Nationally Recognized Statistical Rating Organizations

Federal RegisterJun 8, 2011

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 232, 240, 249, and 249b

[Release No. 34-64514; File No. S7-18-11]

RIN 3235-AL15

Nationally Recognized Statistical Rating Organizations

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rules.

SUMMARY:

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and to enhance oversight, the Securities and Exchange Commission (“Commission”) is proposing amendments to existing rules and new rules that would apply to credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (“NRSROs”). In addition, in accordance with the Dodd-Frank Act, the Commission is proposing a new rule and form that would apply to providers of third-party due diligence services for asset-backed securities. Finally, the Commission is proposing amendments to existing rules and a new rule that would implement a requirement added by the Dodd-Frank Act that issuers and underwriters of asset-backed securities make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. The Commission is requesting comment on the proposed rule amendments and new rules.

DATES:

Comments should be received on or before August 8, 2011.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules.shtml

); or

• Send an e-mail to

rule-comments@sec.gov.

Please include File Number S7-18-11 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-18-11. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules.shtml

). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street NE., Washington, DC 20549. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K. McGowan, Deputy Associate Director, at (202) 551-5521; Randall W. Roy, Assistant Director, at (202) 551-5522; Raymond A. Lombardo, Branch Chief, at (202) 551-5755; Rose Russo Wells, Senior Counsel, at (202) 551-5527; Joseph I. Levinson, Special Counsel, at (202) 551-5598; or Timothy C. Fox, Special Counsel, at (202) 551-5687; Division of Trading and Markets; or, with respect to the proposals for issuers and underwriters of asset-backed securities, Eduardo A. Aleman, Special Counsel, Division of Corporation Finance at (202) 551-3430; Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commission, with respect to NRSROs, is proposing amendments to rules 17 CFR 232.101 (“Rule 101 of Regulation S-T”), 17 CFR 232.201 (“Rule 201 of Regulation S-T”), 17 CFR 240.17g-1 (“Rule 17g-1”), 17 CFR 240.17g-2 (“Rule 17g-2”), 17 CFR 240.17g-3 (“Rule 17g-3”), 17 CFR 240.17g-5 (“Rule 17g-5”), 17 CFR 240.17g-6 (“Rule 17g-6”), 17 CFR 240.17g-7 (“Rule 17g-7”), 17 CFR 249b.300 (“Form NRSRO”), and proposing new rules 17 CFR 240.17g-8 (“Rule 17g-8”) and 17 CFR 240.17g-9 (“Rule 17g-9”).

In addition, the Commission, with respect to providers of third-party due diligence services for asset-backed securities, is proposing new rules 17 CFR 240.17g-10 (“Rule 17g-10”) and 17 CFR 249b.400 (“Form ABS Due Diligence-15E”).

Finally, the Commission, with respect to issuers and underwriters of asset-backed securities, is proposing amendments to 17 CFR 232.314 (“Rule 314 of Regulation S-T”) and 17 CFR 249.1400 (“Form ABS 15G”), and proposing new rule 17 CFR 240.15Ga-2 (“Rule 15Ga-2”).

I. Background

Title IX, Subtitle C of the Dodd-Frank Act,

“Improvements to the Regulation of Credit Rating Agencies,” among other things, establishes new self-executing requirements applicable to NRSROs, requires certain studies,

and requires that the Commission adopt rules applicable to NRSROs in a number of areas.

The NRSRO provisions in the

Dodd-Frank Act augment the Credit Rating Agency Reform Act of 2006 (the “Rating Agency Act of 2006”), which established a registration and oversight program for NRSROs through self-executing provisions added to the Exchange Act and implementing rules adopted by the Commission under the Exchange Act as amended by the Rating Agency Act of 2006.

Title IX, Subtitle C of the Dodd-Frank Act also provides that the Commission shall prescribe the format of a certification that providers of third-party due diligence services would need to provide to each NRSRO producing a credit rating for an asset-backed security to which the due diligence services relate.

Finally, Title IX, Subtitle C of the Dodd-Frank Act establishes a new requirement for issuers and underwriters of asset-backed securities to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

Public Law 111-203, 124 Stat. 1376, H.R. 4173 (July 21, 2010).

See

Public Law 111-203 §§ 939, 939D-939F. On December 17, 2010, the Commission issued a request for comments to inform a required study on standardizing credit ratings terminology.

See Credit Rating Standardization Study,

Securities Exchange Act of 1934 (“Exchange Act”) Release No. 34-63573 (December 17, 2010). On May 10, 2011, the Commission issued a request for comments to assist it in carrying out a required study on, among other matters, the feasibility of establishing a system in which a public or private utility or a self-regulatory organization assigns NRSROs to determine credit ratings for structured finance products.

See Solicitation of Comment to Assist in Study on Assigned Credit Ratings,

Exchange Act Release No. 64456 (May 10, 2011). The Commission also is required to conduct a study of the independence of NRSROs and how that independence affects the ratings issued by NRSROs. The Comptroller General of the United States is required to conduct a study on alternative means for compensating NRSROs in order to create incentives to provide more accurate credit ratings as well as a study on the feasibility and merits of creating an independent professional organization for rating analysts employed by NRSROs.

See

Public Law 111-203 §§ 931-939H. In addition, Title IX, Subtitle D, “Improvements to the Asset-Backed Securitization Process,” contains Section 943, which provides that the Commission shall adopt rules, within 180 days, requiring an NRSRO to include in any report accompanying a credit rating of an asset-backed security a description of the representations, warranties, and enforcement mechanisms available to investors and how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities.

See

Public Law 111-203 § 943. On January 20, 2011, the Commission adopted Rule 17g- 7 to implement Section 943.

See Disclosure for Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act,

Securities Act of 1933 (“Securities Act”) Release No. 9175 (Jan. 20, 2011), 76 FR 4489 (Jan. 26, 2011) and 17 CFR 240.17g-7. Prior to enactment of the Dodd-Frank Act and the adoption of Rule 17g-7, the Commission proposed a different rule to be codified at 17 CFR 240.17g-7.

See Proposed Rules for Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 57967 (June 16, 2008), 73 FR 36212 (June 25, 2008). This proposed rule would have required an NRSRO to publish a report containing certain information with the publication of a credit rating for a structured finance product or, as an alternative, use ratings symbols for structured finance products that differentiate them from the credit ratings for other types of debt securities.

Id.

In November 2009, the Commission announced it was deferring consideration of action on the proposal and separately proposed a different rule to be codified at 17 CFR 240.17g-7 that would have required an NRSRO to annually disclose certain information.

See Proposed Rules for Nationally Recognized Statistical Rating Organizations

Exchange Act Release No. 61051 (Nov. 23, 2009), 74 FR 63866 (Dec. 4, 2009). Although the Commission adopted Rule 17g-7 on January 20, 2011 to implement

Section 943 of the Dodd-Frank Act, the November 23, 2009 proposal remains outstanding.

See

Public Law 109-291 (2006). The Rating Agency Act of 2006, among other things, amended Section 3 of the Exchange Act to add definitions, added Section 15E to the Exchange Act to establish self-executing requirements on NRSROs and provide the Commission with the authority to implement a registration and oversight program for NRSROs, amended Section 17 of the Exchange Act to provide the Commission with recordkeeping, reporting, and examination authority over NRSROs, and amended Section 21B(a) of the Exchange Act to provide the Commission with the authority to assess penalties in administrative proceedings instituted under Section 15E of the Exchange Act.

See

Public Law 109-291 §§ 3 and 4 and 15 U.S.C. 78c, 78o-7, 78q, and 78u-2. The Commission adopted rules to implement a registration and oversight program for NRSROs in June 2007.

See Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 55857 (June 5, 2007), 72 FR 33564 (June 18, 2007). The implementing rules were Form NRSRO, Rule 17g-1, Rule 17g-2, Rule 17g-3, Rule 17g-4, Rule 17g-5, and Rule 17g-6. The Commission has twice adopted amendments to some of these rules.

See Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 59342 (Feb. 2, 2009), 74 FR 6456 (Feb. 9, 2009) and

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 61050 (Nov. 23, 2009), 74 FR 63832 (Dec. 4, 2009). The Commission also has proposed further amendments to these rules, which remain pending.

See Proposed Rules for Nationally Recognized Statistical Rating Organizations,

74 FR 63866 (Dec. 4, 2009). In addition, as noted above, the Commission adopted Rule 17g-7 on January 20, 2011.

See

Public Law 111-203 § 932(a)(8) adding new paragraph (s)(4)(C) to Section 15E of the Exchange Act. 15 U.S.C. 78o-7(s)(4)(C).

See

Public Law 111-203 § 932(a)(8) adding new paragraph (s)(4)(A) to Section 15E of the Exchange Act. 15 U.S.C. 78o-7(s)(4)(A).

II. The Proposed New Rules and Rule Amendments

The Commission's proposed rule amendments and proposed new rules to implement Title IX, Subtitle C of the Dodd-Frank Act are described below.

As used throughout this release, the term “category” of credit rating refers to a distinct level in a rating scale represented by a unique symbol, number, or score. For example, if a rating scale consists of symbols (

e.g.,

AAA, AA, A, BBB, BB, B, CCC, CC, and C), each unique symbol would represent a category in the rating scale. Similarly, if a rating scale consists of numbers (

e.g.,

1, 2, 3, 4, 5, 6, 7, 8, and 9), each number would represent a category in the rating scale. Each category also represents a “notch” in the rating scale. In addition, some NRSRO rating scales attach additional symbols or numbers to the symbols representing categories in order to denote gradations within a category. For example, a rating scale may indicate gradations within a category by attaching a plus or a minus or a number to a rating symbol. For example, AA+, AA, and AA− or AA1, AA2, and AA3 would be three gradations within the AA category. If a rating scale has gradations within a category, each category and gradation within a category would constitute a “notch” in the rating scale. For example, the following symbols would each represent a notch in the rating scale in descending order: AAA, AA+, AA, AA−, A+, A, A−, BBB+, BBB, BBB−, BB+, BB, BB−, CCC+, CCC, CCC−, CC, C and D. Furthermore, for the purposes of this release, changing a credit rating (

e.g.,

upgrading or downgrading the credit rating) means assigning a credit rating at a different notch in the rating scale (

e.g.,

downgrading an obligor assigned an AA rating to an AA− rating or an A+ rating). A “rating action” for the purposes of this release does not necessarily mean changing a credit rating. A rating action is taken when an NRSRO issues an expected or preliminary credit rating before it issues an initial credit rating, issues an initial credit rating, upgrades an existing credit rating, downgrades an existing credit rating (including to a default category), places an existing credit rating on credit watch or review (meaning the NRSRO is actively evaluating whether to change the credit rating), affirms (or confirms) an existing credit rating (meaning the NRSRO announces that it will not change the credit rating), or withdraws a credit rating.

A. Internal Control Structure

1. Self-Executing Requirement

Section 932(a)(2)(B) of the Dodd-Frank Act added paragraph (3) to Section 15E(c) of the Exchange Act.

Section 15E(c)(3)(A) requires an NRSRO to “establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings, taking into consideration such factors as the Commission may prescribe, by rule.”

While Section 15E(c)(3)(A) provides that the Commission “may” prescribe factors an NRSRO would need to take into consideration with respect to an internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings (an “internal control structure”), the requirement that an NRSRO “establish, maintain, enforce, and document an effective internal control structure” is self-executing.

Consequently, an NRSRO must adhere to this self-executing provision irrespective of whether the Commission prescribes factors the NRSRO must take into consideration.

See

Public Law 111-203 § 932(a)(2)(B) and 15 U.S.C. 78o-7(c)(3)(A).

Id.

The Commission preliminarily believes it would be appropriate at this time to defer prescribing factors an NRSRO must take into consideration with respect to its internal control structure. Deferring rulemaking would provide the Commission with the opportunity, through the NRSRO examination process and, as discussed below, the submission of annual reports by the NRSROs, to review how the NRSROs have complied with this self-executing requirement.

This review could inform any future rulemaking the Commission may initiate. Nonetheless, the Commission is requesting extensive comment below on whether it would be appropriate as part of this rulemaking to prescribe factors. Based on the comments received, the Commission may decide to prescribe by rule or identify through guidance the factors an NRSRO would need to consider with respect to its internal control structure.

Section 923(a)(8) of the Dodd-Frank Act struck existing Section 15E(p) of the Exchange Act, which related to the date of applicability of the Rating Agency Act of 2006 and added new Section 15E(p).

See

Public Law 111-203 § 932(a)(8). New Section 15E(p)(3) of the Exchange Act requires, among other things, the Commission staff to conduct an examination of each NRSRO at least annually.

See

15 U.S.C. 78o-7(p)(3). The Commission staff intends to conduct such annual statutory examinations on a cycle based on the Commission's fiscal year. The staff intends to conduct the first annual statutory examination of a newly registered NRSRO in the annual cycle following its registration.

Request for Comment

The Commission generally requests comment on all aspects of Section 15E(c)(3)(A) of the Exchange Act. The Commission also seeks comment on the following:

1. Should the Commission, as part of this rulemaking initiative, prescribe factors that an NRSRO would need to take into consideration when establishing, maintaining, enforcing, and documenting an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings? For example, can the objectives of the self-executing requirement in Section 15E(c)(3)(A) of the Exchange Act be adequately achieved by NRSROs if the Commission does not prescribe factors?

2. Alternatively, should the Commission defer rulemaking in order to review through examination and monitoring the effectiveness of the internal control structures each NRSRO establishes, maintains, enforces, and documents pursuant to Section 15E(c)(3)(A) of the Exchange Act? For example, would it be more appropriate for the Commission to evaluate through examination and the annual reports discussed below in Section II.A.3 of this release whether there is a need to prescribe factors and, if such a need is identified, incorporate in rulemaking or guidance best practices identified through examination and NRSRO reporting?

3. If appropriate to prescribe factors now, should the factors address all elements of the self-executing requirement in Section 15E(c)(3)(A) of the Exchange Act (

i.e.,

the

establishment, maintenance,

enforcement,

and

documentation

of the internal control structure) or should the factors focus on the design (

i.e., establishment

) of the internal control structure or one of the other elements or a combination of some of the elements?

4. If appropriate to prescribe factors now for the

establishment

of an internal control structure, what should those factors be? For example, should the Commission prescribe any of the factors identified in the sub-paragraphs below? In analyzing these potential factors, commenters should address the potential advantages, disadvantages, benefits, and costs that could result if the Commission prescribed any of the factors, as well as the potential effectiveness of the controls and any practical issues related to implementing them.

a. Controls reasonably designed to ensure that a newly developed methodology or proposed update to an in-use methodology for determining credit ratings is subject to an appropriate review process (

e.g.,

by persons who are independent from the persons that developed the methodology or methodology update) and to management approval prior to the new or updated methodology being employed by the NRSRO to determine credit ratings;

Section 15E(t)(3)(A) of the Exchange Act contains a self-executing provision requiring that the board of directors of the NRSRO shall “oversee” the “establishment, maintenance, and enforcement of policies and procedures for determining credit ratings.”

See

15 U.S.C. 78o-7(t)(3)(A). At the same time, Section 15E(r) of the Exchange Act requires the Commission to adopt rules “to ensure that credit ratings are determined using procedures and methodologies, including qualitative and quantitative data and models” that are approved by the board of the NRSRO.

See

15 U.S.C. 78o-7(r)(1)(A).

b. Controls reasonably designed to ensure that a newly developed methodology or update to an in-use methodology for determining credit ratings is disclosed to the public for consultation prior to the new or updated methodology being employed by the NRSRO to determine credit ratings, that the NRSRO makes comments received as part of the consultation publicly available, and that the NRSRO considers the comments before implementing the methodology;

c. Controls reasonably designed to ensure that in-use methodologies for determining credit ratings are periodically reviewed (

e.g.,

by persons who are independent from the persons who developed and/or use the methodology) in order to analyze whether the methodology should be updated;

d. Controls reasonably designed to ensure that market participants have an opportunity to provide comment on whether in-use methodologies for determining credit ratings should be updated, that the NRSRO makes any such comments received publicly available, and that the NRSRO considers the comments;

e. Controls reasonably designed to ensure that newly developed or updated quantitative models proposed to be incorporated into a credit rating methodology are evaluated and validated prior to being put into use;

f. Controls reasonably designed to ensure that quantitative models incorporated into in-use credit rating methodologies are periodically reviewed and back-tested;

g. Controls reasonably designed to ensure that an NRSRO engages in analysis before commencing the rating of a class of obligors, securities, or money market instruments the NRSRO has not previously rated to determine whether the NRSRO has sufficient competency, access to necessary information, and resources to rate the type of obligor, security, or money market instrument;

h. Controls reasonably designed to ensure that an NRSRO engages in 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;

i. Controls reasonably designed to ensure that measures (

e.g.,

statistics) are 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;

j. Controls reasonably designed to ensure that, with respect to determining credit ratings, 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, supervisors, or senior managers before a rating action is formally taken (

e.g.,

having the work reviewed through a rating committee process);

k. Controls reasonably designed to ensure that a credit analyst documents 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 NRSRO's procedures and methodologies for determining credit ratings;

l. Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or internal audits of rating files to analyze whether analysts adhere to the NRSRO's procedures and methodologies for determining credit ratings; or

m. Any other factors that commenters identify and explain.

5. If appropriate to prescribe factors now for the

maintenance

a. Controls reasonably designed to ensure that the NRSRO conducts periodic reviews of whether it has devoted sufficient resources to implement and operate the documented internal control structure as designed;

b. Controls reasonably designed to ensure that the NRSRO conducts periodic reviews or ongoing monitoring to evaluate the effectiveness of the internal control structure and whether it should be updated;

c. Controls designed to ensure that any identified deficiencies in the internal control structure are assessed and addressed on a timely basis;

d. Any other factors that commenters identify and explain.

6. If appropriate to prescribe factors now for the

enforcement

of an internal

control structure, what should those factors be? For example, should the Commission prescribe any of the factors identified in the sub-paragraphs below? In analyzing these potential factors, commenters should address the potential advantages, disadvantages, benefits, and costs that could result if the Commission prescribed any of the factors, as well as the potential effectiveness of the controls and any practical issues related to implementing them.

a. Controls designed to ensure that additional training is provided or discipline taken with respect to employees who fail to adhere to requirements imposed by the internal control structure;

b. Controls designed to ensure that a process is in place for employees to report failures to adhere to the internal control structure; or

c. Any other factors that commenters identify and explain?

7. If appropriate to prescribe factors now for the

documentation

of an internal control structure, what should those factors be? For example, should there be a factor relating to the level of written detail about the internal control structure that should be documented? Are there other factors that should be considered? What potential advantages, disadvantages, benefits, and costs would result if the Commission prescribed any such factors?

8. Identify any other factors that an NRSRO should consider when establishing, maintaining, enforcing, and documenting an internal control structure. Explain the utility of any factors identified as well as the potential advantages, disadvantages, benefits, and costs that could result if the Commission prescribed any such factors.

2. Proposed Amendment to Rule 17g-2

As noted above, Section 15E(c)(3)(A) of the Exchange Act requires an NRSRO, among other things, to

document

its internal control structure.

Thus, the statute itself requires the NRSRO to make this record.

However, the statute does not prescribe how an NRSRO would need to maintain this record.

The Commission preliminarily believes this record should be subject to the same recordkeeping requirements applicable to other records an NRSRO is required to retain pursuant to the NRSRO recordkeeping rule—Rule 17g-2.

Consequently, the Commission proposes adding new paragraph (b)(12) to Rule 17g-2 to identify the internal control structure an NRSRO, among other things, must document pursuant to Section 15E(c)(3)(A) of the Exchange Act as a record that must be retained.

As a result, the various retention and production requirements of paragraphs (c), (d), (e), and (f) of Rule 17g-2 would apply to the documented internal control structure.

See

15 U.S.C. 78o-7(c)(3)(A).

Id.

For example, it does not prescribe how long the document must be retained.

17 CFR 240.17g-2(c), (d), (e), and (f). Section 17(a)(1) of the Exchange Act requires an NRSRO to make and keep such records, and make and disseminate such reports, as the Commission prescribes by rule as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the Exchange Act. 15 U.S.C. 78q(a)(1). The Commission preliminarily believes it would be necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the Exchange Act to apply the record retention requirements of Rule 17g-2 to the internal control structure required pursuant to Section 15E(c)(3)(A) of the Exchange Act (15 U.S.C. 78o-7(c)(3)(A)).

See Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33582 (June 18, 2007) (“The Commission designed [Rule 17g-2] based on its experience with recordkeeping rules for other regulated entities. These other books and records rules have proven integral to the Commission's investor protection function because the preserved records are the primary means of monitoring compliance with applicable securities laws. Rule 17g-2 is designed to ensure that an NRSRO makes and retains records that will assist the Commission in monitoring, through its examination authority, whether an NRSRO is complying with the provisions of Section 15E of the Exchange Act and the rules thereunder.”) (footnotes omitted).

See

proposed new paragraph (b)(12) of Rule 17g-2.

See

17 CFR 240.17g-2(c), (d), (e) and (f). Paragraph (c) of Rule 17g-2 requires an NRSRO to retain the records identified in paragraphs (a) and (b) for three years after the date the record is made or received. 17 CFR 240.17g-2(c). Paragraph (d) requires, among other things, that an NRSRO maintain each record identified in paragraphs (a) and (b) in a manner that makes the original record or copy easily accessible to the principal office of the NRSRO. 17 CFR 240.17g-2(d). Paragraph (e) sets forth the requirements that apply when an NRSRO uses a third-party custodian to maintain its records. 17 CFR 240.17g-2(e). Paragraph (f) requires an NRSRO to promptly furnish the Commission with legible, complete, and current copies, and, if specifically requested, English translations, of the records identified in paragraphs (a) and (b), or any other records of the NRSRO subject to examination under Section 17(b) of the Exchange Act.

See

17 CFR 240.17g-2(f);

see also

15 U.S.C. 78q(b).

Request for Comment

The Commission generally requests comment on all aspects of proposed new paragraph (b)(12) of Rule 17g-2.

3. Proposed Amendments to Rule 17g-3

Section 15E(c)(3)(B) of the Exchange Act provides that the Commission shall prescribe rules requiring an NRSRO to “submit” an annual internal controls report to the Commission, which shall contain: (1) A description of the responsibility of management in establishing and maintaining an effective internal control structure; (2) an assessment of the effectiveness of the internal control structure; and (3) the attestation of the chief executive officer (“CEO”) or equivalent individual.

Rule 17g-3 requires an NRSRO to furnish annual reports to the Commission.

In particular, paragraph (a) of Rule 17g-3 requires an NRSRO to furnish five or, in some cases, six separate reports within 90 days after the end of the NRSRO's fiscal year and identifies the reports that must be furnished.

The first report—the NRSRO's financial statements—must be audited; the remaining reports may be unaudited.

Paragraph (b) of Rule 17g-3 provides that the NRSRO must attach to the reports a signed statement by a duly authorized person that the person has responsibility for the reports and, to the best knowledge of the person, the reports fairly present, in all material respects, the information contained in the reports.

See

15 U.S.C. 78o-7(c)(3)(B)(i)-(iii).

See

17 CFR 240.17g-3.

See

17 CFR 240.17g-3(a)(1)-(6).

Id.

See

17 CFR 240.17g-3(b).

The Commission proposes amending paragraphs (a) and (b) of Rule 17g-3 to implement the rulemaking mandated by Section 15E(c)(3)(B) of the Exchange Act.

The proposed amendment would add a new paragraph (a)(7) to require an NRSRO to file an additional report—the report on the NRSRO's internal control structure—with its annual submission of reports pursuant to Rule 17g-3.

As discussed above in Section II.A.1 of this release, the Commission preliminarily believes it would be appropriate at this time to defer prescribing factors an NRSRO must take into consideration with respect to its internal control

structure. For similar reasons, the Commission preliminarily believes it would be appropriate at this time to implement Sections 15E(c)(3)(B)(i) and (ii) of the Exchange Act through rule text that closely mirrors the statute.

Consequently, proposed new paragraph (a)(7) would require that the internal control report contain: (1) a description of the responsibility of management in establishing and maintaining an effective internal control structure; and (2) an assessment by management of the effectiveness of the internal control structure.

As is the case with the reports currently identified in paragraphs (a)(2) through (a)(6) of Rule 17g-3, the report identified in new paragraph (a)(7) would be unaudited.

While the proposed rule text closely mirrors the statutory text, the Commission is requesting extensive comment below on whether it would be appropriate as part of this rulemaking to provide more explanation in terms of the standards to use in preparing the internal controls report and providing information in the report. Based on the comments received, the Commission may decide to prescribe by rule or identify through guidance such standards.

See

15 U.S.C. 78o-7(c)(3)(B)(i)-(iii). In addition, as a technical amendment, the Commission proposes to amend the title of Rule 17g-3 to replace the words “financial reports” with the words “financial and other reports.” The Commission notes that the report identified in paragraph (a)(6) of Rule 17g-3, the proposed internal control report, and the compliance report discussed below in Section II.K of this release are not financial in nature. The Commission also proposes to add the word “filed” in the title of Rule 17g-3. As discussed below in Section II.M.1 of this release, the Commission is proposing amendments to Rules 17g-1 and 17g-3 to treat certain submissions of Form NRSRO and the Rule 17g-3 annual reports as being “filed” as opposed to being “furnished” to conform to amendments the Dodd-Frank Act made to Section 15E of the Exchange Act.

See

Public Law 111-203 § 932(a). Specifically, the reports identified in paragraphs (a)(1), (2), (3), (4), (5), (7) and (8) of Rule 17g-3 would be “filed” and the report identified in paragraph (a)(6) would be “furnished.”

See

proposed new paragraph (a)(7) of Rule 17g-3.

See

15 U.S.C. 78o-7(c)(3)(B)(i) and (ii).

Compare

15 U.S.C. 78o-7(c)(3)(B)(i) and (ii) with proposed new paragraphs (a)(7)(i) and (ii) of Rule 17g-3.

See

proposed new paragraph (a)(7) of Rule 17g-3.

Section 15E(c)(3)(B)(iii) of the Exchange Act provides that the annual internal controls report must contain an attestation of the NRSRO's CEO, or equivalent individual.

Accordingly, the Commission proposes amending paragraph (b) of Rule 17g-3 to require that the NRSRO's chief executive officer, or, if the firm does not have a CEO, an individual performing similar functions, provide a signed statement that would need to be attached to the report.

15 U.S.C. 78o-7(c)(3)(B)(iii).

See

proposed amendments to paragraph (b) of Rule 17g-3. In particular, the Commission proposes re-organizing existing paragraph (b) of Rule 17g-3 into paragraphs (b)(1) and (b)(2). Paragraph (b)(1) would contain the current requirement that the NRSRO must attach to each of the annual reports required pursuant to paragraphs (a)(1)-(6) a signed statement by a duly authorized person associated with the NRSRO stating that the person has responsibility for the financial reports and, to the best knowledge of the person, the reports fairly present, in all material respects, the information required to be contained in the report. Paragraph (b)(2) of Rule 17g-3 would require that the report on the NRSRO's internal control structure be attested to by the NRSRO's CEO or an individual performing similar functions.

See

proposed paragraph (b)(2) of Rule 17g-3.

Request for Comment

The Commission generally requests comment on all aspects of these proposed amendments to paragraphs (a) and (b) of Rule 17g-3. The Commission also seeks comment on the following:

1. Is the requirement to provide a description of the responsibility of management in establishing and maintaining an effective internal control structure sufficiently explicit? If not, how should the Commission modify proposed paragraph (a)(7) of Rule 17g-3 to make the requirement more understandable? For example, should the Commission provide guidance on how an NRSRO must describe the responsibility of management in establishing and maintaining an effective internal control structure? If so, what should that guidance be? For example, are there existing frameworks that such guidance could be modeled on?

2. In terms of establishing an effective internal control structure, what level of NRSRO management should have primary responsibility for the design of the internal control structure and what level of management should supervise the design of the internal control structure? For example, should managers with direct responsibility for supervising the personnel who use the policies, procedures, and methodologies for determining credit ratings and the personnel who conduct compliance reviews for adherence to those policies, procedures, and methodologies design the internal control structure and a committee of the NRSRO's most senior managers supervise the design of the internal control structure? Should other management or non-management levels of the NRSRO have responsibility for either of these functions? In addition, Section 15E(t)(3)(C) of the Exchange Act provides that the board of directors of the NRSRO shall “oversee” the “effectiveness of the internal control system with respect to the policies and procedures for determining credit ratings.”

How should this statutorily mandated board responsibility be integrated with the responsibility of the NRSRO's management to establish an effective internal control structure?

See

15 U.S.C. 78o-7(t)(3)(A).

3. In terms of establishing an effective internal control structure, should the Commission define the term “internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings”? In terms of establishing an effective internal control structure, should the Commission further define the term “internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings”? If so, how should that term be further defined?

Provide suggested rule text and supporting analysis.

The term “internal control” has been defined in other contexts. For example, the Commission has defined internal control over financial reporting.

See

17 CFR 240.13a-15(f).

4. In terms of establishing an effective internal control structure, should the Commission prescribe a standard in terms of the design? If so, what standard would be appropriate? For example, should the internal control structure be “reasonably designed” to achieve its objectives (a standard required by Sections 15E(g) and (h) of the Exchange Act with respect to policies and procedures of an NRSRO to address, respectively, the misuse of material nonpublic information and conflicts of interest)?

Conversely, is the proposed requirement that the internal control structure be “effective” a sufficient standard?

See

15 U.S.C. 78o-7(g) and (h).

5. In terms of maintaining an effective internal control structure, what level of NRSRO management should have primary responsibility for monitoring the operation of the internal control structure and the NRSRO's adherence to the internal control structure? For example, should managers with direct responsibility for supervising the personnel who use the policies, procedures, and methodologies for determining credit ratings and the personnel who conduct compliance reviews for adherence to those policies, procedures, and methodologies have day-to-day responsibility for monitoring the operation of the internal control structure and the NRSRO's adherence to the internal control structure? Should other management or non-management levels of the NRSRO have responsibility for either of these functions? For example, should the personnel responsible for monitoring the operation of the internal control structure and the NRSRO's adherence to the internal control structure generate periodic (weekly, monthly, quarterly, and/or annual) reports that are provided to the NRSRO's most senior managers and the board about the internal control structure? If so, what information should be contained in those reports? In addition, Section 15E(t)(3)(C) of the Exchange Act provides that the board of directors of the NRSRO shall “oversee” the “effectiveness of the internal control system with respect to the policies and

procedures for determining credit ratings.”

How should this statutorily mandated board responsibility be integrated with the responsibility of the NRSRO's management to maintain an effective internal control structure?

See

15 U.S.C. 78o-7(t)(3)(A).

6. Is the requirement to provide an assessment by management of the effectiveness of the internal control structure sufficiently explicit? If not, how should the Commission modify proposed paragraph (a)(7) of Rule 17g-3 to make the requirement more understandable? For example, given that the NRSRO needs to maintain the internal control structure (

i.e.,

keep it in operation), should the Commission clarify that the assessment should address the effectiveness of the internal control structure during the entire fiscal year covered by the report?

7. In terms of reporting management's assessment of the effectiveness of the internal control structure, should the Commission provide guidance on how an NRSRO must assess the effectiveness of the internal control structure, such as evaluative criteria or standards? If so, what should those criteria or standards be? For example, should the Commission require that management's assessment of the effectiveness of the internal control structure be based on procedures sufficient to evaluate the design of the internal control structure and test its operating effectiveness?

8. In terms of management's assessment of the effectiveness of the internal control structure, should the Commission define the conditions that preclude management from concluding that the internal control structure is effective? If so, how should an ineffective internal control structure be defined? For example, should management be precluded from concluding that the internal control structure is effective if there are one or more instances of “material weaknesses” in the internal control structure? If one or more instances of “material weaknesses” should preclude management from concluding that its internal control structure is effective, then should the Commission define “material weakness”? If so, how should the term “material weakness” be defined? If management cannot conclude that the internal control structure is effective, what corrective action or sanctions should be imposed on the NRSRO?

9. In terms of reporting management's assessment of the effectiveness of the internal control structure, should the Commission provide guidance regarding the topics to be addressed in the report? If so, what should that guidance be? For example, if the Commission prescribes factors that an NRSRO should take into consideration in establishing, maintaining, enforcing, and documenting its internal control structure, should the report specifically reference those factors? In addition, should the report identify or describe the framework management used to conduct the evaluation of the effectiveness of the internal control structure? Moreover, should the report identify deficiencies found during the assessment process? If so, should all deficiencies be identified or only those which preclude management from concluding that the internal control structure is effective? Furthermore, should the Commission require that the report disclose whether there were any significant changes in the internal control structure or other factors that could significantly affect the internal control structure subsequent to the date of the evaluation, including any corrective actions in response to any material weaknesses found during the evaluation?

10. In terms of reporting management's assessment of the effectiveness of the internal control structure, should the report identify any fraud, significant errors, or previously undisclosed conflicts of interest identified during the assessment of the effectiveness of the internal control structure that could have a material effect on the integrity of the NRSRO's procedures and methodologies for determining credit ratings? What other disclosures should the report contain?

11. Should an NRSRO be required to maintain evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the internal control structure that could be used by Commission examination staff to review the adequacy of the assessment? In this regard, should the Commission identify specific objectives of an internal control structure that the evidential matter would need to support? For example, should the evidential matter provide reasonable support for an assessment that the internal control structure is designed to effectively prevent or detect failures of the NRSRO to adhere to its policies, procedures, and methodologies for determining credit ratings? If such specific objectives should be identified, describe them and identify the evidential matter that could be retained to allow the Commission examination staff to review the adequacy of the NRSRO's assessment of the effectiveness of the internal control structure in achieving the objective.

12. With respect to proposed paragraph (b)(2) of Rule 17g-3, should the Commission provide more guidance on the type of management responsibilities that would qualify an individual as one who performs functions similar to a CEO? If so, what are those types of responsibilities?

13. Should the Commission require the internal control report to be filed separately from the Rule 17g-3 annual reports (which are kept confidential to the extent permitted by law) and, instead, require the internal control report to be disclosed to the public on, for example, the Commission's Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system? What would be the benefits and costs of requiring the public disclosure of the report?

14. If it would be appropriate to make the report public, should the Commission prescribe a form for the report? If so, what information should the form require the NRSRO to provide in the disclosure? What would the form look like? Could any of the Commission's current forms serve as a model? If so, identify the forms and explain how they could be tailored to require an NRSRO to provide information about its internal control structure.

B. Conflicts of Interest Relating to Sales and Marketing

Section 932(a)(4) of the Dodd-Frank Act added new paragraph (3) to Section 15E(h) of the Exchange Act.

Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of credit ratings by the NRSRO.

Section 15E(h)(3)(B) of the Exchange Act provides that the Commission's rules must contain two additional provisions.

First, Section 15E(h)(3)(B)(i) requires that the Commission's rules shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.

Second, Section 15E(h)(3)(B)(ii) requires that the Commission's rules shall provide for the suspension or revocation of the registration of an NRSRO if the Commission finds, on the record, after notice and opportunity for a hearing,

that: (1) The NRSRO has committed a violation of a rule issued under Section 15E(h) of the Exchange Act; and (2) the violation affected a rating.

Public Law 111-203 § 932(a)(4) and 15 U.S.C. 78o-7(h)(3).

15 U.S.C. 78o-7(h)(3)(A).

15 U.S.C. 78o-7(h)(3)(B)(i) and (ii).

15 U.S.C. 78o-7(h)(3)(B)(i).

15 U.S.C. 78o-7(h)(3)(B)(ii).

The Commission proposes to implement Sections 15E(h)(3)(A), (B)(i), and (B)(ii) of the Exchange Act by amending the NRSRO conflict of interest rule—Rule 17g-5.

The proposals would amend the rule by: (1) identifying a new prohibited conflict in paragraph (c) of the rule; (2) adding a new paragraph (f) setting forth the finding the Commission would need to make in order to grant a small NRSRO an exemption from the prohibition; and (3) adding a new paragraph (g) setting forth the standard for suspending or revoking an NRSRO's registration for violating a rule adopted under Section 15E(h) of the Exchange Act.

17 CFR 240.17g-5. The Commission adopted and subsequently amended Rule 17g-5 pursuant, in part, to authority in Section 15E(h)(2) of the Exchange Act (15 U.S.C. 78o-7(h)(2)).

See Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33595-33599 (June 18, 2007);

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 6465-6469 (Feb. 9, 2009);

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 63842-63850 (Dec. 4, 2009).

1. Proposed New Prohibited Conflict

As noted above, Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of ratings by the NRSRO.

The Commission is proposing to implement this provision by identifying a new conflict of interest in paragraph (c) of Rule 17g-5.

Paragraph (c) prohibits a person within an NRSRO (as well as the NRSRO itself)

from having any of the conflicts of interest relating to the issuance or maintenance of a credit rating or credit rating agency identified in the paragraph under all circumstances (hereinafter the “absolute prohibitions”).

Proposed new paragraph (c)(8) of Rule 17g-5 would identify a new absolute prohibition; namely, one in which the NRSRO issues or maintains a credit rating where a person within the NRSRO who participates in the sales or marketing of a product or service of the NRSRO or a product or service of a person associated with the NRSRO also participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative or quantitative models.

15 U.S.C. 78o-7(h)(3)(A).

See

proposed new paragraph (c)(8) of Rule 17g-5.

See

paragraph (d) of Rule 17g-5 defining “person within an NRSRO” for purposes of the rule. 17 CFR 240.17g-5(d).

See

17 CFR 240.17g-5(c)(1)-(7). These absolute prohibitions are distinguished from the types of conflicts identified in paragraph (b) of Rule 17g-5, which are prohibited

unless

the NRSRO has taken the steps to address them set forth in paragraph (a) of Rule 17g-5.

See

17 CFR 240.17g-5(a) and (b).

See

proposed new paragraph (c)(8) of Rule 17g-5.

The proposed new absolute prohibition would be designed to address situations in which, for example, individuals within the NRSRO responsible for selling its products and services could seek to influence a specific credit rating to favor an existing or prospective client or the development of a credit rating methodology to favor a class of existing or prospective clients. With regard to methodologies, the Commission notes that its staff found as part of the examination of the activities of the three largest NRSROs in rating residential mortgage-backed securities (“RMBS”) and collateralized debt obligations (“CDOs”) linked to subprime mortgages that it appeared “employees responsible for obtaining ratings business would notify other employees, including those responsible for criteria development, about business concerns they had related to the criteria.”

The absolute prohibition in proposed paragraph (c)(8) of Rule 17g-5 would be designed to insulate individuals within the NRSRO responsible for the analytic function from such sales and marketing concerns and pressures.

See Summary Report of Issues Identified in the Commission Staff's Examination of Select Credit Rating Agencies,

Commission (July 2008), pp. 25-26.

Request for Comment

The Commission generally requests comment on all aspects of proposed new paragraph (c)(8) of Rule 17g-5. The Commission also seeks comment on the following:

1. Would the proposed amendment impact existing governance structures, reporting lines and internal organizations of NRSROs, particularly smaller NRSROs? If so, provide specific information about the nature and consequences of such impacts.

2. Are there sales and marketing activities persons that participate in determining credit ratings or developing or approving procedures or methodologies used for determining credit ratings, including qualitative or quantitative models, could participate in without undermining the goal of proposed paragraph (a)(8) of Rule 17g-5? If so, what types of activities? How could proposed new paragraph (a)(8) of Rule 17g-5 be modified to retain an absolute prohibition and at the same time not prohibit persons who participate in determining credit ratings or developing or approving procedures or methodologies used for determining credit ratings, including qualitative or quantitative models, to participate in sales and marketing activities that do not expose them to business concerns that could compromise their analytical integrity?

3. Should the Commission provide guidance on what constitutes a sales and marketing activity? If so, how should the Commission define “sales and marketing activities”? In addition, should the Commission define what it means to “participate in sales and marketing activities”? Similarly, should the Commission define what it means to “participate in developing or approving procedures and methodologies used for determining credit ratings”? If so, how should the Commission define these terms?

4. Identify other requirements applicable to NRSROs that are designed to address this conflict of interest.

2. Proposed Exemption for “Small” NRSROs

Section 15E(h)(3)(B)(i) of the Exchange Act requires that the Commission's rules under Section 15E(h)(3)(A) shall provide for exceptions for small NRSROs with respect to which the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.

To implement this provision, the Commission is proposing to amend Rule 17g-5 by adding a new paragraph (f).

Proposed paragraph (f) would provide a mechanism for a small NRSRO to apply in writing for an exemption from the absolute prohibition proposed in new paragraph (c)(8).

In particular,

proposed new paragraph (f) of Rule 17g-5 would provide that upon written application by an NRSRO, the Commission may exempt, either conditionally or unconditionally or on specified terms and conditions, such NRSRO from the provisions of paragraph (c)(8) of Rule 17g-5 if the Commission finds that due to the small size of the NRSRO it is not appropriate to require the separation within the NRSRO of the production of credit ratings from sales and marketing activities and such exemption is in the public interest.

See

15 U.S.C. 78o-7(h)(3)(B)(i).

See

proposed new paragraph (f) of Rule 17g-5.

Section 36 of the Exchange Act provides that the Commission, by rule, regulation, or order, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities or transactions from any provision or provisions of the Exchange Act or any rule or regulation thereunder, to the extent that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors. 17 U.S.C. 78mm. Consequently, an NRSRO could request to be exempt from the proposed sales and marketing prohibition pursuant to this more general authority in Section 36.

See id.

Nonetheless, the Commission has adopted rules providing mechanisms for registrants—such as broker-dealers—to request an exemption from specific rule requirements.

See, e.g.,

17 CFR 240.15c3-1(b)(3); 17 CFR 240.15c3-3(k)(3); and 17 CFR 240.17a-5(m)(3). The Commission preliminarily believes proposed paragraph (f) of Rule 17g-5 should parallel such provisions.

See

proposed new paragraph (f) of Rule 17g-5.

The Commission preliminarily believes that the absolute prohibition should apply to all NRSROs. However, the Commission notes that in some cases the small size of an NRSRO could make a complete separation of the sales and marketing function from the credit rating analytical function inappropriate. For example, the NRSRO may not have enough staff (or the resources to hire additional staff) to establish separate functions. In such a case, the Commission would entertain requests for relief. In granting such relief, the Commission may impose conditions designed to preserve as much of the separation between these two functions as possible.

Request for Comment

The Commission generally requests comment on all aspects of proposed new paragraph (f) of Rule 17g-5. The Commission also seeks comment on the following:

1. The Commission notes that Section 15E(h)(3)(A) of the Exchange Act provides that the Commission shall issue rules to prevent the sales and marketing considerations of an NRSRO from influencing the production of credit ratings by the NRSRO. Section 15E(h)(3)(B)(i) requires that the Commission's rules shall provide for exceptions for small NRSROs with respect to which the Commission determines that the

separation

of the production of ratings and sales and marketing activities is not appropriate (emphasis added). Why would the separation of the production of ratings from sales and marketing activities be appropriate for NRSROs that are not small but might not be appropriate for NRSROs that are small? For example, does the small size of an NRSRO make the conflict less likely to influence ratings? If so, why? Alternatively, could the small size of an NRSRO make the application of the absolute prohibition impractical, thus preventing a small credit rating agency from seeking registration or a small NRSRO from maintaining its registration? If so, would the adverse impact on competition outweigh the benefit of applying the absolute prohibition to a small NRSRO? If so, explain how.

2. Would the case-by-case approach proposed by the Commission appropriately implement Section 15E(h)(3)(B)(i) of the Exchange Act? If not, how should the proposal be modified? For example, should the Commission prescribe an objective self-executing exemption from the absolute prohibition in proposed paragraph (c)(8) of Rule 17g-5? For example, should the exemption be automatic for “small” NRSROs? If so, how should the Commission define a small NRSRO? For example, should the definition be based on the total assets of the NRSRO? In this regard, should the Commission adopt a rule that exempts any NRSRO that has total assets of $5 million or less from the absolute prohibition given that is how the Commission currently defines a small NRSRO for purposes of the Regulatory Flexibility Act?

How would such an exemption work in practice? For example, would such a rule need to provide for a transition period for an NRSRO that crosses the total asset threshold to provide time to establish the separate sales and marketing function? How long should such a transition period be? For example, should it be 90, 120, 180 or some other number of days after the required filing date of the NRSRO's audited financial statements indicating the threshold was crossed are required to be filed with the Commission?

See

Section VII.C of this release;

see also

5 U.S.C. 603(a),

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR 33618 (June 18, 2007);

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 6481 (Feb. 9, 2009); and

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 63863 (Dec. 4, 2009).

3. What other factors should the Commission consider in analyzing whether the small size of an NRSRO makes it not appropriate to require the separation of the production of credit ratings from sales and marketing activities? Should the Commission consider the annual revenues of the NRSRO? Should the Commission consider the number of employees of the NRSRO? Would consideration of the number of employees create a disincentive to devote resources to adequately staff the NRSRO? Are there factors in addition to an NRSRO's size the Commission should consider in analyzing whether to grant an exemption under this proposal? If so, please describe any such factors.

4. If the Commission granted relief to an NRSRO, should the Commission specify conditions for obtaining the relief? If so, what should those conditions be? For example, should the conditions limit the number of credit analysts that can participate in sales and marketing activities, limit the manner in which they can participate in such activities, require additional procedures to address the conflict, and require additional procedures to document how credit analysts participate in sales and marketing activities? If any of these conditions would be appropriate, describe how they could be implemented in practice.

3. Suspending or Revoking a Registration

Section 15E(h)(3)(B)(ii) of the Exchange Act specifies that the Commission's rules under Section 15E(h) of the Exchange Act shall provide for suspension or revocation of the registration of an NRSRO if the Commission finds, on the record, after notice and opportunity for a hearing, that the NRSRO has committed a violation of “a rule issued under this subsection” and the violation of the rule affected a credit rating.

While Section 15E(h)(3)(A) relates only to the conflict arising from sales and marketing activities, Section 15E(h)(3)(B)(ii)—by using the term “subsection”—has a broader scope in that it refers to all rules issued under Section 15E(h) of the Exchange Act.

Consequently, the rule implementing Section 15E(h)(3)(B)(ii) must provide for the suspension or revocation of an NRSRO's registration for violations of any rule adopted under Section 15E(h).

Moreover, the Commission notes that Section 15E(h)(3)(B)(ii) does not require that the violation of the rule be “willful.”

15 U.S.C. 78o-7(h)(3)(B)(ii).

See id.

Id.

Currently, the Commission can seek to suspend or revoke the registration of an NRSRO, in addition to other potential sanctions, under Section 15E(d) of the Exchange Act.

In particular, Section 15E(d) provides that the Commission shall, by order, censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding 12 months, or revoke the registration of an NRSRO if the Commission finds, “on the record after notice and opportunity for a hearing,” that such sanction is

“necessary for the protection of investors and in the public interest” and the NRSRO, or a person associated with the NRSRO, has engaged in one or more of six categories of conduct.

The first category is that the NRSRO or an associated person has: committed or omitted any act, or has been subject to an order or finding, enumerated in subparagraphs (A), (D), (E), (G), or (H) of Section 15(b)(4) of the Exchange Act; has been convicted of any offense identified in Section 15(b)(4)(B) of the Exchange Act; or has been enjoined from any action, conduct, or practice identified in Section 15(b)(4)(C) of the Exchange Act.

The acts enumerated in Section 15(b)(4)(D) of the Exchange Act include that the person has willfully violated any provision of the Exchange Act or the rules or regulations under the Exchange Act.

Therefore, the Commission has the ability, under Section 15E(d), to suspend or revoke the registration of an NRSRO for a willful violation of Rule 17g-5, but does not have the power to do so under Section 15E(d) for violations of Rule 17g-5 that are not willful.

See

15 U.S.C. 78o-7(d).

See

15 U.S.C. 78o-7(d)(1)(A);

see also

15 U.S.C. 78o(b)(4)(A), (B), (C), (D), (E), (G), and (H).

15 U.S.C. 78o(b)(4)(D).

See

15 U.S.C. 78o-7(d)(1)(A) and 15 U.S.C. 78o(b)(4)(D).

The Commission preliminarily believes a rule implementing Section 15E(h)(3)(B)(ii) of the Exchange Act should work in conjunction with Sections 15E(d) and 21C of the Exchange Act.

Specifically, proposed new paragraph (g) of Rule 17g-5 would provide that in a proceeding pursuant to Section 15E(d) or Section 21C of the Exchange Act, the Commission shall suspend or revoke the registration of an NRSRO if the Commission finds in such proceeding that the NRSRO has violated a rule issued under Section 15E(h) of the Exchange Act, the violation affected a rating, and that suspension or revocation is necessary for the protection of investors and in the public interest.

The Commission preliminarily believes this provision is appropriately placed in Rule 17g-5 given that it is the predominant rule issued under Section 15E(h) of the Exchange Act.

15 U.S.C. 78o-7(d) and 15 U.S.C. 78u-3.

See

proposed new paragraph (g) of Rule 17g-5;

see also

15 U.S.C. 78o-7(d) and (h), and 78u-3. Section 21C of the Exchange Act provides the Commission with authority, among other things, to enter an order requiring, among other things, that a person cease-and-desist from continuing to violate, or future violations of, a provision of the Exchange Act or any rule or regulation thereunder. Proposed paragraph (g) of Rule 17g-5 would provide that the Commission can issue an order in a cease-and-desist proceeding suspending or revoking the registration of an NRSRO.

Id.

See, e.g.,

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33595-33599 (June 18, 2007),

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 6465-6469 (Feb. 9, 2009), and

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR 63842-63850 (Dec. 4, 2009).

The first two proposed findings in proposed paragraph (g) of Rule 17g-5 would mirror the text of Section 15E(h)(3)(B)(ii) of the Exchange Act.

The final finding—that the suspension or revocation is necessary for the protection of investors and in the public interest—is a common finding that the Commission must make to take disciplinary action against a registered person or entity.

It is not, however, a finding that the Commission must make in a proceeding under Section 21C.

Further, unlike Section 15E(d) of the Exchange Act, the Commission can take action under Section 21C for violations of the securities laws even if such violations are not willful.

Moreover, Section 15E(h)(3)(B)(ii) of the Exchange Act does not prescribe the maximum amount of time for which an NRSRO could be suspended, whereas Section 15E(d) provides that a suspension shall not exceed 12 months.

Consequently, a proceeding pursuant to paragraph (g) of Rule 17g-5 brought under Section 21C could result in a suspension that exceeds 12 months. Given that Section 21C of the Exchange Act has a lower threshold for the intent to establish a violation, and given the substantial consequences of suspending or revoking a registration, the Commission preliminarily believes that the public interest finding would be an appropriate predicate to a suspension or revocation of an NRSRO's registration under Section 21C of the Exchange Act.

Compare

the first two findings in proposed new paragraph (g) of Rule17g-5 (that the NRSRO has violated a rule issued under Section 15E(h) of the Act; and the violation affected a rating) with Sections 15E(h)(3)(B)(ii)(I) and (II) of the Exchange Act, respectively. 15 U.S.C. 78o-7(h)(3)(B)(ii)(I) and (II).

For example, the Commission must make this finding to take action under Section 15E(d) of the Exchange Act.

See

15 U.S.C. 78o-7(d).

See

15 U.S.C. 78u-3.

Compare

15 U.S.C. 78o-7(d) and 15 U.S.C. 78u-3.

Compare

15 U.S.C. 78o-7(h)(3)(B)(ii) and 15 U.S.C. 78o-7(d).

Request for Comment

The Commission generally requests comment on all aspects of proposed new paragraph (g) of Rule 17g-5. The Commission also seeks comment on the following:

1. Should the Commission propose, pursuant to Section 15E(h)(3)(B)(ii) of the Exchange Act, an independent and alternative process for suspending or revoking an NRSRO's registration for a violation of a rule issued under Section 15E(h) (

i.e.,

a proceeding that is not pursuant to Sections 15E(d) and 21C of the Exchange Act)? If so, how should such a separate proceeding operate? For example, should it require the same findings proposed above or alternative or additional findings?

2. In terms of the finding that “the violation affected a rating,” what type of factual predicate should support such a finding? For example, would it be appropriate to make such a finding if the Commission determined that the violation caused the NRSRO to issue a credit rating that was not based solely on its documented procedures and methodologies for determining credit ratings (

e.g.,

the Commission finds that undue influence impacted the credit rating assigned to the rated obligor, security, or money market instrument because strictly adhering to the procedures and methodologies would have resulted in the NRSRO issuing a credit rating at a lower or higher notch in the applicable rating scale)?

3. With respect to proposed new paragraph (g) of Rule 17g-5, should the proposed rule include additional or alternative findings that the Commission would need to make to revoke or suspend the registration of an NRSRO in a proceeding under Sections 15E(d) or 21C? If so, what should those findings be? For example, should the Commission need to find that the violation harmed investors or other users of credit ratings?

4. Should the Commission, as proposed, require a public interest finding in order to suspend or revoke an NRSRO's registration in a proceeding under paragraph (g) of Rule 17g-5 pursuant to Section 21C, or should the rule provide for the suspension or revocation of an NRSRO's registration solely based on a finding that a violation of a rule affected a rating?

5. With respect to proposed new paragraph (g) of Rule 17g-5, should the rule incorporate only Section 15E(d) of the Exchange Act? If so, why? Alternatively, should it incorporate only Section 21C of the Exchange Act? If so, why?

6. As noted above, there would be no limit on the amount of time for which the Commission could suspend the registration of an NRSRO in a proceeding under Section 21C of the Exchange Act and proposed paragraph (g) of Rule 17g-5. Should the Commission add such a time limit to be consistent with Section 15E(d) of the Exchange Act? Alternatively, does the

different standard provide the Commission with appropriate flexibility to seek longer suspensions?

C. “Look-Back” Review

Section 932(a)(4) of the Dodd-Frank Act amended Section 15E(h) of the Exchange Act to add a new paragraph (4).

The Commission is proposing to implement rulemaking required in Section 15E(h)(4)(A)(ii) of the Exchange Act through proposed paragraph (c) of new Rule 17g-8.

In addition, the Commission is proposing to amend Rule 17g-2 to apply that rule's record retention and production requirements to the policies and procedures required pursuant to the self-executing provisions in Section 15E(h)(4)(A) of the Exchange Act and pursuant to proposed paragraph (c) of new Rule 17g-8.

See

Public Law 111-203 § 932(a)(4) and 15 U.S.C. 78o-7(h)(4).

New Rule 17g-8 would be codified at 17 CFR 240.17g-8, if adopted. In addition, new Rule 17g-8, as proposed, would consolidate requirements that NRSROs have policies and procedures in a number of areas. As discussed below in Section II.F.1 of this release, proposed paragraph (a) of new Rule 17g-8 would require an NRSRO to establish policies and procedures with respect to credit rating methodologies. In addition, as discussed below in Section II.J.1 of this release, proposed paragraph (b) of new Rule 17g-8 would require an NRSRO to establish policies and procedures with respect to the use of credit rating symbols, numbers, and scores. And, as discussed in this section of the release, the Commission is proposing to implement rulemaking specified in Section 15E(h)(4)(A)(ii) of the Exchange Act (15 U.S.C. 78o-7(h)(4)(A)(ii)), in part, by proposing paragraph (c) of new Rule 17g-8.

See

15 U.S.C. 78o-7(h)(4)(A), proposed paragraph (c) of new Rule 17g-8, and proposed new paragraph (a)(9) of Rule 17g-2.

1. Proposed Paragraph (c) of New Rule 17g-8

Sections 15E(h)(4)(A)(i) and (ii) of the Exchange Act require an NRSRO to establish, maintain, and enforce policies and procedures reasonably designed to ensure that, in any case in which an employee of a person subject to a credit rating of the NRSRO or the issuer, underwriter, or sponsor of a security or money market instrument subject to a credit rating of the NRSRO, was employed by the NRSRO and participated in any capacity in determining credit ratings for the person or the securities or money market instruments during the 1-year period preceding the date an action was taken with respect to the credit rating, the NRSRO shall: (1) Conduct a review to determine whether any conflicts of interest of the employee influenced the credit rating (a “look-back review”); and (2) take action to revise the rating if appropriate,

in accordance with such rules as the Commission shall prescribe.

Consequently, Section 15E(h)(4)(A)(i) of the Exchange Act contains a self-executing provision requiring an NRSRO to establish, maintain, and enforce policies and procedures as described above to conduct look-back reviews, and Section 15E(h)(4)(ii) contains a provision mandating Commission rulemaking with respect to requirements for an NRSRO to revise a credit rating in certain circumstances.

See

15 U.S.C. 78o-7(h)(4)(A)(i) and (ii) (emphasis added).

Id.

The Commission proposes to implement the rulemaking required in Section 15E(h)(4)(A)(ii) of the Exchange Act by proposing paragraph (c) of new Rule 17g-8.

Proposed paragraph (c) would require that the policies and procedures the NRSRO establishes, maintains, and enforces pursuant to Section 15E(h)(4)(A) of the Exchange Act must address instances in which a review conducted pursuant to those policies and procedures determines that a conflict of interest influenced a credit rating assigned to an obligor, security, or money market instrument by including, at a minimum, procedures that are reasonably designed to ensure the NRSRO will: (1) Immediately place the credit rating on credit watch; (2) promptly determine whether the credit rating must be revised so it no longer is influenced by a conflict of interest and is solely the product of the NRSRO's documented procedures and methodologies for determining credit ratings; and (3) promptly publish a revised credit rating, if appropriate, or affirm the credit rating if appropriate.

See

proposed paragraph (c) of new Rule 17g-8 and 15 U.S.C. 78o-7(h)(4)(A)(ii).

See

proposed paragraphs (c)(1), (2) and (3) of new Rule 17g-8.

The Commission acknowledges that Section 15E(c)(2) of the Exchange Act provides, in pertinent part, that the Commission may not regulate the substance of credit ratings or the procedures and methodologies by which an NRSRO determines credit ratings.

The Commission preliminarily believes that the steps described above would not regulate the procedures and methodologies by which an NRSRO determines credit ratings because the NRSRO would apply its own procedures and methodologies to determine whether the credit rating should be revised. Moreover, the placement of a credit rating on credit watch is not a determination of a credit rating (

i.e.,

it does not change the credit rating) but rather is a means of providing notice to users of the NRSRO's credit ratings that an active evaluation of the credit rating is underway. For these reasons, the Commission preliminarily believes that the approach in proposed paragraph (c) of new Rule 17g-8 appropriately avoids regulating the substance of credit ratings or the procedures and methodologies an NRSRO uses to determine credit ratings but, at the same time, requires an NRSRO to have procedures reasonably designed to ensure that it immediately provides notification and promptly address a credit rating that is influenced by a conflict of interest.

The Commission also preliminarily believes that the actions prescribed in proposed paragraph (c) of new Rule 17g-8 are steps a prudent NRSRO would take in the normal course when discovering a conflict of interest influenced the determination of a credit rating. Nonetheless, the Commission is soliciting comment on these issues below.

15 U.S.C. 78o-7(c)(2).

The Commission also notes an NRSRO would, among other things, violate Section 15E(h)(1) of the Exchange Act and Rule 17g-5, among other rules, if it continued to assign an obligor, security, or money, market instrument a credit rating that, absent the undue influence of the conflict of interest, would be different because the NRSRO could not be deemed to have policies and procedures reasonably designed to address and manage conflicts of interest that can arise from its business under such a circumstance.

See

15 U.S.C. 78o-7(h) and 17 CFR 17g-5.

Proposed paragraph (c)(1) of new Rule 17g-8 would require the NRSRO to have procedures reasonably designed to ensure that, upon the NRSRO's discovery of the conflict, it immediately publishes a rating action placing the applicable credit ratings of the obligor, security, or money market instrument on credit watch or review.

When an NRSRO publishes a rating action indicating the current credit rating assigned to an obligor, security, or money market instrument (or a class of obligors, securities, or money market instruments) is on credit watch or under review, the purpose is to notify users of the NRSRO's credit ratings that the credit rating is undergoing a process of evaluation that may result in it being upgraded or downgraded.

The Commission preliminarily believes an NRSRO should have policies and procedures reasonably designed to ensure that the users of its credit ratings are provided immediate notice of the discovery that a conflict influenced a credit rating assigned to an obligor, security, or money market instrument.

The Commission also preliminarily believes an effective means of providing such notice would be to place the obligor, security, or money market instrument on credit watch.

See

proposed paragraph (c)(1) of new Rule 17g-8.

For example, an NRSRO may place a credit rating on negative credit watch, which means it is evaluating whether to downgrade the credit rating, or on positive credit watch, which means it is evaluating whether to upgrade the credit rating.

Proposed paragraph (c)(1) of new Rule 17g-8 also would provide that the policies and procedures must be reasonably designed to ensure the NRSRO includes the information required by paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7 with the publication of the rating action placing the credit rating of the obligor, security, or money market instrument on credit watch.

As discussed below in Section II.G of this release, the Commission is proposing to implement Section 15E(s) of the Exchange Act, in part, by requiring, in proposed new paragraph (a) of Rule 17g-7, that an NRSRO generate a form to be included with the publication of a credit rating.

Proposed paragraph (a) of Rule 17g-7, among other things, would prescribe certain qualitative and quantitative information that must be disclosed in the form.

The Commission is proposing that the qualitative information in the form include certain disclosures that would need to be made if the rating action results from a look-back review conducted pursuant to Section 15E(h)(4)(A)(i) of the Exchange Act and proposed paragraph (c) of new Rule 17g-8.

Specifically, when a credit rating is placed on credit watch, proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7 would require the NRSRO to provide in the form published with the rating action an explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest and the date and associated credit rating of each prior rating action the NRSRO currently has determined was influenced by the conflict.

This would alert users of the NRSRO's credit ratings that the credit rating assigned to the obligor, security, or money market instrument might be revised to address a conflict of interest and would identify the prior rating action or actions the NRSRO has determined were influenced by the conflict. With respect to identifying the prior rating actions, the Commission is proposing that the rule require the NRSRO to provide the date and associated credit rating of such actions the NRSRO “currently has determined” were influenced by the conflict.

The Commission's proposed use of the term “currently” is designed to conform to the requirement of proposed paragraph (c)(1) of Rule 17g-8 that the NRSRO have procedures designed to place the credit rating of the obligor, security, or money market instrument on credit watch

immediately

upon the discovery that a conflict influenced a prior credit rating action (

i.e.,

not wait until the NRSRO has determined whether additional credit ratings previously assigned to the obligor, security, or money market instrument also were influenced by the conflict). The Commission preliminarily believes that the best approach would be to alert users of the NRSRO's credit ratings as soon as possible after a conflict is discovered.

Id.; see

also

proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7.

See

15 U.S.C. 78o-7(s) and proposed new paragraph (a) of Rule 17g-7.

See

proposed new paragraphs (a)(1)(ii)(A)-(N) of Rule 17g-7.

See

proposed new paragraphs (a)(1)(ii)(J)(

)(

)-(

iii

) of Rule 17g-7 and related discussion below in Section II.G.3 of the release.

See

proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7.

Id.

Proposed paragraph (c)(2) of new Rule 17g-8 would require the NRSRO to have procedures reasonably designed to ensure it promptly determines whether the current credit rating assigned to the obligor, security, or money market instrument must be revised so that it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings.

The goal would be to ensure as quickly as possible that the credit rating assigned to the obligor, security, or money market instrument is solely a product of the NRSRO's procedures and methodologies for determining credit ratings (

i.e.,

is in no way influenced by the conflict). With respect to making this determination, the Commission preliminarily believes one approach would be to apply

de novo

the NRSRO's procedures and methodologies for determining credit ratings to the rated obligor, security, or money market instrument and revise the current credit rating if the

de novo

application produces a credit rating at a different notch on the rating scale.

See

proposed paragraph (c)(2) of new Rule 17g-8.

The Commission does not expect an NRSRO would revise a credit rating in every circumstance in which an earlier rating action was influenced by a conflict of interest. The Commission preliminarily notes that Section 15E(h)(4)(A)(ii) of the Exchange Act provides that the NRSRO's policies and procedures shall be reasonably designed to, among other things, ensure that the NRSRO takes action to revise the credit rating “if appropriate.”

It is possible, for example, that in the period since the NRSRO published the conflicted credit rating events unrelated to the conflict occurred that when factored into a

de novo

application of the NRSRO's procedures and methodologies for determining credit ratings would produce a credit rating at the same notch in the rating scale as the credit rating that was influenced by the conflict.

The Commission preliminarily believes a requirement that the NRSRO nonetheless revise the credit rating could interfere with the NRSRO's procedures and methodologies for determining credit ratings in that it would force the NRSRO to change the credit rating assigned to the obligor, security, or money market instrument to a different notch in the rating scale than would be the case if the credit rating were solely a product of the NRSRO's procedures and methodologies. Consequently, a mandatory revision requirement could, in effect, require the NRSRO to publish a credit rating that was inaccurate from the perspective of those procedures and methodologies.

15 U.S.C. 78o-7(h)(4)(A)(ii).

For example, assume that nine months ago an analyst upgraded the credit rating assigned to an issuer's securities from BBB to AA. The analyst leaves the NRSRO to work for the issuer. The analyst's new employment triggers a look-back review of the rating action upgrading the credit rating from BBB to AA pursuant to Section 15E(h)(4)(A)(i) of the Exchange Act. The look-back review determines the credit rating should not have been upgraded from BBB to AA at that point in time and the analyst's action in upgrading the credit rating was influenced by the prospect of employment with the issuer. The NRSRO performs a

de novo

review of the credit rating assigned to the issuer by applying its procedures and methodologies for determining credit ratings. This review—as required by the procedures and methodologies—takes into consideration favorable financial results the issuer reported three months ago. Consequently, the process of re-rating the issuer's securities determines the current credit rating should be AA.

Proposed paragraph (c)(3) of new Rule 17g-8 would require that the NRSRO have procedures reasonably designed to ensure it promptly publishes a revised credit rating, if appropriate, or an affirmation of the credit rating, if appropriate, based on the determination of whether the current credit rating assigned to the obligor, security, or money market instrument must be revised.

The Commission's intent is for the NRSRO to have procedures that are reasonably designed to notify users of the NRSRO's credit ratings as quickly as possible, whether the credit rating assigned to the obligor, security, or money market instrument will be

changed or remain the same.

The goal would be to promptly remove the uncertainty surrounding the credit rating to limit the potential that investors and other users of credit ratings might make investment or other credit based decisions based on incomplete information.

See

proposed paragraphs (c)(3)(i) and (ii) of new Rule 17g-8;

see also

proposed new paragraphs (a)(1)(ii)(J)(3)(ii) and (iii) of Rule 17g-7.

The Commission notes that, in the case of an NRSRO that makes its rating actions available only to subscribers, former subscribers who made an investment or other credit based decision using the credit rating likely would not receive notice that the credit rating was influenced by a conflict of interest as well as any changes made to the credit rating as a result of the “look-back” review.

As with the placement of the credit rating on credit watch, proposed paragraph (c)(3) of new Rule 17g-8 would require that the NRSRO's procedures would need to be reasonably designed to ensure that information required pursuant to proposed new paragraph (a)(1)(ii)(J)(

)(ii) and (iii) of Rule 17g-7, respectively, is included with the publication of a revised or affirmed credit rating.

In the case of a revised rating, proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7 would require the NRSRO to provide in the form published with the rating action an explanation that the reason for the action is the discovery that a credit rating assigned to the obligor, security, or money market instrument in one or more prior rating actions was influenced by a conflict of interest, the date and associated credit rating of each prior rating action the NRSRO has determined was influenced by the conflict, and an estimate of the impact the conflict had on each such prior rating action.

Similarly, in the case of an affirmed rating, proposed new paragraph (a)(1)(ii)(J)(

)(

iii

) of Rule 17g-7 would require the NRSRO to provide an explanation of why no rating action was taken to revise the credit rating notwithstanding the conflict, the date and associated credit rating of each prior rating action the NRSRO has determined was influenced by the conflict, and an estimate of the impact the conflict had on each such prior rating action.

See

proposed paragraphs (c)(3)(i) and (ii) of new Rule 17g-8.

See

proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7.

See

proposed new paragraph (a)(1)(ii)(J)(

)(

iii

) of Rule 17g-7.

As indicated in the proposed disclosures, the NRSRO would need to include an estimate of the impact the conflict had on each prior rating action influenced by the conflict.

The Commission preliminarily believes one approach an NRSRO could take to making such an estimate would be to apply

de novo

its procedures and methodologies for determining credit ratings to the rated obligor, security, or money market instrument using information and inputs as of the time period for which it was determined that the credit rating was influenced. In other words, under this approach the NRSRO would reconstruct the past rating action through a “conflict-free” application of its procedures and methodologies for determining credit ratings. The NRSRO then could compare the credit ratings and disclose the difference between the rating action that was influenced by a conflict and the reconstructed rating action.

See

proposed paragraph (c)(2)(i) of new Rule 17g-8;

see also

proposed paragraph (c)(2)(ii) of Rule 17g-8.

The disclosures required by proposed new paragraphs (a)(1)(ii)(J)(

)(

), (

) and (

iii

) of Rule 17g-7 would alert users of the NRSRO's credit ratings that the rating action was taken because a conflict of interest had influenced one or more credit ratings assigned to the obligor, security, or money market instrument.

In addition, the estimate of the impact of the conflict would provide users of the NRSRO's credit ratings with a sense of the magnitude of the variation between the credit rating influenced by the conflict and the credit rating that would have been determined had the conflict not existed. The users of the NRSRO's credit ratings could consider this information in evaluating the ability of the NRSRO to manage conflicts of interest in the production of credit ratings. Moreover, if the variation between the credit rating influenced by the conflict and the “un-conflicted” credit rating was large (

e.g.,

2 or 3 notches in the applicable rating scale), users of the NRSRO's credit ratings could consider the potential risk of using the NRSRO's credit ratings to make investment or other credit-based decisions (particularly if the revision downgraded the credit rating to a low category in the rating scale).

See

proposed paragraphs (a)(1)(ii)(J)(

)(

), (

) and (

iii

) of Rule 17g-7.

Request for Comment

The Commission generally requests comment on all aspects of proposed paragraph (c) of new Rule 17g-8. The Commission also seeks comment on the following:

1. Would the requirements to have procedures reasonably designed to ensure the NRSRO takes the steps set forth in proposed paragraphs (c)(1), (2), and (3) of new Rule 17g-8 alter the procedures and methodologies an NRSRO uses to determine credit ratings? For example, would an NRSRO take materially different steps if a look-back review conducted pursuant to Section 15E(h)(4)(A) of the Exchange Act determined that a credit rating was influenced by a conflict of interest? If so, describe in detail how those steps would differ.

2. Under Section 15E(h)(4)(A)(i) of the Exchange Act, an NRSRO must, in certain circumstances, conduct a review to determine whether any conflicts of interest of an employee influenced the credit rating. Should the Commission define what it means to have a conflict of interest “influence” a credit rating? If so, how should this term be defined? For example, should a credit rating be deemed “influenced” if the NRSRO would have taken a different rating action with respect to the credit rating in the absence of the conflict?

3. How would an NRSRO determine whether this conflict influenced a credit rating? Describe the types of evidence that would support such a determination. What steps could an NRSRO take to analyze whether this conflict influenced a credit rating? Are there any practical issues with respect to making such a determination? If so, describe them.

4. Is there any reason an NRSRO should not have procedures reasonably designed to ensure it immediately publishes a rating action placing the obligor, security, or money market instrument on credit watch based on the discovery of the conflict and include with the publication of the rating action the information required by proposed new paragraph (a)(1)(ii)(J)(3)(

) of Rule 17g-7 as would be required by proposed paragraph (c)(1) of Rule 17g-8? If so, please explain in detail the rationale for not disclosing this information immediately in this manner. In addition, if a commenter agrees with the objective of the requirement but not the manner of disclosure, describe any alternative means of disclosure that would achieve the objective.

5. What practical issues should the Commission consider in implementing proposed paragraph (c)(1) of new Rule 17g-8? How could the proposal be modified to address any practical issues identified without undermining the objectives of the proposal?

6. Would the information required by proposed new paragraph (a)(1)(ii)(J)(

)(

) of Rule 17g-7 to be included in the form published with a rating action placing the obligor, security, or money market instrument on credit watch be useful to the users of the NRSRO's credit ratings? Is there additional or alternative information that should be provided? If so, please describe such additional or alternative information.

7. Is there any reason an NRSRO would not have procedures reasonably designed to ensure it promptly determines whether the current credit rating assigned to the obligor, security, or money market instrument must be revised so it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings as would be required pursuant to proposed paragraph (c)(2) of new Rule 17g-8? If so, please explain in detail the rationale for not promptly making such a determination. In addition, are there alternative approaches to addressing conflicts of interest influencing credit ratings that the Commission should consider? If so, please identify and describe them.

8. What practical issues should the Commission consider in implementing proposed paragraph (c)(2) of new Rule 17g-8? How could the proposal be modified to address any practical issues identified without undermining the objectives of the proposal?

9. Should the Commission be more prescriptive in terms of how an NRSRO would be required to determine whether the current credit rating assigned to the obligor, security, or money market instrument must be revised so it no longer is influenced by a conflict of interest and is solely a product of the documented procedures and methodologies the NRSRO uses to determine credit ratings? If so, what actions should the Commission require be included in the NRSRO's policies and procedures? For example, should the Commission specifically require the NRSRO to apply

de novo

its policies and procedures for determining credit ratings in the ways described above?

10. Would a

de novo

application of the NRSRO's policies and procedures for determining credit ratings be sufficient to address the conflict of interest? Are there alternative or additional approaches to determining whether a credit rating influenced by a conflict of interest should be revised?

11. Is there any reason an NRSRO should not have procedures reasonably designed to ensure that it promptly publishes, as applicable, a revised credit rating or an affirmation of the current credit rating based on the determination of whether the current credit rating assigned to the obligor, security, or money market instrument must be revised and include with the rating action the information required by proposed new paragraphs (a)(1)(ii)(J)(

)(

) or (

iii

) of Rule 17g-7, as applicable, as would be required pursuant to paragraph (c)(3) of new Rule 17g-8? If so, please explain in detail the rationale for not promptly revising or affirming the current credit rating.

12. What practical issues should the Commission consider in implementing proposed paragraph (c)(3) of new Rule 17g-8 that would require an NRSRO to have procedures reasonably designed to ensure that it promptly publishes, as appropriate, a revised credit rating or an affirmation of the current credit rating and includes with the rating action the information required by proposed new paragraphs (a)(1)(ii)(J)(

)(

) and (

iii

) of Rule 17g-7? For example, would the requirement to estimate the impact the conflict had on the prior rating actions substantially prolong the time between placing the credit rating on credit watch and either publishing a revised credit rating or affirming the current credit rating? How could the proposal be modified to address any practical issues identified without undermining the objective of promptly addressing a credit rating influenced by a conflict of interest and at the same time providing investors and other users of credit ratings with the information about the conflict?

13. In terms of estimating the impact of a conflict on a past rating action, would a feasible approach be to apply

de novo

the procedures and methodologies for determining credit ratings to the relevant obligor, security, or money market instrument using information and inputs as of the time period in which the conflicted credit rating was determined? Would this approach result in a meaningful estimate? Are there alternative or additional steps that could be taken to estimate the impact?

14. Would the information required by proposed new paragraphs (a)(1)(ii)(J)(

)(

) and (

iii

) of Rule 17g-7 to be included in the form published with a revised or affirmed credit rating, respectively, be useful to the users of the NRSRO's credit ratings? Is there additional or alternative information that should be provided? If so, please describe such additional or alternative information.

15. How would the proposals impact obligors and issuers subject to a credit rating determined through the “look-back” review to be influenced by the conflict of interest?

16. In the case of an NRSRO that only makes its rating actions available to subscribers, former subscribers likely would not receive the proposed notices. Does this raise a significant issue that the Commission should address? If so, describe alternatives that could be used to address this issue.

2. Proposed Amendment to Rule 17g-2

Section 15E(h)(4)(A) of the Exchange Act requires an NRSRO “to establish, maintain, and enforce policies and procedures” but does not explicitly require an NRSRO to “document” such policies and procedures.

Nonetheless, the Commission preliminarily believes that documenting these policies and procedures is necessary in order to carry out the statute's mandate. The Commission also preliminarily believes they should be documented because, among other reasons, it is a sound practice for any organization to document its policies and procedures to promote better understanding of them among the individuals within the organization and thereby to promote compliance with such policies and procedures. In addition, for the reasons discussed in Section II.A.2 of this release, the Commission preliminarily believes that the policies and procedures should be subject to the same recordkeeping requirements that apply to other records an NRSRO is required to retain pursuant to Rule 17g-2.

For these reasons, the Commission proposes adding paragraph (a)(9) to Rule 17g-2 to identify the policies and procedures an NRSRO is required to establish, maintain, and enforce pursuant to Section 15E(h)(4)(A) of the Exchange Act and paragraph (c) of Rule 17g-8 as a record an NRSRO must make and retain.

As a result, the policies and procedures would need to be documented in writing and be subject to the record retention and production requirements in paragraphs (c) through (f) of Rule 17g-2.

100

See

15 U.S.C. 78o-7(h)(4)(A).

17 CFR 240.17g-2.

See

proposed new paragraph (a)(9) to Rule 17g-2;

see also

Section 17(a)(1) of the Exchange Act, which requires an NRSRO to make and keep such records, and make and disseminate such reports, as the Commission prescribes by rule as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the Exchange Act. 15 U.S.C. 78q(a)(1).

100

See

17 CFR 240.17g-2(c)-(f).

Request for Comment

The Commission generally requests comment on all aspects of proposed new paragraph (a)(9) of Rule 17g-2.

D. Fines and Other Penalties

Section 932(a)(8) of the Dodd-Frank Act amended Section 15E of the Exchange Act to add new subsection (p), which contains four paragraphs: (1), (2), (3), and (4).

101

Section 15E(p)(4)(A) provides that the Commission shall establish, by rule, fines and other penalties applicable to any NRSRO that

violates the requirements of Section 15E of the Exchange Act and the rules under the Exchange Act.

102

101

See

Public Law 111-203 § 932(a)(8) and 15 U.S.C. 78o-7(p)(1)-(4).

102

See

15 U.S.C. 78o-7(p)(4)(A).

The Exchange Act already provides a wide range of fines, penalties, and other sanctions applicable to NRSROs for violations of any section of the Exchange Act (including Section 15E) and the rules under the Exchange Act (including the rules under Section 15E).

103

For example, Section 15E(d)(1) of the Exchange Act provides that the Commission shall censure an NRSRO, place limitations on the activities, functions, or operations of an NRSRO, suspend an NRSRO for a period not exceeding 12 months, or revoke the registration of an NRSRO if, among other reasons, the NRSRO violates Section 15E of the Exchange Act or the Commission's rules thereunder.

104

In addition, Section 932(a)(3) of the Dodd-Frank Act amended Section 15E(d) to explicitly provide additional potential sanctions.

105

First, it provided the Commission with the authority to seek sanctions against persons associated with, or seeking to become associated with, an NRSRO.

106

Under these amendments, the Commission can censure such persons, place limitations on the activities or functions of such persons, suspend such persons for a period not exceeding 1 year, or bar such persons from being associated with an NRSRO.

107

Second, Section 932(a)(3) of Dodd-Frank Act amended Section 15E(d) to provide the Commission with explicit authority to temporarily suspend or permanently revoke the registration of an NRSRO in a particular class or subclass of credit ratings if the NRSRO does not have adequate financial and managerial resources to consistently produce credit ratings with integrity.

108

103

See

15 U.S.C. 78o-7(d), 15 U.S.C. 78u, 15 U.S.C. 78u-1, 15 U.S.C. 78u-2, 15 U.S.C. 78u-3 and 15 U.S.C. 78ff.

104

See

Section 15E(d)(1)(A)-(F) of the Exchange Act (15 U.S.C. 78o-7(d)(1)(A)-(F)), as amended by the Dodd-Frank Act.

105

See

Public Law 111-203 § 932(a)(3) and 15 U.S.C. 78o-7(d).

106

15 U.S.C. 78o-7(d)(1).

107

Id.

108

See

Public Law 111-203 § 932(a)(3) and 15 U.S.C. 78o-7(d)(2). Prior to this amendment, the Commission already had authority to suspend or revoke the registration of an NRSRO if it failed to maintain adequate financial and managerial resources to consistently produce credit ratings with integrity.

See

Section 15E(d)(5) of the Exchange Act (15 U.S.C. 78o-7(d)(5)) before being amended by the Dodd-Frank Act, which re-designated paragraph (d)(5) of Section 15E as paragraph (d)(1)(E) (15 U.S.C. 78o-7(d)(1)(E)). Section 15E(d)(2) of the Exchange Act, however, provides explicit authority to target a suspension or registration revocation to a specific class or subclass of security.

See

15 U.S.C. 78o-7(d)(2).

Furthermore, Sections 21, 21A, 21B, 21C, and 32 of the Exchange Act provide additional means to sanction an NRSRO for violations of the provisions of the Exchange Act such as the self-executing provisions in Section 15E of the Exchange Act and the rules under the Exchange Act.

109

See

15 U.S.C. 78o-7, 15 U.S.C. 78u, 15 U.S.C. 78u-1, 15 U.S.C. 78u-2, 15 U.S.C. 78u-3 and 15 U.S.C. 78ff, respectively. In fact, the Dodd-Frank Act amended Section 21B of the Exchange Act (15 U.S.C. 78u-2) to provide the Commission with the authority to assess money penalties in cease and desist proceedings under Section 21C (15 U.S.C. 78u-3).

See

Section 929P(a)(2) of the Dodd-Frank Act.

The Commission preliminarily believes these provisions of the Exchange Act, as amended by the Dodd-Frank Act, provide a sufficiently broad range of means to impose fines, penalties, and other sanctions on an NRSRO for violations of Section 15E of the Exchange Act and the rules thereunder. For example, the fines, penalties, and sanctions applicable to NRSROs are similar in scope to the fines, penalties, and sanctions applicable to other registrants under the Exchange Act, such as broker-dealers. Moreover, since enactment of the Rating Agency Act of 2006, the Commission has not identified a specific need for a fine or penalty applicable to NRSROs not otherwise provided for in the Exchange Act. Consequently, the Commission preliminarily believes it would be appropriate at this time to defer establishing new fines or penalties in addition to those provided for in the Exchange Act. However, in the future, the Commission may use the authority in Section 15E(p)(4)(A) of the Exchange Act if a specific need is identified. For the foregoing reasons, to implement Section 15E(p)(4)(A) of the Exchange Act at this time, the Commission proposes to amend the instructions to Form NRSRO by adding new Instruction A.10.

110

This new instruction would provide notice to credit rating agencies applying for registration and NRSROs that an NRSRO is subject to applicable fines, penalties, and other available sanctions set forth in Sections 15E, 21, 21A, 21B, 21C, and 32 of the Exchange Act (15 U.S.C. 78o-7, 78u, 78u-1, 78u-2, 78u-3, and 78ff, respectively) for violations of the securities laws.

110

See

proposed new Instruction A.10 to Form NRSRO.

Request for Comment

The Commission generally requests comment on all aspects of proposed new Instruction A.10 to Form NRSRO. The Commission also seeks comment on the following:

1. Are the fines, penalties and other sanctions applicable to NRSROs in Sections 15E, 21, 21A, 21B, 21C, and 32 of the Exchange Act sufficient? If not, what additional fines and penalties should the Commission establish by rule?

E. Public Disclosure of Information About the Performance of Credit Ratings

Section 932(a)(8) of the Dodd-Frank Act amended Section 15E of the Exchange Act to add new subsection (q), which contains paragraphs (1) and (2).

111

Section 15E(q)(1) provides that the Commission shall, by rule, require each NRSRO to publicly disclose information on the initial credit ratings determined by the NRSRO for each type of obligor, security, and money market instrument, and any subsequent changes to such credit ratings, for the purpose of allowing users of credit ratings to evaluate the accuracy of ratings and compare the performance of ratings by different NRSROs.

112

Section 15E(q)(2) provides that the Commission's rules shall require, at a minimum, disclosures that:

111

See

Public Law 111-203 § 932(a)(8) and 15 U.S.C. 78o-7(q)(1) and (2).

112

See

15 U.S.C. 78o-7(q)(1).

• Are comparable among NRSROs, to allow users of credit ratings to compare the performance of credit ratings across NRSROs;

113

See

15 U.S.C. 78o-7(q)(2)(A).

• Are clear and informative for investors having a wide range of sophistication who use or might use credit ratings;

114

See

15 U.S.C. 78o-7(q)(2)(B).

• Include performance information over a range of years and for a variety of types of credit ratings, including for credit ratings withdrawn by the NRSRO;

115

See

15 U.S.C. 78o-7(q)(2)(C).

• Are published and made freely available by the NRSRO, on an easily accessible portion of its Web site, and in writing, when requested;

116

See

15 U.S.C. 78o-7(q)(2)(D).

• Are appropriate to the business model of an NRSRO;

117

and

117

See

15 U.S.C. 78o-7(q)(2)(E).

• Require an NRSRO to include an attestation with any credit rating it issues affirming that no part of the rating was influenced by any other business activities, that the rating was based solely on the merits of the instruments being rated, and that such rating was an independent evaluation of the risks and merits of the instrument.

118

See

15 U.S.C. 78o-7(q)(2)(F). As discussed below in Section II.G.4 of this release, the

Commission preliminarily believes that the attestation requirement specified in Section 15E(q)(2)(F) should be incorporated into the rule the Commission is proposing to implement Section 15E(s) of the Exchange Act, which specifies, among other things, that the Commission adopt rules requiring an NRSRO to generate a form to be included with the publication of a credit rating.

See

15 U.S.C. 78o-7(s) and proposed new paragraph (a)(1)(iii) of Rule 17g-7.

Currently, the Commission's rules require NRSROs to publish two types of information about the performance of their credit ratings: (1) Performance statistics

119

and (2) ratings histories.

120

As discussed in detail below, the Commission proposes to implement the rulemaking mandated in Section 15E(q) of the Exchange Act, in substantial part, by significantly enhancing the requirements for generating and disclosing this information by amending the instructions to Form NRSRO as they relate to Exhibit 1 and amending Rule 17g-1, Rule 17g-2, and Rule 17g-7.

121

119

See

Exhibit 1 to Form NRSRO and Instruction H to Form NRSRO (as it relates to Exhibit 1). This type of disclosure shows the performance of an NRSRO's credit ratings in the aggregate through statistics. Specifically, it provides the percent of rated obligors, securities, and money market instruments in each category of credit rating in a rating scale (

e.g.,

AAA, AA, A, BBB, BB, B, CCC, CC, and C) that over a given time period were downgraded or upgraded to another credit rating category (“transition rates”) and went into default (“default rates”). The goal is to provide a mechanism for users of credit ratings to compare the statistical performance of credit ratings across NRSROs.

120

See

17 CFR 240.17g-2(d). This type of disclosure shows the credit rating history of a given rated obligor, security, or money market instrument. Specifically, it shows the initial credit rating and all subsequent modifications to the credit rating (such as upgrades, downgrades, and placements on watch) and the dates of such actions. The goal is to allow users of credit ratings to compare how different NRSROs rated an individual obligor, security, or money market instrument and how and when those ratings were changed over time. The disclosure of ratings histories also is designed to provide “raw data” that can be used by third parties to generate independent performance statistics such as transition and default rates.

121

See

proposed amendments to Instruction H to Form NRSRO (as it relates to Exhibit 1), paragraph (i) of Rule 17g-1, paragraph (d) of Rule 17g-2, and proposed new paragraph (b) of Rule 17g-7.

1. Proposed Enhancements to Disclosures of Performance Statistics

The Commission proposes to implement the rulemaking mandated in Section 15E(q) of the Exchange Act, in part, by amending Instruction H to Form NRSRO (the “instructions for Exhibit 1”) and Rule 17g-1.

122

See

proposed amendments to the instructions for Exhibit 1 and paragraph (i) of Rule 17g-1.

a. Proposed Amendments to Instructions for Exhibit 1

Exhibit 1 is part of the registration application a credit rating agency seeking to be registered as an NRSRO (an “applicant”) must submit to the Commission and an NRSRO must file with the Commission, keep up-to-date, and publicly disclose.

123

Section 15E(a)(1)(B)(i) of the Exchange Act requires that the registration application include performance measurement statistics over short-term, mid-term, and long-term periods (as applicable).

124

The Commission implemented this requirement, in large part, through Exhibit 1 to Form NRSRO and the instructions for Exhibit 1.

125

Section 15E(b)(1)(A) of the Exchange Act provides that the performance measurement statistics must be updated annually in an annual submission of the registration application required by Section 15E(b)(2) (the “annual certification”).

126

123

In particular, Section 15E(a)(1)(A) of the Exchange Act requires an applicant to furnish an application for registration to the Commission, in such form as the Commission shall require, by rule or regulation.

See

15 U.S.C. 78o-7(a)(1)(A). Section 15E(a)(1)(B) of the Exchange Act identifies information that must be included in the application for registration.

See

15 U.S.C. 78o-7(a)(1)(B)(i)-(x). The Commission implemented Sections 15E(a)(1)(A) and (B) of the Exchange Act by adopting Form NRSRO.

See

Form NRSRO;

see also

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33569-33582 (June 18, 2007). Section 15E(a)(3) of the Exchange Act provides that the Commission, by rule, shall require an NRSRO, upon being granted registration, to make the information and documents in its completed application for registration, or in any amendment to its application, publicly available on its Web site, or through another comparable, readily accessible means, except for certain information that is submitted on a confidential basis.

See

15 U.S.C. 78o-7(a)(3). The Commission implemented this provision by adopting paragraph (i) of Rule 17g-1.

See

17 CFR 240.17g-1(i);

see also

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33569 (June 18, 2007). Section 15E(b)(1) requires an NRSRO to promptly amend its application for registration if any information or document provided therein becomes materially inaccurate; however, (as discussed below) certain information does not have to be updated and other information must be updated only on an annual basis.

See

15 U.S.C. 78o-7(b)(1);

see also

15 U.S.C. 78o-7(b)(1) and 15 U.S.C. 78o-7(a)(1)(B)(ix). The Commission implemented this provision by adopting Form NRSRO and paragraph (e) of Rule 17g-1.

See

Form NRSRO and 17 CFR 240.17g-1(e);

see also

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33567, 33569-33582 (June 18, 2007).

124

See

15 U.S.C. 78o-7(a)(1)(B)(i).

125

See

instructions for Exhibit 1.

126

See

15 U.S.C. 78o-7(b)(1) and (2). In particular, Section 15E(b)(2) of the Exchange Act provides that not later than 90 days after the end of each calendar year, an NRSRO shall file with the Commission an amendment to its registration application, in such form as the Commission, by rule, may prescribe: (1) Certifying that the information and documents in the application for registration continue to be accurate; and (2) listing any material change that occurred to such information and documents during the previous calendar year.

See

15 U.S.C. 78o-7(b)(2). The Commission implemented these provisions by adopting Form NRSRO and paragraph (f) of Rule 17g-1.

See

Form NRSRO and 17 CFR 240.17g-1(f);

see also

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33567, 33569-33582 (June 18, 2007).

The instructions for Exhibit 1 require an applicant and NRSRO to provide performance measurement statistics of the credit ratings of the applicant or NRSRO, including performance measurement statistics of the credit ratings separately for each class of credit rating for which the applicant is seeking registration or the NRSRO is registered.

127

The classes of credit ratings for which an NRSRO can be registered are enumerated in the definition of “nationally recognized statistical rating organization” in Section 3(a)(62) of the Exchange Act: (1) Financial institutions, brokers, or dealers;

128

(2) insurance companies;

129

(3) corporate issuers;

130

(4) issuers of asset-backed securities (as that term is defined in Section 1101(c) of part 229 of Title 17, Code of Federal Regulations, “as in effect on the date of enactment of this paragraph”);

131

and (5) issuers of government securities, municipal securities, or securities issued by a foreign government.

132

With respect to the fifth class of credit ratings, the instructions for Exhibit 1 require the NRSRO to provide performance measurement statistics for the following three subclasses (as opposed to the class

as a whole): sovereigns, United States public finance, and international public finance.

133

127

See

instructions for Exhibit 1.

128

See

15 U.S.C. 78c(a)(62)(A)(i).

129

See

15 U.S.C. 78c(a)(62)(A)(ii).

130

See

15 U.S.C. 78c(a)(62)(A)(iii).

131

See

15 U.S.C. 78c(a)(62)(A)(iv). The instructions for Exhibit 1 broaden this class of credit rating to include a credit rating of any security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction. The intent of the instruction is to include in the class (and, therefore, in the performance statistics for the class) credit ratings for structured finance products that are outside the scope of the definition referenced in Section 3(a)(62)(A)(iv) of the Exchange Act.

See

15 U.S.C. 78c(a)(62)(A)(iv) and

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 6458 (Feb. 9, 2009). As discussed below, the Commission is proposing to continue to use a broadened definition in the proposed new instructions for Exhibit 1. Moreover, the term “structured finance product” as used throughout this release refers broadly to any security or money market instrument issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction.

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 63832, footnote 3 (Dec. 4, 2009). This broad category of financial instrument includes an “asset-backed security” as defined in Section 3(a)(77) of the Exchange Act (15 U.S.C. 78c(a)(77)) and other types of structured debt instruments such as collateralized debt obligations CDOs, including synthetic and hybrid CDOs.

Id.

The term “Exchange Act-ABS” as used throughout this release refers more narrowly to an “asset-backed security” as defined in Section 3(a)(77) of the Exchange Act. 15 U.S.C. 78c(a)(77).

132

See

15 U.S.C. 78c(a)(62)(A)(v).

133

See

instructions for Exhibit 1.

In addition, the instructions require that the performance measurement statistics “must at a minimum show the performance of credit ratings in each class over 1-year, 3-year, and 10-year periods (as applicable) through the most recent calendar year-end, including, as applicable: historical ratings transition and default rates within each of the credit rating categories,

134

notches, grades, or rankings used by the Applicant/NRSRO as an indicator of the assessment of the creditworthiness of an obligor, security, or money market instrument in each class of credit rating.”

135

Paragraph (i) of Rule 17g-1 provides, among other things, that the NRSRO must make the annual certification publicly available within 10 business days of furnishing the annual certification to the Commission.

136

134

The transition rate is the percentage of ratings at a given rating notch that transition to another specified rating notch over a given time period. Only ratings that were outstanding at the beginning of the time period are used in the calculation of the transition rate. Transition rates are generally used to measure the stability of the ratings. The default rate is the percentage of ratings at a given rating notch that have defaulted over a given time period. Only the ratings that were outstanding at the beginning of the time period are used in the calculation.

135

See

instructions for Exhibit 1.

136

See

17 CFR.240.17g-1(i).

Currently, the instructions for Exhibit 1 do not prescribe the methodology an NRSRO must use to calculate and present the performance measurement statistics; nor do the instructions limit the type of information that can be disclosed in the Exhibit.

137

Consequently, NRSROs have used different techniques to produce performance measurement statistics, which has limited the ability of investors and other users of credit ratings to compare the performance of credit ratings across NRSROs.

138

In addition, several NRSROs have included substantial amounts of information in Exhibit 1 about performance measurement statistics, in addition to transition and default rates. These practices make the presentation of information in the Exhibits widely inconsistent across NRSROs.

137

When adopting Form NRSRO, the Commission explained that the instructions would not prescribe how NRSROs must calculate transition rates and default rates, noting that commenters had opposed a standard approach because NRSROs use different methodologies to determine credit ratings.

See Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

72 FR at 33574 (June 18, 2007). The Commission stated that it intended to continue to consider the issue “to determine the feasibility, as well as the potential benefits and limitations, of devising measurements that would allow reliable comparisons of performance between NRSROs.”

Id.

The Commission incrementally standardized the disclosure requirements in Exhibit 1 by amending the Form in 2009 to require an NRSRO to disclose transition and default rates for each class of credit rating for which it was registered and for 1-, 3-, and 10-year periods.

See Amendments to Rules for Nationally Recognized Statistical Rating Organizations

74 FR at 6457-6459 (Feb. 9, 2009).

138

See, e.g.,

Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance Related Disclosures,

GAO Report 10-782 (Sept. 2010) (“GAO Report 10-782”).

For the foregoing reasons and to implement Section 15E(q) of the Exchange Act, the Commission is proposing significant enhancements to the requirements to disclose performance measurement statistics in Exhibit 1.

139

The enhancements would confine the disclosures in the Exhibit to transition and default rates and certain limited supplemental information. Moreover, the enhancements would standardize the production and presentation of the transition and default rates.

140

Specifically, the Commission preliminarily believes that the transition and default rates in Exhibit 1 should be produced using a “single cohort approach.”

141

As explained below, under this approach, an applicant and NRSRO, on an annual basis, would be required to compute how the credit ratings assigned to obligors, securities, and money market instruments in a particular class or subclass of credit rating that were outstanding on the date 1, 3, and 10 years prior to the most recent calendar year-end performed during the respective 1-, 3-, and 10-year time period. The Commission's intent in proposing these enhancements is to make the Exhibit 1 disclosures simply presented, easy to understand, uniform in appearance, and comparable across NRSROs.

142

139

See

15 U.S.C. 78o-7(q) and proposed amendments to instructions for Exhibit 1.

140

See

15 U.S.C. 78o-7(q)(2)(B).

141

See

GAO Report 10-782, pp. 27-37 (comparing, among other things, a single cohort approach—the model for the Commission's proposal—with an average cohort approach).

see also

15 U.S.C. 78o-7(b)(1)(A) and 17 CFR 240.17g-1(f). While paragraph (f) of Rule 17g-1 currently requires the annual certification to be “furnished,” the Commission is proposing, as discussed below in Section II.M.1 of the release, to replace the term “furnished” with the term “filed” in a number of the NRSRO rules, including Rule 17g-1.

164

See

proposed new paragraph (1) of the instructions for Exhibit 1. As discussed below in Section II.E.1.b of this release, the Commission is proposing to amend paragraph (i) of Rule 17g-1 (17 CFR 240.17g-1(i)) to implement Section 15E(q)(2)(D) of the Exchange Act, which provides that the Commission's rules must require that the information about the performance of credit ratings be published and made freely available on an easily accessible portion of an NRSRO's Web site, and in writing when requested.

See

15 U.S.C. 78o-7(q)(2)(D). As discussed below, the proposed amendment to paragraph (i) of Rule 17g-1 (17 CFR 240.17g-1(i)) would require an NRSRO to publish and make freely available on an easily accessible portion of its Web site all of Form NRSRO (

i.e.,

not just Exhibit 1). However, only Exhibit 1 would need to be made freely available in writing when requested.

Proposed Paragraph (2) of the Instructions for Exhibit 1.

Proposed new paragraph (2) of the instructions for Exhibit 1 would prescribe how an applicant and NRSRO must present the performance measurement statistics and other required information in the Exhibit.

165

Specifically, it would require that the Transition/Default Matrices for each applicable class and subclass of credit ratings be presented in the order that the classes and subclasses are identified in proposed paragraphs (1)(A) through (E) of Exhibit 1. In addition, the order of the Transition/Default Matrices for a given class or subclass would need to be: The 1-year matrix, the 3-year matrix, and then the 10-year matrix.

Proposed new paragraph (2) also would provide that if the applicant or NRSRO did not issue credit ratings in a particular class or subclass for the length of time necessary to produce a Transition/Default Matrix for a 1-, 3-, or 10-year period, it would need to explain that fact in the location where the Transition/Default Matrix would have been presented in the Exhibit.

166

165

See

proposed new paragraph (2) of the instructions for Exhibit 1.

166

For example, if an NRSRO is registered in the corporate issuer class but has been issuing credit ratings for only 7 years in that class, it could not produce a 10-year Transition/Default Matrix for the class. Instead, the NRSRO would need to provide an explanation in the location where a 10-year Transition/Default Matrix would have been located (

i.e.,

after the 3-year matrix) that it had not been issuing credit ratings in that class for a sufficient amount of time to produce a 10-year Transition/Default Matrix.

Similar to the current Instructions, proposed paragraph (2) would require an applicant and NRSRO to clearly define in Exhibit 1, after the presentation of all applicable Transition/Default Matrices, each symbol, number, or score in the rating scale used by the applicant or NRSRO to denote a credit rating category and notches within a category for each class and subclass of credit ratings in any Transition/Default Matrix presented in the Exhibit.

167

The instructions also would require the applicant or NRSRO to clearly explain the conditions under which it classifies obligors, securities, or money market instruments as being in default. As discussed below, the Commission preliminarily believes that obligors, securities, and money market instruments that the applicant or NRSRO has classified as being in default as of the period start date for a Transition/Default Matrix should be excluded from the statistics in the matrix. Also, as discussed below, the Commission is proposing a standard definition of “default” for the purpose of calculating default rates. In addition, also as discussed below, where an applicant or NRSRO has a definition of “default” that is broader than this standard definition, the instructions would require the applicant or NRSRO to supplement the standard definition with its internal definition. For these reasons, the Commission believes it would be useful for investors and other users of credit ratings to know how an NRSRO defines default.

167

Compare

current instructions for Exhibit 1,

with

proposed new paragraph (2). As discussed in Section II.J.2 of this release, the Commission is proposing to implement Section 938(a)(2) of the Dodd-Frank Act through paragraph (b)(2) of new Rule 17g-8, which would require an NRSRO to have policies and procedures reasonably designed to clearly define the meaning of any symbol used by the NRSRO to denote a credit rating, including in Exhibit 1 to Form NRSRO.

See

Public Law 111-203 § 938(a)(2) and proposed paragraph (b)(2) of new Rule 17g-8.

Similar to the current instructions, proposed paragraph (2) would require that an applicant and NRSRO provide in Exhibit 1 the uniform resource locator (URL) of its corporate Internet Web site where the credit rating histories required to be disclosed pursuant to paragraph (b) of Rule 17g-7 would be located (in the case of an applicant) or are located (in the case of an NRSRO).

168

Compare

current instructions for Exhibit 1,

with

proposed new paragraph (2). As discussed below in Section II.E.2 of this release, the Commission is proposing to amend Rule 17g-2 (17 CFR 240.17g-2) and Rule 17g-7 (17 CFR 240.17g-7) to enhance the credit rating history disclosure requirements currently located in Rule 17g-2. Among other things, the Commission proposes relocating the credit rating history disclosure requirements from Rule 17g-2 to proposed new paragraph (b) of Rule 17g-7.

See

proposed amendments to paragraph (d) of Rule 17g-2 and proposed new paragraph (b) of Rule 17g-7.

Finally, proposed paragraph (2) would provide that Exhibit 1 must contain no performance measurement statistics or information other than as described in, and required by, the instructions for Exhibit 1; except the applicant or NRSRO would be permitted to provide, after the presentation of all required Transition/Default Matrices and other required disclosures, Internet Web site URLs where other information relating to performance measurement statistics of the applicant or NRSRO is located.

169

As noted above, some NRSROs include substantial amounts of information in Exhibit 1 about the performance of their credit ratings. The Commission preliminarily believes information in addition to the disclosures that would be required under the enhancements to Exhibit 1 may be useful to investors and other users of credit ratings. However, the Commission also preliminarily believes disclosing this related information in Exhibit 1 would make the Exhibit less easy to use in terms of locating a particular Transition/Default Matrix and comparing it with the matrices of other NRSROs. Consequently, the Commission preliminarily believes an appropriate balance would be to exclude related information from the Exhibit but permit an NRSRO to cross-reference such information by providing Internet Web site URLs at the end of the Exhibit.

169

See

proposed new paragraph (2) of the instructions for Exhibit 1.

Proposed Paragraph (3) of the Instructions for Exhibit 1.

Proposed paragraph (3) of the Instructions for Exhibit 1 would prescribe how an applicant and NRSRO must design a Transition/Default Matrix.

170

The instructions would require an applicant and NRSRO to produce a 1-, 3-, and 10-year Transition/Default Matrix for each applicable class and subclass of credit rating that resembles, in design, the Transition/Default Matrix in Figure 1 below.

171

170

See

proposed new paragraph (3) of the instructions for Exhibit 1.

171

However, as explained below, the top row and first column would be based on the rating scale used by the applicant or NRSRO for the applicable class or subclass of credit ratings. For example, in the Sample Transition/Default Matrix, there are nine categories denoted by the symbols: AAA, AA, A, BBB, BB, B, CCC, CC, and C but no notches within those categories. An NRSRO that uses notches in its ratings scale (

e.g.,

AA+, AA, and AA-) would need to include the symbol for each notch in the individual cells of the first column and top row. However, as discussed below, the applicant or NRSRO would exclude a “default” category even if it uses such a category in its rating scale (though, as explained below, there would be a column with the heading “Default” in the matrix that would depict the percent of rated obligors, securities, and money market instruments that went into default during the relevant time period based on a standard definition of “default” in the instructions for Exhibit 1 (

i.e.,

not on the definition of the applicant or NRSRO).

Figure 1—Corporate Issuers—10-Year Transition and Default Rates

[December 31, 2000 through December 31, 2010]

Credit rating scale

Number of ratings outstanding as of 12/31/2000

AAA

BBB

CCC

Default

Paid

off

Withdrawn

(other)

AAA

50%

10%

40%

2000

39%

12%

10%

19%

4000

34%

15%

10%

18%

BBB

3600

28%

15%

10%

17%

1000

20%

14%

16%

37%

500

20%

15%

CCC

300

15%

25%

20%

200

10%

38%

30%

10%

160

10%

67%

12%

Total

11,770

A sample Transition/Default Matrix similar to Figure 1 would be depicted in proposed new paragraph (3) to provide a visual representation of how to design and present a matrix.

172

In addition to the visual depiction, proposed new paragraph (3) would contain narrative instructions on how to design a matrix. First, the narrative instructions would prescribe the headings for each required column in a Transition/Default Matrix by referring to the cells in the top row of the table (the “header row”).

173

The narrative instructions would require that the first and second cells in the header row contain the headings, respectively, “Credit Rating Scale” and “Number of Ratings Outstanding as of [insert the applicable date].”

174

The applicable date would be the date 1, 3, or 10 years prior to the most recent calendar year-end depending on whether the Transition/Default Matrix was being produced for a 1-, 3-, or 10-year period. The next sequence of cells in the header row would need to contain, in order from left to right, each credit rating symbol, number, or score used to denote a category and a notch within a category in the rating scale used by the applicant or NRSRO for the applicable class or subclass of credit ratings in descending order from the highest to the lowest notch.

175

The narrative instructions would require that the applicant or NRSRO not include a “default” category in the header row even if such a category is used in the rating scale.

176

The narrative instructions would require that the cells in the last three columns in the Transition/Default Matrix contain the headings, in order from left to right, “Default”, “Paid Off”, and “Withdrawn (other).”

177

172

See

proposed new paragraph (3) of the instructions for Exhibit 1.

173

See

proposed new paragraph (3) of the instructions for Exhibit 1.

174

See, e.g.,

the 1st and 2nd columns of the Sample Transition/Default Matrix in Figure 1.

175

See

proposed new paragraph (3) of the instructions for Exhibit 1;

see also

the 3rd through 11th columns of the Sample Transition/Default Matrix in Figure 1.

176

The Commission's reasoning for proposing to exclude a category of “default” from the first column is explained below.

177

See

proposed new paragraph (3) of the instructions for Exhibit 1;

see also

the 12th through 14th columns of the Sample Transition/Default Matrix in Figure 1.

Next, the narrative instructions would require that the first column have a separate cell containing each credit rating symbol, number, or score in the rating scale used by the applicant or NRSRO to denote a category and a notch within a category for the applicable class or subclass of credit ratings in descending order from the highest to the lowest notch.

178

The applicant or NRSRO would be required to populate the column with the credit rating symbols, numbers, or scores in descending order from the highest to the lowest notch. Consistent with the header row, the narrative instructions also would require that the first column not include a “default” category if the applicant or NRSRO uses such a category in its rating scale. The last cell in the first column would need to contain the term “Total.”

179

178

See, e.g.,

the first column of the Sample Transition/Default Matrix in Figure 1.

179

See

proposed new paragraph (3) of the instructions for Exhibit 1;

see also

the first column of the Sample Transition/Default Matrix in Figure 1.

Finally, the narrative instructions would require that the Transition/Default Matrix have a title identifying the applicable class or subclass of credit ratings, the period covered (1, 3, or 10 years), and start date and end date for the period.

Proposed Paragraph (4) of the Instructions for Exhibit 1.

Proposed new paragraph (4) of the instructions for Exhibit 1 would prescribe how an applicant or NRSRO would need to populate a Transition/Default Matrix with data and statistical information.

180

First, proposed new paragraph (4)(A) would prescribe how to populate the cells of the second column headed “Number of Ratings Outstanding [as the Start Date].”

181

First, the applicant or NRSRO would be required to determine a start-date cohort consisting of the obligors, securities, and money market instruments in the applicable class or subclass of credit ratings that were assigned a credit rating (other than an expected or preliminary credit rating)

182

that was outstanding as of the start date for the applicable period (

i.e.,

the date 1, 3, or 10 years prior to the most recently ended calendar year).

183

Consequently, the start-date cohort would exclude any obligor, security, or money market instrument that received an initial credit rating in the class or subclass after the start date.

184

180

See

proposed paragraph (4) of the instructions for Exhibit 1.

181

See

proposed paragraph (4)(A) of the instructions for Exhibit 1;

see also

the 2nd column of the Sample Transition/Default Matrix in Figure 1.

182

“Expected” or “preliminary” credit ratings most commonly are issued by an NRSRO with respect to a structured finance product at the time the issuer commences the offering and typically are included in pre-sale reports. Expected or preliminary credit ratings may include a range of ratings, or any other indications of a credit rating used prior to the assignment of an initial credit rating for a new issuance. As such, the Commission preliminarily believes they should be excluded from the Transition/Default Matrices since the issuance of the “initial” credit rating is the first formal expression of the NRSRO's view of the relative creditworthiness of the obligor, security, or money market instrument.

183

For example, if the most recent year end was December 31, 2010, the NRSRO would need to determine all the obligors, securities, and money market instruments with credit ratings outstanding in the relevant class as of December 31, 2009 (for the 1-year Transition/Default Matrix), December 31, 2007 (for the 3-year Transition/Default Matrix), and December 31, 2000 (for the 10-year Transition/Default Matrix). Because some obligors, securities, and money market instruments have characteristics that could cause them to be assigned more than one class of credit rating, the Commission is seeking comment below in Section II.M.4.a of this release on which class would be the most appropriate for certain types of obligors, securities, and money market instruments. Based on the comments received in response to those questions, the Commission may decide to prescribe by rule or identify through guidance how certain types of obligors, securities, and money market instruments should be classified for the purpose of determining start-date cohorts.

184

For example, a Transition/Default Matrix covering a 10-year period would not include obligors, securities, and money market instruments that had been rated by the NRSRO for less than 10 years. However, these obligors, securities, and money instruments may be included in the start-date cohorts for the 1- and 3-year matrices for the class or subclass.

In addition, the proposed instructions would provide that the applicant or NRSRO must exclude from the start-date cohort any obligors, securities, or money

market instruments that were classified by the applicant or NRSRO as being in default as of the period start date.

185

The Commission preliminarily believes that the Transition/Default Matrices should not include obligors, securities, and money market instruments the applicant or NRSRO has classified as in default.

186

The reason is that, if an applicant or NRSRO classifies an obligor, security, or money market instrument as in default, the applicant or NRSRO is no longer assessing the relative likelihood that the obligor, security, or money market will continue to meet its obligations to make timely payments of principal and interest as they come due (

i.e.,

not default on its obligations). Consequently, as long as the obligor, security, or money market instrument continues to be classified as in default there is no credit rating performance to measure. However, if an obligor, security, or money market instrument is upgraded from the default category because, for example, the obligor emerges from a bankruptcy proceeding, the obligor would need to be included in a Transition/Default Matrix that has a start date after the upgrade.

187

185

See

proposed paragraph (4)(A) of the instructions for Exhibit 1. As indicated, the determination of whether an obligor, security, or money market instrument should be excluded from the start date cohort would be based on the definition of “default” used by the applicant or NRSRO. As discussed below, in determining the outcome of a credit rating assigned to an obligor, security, and money market instrument during the applicable time period covered by a Transition/Default Matrix, the applicant or NRSRO would need to use a standard definition of “default” in proposed new paragraph (4)(B)(iii) as opposed to its own definition. The Commission recognizes that the use of a standard definition of “default” to determine the outcome of a credit rating during the applicable time period could result in an obligor, security, or money market instrument being included in the start-date cohort that, as of the start date, would be classified as in “default” under the proposed definition of “default” in paragraph (4)(B)(iii). In other words, the applicant or NRSRO may not have classified the obligor, security, or money market instrument as in default as of the start date using its own narrower definition. In this case, the Commission preliminarily believes such an obligor, security, or money market instrument should be included in the start-date cohort since the applicant or NRSRO had assigned it a credit rating representing a relative assessment of the likelihood of default (rather than a classification of default) on the start date. Therefore, the performance of the applicant or NRSRO in rating that obligor, security, or money market instrument should be incorporated into the default rate.

186

This does not mean that the obligor, security or money market instrument would never be reflected in default rates. For example, assume that as of the date 10 years prior to the most recently ended calendar year-end an obligor in the corporate issuer class was assigned a credit rating of BBB. This obligor would be included in the start-date cohort for the 10-year Transition/Default Matrix and grouped with the other obligors, securities, and/or money market instruments assigned BBB ratings. Further, assume that during the first seven years of the 10-year period, the credit rating of the obligor was downgraded from BBB to

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