Friday, March 30, 2012

Credit Rating Agency Regulation in the US


This week, I would like to build on my last week’s article about the existing and proposed regulation of credit rating agencies (CRA) in the EU by discussing the current status of such regulation in the US.


Basics of the Dodd Franck Reform of CRA Regulation


On January 5, 2010, the Dodd Franck Act has provided for significant changes in the US regulation on CRA.

The reasons for the American legislator to amend the existing regulation were

  • the systemic importance of credit ratings;
  • the reliance placed on credit ratings by individual investors, institutional investors, and financial regulators;
  • the central role of CRA in capital formation;
  • the importance of credit ratings for the efficient performance of the US economy.

The Dodd Franck act starts off with the basic finding that “credit rating agencies face conflicts of interest”. The new legislation intends to contain such conflicts by “careful monitoring” and by “giving clearer authority to the Securities and Exchange Commission”.

First of all, the new regulation distinguishes 3 types of rating agencies:

  • Credit Rating Agency: The legal definition comprises only such agencies whose ratings are publicly available for free or a reasonable fee, which employ a quantitative and/or qualitative model, and whose business model is based on a payment by issuers, investors, or other market participants. The aforementioned conditions are cumulative conditions.
  • Nationally Recognized Statistical Rating Organization (NRSRO): Such rating organization must be registered with the SEC to issue ratings certified by qualified institutional buyers such as financial institutions, insurance companies, corporate issuers, issuers of asset-backed securities, and issuers of government and municipal securities.
  • Person associated with a NRSRO: The legal definition includes any person controlling a NRSRO (partner, officer, director, branch manager, etc.) as well as any person controlled by a NRSRO (namely employees).

The bulk of new legislation applies to NRSRO and any person associated with a NRSRO.


Current Status of US CRA Regulation





Relationship CRA / SEC

The relationship between the CRA and the SEC is characterized by the obligation of the CRA to register and the possibility of the SEC to cancel this registration.
It is important to note that the obligation to register only applies to CRA who want to be treated as NRSRO. The Securities Exchange Act 1934 contains detailed information regarding the content of the CRA’s application. The main reason for the SEC to refuse registration is an applicant CRA “not having adequate financial and managerial resources to consistently produce credit ratings with integrity and to materially comply with the procedures and methodologies disclosed”.
Generally speaking, the SEC can cancel the registration if this is “necessary for the protection of investors and in the public interest” and one of the enumerated cases of cancellation (such us commission of crimes and violation of securities laws) exists.

Relationship CRA / Investors

Prohibited acts include the following:
  • Bundle the issuing of credit ratings with other products or services of the NRSRO
  • Threaten to lower a credit rating of securities of an asset pool unless other securities of such asset pool are also rated by the same NRSRO.
  • Threaten to modify a credit rating unless the obligor purchases the credit rating or any other service or product of the NRSRO.

Relationship CRA / Issuer

As regards the international organization of CRA, the most important set of regulations is the management of conflicts of interest. The current US CRA regulation distinguishes conflicts of interests as per § 240.17g-5 (b) and prohibited conflicts of interests as per § 240.17g-5 (c). In the first case the NRSRO must disclose the existence of the conflict of interest but can nevertheless issue a credit rating. In the second case, it is not allowed to issue a credit rating.



Resources:

  • Dodd Franck Act as of January 5, 2012
  • Securities Exchange Act 1934 as amended lastly on January 3, 2012
  • SEC Rules and Regulations Part 240, §§ 240.17g-1 et seq.
  • SEC Proposed Rules for Nationally Recognized Statistical Rating Organizations as of May 18, 2011