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Every financial crisis needs a few prime culprits in the business world in order to deflect blame from Congress and financial regulators. The subprime meltdown and subsequent credit crisis were caused by basic economic and demographic factors, including years of low interest rates, which were then raised in June 2004, and the cooling of the housing market in 2006. 1 A decade ago, five percent of mortgage loan originations were subprime, but by 2005, approximately 20 percent were in this category. 2 Lax mortgage underwriting standards and securitization, that is, the transformation of pools of home loans into bonds, contributed to a real estate bubble, which then collapsed. This securitization was significantly advanced by government-sponsored enterprises, Fannie Mae and Freddie Mac. So unregulated mortgage lenders, bank lenders, bank regulators, the Federal Reserve Board, Fannie Mae, Freddie Mac, and their regulator, all participated in pumping up the subprime market, and Congress remained oblivious to the dangers involved. Securities industry firms and the Securities and Exchange Commission (SEC) also have shouldered some of the blame for the crisis. Investment banks that issued mortgage-backed securities have come in for criticism and have become defendants in lawsuits by mortgage-backed securities investors. 3 Inevitably, there will be calls for reform and new regulation of all of these market participants. But among the key players already singled out as objects for new regulation are the credit rating agencies (CRAs). As of February 2008, Moody’s Investors Service had downgraded at least one tranche of 94.2 percent of the subprime residential mortgage-backed securities it rated in 2006, and, as of March 2008, Standard and Poor’s Rating Services had downgraded 44.3 percent of the subprime residential mortgage-backed securities it had rated between the first quarter of 2005 and the third quarter of 2007, including 87.2 percent of second-lien-backed securities. 4 Scrutiny of Credit Rating Agencies This abysmal record of performance by the two largest CRAs has led to intense scrutiny of their conduct and calls for their regulation by various agencies. CRAs analyze and evaluate the creditworthiness of issuers of debt securities, including mortgage-backed debt. While CRA ratings are often thought to represent a judgement on the worthiness of an investment because of the use of the term “investment grade” to refer to highly rated securities, the opinions of CRAs relate solely to the likelihood that a particular debt security will perform according to its terms. A high credit rating is not supposed to be viewed as an opinion that the debt instrument is a good investment. 5 In 1975, the SEC adopted the term nationally recognized statistical rating organization (NRSRO) to determine appropriate capital charges for broker-dealers under the SEC’s net capital rule according to an objective benchmark. 6 In 1981, the SEC then changed its historic practice of precluding the disclosure of ratings in securities offerings and encouraged such disclosure. 7 Further, the SEC adopted provisions allowing certain types of streamlined offerings to turn on whether a debt security had an investment grade rating. 8 Marketplace and regulatory reliance on credit ratings then gradually increased, and the concept of “investment grade” securities, as approved by an NRSRO became embedded in a wide range of U.S. regulation of financial institutions, as well as laws relating to credit worthiness. 9 The SEC had never passed a rule defining NRSROs, but rather, recognized agencies as such through a no-action letter process. The SEC staff considered a number of factors, but the most important one was that the agency was “nationally recognized” for the reliability of its ratings. 10 This opaque process, and the highly concentrated number of NRSROs led to criticism of the SEC’s procedures, and, in 1997, the SEC proposed codifying its criteria for recognizing an NRSRO and giving a rejected organization a right to appeal denial of such a designation. 11 This proposal was never acted upon, however. Regulation Controversy Government regulation of CRAs was and remains controversial. Some believe that the NRSRO designation was a barrier to competition in the credit rating business. Others argue that the SEC lacks competence to substantively regulate CRAs and that such authority would be inappropriate because the activities of CRAs are the issuance of opinions, possibly protected by the First Amendment. 12 But the failure of the CRAs to promptly adjust ratings or forecast the demise of issuers which went bankrupt when the stock market technology bubble burst led to scrutiny of their performance and raised questions as to whether their lack of regulation, and the SEC’s process for designating NRSROs was appropriate. Accordingly, the Sarbanes-Oxley Act of 2002 mandated that the SEC study the role and function of CRAs and submit a report to Congress in not less than 180 days after the passage of the act. 13 This study was required to cover the following areas: the role of CRAs in evaluating issuers; the importance of that role to investors and the markets; impediments to accurate appraisals of the financial resources and risks of securities issuers; barriers to entry to the CRA business; measures to improve dissemination of CRA appraisals; and conflicts of interest in rating operations. The SEC issued this required report, but the report did not draw any firm conclusions concerning how, if at all, CRAs should be regulated. Instead, the SEC stated that it intended to issue a Concept Release covering the following issues: mandating disclosure by NRSROs about the ratings process and other matters; conflicts of interest; anticompetitive or unfair practices; reducing barriers to entry; and ongoing SEC oversight of CRAs. 14 This Concept Release was then issued in June 2003, 15 but was never acted upon. CRA Reform Act Instead, in 2006 Congress passed the Credit Rating Agency Reform Act (CRA Reform Act), which established a system of registration and regulation of NRSROs and instructed the SEC to formulate implementing rules. 16 The CRA Reform Act effected three changes in the SEC’s regulation of NRSROs. • First, it added definitions of “credit rating,” “credit rating agency,” “nationally recognized statistical rating organization” and “person associated” with an NRSRO. 17 • Second, it replaced the SEC’s no-action letter procedure for recognizing NRSROs with a registration procedure, and in addition, imposed substantive requirements on NRSROs with respect to misuse of nonpublic information, conflicts of interest and anticompetitive or abusive conduct. 18 • Third, it amended the Exchange Act to include NRSROs among the types of entities subject to SEC record keeping and reporting requirements. 19 In June 2007, the SEC passed rules implementing the CRA Reform Act. These rules set forth basic registration requirements for NRSROs, and obligations to update registration forms. 20 Further rules subject NRSROs to record keeping and annual financial reporting requirements, 21 and require NRSROs to establish procedures to prevent the misuse of confidential information and to manage conflicts of interest. 22 Finally, NRSROs are prohibited from certain anticompetitive or abusive practices, relating to tying the issuance or level of a credit rating to an issuer’s purchase of services or products in addition to the credit rating. 23 Proposed Rules After the CRA Reform Act was passed, a total of nine CRAs registered with the SEC. 24 The SEC now has out for comment several proposals amending its initial rules under the CRA Reform Act, and establishing new rules for the rating agencies. Proposed rules would regulate conflicts of interests, disclosures, internal policies and business practices of CRAs. To some extent, these rules are predicated upon a sweeping investigation of CRAs and the SEC’s findings of questionable conduct in the rating of subprime mortgage-backed securities, especially with regard to disclosure and documentation of the ratings process and management of conflicts of interest. 25 The SEC’s first proposed rule-making package addresses the imposition of additional requirements on NRSROs to better assure integrity in their credit-rating procedures, and separate the rating of structured financial products from the rating of other securities. 26 CRAs would be required to make extensive disclosures about the information they receive in issuing ratings, and their methodology in doing so. With regard to structured products, not only would the proposed rules require more disclosure about the payment for ratings by issuers, but would also prohibit credit analysts from making recommendations to obligors, issuers, underwriters and sponsors about how to obtain a desired credit rating during the rating process. New rules would also prohibit credit analysts from participating in fee discussions for a rating, or receiving gifts from an issuer. Another proposed new rule would require an NRSRO to publish a report, each time it issues a credit rating for a structured finance product, describing how the ratings procedures and methodologies and credit-risk characteristics for structured finance products differ from those of other types of rated instruments. Alternatively, structured products could be rated with the use of a special symbol, differentiating them from other credits. SEC Proposals The SEC then issued three simultaneous proposals designed to reduce the reliance of regulated entities on CRA ratings. In one release, the SEC proposed to replace the use of securities ratings by NRSROs in rule and form requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934 for asset-backed securities with alternative criteria such as investor sophistication, minimum denomination, or experience criteria, and to replace the use of ratings for other securities with a test as to the dollar amount of certain securities issued during the last three years. 27 Another release proposed to delete references to ratings in the rules relating to whether an alternative trading system needs to register with the SEC as a national securities exchange. 28 The third release proposed to amend five rules under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 that rely on NRSRO ratings. 29 The European Union Although there is general agreement that CRAs need new regulation, the SEC’s proposals are controversial. Furthermore, the European Union (EU) has its own ideas about how to deal with CRA failures and intends to propose legislation to oversee and supervise CRAs. 30 Two consultation documents have been issued by the EU seeking views on an accelerated schedule. One document proposes a registration and supervision scheme, either by the Committee of European Securities Regulators or a new agency. The second document seeks to lessen reliance on ratings in the issuance of securities. 31 Although these ideas are similar to the SEC’s new and proposed regime for CRAs, and both are based to some extent on standards for CRAs formulated by the International Organization of Securities Commissions, it is unlikely that the SEC’s rules and the EU’s rules will be identical. Roberta S. Karmel is Centennial Professor and codirector of the Dennis J. Block Center for the Study of International Business Law at Brooklyn Law School. She is a former commissioner of the SEC. Maximillian Verrelli, a Brooklyn Law School student, assisted in the preparation of this column. Endnotes: 1. See Fatan Sabry & Thomas Schopflocher, “The Subprime Meltdown: Not Again!,” 26-7 ABIJ 1, 42 (2007). A Primer, NERA Working Paper 21 June 2007, available at www.nera.com/Publication.asp?p_ID=3209, at 9. 2. Id. at 1. 3. See Faten Sabry, Anmol Sinha & Sungi Lee, “Subprime Securities Litigation: Key Players, Rising Stakes, and Emerging Trends” 6, (NERA Economic Consulting, Working Paper 3 July 2008, available at www.nera.com/Publication.asp?p_ID=3534. 4. Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 57,967, 73 Fed. Reg. 36,212, at 36,217 (June 25, 2008), at 36217. 5. International Organization of Securities Commissions Technical Committee of IOSCO, “The Role of Credit Rating Agencies in Structured Finance Markets,” at text n.8 (March 2008), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD263.pdf [hereinafter IOSCO, The Role of CRAs], at text at n.8. 6. Id. at 6. 7. See Disclosure of Ratings in Registration Statements, Securities Act Release No. 6,336, 46 Fed. Reg. 42,024 (Aug. 6, 1981); Adoption of Integrated Disclosure System, Securities Act Release No. 6,383, 47 Fed. Reg. 11,380 (March 3, 1982). 8. Security Ratings, Securities Act Release No. 8,940, 73 Fed. Reg. 40,106 (July 11, 2008). 9. IOSCO, The Role of CRAs, supra note 4, at 7-8. 10. Claire A. Hill, “Regulating the Rating Agencies,” 82 Wash. U. L. Q. 43, 55 (2004). Other factors taken into consideration were organizational structure; size and experience of staff; the agency’s independence from the company it rates; and internal procedures to prevent misuse of inside information. Id. at 55-56. 11. Capital Requirements for Brokers or Dealers Under the Securities Exchange Act of 1934, Exchange Act Release No. 39,457, 66 SEC Docket 254 (Dec. 17, 1997). 12. Concept Release: Rating Agencies and the Use of Credit Ratings Under the Federal Securities Law, Exchange Act Release No. 47,972, 68 Fed. Reg.35,258 (June 12, 2003), at 4 [hereinafter Concept Release]. 13. SOX, §702. Sarbanes-Oxley, §702, 15 U.S.C. §78j-1 (2002). 14. Sarbanes-Oxley Report, at 43-45. SEC, Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets (January 2003), at 43-45, available at http://www.sec.gov/news/studies/credratingreport0103.pdf. 15. Concept Release, supra note 12. 16. Pub. L. No. 109-291 (2006). Implementing SEC rules were issued in June 2007. 17. Securities Exchange Act of 1934, §3(a)(62), 15 U.S.C. §78c (a)(62). 18. Securities Exchange Act of 1934, §15E, 15 U.S.C. §78o-7 . 19. Securities Exchange Act of 1934, §17(a), 15 U.S.C. §78q. 20. Exchange Act Rule 17g-1, 17 C.F. R. §240.17g-1. 21. Exchange Act Rules 17g-2, g-3, 17 C.F.R. §§240.17g-2, g-3. 22. Exchange Act Rules 17g-4, g-5, 17 C.F.R. §§240.17g-4, g-5. 23. Exchange Act Rule 17g-6, 17 C.F.R. §240.17g-6. 24. Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 57,967, 73 Fed. Reg. 36,212 (June 25, 2008), at n. 7. 25. Staff of the Office of Compliance Inspections and Examinations, Division of Trading and Markets and Office of Economic Analysis, Summary of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, text at 1-2, (July 2008). See Joanne Chung & Michael Mackenzie, “SEC sees conflicts of interest at rating agencies,” Fin. Times, July 8, 2008, at 1. 26. Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 57,967, 73 Fed. Reg. 36,212 (June 25, 2008). 27. Security Ratings, Securities Act Release No. 8,940, 73 Fed. Reg. 40,106 (July 11, 2008). 28. References to Ratings of Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 58,070, 73 Fed. Reg. 40,088 (July 11, 2008). 29. References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28,327, 73 Fed. Reg. 40,124 (July 11, 2008). 30. Nikki Taitl & Paul J. Davies, “Brussels outlines supervision plans to oversee for rating agencies,” Fin. Times, Aug. 1, 2008, at 2. 31. See Press Release, European Commission, Consultation by the Commission services on Credit Rating Agencies, (July 31, 2008), available at http://europa.eu/rapid/pressReleasesAction.do?reference=IP/08/1224&format=HTML&age.

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