Roberta S. Karmel
Roberta S. Karmel ()

The Financial Crisis Inquiry Commission, which examined the causes of the financial and economic crisis of 2008, concluded that “the failures of credit rating agencies were essential cogs in the wheel of financial destruction” and the “three [dominant] credit rating agencies were key enablers of the financial meltdown.”1 Criticism of the conduct and competence of credit rating agencies (CRAs) after 2008 focused on the huge number of write-downs of highly rated residential mortgage-backed securities and collateralized-debt obligations, but critical scrutiny of CRAs had been ongoing since the late 1990s.

In 2006, Congress passed the Credit Rating Agency Reform Act,2 which gave the Securities and Exchange Commission (SEC) limited regulation of CRAs. The Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank)3 mandated much more regulatory oversight. This column will review the provisions of Dodd-Frank applicable to CRAs and the progress of the SEC in implementing those provisions.

Regulation of CRAs

CRAs analyze and evaluate the creditworthiness of corporate and sovereign issuers of debt securities. While CRA ratings are often regarded as a judgment on the worthiness of an investment, CRAs claim that their opinions relate solely to the likelihood that a particular debt security will perform according to its terms. In 1975, the SEC adopted the term “nationally recognized statistical rating organization” (NRSRO) to determine capital charges for broker-dealers for purposes of the SEC’s net capital rule. Marketplace and regulatory reliance on credit ratings then gradually increased, and the concept of an NRSRO became embedded in a wide range of U.S. regulations of financial institutions, as well as state, federal, and foreign laws relating to creditworthiness.

The decision to impose government regulation on CRAs in the United States in 2006 was controversial and to some extent remains so. Some argued that the NRSRO designation was a barrier to competition in the rating business. Others argued that the SEC lacked authority to substantively regulate CRAs because the activities of these firms are journalistic and protected by the First Amendment. Even when Congress imposed SEC regulation on CRAs, hesitancy about government control of ratings led to a provision in the 2006 statute that expressly prohibits the SEC from regulating “the substance of credit ratings or the procedures and methodologies by which any [CRA] determines credit ratings.”4

For many years, the CRAs sold subscriptions to investors to pay for issuer credit ratings, but in recent years, an issuer pay model has prevailed. Furthermore, CRAs became public companies or subsidiaries of public companies and were motivated to increase their earnings. Then, during the bubble years preceding the 2008 financial meltdown, CRAs were actively engaged in rating securitized financial products and often participated in the structuring of these products in order to give them a high credit rating. More recently, CRAs have been criticized for their sovereign debt ratings.

Dodd-Frank enhanced the regulation and oversight of NRSROs by imposing new reporting, disclosure and examination requirements. Further, Dodd-Frank mandated the creation of the Office of Credit Ratings within the SEC, which was established in June 2012. Since Dodd-Frank was passed, the SEC adopted a number of rules applicable to NRSROs relating to the registration of NRSROs, required business records and public disclosure of ratings history data, audited and other financial reports, the establishment of procedures regarding material non-public information, conflicts of interest, prohibitions against unfair, abusive or coercive practices, and requirements for, including information regarding representations, warranties and enforcement mechanisms available to investors.5

The Credit Rating Agency Reform Act and Dodd-Frank also required that the SEC make certain annual reports to Congress. In December 2013, the SEC staff issued a summary report on the SEC’s examination of each NRSRO (examinations report)6 and an annual report on registered CRAs.7 These reports detail the SEC’s progress in imposing new regulations on NRSROs and continuing shortcomings in their regulation.

Much of the annual report is devoted to an analysis of competition within the NRSRO industry. The industry remains concentrated, with only 10 NRSROs registered with the SEC, and three of them—S&P, Moody’s and Fitch having issued 96.5 percent of all outstanding ratings as of Dec. 31, 2012, only a slight decline from year end 2007.8 Although the examinations report reveals a number of weaknesses in the management of conflicts of interest, implementation of ethics policies and internal supervisory controls, the report does not name names, so it is not possible to discern which of the CRAs has failed to fully reform its practices and procedures.

When Dodd-Frank was under consideration by Congress, two somewhat contradictory ideas were vetted with regard to rating agency reform. Both of these ideas were based on the belief that CRAs were an unacceptable oligopoly because three big NRSROs dominated the field. First, there was a view that all references to ratings should be deleted from SEC regulations and the regulations of other government agencies. A provision to this effect was included in Dodd-Frank as passed.

Second, was a proposal for a self-regulatory or other organization that would assign an offering to NRSROs for a rating. This proposal, contained in the Franken-Wicker amendment to Dodd-Frank, was put into the Senate bill, but was not included in the final statute. However, the SEC was tasked with considering an assigned rating system or proposing some alternative method for dealing with conflicts of interest in the ratings process.

Recent Moves

On Dec. 27, 2013, the SEC passed rules removing references to NRSRO rating in several of its rules and forms.9 The use of the term NRSRO was devised in order to provide a method for determining net capital charges by broker-dealers on different grades of debt securities under Rule 15c3-1, the net capital rule, which prescribes a net liquid assets test for purposes of determining whether a firm has sufficient liquid assets for an orderly wind-down of its business in the event of financial failure. The rule prescribes differing haircut amounts for classes of securities, which measure whether there are market or credit risks that prevent the securities from having a ready market. Previously, commercial paper, nonconvertible debt and preferred stock rated in high rating categories by at least two NRSROs were included in the classes of securities that had lower haircuts than other securities.

In the rules removing references to credit ratings in Rule 15c3-1, the SEC substituted an alternative standard of “creditworthiness” as a condition for qualifying for the lower haircut treatment.10 As a conceptual matter, this sounds simple, but as a practical matter broker-dealers will be required to engage in some complicated procedures in order to apply a creditworthiness standard. A broker-dealer will be required to establish, document, maintain, and enforce policies and procedures to assess and monitor the creditworthiness of each security or money market instrument to determine whether an investment has only a minimal amount of risk. In order to guide broker-dealers in developing adequate procedures for determining creditworthiness, the SEC set forth a list of factors to be considered, as follows: credit spreads; securities-related research; internal or external credit risk assessments; default statistics; inclusion in an index; enhancements and priorities; price, yield/and/or volume; and asset class-specific factors.11

When credit ratings were used to compute net capital, broker-dealers and examiners had an objective standard for determining whether securities had a ready market. The more subjective approach in the new rules could result in inconsistent net capital treatment across broker-dealers. Further, the SEC and self-regulatory organization examiners may second-guess a broker-dealer’s determination.

Although the SEC has stated that it “does not intend for the new standard to result in a more liberal requirement that broadens the scope of the rule by allowing more positions to qualify for the lower haircuts,”12 it is not hard to imagine efforts to game the new system. In any event, it is likely that the rule will affect the net capital levels in the broker-dealer industry.13 Further, the cost and complexity of developing a credit evaluation infrastructure required by the new rules may be beyond the means of smaller broker-dealers.14

The new rules could also have unforeseen adverse consequences for security issuers, NRSROS and other providers of credit risk analysis. The SEC and other agencies are required to consider the costs and benefits of any new regulation. Unfortunately, Congress does not do so when passing new legislation. Despite the problems that surfaced in 2008 with regard to credit ratings, removing references to them in the SEC’s net capital rules as mandated by Dodd-Frank may cause greater problems than have been solved.

Other SEC rules in which references to NRSRO ratings have been removed are Rule 10b-10, which provides for disclosures in broker-dealer confirmations to customers; Rule 5b-3 under the Investment Company Act, which permits funds to look through repurchase agreements to the underlying collateral securities; and forms N-1A, N-2, and N-3, which contain requirements for mutual funds to report information to shareholders, including information about the credit quality of their portfolios. These rules also now contain a credit quality and liquidity criteria designed to achieve the same purposes as NRSRO credit ratings.

Conflicts of Interest

Section 939F of Dodd-Frank required the SEC to conduct a study and report to Congress on the conflicts of interest associated with issuer-pay and subscriber-pay models for CRAs and the feasibility of establishing a system in which a public or private utility or a self-regulatory organization would assign NRSROs the determination of credit ratings for structured finance products. This controversial system was set forth in the Senate bill for Dodd-Frank but was deleted in conference and instead handed off to the SEC for decision. Further, Dodd-Frank in its final form required the SEC to pass a rule to implement a system for assigned credit ratings unless the SEC determines that an alternative system would better serve the public interest.

The SEC attempted to create an alternative system in November 2011, when it adopted Rule 17g-5 to create a mechanism for an NRSRO not hired to rate an offering to determine a credit rating for a structured finance product and to obtain the same information provided to a hired NRSRO. Although the rule has generated some comments by non-hired NRSROs on ratings by others, it has not generated a viable alternative to the assigned ratings system. However, the assigned ratings system remains very controversial because some believe it would create moral hazard by putting a government imprimatur on ratings and because it might be unconstitutional, depending on how it is structured and operated.

In December 2012, the SEC issued the required report to Congress on assigned ratings, but did not offer any conclusion on an assigned ratings system.15 Rather, the SEC staff suggested some reforms to the Rule 17g-5 program and set forth some other possible alternatives to an assigned ratings system. The staff found benefits, but also a number of problems with an assigned ratings system and recommended that if the SEC decided to go ahead with an assigned ratings system it should go to Congress for start-up funding and other matters. On May 14, 2013, the SEC held a Credit Ratings Roundtable to discuss this staff report on assigned ratings, but to date has not issued any proposals to deal with implementation of an assigned ratings system.16

Another conflict of interest issue assigned to the SEC for study by Dodd-Frank was the independence of NRSROs and conflicts of interest involved in their provision of ancillary services to clients. This is the same problem the SEC faced for many years in regulating auditors of the SEC registered issuers until the Sarbanes-Oxley Act prohibited such auditors from providing most ancillary services to audit clients.17 In November 2013, the Office of Credit Ratings of the SEC prepared the required report,18 which describes the ancillary services of the NRSROs and how they are managed. The SEC staff did not find that the NRSROs have been unable to manage such conflicts as ancillary services range only between 10 and 28 percent of total revenue.19

Yet, given the SEC rulemaking deleting references to ratings in the net capital and other rules, NRSROs may well find they need to develop and offer ancillary services. It would seem, therefore, that this is a space to watch for future SEC analysis and regulation.

Action Abroad

This column has not covered the regulatory initiatives by the European Union (EU) or the International Organization of Securities Commissions (IOSCO) with regard to CRAs. Nevertheless, an IOSCO Code of Conduct and EU Credit ratings regulations are noted in the SEC’s credit rating independence study.20 Also, on July 30, 2013, IOSCO published a report recommending the creation of supervisory colleges for the examination of internationally active CRAs, and inaugural meetings of the colleges were held in November 2013.21 In December 2013, the EU securities regulator issued a report criticizing the confidentiality and timing of sovereign debt rating releases by S&P, Moody’s and Fitch and failures to use qualified staff to prepare them.22 Further regulatory action against CRAs abroad can therefore be anticipated.


The reform of CRAs mandated by Dodd-Frank was broad. In reality, while the SEC had actively pursued these mandates, it has not yet transformed the NRSRO industry in a significant way. Whether the Office of Credit Ratings and its work, or implementation of an assigned ratings system or alternative system, will do so remains to be seen.

Roberta S. Karmel is Centennial Professor of Law and co-director of the Block Center for the Study of International Business Law at Brooklyn Law School. She is a former commissioner of the Securities and Exchange Commission. Michael Tse, a Brooklyn Law School student, assisted in the preparation of this column.


1. Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, at xxv (2011), available at

2. Credit Rating Agency Reform Act of 2006, 15 U.S.C. §78o-7 (2012).

3. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

4. Credit Rating Agency Reform Act of 2006, 15 U.S.C. §78o-7(c)(2)(2012).

5. 17 C.F.R. §240.17g-1 -17g-7(2013).

6. 2013 Summary Report of Commission Staff’s Examination of Each Nationally Recognized Statistical Rating Organization As Required by Section 15E(p)(3)(C) of the Securities Exchange Act of 1934 (2013), available at

7. Annual Report on Nationally Recognized Statistical Rating Organizations As Required by Section 6 of the Credit Rating Agency Reform Act of 2006 (2013), available at

8. Id. at 9.

9. Removal of Certain References to Credit Ratings Under the Securities Exchange Act of 1934, 79 Fed. Reg. 1522 (Jan. 8, 2014); Removal of Certain References to Credit Ratings Under the Investment Company Act, 79 Fed. Reg. 1316 (Jan. 8, 2014).

10. Removal of Certain References to Credit Ratings Under the Securities Exchange Act of 1934, 79 Fed. Reg. 1522, 1524 (Jan. 8, 2014).

11. Id. at 1527-28.

12. Id. at 1526.

13. Id. at 1544.

14. Id. at 1546.

15. Report to Congress on Assigned Credit Ratings As Required by Section 939F of the Dodd-Frank Wall Street Reform and Consumer Protection Act (2012), available at

16. See Annual Report, supra note 7, at 24.

17. Sarbanes-Oxley Act of 2002, 15 U.S.C. §78j-1(g) (2012).

18. Report to Congress, Credit Rating Agency Independence Study As Required by Section 939C of the Dodd-Frank Wall Street Reform and Consumer Protection Act (2013), available at

19. Id. at 46.

20. Id. at 15-17.

21. Annual Report, supra note 7, at 2.

22. Joe Kirwin, “ESMA Faults Credit Rating Agencies on Conflict Issues, Confidentiality, Expertise,” World Securities Law Report (BNA), Dec. 13, 2013, at 15.