘pad’’ statistics.
The Commission generally requests
comment on all aspects of these
proposed amendments. In addition, the
Commission requests comment on the
following questions related to the
proposals.
• Should the Commission prescribe
specific standards for the performance
statistics, such as requiring an NRSRO
to disclose how its credit ratings
performed relative to metrics such as
credit spreads? Commenters endorsing
such an approach should provide
specific details as to how it could be
implemented; taking into consideration
factors such as the issues related to the
difficulty of obtaining timely and
consistent pricing information for many
debt instruments and the volatility of
credit spreads.
• Should the Commission require
performance statistics in a more
granular form than by class of credit
ratings? For example, should the
Commission require for structured
finance products statistics by more
narrowly defined asset classes such as
CDOs and RMBS or types of assetbacked securities such as those backed
by home loans, credit cards, or
commercial real estate? Commenters
endorsing greater granularity should
provide specific details, including
definitions of the credit rating classes.
• Should the Commission prescribe
different time periods for the short,
medium, and long term statistics than 1,
3, and 10 years, respectively. For
example, should the periods be 6
months, 2 years and 7 years or 2, 5, and
15 years or some other set of time
periods?
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2. Enhanced Disclosure of Ratings
Methodologies
The Commission is proposing to
amend the instructions for Exhibit 2 to
Form NRSRO to require enhanced
disclosures about the procedures and
methodologies an NRSRO uses to
determine credit ratings. Section
15E(a)(1)(B)(ii) of the Exchange Act
requires that an application for
registration as an NRSRO contain
information regarding the procedures
and methodologies used by the firm to
determine credit ratings.140 The
Commission implemented this
requirement by prescribing through the
instructions to Form NRSRO that an
applicant and NRSRO must provide
general descriptions of their procedures
and methodologies for determining
credit ratings and that the descriptions
must be sufficiently detailed to provide
users of credit ratings with an
understanding of the procedures and
methodologies. The instructions also
identified various areas that are required
to be addressed in Exhibit 2, including,
as applicable, descriptions of the
NRSRO’s policies for determining
whether to initiate a credit rating; the
public and non-public sources of
information used in determining credit
ratings, including information and
analysis provided by third-party
venders; and the quantitative and
qualitative models and metrics used to
determine credit ratings.
The Commission is proposing to add
three additional areas that an applicant
and a registered NRSRO would be
required to address in the descriptions
of its procedures and methodologies in
Exhibit 2. The inclusion of these would
serve to better disclose the actions an
applicant and NRSRO is, or is not
taking, in determining credit ratings.
The additional areas required to be
addressed in the exhibit would be:
• Whether and, if so, how
information about verification
performed on assets underlying or
referenced by a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
is relied on in determining credit
ratings;
• Whether and, if so, how
assessments of the quality of originators
of assets underlying or referenced by a
security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction play a part in the
determination of credit ratings; and
140 15
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• How frequently credit ratings are
reviewed, whether different models or
criteria are used for ratings surveillance
than for determining initial ratings,
whether changes made to models and
criteria for determining initial ratings
are applied retroactively to existing
ratings, and whether changes made to
models and criteria for performing
ratings surveillance are incorporated
into the models and criteria for
determining initial ratings.
The Commission is proposing these
amendments, in part, under authority to
require such additional information in
the application as it finds necessary or
appropriate in the public interest or for
the protection of investors.141 The
Commission preliminarily believes the
proposed new disclosure requirements
for Exhibit 2 are necessary and
appropriate and in the public interest or
for the protection of investors.
Specifically, they are designed to
provide greater clarity around three
areas of the NRSROs’ rating processes,
particularly for structured finance
products, where questions have been
raised in the context of the credit market
turmoil: Namely, the verification
performed on information provided in
loan documents; the quality of loan
originators; and the surveillance of
existing ratings and how changes to
models are applied to existing ratings.
The amendments are designed to
enhance the disclosures NRSROs make
in these areas and, thereby, allow users
of credit ratings to better evaluate the
quality of their ratings processes.
The first proposed amendment would
require an NRSRO to disclose whether
it considers in its rating process for
structured finance product steps taken
to verify information about the assets in
the pool backing the structured finance
product. Underwriters and sponsors of
structured finance products frequently
take some steps to verify information
provided by borrowers in loan
documentation. Generally, they have
been reluctant to provide this
information to NRSROs for proprietary
reasons. The proposed amendment
would not require that the NRSROs
incorporate verification (or the lack of
verification) into their ratings processes.
Rather, it would require an NRSRO to
disclose whether and, if so, how
information about verification
performed on the assets is relied on in
determining credit ratings for structured
finance products. For example, an
NRSRO would need to disclose, as
applicable: If it does not consider steps
taken to verify the information; if it
141 See Section 15E(a)(1)(B)(x) of the Exchange
Act (15 U.S.C. 78o–7(a)(1)(B)(x)).
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requires some minimum level of
verification to be performed before it
will determine a credit rating for a
structured finance product; and how it
incorporates the level of verification
performed into its procedures and
methodologies for determining credit
ratings (e.g., if it compensates for the
lack of verification by requiring greater
levels of credit enhancement for the
tranche securities).
The Commission preliminarily
believes this disclosure would benefit
users of credit ratings by providing
information about the potential
accuracy of an NRSRO’s credit ratings.
As noted above, the NRSROs determine
credit ratings for structured finance
products based on assumptions in their
models as to how the assets underlying
the instruments will perform under
varying levels of stress. These
assumptions are based on the
characteristics of the assets (e.g., value
of the property, income of the borrower)
as reported by the arranger of the
structured finance product. If this
information is inaccurate, the capacity
of the model to predict the potential
future performance of the assets may be
significantly impaired. Consequently,
information about whether an NRSRO
requires that some level of verification
be performed or takes other steps to
account for the lack of verification or a
low level of verification would be useful
to users of credit ratings in assessing the
potential for an NRSRO’s credit ratings
to be adversely impacted by bad
information about the assets underlying
a rated structured finance product.
The second proposed amendment
would require an NRSRO to disclose
whether it considers qualitative
assessments of the originator of assets
underlying a structured finance product
in the rating process for such products.
Certain qualities of an asset originator,
such as its experience and underwriting
standards, may impact the quality of the
loans it originates and the accuracy of
the associated loan documentation.
This, in turn, could influence how the
assets ultimately perform and the ability
of the NRSRO’s models to predict their
performance. Consequently, the failure
to perform any assessment of the loan
originators could increase the risk that
an NRSRO’s credit ratings may not be
accurate. Therefore, disclosures as to
whether the NRSRO performs any
qualitative assessments of the
originators would be useful in
comparing the efficacy of the NRSRO’s
procedures and methodologies.
The third proposed amendment
would require an NRSRO to disclose the
frequency of its surveillance efforts and
how changes to its quantitative and
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qualitative ratings models are
incorporated into the surveillance
process. The Commission believes that
users of credit ratings would find
information about these matters useful
in comparing the ratings methodologies
of different NRSROs. For example, how
often and with what models an NRSRO
monitors its credit ratings would be
relevant to assessing the accuracy of the
ratings insomuch as ratings based on
stale information and outdated models
may not be as accurate as ratings of like
products determined using newer data
and models. Moreover, with respect to
new types of rated obligors and debt
securities, the NRSROs refine their
models as more information about the
performance of these obligors and debt
securities is observed and incorporated
into their assumptions. Consequently, as
the models evolve based on more robust
performance data, credit ratings of
obligors or debt securities determined
using older models may be at greater
risk for being inaccurate than the newer
ratings. Therefore, whether the NRSRO
verifies the older ratings using the
newer methodologies would be useful to
users of credit ratings in assessing the
accuracy of the credit ratings.
The Commission generally requests
comment on all aspects of the proposed
amendments. In addition, the
Commission requests comment on the
following question related to the
proposals.
• Are there other areas of the ratings
process where enhanced disclosure on
Form NRSRO would benefit investors
and other users of credit ratings?
Commenters endorsing further
disclosures should specifically identify
them.
D. Amendment to Rule 17g–3 (Report of
Credit Rating Actions)
The Commission adopted Rule 17g–3
pursuant to authority in Section
15E(k) 142 of the Exchange Act, which
requires an NRSRO to furnish to the
Commission, on a confidential basis 143
and at intervals determined by the
Commission, such financial statements
and information concerning its financial
condition as the Commission, by rule,
may prescribe as necessary or
appropriate in the public interest or for
the protection of investors. The statute
also provides that the Commission may,
by rule, require that the financial
statements be certified by an
independent public accountant.144 In
142 15
U.S.C. 78o–7(k).
applicant can request that the Commission
keep this information confidential. See Section 24
of the Exchange Act (15 U.S.C. 78x), 17 CFR
240.24b–2, 17 CFR 200.80 and 17 CFR 200.83.
144 Id.
143 An
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addition, Section 17(a)(1) of the
Exchange Act 145 requires an NRSRO to
make and keep such records, and make
and disseminate such reports, as the
Commission prescribes by rule as
necessary or appropriate in the public
interest, for the protection of investors,
or otherwise in furtherance of the
Exchange Act.146
Rule 17g–3 requires an NRSRO to
furnish the Commission on an annual
basis the following reports: Audited
financial statements; unaudited
consolidated financial statements of the
parent of the NRSRO, if applicable; an
unaudited report concerning revenue
categories of the NRSRO; an unaudited
report concerning compensation of the
NRSRO’s credit analysts; and an
unaudited report listing the largest
customers of the NRSRO. The rule
further requires an NRSRO to furnish
the Commission these reports within 90
days of the end of its fiscal year.
The Commission is proposing to
amend Rule 17g–3 to require an NRSRO
to furnish the Commission with an
additional annual report of the number
of credit rating actions during the fiscal
year in each class of security for which
the NRSRO is registered. Specifically,
the amendment would add a new
paragraph (a)(6) to Rule 17g–3, which
would require an NRSRO to provide the
Commission with a report of the number
of credit rating actions (upgrades,
downgrades, and placements on watch
for an upgrade or downgrade) during the
fiscal year in each class of credit ratings
for which the NRSRO is registered with
the Commission. A note to paragraph
(a)(6) would clarify that for the purposes
of reporting credit rating actions in the
asset-backed security class of credit
ratings described in Section
3(a)(62)(B)(iv) of the Rating Agency
Act 147 an NRSRO would need to
include credit rating actions on any
security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction. This is designed
to ensure the inclusion of information
about ratings actions for credit ratings of
structured finance products that do not
meet the narrower statutory definition
of ‘‘issuers of asset-backed securities (as
that term is defined in section 1101(c)
of part 229 of title 17, Code of Federal
Regulations).’’ 148
The Commission is proposing this
amendment, in part, under authority to
require an NRSRO to ‘‘make and
145 15
U.S.C. 78q(a)(1).
Section 5 of the Rating Agency Act and
15 U.S.C. 78q(a)(1).
147 15 U.S.C. 78c(a)(62)(B)(iv).
148 See Id.
146 See
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disseminate such reports as the
Commission, by rule, prescribes as
necessary or appropriate in the public
interest, for the protection of investors,
or otherwise in furtherance of the
purposes of [the Exchange Act].’’ 149 The
Commission preliminarily believes this
proposed amendment is necessary and
appropriate in the public interest, for
the protection of investors, or otherwise
in furtherance of the purposes of the
Exchange Act because it would assist
the Commission in its examination
function of NRSROs. Large spikes in
ratings actions within a class of credit
ratings could indicate the processes for
determining the ratings may be
compromised by inappropriate factors.
For example, a substantial increase in
the number of downgrades in a
particular class of credit ratings may be
indicative of the fact that the initial
ratings were higher than the NRSRO’s
procedures and methodologies would
have implied because the NRSRO
sought to gain favor with issuers and
underwriters by issuing higher ratings.
A substantial increase in upgrades also
could be the result of the NRSRO
attempting to gain favor with issuers
and underwriters.
The Commission recognizes that an
increase in the number of ratings actions
in a particular class of credit ratings
may be the result of macroeconomic
factors broadly impacting the rated
obligors or securities. In this case, the
ratings actions would be the result of
appropriate credit analysis and not
inappropriate extraneous factors. On the
other hand, large numbers of actions
could be a signal that the process for
rating and monitoring ratings in the
impacted class has been compromised
by improper practices such as failing to
adhere to disclosed and internally
documented ratings procedures and
methodologies, having prohibited
conflicts, failing to establish reasonable
procedures to manage conflicts, or
engaging in unfair, coercive, or abusive
conduct. Consequently, the report
would be a valuable tool to improve the
focus of examination resources.
The Commission generally requests
comment on all aspects of this proposed
amendment. In addition, the
Commission requests comment on the
following questions related to the
proposal.
• Could the performance statistics
currently required in Exhibit 1 to Form
NRSRO, as well as the proposed
enhancements to those statistics, be
used to target potential problem areas in
an NRSRO’s credit rating processes in
149 See
Section 17(a)(1) of the Exchange Act (15
U.S.C. 78q(a)(1)).
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the same manner as this proposed report
thereby making the report redundant?
• Should the Commission also
require NRSROs to furnish an ‘‘early
warning’’ report to the Commission
when the number of downgrades in a
class of credit ratings passes a certain
percentage threshold (e.g., 5%, 10%,
15%, or 20%) within a number of
calendar or business days (e.g., 2, 5, 10,
or 15 days) after the threshold is passed,
similar to the broker-dealer notification
rule (See 17 CFR 240.17a–11)?
III. Proposed New Rule 17g–7 (Special
Reporting or Use of Symbols to
Differentiate Credit Ratings for
Structured Finance Products)
The Commission is proposing a new
rule, Rule 17g–7, to address concerns
that certain investors assumed the risk
characteristics for structured finance
products, particularly highly rated
instruments, were the same as for other
types of similarly rated instruments.
This proposal also is designed to
address concerns that some investors
may not have performed internal risk
analysis on structured finance products
before purchasing them, although at
least one survey indicates that many
institutional investors asserted that this
was not a widespread problem.150
Specifically, under proposed Rule 17g–
7, each time an NRSRO published a
credit rating for a structured finance
product it also would be required to
publish a report describing how the
credit ratings procedures and
methodologies and credit risk
characteristics for structured finance
products differ from those of other types
of rated instruments such as corporate
and municipal debt securities. The
objective of this proposal is to alert
investors that there are different rating
methodologies and risk characteristics
associated with structured finance
products. As an alternative to
publishing the report, an NRSRO would
be allowed to use ratings symbols for
structured finance products that
differentiated them from the credit
ratings for other types of debt securities.
More specifically, paragraph (a) of
proposed Rule 17g–7 would require an
NRSRO to publish a report
accompanying every credit rating it
publishes for a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
that describes the rating methodology
used to determine the credit rating and
how it differs from a rating for any other
150 See Introducing Assumption Volatility Scores
and Loss Sensitivities for Structured Finance
Securities, Moody’s, May 14, 2007, p. 3.
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type of obligor or debt security and how
the risks associated with a security or
money market instrument issued by an
asset pool or as part of any asset-backed
or mortgage-backed securities
transaction are different from other
types of rated obligors and debt
securities. A possible risk associated
with this approach is that investors
would come to view such reports as
‘‘boilerplate’’ and therefore would not
review them.
However, the Commission
preliminarily believes that requiring an
NRSRO to publish such a report along
with each publication of a credit rating
for a structured finance product likely
would provide certain investors with
useful information about structured
finance products. The goal of the
proposal is to spur investors to perform
more rigorous internal risk analysis on
structured finance products so that they
do not overly rely on NRSRO credit
ratings in making investment decisions.
A possible ancillary benefit of such
reports is that they could cause certain
investors to seek to better understand
risks that are not necessarily addressed
in credit ratings of structured products,
such as market and liquidity risk.
Because the goal of the rule is to foster
greater independent analysis by
investors, the Commission preliminarily
believes that permitting an NRSRO to
comply with the rule by differentiating
its structured finance product rating
symbols would be an equally effective
alternative. The differentiated symbol
would alert investors that a structured
product was being rated and, therefore,
raise the question of how it differs from
other types of debt instruments.
The Commission is not proposing to
require that specific rating symbols be
used to distinguish credit ratings for
structured finance products. An NRSRO
would be permitted to choose the
appropriate symbol. The Commission
preliminarily believes that methods for
identifying credit ratings for structured
finance products could include using a
different rating symbol altogether, such
as a numerical symbol, or appending
identifying characters to existing ratings
scales, e.g., ‘‘AAA.sf’’ or ‘‘AAASF.’’
The Commission is proposing these
amendments under authority to require
an NRSRO to ‘‘make and disseminate
such reports as the Commission, by rule,
prescribes as necessary or appropriate in
the public interest, for the protection of
investors, or otherwise in furtherance of
the purposes of [the Exchange Act].’’151
The Commission preliminarily believes
these proposed amendments are
151 See Section 17(a)(1) of the Exchange Act (15
U.S.C. 78q(a)(1)).
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Federal Register / Vol. 73, No. 123 / Wednesday, June 25, 2008 / Proposed Rules
necessary and appropriate in the public
interest, for the protection of investors,
or otherwise in furtherance of the
purposes of the Exchange Act because
they are designed to encourage investors
to perform greater levels of internal risk
assessment of structured finance
products by putting them on notice that
these products have different
characteristics than other types of rated
debt instruments. The Commission does
acknowledge the risks related to these
proposals as outlined above.
The Commission generally requests
comment on all aspects of this proposed
rule. In addition, the Commission
requests comment on the following
questions related to the proposal.
• Would the use of different rating
symbols for structured products impact
automated securities trading, routing,
settlement, clearance, trade
confirmation, reporting, processing, and
risk management systems and any other
systems that are programmed to use
standard credit rating symbols across all
product classes? Commenters should
describe how these systems may be
impacted and associated costs to
address the impacts on the firm such as
costs to change or update the systems.
Commenters also should describe how
the impacts to these systems could
impact trading activity in the markets
for structured finance products.
• Is the proposed rule sufficiently
clear about the types of securities and
money market instruments to which it
applies? Are there securities to which
the proposal applies that should not be
subject to the requirement of a report or
a differentiated symbol?
• Would the use of different rating
symbols have consequences for
investment guidelines and covenants in
legal documents that use credit ratings
to distinguish finance instruments?
Commenters should describe the
potential consequences and associated
costs to market participants and to the
finance markets more broadly.
• Would the use of different rating
symbols or reports dissuade purchases
of structured finance products?
• Would the reports or differentiated
symbols achieve the Commission’s
stated goal of encouraging investors to
perform more internal risk assessments
of structured finance products? Could
the reports cause investors to ignore
other relevant disclosures or lead to
confusion?
• Should the rule be expanded to
require reports or different ratings
symbols for each class of credit ratings
identified in Section 3(a)(62)(B) of the
Exchange Act (15 U.S.C. 78c(a)(62)(B));
namely: (1) Financial institutions,
brokers, or dealers; (2) insurance
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companies; (3) corporate issuers; (4)
issuers of asset-backed securities; and
(5) issuers of government securities,
municipal securities or securities issued
by a foreign government? Alternatively,
should the rule be expanded to require
reports or different ratings symbols for
only certain of these classes or
subclasses such as for municipal
securities?
• Should the rule prohibit an NRSRO
from using a common set of symbols
(e.g., AAA, AA, A, BBB, BB, B, CCC, CC,
C) to rate different types of obligors and
debt securities (e.g., corporate debt and
municipal debt) where the NRSRO uses
different methodologies for determining
such ratings? Would such a proposal
raise any questions relating to the scope
of the Commission’s legal authority in
this area?
• Should the rule allow the use of a
common set of symbols only if the
NRSRO determines additional types of
ratings to distinguish the different risk
characteristics of the different types of
obligors and debt securities? For
example, the rule could require the
determination of ratings to distinguish
the potential volatility of the credit
ratings of different classes of obligors
and debt securities or the differing
levels of market and liquidity risk
associated with different classes of debt
securities. Would such disclosures raise
any concerns regarding liability if they
were found to be deficient?
IV. Paperwork Reduction Act
Certain provisions of the proposed
rule amendments contain a ‘‘collection
of information’’ within the meaning of
the Paperwork Reduction Act of 1995
(‘‘PRA’’).152 The Commission is
submitting these proposed amendments
and proposed rule to the Office of
Management and Budget (‘‘OMB’’) for
review in accordance with the PRA. An
agency may not conduct or sponsor, and
a person is not required to comply with,
a collection of information unless it
displays a currently valid control
number. The titles for the collections of
information are:
(1) Rule 17g–1, Application for
registration as a nationally recognized
statistical rating agency; Form NRSRO
and the Instructions for Form NRSRO
(OMB Control Number 3235–0625);
(2) Rule 17g–2, Records to be made
and retained by nationally recognized
statistical rating organizations (OMB
Control Number 3235–0628);
(3) Rule 17g–3, Annual reports to be
furnished by nationally recognized
statistical rating organizations (OMB
Control Number 3235–0626);
152 44
PO 00000
U.S.C. 3501 et seq.; 5 CFR 1320.11.
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(4) Rule 17g–5, Conflicts of interest (a
proposed new collection of
information); and
(5) Rule 17g–7, Credit rating reports to
be furnished by nationally recognized
statistical rating organizations (a
proposed new collection of
information).
A. Collections of Information Under the
Proposed Amendments
The Commission is proposing for
comment rule amendments to prescribe
additional requirements for NRSROs to
address concerns that have arisen with
respect to their role in the credit market
turmoil. These proposed amendments
would modify rules the Commission
adopted in 2007 to implement
registration, recordkeeping, financial
reporting, and oversight rules under the
Rating Agency Act. Additionally, the
Commission is proposing a new rule
under authority provided in the Rating
Agency Act.153 Certain of the proposed
amendments and the proposed new rule
would contain recordkeeping and
disclosure requirements that would be
subject to the PRA. The collection of
information obligations imposed by the
proposed amendments and proposed
new rule would be mandatory. The
proposed amendments and proposed
new rule, however, would apply only to
credit rating agencies that are registered
with the Commission as NRSROs. Such
registration is voluntary.154
In summary, the proposed rule
amendments and proposed new rule
would require: (1) An NRSRO to
provide enhanced disclosure of
performance measurements statistics
and the procedures and methodologies
used by the NRSRO in determining
credit ratings for structured finance
products and other debt securities on
Form NRSRO; (2) an NRSRO to make,
keep and preserve additional records
under Rule 17g–2; 155 (3) an NRSRO to
make its rating actions and the date of
such actions from the initial credit
rating to the current credit rating
publicly available in an XBRL
Interactive Data File no later than six
months after the date of the rating
action; 156 (4) an NRSRO to furnish the
Commission with an additional annual
report; 157 (5) disclosure of certain
information about securities being rated
beginning on the date the issuer or
depositor sets the offering price of the
securities being rated ;158 and (6) an
153 Proposed
154 See
Rule 17g–7.
section 15E of the Exchange Act (15 U.S.C.
78o–7).
155 17 CFR 240.17g–2.
156 See proposed Rule 17g–2(a)(2)(iv) and (d).
157 See proposed Rule 17g–3(a)(6).
158 See proposed Rule 17g–5(a)(3) and (b)(9).
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NRSRO to attach a report to its credit
ratings for structured finance products
describing the rating methodology used
and how it differs from the
determination of ratings for other types
of securities or use a symbol that
identifies the rated security as a
structured finance product.159
B. Proposed Use of Information
The proposed amendments and new
rule would enhance the framework for
Commission oversight of NRSROs in
response to the recent credit market
turmoil.160 The collections of
information in the proposed
amendments and new rule are designed
to assist the Commission in effectively
monitoring, through its examination
function, whether an NRSRO is
conducting its activities in accordance
with section 15E of the Exchange Act 161
and the rules thereunder. In addition,
these proposed amendments and the
new rule are designed to assist users of
credit ratings by proposing to require
the disclosure of additional information
with respect to an NRSRO that could be
used to compare the credit ratings
quality of different NRSROs,
particularly with respect to structured
finance products. The Commission
believes that the information that
NRSROs would have to make public as
a result of the proposed amendments
would advance one of the primary
objectives of the Rating Agency Act, as
noted in the accompanying Senate
Report, to ‘‘facilitate informed decisions
by giving investors the opportunity to
compare ratings quality of different
firms.’’ 162
C. Respondents
In adopting the final rules under the
Rating Agency Act, the Commission
estimated that approximately 30 credit
rating agencies would be registered as
NRSROs.163 The Commission believes
that this estimate continues to be
appropriate for identifying the number
of respondents for purposes of the
proposed amendments and for proposed
new Rule 17g–7. Since the initial set of
rules under the Rating Agency Act
became effective in June 2007, nine
credit rating agencies have registered
with the Commission as NRSROs.164
The registration program has been in
hsrobinson on PROD1PC76 with PROPOSALS2
159 See
160 See
proposed Rule 17g–7.
17 CFR 17g–1 through 17g–6, and Form
NRSRO.
161 15 U.S.C. 78o–7.
162 See Senate Report, p. 8.
163 See Adopting Release, 72 FR at 33606–33607.
164 A.M. Best Company, Inc.; DBRS Ltd.; Fitch.;
Japan Credit Rating Agency, Ltd.; Moody’s; Rating
and Investment Information, Inc.; S&P; LACE
Financial Corp.; and Egan-Jones Rating Company.
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effect for less than a year; consequently,
the Commission expects additional
entities will register. While 20 more
entities may not ultimately register, the
Commission believes the estimate is
within reasonable bounds and
appropriate given that it adds an
element of conservatism as it increases
paperwork burden estimates as well as
cost estimates.
In addition, proposed Rule 17g–
5(a)(3) 165 would require the disclosure
of certain information provided to, and
used by, an NRSRO in determining an
initial rating for a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
and for monitoring those ratings. The
rule would not specify which party
would disclose such information: The
NRSRO, sponsor, issuer, depositor,
trustee or some other person. The
Commission believes that the most
likely persons to disclose this
information would be structured finance
product arrangers, managers, or trustees
as they are the entities that generate the
information and provide it to the
NRSROs. For purposes of the PRA
estimate for proposed Rule 17g–5(a)(3),
based on staff information gained from
the NRSRO examination process, the
Commission estimates that there would
be approximately 200 respondents. As
noted throughout the release, the
number of arrangers bringing structured
finance products to market is small
relative to the number of deals.
The Commission generally requests
comment on all aspects of these
proposed estimates for the number of
respondents. In addition, the
Commission requests specific comment
on the following items related to these
estimates.
• Should the Commission use the
number of credit rating agencies
currently registered as NRSROs rather
the estimated number of 30 ultimate
registrants? Alternatively, is there a
basis to estimate a different number of
likely registrants?
• Is the Commission correct in
believing that structured product
arrangers, managers, and trustees would
be the entities that disclose the
information required under the
proposed amendments to Rule 17g–5(a)?
• Are there sources that could
provide credible information that could
be used to determine the number of
credit rating agencies and other NRSROs
that would be subject to the proposed
paperwork burdens? Commenters
should identify any such sources and
explain how a given source could be
165 See
PO 00000
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36237
used to either support the Commission’s
estimate or arrive at a different estimate.
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
D. Total Annual Recordkeeping and
Reporting Burden
As discussed in further detail below,
the Commission estimates the total
recordkeeping burden resulting from the
proposed amendments and proposed
new rule would be approximately
1,434,690 hours on an annual basis 166
and 64,500 hours on a one-time basis.167
The total annual and one-time hour
burden estimates described below are
averages across all types of NRSROs
expected to be affected by the proposed
amendment and new rule. The size and
complexity of NRSROs range from small
entities to entities that are part of
complex global organizations employing
thousands of credit analysts.
Consequently, the burden hour
estimates represent the average time
across all NRSROs. The Commission
further notes that, given the significant
variance in size between the largest
NRSROs and the smallest NRSROs, the
burden estimates, as averages across all
NRSROs, are skewed higher because the
largest firms currently predominate in
the industry.
1. Amendments to Form NRSRO
The proposed amendments to Form
NRSRO would change the instructions
for the Form to require that NRSROs
provide more detailed credit ratings
performance statistics in Exhibit 1 and
disclose with greater specificity
information about the procedures and
methodologies used to determine
structured finance and other credit
ratings in Exhibit 2.168 The Commission
expects these proposed amendments
would not have a material effect on the
respondents’ hour burden. The
Commission believes that the total
annual burden hours of 2,100 currently
approved by OMB would not change for
Rule 17g–1 and Form NRSRO materially
because the additional disclosures
would be included within the overall
preparation of the initial Form NRSRO
for new applicants. Additionally, the
Commission believes that the nine
currently registered NRSROs could be
166 This total is derived from the total annual
hours set forth in the order that the totals appear
in the text: 390 + 300 + 4,000 + 150,000 + 1,280,000
= 1,434,690.
167 This total is derived from the total one-time
hours set forth in the order that the totals appear
in the text: 900 + 900 + 60,000 + 1,500 + 300 + 900
= 64,500.
168 17 CFR 240.17g–1 and Form NRSRO.
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required to prepare and furnish an
amended Form NRSRO to update their
registration applications if the
Commission were to adopt the proposed
amendments (i.e., nine amended Form
NRSROs). However, the Commission
believes these potential nine furnishings
of Form NRSRO are accounted for in the
currently approved PRA collection for
Rule 17g–1, which includes an estimate
that each NRSRO would file two
amendments to Form NRSRO per
year.169
The Commission generally requests
comment on all aspects of these
proposed burden estimates for Rule
17g–1 and Form NRSRO, proposed to be
amended. In addition, the Commission
requests specific comment on the
following items related to these
estimates:
• Would the proposed additional
disclosure requirements increase the
burden hours from the amount currently
budgeted for Rule 17g–1 and Form
NRSRO?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
hsrobinson on PROD1PC76 with PROPOSALS2
2. Amendments to Rule 17g–2
Rule 17g–2 requires an NRSRO to
make and keep current certain records
relating to its business and requires an
NRSRO to preserve those and other
records for certain prescribed time
periods.170 The Commission’s current
estimate for the average one-time
burden of implementing a
recordkeeping system to comply with
Rule 17g–2 is 300 hours.171
Additionally, the total annual burden
currently approved by OMB for Rule
17g–2 is 7,620 hours, which represents
the average annual amount of time an
NRSRO will spend to make and
maintain these records (254 hours per
year) multiplied by 30 respondents.172
The proposed amendments to Rule
17g–2 would require an NRSRO to make
and retain two additional records and
retain a third type of record. The records
to be made and retained would be: (1)
A record of the rationale for any
material difference between the credit
rating implied by the model and the
final credit rating issued, if a
quantitative model is a substantial
component in the process of
169 See
Adopting Release, 72 FR at 33609. To
date, only one of the seven NRSROs that have been
registered with the Commission since September
2007 has furnished the Commission with an
amended Form NRSRO since registering with the
Commission.
170 17 CFR 240.17g–2.
171 See Adopting Release, 72 FR at 33608.
172 See Adopting Release, 72 FR at 33610.
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determining a credit rating;173 and (2) a
record showing the history and dates of
all previous rating actions with respect
to each current credit rating.174 The
proposed amendments to Rule 17g–2
would require an NRSRO to make the
second set of records—rating actions
related to current ratings—publicly
available in an XBRL Interactive Data
File.175 In addition, the proposed
amendments would require an NRSRO
to retain communications that contain
any complaints by an obligor, issuer,
underwriter, or sponsor about the
performance of a credit analyst.176
With respect to the proposed
amendments to Rule 17g–2, the
Commission estimates, based on staff
information gained from the NRSRO
examination process, that the total onetime and annual record recordkeeping
burdens would increase approximately
10% and 5%, respectively.177 Thus, the
Commission estimates that the one-time
burden that each NRSRO would spend
implementing a recordkeeping system to
comply with Rule 17g–2 as proposed to
be amended would be approximately
330 hours,178 for a total one-time burden
of 9,900 hours for 30 NRSROs.179 The
Commission estimates that an NRSRO
would spend an average of 267 hours
per year180 to make and retain records
under Rule 17g–2 as proposed to be
amended, for a total annual hour burden
under Rule 17g–2 of 8,010 hours.181
This estimate would result in an
increase in the currently approved PRA
burden under Rule 17g–2 of 390 annual
burden hours.182 As discussed above,
the increase in annual burden hours
would result from the increase in the
number of records an NRSRO would be
required to make and retain under the
proposed amendments to Rule 17g–2.
In addition, the proposed
amendments to Rule 17g–2 would
173 Proposed
paragraph (a)(2)(iii) of Rule 17g–2.
paragraph (a)(8) of Rule 17g–2.
175 Proposed amendment to Rule 17g–2(d).
176 Proposed paragraph (b)(8) of Rule 17g–2.
177 The Commission believes that the one-time
burden to set up and/or modify a recordkeeping
system to comply with the proposed amendments
would be greater than the ongoing annual burden.
Once an NRSRO has set up or modified its
recordkeeping system to comply with the proposed
amendments, its annual hour burden would be
increased only to the extent it would be required
to make and retain additional records.
178 300 hours × 1.10 = 330 hours. This would
result in an increase of approximately 30 hours per
NRSRO for the one-time hour burden.
179 330 hours × 30 respondents = 9,900 hours. The
proposed amendments would result in an increase
of 900 total one-time burden hours.
180 254 hours × 1.05 = 267 hours. The proposed
amendments would result in an increase of
approximately 13 annual burden hours per NRSRO
for Rule 17g–2.
181 267 hours × 30 respondents = 8,010 hours.
182 8,010 hours ¥ 7,620 hours = 390 hours.
174 Proposed
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require an NRSRO to make the records
of its rating actions publicly available in
an XBRL Interactive Data File.183
The Commission believes that an
NRSRO would choose to make this
information available through its
Internet Web site and that each NRSRO
already has, or would have, an Internet
Web site. Therefore, based on staff
information gained from the NRSRO
examination process, the Commission
estimates that, on average, an NRSRO
would spend approximately 30 hours to
publicly disclose the history of its rating
actions for each credit rating in an XBRL
Interactive Data File and, thereafter, 10
hours per year to update this
information.184 Accordingly, the total
aggregate one-time burden to the
industry to make the history of rating
actions publicly available in an XBRL
Interactive Data File would be 900
hours,185 and the total aggregate annual
burden hours would be 300 hours.186
Under the currently approved PRA
collection for Rule 17g–2, the
Commission estimated that an NRSRO
may need to purchase recordkeeping
system software to establish a
recordkeeping system in conformance
with Rule 17g–2.187 The Commission
estimated that the cost of the software
would vary based on the size and
complexity of the NRSRO. Also, the
Commission estimated that some
NRSROs would not need such software
because they already have adequate
recordkeeping systems or, given their
small size, such software would not be
necessary. Based on these estimates, the
Commission estimated that the average
cost for recordkeeping software across
all NRSROs would be approximately
$1,000 per firm, with an aggregate onetime cost to the industry of $30,000. The
Commission estimates that the proposed
amendments to Rule 17g–2 would not
alter this estimate or that any increases
in the cost would be de minimis.
The Commission generally requests
comment on all aspects of these
proposed burden estimates for Rule
17g–2. In addition, the Commission
requests specific comment on the
following items related to these burden
estimates:
• Are there publicly available reports
or other data sources the Commission
183 See
proposed amendment to Rule 17g–2(d).
Commission also bases this estimate on
the current one-time and annual burden hours for
an NRSRO to publicly disclose its Form NRSRO. No
alternatives to these estimates as proposed were
suggested by commenters. See Adopting Release, 72
FR at 33609.
185 30 hours × 30 NRSROs = 900 hours.
186 10 hours × 30 NRSROs = 300 hours.
187 See Adopting Release, 72 FR at 33609, 33610.
184 The
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should consider in arriving at these
burden estimates?
• Are the estimates that these
amendments would result in an increase
to the current total one-time and annual
recordkeeping burdens of approximately
10% and 5% accurate? If not, should
they be higher or lower?
• Are the estimates that the
requirement to make records of rating
actions publicly available in an XBRL
Interactive Data File would result in an
increased one-time burden for each
NRSRO of approximately 30 hours to
publicly disclose the history of its rating
actions for each credit rating in an XBRL
Interactive Data File and, thereafter, 10
hours per year to update this
information accurate? If not, should
they be higher or lower?
• Is the estimate that the NRSROs
would incur no additional costs (or that
any additional costs would be de
minimis) to update recordkeeping
systems to comply with the proposed
new recordkeeping requirements
accurate? If not, what would the
additional costs be?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
hsrobinson on PROD1PC76 with PROPOSALS2
3. Proposed Amendment to Rule 17g–3
Rule 17g–3 requires an NRSRO to
furnish certain financial reports to the
Commission on an annual basis,
including audited financial statements
as well as other financial reports.188 The
Commission is proposing to amend Rule
17g–3 to require an NRSRO to furnish
the Commission with an additional
report: an unaudited report of the
number of credit ratings that were
changed during the fiscal year in each
class of credit ratings for which the
NRSRO is registered with the
Commission.189
The total annual burden currently
approved by OMB for Rule 17g–3 is
6,000 hours, based on the fact that it
would take an NRSRO, on average,
approximately 200 hours to prepare for
and file the annual reports.190 In
addition, the total annual cost burden
currently approved by OMB is $450,000
to engage the services of an independent
public accountant to conduct the annual
audit as part of the preparation of the
first report required by Rule 17g–3.191
188 17
CFR 240.17g–3.
proposed Rule 17g–3(a)(6).
190 200 hours × 30 NRSROs = 6,000 hours. See
Adopting Release, 72 FR at 33610.
191 Rule 17g–3 currently requires five reports.
Only the first report—financial statements—need be
audited. The two new reports proposed to be
required by the amendments would not need to be
audited.
189 See
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This estimate is based on 30 NRSROs
hiring an independent public
accountant on an annual basis for an
average of $15,000.192
The Commission believes that the
proposed amendment to Rule 17g–3 that
would require a report on an NRSRO’s
rating changes during a fiscal year
would have a de minimis effect on the
annual hour burden for the current PRA
collection for Rule 17g–3. The
Commission preliminarily believes that
an NRSRO already would have this
information with respect to each class of
credit ratings for which it is registered.
In addition, the proposed amendment
does not prescribe a format for the
report. Consequently, the Commission
estimates that proposed Rule 17g–3(a)(6)
would not have a significant effect on
the total annual hour burden currently
approved for the PRA for Rule 17g–3.
The Commission generally requests
comment on all aspects of these
proposed burden estimates for Rule
17g–3. In addition, the Commission
requests specific comment on the
following items related to these burden
estimates:
• Are there publicly available reports
or other data sources the Commission
should consider in arriving at these
burden estimates?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
4. Amendments to Rule 17g–5
Rules 17g–5 requires an NRSRO to
manage and disclose certain conflicts of
interest.193 The rule also prohibits
specific types of conflicts of interest.194
The proposed amendments to Rule 17g–
5 would add an additional conflict to
paragraph (b) of Rule 17g–5. This
proposed conflict of interest would be
issuing or maintaining a credit rating for
a security or money market instrument
issued by an asset pool or as part of an
asset-backed or mortgage-backed
securities transaction that was paid for
by the issuer, sponsor, or underwriter of
the security or money market
instrument.195 Under the proposal, an
NRSRO would be prohibited from
issuing a credit rating for a structured
finance product, unless certain
information about the transaction and
the assets underlying the structured
finance product are disclosed.196
Specifically, the following information
192 $15,000 × 30 NRSROs = $450,000. See
Adopting Release, 72 FR at 33610.
193 17 CFR 240.17g–5.
194 17 CFR 240.17g–5(c).
195 See proposed Rule 17g–5(b)(9). The current
paragraph (b)(9) would be renumbered as (b)(10).
196 See proposed Rule 17g–5(a)(3).
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would need to be made publicly
available beginning on the date the
underwriter, issuer or depositor set the
offering price of the securities being
rated: (1) All information provided to
the NRSRO that is used in determining
the initial credit rating, including
information about the characteristics of
the assets underlying or referenced by
the security or money market
instrument, and the legal structure; and
(2) all information provided to the
NRSRO by the issuer, underwriter,
sponsor, depositor or trustee that is used
by the NRSRO in undertaking credit
rating surveillance on the security or
money market instrument.197 In a
private offering, the above information
would need to be made available on the
date the underwriter and the issuer or
depositor set the offering price of the
securities being rated only to credit
rating agencies and investors; it would
need to be made publicly available,
however, no later than one business day
after the offering closes.
The proposed rule would not specify
which party would disclose the
information: the NRSRO, sponsor,
issuer, depositor or trustee. The
Commission preliminarily believes that
in order to avoid conflicts with
Securities Act prohibitions on general
solicitations as well as to avoid making
the NRSRO liable for the accuracy of
information that would originally be
supplied by the arrangers and trustees of
structured products, this information
would likely be disclosed by those
arrangers and trustees. The Commission
estimates that there would be
approximately 200 such entities. For
purposes of this PRA, the Commission
estimates that it would take a
respondent approximately 300 hours to
develop a system, as well as policies
and procedures, for the disclosures
required by the proposed rule. This
estimate is based on the Commission’s
experience with, and burden estimates
for, the recordkeeping requirements for
NRSROs.198 Accordingly, the
Commission believes, based on staff
experience, that a respondent would
take approximately 300 hours on a onetime basis to implement a disclosure
system to comply with the proposal in
that a respondent would need a set of
policies and procedures for disclosing
the information, as well as a system for
making the information publicly
available. This would result in a total
one-time hour burden of 60,000 hours
for 200 respondents.199
197 See
proposed Rule 17g–5(a)(3)(i)–(iii).
Adopting Release, 72 FR at 33609.
199 300 hours × 200 respondents = 60,000 hours.
198 See
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In addition to the one-time hour
burden, disclosure would also be
required under the proposed rule on a
transaction by transaction basis when an
initial rating is determined. Based on
staff experience, the Commission
estimates that each respondent would
disclose information with respect to
approximately 20 new transactions per
year and that it would take
approximately 1 hour per transaction to
make the information publicly available.
This estimate is based on the
Commission’s expectation that the
respondent will have already
implemented the system and policies
and procedures for disclosure. The
Commission estimates that a large
NRSRO would have rated
approximately 2,000 new RMBS and
CDO transactions in a given year. The
Commission is basing this estimate on
the number of new RMBS and CDO
deals rated in 2006 by two of the largest
NRSROs which rated structured finance
transactions. The Commission adjusted
this number to approximately 4,000
transactions in order to include other
types of structured finance products,
including commercial MBS and other
consumer assets. Therefore, the
Commission estimates for purposes of
the PRA that each respondent would
arrange approximately 20 new
transactions per year: 4,000 new
transactions/200 arrangers = 20 new
transactions. The Commission notes that
the number of new transactions
arranged per year would vary by the size
of arranger and that this estimate would
be an average across all respondents.
Larger respondents may arrange in
excess of 20 new deals per year, while
a smaller entity may only arrange one or
two new deals on an annual basis.
Based on this analysis, the Commission
estimates that it would take a
respondent approximately 20 hours 200
to disclose this information under the
proposed rule, on an annual basis, for a
total aggregate annual hour burden of
4,000 hours.201
In addition, proposed Rule 17g–
5(a)(ii) would require disclosure of
information provided to an NRSRO that
is used by an NRSRO in undertaking
credit rating surveillance on a security
or money market instrument. Because
surveillance would cover more than just
initial ratings, the Commission
estimates based on staff information
gained from the NRSRO examination
process that monthly disclosure would
be required with respect to
approximately 125 transactions on an
ongoing basis. Also based on staff
200 20
201 20
transactions × 1 hour = 20 hours.
hours × 200 respondents = 4,000 hours.
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information gained from the NRSRO
examination process, the Commission
estimates that it would take a
respondent approximately 0.5 hours per
transaction to disclose the information.
Therefore, the Commission estimates
that each respondent would spend
approximately 750 hours 202 on an
annual basis disclosing information
under proposed Rule 17g–5, for a total
aggregate annual burden hours of
150,000 hours.203
The Commission generally requests
comment on all aspects of these
proposed burden estimates for Rule
17g–5. In addition, the Commission
requests specific comment on the
following items related to these
estimates:
• Are there publicly available reports
or other data sources the Commission
should consider in arriving at these
burden estimates?
• Are the estimates of the one-time
and recurring burdens of the proposed
additional disclosures accurate? If not,
should they be higher or lower?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
5. Proposed Rule 17g–7
The Commission is proposing a new
rule—Rule 17g–7—which would
address concerns that investors believe
that the risk characteristics for a
structured finance product are the same
as for other types of obligors or debt
securities. Proposed Rule 17g–7 would
require an NRSRO to attach a report
each time it publishes a credit rating for
a structured finance product describing
how the ratings procedures and
methodologies differ from those for
other types of obligors or debt
securities.204 Proposed Rule 17g–7
would include an exemption to this
requirement, however, if the NRSRO
used credit rating symbols for structured
finance products that identify the
product as such as distinct from any
other type of obligor or debt security.
The Commission believes that proposed
Rule 17g–7 205 would provide users of
credit ratings with useful information
either through the report or the
differentiated symbol upon which to
base their investment decisions.
The Commission expects that most
NRSROs already have documented their
methodologies and procedures in place
to determine credit ratings for
202 125 transactions × 30 minutes × 12 months =
45,000 minutes/60 minutes = 750 hours.
203 750 hours × 200 respondents = 150,000 hours.
204 See proposed Rule 17g–7.
205 See proposed Rule 17g–7.
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structured finance products and
corporate debt securities, and have
disclosed such policies and procedures
if they have registered with the
Commission as an NRSRO. The
Commission expects, however, that an
NRSRO would have to compile and/or
modify these documents to comply with
the specific reporting requirements that
would be mandated by the proposed
rule. Based on staff information gained
from the NRSRO examination process,
the Commission estimates that it would
take an NRSRO approximately 50
hours 206 to draft the report required
under the proposed rule for a total onetime hour burden of 1,500 hours.207
The Commission also estimates that it
would take an NRSRO additional time
to publish the report each time a credit
rating for a structured finance product is
published and to monitor the
publications of structured finance credit
ratings to ensure compliance with the
proposed rule. Based on the average
number of credit ratings of asset-backed
securities outstanding as of the latest
fiscal year of the three largest NRSROs,
the Commission estimates that an
NRSRO would publish approximately
128,000 asset-backed credit ratings per
year.208 The Commission notes that this
number may not include all structured
finance ratings, since some may not fit
within the statutory definition of assetbacked security. However, the
Commission also notes that the issuance
of RMBS has dropped dramatically off
recent highs. Accordingly, the
Commission believes the number of
asset-backed ratings reported in Form
NRSRO is a reasonable proxy for the
number of structured finance ratings.
The Commission also notes that, as
discussed below, the burden estimate
identifies 30 respondents. However,
most of the structured finance ratings
are concentrated in the largest 3 or 4
NRSROs. Accordingly, the average
number of structured finance ratings
issued per NRSRO each year may be
considerably lower than 128,000. For
these reasons, the Commission believes
the estimate is fairly conservative.
The Commission estimates that an
NRSRO would publish a rating action
206 The Commission based this estimate on the
estimated number of hours it would take an NRSRO
to comply with Rule 17g–4 to develop policies and
procedures to prevent the misuse of material
nonpublic information. See Adopting Release, 72
FR at 33611.
207 50 hours × 30 NRSROs = 1,500 hours.
208 This estimate uses the average of the
approximate number of credit ratings for assetbased securities as defined in 17 CFR 229.1101(c)
that S&P, Moody’s and Fitch had outstanding as of
the most recent calendar year end as reported in
their annual certifications. (S&P: 197,700; Moody’s:
110,000; and Fitch: 75,278).
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with respect to a particular structured
finance rating approximately 4 times per
year for a total of 512,000
publications.209 The Commission notes
that this estimate would include
publication of an initial rating,
upgrades, downgrades and any
affirmations published in a given year.
Based on staff experience, the
Commission estimates that an NRSRO
would spend approximately 5 minutes
ensuring that the required report was
published along with the credit rating,
for a total of 42,667 annual burden
hours 210 per respondent, and a total of
1,280,000 hours 211 across 30 NRSROs.
Finally, the Commission estimates,
based on staff experience, that it would
take an NRSRO approximately 10 hours
per year to review and update the report
to ensure that the disclosure was
accurate and up-to-date for a total
aggregate annual hour burden to the
industry of 300 hours.212 The
Commission believes, therefore, that the
aggregate one-time and annual burden
hours under proposed Rule 17g–7(a)
would be 1,280,000 and 1,800 hours,213
respectively.
The Commission believes, however,
that most, if not all, NRSROs would opt
to differentiate their ratings under
paragraph (b) of proposed Rule 17g–
7,214 rather than publish a report. The
Commission believes that an NRSRO
would likely choose to use a specific
credit rating symbol to indicate that the
particular credit rating relates to
structured product as distinct from a
credit rating for any other category of
security or issuer. The Commission
believes that an NRSRO would choose
to employ this symbology approach
because it would be more efficient and
less burdensome than ensuring that the
appropriate report was published along
with the credit rating. The Commission
believes that the implementation of a
different rating symbol would entail a
one-time burden of approximately 30
hours to develop the symbol for a total
aggregate one-time burden to the
industry of 900 hours.215
Because the Commission believes that
NRSROs will choose to differentiate
their ratings under paragraph (b) of
proposed Rule 17g–7 rather than
× 4 = 512,000 ratings publications.
× 5 minutes per report = 2,560,000
minutes/60 minutes per hour = 42,667 hours.
211 42,667 hours × 30 NRSROs = 1,280,000 hours.
212 This estimate is based on the number of hours
it would take an NRSRO to complete an annual
certification on Form NRSRO. See Adopting
Release, 72 FR at 33609. 10 hours × 30 NRSROs =
300 hours.
213 1,500 + 300 hours.
214 See proposed Rule 17g–7(b).
215 30 hours × 30 NRSROs.
209 128,000
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210 512,000
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publish a report under paragraph (a) of
the proposed new rule, the Commission
believes that the appropriate estimate
for the aggregate one-time burden to the
industry under proposed Rule 17g–7 is
900 hours. The Commission generally
requests comment on all aspects of these
proposed burden estimates for Rule
17g–7. In addition, the Commission
requests specific comment on the
following items related to these burden
estimates:
• Is the Commission incorrect in its
belief that NRSROs would opt to use a
different rating symbol rather than to
publish a report with each structured
product rating? If so, what percentage of
NRSROs would be likely to opt to
publish a report?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
E. Collection of Information Is
Mandatory
The recordkeeping and notice
requirements for the proposed
amendment and the proposed new rule
would be mandatory.
F. Confidentiality
The disclosures proposed to be
required under the amendments to Rule
17g–1 and Form NRSRO would be made
publicly available on Form NRSRO. The
books and records information proposed
to be collected under the proposed
amendments to Rule 17g–2 would be
stored by the NRSRO and made
available to the Commission and its
representatives as required in
connection with examinations,
investigations, and enforcement
proceedings. However, an NRSRO
would be required to make the record of
rating actions under proposed Rule 17g–
2(a)(8) publicly available in an XBRL
Interactive Data File no later than six
months after the date of the rating
action.216 The information proposed to
be collected under the proposed
amendment to Rule 17g–3 would be
generated from the internal records of
the NRSRO and would be furnished to
the Commission on a confidential basis,
to the extent permitted by law.217 The
information under Rule 17g–5(a)(3)
would be made publicly available or
available to certain permitted persons.
The information proposed to be
required under proposed new Rule 17g–
7 would be made publicly available.
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proposed Rule 17g–2(a)(8) and (d).
U.S.C. 78o–7(k).
G. Record Retention Period
The records required under the
proposed amendments to Rule 17g–1
and Form NRSRO, Rule 17g–2, and 17g–
3 would need to be retained by the
NRSRO for at least three years.218
H. Request for Comment
The Commission requests comment
on the proposed collections of
information in order to: (1) Evaluate
whether the proposed collection of
information is necessary for the proper
performance of the functions of the
Commission, including whether the
information would have practical
utility; (2) evaluate the accuracy of the
Commission’s estimates of the burden of
the proposed collections of information;
(3) determine whether there are ways to
enhance the quality, utility, and clarity
of the information to be collected; (4)
evaluate whether there are ways to
minimize the burden of the collection of
information on those who respond,
including through the use of automated
collection techniques or other forms of
information technology; and (5) evaluate
whether the proposed rules would have
any effects on any other collection of
information not previously identified in
this section.
Persons who desire to submit
comments on the collection of
information requirements should direct
their comments to the OMB, Attention:
Desk Officer for the Securities and
Exchange Commission, Office of
Information and Regulatory Affairs,
Washington, DC 20503, and should also
send a copy of their comments to
Secretary, Securities and Exchange
Commission, 100 F Street, NE.,
Washington, DC 20549–1090, and refer
to File No. S7–13–08. OMB is required
to make a decision concerning the
collections of information between 30
and 60 days after publication of this
document in the Federal Register;
therefore, comments to OMB are best
assured of having full effect if OMB
receives them within 30 days of this
publication. Requests for the materials
submitted to OMB by the Commission
with regard to these collections of
information should be in writing, refer
to File No. S7–13–08, and be submitted
to the Securities and Exchange
Commission, Records Management
Office, 100 F Street, NE., Washington,
DC 20549–1110.
V. Costs and Benefits of the Proposed
Rules
The Commission is sensitive to the
costs and benefits that result from its
rules. The Commission has identified
216 See
217 15
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218 17
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certain costs and benefits of the
proposed amendments and the
proposed new rule and requests
comment on all aspects of this costbenefit analysis, including identification
and assessment of any costs and benefits
not discussed in the analysis.219 The
Commission seeks comment and data on
the value of the benefits identified. The
Commission also welcomes comments
on the accuracy of its cost estimates in
each section of this cost-benefit
analysis, and requests those commenters
to provide data so the Commission can
improve the cost estimates, including
identification of statistics relied on by
commenters to reach conclusions on
cost estimates. Finally, the Commission
seeks estimates and views regarding
these costs and benefits for particular
types of market participants, as well as
any other costs or benefits that may
result from the adoption of these
proposed rule amendments.
hsrobinson on PROD1PC76 with PROPOSALS2
A. Benefits
The purposes of the Rating Agency
Act, as stated in the accompanying
Senate Report, are to improve ratings
quality for the protection of investors
and in the public interest by fostering
accountability, transparency, and
competition in the credit rating
industry.220 As the Senate Report states,
the Rating Agency Act establishes
‘‘fundamental reform and improvement
of the designation process’’ to further
the belief that ‘‘eliminating the artificial
barrier to entry will enhance
competition and provide investors with
more choices, higher quality ratings,
and lower costs. 221
The proposed amendments and new
rule would be issued pursuant to
specific grants of rulemaking authority
in the Rating Agency Act as well as the
219 For the purposes of this cost/benefit analysis,
the Commission is using salary data from the
Securities Industry and Financial Markets
Association (‘‘SIFMA’’) Report on Management and
Professional Earnings in the Securities Industry
2007, which provides base salary and bonus
information for middle-management and
professional positions within the securities
industry. The Commission believes that the salaries
for these securities industry positions would be
comparable to the salaries of similar positions in
the credit rating industry. Finally, the salary costs
derived from the report and referenced in this cost
benefit section, are modified to account for an 1800hour work year and multiplied by 5.35 to account
for bonuses, firm size, employee benefits and
overhead. The Commission used comparable
assumptions in adopting the final rules
implementing the Rating Agency Act in 2007,
requested comments on such assumptions, and
received no comments in response to its request.
See Adopting Release, 72 FR at 33611, note 576.
Hereinafter, references to data derived from the
report as modified in the manner described above
will be cited as ‘‘SIFMA 2007 Report as Modified.’’
220 Senate Report, p. 2.
221 Id, p. 7.
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Commission’s authority under the
Exchange Act. The amendments are
designed to further the goals of the
Rating Agency Act and to enhance the
Commission’s oversight of NRSROs, in
light of the recent credit market turmoil.
Since the adoption of the final rules
implementing the Rating Agency Act in
2007,222 and in response to the recent
concerns about the role of credit rating
agencies in the credit market turmoil,
the Commission has identified a number
of areas where it would be appropriate
to enhance the current regulatory
program for NRSROs.
Consequently, the Commission is
proposing amendments and a new rule
that are designed to address concerns
raised about the role NRSROs played in
the credit turmoil by proposing to
enhance the disclosure of credit ratings
performance measurement statistics;
increase the disclosure of information
about the assets underlying structured
finance products; require more
information about the procedures and
methodologies used to determine
structured finance ratings; and address
conflicts of interest arising from the
structured finance rating process. As
discussed below, the Commission
believes that these proposed
amendments and proposed new rule
would further the purpose of the Rating
Agency Act to improve the quality of
credit ratings by fostering
accountability, transparency, and
competition in the credit rating
industry, particularly with respect to
credit ratings for structured finance
products.223
Rule 17g–1 prescribes a process for a
credit rating agency to register with the
Commission as an NRSRO using Form
NRSRO, 224 and requires that a credit
rating agency provide information
required under Section 15E(a)(1)(B) of
the Exchange Act and certain additional
information.225 Form NRSRO is also the
means by which NRSROs update the
information they must publicly disclose.
The proposed amendments to the
instructions to Exhibit 1 to Form
NRSRO would require NRSROs to
provide more detailed performance
statistics and, thereby, make it easier for
users of credit ratings to compare the
ratings performance of the NRSROs.226
In addition, these proposed
amendments could make it easier for an
NRSRO to demonstrate that it has a
222 See
Adopting Release.
Senate Report, p. 2.
224 See Rule 17g–1.
225 See Section 15E(a)(1)(B) of the Exchange Act.
15 U.S.C. 78o–7(a)(1)(B).
226 17 CFR 240.17g–1 and Form NRSRO.
223 See
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superior ratings methodology or
competence and, thereby, attract clients.
The proposed amendments to the
instructions to Exhibit 2 of Form
NRSRO are designed to provide greater
clarity around three areas of the
NRSROs’ rating processes for structured
finance products that have raised
concerns in the context of the recent
credit market turmoil: the level of
verification performed on information
provided in loan documents; the quality
of loan originators; and the on-going
surveillance of existing ratings and how
changes made to a model used for initial
ratings are applied to existing ratings.
The additional information provided by
the proposed amendments would assist
users of credit ratings in making more
informed decisions about the quality of
an NRSRO’s ratings processes,
particularly with regard to structured
finance products.
The Commission preliminarily
believes that these proposed enhanced
disclosures in the Exhibits to Form
NRSRO could make it easier for market
participants to select the NRSROs that
are performing best and have the highest
quality processes for determining credit
ratings. The potential result could be
increased competition and the
promotion of capital formation through
a restoration of confidence in credit
ratings.
The proposed amendments to Rule
17g–2 are designed to assist the
Commission in its examination function
and provide greater information to users
of credit ratings about the performance
of an NRSRO’s credit ratings. The
additional records would be: (1) A
record of the rationale for any material
difference between the credit rating
implied by the model and the final
credit rating issued, if a quantitative
model is a substantial component in the
process of determining a credit
rating;227 (2) a record showing the
history and dates of all previous rating
actions with respect to each current
credit rating;228 and (3) any complaints
regarding the performance of a credit
analyst in determining credit ratings.229
These proposed records would assist the
Commission in monitoring whether an
NRSRO is complying with provisions of
Section 15E of the Exchange Act and the
rules thereunder. This would include
monitoring whether an NRSRO is
operating consistently with the
methodologies and procedures it
establishes (and discloses) to determine
credit ratings and its policies and
procedures designed to ensure the
227 Proposed
paragraph (a)(2)(iii) of Rule 17g–2.
paragraph (a)(8) of Rule 17g–2.
229 Proposed paragraph (b)(8) of Rule 17g–2.
228 Proposed
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impartiality of its credit ratings,
including its ratings of structured
finance products.
In addition, the proposed
amendments to Rule 17g–2, which
would require an NRSRO to make its
rating actions history publicly available
in an XBRL Interactive Data File, would
allow the marketplace to develop
performance measurement statistics that
would supplement those already
required to be published by NRSROs in
Exhibit 1 to Form NRSRO. This
proposed amendment is designed to
leverage the expertise of the
marketplace and, thereby, provide users
of credit ratings with innovative and
potentially more useful metrics with
which to compare NRSROs. This could
make NRSROs more accountable for
their ratings by enhancing the
transparency of their ratings
performance. By proposing to require an
XBRL Interactive Data File the
Commission also believes the proposed
amendment would allow investors,
analysts, and the Commission staff to
capture and analyze the ratings action
data more quickly and at less of a cost
than is possible using another format.
The Commission preliminarily
believes that the proposed amendments
to Rule 17g–2 would enhance the
Commission’s oversight of NRSROs and,
with respect to the public disclosure of
ratings history, provide the marketplace
with the raw materials to develop
metrics for comparing the ratings
performance of NRSROs. This could, in
turn, help in restoring confidence in
credit ratings and, thereby, promote
capital formation. Increased disclosure
of ratings history could make the ratings
performance of the NRSROs more
transparent to the marketplace and,
thereby, highlight those firms that do a
better job analyzing credit risk. This
could benefit smaller NRSROs to the
extent they have performed better than
others by alerting the market to their
superior competence.
The proposed amendment to Rule
17g-3 would require an NRSRO to
furnish an additional annual report to
the Commission: An unaudited report of
the number of credit ratings that were
changed during the fiscal year in each
class of credit ratings for which the
NRSRO is registered with the
Commission.230 The proposed new
report is designed to enhance the
Commission’s oversight of NRSROs by
providing the Commission with
additional information to assist in the
monitoring of NRSROs for compliance
with their stated policies and
procedures. For example, the proposed
230 See
proposed Rule 17g–3(a)(6).
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new report would allow examiners to
target potential problem areas in an
NRSRO’s rating processes by
highlighting spikes in rating actions
within a particular class of credit rating.
The proposed amendments to Rule
17g–5 would prohibit an NRSRO from
issuing a rating for a structured product
unless information about the assets
underlying the rated security is made
available to certain persons.231 These
proposed rule amendments would
prohibit an NRSRO from issuing or
maintaining a credit rating where the
NRSRO or an affiliate provided
recommendations on the structure of the
transaction being rated; a credit analyst
or person involved in the ratings
process participated in fee negotiations;
or a credit analyst or a person
responsible for approving a credit rating
received gifts from the obligor being
rated, or from the issuer, underwriter, or
sponsor of the securities being rated,
other than items provided in the context
of normal business activities such as
meetings that have an aggregate value of
no more than $25.232 The Commission
believes that the proposed amendments
to Rule 17g–5 would promote the
disclosure and management of conflicts
of interest and mitigate potential undue
influences on an NRSRO’s credit rating
process, particularly with respect to
credit ratings for structured finance
products.233 This would in turn increase
confidence in the integrity of NRSRO
ratings and, thereby, promote capital
formation. In addition, the proposed
disclosure of additional information
regarding the assets underlying a
structured finance transaction 234 would
allow for unsolicited ratings that could
help address ratings shopping by
exposing an NRSRO whose ratings
methodologies are less conservative in
order to gain business. It also could
mitigate the impact of rating shopping,
since NRSROs not hired to rate a deal
could nonetheless issue a credit rating.
These potential impacts of the rule
proposal could help to restore
confidence in credit ratings and,
thereby, promote capital formation.
Also, by creating a mechanism for
determining unsolicited ratings, they
could increase competition by allowing
smaller NRSROs to demonstrate
proficiency in rating structured
products.
Proposed Rule 17g–7 would address
concerns that investors may believe that
the risk characteristics for a structured
finance product are the same as for
231 See
proposed Rule 17g–5(a)(3) and (b)(9).
proposed Rule 17 CFR 240.17g–5(c)(5)–(7).
233 See 15 U.S.C. 78o–7(a)(1)(B)(vi) and (h).
234 See proposed Rule 17 CFR 240.17g–5(a)(3).
232 See
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other types of obligors or debt securities
by requiring an NRSRO to attach a
report each time it publishes a credit
rating for a structured finance product
describing how the ratings procedures
and methodologies differ from those
ratings for other types of obligors or debt
securities.235 Alternatively, an NRSRO
would be permitted to use rating
symbols for structured finance products
that differentiate them from its other
credit ratings. The Commission believes
this proposed rule would address
potential confusion by investors as to
the different characteristics of
structured finance products when
compared to other types of obligors or
debt securities and help them in
assessing the risks involved with
different types of securities and promote
better informed investment decisions.
The Commission generally requests
comment on all aspects of these
proposed benefits. In addition, the
Commission requests specific comment
on the following items related to these
benefits.
• Are there metrics available to
quantify these benefits and any other
benefits the commenter may identify,
including the identification of sources
of empirical data that could be used for
such metrics.
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these benefit estimates.
B. Costs
The cost of compliance with the
proposed amendments and new rule to
a given NRSRO would depend on its
size and the complexity of its business
activities. The size and complexity of
NRSROs vary significantly. Therefore,
the cost could vary significantly across
NRSROs. Instead, the Commission is
providing estimates of the average cost
per NRSRO, as a result of the proposed
amendments, taking into consideration
the range in size and complexity of
NRSROs and the fact that many already
may have established policies,
procedures and recordkeeping systems
and processes that would comply
substantially with the proposed
amendments. Additionally, the
Commission notes that nine credit
rating agencies are currently registered
with the Commission as NRSROs and
subject to the Act and its implementing
regulations. The cost of compliance
would also vary depending on which
classes of credit ratings an NRSRO
issues. NRSROs which issue credit
ratings for structured finance products
would incur higher compliance costs
235 See
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than those NRSROs which do not issue
such credit ratings or issue very few
credit ratings in that class.
For these reasons, the cost estimates
represent the average cost across all
NRSROs and take into account that
some firms would only need to augment
existing policies, procedures and
recordkeeping systems and processes to
come into compliance with the
proposed amendments.
1. Proposed Amendments to Form
NRSRO
As discussed above, the Commission
is proposing to amend the instructions
to Exhibit 1 to Form NRSRO to provide
more detailed performance statistics.
Currently, the instructions require the
disclosure of performance measurement
statistics of the credit ratings of the
‘‘Applicant/NRSRO over the short-term,
mid-term and long-term periods (as
applicable) through the most recent
calendar year end.’’ The proposed
amendments would augment these
instructions to require the disclosure of
separate sets of default and transition
statistics for each class of credit ratings.
In addition, the class-by-class
disclosures would need to be broken out
over 1, 3 and 10 year periods.236
The proposed amendments would
also amend the instructions to Exhibit 2
to Form NRSRO to require enhanced
disclosures about the procedures and
methodologies an NRSRO uses to
determine credit ratings, including
whether and, if so, how information
about verification performed on assets
underlying a structured finance
transaction is relied on in determining
credit ratings; whether and, if so, how
assessments of the quality of originators
of assets underlying a structured finance
transaction factor into the determination
of credit ratings; and how frequently
credit ratings are reviewed, whether
different models are used for ratings
surveillance than for determining credit
ratings, and whether changes made to
models and criteria for determining
initial ratings are applied retroactively
to existing ratings. As discussed above,
the Commission estimates that for PRA
purposes the total one-time and annual
hour burdens and the cost would have
a neutral effect, resulting in no overall
change in hours or cost for the currently
approved PRA collection.
The Commission preliminarily
believes, however, NRSROs may incur a
cost of compliance in updating their
performance metric statistics to conform
to the new requirements set forth in the
proposed rule amendments. Under the
236 See proposed instructions to Exhibit 1, Form
NRSRO.
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current instructions to Exhibit 1 to Form
NRSRO, an NRSRO must disclose its
performance metrics over short, mid,
and long-term periods. Thus, the current
Form NRSRO instructions to Exhibit 1
allow an NRSRO to use its own
definitions of ‘‘short, mid, and longterm periods’’ and to include all credit
ratings, regardless of class of rating, in
one set of metrics. Under the proposed
amendments, an NRSRO would be
required to break out on a class-by-class
basis performance statistics over 1, 3
and 10-year periods. The Commission
believes that existing NRSROs would
incur costs to conform their current
performance statistics with the
requirements of this proposed
amendment to Exhibit 1.
The Commission estimates that it
would take each NRSRO currently
registered with the Commission
approximately 50 hours to review its
performance measurement statistics and
to develop and implement any changes
necessary to comply with the proposed
amendment. The Commission is basing
this estimate on the amount of time the
Commission estimated that it would
take an NRSRO to establish procedures
in conformance with Rule 17g–4 and on
information gained from the NRSRO
examination process.237 For these
reasons, the Commission estimates that
the average one-time cost to an NRSRO
would be $12,740 238 and the total
aggregate cost to the currently registered
NRSROs would be $114,660.239
The Commission generally requests
comment on all aspects of these
proposed cost estimates for the
proposed amendments to Form NRSRO.
In addition, the Commission requests
specific comment on the following
items related to these cost estimates:
• Would these proposals impose costs
on other market participants, including
persons who use credit ratings to make
investment decisions or for regulatory
purposes, and persons who purchase
services and products from NRSROs?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
237 See 17 CFR 240.17g–4; Adopting Release, 72
FR at 33616.
238 The Commission estimates that a Compliance
Attorney (40 hours) and a Programmer Analyst (10
hours) would perform these responsibilities. The
SIFMA 2007 Report as Modified indicates that the
average hourly rates for a Compliance Attorney and
a Programmer Analyst are $270 and $194 per hour,
respectively. Therefore, the average one-time cost to
an NRSRO would be $12,740 [(40 hours × $270) +
(10 hours × $194)].
239 $12,740 × 9 NRSROs = $114,660.
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2. Proposed Amendments to Rule 17g–
2
Rule 17g–2 requires an NRSRO to make
and preserve specified records related to
its credit rating business.240 As
discussed above, the proposed
amendments to Rule 17g–2 would
require an NRSRO to make and retain
two additional records and retain a third
type of record. The records to be made
and retained would be: (1) A record of
the rationale for any material difference
between the credit rating implied by the
model and the final credit rating issued,
if a quantitative model is a substantial
component in the process of
determining a credit rating; 241 and (2) a
record showing the history and dates of
all previous rating actions with respect
to each current credit rating.242 The
proposed amendments to Rule 17g–2
would require an NRSRO to make the
second record-rating actions related to
current ratings publicly available in an
XBRL Interactive Data File.243 In
addition, the proposed amendments
would require an NRSRO to retain
communications that contain any
complaints by an obligor, issuer,
underwriter, or sponsor about the
performance of a credit analyst.244
As discussed with respect to the PRA,
the Commission estimates that, based on
staff experience, the total one-time and
annual recordkeeping burdens would
increase approximately 10% and 5%,
respectively. Thus, the Commission
estimates that the one-time hour burden
that each NRSRO would spend
implementing a recordkeeping system to
comply with Rule 17g–2 would be
approximately 330 hours (an increase of
30 hours) 245 for a total one-time burden
of 9,900 hours (an increase of 900
hours).246
The Commission estimates that an
NRSRO would spend an average of 267
hours per year (an increase of 13
hours) 247 to make and maintain records
under Rule 17g–2, for a total annual
hour burden of 8,010 hours.248 This
estimate would increase the currently
approved PRA burden under Rule 17g–
2 by 390 hours.249 For these reasons, the
Commission estimates that an NRSRO
would incur an average one-time cost of
$7,350 and the average annual cost of
$3,185, as a result of the proposed
240 17
CFR 240.17g–2.
paragraph (a)(2)(iii) of Rule 17g–2.
242 Proposed paragraph (a)(8) of Rule 17g–2.
243 Proposed amendment to Rule 17g–2(d).
244 Proposed paragraph (b)(8) of Rule 17g–2.
245 300 hours × 1.10 = 330 hours.
246 330 hours × 30 respondents = 9,900 hours.
247 254 hours × 1.05 = 267 hours.
248 267 hours × 30 respondents = 8,010 hours.
249 8,010 hours¥7,620 hours = 390 hours.
241 Proposed
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amendments.250 Consequently, the total
aggregate one-time cost attributable to
the proposed amendments would be
$220,500 251 and the total aggregate
annual cost to the industry would be
$95,550.252
In addition, the proposed
amendments to Rule 17g–2 would
require an NRSRO to make the records
of its rating actions publicly available in
an XBRL Interactive Data File.253 As
discussed with respect to the PRA, the
Commission estimates that, on average,
an NRSRO would spend approximately
30 hours to publicly disclose this ratings
history information in an XBRL
Interactive Data File and, thereafter, 10
hours per year to update its rating action
history.254 Accordingly, the total
aggregate one-time burden to the
industry to make the history of its rating
actions publicly available in an XBRL
Interactive Data File would be 900
hours 255 and the total aggregate annual
burden hours would be 300 hours.256
Furthermore, as discussed in the PRA
the Commission estimates there will be
30 NRSROs. For these reasons, the
Commission estimates that an NRSRO
would incur an average one-time cost of
$8,670 and an average annual cost of
$2,890, as a result of the proposed
amendment.257 Consequently, the total
aggregate one-time cost to the industry
would be $260,100 258 and the total
aggregate annual cost to the industry
would be $86,700.259
As discussed with respect to the PRA,
the Commission estimated that an
NRSRO may have to purchase
recordkeeping software to establish a
recordkeeping system in conformance
with Rule 17g–2. The Commission
estimated that the cost of the software
250 The Commission estimates that an NRSRO
will have a Compliance Manager perform these
responsibilities. Based on the average hourly rate
for a Compliance Manager of $245, the average one
time cost will be $7,350 (30 hours × $245 per hour)
and the average annual cost will be $3,185 (13
hours × $245 per hour).
251 $7,350 × 30 NRSROs = $220,500.
252 $3,185 × 30 NRSROs = $95,550.
253 See proposed amendment to Rule 17g–2(d).
254 The Commission also bases this estimate on
the estimated one-time and annual burden hours it
would take an NRSRO to publicly disclose its Form
NRSRO on its Web site. No comments were
received on these estimates in the final rule release.
See Adopting Release, 72 FR at 33609.
255 30 hours × 30 NRSROs = 900 hours.
256 10 hours × 30 NRSROs = 300 hours.
257 The Commission estimates that an NRSRO
would have a Senior Programmer perform these
responsibilities. The SIFMA 2007 Report as
Modified indicates that the average hourly cost for
a Senior Programmer is $289. Therefore, the average
one-time cost would be $8,670 [(30 hours) × ($289
per hour)] and the average annual cost would be
$2,890 [(10 hours per year) × ($289 per hour)].
258 900 hours × $289 per hour.
259 300 hours × $289 per hour.
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will vary based on the size and
complexity of the NRSRO. Also, the
Commission estimated that some
NRSROs would not need such software
because they already have adequate
recordkeeping systems or, given their
small size, such software would not be
necessary. Based on these estimates, the
Commission estimated that the average
cost for recordkeeping software across
all NRSROs would be approximately
$1,000 per firm. Therefore, the
estimated one-time cost to the industry
would be $30,000. The Commission
estimates that the proposed
amendments to Rule 17g–2 would not
alter this estimate or that any increases
in the cost would be de minimis.
Finally, proposed paragraph (a)(8) to
Rule 17g–2 would require an NRSRO to
create and maintain a record showing
all rating actions and the date of such
actions from the initial rating to the
current rating identified by the name or
rated security or obligor, and, if
applicable, the CUSIP of the rated
security or the Central Index Key (CIK)
number of the rated obligor.260 The
Commission estimates that an NRSRO
could be required to purchase a license
from the CUSIP Service Bureau in order
to access CUSIP numbers for the
securities it rates. The CUSIP Service
Bureau’s operations are covered by fees
paid by issuers and licensees of the
CUSIP Service Bureau’s data. Issuers
pay a one-time fee for each new CUSIP
assigned, and licensees pay a renewable
subscription or a license fee for access
and use of the CUSIP Service Bureau’s
various database services. The CUSIP
Service Bureau’s license fees vary based
on usage, i.e., how many securities or by
type of security or business line.261 The
Commission estimates that the license
fees incurred by an NRSRO would vary
depending on the size of the NRSRO
and the number of credit ratings it
issues. For purposes of this cost
estimate, the Commission estimates that
260 See proposed Rule 17g–2(a)(8). The Central
Index Key (CIK) is used on the Commission’s
computer systems to identify corporations and
individual people who have filed disclosure with
the Commission. Anyone may search https://
www.edgarcompany.sec.gov for a company, fund, or
individual CIK. There is no fee for this service.
CUSIP stands for Committee on Uniform Securities
Identification Procedures. A CUSIP number
identifies most securities, including: Stocks of all
registered U.S. and Canadian companies, U.S.
government and municipal bonds, as well as
structured finance issuances. The CUSIP system—
owned by the American Bankers Association and
operated by Standard & Poor’s—facilitates the
clearing and settlement process of securities. The
CUSIP number consists of nine characters
(including letters and numbers) that uniquely
identify a company or issuer and the type of
security.
261 See https://www.cusip.com/static/html/
webpage/service_fees.html#lic_fees.
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36245
an NRSRO would incur a fee of
$100,000 to obtain access to the CUSIP
numbers for the securities it rates.
Consequently, the estimated total onetime cost to the industry would be
$3,000,000.262
The Commission generally requests
comment on all aspects of these cost
estimates for the proposed amendments
to Rule 17g–2. In addition, the
Commission requests specific comment
on the following items related to these
cost estimates:
• Would these proposals impose costs
on other market participants, including
persons who use credit ratings to make
investment decisions or for regulatory
purposes, and persons who purchase
services and products from NRSROs?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
3. Proposed Amendment to Rule
17g–3
Rule 17g–3 requires an NRSRO to
furnish audited annual financial
statements to the Commission,
including certain specified
schedules.263 The proposed amendment
to Rule 17g–3 would require an NRSRO
to furnish the Commission with an
additional annual report: An unaudited
report of the number of credit ratings
that were changed during the fiscal year
in each class of credit ratings for which
the NRSRO is registered with the
Commission. The Commission believes
that the annual costs to NRSROs to
comply with the proposed amendment
to Rule 17g–3 would be de minimis, as
the Commission preliminarily believes
that a credit rating agency already
would have this information with
respect to each class of credit ratings for
which it is registered. In addition, the
proposed amendment does not prescribe
a format for the report. Consequently,
the Commission estimates that proposed
Rule 17g–3(a)(6) would not have a
significant effect on the total average
annual cost burden currently estimated
for Rule 17g–3.
The Commission generally requests
comment on all aspects of these cost
estimates for the proposed amendment
to Rule 17g–3. In addition, the
Commission requests specific comment
on the following items related to these
cost estimates:
• Would this proposal impose costs
on other market participants, including
persons who use credit ratings to make
investment decisions or for regulatory
× 30 NRSROs = $3,000,000.
CFR 240.17g–3.
262 $100,000
263 17
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purposes, and persons who purchase
services and products from NRSROs?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
4. Proposed Amendments to Rule
17g–5
Rule 17g–5 requires an NRSRO to
manage and disclose certain conflicts of
interest.264 The proposed amendments
would add an additional conflict to
paragraph (b) of Rule 17g–5. This
proposed conflict of interest would be
issuing or maintaining a credit rating for
a security or money market instrument
issued by an asset pool or as part of an
asset-backed or mortgage-backed
securities transaction that was paid for
by the issuer, sponsor, or underwriter of
the security or money market
instrument.265 Unlike the other conflicts
of interest in paragraph (b) of Rule 17g–
5, NRSROs would be prohibited from
issuing a rating, unless certain
information about the transaction and
the assets underlying the structured
product being rated were disclosed,
pursuant to proposed Rule 17g–5(a)(3)(i)
and (ii).266
Specifically, proposed Rule 17g–
5(a)(3)(i) and (ii) would require the
disclosure of certain information about
the assets underlying a structured
product that is provided to an NRSRO
and used in determining an initial rating
and monitoring the rating. While the
proposed rule would require disclosure
of certain information, the rule would
not specify which party would disclose
the information. For purposes of this
PRA, the Commission estimates that it
would take a respondent approximately
300 hours to develop a system, as well
as policies and procedures to disclose
the information as required under the
proposed rule. This would result in a
total one-time hour burden of 60,000
hours for 200 respondents.267 For these
reasons, the Commission estimates that
the average one-time cost to each
respondent would be $65,850 268 and
264 17
CFR 240.17g–5.
proposed Rule 17g–5(b)(9). The current
paragraph (b)(9) would be renumbered as (b)(10).
266 See proposed Rule 17g–5(a)(3).
267 300 hours × 200 respondents = 60,000 hours.
268 The Commission estimates an NRSRO would
have a Compliance Manager and a Programmer
Analyst perform these responsibilities, and that
each would spend 50% of the estimated hours
performing these responsibilities. The SIFMA 2007
Report as Modified indicates that the average
hourly cost for a Compliance Manager is $245 and
the average hourly cost for a Programmer Analyst
is 194. Therefore, the average one-time cost to an
NRSRO would be $[150 hours × $245) + (150 hours
× $194)] = $65,850.
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265 See
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the total aggregate one-time cost to the
industry would be $13,116,000.269
As discussed with respect to the PRA,
in addition to the one-time hour burden,
respondents also would be required to
disclose the required information under
proposed Rule 17g–5(a)(3)(i) on a
transaction by transaction basis. Based
on staff information gained from the
NRSRO examination process, the
Commission estimates that the proposed
amendments would require each
respondent to disclose information with
respect to approximately 20 new
transactions per year and that it would
take approximately 1 hour per
transaction to make the information
publicly available.270 Therefore, as
discussed with respect to the PRA, the
Commission estimates that it would take
a respondent approximately 20 hours 271
to disclose this information under
proposed Rule 17g–5(a)(i) and (ii), on an
annual basis, for a total aggregate annual
hour burden of 4,000.272 For these
reasons, the Commission estimates that
the average annual cost to a respondent
would be $4,100 273 and the total annual
cost to the industry would be
$820,000.274
Proposed Rule 17g–5(a)(ii) would
require respondents to disclose
information provided to an NRSRO that
is used by an NRSRO in undertaking
credit rating surveillance on a
structured product. Because
surveillance would cover more than just
initial ratings, the Commission
estimates that a respondent would be
required to disclose information with
respect to approximately 125
transactions on an ongoing basis and
that the information would be provided
to the NRSRO on a monthly basis. As
discussed with respect to the PRA, the
Commission estimates that each
respondent would spend approximately
750 hours 275 on an annual basis
× 200 respondents = $13,116,000.
estimate assumes the respondent has
already implemented the system and policies and
procedures for disclosure. The Commission cannot
estimate the number of initial transactions per year
with certainty. The Commission believes that the
number of deals that each respondent will disclose
information on will vary widely based on the size
of the entity. In addition, the Commission
preliminarily believes that the number of assetbacked or mortgaged-backed issuances being rated
by NRSROs in the next few years would be difficult
to predict given the recent credit market turmoil.
271 20 transactions × 1 hour = 20 hours.
272 20 hours × 200 respondents = 4,000 hours.
273 The Commission estimates an NRSRO would
have a Webmaster perform these responsibilities.
The SIFMA 2007 Report as Modified indicates that
the average hourly cost for a Webmaster is $205.
Therefore, the average one-time cost to a respondent
would be 20 hours × $205 = $4,100.
274 $4,100 × 200 respondents = $820,000.
275 125 transactions × 30 minutes × 12 months =
45,000 minutes/60 minutes = 750 hours.
269 $65,580
270 This
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disclosing the information for a total
aggregate annual burden hours of
150,000 hours.276 For these reasons, the
Commission estimates that the average
annual cost to a respondent would be
$153,750 277 and the total annual cost to
the industry would be $30,750,000.278
The Commission is also proposing to
amend paragraph (c) to Rule 17g–5 to
add three additional prohibited conflicts
of interest.279 The Commission
estimates that the amendments to
paragraph (c) to Rule 17g–5 generally
would impose de minimis costs on an
NRSRO. However, the Commission
recognizes that an NRSRO may incur
costs related to training employees
about the requirements with respect to
these proposed amendments. It also is
possible that the proposed amendments
could require some NRSROs to
restructure their business models or
activities, in particular with respect to
their consulting services.
The Commission generally requests
comment on all aspects of these cost
estimates for the proposed amendments
to Rule 17g–5. In addition, the
Commission requests specific comment
on the following items related to these
cost estimates:
• Would the proposals for additional
disclosure impose costs on issuers,
underwriters, sponsors, depositors, or
trustees?
• Would these proposals impose costs
on other market participants, including
persons who use credit ratings to make
investment decisions or for regulatory
purposes, and persons who purchase
services and products from NRSROs?
• Would there be costs in addition to
those identified above, such as costs
arising from systems changes and
restructuring business practices to
account for the new reporting
requirement?
• Would the proposed amendments
to paragraph (c) of Rule 17g–5 impose
training and restructuring costs?
• Would the proposed amendments
to paragraph (c) of Rule 17g–5 impose
personnel costs?
• Would the proposed amendments
to paragraph (c) of Rule 17g–5 impose
any additional costs on an NRSRO that
is part of a large conglomerate related to
monitoring the business activities of
persons associated with the NRSRO,
such as affiliates located in other
hours × 200 respondents = 150,000 hours.
Commission estimates an NRSRO would
have a Webmaster perform these responsibilities.
The SIFMA 2007 Report as Modified indicates that
the average hourly cost for a Webmaster is $205.
Therefore, the average one-time cost to a respondent
would be 750 hours × 205 = $153,750.
278 $153,750 × 200 respondents = $30,750,000.
279 See proposed Rule 17g–5(c)(5)–(7).
276 750
277 The
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countries, to comply with the proposed
requirement?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
5. Proposed Rule 17g–7
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The Commission is proposing a new
rule—proposed Rule 17g–7—which
would require an NRSRO to attach a
report each time it publishes a credit
rating for a structured finance product
describing how the ratings procedures
and methodologies differ from those for
corporate debt.280 Alternatively, an
NRSRO would be permitted to use
rating symbols for structured finance
products that differentiate them from its
other credit ratings. The Commission
expects that most NRSROs already have
methodologies in place to determine
credit ratings for structured finance
products and corporate debt securities,
and disclosed such policies and
procedures if they have registered as an
NRSRO. The Commission expects,
however, that an NRSRO would have to
conform these disclosures into a report
to comply with the specific
requirements in the proposed rule. As
discussed above with respect to PRA,
the Commission estimates that it would
take approximately 50 hours for an
NRSRO to compile and write
disclosures to comply with the
proposed rule and that there would be
30 NRSROs. For these reasons, the
Commission estimates that the average
one-time cost to an NRSRO would be
$12,250 281 and the total aggregate onetime cost to the industry would be
$367,500.282
As discussed above with respect to
the PRA, the Commission also estimates
that it would take an NRSRO additional
time to attach the report to each credit
rating for a structured finance product
and to monitor the report on an ongoing
basis to ensure that the disclosure was
accurate. Based on staff experience staff
information gained from the NRSRO
examination process, the Commission
estimates that an NRSRO would spend
approximately 5 minutes to attach each
proposed report to the estimated
128,000 asset-backed credit ratings per
NRSRO, four times per year, as
discussed above, for a total of 42,667
280 See
proposed Rule 17g–3A.
Commission estimates an NRSRO would
have a Compliance Manager perform these
responsibilities. The SIFMA 2007 Report as
Modified indicates that the average hourly cost for
a Compliance Manager is $245. Therefore, the
average one-time cost to an NRSRO would be
$12,250 (50 hours × $245).
282 30 NRSROs × $12,250 = $367,500.
281 The
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annual burden hours 283 per respondent,
and a total of 1,280,010 annual burden
hours 284 for 30 NRSROs. For these
reasons, the Commission estimates that
the average annual cost to an NRSRO
would be $4,373,265 285 and the total
aggregate annual cost to the industry
would be $131,197,950.286
Finally, as discussed with respect to
the PRA, the Commission estimates,
based on staff experience, that it would
take an NRSRO approximately 10 hours
per year to review and update the report
to ensure the disclosure was accurate
and up-to-date for a total aggregate
annual hour burden to the industry of
300 hours.287 For these reasons, the
Commission estimates that the average
annual cost to an NRSRO would be
$2,700 288 and the total aggregate annual
cost to the industry would be
$81,000.289
The Commission generally requests
comment on all aspects of these cost
estimates for the proposed amendments
to Rule 17g–7. In addition, the
Commission requests specific comment
on the following items related to these
cost estimates:
• Would the use of different rating
symbols for structured products impact
automated securities trading, routing,
settlement, clearance, trade
confirmation, reporting, processing, and
risk management systems and any other
systems that are programmed to use
standard credit rating symbols across all
product classes?
• Would the use of different rating
symbols have consequences for
investment guidelines and covenants in
legal documents that use credit ratings
to distinguish finance instruments?
• Would these proposals impose costs
on other market participants, including
persons who use credit ratings to make
investment decisions or for regulatory
283 128,000 × 4 = 512,000 reports × 5 minutes per
report = 2,560,000 minutes/60 minutes per hour =
42,667 hours.
284 42,667 hours × 30 NRSROs = 1,280,010 hours.
285 The Commission estimates an NRSRO would
have a Webmaster perform these responsibilities.
The SIFMA 2007 Report as Modified indicates that
the average hourly cost for a Webmaster is $205.
Therefore, the average one-time cost to an NRSRO
would be $4,373,265 (21,333 hours × $205).
286 $4,373,265 × 30 NRSROs = $131,197,950.
287 This estimate is based on the number of hours
it would take an NRSRO to complete an annual
certification on Form NRSRO. See Exchange Act
Release No. 55857 (June 5, 2007), 72 FR 33564,
33609 (June 18, 2007). 10 hours × 30 NRSROs = 300
hours.
288 The Commission estimates an NRSRO would
have a Compliance Attorney perform these
responsibilities. The SIFMA 2007 Report as
Modified indicates that the average hourly cost for
a Compliance Attorney is $270. Therefore, the
average one-time cost to an NRSRO would be
$2,700 (10 hours × $270).
289 $2,700 × 30 NRSROs = $81,000.
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purposes, and persons who purchase
services and products from NRSROs?
• Would there be costs in addition to
those identified above, such as costs
arising from systems changes and
restructuring business practices to
account for the new reporting
requirement?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
C. Total Estimated Costs and Benefits of
This Rulemaking
As discussed above, the proposed
amendments and new rules are
expected to have both benefits and costs
for investors and the credit rating
industry as a whole. The Commission
believes the benefits to investors and
other users of credit ratings, especially
with respect to investments in
structured finance products would be
quite substantial, but are difficult to
quantify. Similarly difficult to quantify
are the expected benefits to the
Commission’s oversight over NRSROs
due to the enhanced recordkeeping,
disclosure and reporting requirements.
Moreover, not all the costs the
Commission anticipates would result
from this rulemaking are quantifiable.
Based on the figures discussed above,
however, the Commission estimates that
the first year quantifiable costs related
to this proposed rulemaking would be
approximately $180,175,810.290
VI. Consideration of Burden on
Competition and Promotion of
Efficiency, Competition, and Capital
Formation
Under Section 3(f) of the Exchange
Act,291 the Commission shall, when
engaging in rulemaking that requires the
Commission to consider or determine if
an action is necessary or appropriate in
the public interest, consider whether the
action will promote efficiency,
competition, and capital formation.
Section 23(a)(2) of the Exchange Act 292
requires the Commission to consider the
anticompetitive effects of any rules the
Commission adopts under the Exchange
Act. Section 23(a)(2) prohibits the
Commission from adopting any rule that
would impose a burden on competition
not necessary or appropriate in
furtherance of the purposes of the
Exchange Act. As discussed below, the
Commission’s preliminary view is that
the proposed amendments and new
290 $17,078,760 (total one-time costs) +
$163,097,810 (total annual costs) = $180,175,810.
291 15 U.S.C. 78c(f).
292 15 U.S.C. 78w(a)(2).
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rules should promote efficiency,
competition, and capital formation.
The proposed amendments to the
Instructions to Exhibit 1 to Form
NRSRO would require NRSROs to make
more comparable disclosures about the
performance of their credit ratings.
These could make it easier for an
NRSRO to demonstrate that it has a
superior ratings methodology or
competence and, thereby, attract clients.
In addition, the proposed amendments
to the instructions to Exhibit 2 are
designed to enhance the disclosures
NRSROs make with respect to their
methodologies for determining credit
ratings. The Commission believes these
enhanced disclosures would make it
easier for users of credit ratings to
compare the quality of the NRSRO’s
procedures and methodologies for
determining credit ratings. The greater
transparency that would result from all
these enhanced disclosures could make
it easier for market participants to select
the NRSROs that are performing best
and have the highest quality processes
for determining credit ratings. This
could increase competition and promote
capital formation by restoring
confidence in the credit ratings, which
are an integral part of the capital
formation process.
The proposed amendments to Rule
17g–2 are designed to enhance the
Commission’s oversight of NRSROs and,
with respect to the public disclosure of
ratings history, provide the marketplace
with the raw materials to develop
metrics for comparing the ratings
performance of NRSROs. Enhancing the
Commission’s oversight could help in
restoring confidence in credit ratings
and, thereby, promote capital formation.
Increased disclosure of ratings history
could make the ratings performance of
the NRSROs more transparent to the
marketplace and, thereby, highlight
those firms that do a better job analyzing
credit risk. This could benefit smaller
NRSROs to the extent they have
performed better than others by alerting
the market to their superior competence.
The proposed amendment to Rule
17g–3 is designed to enhance the
Commission’s oversight of NRSROs.
Enhancing the Commission’s oversight
could help in restoring confidence in
credit ratings and, thereby, promote
capital formation.
The proposed amendments to
paragraphs (a) and (b) of Rule 17g–5
would enhance the disclosures made
about assets underlying structured
finance products. The goal of these
proposals is to provide a mechanism for
NRSROs to determine unsolicited credit
ratings and other market participants
and observers to independently assess
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the creditworthiness of structured
finance products. This could expose
NRSROs whose procedures and
methodologies for determining credit
ratings are less conservative in order to
gain business. It also could mitigate the
impact of rating shopping, since
NRSROs not hired to rate a deal could
nonetheless issue a credit rating. These
potential impacts of the rule proposal
could help to restore confidence in
credit ratings and, thereby, promote
capital formation. Also, by creating a
mechanism for determining unsolicited
ratings, they could increase competition
by allowing smaller NRSROs to
demonstrate proficiency in rating
structured products.
The proposed amendments to
paragraph (c) of Rule 17g–5 would
prohibit NRSROs and their affiliates
from providing consulting or advisory
services, prohibit analysts from
participating in fee negotiations, and
prohibit credit analysts or persons
responsible for approving a credit rating
receiving gifts from the obligor being
rated, or from the issuer, underwriter, or
sponsor of the securities being rated,
other than items provided in the context
of normal business activities such as
meetings that have an aggregate value of
no more than $25. These proposals
could increase confidence in the
integrity of NRSROs and the credit
ratings they issue. This could help to
restore confidence in credit ratings and,
thereby, promote capital formation.
Proposed new Rule 17g–7 would
provide users of credit ratings with
useful information about structured
product ratings. This could help them in
assessing the risk of securities and
promote better informed investment
decisions. This could increase the
efficiency of the capital markets by
making structured finance ratings more
transparent.
The Commission generally requests
comment on all aspects of this analysis
of the burden on competition and
promotion of efficiency, competition,
and capital formation. In addition, the
Commission requests specific comment
on the following items related to this
analysis:
• Would the proposed amendments
have an adverse effect on efficiency,
competition, and capital formation that
is neither necessary nor appropriate in
furtherance of the purposes of the
Exchange Act?
Commenters should provide specific
data and analysis to support any
comments they submit with respect to
these burden estimates.
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VII. Consideration of Impact on the
Economy
For purposes of the Small Business
Regulatory Enforcement Fairness Act of
1996, or ‘‘SBREFA,’’ 293 the Commission
must advise OMB whether a proposed
regulation constitutes a major rule.
Under SBREFA, a rule is ‘‘major’’ if it
has resulted in, or is likely to result in:
• An annual effect on the economy of
$100 million or more;
• A major increase in costs or prices
for consumers or individual industries;
or
• A significant adverse effect on
competition, investment, or innovation.
If a rule is ‘‘major,’’ its effectiveness
will generally be delayed for 60 days
pending Congressional review. The
Commission requests comment on the
potential impact of each of the proposed
amendments on the economy on an
annual basis. Commenters are requested
to provide empirical data and other
factual support for their view to the
extent possible.
VIII. Initial Regulatory Flexibility
Analysis
The Commission has prepared the
following Initial Regulatory Flexibility
Analysis (‘‘IRFA’’), in accordance with
the provisions of the Regulatory
Flexibility Act,294 regarding proposed
amendments to Form NRSRO, Rule 17g–
2, Rule 17g–3, and Rule 17g–5 and
regarding proposed Rule 17g–7 under
the Exchange Act.
The Commission encourages
comments with respect to any aspect of
this IRFA, including comments with
respect to the number of small entities
that may be affected by the proposed
amendments. Comments should specify
the costs of compliance with the
proposed amendments and suggest
alternatives that would accomplish the
goals of the amendments. Comments
will be considered in determining
whether a Final Regulatory Flexibility
Analysis is required and will be placed
in the same public file as comments on
the proposed amendments. Comments
should be submitted to the Commission
at the addresses previously indicated.
A. Reasons for the Proposed Action
The proposed amendments would
prescribe additional requirements for
NRSROs to address concerns raised
about the role of credit rating agencies
in the recent credit market turmoil. The
proposed amendments are designed to
enhance and strengthen the rules the
293 Pub. L. 104–121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C.
and as a note to 5 U.S.C. 601).
294 5 U.S.C. 603.
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Commission adopted in 2007 to
implement specific provisions of the
Rating Agency Act.295 The Rating
Agency Act defines the term ‘‘nationally
recognized statistical rating
organization’’ as a credit rating agency
registered with the Commission,
provides authority for the Commission
to implement registration,
recordkeeping, financial reporting, and
oversight rules with respect to registered
NRSROs.
B. Objectives
The proposed amendments and new
rules would enhance and strengthen the
rules the Commission adopted in 2007
to implement specific provisions of the
Rating Agency Act. The objectives of the
Rating Agency Act are ‘‘to improve
ratings quality for the protection of
investors and in the public interest by
fostering accountability, transparency,
and competition in the credit rating
industry.’’ 296 The proposed
amendments and new rules are
designed to further enhance these
objectives and assist the Commission in
monitoring whether an NRSRO
complies with the provisions of the
Rating Agency Act and rules
thereunder, consistent with the
Commission’s statutory mandate to
adopt rules to implement the NRSRO
regulatory program, and provide
information regarding NRSROs to the
public and to users of credit ratings.
These proposed amendments would
also prescribe additional requirements
for NRSROs to address concerns raised
about the role of credit rating agencies
in the recent credit market turmoil,
including concerns with respect to the
determination of credit ratings for
structured finance products.
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C. Legal Basis
Pursuant to the Sections 3(b), 15E,
17(a), 23(a) and 36 of the Exchange
Act.297
D. Small Entities Subject to the Rule
Paragraph (a) of Rule 0–10 provides
that for purposes of the Regulatory
Flexibility Act, a small entity ‘‘[w]hen
used with reference to an ‘issuer’ or a
‘person’ other than an investment
company’’ means ‘‘an ‘issuer’ or ‘person’
that, on the last day of its most recent
fiscal year, had total assets of $5 million
or less.’’ 298 The Commission believes
that an NRSRO with total assets of $5
million or less would qualify as a
‘‘small’’ entity for purposes of the
Regulatory Flexibility Act.
As noted in the Adopting Release,299
the Commission believes that
approximately 30 credit rating agencies
ultimately would be registered as an
NRSRO. Of the approximately 30 credit
rating agencies estimated to be
registered with the Commission, the
Commission estimates that
approximately 20 may be ‘‘small’’
entities for purposes of the Regulatory
Flexibility Act.300
E. Reporting, Recordkeeping, and Other
Compliance Requirements
The proposals would amend Form
NRSRO to elicit certain additional
information regarding the performance
data for the credit ratings and the
methods used by a credit rating agency
for issuing credit ratings.301
The proposals would amend Rule
17g–2 to establish additional
recordkeeping requirements.302 The
proposed amendments would require an
NRSRO to make and retain two
additional records and retain a third
type of record. The records would be:
(1) A record of the rationale for any
material difference between the credit
rating implied by the model and the
final credit rating issued, if a
quantitative model is a substantial
component in the process of
determining a credit rating; 303 (2) a
record showing the history and dates of
all previous rating actions with respect
to each current credit rating; 304 and (3)
any complaints about the performance
of a credit analyst.305 These records
would assist the Commission, through
its examination process, in monitoring
whether the NRSRO continues to
maintain adequate financial and
managerial resources to consistently
produce credit ratings with integrity (as
required under the Rating Agency Act)
and whether the NRSRO was complying
with the provisions of the Exchange Act
including the provisions of the Rating
Agency Act, the rules adopted
thereunder, and the NRSRO’s disclosed
policies and procedures.
The proposals would amend Rule
17g–3 to require an NRSRO to furnish
the Commission with an additional
annual report: the number of
downgrades in each class of credit
ratings for which it is registered and the
description of the findings from an
299 Adopting
295 Pub.
L. 109–291 (2006); see also Exchange Act
Release No. 55857 (June 5, 2007), 72 FR 33564,
33609 (June 18, 2007).
296 See Senate Report.
297 15 U.S.C. 78c(b), 78o–7, 78q(a), and 78w.
298 17 CFR 240.0–10(a).
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Release, 72 FR at 33618.
17 CFR 240.0–10(a).
301 See proposed amendments to Form NRSRO.
302 See proposed amendments to Rule 17g–2.
303 Proposed paragraph (a)(2)(iii) of Rule 17g–2.
304 Proposed paragraph (a)(8) of Rule 17g–2.
305 Proposed paragraph (b)(8) of Rule 17g–2.
300 See
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36249
independent review.306 This
requirement is designed to assist the
Commission in its examination function
and to require an NRSRO to assess the
integrity of its rating process. It also is
designed to assist the Commission in
monitoring whether the NRSRO is
complying with provisions of the Rating
Agency Act and the rules adopted
thereunder.
The proposals would amend
paragraphs (a) and (b) of Rule 17g–5 to
prohibit an NRSRO from issuing a credit
rating for a structured product unless
certain information about the assets
underlying the product are disclosed.
The proposals would amend paragraph
(c) of Rule 17g–5 to prohibit NRSROs
and their affiliates from providing
consulting or advisory services, prohibit
analysts from participating in fee
negotiations, and prohibit credit
analysts or persons responsible for
approving a credit rating received gifts
from the obligor being rated, or from the
issuer, underwriter, or sponsor of the
securities being rated, other than items
provided in the context of normal
business activities such as meetings that
have an aggregate value of no more than
$25.307
The proposals would amend Rule
17g–7 to require an NRSRO to attach a
report each time it publishes a credit
rating for a structured finance product
describing how the ratings procedures
and methodologies and credit risk
characteristics for structured products
differ from those for other types of
obligors and debt securities. An NRSRO
could avoid having to attach the report
if it used ratings symbols for structured
products that differentiate them from its
other types of credit ratings.308
F. Duplicative, Overlapping, or
Conflicting Federal Rules
The Commission believes that there
are no federal rules that duplicate,
overlap, or conflict with the proposed
amendments or new rule.
G. Significant Alternatives
Pursuant to Section 3(a) of the
RFA,309 the Commission must consider
certain types of alternatives, including:
(1) The establishment of differing
compliance or reporting requirements or
timetables that take into account the
resources available to small entities; (2)
the clarification, consolidation, or
simplification of compliance and
reporting requirements under the rule
for small entities; (3) the use of
306 See
proposed amendment to Rule 17g–3.
proposed amendment to Rule 17g–5.
308 See proposed Rule 17g–7.
309 5 U.S.C. 603(c).
307 See
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performance rather than design
standards; and (4) an exemption from
coverage of the rule, or any part of the
rule, for small entities.
The Commission is considering
whether it is necessary or appropriate to
establish different compliance or
reporting requirements or timetables; or
clarify, consolidate, or simplify
compliance and reporting requirements
under the rule for small entities.
Because the proposed amendments and
proposed new rule are designed to
improve the overall quality of ratings
and enhance the Commission’s
oversight, the Commission is not
proposing to exempt small entities from
coverage of the rule, or any part of the
rule. The proposed amendments and
new rules allow NRSROs the flexibility
to develop procedures tailored to their
specific organizational structure and
business models. The Commission also
does not believe that it is necessary at
this time to consider whether small
entities should be permitted to use
performance rather than design
standards to comply with the proposed
amendments as the amendments already
propose performance standards and do
not dictate for entities of any size any
particular design standards that must be
employed to achieve the Act’s
objectives.
H. Request for Comments
The Commission encourages the
submission of comments to any aspect
of this portion of the IRFA. Comments
should specify costs of compliance with
the proposed amendments and suggest
alternatives that would accomplish the
objective of the proposed amendments
IX. Statutory Authority
The Commission is proposing
amendments to Form NRSRO and Rules
17g–2, 17g–3, and 17g–5 and is
proposing new rule 17g–7 pursuant to
the authority conferred by the Exchange
Act, including Sections 3(b), 15E, 17,
23(a) and 36.310
Text of Proposed Rules
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List of Subjects in 17 CFR Parts 240 and
249b
Brokers, Reporting and recordkeeping
requirements, Securities.
In accordance with the foregoing, the
Commission proposes to amend Title
17, Chapter II of the Code of Federal
Regulations as follows.
310 15
U.S.C. 78c(b), 78o–7, 78q, 78w, and 78mm.
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PART 240—GENERAL RULES AND
REGULATIONS, SECURITIES
EXCHANGE ACT OF 1934
1. The authority citation for part 240
continues to read in part as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j,
77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn,
77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j,
78j–1, 78k, 78k–1, 78l, 78m, 78n, 78o, 78p,
78q, 78s, 78u5, 78w, 78x, 78ll, 78mm, 80a–
20, 80a–23, 80a–29, 80a–37, 80b–3, 80b–4,
80b–11, and 7201 et seq.; and 18 U.S.C. 1350,
unless otherwise noted.
*
*
*
*
*
2. Section 240.17g–2 is amended by:
a. Removing paragraph (a)(2)(iv);
b. Redesignating paragraph (a)(2)(iii)
as paragraph (a)(2)(iv);
c. In newly redesignated paragraph
(a)(2)(iv), removing ‘‘; and’’ and in its
place adding a period;
d. Adding new paragraph (a)(2)(iii);
e. Adding paragraph (a)(8);
f. In paragraph (b)(7), revising the
phrase ‘‘maintaining, changing,’’ to read
‘‘maintaining, monitoring, changing,’’;
g. Redesignating paragraphs (b)(8),
(b)(9), and (b)(10) as paragraphs (b)(9),
(b)(10), and (b)(11), respectively;
h. Adding new paragraph (b)(8); and
i. In paragraph (d), adding a sentence
to the end of the paragraph.
The additions read as follows:
§ 240.17g–2 Records to be made and
retained by nationally recognized statistical
rating organizations.
(a) * * *
(2) * * *
(iii) If a quantitative model was a
substantial component in the process of
determining the credit rating, a record of
the rationale for any material difference
between the credit rating implied by the
model and the final credit rating issued;
and
*
*
*
*
*
(8) A record showing 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.
(b) * * *
(8) Any communications that contain
complaints about the performance of a
credit analyst in initiating, determining,
maintaining, monitoring, changing, or
withdrawing a credit rating.
*
*
*
*
*
(d) * * * In addition, the records
required to be retained pursuant to
paragraph (a)(8) of this section must be
made publicly available on the
corporate Web site of the NRSRO in an
XBRL Interactive Data File that uses a
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machine-readable computer code that
presents information in eXtensible
Business Reporting Language in
electronic format no later than six
months after the date of the rating
action.
*
*
*
*
*
3. Section 240.17g–3 is amended by:
a. Adding paragraph (a)(6); and
b. Revising paragraph (b).
The additions and revision read as
follows:
§ 240.17g–3 Annual financial reports to be
furnished by nationally recognized
statistical rating organizations.
(a) * * *
(6) The number of credit ratings
actions taken during the fiscal year in
each class of credit ratings identified in
section 3(a)(62)(B) of the Act (15 U.S.C.
78c(a)(62)(B)) for which the nationally
recognized statistical rating organization
is registered with the Commission.
Note to paragraph (a)(6): A nationally
recognized statistical rating organization
registered in the class of credit ratings
described in section 3(a)(62)(B)(iv) of the Act
(15 U.S.C. 78c(a)(62)(B)(iv)) must include
credit ratings actions taken on credit ratings
of any security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed securities
transaction for purposes of reporting the
number of credit ratings actions in this class.
(b) The nationally recognized
statistical rating organization must
attach to the financial reports furnished
pursuant to paragraphs (a)(1) through
(a)(6) of this section a signed statement
by a duly authorized person associated
with the nationally recognized
statistical rating organization stating
that the person has responsibility for the
financial reports and, to the best
knowledge of the person, the financial
reports fairly present, in all material
respects, the financial condition, results
of operations, cash flows, revenues,
analyst compensation, and credit rating
actions of the nationally recognized
statistical rating organization for the
period presented.
*
*
*
*
*
4. Section 240.17g–5 is amended by:
a. Removing the word ‘‘and’’ at the
end of paragraph (a)(1);
b. Removing the period at the end of
paragraph (a)(2) and in its place adding
‘‘; and’’;
c. Adding paragraph (a)(3);
d. Redesignating paragraph (b)(9) as
paragraph (b)(10);
e. Adding new paragraph (b)(9);
f. Removing the word ‘‘or’’ at the end
of paragraph (c)(3);
g. Removing the period at the end of
paragraph (c)(4) and in its place adding
a semi-colon; and
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h. Adding paragraphs (c)(5), (c)(6),
and (c)(7).
The additions read as follows:
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§ 240.17g–5
Conflicts of interest.
(a) * * *
(3) In the case of the conflict of
interest identified in paragraph (b)(9) of
this section, the following information
is disclosed through a means designed
to provide reasonably broad
dissemination:
(i) (A) All information provided to the
nationally recognized statistical rating
organization by the issuer, underwriter,
sponsor, depositor, or trustee that is
used in determining the initial credit
rating for the security or money market
instrument, including information about
the characteristics of the assets
underlying or referenced by the security
or money market instrument, and the
legal structure of the security or money
market instrument, with such
information to disclosed publicly in an
offering registered under the Securities
Act of 1933 (15 U.S.C. 77a et seq.) on
the date the underwriter and the issuer
or depositor set the offering price of the
securities being rated;
(B) In offerings that are not registered
under the Securities Act of 1933 (15
U.S.C. 77a et seq.), the information in
paragraph (a)(3)(i)(A) of this section
must be disclosed to investors and
credit rating agencies on the date the
underwriter and the issuer or depositor
set the offering price of the securities
being rated, and disclosed publicly on
the first business day after the
transaction closes; and
(ii) All information provided to the
nationally recognized statistical rating
organization by the issuer, underwriter,
sponsor, depositor, or trustee that is
used by the nationally recognized
statistical rating organization in
undertaking credit rating surveillance
on the security or money market
instrument, including information about
the characteristics and performance of
the assets underlying or referenced by
the security or money market
instrument, with such information to be
disclosed publicly at the time such
information is provided to the
nationally recognized statistical rating
organization.
(b) * * *
(9) Issuing or maintaining a credit
rating for a security or money market
instrument issued by an asset pool or as
part of any asset-backed or mortgagebacked securities transaction that was
paid for by the issuer, sponsor, or
underwriter of the security or money
market instrument.
*
*
*
*
*
(c) * * *
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(5) The nationally recognized
statistical rating organization issues or
maintains a credit rating with respect to
an obligor or security where the
nationally recognized statistical rating
organization or a person associated with
the nationally recognized statistical
rating organization made
recommendations to the obligor or the
issuer, underwriter, or sponsor of the
security about the corporate or legal
structure, assets, liabilities, or activities
of the obligor or issuer of the security;
(6) The nationally recognized
statistical rating organization issues or
maintains a credit rating where the fee
paid for the rating was negotiated,
discussed, or arranged by a person
within the nationally recognized
statistical rating organization 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; or
(7) The nationally recognized
statistical rating organization issues or
maintains a credit rating where a credit
analyst who participated in determining
or monitoring the credit rating, or a
person responsible for approving the
credit rating received gifts, including
entertainment, from the obligor being
rated, or from the issuer, underwriter, or
sponsor of the securities being rated,
other than items provided in the context
of normal business activities such as
meetings that have an aggregate value of
no more than $25.
*
*
*
*
*
5. Section 240.17g–7 is added to read
as follows:
§ 240.17g–7 Credit rating reports to be
furnished by nationally recognized
statistical rating organizations.
(a) A nationally recognized statistical
rating organization must attach a report
each time it publishes a credit rating for
a security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction that describes the
rating methodology used to determine
such credit rating and how it differs
from the determination of ratings for
any other type of obligor or debt
security and how the credit risk
characteristics associated with a
security or money market instrument
issued by an asset pool or as part of any
asset-backed or mortgage-backed
securities transaction differ from those
of any other type of obligor or debt
security.
(b) Exemption from attaching report.
A nationally recognized statistical rating
organization is not required to attach the
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36251
report each time it publishes a credit
rating as prescribed by paragraph (a) of
this section if the credit rating symbol
used by the nationally recognized
statistical rating organization to indicate
the credit rating identifies the credit
rating as relating to a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
as distinct from a credit rating for any
other type of obligor or debt security.
PART 249b—FURTHER FORMS,
SECURITIES EXCHANGE ACT OF 1934
6. The authority citation for part 249b
continues to read in part as follows:
Authority: 15 U.S.C. 78a et seq., unless
otherwise noted;
*
*
*
*
*
7. Form NRSRO (referenced in
§ 249b.300) is amended by revising
Exhibits 1 and 2 in section H, Item 9 of
the Form NRSRO Instructions to read as
follows:
Note: The text of Form NRSRO and this
amendment does not appear in the Code of
Federal Regulations.
Form NRSRO
*
*
*
*
*
Form NRSRO Instructions
*
*
*
*
*
H. Instructions for Specific Line Items
*
*
*
*
*
Item 9. Exhibits. * * *
Exhibit 1. Provide in this Exhibit
performance measurement statistics of
the credit ratings of the Applicant/
NRSRO, including performance
measurement statistics of the credit
ratings seperately for each class of credit
rating for which the Applicant/NRSRO
is seeking registration or is registered (as
indicated in Item 6 and/or 7 of Form
NRSRO) and any other broad class of
credit rating issued by the Applicant/
NRSRO. For the purposes of this
Exhibit, an Applicant/NRSRO registered
in the class of credit ratings described
in Section 3(a)(62)(B)(iv) of the Act (15
U.S.C. 78c(a)(62)(B)(iv)) must include
credit ratings of any security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
for purposes of reporting the
performance measurement statistics for
this class. The performance
measurement 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
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hsrobinson on PROD1PC76 with PROPOSALS2
and default rates within each of the
credit rating categories, notches, grades,
or rankings used by the Applicant/
NRSRO as an indicator of the
assessment of the creditworthiness of an
obligor, security, or money market
instrument in each class of credit rating.
The default statistics must include
defaults relative to the initial rating and
must incorporate defaults that occur
after a credit rating is withdrawn. As
part of this Exhibit, define the credit
rating categories, notches, grades, and
rankings used by the Applicant/NRSRO
and explain the performance
measurement statistics, including the
inputs, time horizons, and metrics used
to determine the statistics. Also provide
in this Exhibit the Web site address
where the records of credit rating
actions required under 17 CFR 240.17g–
2(a)(8) are, or will be, made publicly
available in an XBRL Interactive Data
File pursuant to the requirements of 17
CFR 240.17g–2(d).
Exhibit 2. Provide in this Exhibit a
general description of the procedures
and methodologies used by the
Applicant/NRSRO to determine credit
ratings, including unsolicited credit
ratings within the classes of credit
ratings for which the Applicant/NRSRO
is seeking registration or is registered.
The description must be sufficiently
detailed to provide users of credit
ratings with an understanding of the
processes employed by the Applicant/
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NRSRO in determining credit ratings,
including, as applicable, descriptions of:
policies for determining whether to
initiate a credit rating; a description of
the public and non-public sources of
information used in determining credit
ratings, including information and
analysis provided by third-party
vendors; whether and, if so, how
information about verification
performed on assets underlying or
referenced by a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
is relied on in determining credit
ratings; the quantitative and qualitative
models and metrics used to determine
credit ratings, including whether and, if
so, how assessments of the quality of
originators of assets underlying or
referenced by a security or money
market instrument issued by an asset
pool or as part of any asset-backed or
mortgage-backed securities transaction
factor into the determination of credit
ratings; the methodologies by which
credit ratings of other credit rating
agencies are treated to determine credit
ratings for securities or money market
instruments issued by an asset pool or
as part of any asset-backed or
mortgaged-backed securities transaction;
the procedures for interacting with the
management of a rated obligor or issuer
of rated securities or money market
instruments; the structure and voting
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process of committees that review or
approve credit ratings; procedures for
informing rated obligors or issuers of
rated securities or money market
instruments about credit rating
decisions and for appeals of final or
pending credit rating decisions;
procedures for monitoring, reviewing,
and updating credit ratings, including
how frequently credit ratings are
reviewed, whether different models or
criteria are used for ratings surveillance
than for determining initial ratings,
whether changes made to models and
criteria for determining initial ratings
are applied retroactively to existing
ratings, and whether changes made to
models and criteria for performing
ratings surveillance are incorporated
into the models and criteria for
determining initial ratings; and
procedures to withdraw, or suspend the
maintenance of, a credit rating. An
Applicant/NRSRO may provide in
Exhibit 2 the location on its Web site
where additional information about the
procedures and methodologies is
located.
*
*
*
*
*
Dated: June 16, 2008.
By the Commission.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. E8–13887 Filed 6–24–08; 8:45 am]
BILLING CODE 8010–01–P
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]]>Agencies
[Federal Register Volume 73, Number 123 (Wednesday, June 25, 2008)]
[Proposed Rules]
[Pages 36212-36252]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-13887]
[[Page 36211]]
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Part III
Securities and Exchange Commission
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17 CFR Parts 240 and 249b
Proposed Rules for Nationally Recognized Statistical Rating
Organizations; Proposed Rule
Federal Register / Vol. 73, No. 123 / Wednesday, June 25, 2008 /
Proposed Rules
[[Page 36212]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 249b
[Release No. 34-57967; File No. S7-13-08]
RIN 3235-AK14
Proposed Rules for Nationally Recognized Statistical Rating
Organizations
AGENCY: Securities and Exchange Commission (``Commission'').
ACTION: Proposed rule.
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SUMMARY: In the first of three related actions the Commission is
proposing rule amendments that would impose additional requirements on
nationally recognized statistical rating organizations (``NRSROs'') in
order to address concerns about the integrity of their credit rating
procedures and methodologies in the light of the role they played in
determining credit ratings for securities collateralized by or linked
to subprime residential mortgages. Second, the Commission also makes a
proposal related to structured finance products rating symbology. And
third, in the near future, the Commission intends to propose rule
amendments that would be intended to reduce undue reliance in the
Commission's rules on NRSRO ratings.
DATES: Comments should be received on or before July 25, 2008.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (https://
www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-13-08 on the subject line; or
Use the Federal eRulemaking Portal (https://
www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-13-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (https://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at (202) 551-5525; Thomas K. McGowan, Assistant Director, at
(202) 551-5521; Randall W. Roy, Branch Chief, at (202) 551-5522; Joseph
I. Levinson, Attorney, at (202) 551-5598; Carrie A. O'Brien, Attorney,
at (202) 551-5640; Sheila D. Swartz, Special Counsel, at (202) 551-
5545; Rose Russo Wells, Special Counsel, at (202) 551-5527; Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-6628 or, with respect to questions involving
the proposed amendments as they implicate the Securities Act of 1933,
Kathy Hsu, Special Counsel, at (202) 551-3306 or Eduardo Aleman,
Special Counsel, at (202) 551-3646; Division of Corporation Finance,
Securities and Exchange Commission, 100 F Street, NE, Washington, DC
20549-3628.
SUPPLEMENTARY INFORMATION:
I. Background
A. Introduction
Beginning in the early 2000s, originators started to increasingly
make residential mortgage loans based on lower underwriting standards
(``subprime loans'').\1\ For the first few years there did not appear
to be any negative repercussions from this lending practice. However,
beginning in mid-2006, home values leveled off and soon began to
decline, which, in turn, led to a corresponding increase in
delinquencies and, ultimately, defaults in subprime loans.\2\ This
marked increase in subprime loan delinquencies and, ultimately, in
defaults has had substantial adverse effects on the markets for, and
market values and liquidity of, residential mortgage-backed securities
(``RMBS'') backed by subprime loans and on collateralized debt
obligations (``CDOs'') linked to such loans (collectively ``subprime
RMBS and CDOs'').\3\
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\1\ There is no standard definition of a subprime loan. However,
such a loan can broadly be described as a mortgage loan that does
not conform to the underwriting standards required for sale to the
government sponsored enterprises (non-conforming loans) and are made
to borrowers who: (1) Have weakened credit histories such as payment
delinquencies, charge-offs, judgments, and bankruptcies; (2) have
reduced repayment capacity as measured by credit scores (e.g.,
FICO), debt-to-income ratios, loan-to-value rations, or other
criteria; (3) have not provided documentation to verify all or some
of the information, particularly financial information, in their
loan applications; or (4) have any combination of these factors.
Non-conforming loans made to less risky borrowers fall into two
other classifications: jumbo and Alt-A.
\2\ See e.g., Testimony of John C. Dugan, Comptroller of the
Currency, before the U.S. Senate Committee on Banking, Housing, and
Urban Affairs (March 4, 2008) (``Dugan March 4, 2008 Senate
Testimony''), pp. 8-12; Statement of Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation, before U.S. Senate Committee
on Banking, Housing, and Urban Affairs (March 4, 2008) (``Bair March
4, 2008 Senate Statement''), pp. 5-6.
\3\ See e.g., Dugan March 4, 2008 Senate Testimony, pp. 12-14;
Bair March 4, 2008 Senate Statement, pp. 6-7.
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Moreover, the impacts from the troubles experienced by subprime
loans extended beyond subprime RMBS and CDOs to the broader credit
markets and the economy as a whole.\4\ As a result, the parties that
participated in various parts of the process of making subprime loans,
packaging them into subprime RMBS and CDOs, and selling these debt
instruments, including mortgage brokers, loan originators, securities
sponsors and underwriters, and NRSROs have come under intense scrutiny.
Today, the Commission is proposing a series of new requirements that
are designed to address concerns that have been raised about NRSROs in
light of the role they played in this process. Additionally, two weeks
from today, the Commission will complete its proposal of this series of
rule changes. These changes would be intended to reduce undue reliance
in the Commission's rules on NRSRO ratings, thereby promoting increased
investor due diligence.
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\4\ See e.g., Statement of Ben S. Bernanke, Chairman, Board of
Governors of the Federal Reserve System, before the U.S. Senate
Committee on Banking, Housing, and Urban Affairs (February 28, 2008)
(``Bernanke February 28, 2008 Senate Statement''), pp. 1-3; Dugan
March 4, 2008 Senate Testimony, pp. 12-15.
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B. The Credit Rating Agency Reform Act of 2006
The purpose of the Credit Rating Agency Reform Act of 2006 (the
``Rating Agency Act''), enacted on September 29, 2006, is to ``improve
ratings quality for the protection of investors and in the public
interest by fostering accountability, transparency, and competition in
the credit rating industry.'' \5\ The operative provisions of the
Rating Agency Act became applicable upon the Commission's
[[Page 36213]]
adoption in June 2007 of a series of rules implementing a registration
and oversight program for credit rating agencies that register as
NRSROs.\6\
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\5\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs to Accompany S. 3850, Credit Rating Agency Reform Act
of 2006, S. Report No. 109-326, 109th Cong., 2d Sess. (Sept. 6,
2006) (``Senate Report''), p. 1.
\6\ See Oversight of Credit Rating Agencies Registered as
Nationally Recognized Statistical Rating Organizations, Securities
Exchange Act of 1934 (``Exchange Act'') Release No. 55857 (June 5,
2007), 72 FR 33564 (June 18, 2007) (``Adopting Release''). The rules
adopted by the Commission prescribe: how a credit rating agency must
apply to the Commission for registration as an NRSRO (Rule 17g-1 (17
CFR 240.17g-1)); the form of the application and the information
that must be provided in the application (Form NRSRO and the
Instructions to Form NRSRO (17 CFR 240.249b.300)); the records an
NRSRO must make and maintain (Rule 17g-2 (17 CFR 240.17g-2)); the
reports an NRSRO must furnish to the Commission annually (Rule 17g-3
(17 CFR 240.17g-3)); the areas that must be addressed in an NRSRO's
procedures to prevent the misuse of material nonpublic information
(Rule 17g-4 (17 CFR 240.17g-4)); the types of conflicts of interest
an NRSRO must disclose and manage or is prohibited from having (Rule
17g-5 (17 CFR 240.17g-5)); and certain unfair, coercive, or abusive
practices an NRSRO is prohibited from engaging in (Rule 17g-6 (17
CFR 240.17g-6)).
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To date, a total of nine credit rating agencies have been granted
registration with the Commission as NRSROs pursuant to the Rating
Agency Act and the rules thereunder.\7\ These registrants include the
credit rating agencies most active in rating subprime RMBS and CDOs:
Fitch Ratings, Inc. (``Fitch''), Moody's Investors Service
(``Moody's''), and Standard and Poor's Rating Services (``S&P'').\8\ In
the fall of 2007, the Commission, exercising the new authority
conferred by the Rating Agency Act, began a staff examination of the
NRSROs' activities in rating subprime RMBS and CDOs in order to review
whether they adhered to their stated and documented procedures and
methodologies for rating these debt instruments and the extent, if any,
to which their ratings may have been impaired by conflicts of
interest.\9\
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\7\ See Commission Orders granting registration of A.M. Best
Company, Inc. (34-56507, September 24, 2007), DBRS Ltd. (34-56508,
September 24, 2007), Fitch, Inc. (34-56509, September 24, 2007),
Japan Credit Rating Agency, Ltd, (34-56510, September 24, 2007),
Moody's Investor Services, Inc. (34-56511, September 24, 2007),
Rating and Investment Information, Inc. (34-56512, September 24,
2007), Standard & Poor's Rating Services (34-56513, September 24,
2007), Egan-Jones Rating Company (34-57031, December 21, 2007) and
LACE Financial Corp. (34-57300, February 11, 2008).
\8\ According to their most recent Annual Certifications on Form
NRSRO, S&P rates 197,700 issuers of asset-backed securities, the
category that includes RMBS, Moody's rates 110,000 such issuers, and
Fitch rates 75,278 such issuers. No other registered NRSRO reports
rating more than 1,000 issuers of asset-backed securities. See
Standard & Poor's 2007 Annual Certification on Form NRSRO, available
at https://www.standardandpoors.com; Moody's Investor Services 2007
Annual Certification on Form NRSRO, available at https://
www.moodys.com; Fitch, Inc. 2007 Annual Certification on Form NRSRO,
available at https://www.fitchratings.com.
\9\ See Testimony of Christopher Cox, Chairman, Commission,
before the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (April 22, 2008) (``Cox April 22, 2008 Senate Testimony''),
pp. 2-3.
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In addition to the examination, the Commission has worked closely
with other regulators and supervisors of the financial markets in
analyzing the credit market turmoil and in developing recommendations
and principles for market participants, including NRSROs.\10\ For
example, the President's Working Group on Financial Markets issued a
Policy Statement on Financial Market Developments in March 2008.\11\
Further, as a member of the International Organization of Securities
Commissions (``IOSCO''), the Commission played a substantial role in
drafting The Role of Credit Rating Agencies in Structured Finance
Markets, which was issued for consultation by IOSCO in March 2008.\12\
Also, the Commission, as part of its participation in the Financial
Stability Forum, worked with its counterparts in the U.S. and abroad on
The Report of the Financial Stability Forum on Enhancing Market and
Institutional Resilience released in April 2008, which discussed credit
rating agencies.\13\
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\10\ See Id, p. 4.
\11\ A copy of the policy statement is available at: https://
www.ustreas.gov.
\12\ A copy of the report is available at: https://www.iosco.org.
\13\ A copy of the report is available at: https://
www.fsforum.org.
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These and other efforts have assisted the Commission in identifying
a number of areas in which its current NRSRO rules could be augmented
to address concerns about the role NRSROs played in the credit market
turmoil.\14\ As a result, the Commission is proposing amendments to its
existing NRSRO rules and a new rule with the goal of improving the
quality of credit ratings determined by NRSROs generally and, in
particular, for structured finance products such as RMBS and CDOs.\15\
These proposals and the proposals to be considered in two weeks are
designed to:
---------------------------------------------------------------------------
\14\ See Cox April 22, 2008 Senate Testimony, pp. 6-8.
\15\ The term ``structured finance product'' as used throughout
this release refers broadly to any security or money market
instrument issued by an asset pool or as part of any asset-backed or
mortgage-backed securities transaction. This broad category of
financial instrument includes, but is not limited to, asset-backed
securities (``ABS'') such as RMBS and to other types of structured
debt instruments such as CDOs, including synthetic and hybrid CDOs.
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Enhance the disclosure and comparability of credit ratings
performance statistics;
Increase the disclosure of information about structured
finance products;
Require more information about the procedures and
methodologies used to determine credit ratings for structured finance
products;
Strengthen internal control processes through reporting
requirements; and
Address conflicts of interest arising from the process of
rating structured finance products; and
Reduce undue reliance in the Commission's rules on NRSRO
ratings, thereby promoting increased investor due diligence.
The Commission believes these proposals would further the purpose
of the Rating Agency Act to improve the quality of NRSRO credit ratings
by fostering accountability, transparency, and competition in the
credit rating industry.\16\
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\16\ See Senate Report, p. 2.
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C. The Role of Credit Ratings in the Credit Market Turmoil
The growth in the origination of subprime loans began in the early
2000s.\17\ For example, Moody's reports that subprime loans amounted to
$421 billion of the $3.038 trillion in mortgages originated in 2002
(14%) and $640 billion of the $2.886 trillion in mortgages originated
in 2006 (22%).\18\ This growth was facilitated by steadily rising home
values and a low interest rate environment.\19\ In addition, increases
in the breadth of the credit risk transfer markets as a result of new
investors willing to purchase credit based structured finance products
provided an opportunity for lenders to originate subprime loans and
then move them off their balance sheets by packaging and selling them
through the securitization process to investors as subprime RMBS and
CDOs.\20\ The investors in subprime RMBS and CDOs included domestic and
foreign mutual funds, pension funds, hedge funds, banks, insurance
companies, special investment vehicles, and state government operated
funds.
---------------------------------------------------------------------------
\17\ See e.g., Statement of Sheila C. Bair, Chairman, Federal
Deposit Insurance Corporation, before U.S. Senate Committee on
Banking, Housing, and Urban Affairs (January 31, 2008) (``Bair
January 31, 2008 Senate Statement''), p. 4.
\18\ According to Moody's, subprime mortgage loans represented
$421 billion of $3.038 trillion total mortgage origination in 2002
and $640 billion of $2.886 trillion total mortgage origination in
2006. See A Short Guide to Subprime, Moody's, March 25, 2008, p. 1.
\19\ See e.g., Dugan March 4, 2008 Senate Testimony, pp. 8-11.
\20\ Id.
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This ``originate to distribute'' business model created demand for
residential
[[Page 36214]]
mortgage loans, including subprime loans. For example, according to
Moody's, of the approximately $2.5 trillion worth of mortgage loans
originated in 2006, $1.9 trillion were securitized into RMBS and
approximately 25%, or $520 billion worth, of these loans were
categorized as subprime.\21\ The demands of the loan securitization
markets encouraged lenders to lower underwriting standards to maintain
a steady volume of loans and to use less traditional products such as
adjustable rate, negative amortization, and closed-end second lien
mortgages.\22\
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\21\ Subprime Residential Mortgage Securitizations: Frequently
Asked Questions, Moody's, April 19, 2007, p. 1.
\22\ See e.g., Bernanke February 28, 2008 Senate Testimony, p.
1; Dugan March 4, 2008 Senate Testimony, pp. 8-10.
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1. The Creation of Subprime RMBS and CDOs
The creation of an RMBS begins by packaging a pool of mortgage
loans, usually numbering in the thousands, and transferring them to a
bankruptcy remote trust. The trust purchases the loan pool and becomes
entitled to the interest and principal payments made by the borrowers.
The trust finances the purchase of the loan pool through the issuance
of RMBS. The monthly interest and principal payments from the loan pool
are used to make monthly interest and principal payments to the
investors in the RMBS.
The trust typically issues different classes of RMBS (known as
``tranches'') offering a sliding scale of coupon rates based on the
level of credit protection afforded to the security. Credit protection
is designed to shield the tranche securities from loss of interest and
principal arising from defaults of the loans backing the RMBS. The
degree of credit protection afforded a tranche security is known as its
``credit enhancement'' and is provided through several means. The
primary source of credit enhancement is subordination, which creates a
hierarchy of loss absorption among the tranche securities. For example,
if a trust issued securities in 10 different tranches of securities,
the first (or senior) tranche would have nine subordinate tranches, the
next highest tranche would have eight subordinate tranches and so on
down the capital structure. Losses of interest and principal
experienced by the trust from delinquencies and defaults among loans in
the pool are allocated first to the lowest tranche until its principal
amount is exhausted and then to the next lowest tranche and so on up
the capital structure. Consequently, the senior tranche would not incur
any loss until the principal amounts from all the lower tranches have
been exhausted through the absorption of losses from the underlying
loans.
A second form of credit enhancement is over-collateralization,
which is the amount that the principal balance of the mortgage pool
underlying the trust exceeds the principal balance of the tranche
securities issued by the trust. This excess principal creates an
additional ``equity'' tranche below the lowest tranche security to
absorb losses. In the example above, the equity tranche would sit below
the 10th tranche security and protect it from the first losses
experienced as a result of defaulting loans.
A third form of credit enhancement is excess spread, which consists
of the amount by which the interest derived from the underlying loans
in the aggregate exceeds interest payments due to investors in the
tranche securities in the aggregate plus the administrative expenses of
the trust such as fees due the loan servicer as well as premiums due on
derivatives contracts and bond insurance. In other words, the excess
spread is the amount that the monthly interest income from the pool of
loans exceeds the weighted average interest due to the RMBS
bondholders. This excess spread can be used to build up loss reserves
or pay off delinquent interest payments due to a tranche security.
A fourth form of credit enhancement sometimes employed is bond
insurance. When used, bond insurance is typically purchased only for
the senior RMBS tranche.
The creation of a typical CDO is similar to that of an RMBS. A
bankruptcy remote trust is created to hold the CDO's assets and issue
its securities. The underlying assets, however, are generally debt
securities rather than mortgage loans. The CDO trust uses the interest
and principal payments from the approximately 200 underlying debt
securities to make interest and principal payments to investors in the
securities issued by the trust. The trust is structured to provide
differing levels of credit enhancement to the securities it issues.
Similar to RMBS, credit enhancement is provided through subordination,
over-collateralization, excess spread, and bond insurance. In addition
to the underlying assets, one significant difference between a CDO and
an RMBS is that the CDO may be actively managed such that its
underlying assets change over time, whereas the mortgage loan pool
underlying an RMBS remains static for the most part.
In recent years, CDOs have been some of the largest purchasers of
subprime RMBS and the drivers of demand for those securities. For
example, according to Fitch, the average percentage of subprime RMBS in
the collateral pools of CDOs it rated grew from 43.3% in 2003 to 71.3%
in 2006.\23\ Generally, the CDOs holding subprime RMBS issued fell into
one of two categories: High grade and mezzanine. High grade CDOs are
generally defined as those that hold RMBS tranches with AAA, AA, or A
credit ratings, whereas mezzanine CDOs are those that hold RMBS
tranches rated predominantly BBB. Securities issued by mezzanine CDOs
pay higher yields than those issued by high grade CDOs since the BBB-
rated RMBS underlying the mezzanine CDOs pay higher yields than the AAA
to A rated RMBS underlying high grade CDOs. In addition to CDOs holding
subprime RMBS, a market for CDOs holding other CDOs that held subprime
RMBS developed in recent years. These debt instruments are known as
``CDOs-squared.''
---------------------------------------------------------------------------
\23\ Rating Stability of Fitch-Rated Global Cash Mezzanine
Structured Finance CDOs with Exposure to U.S. Subprime RMBS, Fitch,
April 2, 2007, p. 1.
---------------------------------------------------------------------------
As the market for mortgage related CDOs grew, CDO issuers began to
use credit default swaps to replicate the performance of subprime RMBS
and CDOs. In this case, rather than purchasing subprime RMBS or CDOs,
the CDO entered into credit default swaps referencing subprime RMBS or
CDOs, or indexes on RMBS. These CDOs, in some cases, are composed
entirely of credit default swaps (``synthetic CDOs'') or a combination
of credit default swaps and cash RMBS (``hybrid CDOs''). The use of
credit default swaps allowed the CDO securities to be issued more
quickly, since the issuer did not have to wait to accumulate actual
RMBS for the underlying collateral pool.
2. Determining Credit Ratings for Subprime RMBS and CDOs
A key step in the process of creating and ultimately selling a
subprime RMBS and CDO is the issuance of a credit rating for each of
the tranches issued by the trust (with the exception of the most junior
``equity'' tranche). The credit rating for each rated tranche indicated
the credit rating agency's view as to the creditworthiness of the debt
instrument in terms of the likelihood that the issuer would default on
its obligations to make interest and principal payments on the debt
instrument.\24\ To varying degrees,
[[Page 36215]]
many investors rely on credit ratings in making the decision to
purchase subprime RMBS or CDOs, particularly with respect to the senior
AAA rated tranches. Some investors use the credit ratings to assess the
risk of the debt instruments. In part, this may be due to the large
number of debt instruments in the market and their complexity. Other
investors use credit ratings to satisfy client investment mandates
regarding the types of securities they can invest in or to satisfy
regulatory requirements based on certain levels of credit ratings, or a
combination of these conditions. Moreover, investors typically only
have looked to ratings issued by Fitch, Moody's, and S&P, which causes
the arrangers \25\ of the subprime RMBS and CDOs to use these three
NRSROs to obtain credit ratings for the tranche securities they brought
to market.
---------------------------------------------------------------------------
\24\ See, e.g., Inside the Ratings: What Credit Ratings Mean,
Fitch, August 2007 (``Inside the Ratings''), p. 2; Testimony of
Michael Kanef, Group Managing Director, Moody's Investors Service,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (September 26, 2007) (``Kanef September 26, 2007
Senate Testimony''), p. 2; Principles-Based Rating Methodology For
Global Structured Finance Securities, S&P, May 29, 2007, p. 3. Since
credit ratings are issued for tranches of RMBS and CDOs
individually, rather than for the issuers of those tranches, the
NRSRO credit ratings are estimates of the probability of default of
each RMBS or CDO tranche as an independent instrument.
\25\ As bankruptcy remote stand-alone legal entities, RMBS and
CDO trusts had no employees. Consequently, they relied on third-
parties to create and manage them. The term ``arranger'' is used
herein to refer to the party that oversees the creation of the RMBS
and CDO, which would include the process of obtaining credit ratings
for the various tranches. Frequently, the arranger also served as
the underwriter of the securities.
---------------------------------------------------------------------------
The procedures followed by these three NRSROs in developing ratings
for subprime RMBS are generally similar. The arranger of the RMBS
initiates the rating process by sending the credit rating agency a
range of data on each of the subprime loans to be held by the trust
(e.g., principal amount, geographic location of the property, credit
history and FICO score of the borrower, ratio of the loan amount to the
value of the property, and type of loan: First lien, second lien,
primary residence, secondary residence), the proposed capital structure
of the trust, and the proposed levels of credit enhancement to be
provided to each RMBS tranche issued by the trust. Upon receipt of the
information, the NRSRO assigns a lead analyst who is responsible for
analyzing the loan pool, proposed capital structure, and proposed
credit enhancement levels and, ultimately, for formulating a ratings
recommendation for a rating committee composed of analysts and/or
senior-level personnel not involved in the analytic process.
The next step in the ratings process is the development of
predictions, based on a quantitative expected loss model and other
qualitative factors, as to how many of the loans in the collateral pool
would default under stresses of varying severity. This analysis also
includes assumptions as to how much principal would be recovered after
a defaulted loan is foreclosed. Each NRSRO generally uses between 40
and 60 specific credit characteristics to analyze each loan in the
collateral pool of an RMBS in order to assess the potential future
performance of the loan under various possible scenarios. These
characteristics include the loan information described above as well as
the amount of equity that the borrowers have in their homes, the amount
of documentation provided by borrowers to verify their assets and/or
income levels, and whether the borrowers intend to rent or occupy the
homes.\26\
---------------------------------------------------------------------------
\26\ See, e.g., Kanef September 26, 2007, Senate Testimony, p.
7.
---------------------------------------------------------------------------
The purpose of this loss analysis is to determine how much credit
enhancement a given tranche security would need for a particular
category of credit rating. The severest stress test (i.e., the one that
would result in the greatest number of defaults among the underlying
loans) is run to determine the amount of credit enhancement required
for an RMBS tranche issued by the trust to receive an AAA rating. For
example, this test might result in an output that predicted that under
the ``worst case'' scenario, 40 percent of the loans in the underlying
pool would default and that after default the trust would recover only
50 percent of the principal amount of each loan in foreclosure.
Consequently, to get an AAA rating, an RMBS tranche security issued by
the trust would need credit enhancement sufficient to cover at least 20
percent of the principal amount of all the RMBS tranches issued by the
trust. In other words, absent other forms of credit enhancement such as
excess spread, at least 20 percent of the principal amount of the RMBS
tranches issued by the trust, including the equity tranche, would have
to be subordinate to the senior tranche and, therefore, obligated to
absorb the losses resulting from 40% of the underlying loans
defaulting.\27\ The next severest stress test is run to determine the
amount of credit enhancement required of the AA tranche and so on down
the capital structure. The lowest rated tranche (typically BB or B) is
analyzed under a more benign market scenario. Consequently, its
required level of credit enhancement--typically provided primarily or
exclusively by a subordinate equity tranche--is based on the number of
loans expected to default in the normal course given the lowest
possible level of macroeconomic stress.
---------------------------------------------------------------------------
\27\ To the extent that the RMBS included other forms of credit
enhancement besides the subordination and over-collateralization
provided in this example, e.g., excess spread, this 20 percent
subordination figure would be reduced accordingly.
---------------------------------------------------------------------------
Following the determination of the level of credit enhancement
required for each credit rating category, the next step in the ratings
process is to check the proposed capital structure of the RMBS against
these requirements. For example, if the proposed structure would create
a senior RMBS tranche that had 18 percent of the capital structure
subordinate to it (the other RMBS tranches, including, as applicable,
an equity tranche), the analyst reviewing the transaction might
conclude that based on the output of the loss model the senior tranche
should be rated AA since it would need 20 percent subordination to
receive an AAA credit rating. Additionally, the analyst could take
other factors into consideration such as the quality of the loan
servicer or the actual performance of similar pools of loans underlying
other RMBS trusts to determine that in this case 18 percent
subordination would be sufficient to support an AAA rating (to the
extent these factors were not covered by the model).
Typically, if the analyst concludes that the capital structure of
the RMBS did not support the desired ratings--in the example above, if
it determined that 18 percent credit enhancement is insufficient for
the desired AAA rating--this preliminary conclusion would be conveyed
to the arranger. The arranger could accept that determination and have
the trust issue the securities with the proposed capital structure and
the lower rating or adjust the structure to provide the requisite
credit enhancement for the senior tranche to get the desired AAA rating
(e.g., shift 2 percent of the principal amount of the senior tranche to
a lower tranche or add or remove certain mortgages from the proposed
asset pool). Generally, arrangers aim for the largest possible senior
tranche, i.e., to provide the least amount of credit enhancement
possible, since the senior tranche--as the highest rated tranche--pays
the lowest coupon rate of the RMBS' tranches and, therefore, costs the
arranger the least to fund.
The next step in the process is a cash flow analysis on the
interest and principal expected to be received by the trust from the
pool of subprime loans to determine whether it will be sufficient to
pay the interest and principal due on each RMBS tranche issued by the
trust. The NRSROs use quantitative cash flow
[[Page 36216]]
models that analyze the amount of principal and interest payments
expected to be generated from the loan pool each month over the terms
of the RMBS tranche securities under various stress scenarios. The
outputs of this model are compared against the priority of payments
(the ``waterfall'') to the RMBS tranches specified in the trust legal
documents. The waterfall documentation could specify over-
collateralization and excess spread triggers that, if breached, would
reallocate principal and interest payments from lower tranches to
higher tranches until the minimum levels of over-collateralization and
excess spread were reestablished. Ultimately, the monthly principal and
interest payments derived from the loan pool need to be enough to
satisfy the monthly payments of principal and interest due by the trust
to the investors in the RMBS tranches as well as to cover the
administrative expenses of the trust.
In addition to expected loss and cash flow analysis, the analysts
review the legal documentation of the trust to evaluate whether it is
bankruptcy remote, i.e., isolated from the effects of any potential
bankruptcy or insolvency of the arranger. They also review operational
and administrative risk associated with the trust, using the results of
periodic examinations of the principal parties involved in the issuance
of the security, including the mortgage originators, the issuer of the
security, the servicer of the mortgages in the loan pool, and the
trustee.\28\ In assessing the servicer, for example, an NRSRO might
review its past performance with respect to loan collection, billing,
recordkeeping, and the treatment of delinquent loans.
---------------------------------------------------------------------------
\28\ Principal parties are not rated de novo in each RMBS
transaction; rather, each NRSRO has its own procedures and schedules
for reviewing those parties on a periodic basis in order to
incorporate its assessment of those entities into the rating
process.
---------------------------------------------------------------------------
Following these steps, the analyst develops a rating recommendation
for each RMBS tranche, which then is presented to a rating committee
composed of analysts and/or senior-level personnel not involved in the
analytic process. The rating committee votes on the ratings for each
tranche and usually approaches the arranger privately to notify it of
the ratings decisions. In most cases, an arranger can appeal a rating
decision, although the appeal is not always granted (and, if granted,
may not necessarily result in any change in the rating decision). Final
ratings decisions are published and subsequently monitored through
surveillance processes. The NRSRO typically is paid only if the credit
rating is issued, though sometimes it receives a breakup fee for the
analytic work undertaken even if the credit rating is not issued.
The process for assigning ratings to subprime CDOs also involves a
review of the creditworthiness of each tranche of the CDO. As with
RMBS, the process centers on an examination of the pool of assets held
by the trust and analysis of how they would perform individually and in
correlation during various stress scenarios. However, this analysis is
based primarily on the credit rating of each RMBS or CDO in the
underlying pool or referenced through a credit default swap entered
into by the CDO. In other words, the credit rating is the primary
characteristic of the underlying debt instruments that the NRSROs take
into consideration when performing their loss analysis. Hence, this
review of the debt instruments in the collateral pool and the potential
correlations among those securities does not ``look through'' those
securities to their underlying asset pools. The analysis, consequently,
generally only goes one level down to the credit ratings of the
underlying instruments or reference securities.
CDOs collateralized by RMBS or by other CDOs often are actively
managed. Consequently, there can be frequent changes to the composition
of the cash assets (RMBS or CDOs), synthetic assets (credit default
swaps), or combinations of cash and synthetic assets in the underlying
pool. As a result, NRSRO ratings for managed CDOs are based not on the
closing date composition of the pool but instead on covenanted limits
for each potential type of asset that could be put in the pool.
Typically, following a post-closing period in which no adjustments can
be made to a CDO's collateral pool, the CDO's manager has a
predetermined period of several years in which to adjust that asset
pool through various sales and purchases pursuant to covenants set
forth in the CDO's indenture. These covenants set limitations and
requirements for the collateral pools of CDOs, often by establishing
minimum and maximum concentrations for certain types of securities or
certain ratings.
NRSROs use a CDO's indenture guidelines to run ``worst-case''
scenarios based on the various permutations of collateral permitted
under the indenture. For example, an indenture might specify that a
CDO's collateral pool must include between 10 and 20 percent AAA-rated
subprime RMBS, with the remaining 80 to 90 percent composed of
investment-grade, but not AAA, subprime RMBS. In preparing a rating for
that CDO, an NRSRO will run its models based on all possible collateral
pools permissible under the indenture guidelines, placing the most
weight on the results from the weakest potential pools (i.e., the
minimum permissible amount, 10 percent, of AAA-rated securities and the
lowest-rated investment grade securities for the remaining 90 percent).
As with RMBS ratings, the model results are then compared against the
capital structure of the proposed CDO to confirm that the level of
subordination, over-collateralization and excess spread available to
each tranche provides the necessary amount of credit enhancement to
sustain a particular rating.
3. The Downgrades in Credit Ratings of Subprime RMBS and CDOs
As noted above, the development of the credit risk transfer markets
gave rise to an ``originate to distribute'' model whereby mortgage
loans are originated with the intent to securitize them. Under this
model, arrangers earn fees from originating, structuring, and
underwriting RMBS and servicing the loans underlying the RMBS, as well
as frequently a third set of fees from structuring, underwriting, and
managing CDOs composed of RMBS. Moreover, the yields offered by
subprime RMBS and CDO tranches (as compared to other types of similarly
rated debt instruments) led to increased investor demand for these debt
instruments. The originate to distribute model creates incentives for
originating high volumes of mortgage loans while simultaneously
reducing the incentives to maintain high underwriting standards for
making such loans. The continued growth of the housing market through
2006, which led to increased competition among lenders, also
contributed to looser subprime loan underwriting standards.\29\
---------------------------------------------------------------------------
\29\ See e.g., Dugan March 4, 2008 Senate Testimony, p. 10;
Bernanke February 28, 2008 Senate Testimony, p. 1.
---------------------------------------------------------------------------
By mid-2006, however, the steady rise in home prices that had
fueled this growth in subprime lending came to an end as prices began
to decline.\30\ Moreover, widespread areas of the country began to
experience declines whereas, in the past, poor housing markets
generally had been confined to distinct geographic areas.\31\ The
downturn in the housing market has been accompanied by a marked
increase
[[Page 36217]]
in delinquencies and defaults of subprime loans.\32\
---------------------------------------------------------------------------
\30\ See e.g., Id; Bair March 4, 2008 Senate Statement, pp. 5-8;
Bair January 31, 2008 Senate Statement, p. 3.
\31\ See e.g., Bair January 31, 2008 Senate Statement, p. 3.
\32\ Id.
---------------------------------------------------------------------------
The increases in delinquency and default rates have been
concentrated in loans made in 2006 and 2007, which indicates that
borrowers have been falling behind within months of the loans being
made.\33\ For example, by the fourth quarter of 2006, the percentage of
subprime loans underlying RMBS rated by Moody's that were in default
within six months of the loans being made stood at 3.54 percent, nearly
four times the average six month default rate of 0.90 percent between
the first quarter of 2002 and the second quarter of 2005. Similarly,
default rates for subprime loans within 12 months of the loans being
made rose to 7.39 percent as compared to 2.00 percent for the period
from the first quarter of 2002 through the second quarter of 2005.\34\
Figures released by S&P show similar deterioration in the performance
of recent subprime loans.\35\ According to S&P, the serious delinquency
rate \36\ for subprime loans underlying RMBS rated by S&P within twelve
months of the initial rating was 4.97 percent of the current aggregate
pool balance for subprime RMBS issued in 2005, 10.55 percent for
subprime RMBS issued in 2006, and 15.19 percent for subprime RMBS
issued in 2007.\37\
---------------------------------------------------------------------------
\33\ See e.g., Bair March 24, 2008 Senate Statement, p. 6
(``Serious delinquency rates on subprime mortgages securitized in
2006 are significantly higher than those for any of the previous
three years.'').
\34\ Early Defaults Rise in Mortgage Securitizations: Updated
Data Show Continued Deterioration, Moody's, September 19, 2007, pp.
3-4.
\35\ U.S. Subprime RMBS Performance Update: January 2008
Distribution Date, S&P, February 25, 2008, p. 1.
\36\ Defined as 90-plus day delinquencies, foreclosures, and
real estate owned. Id.
\37\ Id.
---------------------------------------------------------------------------
Along with the deterioration in the performance of subprime loans,
there has been an increase in the losses incurred after the loans are
foreclosed. According to S&P, the actual realized losses on loans
underlying 2007 subprime RMBS after 12 months of seasoning were 65
percent higher than the losses recorded for RMBS issued in 2006 at the
same level of seasoning.\38\
---------------------------------------------------------------------------
\38\ Id.
---------------------------------------------------------------------------
The rising delinquencies and defaults in subprime loans backing the
RMBS rated by the NRSROs has exceeded the projections on which they
based their initial ratings. Furthermore, the defaults and foreclosures
on subprime loans have resulted in realizable losses to the lower RMBS
tranches backed by the loans and, correspondingly, to the lower CDO
tranches backed by those RMBS. As discussed above, the reduction in the
amount of monthly principal and interest payments coming from the
underlying pool of subprime loans or, in the case of a CDO, RMBS
tranches or other CDO tranches is allocated to the tranches in
ascending order. In addition to directly impairing the affected
tranche, the losses--by reducing the principal amount of these
tranches--decreased the level of subordination protecting the more
senior tranches. In other words, losses suffered by the junior tranches
of an RMBS or CDO directly reduced the level of credit enhancement--the
primary factor considered by NRSROs in rating tranched securities--
protecting the senior tranches of the instrument. These factors have
caused the NRSROs to reevaluate, and in many cases downgrade, their
ratings for these instruments.
As of February 2008, Moody's had downgraded at least one
tranche of 94.2 percent of the subprime RMBS deals it rated in 2006
(including 100 percent of 2006 RMBS deals backed by subprime second-
lien mortgage loans) and 76.9 percent of all subprime RMBS deals it
rated in 2007. Overall, 53.7 percent and 39.2 percent of 2006 and 2007
tranches, respectively, had been downgraded by that time. RMBS tranches
backed by first lien loans issued in 2006 were downgraded an average of
6.0 notches from their original ratings, while RMBS tranches backed by
second-lien loans issued that year were downgraded 9.7 notches on
average. The respective figures for 2007 first- and second-lien backed
tranches were 5.6 and 7.8 notches.\39\
---------------------------------------------------------------------------
\39\ U.S. Subprime RMBS 2005-2007 Vintage Rating Actions Update:
January 2008, Moody's, February 1, 2008, pp. 2-4.
---------------------------------------------------------------------------
As of March 2008, S&P had downgraded 44.3 percent of the
subprime RMBS tranches it had rated between the first quarter of 2005
and the third quarter of 2007, including 87.2 percent of second-lien
backed securities. Downgrades to subprime RMBS issued in 2005 averaged
four to six notches, while the average for those issued in 2006 and
2007 was 6.0 to 11 notches.\40\
---------------------------------------------------------------------------
\40\ Transition Study: Structured Finance Rating Transition And
Default Update as of March 21, 2008, S&P, March 28, 2008, pp. 2-3.
---------------------------------------------------------------------------
As of December 7, 2007, Fitch had issued downgrades to
1,229 of the 3,666 tranches of subprime RMBS issued in 2006 and the
first quarter of 2007, representing a par value of $23.8 billion out of
a total of $193 billion.\41\ Subsequently, on February 1, 2008, Fitch
placed all subprime first-lien RMBS issued in 2006 and the first half
of 2007, representing a total outstanding balance of approximately $139
billion, on Rating Watch Negative.\42\
---------------------------------------------------------------------------
\41\ U.S. RMBS Update, Fitch, February 20, 2008 p. 5.
\42\ Update on U.S. Subprime and Alt-A: Performance And Rating
Reviews, Fitch, March 20, 2008, p. 13.
---------------------------------------------------------------------------
The extensive use of subprime RMBS in the collateral pools of CDOs
has led to similar levels of downgrade rates for those securities as
well. Moreover, the use of subprime RMBS as reference securities for
synthetic CDOs magnified the effect of RMBS downgrades on CDO ratings.
Surveillance of CDO credit ratings has been complicated by the fact
that the methodologies used by the NRSROs to rate them relied heavily
on the credit rating of the underlying RMBS or CDOs. Consequently, to
adjust the CDO rating, the NRSROs first have needed to complete their
reviews of the ratings for the underlying RMBS or adjust their
methodologies to sufficiently account for the anticipated poor
performance of the RMBS.\43\ Ultimately, the NRSROs have downgraded a
substantial number of CDO ratings.
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\43\ For example, in November 2007, Fitch announced that in
rating CDOs with asset pools which included subprime RMBS, it would
adjust all subprime RMBS securities on Rating Watch Negative
downwards by three categories--or notches--(six in the case of 2007
subprime RMBS rated BBB+ or lower) before factoring them into a re-
assessment of the CDO's rating. See Global Criteria for the Review
of Structured Finance CDOs With Exposure to U.S. Subprime RMBS,
Fitch, November 15, 2007, p. 4.
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Over the course of 2007, Moody's issued 1,655 discrete
downgrade actions (including multiple rating actions on the same
tranche), which constituted roughly ten times the number of downgrade
actions in 2006 and twice as many as in 2002, previously the most
volatile year for CDOs. Further, the magnitude of the downgrades
(number of notches) was striking. The average downgrade was roughly
seven notches as compared to a previous average of three to four
notches prior to 2007. In the words of a March 2008 report by Moody's,
``[T]he scope and degree of CDO downgrades in 2007 was unprecedented.''
\44\
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\44\ 2008 U.S. CDO Outlook and 2007 Review, Moody's, March 3,
2008, p. 6.
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As of April 1, 2008, S&P had downgraded 3,068 tranches
from 705 CDO transactions, totaling $321.9 billion in issuance, and
placed 443 ratings from 119 transactions, with a value of $33.8
billion, on CreditWatch negative, ``as a result of stress in the
[[Page 36218]]
U.S. residential mortgage market and credit deterioration of U.S.
RMBS.'' \45\
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\45\ 86 Ratings Lowered On 20 U.S. CDOs Of ABS Deals; $9.107
Billion In Issuance Affected, S&P, April 1, 2008, p. 1.
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By mid-December, 2007, Fitch had issued downgrades to 158
of the 431 CDOs it had rated with exposure to RMBS.\46\ Among the 30
CDOs with exposure to the subprime RMBS which ``suffered the greatest
extent and magnitude of negative rating migration,'' all but $82.7
million of the $20.7 billion in balance was downgraded.\47\
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\46\ Summary of Global Structured Finance CDO Rating Actions,
Fitch, December 14, 2007, p. 1.
\47\ Id., p. 6.
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The scope and magnitude of these downgrades has caused a loss of
confidence among investors in the reliability of RMBS and CDO credit
ratings issued by the NRSROs.\48\ This lack of confidence in the
accuracy of NRSRO ratings has been a factor in the broader dislocation
in the credit markets.\49\ For example, the complexity of assessing the
risk of structured finance products and the lack of commonly accepted
methods for measuring the risk has caused investors to leave the
market, including the market for AAA instruments, particularly
investors that had relied primarily on NRSRO credit ratings in
assessing whether to purchase these instruments.\50\ This has had a
significant impact on the liquidity of the market for these
instruments.\51\
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\48\ See, e.g., Dugan March 4, 2008 Senate Testimony, p. 13.
\49\ Id., Bair March 4, 2008 Senate Statement, p. 7.
\50\ Id., Bernanke February 28, 2008 Senate Testimony, p. 3.
\51\ See, e.g., Dugan March 4, 2008 Senate Testimony, p. 13;
Bair January 31, 2008 Senate Testimony, pp. 3-4.
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In the wake of these events, the NRSROs that rated subprime RMBS
and CDOs have come under intense criticism and scrutiny. It has been
suggested that changes may be needed to address the conflicts of
interest inherent in the process of rating RMBS and CDOs.\52\ The
NRSROs that have been the primary ratings providers for subprime RMBS
and related CDOs each operate under an ``issuer-pays'' model in which
they are paid by the arranger to rate a proposed RMBS or CDO. The
arranger has an economic interest in obtaining the highest credit
rating possible for each security issued by the trust and the NRSRO has
an economic interest in having the arranger select it to rate the next
RMBS or CDO brought by the arranger to market. Observers have
questioned whether, given the incentives created by this arrangement,
the NRSROs are able to issue unbiased ratings, particularly as the
volume of deals brought by certain arrangers increased in the mid-
2000s.\53\ The above concerns are compounded by the arrangers' ability
to ``ratings shop.'' Ratings shopping is the process by which an
arranger will bring its proposed RMBS and CDO transaction to multiple
NRSROs and choose, on a deal-wide or tranche-by-tranche basis, which
two (or in some cases one) to use based on the preliminary ratings of
the NRSROs.
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\52\ See, e.g., Opening Statement of Senator Richard C. Shelby
for the Hearing of the U.S. Senate Committee on Banking, Housing,
and Urban Affairs (September 26, 2007), pp. 1-2.
\53\ See, e.g., Testimony of Professor John C. Coffee, Jr.,
Adolf A. Berle Professor of Law, Columbia University Law School,
before the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (September 26, 2007), pp. 4-5.
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In addition, the interaction between the NRSRO and the arranger
during the RMBS and CDO rating process has raised concerns that the
NRSROs are rating products they designed (i.e., evaluating their own
work).\54\ A corporate issuer is more constrained in how it can adjust
in response to an NRSRO to improve its creditworthiness in order to
obtain a higher rating. In the context of structured finance products,
the arranger has much more flexibility to make adjustments to obtain a
desired credit rating by, for example, changing the composition of the
assets in the pool held by the trust or the subordination levels of the
tranche securities issued by the trust. In fact, an arranger frequently
will inform the NRSRO of the rating it wishes to obtain for each
tranche and will choose an asset pool, trust structure, and credit
enhancement levels based on its understanding of the NRSRO's
quantitative and qualitative models. The credit analyst will use the
expected loss and cash flow models to, in effect, check whether the
proposed assets, trust structure and credit enhancement levels are
sufficient to support the credit ratings desired by the arranger.
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\54\ See, e.g., Opening Statement of Senator Jack Reed for the
Hearing of the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (September 26, 2007), pp. 1-2.
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The NRSRO rules adopted by the Commission in June of 2007 preceded
the full emergence of the credit market turmoil. The Commission, in
light of its experience since the final rules became effective, is
proposing amendments to those rules and a new rule with the goal of
further enhancing the utility of NRSRO disclosure to investors,
strengthening the integrity of the ratings process, and more
effectively addressing the potential for conflicts of interest inherent
in the ratings process for structured finance products.
II. Proposed Amendments
A. Amendments to Rule 17g-5
The Commission adopted Rule 17g-5, in part, pursuant to authority
``to prohibit, or require the management and disclosure of, any
conflicts of interest relating to the issuance of credit ratings by an
[NRSRO].'' \55\ The rule identifies a series of conflicts arising from
the business of determining credit ratings. Under the rule, some of
these conflicts must be disclosed and managed, while other specified
conflicts are prohibited outright.
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\55\ See Section 15E(h)(2) of the Exchange Act (15 U.S.C. 78o-
7(h)(2)).
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Paragraph (a) of Rule 17g-5 prohibits an NRSRO from having a
conflict identified in paragraph (b) of the rule unless the NRSRO
discloses the type of conflict on Form NRSRO and establishes,
maintains, and enforces procedures to manage it.\56\ Paragraph (b)
identifies eight types of conflicts, which include being paid by
issuers or underwriters to determine credit ratings with respect to
securities or money market instruments they issue or underwrite \57\ or
being paid by persons for subscriptions to receive or access credit
ratings where such persons also may own investments or have entered
into transactions that could be favorably or adversely impacted by a
credit rating.\58\
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\56\ 17 CFR 240.17g-5(a).
\57\ 17 CFR 240.17g-5(b)(1).
\58\ 17 CFR 240.17g-5(b)(5).
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Paragraph (c) of Rule 17g-5 prohibits outright four types of
conflicts of interest. Consequently, an NRSRO would violate the rule if
it has the type of conflict described in paragraph (c) even if it
disclosed the conflict and established procedures to manage it. In the
Adopting Release, the Commission explained that these conflicts were
prohibited because they would be difficult to manage given their
potential to cause undue influence.\59\
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\59\ Adopting Release, 72 FR at 33598.
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The Commission is proposing to amend Rule 17g-5 to require the
disclosure and establishment of procedures to manage an additional
conflict and to prohibit certain other conflicts outright, as described
below.
[[Page 36219]]
1. Addressing the Particular Conflict Arising From Rating Structured
Finance Products by Enhancing the Disclosure of Information Used in the
Rating Process
a. The Proposed Amendment
The Commission is proposing to amend Rule 17g-5 \60\ to add to the
list of conflicts that must be disclosed and managed the additional
conflict of repeatedly being paid by certain arrangers to rate
structured finance products. This conflict is a subset of the broader
conflict already identified in paragraph (b)(1) of Rule 17g-5; namely,
``being paid by issuers and underwriters to determine credit ratings
with respect to securities or money market instruments they issue or
underwrite.'' \61\ In the case of structured finance products, the
Commission preliminarily believes this ``issuer/underwriter-pay''
conflict is particularly acute because certain arrangers of structured
finance products repeatedly bring ratings business to the NRSROs.\62\
As sources of constant deal based revenue, some arrangers have the
potential to exert greater undue influence on an NRSRO than, for
example, a corporate issuer that may bring far less ratings business to
the NRSRO.\63\ Consequently, the Commission is proposing amendments to
Rule 17g-5 that would require additional measures to address this
particular type of ``issuer/underwriter-pay'' conflict.
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\60\ 17 CFR 240.17g-5.
\61\ 17 CFR 240.17g-5(b)(1). As the Commission noted when
adopting Rule 17g-5, the concern with conflict identified in
paragraph (b)(1) ``is that an NRSRO may be influenced to issue a
more favorable credit rating than warranted in order to obtain or
retain the business of the issuer or underwriter.'' Adopting
Release, 72 FR at 33595.
\62\ See e.g., Testimony of Professor John C. Coffee, Jr., Adolf
A. Berle Professor of Law, Columbia University Law School, before
the U.S. Senate Committee on Banking, Housing, and Urban Affairs
(April 22, 2008) (``Coffee April 22, 2008 Senate Testimony''), pp.
4-6.
\63\ Id.
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Specifically, the proposed amendment would re-designate paragraph
(b)(9) of Rule 17g-5 as paragraph (b)(10) and in new paragraph (b)(9)
identify the following conflict: issuing or maintaining a credit rating
for a security or money market instrument issued by an asset pool or as
part of any asset-backed or mortgage-backed securities transaction that
was paid for by the issuer, sponsor, or underwriter of the security or
money market instrument. To address this conflict, proposed new
paragraph (a)(3) would require that as a condition to the NRSRO rating
a structured finance product the information provided to the NRSRO and
used by the NRSRO in determining the credit rating would need to be
disclosed through a means designed to provide reasonably broad
dissemination of the information.\64\ The intent behind this disclosure
is to create the opportunity for other NRSROs to use the information to
rate the instrument as well. Any resulting ``unsolicited ratings''
could be used by market participants to evaluate the ratings issued by
the NRSRO hired to rate the product and, in turn, potentially expose an
NRSRO whose ratings were influenced by the desire to gain favor with
the arranger in order to obtain more business.\65\
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\64\ This proposed requirement would be in addition to the
current requirements of paragraph (a) that an NRSRO disclose the
type of conflict of interest in Exhibit 6 to Form NRSRO; and
establish, maintain and enforce written policies and procedures to
address and manage the conflict of interest. 17 CFR 240 17g-5(a)(1)
and (2).
\65\ As used herein, an ``unsolicited rating'' is one that is
determined without the consent and/or payment of the obligor being
rated or issuer, underwriter, or arranger of the securities being
rated.
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The proposed amendment would require the disclosure of information
provided to an NRSRO by the ``issuer, underwriter, sponsor, depositor,
or trustee.'' The Commission preliminarily believes that, taken
together, t
