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From Securities Regulation Daily, August 27, 2014

SEC split on new rating agency rules, unified on ABS reforms

By Jacquelyn Lumb and Jim Hamilton, J.D., LL.M.

Implementing the Dodd-Frank Act credit rating agency provisions, the SEC today adopted, by a 3-2 vote, regulations meant to improve the quality of credit ratings and increase credit rating agency accountability. Noting that credit rating agencies are crucial gatekeepers in the debt markets, SEC Chair Mary Jo White hailed the rules as a critical package of changes that create an extensive framework of robust reforms.

The SEC also unanimously approved new rules to enhance disclosure and strengthen investor protections related to offerings of asset-backed securities (ABS). White noted that securitizations were at the epicenter of the financial crisis. The rules the SEC adopted today address the failures in the ABS markets by requiring the disclosure of extensive asset-level information for residential and commercial mortgage-backed securities and securities backed by auto loans and leases. They also replace references to credit ratings with other credit-worthiness standards. White said these reforms will make a real difference to investors and to the financial markets. The SEC posted a draft version of the ABS rules late this afternoon.

John Arnholz, partner and leader of the structured transactions group at Bingham McCutchen LLP, said the ABS rules may provide needed clarity: “The asset-level disclosure embodied in the SEC rules is what many in the investor community had asked for, and the rules also appear to be responsive to congressional concerns. The rules also remove the regulatory uncertainty that had been hanging over the securitization sector of the financial industry.”

Credit ratings. Chair White highlighted two important areas of reform: internal controls and not allowing sales and marketing to influence ratings. The regulations implement the Dodd-Frank Act requirement for effective internal controls by establishing specific factors that the credit rating agency must consider in developing and implementing its internal controls. But she emphasized that there is no safe harbor. Rather, a rating agency must consider the specified factors and other factors in developing its own effective internal controls, which will be tailored to its particular business and governance structure. The second set of reforms highlighted by White are the measures to prevent the sales and marketing considerations of a credit rating agency from influencing its production of credit ratings.

Commissioner Luis Aguilar noted that the reforms will protect the credit rating process from undue influence and make the process more transparent. In his view, the centerpiece of the new regime is the delinking of marketing and sales from the rating process, thereby addressing the conflict of interest problem. The changes will buttress the reliability of credit ratings. They provide a solid foundation for internal controls, while allowing rating agencies to tailor their internal controls. But Commissioner Aguilar said that more work needs to be done in the future, and called on the SEC to address the issuer-pays model because of conflicts of interest in that process. Commissioner Kara Stein also called for action on the issuer-pays model.

The changes would enhance internal control structures and establish stronger conflict-of-interest requirements at credit rating agencies, as well as mandate new procedures designed to protect the integrity of rating methods. The SEC regulations create enhanced look-back review policies and procedures to determine whether a credit analyst’s prospects of future employment influenced a credit rating and increase the public disclosure of credit rating performance. There will be enhanced disclosure requirements for issuers and underwriters of asset-backed securities with respect to their use of third-party due diligence services. The new rules establish certification requirements for providers of third-party due diligence services with respect to asset-backed securities. The rules establish training, experience, and competence standards for those who participate in the credit rating process.

The regulations require credit rating agencies to establish, maintain, and enforce internal controls reasonably designed to ensure that a methodology for determining credit ratings is subject to an appropriate review process by persons who are independent from the persons that developed the methodology. The controls must be approved by management before they are used to determine credit ratings. The internal controls must also be reasonably designed to ensure that a methodology for determining credit ratings is disclosed to the public for consultation prior to being employed to determine credit ratings, that the rating agency makes comments received as part of the consultation publicly available, and that the agency considers the comments before implementing the methodology.

Further, any new quantitative models proposed to be incorporated into a credit rating methodology must be evaluated and validated prior to being put into use. They will also be subjected to periodic review and back-testing.

The controls must ensure that a rating agency engages in analysis before commencing the rating of a class of obligors, securities, or money market instruments that it has not previously rated to determine if the agency has sufficient competency, access to necessary information, and resources to rate the type of obligor, security, or money market instrument. Similarly, there must be analysis before commencing the rating of an exotic or bespoke type of obligor, security, or money market instrument to review the feasibility of determining a credit rating.

Measures such as statistics should be used to evaluate the performance of credit ratings as part of the review of in-use methodologies for determining credit ratings to analyze whether the methodologies should be updated or the work of the analysts employing the methodologies should be reviewed. Separately, the internal controls must ensure that the work and conclusions of the lead credit analyst developing an initial credit rating, or conducting surveillance on an existing credit rating, is reviewed by other analysts or by senior managers before a rating action is formally taken. Further, a credit analyst should document the steps taken in developing an initial credit rating or conducting surveillance on an existing credit rating with sufficient detail to permit an after-the-fact review or internal audit of the rating file to analyze whether the analyst adhered to the rating agency’s procedures and methodologies for determining credit ratings. The rating agency should also conduct periodic reviews or internal audits of rating files to analyze whether analysts adhere to the procedures and methodologies.

The rating agency must devote sufficient resources to implement and operate the documented internal control structure as designed. Any identified deficiencies in the internal controls must be assessed and addressed on a timely basis. Moreover, additional training must be conducted or discipline taken with respect to employees who fail to adhere to the internal control requirements. There also must be a process in place for employees to report failures to adhere to the internal controls.

Under the new regime, credit rating agencies must file a certified annual report with the SEC regarding the internal control structure. The report must contain a description of the responsibility of management in establishing and maintaining an effective internal control structure and whether the internal controls have been effective, as well as a description of each material weakness in the internal controls identified during the fiscal year, if any, and a description of how each identified material weakness was addressed.

A credit rating agency cannot issue a credit rating if a person within the agency who participated in determining or monitoring the credit rating, or developing or approving methodologies used for determining the rating, also participates in sales or marketing of a product or service of the rating agency or is influenced by sales or marketing considerations. The SEC can exempt a rating agency from the sales and marketing prohibition if the Commission finds that, due to the small size of the agency, it is not appropriate to require the separation of the production of credit ratings from sales and marketing activities. The exemption must also be in the public interest.

The regulations require a credit rating agency to publish two items when taking rating actions: 1) a form containing the quantitative and qualitative information about the credit rating; and 2) any certification of a provider of third-party due diligence services received by the credit rating agency that relates to the credit rating.

ABS reforms. The new ABS rules will implement the provisions of the Dodd-Frank Act that require issuers to provide standardized asset-level information using eXtensible Mark-up Language (XML). This tagged data format will allow investors to more easily analyze the credit quality of obligors, the collateral related to each asset, and the cash flows related to a particular asset, such as the terms, expected payment amounts, and any changes in payment terms over time. The asset-level information will be included in the offering prospectus and in ongoing reports.

Most public offerings of ABS are conducted through shelf offerings. The rules require issuers using a shelf registration to file a preliminary prospectus with transaction-specific information at least three days before the first sale of securities in the offering. This requirement will give investors more time to consider the structure, assets, and contractual rights associated with the offering.

The eligibility criteria for shelf offerings of ABS were revised to replace the investment grade requirements. The new provisions require the chief executive officer of the depositor to provide a certification at the time of the offering about the disclosure in the prospectus and the structure of the securitization. The assets must be reviewed for compliance with the representations and warranties if certain triggering events occur. The transaction documents must include a dispute resolution provision.

The new rules permit a pay-as-you-go registration fee option in which issuers may pay at the time of the filing of the preliminary prospectus rather than paying all fees upfront upon the filing of the registration statement. New Forms SF-1 and SF-3 will replace current Forms S-1 and S-3 for ABS issuers in order to distinguish them from corporate filers and to tailor them for ABS offerings. A single prospectus will be filed for each takedown from the shelf offering. The SEC also adopted changes to Forms 10-D, 10-K and 8-K, including the disclosure of any material instances of noncompliance with the Regulation AB servicing criteria.

The new disclosure requirements will include additional information about transaction parties and about any modifications to the terms of the underlying assets. Revisions to Regulation AB will standardize the static pool disclosure, revise the definition of asset-backed securities, and require the disclosure, on an aggregated basis, of the types and amount of assets that do not meet the underwriting criteria described in the prospectus.

Commissioner Luis Aguilar noted that the SEC has not completed its ABS work. He said it is crucial to complete the other ABS proposals and the risk-retention rules. The SEC should require issuers to provide asset-level information across almost all asset classes, in his view, including equipment loans and leases, student loans, and inventory financings as mentioned in the 2010 proposal. Aguilar also called for issuers to provide the same disclosure in private offerings and resales under Rule 144A as for registered offerings.

Commissioner Daniel Gallagher welcomed the rule adoption as a return to the SEC’s role in mandating disclosure so that investors can make informed decisions. He expressed regret that the SEC cannot allow time to see how these rules work before forging ahead with the risk-retention rules, which he sees as redundant and a departure from the SEC’s traditional role.

Commissioner Kara Stein regretted that the SEC had put on hold its consideration of a software engine/waterfall model, which, in her view, would have assisted investors in conducting due diligence during the three days before the first sale of the securities. This program would model the contractual cash flow provisions of ABS. Stein said the SEC should return to this important initiative.

The rules adopted today, unlike a number of the Dodd-Frank Act provisions, actually address issues that contributed to the financial crisis, according to Commissioner Michael Piwowar. He was pleased that the SEC obtained guidance from the Consumer Financial Protection Bureau to ensure that the asset- and loan-level disclosure will not raise implications for issuers or for the SEC under the Fair Credit Reporting Act.

Piwowar also commended the staff for its procedural decisions in connection with this rulemaking. Reopening the comment period to address the staff memorandum on privacy resulted in a better final rule, in his view.

Registrants must use Forms SF-1 and SF-3 no later than one year after the publication of the ABS rules in the Federal Register, along with the related rules and disclosures. Offerings of ABS backed by residential and commercial mortgages, auto loans, auto leases, and debt securities must comply with the asset-level disclosure requirements no later than two years after publication in the Federal Register. Beginning one year after the publication of the rules in the Federal Register, Forms 10-D or 10-K must comply with the new rules and disclosures, other than the asset-level disclosures.

Attorneys: John Arnholz (Bingham McCutchen LLP).

MainStory: TopStory CreditRatingAgencies DoddFrankAct FormsFilings PublicCompanyReportingDisclosure RiskManagement SecuritiesOfferings

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