SEC Proposes New Rules on Credit Ratings of Structured Products; New York Attorney General Announces Agreement with Rating Agencies on RMBS Ratings Practices

At its open meeting on June 11, 2008, the SEC voted to propose new rules and rule revisions that would apply to nationally recognized statistical rating organizations (NRSROs) issuing ratings of structured products. Chairman Cox stated that the proposals are a response to the subprime mortgage crisis and are intended to “promote transparency, accountability, and competition in the credit rating agency industry.”

The proposals are in three parts: The first part addresses conflicts of interest in the ratings process and mandates public reporting of specified ratings-related information by NRSROs; the second part requires NRSROs to differentiate their ratings of structured products from their ratings of corporate debt; and the third part proposes reforms to the use of ratings in the SEC’s own rules. At the open meeting on June 11, the Commission discussed the first two parts and voted to propose them for public comment. The third part of the proposals will be discussed and voted on at a June 25 meeting.

The principal proposals concerning conflicts would:

• Require disclosure of the fact that a rating of a structured finance transaction was paid for by an arranger of the transaction;
• Prohibit an NRSRO from issuing a rating of a structured product with respect to which it made structuring recommendations; and
• Prohibit NRSRO personnel who are involved in the ratings process from negotiating fees for ratings or receiving gifts over $25 from transaction arrangers.

The principal proposals concerning reporting would:

• Require NRSROs to make all of their initial structured product ratings and subsequent rating actions publicly available in a way that will facilitate comparison of their performance;
• Require NRSROs to document their rationale if an assigned structured finance rating differs from the rating implied by the NRSRO’s quantitative model;
• Require NRSROs to publish performance statistics for 1, 3 and 10 years within each rating category in a way that facilitates comparison with their competitors in the industry;
• Require NRSROs to make an annual report of the number of ratings actions they took in each ratings class, and to maintain an XBRL database of all rating actions on their websites;
• Require disclosure of ratings methodologies for structured products, including data on the underlying assets;
• Require disclosures concerning NRSROs’ reliance on asset verification procedures of others and the role that the NRSRO’s evaluation of an asset originator’s quality plays in the rating; and
• Require disclosure of how frequently credit ratings are reviewed, whether different models are used for ratings surveillance than for initial ratings, and whether changes made to models are applied retroactively to existing ratings.

The proposal concerning differentiation of structured finance ratings from traditional corporate ratings permits NRSRO’s to choose between two alternatives. NRSROs could either:

• At the time a structured finance rating is assigned, publish a report describing how the applicable ratings methodology differs from that used in corporate finance ratings and how the risks of the structured product differ from those encountered in corporate debt; or
• Adopt symbols for structured finance ratings that differentiate them from those used for corporate debt (either by creating totally different ratings category symbols or adding subscripts or other indicators to existing ratings symbols that designate ratings assigned to structured products).

Commissioner Atkins dissented from the proposal to require differentiated structured finance ratings, citing costs, concerns as to whether the proposals would achieve the intended purpose and potential unintended consequences. Chairman Cox and staff members acknowledged that the adoption of differentiated ratings could lead to problems such as investors’ forced liquidation of investments that do not meet investment guidelines based on the old ratings, and noted that the proposal will specifically request comments on the possible effects of imposing such a requirement.

The SEC action on the proposals comes the week after the New York Attorney General announced agreements with Standard & Poor’s, Moody’s and Fitch in which the country’s three largest rating agencies agreed to implement changes to their procedures for rating residential mortgage-backed securities (RMBS) transactions, including:

• Charging fees for work performed on RMBS transactions whether or not a rating is issued;
  Disclosing information about RMBS transactions submitted for review whether or not a rating is issued;
• Establishing criteria to evaluate mortgage loan originators and disclosing those evaluations;
• Establishing criteria for underwriters’ due diligence review of the loans underlying RMBS transactions and reviewing and disclosing the results of those reviews;
• Reviewing annually the independence of their RMBS ratings business; and
• Requiring transaction parties to make representations concerning loans underlying RMBS transactions.

Click here for the SEC press release on their rating agency actions: http://sec.gov/news/press/2008/2008-110.htm

Click here for the New York Attorney General’s press release on the agreement with the rating agencies: http://www.oag.state.ny.us/press/2008/june/june5a_08.html

The proposing release for the SEC’s actions is not yet available. The proposal will be subject to a 30 day comment period.

Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under the “Structured Finance” or “Capital Markets” sections of this website if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP