[This story previously appeared in Securities Regulation Daily.]
By John Filar Atwood
Commissioners Michael Piwowar and Daniel Gallagher issued scathing dissents to the adoption last week of new requirements for credit rating agencies, with Gallagher calling them “ill-conceived” and “a fundamental abandonment of the tenets of good government.” Piwowar questioned whether the reforms would have any practical benefit for investors.
New rules. The rules to which the commissioners objected establish new requirements for credit rating agencies in order to provide greater internal governance and transparency, improve the quality of credit ratings, and increase credit rating agency accountability. Implementation of the rules was mandated by the Dodd-Frank Act.
While the new rules contain numerous provisions, Gallagher and Piwowar objected to two sections in particular. First is the requirement that nationally recognized statistical rating organizations (NRSROs) establish, maintain and enforce an internal control structure. Second is the amendment of 1934 Act Rule 17g-5 to mandate the separation of ratings determinations from NRSRO sales and marketing activities.
Internal controls. With respect to internal controls, Gallagher said in dissenting remarks that he favored an approach where the SEC provided guidance on the factors an NRSRO should consider in the release accompanying the rules, along with a statement that the staff would examine internal control structures carefully and would revisit the rules to address any shortcomings. Instead, he noted, the factors are listed in the rule’s text and impose a mandate on NRSROs to take the listed factors into consideration.
Gallagher said that this inappropriately places the focus on the process by which an NRSRO develops its internal controls rather than on the controls themselves. In addition, he believes it creates the potential for a safe harbor by giving an NRSRO deemed to have inadequate internal controls the ability to defend itself by pointing to the factors in the rule text and demonstrating that it took them all into consideration.
Piwowar also favored leaving specific factors out of the rule and possibly prescribing specific standards after seeing how NRSROs handled the new requirements. In his written statement, he said that the rule gives NRSROs no flexibility to tailor their internal control structures to their particular circumstances because it lays out 17 factors they must consider when developing the internal controls.
Separation from sales and marketing. On the issue of separating ratings determination from sales and marketing activities, Piwowar noted that the final rule does not stop with prohibiting sales and marketing employees from participating in ratings determinations, but includes language that prohibits an NRSRO from having an employee involved in the ratings determination process from being “influenced by” sales and marketing considerations. He believes this sets an impossible standard, as any NRSRO that grows its business in any asset class could be said to have the ratings process “influenced by” sales and marketing considerations.
Gallagher, who supported a re-proposal of the rules to address both the internal controls and sales and marketing issues, said the Commission has created a dangerous precedent by creating a catch-all prohibition against someone who is influenced by sales and marketing considerations. The provision lacks any limits to curtail its universal application, he said, adding that he expects courts to strike down the “vague and unverifiable” influence clause.
Other reactions. Other securities industry participants also weighed in on the adoption of the new credit rating agency rules. Dennis Kelleher, president of Wall Street watchdog Better Markets, said that the new rules made at least two significant improvements, citing the provision to prevent sales and marketing incentives from influencing the ratings process, and the inclusion of specific factors that the rating agencies must consider as they develop their internal controls structures. He noted that the SEC has more work to do to eliminate conflicts of interest that persist in the ratings industry, and urged the Commission to adopt a system that will prevent issuers from buying good ratings by selecting and paying the agencies to rate their complex securities.
Americans for Financial Reform (AFR) said that it is pleased that the rules have been finalized, adding that the rules were improved to contain much stronger language addressing the impact of conflicts of interest and sales considerations on the quality of credit ratings. The group noted that conflicts of interest have been a major contributor to deceptive and misleading ratings.
The group said that much remains to be done because the fundamental business incentives of credit rating agencies continue to encourage ratings inflation. AFR believes that the new credit rating rules fall short in requirements for meaningful transparency and consistency of ratings across asset classes. In addition, it said that the new requirements for asset-backed securities have loopholes since they do not appear to cover privately issued structured finance products and certain significant asset classes.