This is part 2 of a two-part executive summary on the SEC issuance of amendments, new rules, and new forms affecting nationally recognized statistical rating organizations (“NRSROs”)
On August 27, 2014, the SEC in accordance with the Dodd-Frank Act and to enhance their oversight: (i) issued amendments to existing rules and new rules that apply to credit rating agencies registered with them as NRSROs; (ii) adopted a new rule and form that apply to providers of third-party due diligence services for asset-backed securities; and (iii) adopted amendments to existing rules and a new rule that implement a requirement added by the Dodd-Frank Act that issuers and underwriters of asset-backed securities make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.
For purposes of this write-up, the intent of the amendments and new rules is to enhance the integrity of how NRSROs determine credit ratings by improving internal governance of NRSROs managing potential principal-agent problems and conflicts of interest in the credit rating process and promoting adherence to the procedures and methodologies for determining credit ratings and compliance with laws and regulations.
The relevant new provisions in the amendments and new rules require a NRSRO among other things to: (1) assess and report on the effectiveness of internal controls; (2) address conflicts of interest relating to sales and marketing activities and employment of former analysts; (3) have policies and procedures relating to their procedures and methodologies for determining credit ratings; (4) have standards of training experience and competence for their credit analysts; and (5) have policies and procedures to promote the consistent use of credit rating symbols.
There are new requirements for NRSROs to file an annual report containing an assessment by management of the effectiveness during the fiscal year of the internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings. Further, NRSROs are now required to establish, maintain, enforce and document policies and procedures reasonably designed to ensure that the procedures and methodologies including qualitative and quantitative data and models the NRSRO uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.
The intent of these new requirements is that in order for to NRSROs to avoid certain conflicts of interest they must have policies and procedures to take certain actions to address credit ratings that are influenced by a conflict of interest.
Further, there is a new requirement that prohibits an NRSRO from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating or developing or approving procedures or methodologies used for determining the credit rating including qualitative and quantitative models also: (i) participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (ii) is influenced by sales or marketing considerations.
NRSROs must have procedures that address instances in which a conflict of interest influenced a credit rating, they must promptly determine whether the current credit rating must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings and to promptly publish a revised credit rating, an affirmation of the credit rating, or potentially place the credit rating on watch or review and in each case include certain disclosures about the existence of the conflict. The intent is to minimize the risks that NRSRO analysts, who may be distorted by the prospect of future employment at an issuer or underwriter, could influence the analyst in determining a credit rating for that issuer or underwriter.
The SEC issued an amendment for which an NRSRO could have its registration suspended or revoked for violating a rule governing conflicts of interest. In addition they amended Form NRSRO to provide notice to a NRSRO or a credit rating agency applying for registration as a NRSRO that a NRSRO is subject to applicable fines penalties and other sanctions under the Exchange Act.
There are new requirements for NRSROs to establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure that: (i) the procedures and methodologies including qualitative and quantitative data and models the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO; and (ii) material changes to the procedures and methodologies including changes to qualitative and quantitative data and models that the NRSRO uses to determine credit ratings are applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply and to the extent that the changes are to surveillance or monitoring procedures and methodologies applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time taking into consideration the number of credit ratings impacted the complexity of the procedures and methodologies used to determine the credit ratings and the type of obligor security or money market instrument being rated.
The new rules and amendments require NRSROs to implement, maintain, enforce, and document standards of training experience and competence for the individuals they employ to participate in the determination of credit ratings that are reasonably designed to achieve the objective that the NRSRO produces accurate credit ratings in the classes of credit ratings for which the NRSRO is registered. At a minimum these standards must include: (i) a requirement for periodic testing of the individuals employed by the NRSRO to participate in the determination of credit ratings on their knowledge of the procedures and methodologies used by the NRSRO to determine credit ratings in the classes and subclasses of credit ratings for which the individual participates in determining credit ratings; and (ii) a requirement that at least one individual with an appropriate level of experience in performing credit analysis but not less than three years participates in the determination of a credit rating.
NRSROs must have reasonably designed policies and procedures relating to: (i) assessing the probability that an issuer of a security or money market instrument will default, fail to make timely payments, or otherwise not make payments in accordance with the terms of the security or money market instrument; (ii) clearly defining each symbol number or score in the rating scale used by the NRSRO and including the definitions in Exhibit 1 to Form NRSRO; and (iii) applying any symbol number or score in the rating scale used by the NRSRO in a manner that is consistent for all types of obligors securities and money market instruments for which the symbol number or score is used.
Finally, NRSROs must retain records of certain internal controls policies, procedures and standards they are required to document. Also, the Exchange Act requires an annual report of the NRSROs designated compliance officer to be filed on a confidential basis with the SEC.
The effective dates particular to the Governance Segment of the new rules of the Exchange Act are as follows: the amendments to existing rules are effective November 14, 2014; except that the amendments to Section 240.17g-3(a)(7) and (b)(2) and Form NRSRO are effective on January 1, 2015; and the amendments to Section 240.17g-2(a)(9), (b)(13), (b)(14), and (b)(15), Section 240.17g-5(a)(3)(iii)(E), (c)(6), (c)(7), and (c)(8), Section 240.17g-7(a) and (b), and Form ABS-15G are effective June 15, 2015. New rules Section 240.15Ga-2, Section 240.17g-8, Section 240.17g-9, Section 240.17g-10, and Form ABS Due Diligence-15E are effective June 15, 2015.