Credit Rating Agencies

Transcription

1 SEC Acts on a Broad Range of Amendments Related to Credit Rating Agencies and the Use of Credit Ratings SUMMARY The SEC has adopted and proposed a number of changes to its rules and forms relating to the use of credit ratings in public offerings, references to ratings in SEC rules and forms, and the oversight of registered credit rating agencies. First, a group of proposed amendments would require issuers to disclose credit ratings and specific, potentially extensive related information when those ratings are used in connection with a registered offering. Registrants would also be required to disclose on Form 8-K any subsequent changes to a previously-disclosed credit rating. Second, the SEC has issued a concept release on whether it should rescind Securities Act Rule 436(g), which currently exempts NRSROs (but not other credit rating agencies) from liability as experts under Section 11 of that Act. Third, the SEC has adopted amendments to remove references to ratings of NRSROs from a few SEC rules and forms, and it has reopened the comment period with respect to similar proposals for other rules and forms. For a discussion of the amendments specifically affecting registered investment companies, see our companion publication, also issued today, titled Use of Credit Ratings Under the Investment Company Act of Finally, the SEC has voted to take action on a number of amendments to its rules governing NRSRO oversight which are intended to increase ratings transparency generally and also to facilitate greater competition in the ratings of structured finance products. The SEC also voted to propose further changes New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 that would increase NRSRO reporting and disclosure requirements, with a principal focus on perceived conflicts of interest. BACKGROUND The SEC has incorporated the term nationally recognized statistical rating organization ( NRSRO ) into various rules and forms for over 30 years, beginning with amendments to its broker-dealer net capital rule in Since then, the term NRSRO has been used by the SEC to define eligibility to use various registration statement forms, 2 and in rules that describe the information that must be disclosed by brokerdealers in customer transaction confirmations, 3 provide an exclusion from the definition of investment company for certain structured finance vehicles issuing highly-rated securities, 4 and regulate the types of securities that can be held by money market funds. 5 The term NRSRO is currently used in over 15 SEC rules and forms (excluding those directly related to NRSRO oversight) as well as in a wide range of rules imposed by individual states and self-regulatory organizations. From 1975 through 2006, the SEC used a no-action letter process to recognize credit rating agencies as NRSROs, eventually identifying seven NRSROs through this process. This changed with the enactment of the Credit Rating Agency Reform Act of 2006 (the CRARA ), which defined the term NRSRO and created a voluntary application and registration system for NRSRO recognition. The stated purpose of the CRARA was to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry. 6 The CRARA granted the SEC rulemaking authority over NRSROs with respect to creating and retaining records, disclosing financial reports, preventing the misuse of material nonpublic information, prohibiting or requiring the management and disclosure of certain conflicts of interest, and prohibiting abusive practices. The SEC adopted initial rules implementing the CRARA in June 2007 and amended those rules in February The amendments primarily required enhanced disclosure of performance measurement statistics and rating methodologies, additional recordkeeping and reporting, and public disclosure of a random sample of 10 percent of the ratings histories of issuer-paid credit ratings. 7 At the same time, the See Exchange Act Rule 15c3-1. See, e.g., Securities Act Forms S-3 and F-3. See Exchange Act Rule 10b-10. See Investment Company Act Rule 3a-7. See Investment Company Act Rule 2a-7. Credit Rating Agency Reform Act of 2006, Pub. L. No , 120 Stat (2006). See Final Rule: Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Rel. No (February 2, 2009). -2-

3 SEC proposed and reproposed additional rule amendments relating to conflicts of interest and the public disclosure of ratings histories for all outstanding issuer-paid ratings. Additional regulatory and legislative proposals regarding credit rating agency oversight have recently been submitted by a number of proponents. The SEC itself has proposed other NRSRO rule amendments that have not been adopted, and the SEC Office of the Inspector General recently released a report containing a number of suggestions for improving NRSRO oversight. 8 Additionally, Senator Jack Reed (D-RI), Representative Paul Kanjorski (D-PA), Senator Christopher Dodd (D-Conn.) and the Obama Administration each have submitted to Congress separate credit rating agency reform legislative proposals, which overlap in a number of areas. 9 REGISTRATION STATEMENT DISCLOSURES REGARDING CREDIT RATINGS The SEC has proposed to impose certain disclosure requirements on issuers in registered securities offerings, including those by closed-end funds, when credit ratings are used in connection with the sale of those securities. 10 Use of a credit rating for this purpose would include any reference to a rating in oral or written selling efforts by an offering participant. Currently, Item 10(c) of Regulation S-K permits, but does not require, registrants to disclose in registration statements and periodic reports the credit ratings assigned to classes of debt securities, convertible debt securities and preferred stock. The proposed rule would add a new paragraph (g) to Item 202 of Regulation S-K to instead require certain disclosures when a registrant uses a credit rating in connection with a registered offering. In brief, the amendments would require such issuers to describe in their registration statements: the credit rating itself, along with information regarding its scope and any material limitations of the credit rating, as well as any related matters covered by the rating (e.g., non-credit payment risks); the identity of the person who paid for the credit rating, and whether the rating agency or its affiliates provided other services to the registrant or its affiliates over a specified period of time (as well as any related fees); and any final ratings not used by a registrant, as well as whether any preliminary ratings were obtained from rating agencies in a practice known as ratings shopping See The SEC s Role Regarding and Oversight of Nationally Recognized Statistical Rating Organizations (NRSROs), Report No. 458 (August 27, 2009), available at See the Rating Accountability and Transparency Enhancement Act of 2009, S. 1073, 111th Cong. (2009) ( RATE Act ) (proposed by Sen. Reed); Accountability and Transparency in Rating Agencies Act, H.R. 3890, 111th Cong. (2009) ( Kanjorski Proposal ) (introduced by Rep. Kanjorski and passed by the House Financial Services Committee); Restoring American Financial Stability Act of 2009, Committee Print, 111th Cong. (2009) ( Dodd Proposal ) (introduced by Sen. Dodd); Subtitle C Improvements to the Regulation of of Title IX Additional Improvements to Financial Markets Regulation, available at titleix_subtc.pdf ( Obama Administration Proposal ). Proposed Rule: Credit Ratings Disclosure, Rel. No (October 7, 2009). -3-

4 An issuer would be required to disclose on a current report on Form 8-K, within four business days, any subsequent changes to the ratings required to be disclosed as described above. 11 Any material impact of such a ratings change (for example, effects on terms of debt instruments, covenant compliance or collateral posting requirements) would also need to be disclosed in the issuer s periodic reports. Comments on the proposed rule are due by December 14, A. TRIGGER FOR REQUIRED DISCLOSURE The proposed disclosure requirements apply in a broad range of circumstances: when the registrant, any selling security holder, any underwriter, or any member of a selling group in a registered offering uses a credit rating... from a credit rating agency [including but not limited to an NRSRO]... with respect to the registrant or a class of securities issued by the registrant, in connection with a registered offering. In addition, if a credit rating is used in connection with a Rule 144A offering or other private placement and the privately-offered securities are exchanged shortly thereafter for substantially identical registered securities (i.e., an Exxon Capital or A/B exchange offer), the rating would need to be disclosed in the exchange-offer registration statement even if the rating is not otherwise used in connection with that registered offering. The rule would not limit the use of ratings in Rule 144A offerings that are not followed by such an exchange offer. However, the proposed disclosure requirements would not apply to unsolicited ratings that are not used in connection with a registered offering. The disclosure requirements also would not apply when the only reference to a credit rating (in an SEC filing) relates to changes to a credit rating, liquidity of the registrant, the cost of funds of a registrant or the terms of agreements that refer to credit ratings, as long as the credit rating is not otherwise used in connection with a registered offering (presumably including with respect to any selling efforts). For example, the SEC would not consider the disclosure requirements to be triggered by the mention of a rating in a risk factor that discussed the risk of failure to maintain a specified rating and the potential impact to the issuer that could result from a change in that rating. The disclosure requirements would also not be triggered by a reference to a rating in the MD&A liquidity discussion, such as where ratings determine compliance with debt covenants, interest or dividend rates, or potential support to variable interest entities. Nevertheless, since the release indicates that the SEC would consider a credit rating to be used in connection with a registered offering if referred to in any oral or written selling efforts by covered persons, it would appear that as a practical matter issuers would have to comply with these requirements whenever a rating has been issued. We believe that the adoption of the rule as proposed would enhance the relative attractiveness of Rule 144A offerings of rated securities, 11 Although the proposed rule would add a new Item 3.04 to Form 8-K to incorporate the required credit rating disclosure, the proposal does not appear to add this Item 3.04 to the list of items included in the safe harbor at General Instruction I.A.3 of Form S-3. Consequently, it would appear that failing to file a timely update to a credit rating on Form 8-K could cause an issuer to lose its eligibility to use Form S

5 especially after recent amendments to Rule 144 in that permit unlimited unregistered resales of privately placed securities within as little as 6 months following issuance. B. REQUIRED INITIAL DISCLOSURE Once the trigger described above is met, the credit rating disclosure proposed by the amendments would be required in registration statements filed under the Securities Act and the Exchange Act, including on Form 10 and Form 20-F. Disclosure would also be required in registration statements filed by closed-end funds on Form N-2 under the Securities Act and the Investment Company Act. 13 The disclosure would include information about the scope of the rating and any material limitations, certain conflicts of interest, and any ratings shopping practices. 1. General Information About the Scope and Limitations of the Rating Specifically, the proposed amendments would require disclosure of the following general information about the credit rating: The identity of the relevant credit rating agency and whether it is an NRSRO; The credit rating assigned and the date on which it was assigned; The relative rank of the credit rating within the rating agency s classification system, and the rating agency s definition or description of the applicable ratings category; All material scope limitations of the rating, and how any contingencies related to the securities are or are not reflected in the rating; For example, a registrant would need to disclose if the credit rating takes into account less than the promised return on a security (e.g., with respect to residual interests, if the credit rating only represents an evaluation of the probability that the nominal fixed obligation will be paid, without evaluating the residual cash flow); Any published designation reflecting the results of any other evaluation performed by the credit rating agency in connection with the rating, along with an explanation of the designation s meaning and relative rank; For example, such a designation could cover an evaluation of prepayment speeds, interest-rate sensitivity, or volatility; Any material differences between the terms of the securities as assumed or considered by the credit rating agency in rating the securities and (i) the minimum obligations of the security specified by the governing instruments; and (ii) the terms of the securities as used in any marketing or selling efforts; For example, disclosure would be required if the yield assumption used to rate the security differs from the expected yield that is disclosed to investors; and For further details, see our prior memorandum titled Private Offering Reform: SEC Publishes Text of Rule 144 and Rule 145 Revisions, published on December 12, Specifically, Item 10.6 of Form N-2, which currently requires certain disclosures if a registrant discloses an NRSRO rating in its prospectus, would be revised to instead require the same disclosure requirements contained in proposed Item 202(g) of Regulation S-K. -5-

6 A statement informing investors that a credit rating is not a recommendation to buy, sell, or hold securities; that it may be subject to revision or withdrawal at any time by the assigning credit rating agency; that each credit rating is applicable only to the specific class of securities to which it applies; and that investors should perform their own evaluation as to whether an investment in the security is appropriate. Where a preliminary prospectus includes information about any credit rating used in connection with a registered offering, including any initial ratings assigned, the proposed amendments would require the registrant to convey to the purchaser any change to that rating (or any different rating) that becomes available before effectiveness. If any such rating changes are made while offers or sales are being made, the registrant would also be required to disclose the changes in a post-effective amendment or a supplement to the prospectus, unless the changes have been disclosed in a document incorporated by reference into a registration statement on Form S-3. The proposing release explains that in connection with a Rule 415 shelf offering conducted on a delayed basis, the final rating could be disclosed in a prospectus supplement or a free writing prospectus, such as a term sheet, if the disclosure was also included in the registration statement (including through disclosure in a prospectus supplement that becomes a part of the registration statement pursuant to Rule 430B). 2. Disclosure of Potential Conflicts of Interest In addition to the general information described above, the proposed amendments to Item 202(g) of Regulation S-K would also require certain disclosures designed to address potential conflicts of interest. Specifically, the registrant would be required to disclose the identity of the person that compensates the credit rating agency for providing the rating. Additionally, if the credit rating agency or its affiliates has provided other non-rating services to the registrant or its affiliates, the disclosure must include a description of such services along with the aggregate fees paid for the non-rating services provided during the registrant s last completed fiscal year and any subsequent interim period up to the filing date. If such non-rating services have been provided, the registrant must also disclose the fee paid for the credit rating that is required to be disclosed. Although the proposal would not require general disclosure of fees paid for the credit rating unless such non-rating services have been provided, the SEC is requesting comment on whether fee information should be disclosed in all circumstances. These requirements could be potentially significant to financial services firms that offer structured products and other users of rating agency services that offer rated securities in registered offerings. 3. Disclosure of Preliminary and Other Final Ratings Proposed Item 202(g) of Regulation S-K would also require certain disclosures regarding the practice of ratings shopping, which involves a registrant soliciting preliminary credit ratings from one or more rating agencies before deciding which agency to engage. 14 If the trigger described above is met and a 14 Provisions focused on ratings shopping were also included in the legislative reform proposals from the Obama Administration and Rep. Kanjorski. The SEC has noted that the practice of ratings -6-

7 registrant is required to disclose a credit rating, the proposal would also require the registrant to disclose all preliminary ratings of the same class of securities obtained from credit rating agencies other than the agency providing the final rating. 15 Similarly, the registrant would also be required to disclose any final credit rating that it obtained but did not use. The proposing release notes that the SEC intends a broad reading of the phrase preliminary credit rating. Specifically, the proposed instructions to Item 202(g) of Regulation S-K provide that the term would include any rating that is not published, any range of ratings, any oral or other indications of a potential rating or range of ratings and all other preliminary indications of a rating. This would include ratings on a particular structure of a security even if not tied to a specific registrant or group of assets. For example, with respect to asset-backed securities, a preliminary rating would also include an indication of a rating with respect to a structure in which the specific pool assets or originators were not yet identified, if the registrant utilizes that structure. The proposal would also require disclosure of a preliminary rating even if there have been changes to the security. For these purposes, a preliminary or final credit rating would be deemed to be obtained by the registrant if it is solicited by or on behalf of the registrant from a credit rating agency. Thus, a rating solicited by an underwriter, deal sponsor or depositor, or any other person involved in structuring a deal would be presumed to be solicited on behalf of the registrant. When a preliminary rating or unused final rating is required to be disclosed, the proposal would require disclosure of substantially the same general information required for final ratings as described above (e.g., the scope of the rating and its material limitations). However, the proposing release notes that registrants would be entitled to rely on Securities Act Rule 409 to omit disclosure if such information cannot be obtained without unreasonable effort or expense. C. REQUIRED SUBSEQUENT DISCLOSURE IN EXCHANGE ACT REPORTS The SEC is also proposing amendments to its Exchange Act rules and forms to require registrants to disclose subsequent changes to a previously-disclosed credit rating. Specifically, once a registrant (including a closed-end fund) receives a notice or other communication from a credit rating agency that the agency has made a final decision to change or withdraw such a rating, the registrant would be required to file a report on Form 8-K within four business days. The required report would include the date the registrant received the notice or communication, the name of the credit rating agency and 15 shopping could lead to ratings inflation, with issuers obtaining preliminary ratings from multiple NRSROs before hiring the NRSRO proposing to provide the highest rating. The proposal would not require disclosure of preliminary ratings obtained from the credit rating agency that issues the final rating. However, Exchange Act Rule 17g-5 prohibits an NRSRO from, among other things, issuing or maintaining a rating when it or its affiliate has made recommendations with respect to the structure of the security. -7-

8 whether it is an NRSRO, and the nature of the credit rating agency s decision. Similar disclosure would be required from foreign private issuers on an annual basis in their reports on Form 20-F. This ongoing disclosure requirement would only apply to credit ratings that are initially required to be disclosed under the proposed rules once they become effective, and would not apply to any previouslyobtained ratings. Additionally, the proposing release notes that under the current rules, a registrant would be required to disclose in its periodic reports any material impact of a change in a previously-disclosed rating. CONCEPT RELEASE ON REMOVING THE EXEMPTION FOR NRSROS FROM LIABILITY UNDER SECTION 11 OF THE SECURITIES ACT The SEC has issued a concept release seeking comment on whether it should propose to rescind Securities Act Rule 436(g). 16 The rule effectively shields NRSROs from liability as experts under Section 11 of the Securities Act for material misstatements or omissions with respect to credit ratings included in a registration statement. Section 7 of the Securities Act requires a registrant to file with the registration statement the written consent of certain experts who are named as having prepared or certified any part of the registration statement, or [are] named as having prepared or certified a report or valuation for use in connection with the registration statement. Rule 436(g) currently provides that a rating issued by an NRSRO with respect to a class of debt securities, convertible debt securities, or preferred stock will not be considered part of the registration statement prepared or certified by a person within the meaning of sections 7 and 11 of the Securities Act. Because of this rule, a registrant is not required to file the consent of an NRSRO with a registration statement, and the NRSRO avoids potential exposure to liability as an expert. Notably, the current Rule 436(g) exemption applies only to NRSROs; other credit rating agencies must submit consents as exhibits to the registration statement, thereby rendering them subject to Section 11 liability as experts, although we believe this happens very infrequently in practice. The concept release notes that if Rule 436(g) was rescinded, NRSROs would be treated as other credit rating agencies for the purposes of Securities Act liability if their credit ratings are disclosed in registration statements. To address practical and timing concerns with respect to the filing of the required consents, the SEC has suggested a framework for such filings. For example, an offering registered on Form S-1 would likely require a consent that would need to be filed prior to effectiveness. With respect to shelf offerings made in reliance on Securities Act Rule 415, the consent filing procedures would depend on whether the applicable rating is specific to the issuer, program or class of securities, or individual issuance. Issuer- 16 Concept Release on Possible Rescission of Rule 436(g) Under the Securities Act of 1933, Rel. No (October 7, 2009) -8-

9 specific ratings would be disclosed in the prospectus that is part of the registration statement, and the consent would be filed before effectiveness. In the case of an issuer-based rating or a program-based rating (such as a medium-term note facility), only a new or changed rating issued by the rating agency after the date of the last consent, or a change in any other information as to which the agency is an expert, would require a new consent. In the case of an issuance-specific rating, a new consent would be required for each issuance. The rescission of Rule 436(g), when combined with the SEC s proposal to require disclosure by registrants of credit ratings used in connection with a registered offering, could significantly increase the exposure of NRSROs to liability under Section 11 of the Securities Act, lead to significant practical changes in the manner in which credit ratings are used in connection with registered offerings, or both. The SEC acknowledges in the concept release a concern that NRSROs, which currently issue the vast majority of credit ratings, might be unwilling to give their consent and take on expert liability under Section 11 of the Securities Act. In addition, any proposed imposition of securities law liability on NRSROs with respect to their credit ratings might well encounter challenges based on First Amendment concerns, as it has been argued that certain ratings reports constitute statements about matters of public concern and should thus be afforded heightened First Amendment protection. 17 Comments on the concept release are due by December 14, REFERENCES TO NRSRO CREDIT RATINGS IN SEC RULES AND FORMS Citing an intent to address concerns that references to NRSRO ratings in Commission rules may have contributed to an undue reliance on those ratings by market participants, the SEC has adopted amendments that would eliminate a number of such references. 18 In addition, the SEC has reopened the comment period for similar proposals with respect to other rules and forms. 19 The adopted amendments became effective on November 12, 2009, and comments on the proposed amendments are due by December 8, Amendments specifically affecting registered investment companies are discussed in See, e.g., In re Enron Corp. Securities, Derivative & ERISA Litigation, 511 F.Supp.2d 742, 825 (S.D. Tex. 2005) (holding in part that nationally published reports about a Top Fortune 500 company s creditworthiness were matters of public concern and thus afforded heightened First Amendment protection). Final Rule: References to Ratings of Nationally Recognized Statistical Rating Organizations, Rel. No (October 5, 2009). These amendments, along with others, were originally proposed in July See Proposed Rule: References to Ratings of Nationally Recognized Statistical Rating Organizations, Rel. No (July 1, 2008); Proposed Rule: Security Ratings, Rel. No (July 1, 2008); Proposed Rule: References to Ratings of Nationally Recognized Statistical Rating Organizations, Rel. No. IC (July 1, 2008). Proposed Rule: References to Ratings of Nationally Recognized Statistical Rating Organizations, Rel. No (October 5, 2009). -9-

10 our companion publication, also issued today, titled Use of Credit Ratings Under the Investment Company Act of A. PROPOSED AMENDMENTS 1. Exchange Act Regulation M Regulation M is designed to prohibit certain activities in connection with a securities offering that could artificially influence the market for the offered security. Currently, these rules include exceptions for distributions of nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities, provided that such securities are rated investment grade by at least one NRSRO. The SEC has proposed to replace the NRSRO investment grade standard with other bright-line alternatives. Specifically, the proposed exception for distributions of non-convertible debt and preferred securities would require that the issuer (i) qualify as a well known seasoned issuer ( WKSI ) pursuant to Securities Act Rule 405 and (ii) have issued, in the prior three years, at least $1 billion aggregate principal amount of registered nonconvertible securities, other than common equity, in primary offerings for cash. 20 With respect to asset-backed securities, the proposed exception would require the offer and sale of the security to be registered using Form S-3, in order to except asset-backed securities that are approximately the equivalent quality of securities currently excepted using the investment grade standard. 2. Securities Act Rule 415 and Related Forms Rule 415, the shelf registration rule, provides eligibility criteria for issuers who wish to conduct primary securities offerings on a delayed or continuous basis. Currently, an offering of non-convertible debt securities, asset-backed securities, or mortgage-related securities (a subset of asset-backed securities) may be registered on Form S-3 or Form F-3 if the securities receive certain minimum NRSRO ratings, regardless of the issuer s public equity float. 21 The proposed amendments would replace these credit rating thresholds with alternative requirements This latter requirement is derived from paragraph (1)(i)(B)(1) of the Rule 405 definition of WKSI, which permits an issuer to qualify as a WKSI if (among other things) it has met this $1 billion offering threshold over the past three years. Alternatively, pursuant to paragraph (1)(i)(A) of the definition of WKSI, an issuer may qualify as a WKSI by (among other things) having a market value of equity of at least $700 million. Under the proposed amendments, an issuer that has qualified as a WKSI by meeting the $700 million market value of equity threshold may not necessarily qualify for the Regulation M exception for distributions of non-convertible debt and preferred securities. To qualify for the Regulation M exception, such an issuer would also need to have met the $1 billion offering threshold. WKSIs may use Form S-3 to register shelf offerings of certain securities that do not meet these rating thresholds. -10-

11 With respect to offerings of non-convertible debt on Form S-3 or Form F-3, a registrant would instead be required to have issued $1 billion of non-convertible securities (other than common equity) in registered primary offerings for cash during the previous three-year period, which is also one of the requirements proposed for the exception to the prohibitions of Regulation M. This change could preclude the use of shelf registration for highly rated but smaller or infrequent issuers, placing them at a potential disadvantage. The credit rating requirements for shelf offerings of asset-backed securities, including mortgage-related securities, would be replaced with requirements that initial and subsequent resales of the offerings be made in minimum denominations of $250,000 and that initial sales be made only to qualified institutional buyers as defined in Securities Act Rule 144A. In addition to reopening the comment period, the SEC has noted that it is currently engaged in a broad review of its regulation of asset-backed securities, and that this review includes an evaluation of alternatives to the credit ratings requirements other than those currently proposed. 3. Investment Company Act Rule 3a-7 Rule 3a-7 under the Investment Company Act provides an exclusion from the definition of investment company for structured finance vehicles if, among other conditions, securities offered to the general public by issuers relying on the rule are rated in one of the four highest ratings categories by at least one NRSRO. An exception to this rating requirement exists for certain securities sold to accredited investors (as defined in Securities Act Regulation D) and qualified institutional buyers, provided that the issuer and underwriters use reasonable care to ensure that all sales and resales are in fact made to such persons. The proposed amendments would remove the above-mentioned references to credit ratings by eliminating entirely the exclusion for structured finance vehicles that offer securities to retail investors. As a result, all structured financings relying on the exclusion in Rule 3a-7 could only be sold or resold to accredited investors and qualified institutional buyers. The proposed amendments also would remove references to NRSRO ratings in two other areas of Rule 3a-7 and replace them with subjective standards. First, paragraph (a)(3) of the rule permits an issuer relying on the rule s exclusion to acquire additional eligible assets or dispose of assets if, among other conditions, the acquisition or disposition would not result in a downgrade to the rating of the issuer s outstanding fixed-income securities. The proposed amendments would replace this condition with a requirement that the issuer have procedures in place to ensure that the acquisition or disposition does not adversely affect the full and timely payment of the outstanding fixed-income securities. Second, paragraph (a)(4) of the rule requires an issuer of certain securities to ensure that the cash flows from the underlying asset pool are periodically deposited in a segregated account consistent with the rating of the outstanding fixed-income securities. The proposed amendments would change this -11-

12 safekeeping provision to require instead that the cash flows be deposited in a segregated account consistent with the full and timely payment of the outstanding fixed income securities. The replacement of bright-line tests based on ratings with the less precise standards articulated in the proposed amendments may raise potential concerns about the ability of some structured finance issuers to comply with Rule 3a-7 on an ongoing basis. Non-compliance with the rule could render an issuer an unregistered investment company, with significant adverse consequences. 22 In the absence of additional guidance, Rule 3a-7 could become a less attractive way to avoid investment company status even for issuers that are willing to exclude retail investors from their offerings. As discussed above, the SEC is also generally reviewing its regulation of asset-backed securities, which may affect the exemptions provided by Rule 3a Exchange Act Rule 10b-10 Rule 10b-10, the broker-dealer transaction confirmation rule, generally requires broker-dealers that effect transactions in certain securities to provide their customers with written notification of certain transaction terms at or before completion of each transaction. With respect to transactions in debt securities (other than government securities), paragraph (a)(8) of Rule 10b-10 requires each such confirmation to include a disclosure if the security is not rated by an NRSRO. The proposed amendments would delete this disclosure requirement; however, the SEC noted that broker-dealers could still voluntarily disclose such information. 5. Investment Advisers Act Rule 206(3)-3T Section 206(3) of the Investment Advisers Act generally prohibits an investment adviser, directly or indirectly acting as principal, knowingly to sell to or purchase from a client any security, without providing a written disclosure to the client and obtaining consent. Rule 206(3)-3T provides an exception from these transaction-specific disclosure and consent requirements for investment advisers that also are registered as broker-dealers, provided certain conditions are met. This exception is available with respect to client transactions where the adviser or its affiliate is the issuer or an underwriter of the security only if the security is a non-convertible debt security that is rated by at least two NRSROs in one of the four highest rating categories. The proposed amendment would replace the NRSRO rating requirement with subjective credit risk and liquidity standards. Specifically, the adviser would be required to make an independent determination that the security is subject to no greater than moderate credit risk and that it is sufficiently liquid that it can be sold at or near its carrying value within a reasonably short period of time. 22 For example, Section 7 of the Investment Company Act generally prohibits the offer, sale, or purchase of securities by an unregistered investment company. Pursuant to Section 47, any contract made in violation of the Investment Company Act may be unenforceable or subject to rescission. -12-

13 Rule 206(3)-3T is set to expire at the end of this year. The SEC has also stated that it intends to consider taking separate, broader action on Rule 206(3)-3T. 6. Exchange Act Rule 15c3-1 Under Rule 15c3-1, the net capital rule, broker-dealers must take a capital charge (or haircut ) against certain types of securities in calculating their net capital. The current rule permits a lower haircut to be taken against certain investment grade rated securities. To qualify for the lower haircut, commercial paper must be rated in one of the three highest rating categories by at least two NRSROs, while nonconvertible debt securities and preferred stock must be rated in one of the four highest rating categories by at least two NRSROs. The SEC has proposed replacing the NRSRO rating standard with two subjective standards for credit risk and liquidity risk. To qualify for the reduced haircut, the proposal would require commercial paper to be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. Nonconvertible debt and preferred stock would have to be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time. In the original July 2008 proposing release, the SEC stated that it expects to take the view that the NRSRO rating thresholds reflected in the current rule would satisfy the new subjective rating standards, although NRSRO ratings would no longer be the only means of qualifying for the reduced haircut. However, in its current request for additional comments, the SEC asks whether it should require additional analysis beyond the NRSRO ratings if broker-dealers continue to rely on those ratings for purposes of satisfying the rule s requirements. The proposal also would remove the authorization to rely on NRSRO ratings for the purposes of determining counterparty credit risk pursuant to Appendices E and F to Rule 15c3-1. Consequently, a broker-dealer or OTC derivatives dealer that wished to use an alternative net capital deduction calculation approach set forth in these Appendices would be required to request SEC approval to determine credit risk weights based on internal calculations. B. ADOPTED AMENDMENTS The adopted amendments remove the distinction between investment grade and non-investment grade corporate debt securities in certain Exchange Act forms and rules relating to Alternative Trading Systems ( ATS ) and pilot trading systems. Under Rule 3a1-1, the SEC may require an ATS to register as a national securities exchange if it represents at least 40% of the average daily trading volume ( ADTV ) in one of eight enumerated classes of securities, or if it represents at least 50% of the ADTV in any single security and at least 5% of the ADTV in any class of securities. Two of the eight classes of securities for purposes of this rule are -13-

14 investment grade corporate debt securities and non-investment grade debt securities. 23 The amendments remove the distinction in Rule 3a1-1 between these two classes of securities, instead replacing them with a single class of corporate debt securities. The SEC made the same change to Regulation ATS. Prior to the amendments, the distinction between investment grade and non-investment grade corporate debt securities was primarily recognized in two aspects of Regulation ATS. These aspects of the regulation impose fair access requirements and capacity, integrity and security standards on any ATS that meets specified ADTV thresholds with respect to certain classes of securities. The adopted amendments also combine these two debt categories with respect to certain trading volume reporting obligations on Form ATS-R and Form PILOT. 24 AMENDMENTS THAT THE SEC HAS VOTED TO ADOPT AND PROPOSE WITH RESPECT TO NRSRO OVERSIGHT On September 17, 2009, the SEC voted to adopt and propose certain amendments to its regulations governing the oversight of NRSROs. The official releases have not yet been published; consequently, the analysis below is based on other information previously published by the SEC. 25 A. AMENDMENTS EXPECTED TO BE ADOPTED 1. Disclosure of Ratings Histories of All Ratings Exchange Act Rule 17g-2 contains recordkeeping and disclosure requirements applicable to NRSROs. The amendments to Rule 17g-2(d) are expected to require each NRSRO to publicly disclose complete ratings action histories (including upgrades, downgrades, affirmations and withdrawals) for all outstanding ratings initially made by the NRSRO as of June 26, To help minimize the adverse revenue impact from providing ratings histories to the public free of charge, the amendments will allow NRSROs to make the disclosures within one year after the action is taken for ratings that are paid for by the obligor being rated or by the issuer, underwriter, or sponsor of the security being rated ( issuer-paid ratings). For subscriber-paid ratings, the permissible delay period will be extended to two years. The disclosures must be made in an online, searchable format. The stated purpose of the disclosure requirement is to provide market participants a broad set of data which they can then analyze in order to assess the accuracy of the ratings issued by NRSROs. Similar An investment grade corporate debt security is a security that, among other things, has been rated in one of the four highest ratings categories by at least one NRSRO. The adopting release notes that in over nine years since Rule 19b-5 and Form PILOT were adopted, no SRO has ever established a pilot trading system pursuant to Rule 19b-5 to trade corporate debt securities. See e.g., Fact Sheet: Strengthening Oversight of Open Meeting of the Securities and Exchange Commission (Sept. 17, 2009), available at

15 disclosure requirements applicable to all outstanding ratings were initially proposed by the SEC in June However, largely in response to serious business concerns raised by commenters, the SEC in February 2009 instead chose to adopt a narrower disclosure requirement and seek further comment on the issue. The February 2009 amendments to Rule 17g-2(d) required each NRSRO to publicly disclose on its website complete ratings action histories for 10% of outstanding issuer-paid ratings only. Such disclosures, which could be made on a 6-month lagged basis, were required for each ratings class in which the NRSRO had made at least 500 issuer-paid ratings. 26 The amendments expected to be adopted will expand the substantive disclosure requirement to all ratings. 2. Disclosures Related to Structured-Finance Ratings Paid for by Arrangers Exchange Act Rule 17g-5 describes certain conflicts of interest that must be disclosed and managed and other conflicts of interest that are prohibited entirely. The expected amendments to Rule 17g-5 will likely add to the list of conflicts that must be disclosed and managed the act of issuing or maintaining a credit rating for certain structured finance products that are paid for by the issuer, sponsor, or underwriter (hereinafter arranger ) of the product. Additionally, the amendments are expected to require an NRSRO that is hired by an arranger to perform a structured finance credit rating to disclose to other NRSROs the relevant transaction; this would be accomplished by the hired NRSRO listing each such transaction on a password-protected website that it maintains. The hired NRSRO also must obtain a reasonably reliable representation from the arranger that the arranger will provide other NRSROs with the same information provided to the hired NRSRO; 27 similarly, the arranger would fulfill this requirement by posting the information on a password-protected website that the arranger itself maintains. Access to these websites would only be granted to competing NRSROs that annually certify to the SEC that they are using the information solely for the purpose of determining credit ratings, and that they will rate a certain percentage of the products for which they obtain information (the percentage originally proposed was 10%). These procedures are intended by the SEC to encourage the provision of competing ratings for structured finance products. To further enable issuers to provide to NRSROs access to product-related information as described above, the SEC has also voted to adopt an amendment to Regulation FD providing that such disclosures do not violate the regulation, even if the NRSROs do not freely publicize their credit ratings The NRSRO ratings classes are (i) financial institutions, brokers or dealers; (ii) insurance companies; (iii) corporate issuers; (iv) issuers of asset-backed securities; and (v) issuers of government securities, municipal securities or foreign government securities. The original proposing release noted that it would not be reasonable for the hired NRSRO to rely on such a representation if it were aware that the arranger had breached prior representations a number of times. -15-

16 B. AMENDMENTS EXPECTED TO BE PROPOSED 1. Additional Disclosures on Form NRSRO Regarding Potential Conflicts of Interest The SEC has voted to propose two amendments to its rules and forms to address the perceived conflict of interest associated with the influence that certain large customers may have on the substance of credit ratings issued by NRSROs. The SEC has voted to propose to amend Form NRSRO, the application form used by credit rating agencies seeking NRSRO designation, to require additional information regarding potential conflicts of interest related to certain large customers. Applicants would be required to disclose the percentage of their net revenue attributable to the 20 largest users of the agency s credit rating services. Additionally, applicants would be required to disclose the percentage of their net revenue attributable to services and products not related to credit ratings. Additionally, the SEC has voted to propose to require each NRSRO to publish on its website annually a consolidated report that contains specific information about each person who paid for a credit rating. The report would include the percentage of net revenue earned by the NRSRO for providing products and services, other than credit rating services, to each such person. The report would also include the relative standing of the person (top 10%, top 25%, top 50%, bottom 50%, or bottom 25%) with respect to the total amount of net revenue attributable to that person. The NRSRO would be required to include the website address of the report whenever it publishes a credit rating in a report, press release, announcement, or website. These types of perceived conflicts have been the focus of attention by the SEC and lawmakers in other recent rulemaking actions and legislative proposals. For example, amendments to the conflict-of-interest rules adopted in February 2009 prohibit NRSROs from issuing or maintaining a rating where the fee paid for the rating was negotiated, discussed, or arranged by a person with responsibility for participating in the determination of credit ratings or the development or approval of rating methodologies. 28 Another amendment adopted by the SEC in February 2009 prohibits NRSROs from issuing or maintaining a rating if an affiliate of the NRSRO has provided certain structuring advice to the issuer. 29 In fact, credit rating agency reform legislation proposed by the Obama Administration would entirely prohibit NRSROs or their affiliates from providing to issuers any consulting services unrelated to a specific credit rating issuance. 30 That legislation would also require each credit rating report to contain a disclosure regarding the number of ratings the NRSRO has provided to the obligor or its affiliates in the preceding two years and the gross amount of fees billed to those entities during that time See Exchange Act Rule 17g-5(c)(6). See Exchange Act Rule 17g-5(c)(5). See Obama Administration Proposal, supra note

17 2. Compliance Review Reports Section 15E(j) of the Exchange Act requires each NRSRO to designate a compliance officer responsible for ensuring compliance with the NRSRO s policies and procedures and with all applicable laws and regulations. Separately, Rule 17g-3 describes certain reports that each NRSRO must furnish annually to the SEC. The SEC has voted to propose to amend the reporting requirements to include a report describing the NRSRO s compliance reviews for the most recently ended fiscal year, similar to provisions in legislative proposals from Senator Reed, Representative Kanjorski and Senator Dodd. 31 The annual compliance report would include an outline of the steps taken to administer the NRSRO s policies and procedures and to ensure compliance with applicable laws and regulations. Additionally, the report would describe any material compliance issues identified by the compliance officer as well as any steps taken to remedy those issues. The report would also list every person within the NRSRO who was advised of those compliance issues. * * * Copyright Sullivan & Cromwell LLP See RATE Act, Kanjorski Proposal and Dodd Proposal, supra note

18 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Robert E. Buckholz, Jr buckholzr@sullcrom.com David B. Harms harmsd@sullcrom.com Frederick Wertheim wertheimf@sullcrom.com Washington, D.C. Eric J. Kadel, Jr kadelej@sullcrom.com Robert S. Risoleo risoleor@sullcrom.com DC_LAN01: