Nationally Recognized Statistical Rating Organizations

SECURITIES AND EXCHANGE COMMISSION

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

[Release No. 34-72936; File No. S7-18-11]

RIN 3235-AL15

Nationally Recognized Statistical Rating Organizations

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rules.

SUMMARY:

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and to enhance oversight, the Securities and Exchange Commission (“Commission”) is: adopting amendments to existing rules and new rules that apply to credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (“NRSROs”); adopting a new rule and form that apply to providers of third-party due diligence services for asset-backed securities; and adopting amendments to existing rules and a new rule that 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 also is adopting certain technical amendments to existing rules.

DATES:

This rule is effective November 14, 2014; except the amendments to § 240.17g-3(a)(7) and (b)(2) and Form NRSRO, which are effective on January 1, 2015; and the amendments to § 240.17g-2(a)(9), (b)(13) through (15), § 240.17g-5(a)(3)(iii)(E), (c)(6) through (8), § 240.17g-7(a) and (b), and Form ABS-15G, which are effective June 15, 2015. The addition of §§ 240.15Ga-2, 240.17g-8, 240.17g-9, 240.17g-10, and Form ABS Due Diligence-15E are effective June 15, 2015.

FOR FURTHER INFORMATION CONTACT:

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; Division of Trading and Markets; Harriet Orol, Branch Chief, at (212) 336-0554; Kevin Vasel, Attorney, at (212) 336-0981; Office of Credit Ratings; or, with respect to the rules for issuers and underwriters of asset-backed securities, Michelle M. Stasny, Special Counsel in the Office of Structured Finance, at (202) 551-3674; Division of Corporation Finance; Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commission, with respect to NRSROs, is adopting amendments to rules 17 CFR 232.101 (“Rule 101 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”), and 17 CFR 249b.300 (“Form NRSRO”); and is adopting 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 adopting new rules 17 CFR 240.17g-10 (“Rule 17g-10”) and 17 CFR 249b.500 (“Form ABS Due Diligence-15E”).

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

Table Of Contents

I. Introduction

A. Background

B. Economic Analysis

1. Guiding Principles9

2. Baseline

a. NRSROs

b. Asset-Backed Security Issuers, Underwriters, and Third-Party Due Diligence Providers

c. Industry Practices

3. Broad Economic Considerations

a. Amendments and Rules Enhancing NRSRO Governance and Integrity of Credit Ratings

b. Amendments and Rules Enhancing Disclosure and Transparency of Credit Ratings

II. Final Rules and Rule Amendments

A. Internal Control Structure

1. Prescribing Factors

2. Amendment to Rule 17g-2

3. Amendments to Rule 17g-3

4. Economic Analysis

B. Sales And Marketing Conflict of Interest

1. New Prohibited Conflict

2. Exemption for “Small” NRSROs

3. Suspending or Revoking a Registration

4. Economic Analysis

C. “Look-Back” Review

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

2. Amendment to Rule 17g-2

3. Economic Analysis

D. Fines and Other Penalties

1. Final Rule

2. Economic Analysis

E. Disclosure of Information About the Performance of Credit Ratings

1. Amendments to Instructions for Exhibit 1 to Form NRSRO

a. Proposal

b. Final Rule

2. Amendments to Rule 17g-1

3. Amendments to Rule 17g-2 and Rule 17g-7

a. Proposal

b. Final Rule

4. Economic Analysis

F. Credit Rating Methodologies

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

2. Amendment to Rule 17g-2

3. Economic Analysis

G. Form And Certifications to Accompany Credit Ratings

1. Paragraph (a) of Rule 17g-7—Prefatory Text

2. Paragraph (a)(1)(i) of Rule 17g-7—Format of the Form

3. Paragraph (a)(1)(ii) of Rule 17g-7—Content of the Form

4. Paragraph (a)(1)(iii) of Rule 17g-7—Attestation

5. Paragraph (a)(2) of Rule 17g-7—Third-Party Due Diligence Certification

6. Economic Analysis

H. Third-Party Due Diligence for Asset-Backed Securities

1. New Rule 15Ga-2 and Amendments to Form ABS-15G

2. New Rule 17g-10

3. New Form ABS Due Diligence-15E

4. Economic Analysis

I. Standards of Training, Experience, and Competence

1. New Rule 17g-9

2. Amendment to Rule 17g-2

3. Economic Analysis

J. Universal Rating Symbols

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

2. Amendment to Rule 17g-2

3. Economic Analysis

K. Annual Report of Designated Compliance Officer

1. Amendment to Rule 17g-3

2. Economic Analysis

L. Electronic Submission of Form NRSRO and the Rule 17g-3 Annual Reports

1. Amendments to Rule 17g-1, Form NRSRO, Rule 17g-3, and Regulation S-T

2. Economic Analysis

M. Other Amendments

1. Changing “Furnish” to “File”

2. Amended Definition of NRSRO

3. Definition of Asset-Backed Security

4. Other Amendments to Form NRSRO

a. Clarification with Respect to Items 6 and 7

b. Clarification with Respect to Exhibit 8

c. Clarification with Respect to Exhibits 10 through 13

5. Economic Analysis

III. Effective Dates

A. Amendments Effective Sixty Days After Publication in the

Federal Register

B. Amendments Effective On January 1, 2015

C. Amendments and New Rules Effective Nine Months After Publication In the

Federal Register

IV. Paperwork Reduction Act

A. Summary of the Collection of Information Requirements

1. Amendments to Rule 17g-1

2. Amendments to Instructions for Exhibit 1 to Form NRSRO

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

B. Use of Information

1. Amendments to Rule 17g-1

2. Amendments to Instructions for Exhibit 1 to Form NRSRO

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

C. Respondents

D. Total Initial and Annual Recordkeeping and Reporting Burdens

1. Amendments to Rule 17g-1

2. Amendments to Form NRSRO Instructions

3. Amendments to Rule 17g-2

4. Amendments to Rule 17g-3

5. Amendments to Rule 17g-5

6. Amendments to Rule 17g-7

7. New Rule 17g-8

8. New Rule 17g-9

9. New Rule 17g-10 and New Form ABS Due Diligence-15E

10. New Rule 15Ga-2 and Amendments to Form ABS-15G

11. Amendments to Regulation S-T

12. Form ID

13. Total Paperwork Burdens

E. Collection of Information Is Mandatory

F. Confidentiality

G. Retention Period of Recordkeeping Requirements

V. Implementation and Annual Compliance Considerations

A. Internal Control Structure

B. Conflicts of Interest Relating to Sales and Marketing

C. “Look-Back” Review

D. Fines and Other Penalties

E. Enhancements to Disclosures of Performance Statistics

F. Enhancements to Rating Histories Disclosures

G. Credit Rating Methodologies

H. Form and Certification To Accompany Credit Ratings

I. New Rule 15ga-2 and Amendments to Form Abs-15g

J. New Rule 17g-10 and New Form ABS Due Diligence-15e

K. Standards of Training, Experience, and Competence

L. Universal Rating Symbols

M. Electronic Submission of Form NRSRO and the Rule 17G-3 Annual Reports

VI. Final Regulatory Flexibility Analysis

A. Need for and Objectives of the Amendments and New Rules

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Rules

1. NRSROs and Providers of Third-Party Due Diligence Services

2. Issuers

D. Reporting, Recordkeeping, and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

VII. Statutory Authority

I. Introduction

A. Background

The Dodd-Frank Act,

1

through Title IX, Subtitle C, “Improvements to the Regulation of Credit Rating Agencies,” among other things, establishes new self-executing requirements applicable to NRSROs and requires that the Commission adopt rules applicable to NRSROs in a number of areas.

2

It also requires certain studies relating to NRSROs.

3

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.

4

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 must provide to each NRSRO producing a credit rating for an asset-backed security to which the due diligence services relate.

5

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.

6

1

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

2

See

Public Law 111-203, 931 through 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). 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,

Securities Exchange Act of 1934 (“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.

See id.

In November 2009, the Commission announced it was deferring consideration of action on that 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). As discussed above, a different rule from either of these proposals ultimately was adopted and codified at 17 CFR 240.17g-7 in January 2011.

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

76 FR 4489.

3

See

Public Law 111-203, 939(h), 939C, 939D, 939E, 939F. Pursuant to section 939(h) of the Dodd-Frank Act, the Commission submitted a staff report to Congress on standardizing credit rating terminology.

See Report to Congress Credit Rating Standardization Study As Required by Section 939(h) of the Dodd-Frank Wall Street Reform and Consumer Protection Act

(Sept. 2012),

available at http://www.sec.gov/news/studies/2012/939h_credit_rating_standardization.pdf

(“2012 Staff Report on Credit Rating Standardization”). Pursuant to section 939F of the Dodd-Frank Act, the Commission submitted a staff report to Congress on the feasibility of establishing a system for assigning NRSROs to determine credit ratings for structured finance products.

See Report to Congress on Assigned Credit Ratings As Required by Section 939F of the Dodd-Frank Wall Street Reform and Consumer Protection Act

(Dec. 2012),

available at http://www.sec.gov/news/studies/2012/assigned-credit-ratings-study.pdf

(“2012 Staff Report on Assigned Credit Ratings”). Pursuant to section 939C of the Dodd-Frank Act, the Commission submitted a staff report to Congress on the independence of credit rating agencies.

See Report to Congress on Credit Rating Agency Independence Study As Required by Section 939C of the Dodd-Frank Wall Street Reform and Consumer Protection Act

(Nov. 2013),

available at http://www.sec.gov/news/studies/2013/credit-rating-agency-independence-study-2013.pdf

(“2013 Staff Report on Credit Rating Agency Independence”).

4

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 for 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 “against any person” in administrative proceedings instituted under section 15E of the Exchange Act.

See

Public Law 109-291, 3 and 4; 15 U.S.C. 78c; 15 U.S.C. 78o-7; 15 U.S.C. 78q; 15 U.S.C. 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);

Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 61050 (Nov. 23, 2009), 74 FR 63832 (Dec. 4, 2009).

5

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)).

6

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).

On May 18, 2011, the Commission proposed for comment amendments to existing rules and new rules in accordance with Title IX, Subtitle C of the Dodd-Frank Act and to enhance oversight of NRSROs.

7

The Commission received a number of comment letters in response to the proposals.

8

The comments on specific proposals are summarized below in the corresponding sections of this release discussing the proposals and the amendments and new rules being adopted today.

7

See Nationally Recognized Statistical Rating Organizations,

Exchange Act Release No. 64514 (May 18, 2011), 76 FR 33420 (June 8, 2011). The Commission also proposed technical amendments to its existing NRSRO rules.

Id.

8

See

letter from Jeffrey W. Rubin, Chair, Business Law Section, American Bar Association, dated Aug. 19, 2011 (“

ABA Letter

”); letter from Bruce E. Stern, Chairman, Association of Financial Guaranty Insurers, dated Aug. 8, 2011 (“

AFGI Letter

”); letter from Gerald W. McEntee, President, American Federation of State, County and Municipal Employees, dated Aug. 5, 2011 (“

AFSCME Letter

”); letter from Marcus Stanley, Policy Director, Americans for Financial Reform, dated Apr. 1, 2014 (“

AFR II Letter

”); letter from Daryl Schubert, Chair, Auditing Standards Board, American Institute of Certified Public Accountants, dated Aug. 10, 2011 (“

AICPA Letter

”); letter from Larry G. Mayewski, Executive Vice President, A.M. Best, dated Aug. 8, 2011 (“

A.M. Best Letter

”); letter from the Honorable Robert E. Andrews, U.S. Congress, House of Representatives, dated Mar. 3, 2012 (“

Andrews Letter

”); letter from Tom Deutsch, Executive Director, American Securitization Forum, dated Aug. 8, 2011 (“

ASF Letter

”); letter from Chris Barnard dated June 30, 2011 (“

Barnard Letter

”); letter from Joel Barton dated Aug. 8, 2011 (“

Barton Letter

”); letter from Marie Benson dated June 16, 2011 (“

Benson Letter

”); letter from Dennis M. Kelleher, President & CEO, and Stephen W. Hall, Securities Specialist, Better Markets, Inc., dated Aug. 8, 2011 (“

Better Markets Letter

”); letter from Zenia Brown dated May 21, 2011 (“

Brown Letter

”); letter from John J. Cadigan, General Partner, CECO LLC, dated June 15, 2011 (“

Cadigan Letter

”); letter from Nancy Campbell dated Sept. 29, 2011 (“

Campbell Letter

”); letter from Barbara Roper, Director of Investor Protection, Consumer Federation of America, and Marcus Stanley, Policy Director, Americans for Financial Reform, dated Aug. 8, 2011 (“

CFA/AFR Letter

”); letter from Micah Hauptman, Financial Services Counsel, and Barbara Roper, Director of Investor Protection, Consumer Federation of America, dated Mar. 3, 2014 (“

CFA II Letter

”); letter from Robert M. Chandler dated June 8, 2011 (“

Chandler Letter

”); letter from Laurel Leitner, Senior Analyst, Council of Institutional Investors, dated Aug. 8, 2011 (“

CII Letter

”); letter from Susan R. Clark dated June 17, 2011 (“

Clark Letter

”); letter from Steven Cohen, Senior Vice President and General Counsel, Clayton Holdings LLC, dated Aug. 8, 2011 (“

Clayton Letter

”); letter from Gregory W. Smith, Chief Operating Officer, General Counsel, Colorado Public Employees Retirement Association, dated Aug. 8, 2011 (“

COPERA Letter

”); letter from Dave Cowen dated May 23, 2011 (“

Cowen Letter

”); letter from Stephen M. Renna, Chief Executive Officer, CRE Finance Council, dated Aug. 8, 2011 (“

CRE Letter

”); letter from Gary D. Cristofani dated July 28, 2011 (“

Cristofani Letter

”); letter from William Michael Cunningham, Creative Investment Research, Inc., dated May 23, 2005 (“

Cunningham I Letter

”); letter from William Michael Cunningham, Creative Investment Research, Inc., dated July 4, 2011 (“

Cunningham II Letter

”); letter from Bonnie Davis dated June 16, 2011 (“

Davis Letter

”); letter from Theresa Day dated June 16, 2011 (“

Day Letter

”); letter from Daniel Curry, President, and Mary Keogh, Managing Director, Regulatory Affairs, DBRS, Inc., dated Aug. 8, 2011 (“

DBRS Letter

”); letter from Daniel Curry, Chief Executive Officer, and Mary Keogh, Managing Director, Global Regulatory Affairs, DBRS, Inc., dated Dec. 5, 2013 (“

DBRS II Letter

”); letter from Deloitte & Touche LLP dated Aug. 8, 2011 (“

Deloitte Letter

”); letter from Sean Egan, Egan-Jones Ratings Company, dated Aug. 5, 2011 (“

EJR Letter

”); letter from Roberta Y. Ely dated June 17, 2011 (“

Ely Letter

”); letter from Ernst & Young LLP dated Aug. 8, 2011 (“

Ernst & Young Letter

”); letter from Anne S. McCulloch, Senior Vice President and Deputy General Counsel, Federal National Mortgage Association, dated Aug. 8, 2011 (“

Fannie Mae Letter

”); letter from Charles D. Brown, General Counsel, Fitch, Inc., dated Aug. 5, 2011 (“

Fitch Letter

”); letter from Marianne Freebury dated June 16, 2011 (“

Freebury Letter

”); letter from Richard M. Whiting, Executive Director and General Counsel, The Financial Services Roundtable, dated Aug. 8, 2011 (“

FSR Letter

”); letter from Myrna D. Gardner dated June 14, 2011 (“

Gardner Letter

”); letter from Corrine M. Garza dated June 14, 2011 (“

Garza Letter

”); letter from David Gaus dated Nov. 1, 2012 (“

Gaus Letter

); letter from William J. Harrington, dated Aug. 8, 2011 (“

Harrington Letter

”); letter from William J. Harrington dated May 29, 2014 (“Harrington II Letter”); letter from Karrie McMillan, General Counsel, Investment Company Institute, dated Aug. 8, 2011 (“

ICI Letter

”); letter from KPMG LLP dated Aug. 8, 2011 (“

KPMG Letter

”); letter from Markus Krebsz dated Nov. 4, 2010 (“

Krebsz Letter

”); letter from Jules B. Kroll, Chairman and CEO, Kroll Bond Rating Agency, Inc., dated Aug. 8, 2011 (“

Kroll Letter

”); letter from Jules B. Kroll, Chairman and CEO, Kroll Bond Rating Agency, Inc., dated August 19, 2014 (“Kroll II Letter”); letter from Francis Lambert dated Aug. 8. 2011 (“

Lambert Letter

”); letter from Kashif Latif dated May 19, 2011 (“

Latif Letter

”); letter from the Honorable Carl Levin, U.S. Senate, Permanent Subcommittee on Investigations, dated Aug. 8, 2011 (“

Levin Letter

”); letter from Dee Longenbaugh dated June 15, 2011 (“

Longenbaugh Letter

”); letter from Ray Lynch dated June 17, 2011 (“

Lynch Letter

”); letter from Craig R. Mills, CraigRMills LLC, dated Aug. 19, 2011 (“

Mills Letter

”); letter from Michel Madelain, President and Chief Operating Officer, Moody's Investors Service, dated Aug. 8, 2011 (“

Moody's Letter

”); letter from Robert Dobilas, President, Morningstar Credit Ratings, LLC, dated Aug. 8, 2011 (“

Morningstar Letter

”); letter from Kevin Overholt dated June 14, 2011 (“

Overholt Letter

”); letter from Maneesh Pangasa dated July 29, 2011 (“

Pangasa Letter

”); letter from PricewaterhouseCoopers, LLP, dated Aug. 8, 2011 (“

PWC Letter

”); letter from William E. Reno dated June 16, 2011 (“

Reno Letter

”); letter from LaVonne L. Rhyneer dated June 17, 2011 (“

Rhyneer Letter

”); letter from Andrew M. Siff, Esquire, Siff & Associates, PLLC, dated June 13, 2011 (“

Siff Letter

”); letter from Deven Sharma, President, Standard and Poor's Ratings Services, dated Aug. 8, 2011 (“

S&P Letter

”); letter from Anne Rutledge, President, TradeMetrics Corporation, dated Aug. 8, 2011 (“

TradeMetrics Letter

”). Copies of these letters are available on the Commission's Web site at:

http://www.sec.gov/comments/s7-18-11/s71811.shtml

. In addition, in connection with the Commission's solicitation of comments on the Commission's request pursuant to the Paperwork Reduction Act of 1995 (44 U.S.C. 3501

et seq.

) for approval of the extension of the previously approved collection of information provided for in Rule 17a-7, several commenters submitted letters that are relevant to this rulemaking.

See

letter from Daniel Curry, President, and Mary Keogh, Managing Director, Regulatory Affairs, DBRS, Inc., dated Apr. 14, 2014 (“

DBRS PRA Letter

”); letter from Angela Y. Liang, Assistant General Counsel, Kroll Bond Rating Agency, Inc., dated Apr. 17, 2014 (“

Kroll PRA Letter

”); and letter from Michael Kanef, Chief Regulatory and Compliance Officer, Moody's Investors Service, dated Apr. 28, 2014 (“

Moody's PRA Letter

”).

B. Economic Analysis

The Commission has performed an economic analysis in connection with today's adoption of the amendments and new rules discussed in section II. of this release. The economic analysis is reflected in this section I.B. of the release as well as throughout the rest of the release.

9

9

The discussion of the amendments and new rules in section II of this release is organized into sections that in large part are based on the distinct rulemaking mandates in Title IX, Subtitle C of the Dodd-Frank Act.

See

sections II.A. through II.M. of this release. Each section includes an economic analysis that focuses specifically on the amendments or rules being discussed in the section.

1. Guiding Principles

Title IX, Subtitle C of the Dodd-Frank Act mandates that the Commission prescribe rules to improve regulation of NRSROs.

10

Section 931 of the Dodd-Frank Act, “Findings,” introduces Title IX, Subtitle C of the Dodd-Frank Act and provides context to what motivated Congress to enact these provisions with respect to NRSROs.

11

In particular, Congress found:

10

See

Public Law 111-203, 931 through 939H, entitled “Improvements to the Regulation of Credit Rating Agencies.”

11

See

Public Law 111-203, 931.

• Because of the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators, the activities and performances of credit rating agencies, including NRSROs, are matters of national public interest, as credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the U.S. economy.

12

12

See

Public Law 111-203, 931(1).

• Credit rating agencies, including NRSROs, play a critical “gatekeeper” role in the debt market that is functionally similar to that of securities analysts, who evaluate the quality of securities in the equity market, and auditors, who review the financial statements of firms. Such role justifies a similar level of public oversight and accountability.

13

13

See

Public Law 111-203, 931(2).

• Because credit rating agencies perform evaluative and analytical services on behalf of clients, much as

other financial “gatekeepers” do, the activities of credit rating agencies are fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts, and investment bankers.

14

14

See

Public Law 111-203, 931(3).

• In certain activities, particularly in advising arrangers of structured financial products on potential ratings of such products, credit rating agencies face conflicts of interest that need to be carefully monitored and that therefore should be addressed explicitly in legislation in order to give clearer authority to the Commission.

15

15

See

Public Law 111-203, 931(4).

• In the recent financial crisis, the ratings on structured financial products have proven to be inaccurate. This inaccuracy contributed significantly to the mismanagement of risks by financial institutions and investors, which in turn adversely impacted the health of the economy in the United States and around the world. Such inaccuracy necessitates increased accountability on the part of credit rating agencies.

16

16

See

Public Law 111-203, 931(5).

The amendments and new rules being adopted today to implement sections 932, 936, and 938 of the Dodd-Frank Act are designed to address these findings of Congress. For example, they are intended to increase the integrity and transparency of credit ratings and promote public oversight and accountability of NRSROs as “gatekeepers” for the primary benefit of the users of credit ratings.

17

The amendments and new rules also prescribe new disclosure requirements relating to structured finance products and, in particular, asset-backed securities.

18

These requirements are designed to address concerns about the role of NRSROs in the financial crisis of 2007-2009

19

in terms of how they rated certain types of structured finance products and, in particular, the inherent conflicts of interest in rating these products.

20

17

See

John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School,

Turmoil in the U.S. credit markets: the role of the credit rating agencies

(Apr. 22, 2008) (testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs), p. 1,

available at http://www.banking.senate.gov/public/_files/OpgStmtCoffeeSenateTestimonyTurmoilintheUSCreditMarkets.pdf

(“Coffee Testimony I”).

18

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. This broad category of financial instrument includes an

asset-backed security

as defined in section 3(a)(79) of the Exchange Act (15 U.S.C. 78c(a)(79)) and other types of structured debt instruments, including synthetic and hybrid collateralized debt obligations (“CDOs”). The term

Exchange Act-ABS

as used throughout this release refers more narrowly to an

asset-backed security

as defined in section 3(a)(79) of the Exchange Act. 15 U.S.C. 78c(a)(79).

19

Throughout this Release, unless indicated otherwise, when the Commission uses the term “financial crisis” it is referring to the financial crisis that took place between 2007 and 2009.

20

See

Public Law 111-203, 931 (setting forth, among other things, Congress' findings with respect to the role played by credit ratings agencies, the services provided by credit ratings agencies, certain conflicts of interests facing credit rating agencies, and inaccuracies in ratings on structured finance products).

In the market for structured finance products, the pool of assets underlying or referenced by the product is often comprised of hundreds of thousands of loans, each requiring time and expense to evaluate. In these markets, the separation between the borrower and the ultimate provider of credit can introduce significant information asymmetries between the parties involved in the securitization process that creates a structured finance product

21

and investors in the product, who may have less information on the credit quality and other relevant characteristics of the asset pool.

22

Further, disclosures to investors regarding the asset pool may not be sufficiently detailed to allow investors to adequately evaluate the quality of the collateral backing the securities and, thereby, assess the credit risk of the securities. Consequently, the market for structured finance products has evolved as a “rated” market in which the credit risk of the products is assessed by credit rating agencies

23

and the valuations of the products depend significantly on credit ratings.

24

To curb their informational disadvantage, certain investors in structured finance products may use credit ratings to inform their investment decisions.

25

21

Asset-backed securitization—the process used to create asset-backed securities—is a financing technique in which financial assets are pooled and converted into instruments that may be offered and sold in the capital markets. In a basic securitization structure, an entity—often a financial institution—originates or otherwise acquires a pool of financial assets, such as mortgage loans, either directly or through an affiliate. It then sells the financial assets, again either directly or through an affiliate, for the purpose of depositing them into a specially created investment vehicle that issues securities “backed” by those financial assets. Payment on the asset-backed securities depends primarily on the cash flows generated by the assets in the underlying pool (and possibly other rights designed to assure timely payment, generally known as “credit enhancements”).

See Asset-Backed Securities,

Securities Act Release No. 8518 (Dec. 22, 2004), 70 FR 1506 (Jan. 7, 2005).

22

See

Adam B. Ashcraft and Til Schuermann,

Understanding the Securitization of Subprime Mortgage Credit,

Staff Report, Federal Reserve Bank of New York, Working Paper No. 318 (2008). The authors identify seven information frictions that can cause moral hazard and adverse selection problems in a subprime mortgage securitization transaction.

23

See

Joshua Coval, Jakub Jurek, and Erik Stafford,

The Economics of Structured Finance,

23(1) J. Econ. Perspectives 3-26 (2009).

24

See

Adam Ashcraft, Paul Goldsmith-Pinkham, Peter Hull, and James Vickery,

Credit Ratings and Security Prices in the Subprime MBS Market,

101(3), Amer. Econ. Rev. 115-119 (2011).

25

See

Frank Partnoy,

Overdependence on Credit Ratings Was a Primary Cause of the Crisis,

in

The Panic of 2008: Causes, Consequences, and Implications for Reform

(Edward Elgar Press 2010, Lawrence Mitchell and Arthur Wilmarth, eds.). References to credit ratings in federal regulations also may have contributed to investor reliance on credit ratings. Section 939A of the Dodd-Frank Act requires each federal agency, including the Commission, to review any regulation issued by such agency that requires the use of an assessment of the creditworthiness of a security or money market instruments and any references to or requirements in such regulations regarding credit ratings.

See

Public Law 111-203, 939A. The section further provides that each such agency shall “modify any such regulations identified by the review . . . to remove any reference to or requirement of reliance on credit ratings, and to substitute in such regulations such standard of creditworthiness as each respective agency shall determine as appropriate for such regulations.”

Id.

Given that investors may not know the quality of the assets underlying structured finance products, certain originators of these assets may attempt to adversely transfer risks of poor origination decisions to investors by creating complex and opaque structured finance products.

26

This risk is especially pronounced when the originator, sponsor, depositor, or underwriter receives compensation before investors learn about the quality of the assets.

27

Because origination fees

are based on transaction volume and risks are transferred to investors, an originator may have the economic incentive to produce as many assets (for example, mortgage loans) as possible without adequately screening their credit quality.

28

26

See

Chris Downing, Dwight Jaffee, and Nancy Wallace,

Is the Market for Mortgage-Backed Securities a Market for Lemons?,

22(7) Rev. Fin. Stud. 2457-2494 (2009). The authors argue that the quality of the assets sold to investors through securitization is lower than the quality of similar assets that are not sold to investors. They find empirical support for this proposition using a comprehensive dataset of sales of mortgage-backed securities (Freddie Mac Participation Certificates) to special-purpose vehicles over the period 1991 through 2002.

27

Several parties may be involved in the securitization process that creates an asset-backed security, including an originator, sponsor, depositor, issuing entity, underwriter, and arranger.

See generally Asset-Backed Securities,

70 FR at 1508. The originator is the entity that creates a financial asset (for example, mortgage loan, auto loan, or credit card receivable) that collateralizes an asset-backed security through an extension of credit or otherwise and that sells the asset to be included in an asset-backed security. The sponsor is the entity that organizes and initiates the asset-backed securities transaction by transferring the financial assets underlying an asset-backed security directly or indirectly to the issuing entity. The depositor is an entity that receives or purchases the financial assets from the sponsor and transfers them to the issuing entity (in some cases the sponsor transfers the financial assets directly to the issuing entity, thereby by-passing the use of a separate depositor). The issuing entity is the trust or other vehicle created at the direction of the sponsor or depositor

that owns or holds the financial assets and in whose name the asset-backed securities are issued. The underwriter is the entity that underwrites the offering of asset-backed securities and sells them to investors. The arranger is an entity that organizes and arranges a securitization transaction, but does not sell or transfer the assets to the issuing entity. It also structures the transaction and may act as an underwriter for the deal. In jurisdictions where an arranger is used, the arranger's role is similar to that of a sponsor in other jurisdictions. In some cases, a single entity may perform more than one function (for example, a financial institution may act as an originator and sponsor). The

issuer

of a structured finance product as used in this release can mean, depending on the context, the issuing entity or the person that organizes and initiates the offering of the structured finance product (for example, the sponsor or depositor). Generally, when this release discusses an issuer taking a specific action in the context of an offering of a structured finance product (for example, making a disclosure), the person that organizes and initiates the offering would be the person taking the action (as opposed to the issuing entity). Further, in the context of the discussion of Rules 17g-10 and 15Ga-2, the term

issuer

(which is defined in Rule 17g-10) includes a sponsor or depositor.

28

See

Amiyatosh Purnanandam,

Originate-to-Distribute Model and the Subprime Mortgage Crisis,

24(6) Rev. Fin. Stud. 1881-1915 (2011). The author argues that, during the financial crisis, banks with high involvement in the originate-to-distribute market originated excessively poor-quality mortgages, consistent with the view that the originating banks did not expend resources to adequately screen the credit quality of their borrowers.

The rating process for structured finance products differs from the rating process for corporate bonds, whose ratings are largely based on publicly available data such as audited financial statements. The data used in rating structured finance products is primarily provided by the sponsor, depositor, or underwriter.

29

Unlike credit ratings for corporate bonds, credit ratings of structured finance products are “highly sensitive to the assumptions of (1) default probability and recovery value, (2) correlation of defaults, and (3) the relation between payoffs and the economic states that investors care about most.”

30

The rating process for these products may happen in the reverse of how a more traditional product is rated because the sponsor, depositor, arranger, or underwriter often decides before the structure is finalized what credit rating it would like for each tranche of securities to be issued, within the limits of what is possible, and structures the product accordingly (for example, with regard to selecting the underlying assets and establishing the credit enhancements applicable to the different tranches of securities). Concerns have been raised that the inherently iterative nature of the process between the credit rating agency and the sponsor, depositor, arranger, or underwriter may give rise to potential conflicts of interest

31

and that credit rating agencies marketing advisory and consulting services to their clients during this process may accentuate the conflict.

32

29

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

(July 2008),

available at http://www.sec.gov/news/studies/2008/craexamination070808.pdf

(“2008 Staff Inspection Report”), pp. 7-10. The report describes the rating process for a residential mortgage-backed security (“RMBS”) and CDO at the three examined credit rating agencies (Standard & Poor's Ratings Services, Moody's Investor's Services, Inc., and Fitch, Inc.). For example, with respect to a involving subprime loans, the arranger of the RMBS typically initiates the rating process by sending the credit rating agency data on each of the subprime loans to be held by the trust (for example, principal amount, geographic location of the property, credit history and FICO score of the borrower, ratio of the loan amount to the value of the property, and type of loan), the proposed capital structure of the trust and the proposed levels of credit enhancement for each tranche issued by the trust.

Id.

at 7. Upon receipt of the information, the credit rating agency assigns a lead analyst who is responsible for analyzing the loan pool, the proposed capital structure, and the proposed credit enhancement levels and, ultimately, for formulating a rating recommendation to a rating committee composed of analysts and/or senior-level analytic personnel.

Id.

at 7. The rating committee votes on the credit ratings for each tranche and usually communicates its decision to the issuer.

Id.

at 9. In most cases, the issuer can appeal a rating decision, although the appeal is not always granted (and, if granted, may not necessarily result in any change in the rating decision). Typically, the credit rating agency is paid for determining the credit rating only if the credit rating is issued.

30

See

Coval, Jurek, and Stafford,

The Economics of Structured Finance,

p. 23. The authors argue that, “unlike corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole.”

Id.

at 23.

31

See

International Organization of Securities Commissions (“IOSCO”),

The Role of Credit Rating Agencies in Structured Finance Markets

(May 2008), p. 5 (“Some critics have argued that the inherently iterative nature of this process may give rise to potential conflicts of interest.”).

32

See

Coffee Testimony I, p. 3, (“Today, the rating agency receives one fee to consult with a client, explain its model, and indicate the likely outcome of the rating process; then, it receives a second fee to actually deliver the rating (if the client wishes to go forward once it has learned the likely outcome)”). Rule 17g-6 prohibits, among other things, an NRSRO from conditioning or threatening to condition the issuance of a credit rating on the purchase by an obligor or issuer, or an affiliate of the obligor or issuer, of any other services or products, including pre-credit rating assessment products, of the NRSRO or any person associated with the NRSRO.

See

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

Just prior to the financial crisis, the size of the structured finance market was considerable. New issuances of RMBS, for example, peaked in 2006 for a total of $801.7 billion.

33

Low interest rates drove investor demand for products that had high yields but also were highly rated by the credit rating agencies.

34

Mortgage originators largely exhausted the supply of traditional quality mortgages and, to keep up with investor demand for RMBS, subprime lending became increasingly popular. As the number of delinquencies on subprime mortgages suddenly soared in late 2007, RMBS lost a considerable amount of value,

35

and investors began to question the accuracy of credit ratings assigned to RMBS and CDOs linked to RMBS.

36

Certain academic studies argue that, as the structured finance market boomed between 2004 and 2007, NRSROs might have had an incentive to generate revenue by relaxing rating standards,

37

inflating credit ratings,

38

facilitating the sale of asset-backed securities by a small number of large issuers,

39

and reducing due diligence in

the presence of investors that solely rely on credit ratings.

40

The concerns about the accuracy of credit ratings fueled an emergent reluctance to invest in these products.

41

The new issuances of RMBS totaled $715.3 billion in 2007 and plunged to $34.5 billion in 2008.

33

The total amount of new issuances is calculated by staff in the Commission's Division of Economics and Risk Analysis (“DERA”) using Asset-Backed Alert and Commercial Mortgage Alert databases. The amounts include only non-agency RMBS sold in the United States through Commission-registered offerings, Rule 144A offerings, or traditional private offerings.

34

See

Testimony of John B. Taylor, the Mary and Robert Raymond Professor of Economics at Stanford University and George P. Shultz Senior Fellow in Economics at Stanford's Hoover Institution, before the Subcommittee on Monetary Policy and Trade Committee on Financial Services, U.S. House of Representatives (Mar. 5, 2013),

available at http://financialservices.house.gov/uploadedfiles/hhrg-113-ba19-wstate-jtaylor-20130305.pdf.

35

See

Board of Governors of the Federal Reserve System (“Federal Reserve”),

Report to the Congress on Risk Retention

(Oct. 2010), pp. 50-51 (discussing the drop in the triple-A and triple-B ABX.HE 2006-2 index (−70% by the end of 2008 for triple-A rated and −95% for triple-B rated subprime RMBS issued in 2006)).

36

See

IOSCO,

The Role of Credit Rating Agencies in Structured Finance Markets,

p. 2.

37

See

John M. Griffin and Dragon Yongjun Tang,

Did Subjectivity Play a Role in CDO Credit Ratings?,

67(4) J. Fin. 1293-1328 (2012). The authors analyze a sample of 916 CDOs and find that a large credit rating agency frequently made positive adjustments outside its main model that resulted in increasingly larger AAA tranche sizes. These adjustments are difficult to explain by likely determinants, such as manager experience or credit enhancements, but exhibit a clear pattern: CDOs with smaller model-implied AAA sizes receive larger adjustments and CDOs with larger adjustments experience more severe subsequent downgrading.

38

See

Vasiliki Skreta and Laura Veldkamp,

Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation,

56 J. Monetary Econ. 678-695 (2009); Efraim Benmelech and Jennifer Dlugosz,

The Credit Rating Crisis,

NBER Working Paper No. 15045 (2009); Bo Becker and Todd Milbourn,

How Did Increased Competition Affect Credit Ratings?,

101 J. Fin. Econ. 493-514 (2011); Andrew Cohen and Mark D. Manuszak,

Ratings Competition in the CMBS Market,

45(1) J. Money, Credit and Banking 93-119 (2013).

39

See

Jie He, Jun Qian, and Philip E. Strahan,

Credit Ratings and the Evolution of the Mortgage-Backed Securities Market,

101(3) Amer. Econ. Rev., 131-135 (2011). The authors find that in 2006 the

mortgage-backed securities (“MBS”) market was highly concentrated among large issuers, with the top five accounting for 39% of all newly issued securities; between 2004 and 2006, a larger fraction of MBS sold by large issuers received triple-A ratings than MBS sold by small issuers; and tranches sold by large issuers then experienced larger price drops than those sold by smaller issuers when the “housing bubble” began to unravel.

40

See

Patrick Bolton, Xavier Freixas, and Joel Shapiro,

The Credit Ratings Game,

67(1) J. of Finance 85-111 (2012),

available at http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2011.01708.x/full.

The authors develop a model of competition among credit rating agencies that includes two types of investors with different incentives to perform due diligence: sophisticated and “trusting” investors. Trusting investors take credit ratings at face value because their compensation depends only marginally on the ex-post returns of the assets they manage. In the authors' view, regulation that forces money managers to only purchase investments with good credit ratings could also provide incentives to be trusting. The authors find that competition can reduce efficiency, as it facilitates rating shopping. Moreover, credit ratings are more likely to be inflated during booms and when investors are more trusting.

41

See

Coval, Jurek, and Stafford,

The Economics of Structured Finance.

In August 2007, the Commission staff initiated examinations of the three largest credit rating agencies to review their role in the turmoil in the subprime mortgage-related securities markets.

42

Among other things, these examinations revealed that the credit rating agencies struggled to adjust the number of staff and resources employed in the rating process to the increasing volume and complexity of RMBS and CDOs.

43

Certain significant aspects of the rating process and methodologies used to rate RMBS and CDOs were not documented or disclosed.

44

The credit rating agencies examined did not have specific written procedures for rating RMBS and CDOs.

45

Also, the credit rating agencies did not appear to have specific written policies and procedures to identify or address errors in their models or methodologies.

46

In certain instances, Commission staff believed that adjustments to models were made without appropriately documenting a rationale for deviations from the model.

47

Processes for performing surveillance and monitoring of outstanding credit ratings on an ongoing basis appeared to be less robust than the processes for determining initial credit ratings.

48

Moreover, in the Commission staff's view, sufficient steps were not taken to prevent considerations of fees, market share, or other business interests from influencing credit ratings or rating criteria.

49

Finally, the examined credit rating agencies appeared to solely rely on the information provided by RMBS sponsors.

50

In particular, they did not appear to verify the integrity and accuracy of such information as, in their view, due diligence duties belonged to other parties and they did not appear to seek representations from sponsors that due diligence was performed.

51

42

See

2008 Staff Inspection Report.

43

See

2008 Staff Inspection Report, p. 10-13.

44

See

2008 Staff Inspection Report, p. 13.

45

See

2008 Staff Inspection Report, p. 16 (“One rating agency maintained comprehensive written procedures for rating structured finance securities, but these procedures were not specifically tailored to rating RMBS and CDOs. The written procedures for the two other rating agencies were not comprehensive and did not address all significant aspects of the RMBS and/or CDO ratings process. For example, written materials set forth guidelines for the structured finance ratings committee process (including its composition, the roles of the lead analyst and chair, the contents of the committee memo and the voting process) but did not describe the ratings process and the analyst's responsibilities prior to the time a proposed rating is presented to a ratings committee.”).

46

See

2008 Staff Inspection Report, p. 17.

47

Id.

at 19.

48

Id.

at 21.

49

Id.

at 24.

50

Id.

at 18.

51

Id.

at 18.

Following the financial crisis, the Dodd-Frank Act mandated regulatory actions intended to enhance regulation, accountability, and transparency of NRSROs.

52

Generally, the majority of the rulemaking mandated by the Dodd-Frank Act addresses all classes of credit ratings, rather than credit ratings for only structured finance products.

53

In implementing the mandate, the amendments and new rules being adopted today are designed to further enhance the governance of NRSROs in their role as “gatekeepers”

54

and increase the transparency of the credit rating process as a whole. Further, as discussed in section II. of this release, the amendments and new rules being adopted today include new requirements designed to enhance transparency with respect to structured finance products, including requirements for NRSROs to disclose information about the performance and history of credit ratings for subclasses of structured finance products and requirements for NRSROs, issuers, underwriters, and providers of third-party due diligence services to disclose information about due diligence services performed with respect to asset-backed securities.

55

52

See

Public Law 111-203, 932, entitled “Enhanced Regulation, Accountability, and Transparency of Nationally Recognized Statistical Rating Organizations.”

53

One commenter suggested that the proposed rules are overly broad in their application and “fail to sufficiently account for the differences between corporate ratings (such as financial strength ratings of insurance companies) and ratings of the structured and asset-backed financial products that contributed to the recent economic crisis.”

See A.M. Best Letter.

The Commission notes that the amendments and new rules being adopted today reflect the statutory mandate that generally, with one exception, was not limited to certain classes of credit ratings. In particular, sections 932, 936 and 938 of the Dodd-Frank Act generally do not focus exclusively on activities relating to rating structured finance products, with the exception of section 932(s)(4) (which focuses on third-party due diligence services with respect to asset-backed securities).

54

See

John C. Coffee, Jr.,

Gatekeepers: The Professions and Corporate Governance,

Oxford University Press (2006).

55

See

sections II.E.1. and II.E.2. of this release (discussing requirements for NRSROs to disclose performance statistics and rating history information for subclasses of structured finance products); sections II.G. and II.H. of this release (discussing requirements to disclose information about third-party due diligence services provided for asset-backed securities).

2. Baseline

The amendments and new rules being adopted today primarily affect NRSROs, issuers, and underwriters of asset-backed securities, and providers of third-party due diligence services for asset-backed securities. To the extent that the new requirements change the business practices of the primarily affected parties, such changes may also affect clients of NRSROs (that is, obligors who pay NRSROs to obtain entity credit ratings, issuers who pay NRSROs to obtain credit ratings for their issued securities, subscribers who pay NRSROs to access credit ratings and research, and persons who pay NRSROs for other services), credit raters or credit rating agencies other than NRSROs, parties involved in asset-backed securities markets (other than issuers, underwriters, third-party due diligence providers, and NRSROs), and users of credit ratings in general.

The baseline against which economic costs and benefits, as well the impact of the amendments and new rules being adopted today on efficiency, competition, and capital formation, are measured is the situation in existence today, prior to the adoption of the amendments and rules. The baseline includes an estimate of the number of entities that will likely be directly affected by the amendments and rules and a description of the relevant features of the regulatory and economic environment in which the affected entities operate. The discussion below identifies the main features of the regulatory and economic baseline, which will be further developed in section II of this release discussing the amendments and rules, including in the

focused economic analyses that follow the discussions of the amendments and rules.

a. NRSROs

As discussed above, 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 for 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 “against any person” in administrative proceedings instituted under section 15E of the Exchange Act.

56

56

See

Public Law 109-291, 3, 4; 15 U.S.C. 78c; 15 U.S.C. 78o-7; 15 U.S.C. 78q; 15 U.S.C. 78u-2.

To implement the Rating Agency Act of 2006, the Commission adopted Rules 17g-1 through 17g-6 and Form NRSRO.

57

Section 943 of the Dodd-Frank Act mandates that the Commission adopt rules 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.

58

In January 2011, the Commission adopted Rule 17g-7 to implement section 943.

59

The Exchange Act, Rules 17g-1 through 17g-7, and Form NRSRO represent the baseline for the amendments and new rules being adopted today in terms of requirements applicable to NRSROs.

57

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

72 FR 33564.

58

See

Public Law 111-203, 943.

59

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

76 FR 4489.

Pursuant to section 6 of the Rating Agency Act of 2006, the Commission is required to submit an annual report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives that includes the views of the Commission on the state of competition, transparency, and conflicts of interest among NRSROs.

60

In addition, section 15E(b) of the Exchange Act provides that not later than ninety days after the end of each calendar year, each 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; (2) listing any material change that occurred to such information or documents during the previous calendar year; and (3) amending its credit ratings performance statistics.

61

Rule 17g-1 requires these filings (“annual certifications”) to be made on Form NRSRO.

62

Further, each NRSRO is required to furnish the Commission with annual reports containing audited financial statements and information about revenues and other matters.

63

The Commission's annual reports submitted to Congress and the NRSROs' annual certifications and annual reports are an integral part of establishing the baseline for the amendments and new rules being adopted today, as discussed below.

60

See

Public Law 109-291, 6. The Commission staff annual reports are available at

http://www.sec.gov/ocr.

61

See

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

62

See

paragraph (f) of Rule 17g-1.

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

72 FR at 33567, 33569-33582.

63

See

17 CFR 240.17g-3.

As of today, there are ten credit rating agencies registered with the Commission as NRSROs.

64

Based on the annual reports the NRSROs furnish with the Commission, in their 2013 fiscal years, the ten NRSROs had $5.4 billion of total revenue—an approximate 6% increase over their 2012 fiscal years. In addition, based on their annual certifications, the NRSROs employed a total of 4,218 credit analysts at the end of the 2013 calendar year. Table 1 shows the number of credit analysts employed by each NRSRO at the end of the 2013 calendar year and, of the total number of credit analysts employed by the NRSROs, the percent of credit analysts at S&P, Moody's, and Fitch (90%) and the remaining seven NRSROs (10%).

64

The ten NRSROs are: A.M. Best Company, Inc. (“A.M. Best”); DBRS, Inc. (“DBRS”); Egan-Jones Ratings Company (“EJR”); Fitch, Inc. (“Fitch”); HR Ratings de Mexico, S.A. de C.V. (“HR Ratings”); Japan Credit Rating Agency, Ltd. (“JCR”); Kroll Bond Rating Agency, Inc. (“Kroll”); Moody's Investor's Services, Inc. (“Moody's”); Morningstar Credit Ratings, LLC (“Morningstar”); and Standard & Poor's Ratings Services (“S&P”).

See

Commission staff,

Annual Report on Nationally Recognized Statistical Rating Organizations

(Dec. 2013), p. 6,

available at http://www.sec.gov/divisions/marketreg/ratingagency/nrsroannrep1213.pdf.

(“2013 Annual Staff Report on NRSROs”).

Table 1—Credit Analysts Employed by NRSROs (as of [—])

NRSROs

Total credit analysts

S&P, Moody's, & Fitch

90%

Other NRSROs

10%

A.M. Best

123

DBRS

98

EJR

7

Fitch

1,102

HR Ratings

34

JCR

57

Kroll

58

Moody's

1,244

Morningstar

30

S&P

1,465

Total

4,218

Note:

The total number of credit analysts, including credit analyst supervisors, is provided by each NRSRO in Exhibit 8 to Form NRSRO, which is available on each NRSRO's Web site.

Among other things, the operations of the ten NRSROs differ in terms of business model, classes of credit ratings for which they are registered, history of issuing credit ratings, size, and market share. Of the ten NRSROs, seven operate primarily under the issuer-pay model,

65

in which an obligor pays the NRSRO to rate it as an entity or an issuer pays the NRSRO to rate the securities it issues.

66

One NRSRO operates exclusively under the subscriber-pay model,

67

in which

subscribers pay a fee to access the credit ratings issued by the NRSRO.

68

Two NRSROs previously operated primarily under the subscriber-pay model but for several years have been issuing an increasing number of credit ratings paid for by the obligor being rated or the issuer of the securities that are rated.

69

65

The seven NRSROs are A.M. Best, DBRS, Fitch, HR Ratings, JCR, Moody's, and S&P.

See

2013 Annual Staff Report on NRSROs, p. 6.

66

The issuer-pay model often raises concerns of potential conflicts of interest because the collection of fees from rated entities and issuers of rated securities, as a principal source of revenue, may provide an NRSRO with an economic incentive to issue inflated ratings as a way to promote business with its clients. Several academic studies try to answer theoretically and empirically the question of whether reputational concerns of a credit rating agency effectively neutralize potential conflicts of interest in the issuer-pay model. The conclusions of these studies are neither unanimous nor definite. For example, recently, Kashyap and Kovrijnykh (2013) found that, under the issuer-pay model, a credit rating is less accurate than under the subscriber-pay model. However, the authors found that subscribers tend to ask for a credit rating inefficiently (that is, when the expected quality of the rated entity or security is sufficiently high) and that the subscriber-pay model suffers from a potential free-riding problem. Cole and Cooley (2014) argue that much of the regulatory concerns with the conflict created by issuers paying for ratings are a distraction. The authors argue that in equilibrium, reputation ensures that credit ratings have value and reflect sound assessments of creditworthiness. Regulatory reliance on credit ratings and the importance of risk-weighted capital in prudential regulation more likely contributed to distorted credit ratings than the matter of who pays for them.

See

Anil Kashyap and Natalia Kovrijnykh,

Who Should Pay for Credit Ratings and How?,

NBER working paper No. 18923 (Mar. 2013); Harold Cole and Thomas F. Cooley,

Rating Agencies,

NBER working paper No. 19972 (Mar. 2014).

67

The one NRSRO is EJR.

See

2013 Annual Staff Report on NRSROs, p. 6.

68

See

2013 Annual Staff Report on NRSROs, p. 23. The subscriber-pay model also is subject to potential conflicts of interest.

See id.

at p. 23. For example, the NRSRO may be aware that an influential subscriber holds a securities position (long or short) that could be advantaged if a credit rating upgrade or downgrade causes the market value of the security to increase or decrease; or that the subscriber invests in newly issued bonds and would obtain higher yields if the bonds were to have lower credit ratings. Another example of a conflict in the subscriber-pay model is that the NRSRO may be aware that a subscriber wishes to acquire a particular security but is prevented from doing so because the credit rating of the security is lower than internal investment guidelines or an applicable contract permit.

69

The two NRSROs are Kroll and Morningstar.

See

2013 Annual Staff Report on NRSROs, p. 7.

The ten NRSROs also differ by the scope of their business and, in particular, by whether their operations include products and services other than credit ratings,

70

which can be provided through business lines, segments, groups, or divisions within the NRSROs or through affiliated companies or other businesses not within the NRSRO.

71

For credit ratings, there are five classes of credit ratings for which a credit rating agency can be registered as an NRSRO: (1) Financial institutions, brokers, or dealers; (2) insurance companies; (3) corporate issuers; (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”); and (5) issuers of government securities, municipal securities, or securities issued by a foreign government.

72

Eight of the NRSROs are registered in multiple classes, while two NRSROs are registered in one class.

73

Table 2 shows the approximate number of outstanding credit ratings as reported by each NRSRO in its annual certification for the 2013 calendar year end, in each of the five categories for which the NRSRO is registered.

70

Ancillary services often raise concerns of potential conflicts of interest because, for example, an NRSRO might issue a more favorable credit rating to an issuer in exchange for purchasing ancillary services, or an issuer that purchases a large amount of ancillary services might pressure the NRSRO to issue a more favorable credit rating for the issuer.

See

2013 Staff Report on Credit Rating Agency Independence, pp. 21-24. Another concern with respect to ancillary services is that they might have involved an NRSRO making recommendations on the structure of a security to be rated.

Id.

at 22-23. Paragraph (c)(5) of Rule 17g-5 prohibits an NRSRO from issuing or maintaining a credit rating with respect to an obligor or security where the NRSRO or a person associated with the NRSRO made recommendations to the obligor or the issuer, underwriter, or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the obligor or issuer of the security.

See

17 CFR 240.17g-5(c)(5). In addition, Rule 17g-6 prohibits, among other things, an NRSRO from: (1) Conditioning or threatening to condition the issuance of a credit rating on the purchase by an obligor or issuer, or an affiliate of the obligor or issuer, of any other services or products, including pre-credit rating assessment products, of the NRSRO or any person associated with the NRSRO; (2) issuing, or offering or threatening to issue, a credit rating that is not determined in accordance with the NRSRO's established procedures and methodologies for determining credit ratings, based on whether the rated person, or an affiliate of the rated person, purchases or will purchase the credit rating or any other service or product of the NRSRO or any person associated with the NRSRO; and (3) modifying, or offering or threatening to modify, a credit rating in a manner that is contrary to the NRSRO's established procedures and methodologies for modifying credit ratings based on whether the rated person, or an affiliate of the rated person, purchases or will purchase the credit rating or any other service or product of the NRSRO or any person associated with the NRSRO.

See

17 CFR 240.17g-6.

71

See

2013 Staff Report on Credit Rating Agency Independence, p. 19.

72

See

15 U.S.C. 78c(a)(62) (defining the term

nationally recognized statistical rating organization

).

73

See

2013 Annual Staff Report on NRSROs, p. 8.

Table 2—Approximate Number of NRSRO Credit Ratings Outstanding by Class of Credit Rating (as of [December 31, 2013])

NRSROs

Financial

institutions

Insurance companies

Corporate issuers

Asset-backed securities

Government securities

Total ratings

S&P, Moody's, & Fitch

84%

74%

92%

90%

99%

97%

Other NRSROs

16%

26%

8%

10%

1%

3%

A.M. Best

N/R

4,492

1,653

56

N/R

6,201

DBRS

13,624

150

3,790

10,706

16,038

44,308

EJR

104

46

877

N/R

N/R

1,027

Fitch

49,821

3,222

15,299

53,612

204,303

326,257

HR Ratings

N/R

N/R

N/R

N/R

189

189

JCR

150

27

463

N/R

56

696

Kroll

15,982

44

2,749

1,401

25

20,201

Moody's

53,383

3,418

40,008

76,464

728,627

901,900

Morningstar

N/R

N/R

N/R

11,567

N/R

11,567

S&P

59,000

7,200

49,700

90,000

918,800

1,124,700

Total

192,064

18,599

114,539

243,806

1,868,038

2,437,046

Note:

The approximate number of NRSRO credit ratings outstanding as of December 31, 2013 is provided by each NRSRO in its annual certification, which is available on each NRSRO's Web site. “N/R” indicates that an NRSRO is not registered for that class of credit rating.

As shown in Table 2, S&P has the greatest number of outstanding credit ratings in each of the five classes. S&P, Moody's, and Fitch are the top three producers of credit ratings in every class of credit ratings except for insurance companies (in this class, A.M. Best has the second highest number of outstanding credit ratings after S&P). Overall, S&P accounts for about 46% of the total NRSRO credit ratings outstanding, followed by Moody's (37%) and Fitch (13%), implying that two NRSROs (S&P and Moody's) account for 83% of all credit ratings outstanding and three NRSROs (S&P, Moody's, and Fitch) account for approximately 97%. Also, as discussed above, Table 1 shows that these three NRSROs employ 90% of the total number of NRSRO credit analysts. Comparing the number of credit ratings outstanding for established NRSROs and newly registered NRSROs may not provide a complete picture of competition in the industry. The incumbent NRSROs (particularly S&P, Moody's, and Fitch) have a longer history of issuing credit ratings, and their credit ratings include those for

debt obligations and obligors that were rated long before the establishment of the newer entrants.

74

74

See

2013 Annual Staff Report on NRSROs, p. 12.

Recent trends in the industry structure are shown in Table 3, which reports the inverse of the Herfindahl-Hirschman Index (HHI) as a measure of industry concentration by rating class.

75

The HHI inverse is calculated from 2007 to 2013 for credit ratings outstanding as reported by the NRSROs in each rating class. Table 3 shows that the NRSRO industry concentration for all rating classes has moderately increased as suggested by the decrease in the HHI inverse since 2010. Despite a monotonic increase in competition in the rating class of asset-backed securities, the NRSRO industry remains concentrated, with the three largest NRSROs accounting for approximately 95% of the NRSROs' 2013 fiscal year total revenue, based on the annual reports the NRSROs furnish to the Commission.

75

The inverse of HHI can be interpreted as the number of equally-sized firms necessary to replicate the degree of concentration in a particular industry.

Table 3—Inverse of Herfindahl-Hirschman Index by Class of Credit Rating

Year

Financial

institutions

Insurance companies

Corporate issuers

Asset-backed securities

Government securities

Total ratings

2007

3.37

4.02

3.27

2.71

2.35

2.65

2008

3.72

4.05

3.79

2.82

2.83

2.99

2009

3.85

3.84

3.18

3.18

2.65

2.86

2010

3.99

3.37

3.17

3.20

2.69

2.88

2011

4.16

3.76

3.02

3.38

2.47

2.74

2012

4.04

3.72

3.00

3.44

2.50

2.75

2013

3.99

3.68

3.03

3.48

2.46

2.72

Note:

The inverse of HHI is determined using the approximate numbers of NRSRO credit ratings outstanding reported in the Commission staff annual reports on NRSROs published in June 2008, September 2009, January 2011, March 2012, December 2012, and December 2013. For the 2013 calendar year end, the inverse of HHI is calculated using the number of outstanding credit ratings reported by NRSROs in their annual certifications.

In particular, for the asset-backed security class—which includes, among other things, RMBS, commercial mortgage backed securities (“CMBS”), and consumer finance and other asset-backed securities—Table 4 below shows the number of credit ratings outstanding from 2007 to 2013. The total number of outstanding credit ratings has significantly decreased (by 38%) since 2007, mostly due to pay-downs of existing asset-backed securities that have not been replaced by newly issued asset-backed securities that are rated by NRSROs.

76

While the three largest NRSROs accounted for 97% of the outstanding credit ratings for asset-backed securities in 2007, this number decreased to 90% in 2013.

76

See

2013 Annual Staff Report on NRSROs, p. 12.

Table 4—Approximate Number of Credit Ratings Outstanding in the Asset-Backed Security Class

NRSROs

2007

2008

2009

2010

2011

2012

2013

S&P, Moody's, & Fitch

97%

96%

94%

94%

91%

91%

90%

Other NRSROs

3%

4%

6%

6%

9%

9%

10%

A.M. Best

54

54

54

54

56

55

56

DBRS

840

7,470

8,430

10,091

9,889

10,054

10,706

EJR

—

14

14

13

13

N/R

N/R

Fitch

72,278

77,480

69,515

64,535

58,315

56,311

53,612

HR Ratings

—

—

—

—

—

N/R

N/R

JCR

68

71

64

N/R

N/R

N/R

N/R

Kroll

246

0

0

0

40

352

1,401

Moody's

110,000

109,261

106,337

101,546

93,913

82,357

76,464

Morningstar

10,235

9,200

8,856

8,322

16,070

13,935

11,567

R&I

214

210

186

N/R

—

—

—

S&P

197,700

198,200

124,600

117,900

108,400

97,500

90,000

Total

391,635

401,960

318,056

302,461

286,696

260,564

243,806

Note:

“N/R” indicates that an NRSRO is not registered for the asset-backed security class of credit ratings and “—” indicates that the credit rating agency was not registered as an NRSRO for the applicable year. Kroll acquired LACE Financial Corp. in August 2010. Morningstar, formerly known as Realpoint LLC, changed its name in 2011. Rating and Investment Information, Inc. (“R&I”) withdrew its registration as an NRSRO with the Commission in October 2011. HR Ratings became registered as an NRSRO in 2012. Statistics come from the Commission staff annual reports on NRSROs published in June 2008, September 2009, January 2011, March 2012, December 2012, and December 2013. For calendar year 2013, the statistics come from the annual certifications of the NRSROs.

In 2013, some of the relatively newer or smaller NRSROs increased their market shares in terms of rating asset-backed securities. Table 5 reports full-year credit rating agency information for 2013, compared to 2007, the year immediately prior to the financial crisis. As the total issuances of asset-backed securities decreased considerably from 2007 to 2013, DBRS has maintained its market share in rating new issuances and has become the most active participant in rating RMBS, while S&P, Moody's and Fitch have lost market shares. DBRS, Kroll, and Morningstar have gained market shares in rating CMBS after the financial crisis and have rated a significant number of newly issued CMBS in 2013. Finally, in the market for rating consumer finance and other asset-backed securities, which has

the largest number of issuances, DBRS and Kroll have increased their market shares, although S&P, Moody's and Fitch continue to play a significant role.

Table 5—Market Shares of Credit Rating Agencies for RMBS, CMBS, and Consumer Finance and Other Asset-Backed Securities, 2013 and 2007

Rank

NRSROs

2013 Issuance

($ mil.)

Number of

offerings

Market share

(%)

2007 Issuance

($ mil.)

Number of

offerings

Market share

(%)

2007-2013 Change

(%)

Residential mortgage-backed securities

1

DBRS

$12,501.90

50

61.4

$12,817.60

20

2.9

−2.5

2

Fitch

9,969.60

23

48.9

253,721.10

318

58.2

−96.1

3

S&P

9,597.50

23

47.1

409,532.40

534

94.0

−97.7

4

Kroll

7,908.70

17

38.8

N/A

N/A

N/A

N/A

5

Moody's

3,796.00

9

18.6

324,923.50

421

74.6

−98.8

Total

20,372.00

68

100.0

435,815.60

575

100.0

−95.3

Commercial mortgage-backed securities

1

Moody's

$62,802.60

67

72.9

$171,787.00

61

74.6

−63.4

2

Fitch

50,447.70

56

58.6

159,687.30

60

69.4

−68.4

3

Kroll

45,140.10

55

52.4

N/A

N/A

N/A

N/A

4

S&P

34,255.20

49

39.8

202,381.00

71

87.9

−83.1

5

DBRS

18,574.90

26

21.6

13,295.30

6

5.8

39.7

6

Morningstar

17,089.00

27

19.8

N/A

N/A

N/A

N/A

Total

86,135.80

122

100.0

230,195.80

86

100.0

−62.6

Consumer finance and other asset-backed securities

1

S&P

$134,860.60

244

69.3

$576,417.90

884

96.7

−76.6

2

Moody's

114,569.90

155

58.9

563,982.90

735

94.6

−79.7

3

Fitch

113,213.80

156

58.2

342,140.10

418

57.4

−66.9

4

DBRS

16,530.60

51

8.5

43,102.70

73

7.2

−61.6

5

Kroll

3,983.10

16

2.0

N/A

N/A

N/A

N/A

Total

194,600.70

341

100.0

596,016.20

981

100.0

−67.3

Note:

A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. Market shares of individual NRSROs do not add up to 100% since more than one NRSRO may rate a particular offering. “N/A” indicates that statistics are not available for 2007. CMBS data relates to U.S. CMBS, including U.S. conduit/fusion and U.S. single borrower. Data comes from Asset-Backed Alert and Commercial Mortgage Alert Web sites, publicly available at

http://www.abalert.com/ranks.php

and

http://www.cmalert.com/ranks.php

.

b. Asset-Backed Security Issuers, Underwriters, and Third-Party Due Diligence Providers

The asset-backed security market that existed in the United States as of the end of 2013 differed significantly from the market prior to the crisis. In 2004, issuing entities of non-agency asset-backed securities held $2.6 trillion in assets, which grew to $4.5 trillion in 2007 and declined to $1.6 trillion in 2013.

77

Table 6 presents issuance amounts, number of offerings, and number of unique issuers for non-agency asset-backed securities, categorized by type of offering.

78

While new issuances of registered asset-backed securities represented the majority of offerings and totaled $1.0 trillion in 2004, they drastically dropped to $140.7 billion in 2008. In 2013, the asset-backed security market totaled $393.6 billion, of which $174.1 billion is the new issuance amount of registered asset-backed securities.

77

This information is derived from data compiled by the Federal Reserve and published in quarterly Z.1 releases, which are available at

http://www.federalreserve.gov/releases/Z1/default.htm

. Statistics include private mortgage pools, consumer credit, business loans, student loans, consumer leases, and trade credit securitization.

78

In this section of the release, the issuer of the asset-back security means the person that primarily organizes and initiates the offering of the asset-backed security, often referred to as the

sponsor

.

Table 6—Issuance Amount, Number of Offerings, and Number of Unique Issuers for Non-Agency Asset-Backed Securities

Year

Issuance amount ($ bln)

Regist'd

144A

Private

Total

Number of offerings

Regist'd

144A

Private

Total

Number of unique issuers

Regist'd

144A

Private

Total

2002

617.13

122.07

2.00

741.20

1,074

491

31

1,596

143

226

17

327

2003

790.47

149.20

0.17

939.85

1,271

589

3

1,863

139

223

3

309

2004

1,024.16

186.53

0.85

1,211.53

1,370

670

2

2,042

131

218

2

298

2005

1,450.33

322.64

3.70

1,776.68

1,594

907

3

2,504

134

300

2

376

2006

1,446.07

623.38

0.50

2,069.95

1,508

1,551

1

3,060

116

406

1

460

2007

1,048.81

518.59

0.55

1,567.95

1,088

1,102

1

2,191

111

342

1

396

2008

140.70

130.80

0.00

271.49

163

240

0

403

51

96

0

128

2009

85.45

120.14

0.00

205.58

80

266

0

346

30

81

0

97

2010

51.01

163.30

14.01

228.32

65

401

4

470

29

145

1

160

2011

74.94

139.06

13.58

227.59

86

291

15

392

39

163

6

179

2012

157.15

186.53

0.00

343.68

157

465

0

622

51

242

0

270

2013

174.06

219.47

0.08

393.61

182

532

1

715

61

294

1

336

Note:

Statistics are calculated by DERA using the Asset-Backed Alert and Commercial Mortgage Alert databases. A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. The offerings are categorized by offering year and offering type (Commission registered, Rule 144A, or traditional private offerings). Non-agency asset-backed securities include RMBS, CMBS, and other asset-backed securities. Non-agency RMBS include residential, Alt-A, subprime RMBS, high loan-to-value (“no-equity”) loans, and non-U.S. residential loans. Auto loan asset-backed securities include asset-backed securities backed by auto loans and auto leases, both prime and subprime, motorcycle loans, recreational vehicle loans, and truck loans. The first set of columns show the total issuance amounts in billions of dollars. The second set of columns show the total number of asset-backed security offerings. The third set of columns show the number of unique issuers of asset-backed securities in each category. The number in the column “Total” may not be the sum of numbers in the columns “Regist'd”, “144A” and “Private” because some issuers may initiate offerings in several categories. Only non-agency asset-backed security offerings sold in the United States and issuers of such offerings are counted.

Issuers of asset-backed securities often include banks, mortgage companies, finance companies, investment banks, and other entities that originate or acquire and package financial assets for resale as asset-backed securities.

79

As reported in Table 6, in 2004 there were 298 unique issuers, while in 2013 there were 336 unique issuers, mostly involved in Rule 144A offerings.

80

The ten most active issuers were responsible for about 30% of the total issuance amounts at the end of 2013.

81

79

See Asset-Backed Securities,

Securities Act No. 8518 (Dec. 22, 2004), 70 FR 1506 (Jan. 7, 2005).

80

The number of issuers varies across segments of the asset-backed security market. For example, as of December of 2013 there were twenty-two and eighty-three issuers involved in RMBS and CMBS offerings, respectively.

81

The market share attributed to the issuer of an asset-backed security is calculated by DERA staff using the Asset-Backed Alert and Commercial Mortgage Alert databases.

As noted in Figure 1 below, an analysis of the segments of the asset-backed security market shows that all segments experienced significant downturns during the crisis but only a few of them have experienced a recovery in the aftermath. Figure 1 focuses on non-agency asset-backed security offerings and reports the issuance volume by main asset classes (RMBS, CMBS, auto loans/leases, credit card loans, student loans, and other asset-backed securities).

ER15SE14.000

As shown in Figure 1, new issuances of non-agency RMBS in 2004 totaled $542 billion, with registered offerings representing the majority of non-agency RMBS issued before the crisis. Non-agency RMBS issuance—which totaled $715 billion in 2007—dropped drastically to $35 billion in 2008. As of the end of 2013, the non-agency RMBS

market remains weak and consists almost exclusively of unregistered RMBS offerings. In particular, new issuances of non-agency RMBS totaled $25 billion in 2013, which represents about 5% of the issuance level in 2004. CMBS experienced a similar drop in issuance levels, though it has rebounded to a level that is closer to the 2004 issuance level than RMBS. In particular, CMBS issuance rose from $96 billion in 2004 to $231 billion in 2007. It then dropped to $12 billion in 2008. It was $86 billion in 2013, which is about 90% of the issuance level in 2004. The consumer finance asset-backed security market also declined drastically in terms of number of offerings and issuance volume after the financial crisis. For example, $70 billion of securities backed by auto loans and leases were issued in 2004, but issuance decreased to $38 billion in 2008. The issuances of consumer finance asset-backed securities, especially those securities backed by auto loans and leases, and other asset-backed securities have steadily increased since 2008 to reach pre-crisis levels of about $75 billion in 2013.

Among the asset-backed security segments, the non-agency RMBS segment has experienced a significant decline in the number of issuers with twenty-two issuers arranging non-agency RMBS (and only one issuer arranging non-agency registered RMBS) as of the end of 2013, compared to fifty-eight issuers in 2004. In the RMBS market, issuers arranging non-agency RMBS encounter competitive pressure from government-sponsored enterprises that arrange RMBS that are guaranteed

82

and exempt from registration and reporting requirements.

83

As non-agency RMBS issuance has declined, issuance of agency RMBS has increased. Issuances of RMBS arranged by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association were $1.4 trillion in 2004 and grew to $1.9 trillion in 2013.

84

82

See

N. Eric Weiss,

GSEs and the Government's Role in Housing Finance: Issues for the 113th Congress,

Congressional Research Service Report for Congress (2013).

83

Mortgage-backed securities issued by government-sponsored enterprises and the Government National Mortgage Association have been and continue to be exempt from registration under the Securities Act and most provisions of the federal securities laws. For example, the mortgage-backed securities issued by the Government National Mortgage Association are exempt securities under section 3(a)(2) of the Securities Act (15 U.S.C. 77c(a)(2)) and section 3(a)(12) of the Exchange Act (15 U.S.C. 78c(a)(12)). The chartering legislation for the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation contain exemptions with respect to the mortgage-backed securities issued by these entities.

See

12 U.S.C. 1723c; 12 U.S.C. 1455g.

84

See

Securities Industry Financial Market Association (“SIFMA”),

U.S. Mortgage-Related Issuance and Outstanding Data from 1996 to May 2014 (issuance), 2002 to 2014 Q1 (outstanding)

(June 3, 2014 update).

Table 7 shows the number of unique underwriters of non-agency asset-backed securities. As of the end of 2013, it is a highly concentrated industry with ninety underwriters (if international securitizations are included in the data) and fifty underwriters (if international securitizations are excluded), with the top ten underwriters by volume underwriting about 70% of the securitizations.

85

85

The market share attributed to an asset-backed security underwriter is calculated by DERA staff using Asset-Backed Alert and Commercial Mortgage Alert databases.

Table 7—Number of Unique Asset-Backed Security Underwriters

Year

Regist'd

144A

Private

Total

excluding internat'l

Internat'l

Total

including internat'l

2002

22

40

15

47

86

107

2003

29

41

3

47

87

109

2004

29

46

2

56

99

123

2005

29

45

3

50

101

118

2006

28

57

1

59

114

137

2007

27

59

1

61

109

132

2008

19

42

0

44

95

113

2009

14

26

0

28

58

72

2010

15

45

1

46

76

90

2011

18

44

5

45

62

79

2012

20

46

0

48

63

81

2013

22

47

0

50

72

90

Note:

Statistics are calculated by DERA staff using the Asset-Backed Alert and Commercial Mortgage Alert databases. A single offering of asset-backed securities may consist of multiple tranches of securities. An NRSRO may rate one or multiple tranches of the securities issued in the offering. The number of unique underwriters of asset-backed securities is divided into categories by type of offering (registered, 144A, private, or international). The total number in the last column may not be the sum of numbers in the columns labeled “Public”, “144A”, “Private,” and “Internat'l” because some underwriters may market offerings in several categories. Only non-agency asset-backed security offerings and underwriters of such deals are counted.

Finally, providers of third-party due diligence services with respect to asset-backed securities are significantly affected by the amendments and new rules being adopted today. The Commission has little information about these firms and the characteristics of the industry. The Commission estimates that there are approximately fifteen providers of third-party due diligence services.

86

Because there are very few publicly traded firms specializing in due diligence, little is known about these service providers in terms of loan review volume, market share, and revenue.

87

86

This number comes from combining the names of third-party due diligence firms cited by Vicki Beal, Senior Vice President of Clayton Holdings, in her testimony before the Financial Crisis Inquiry Commission, and the names of third-party due diligence firms that S&P reviews as a part of its U.S. RMBS rating process.

See

Testimony of Vicki Beal, Senior Vice President of Clayton Holdings before the Financial Crisis Inquiry Commission, (Sept. 23, 2010),

available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0923-Beal.pdf

(“Clayton Testimony”). S&P's updated list of third-party due diligence firms reviewed for U.S. RMBS is available at

https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1246530&SctArtId=208825&from=CM&nsl_code=LIME.

The Commission does not know whether the estimate of fifteen providers of third-party due diligence services captures all of the primary participants in this business but believes that, based on available information, this is a reasonable estimate for purposes of this economic analysis.

87

See

Clayton Testimony, p. 1 (describing the market for due diligence services as “highly fragmented, highly competitive and rapidly changing”).

Asset-backed security issuers and underwriters may use third-party due diligence services to identify issues with loans, to negotiate better prices on pools of loans they are considering for

purchase, and to negotiate expanded representations and warranties in purchase and sale agreements from sellers.

88

The reviews of third-party due diligence providers are performed on an adverse or random sample of loans consistent with the guidelines of clients. Compensation is likely not contingent on due diligence findings or the ultimate performance of the loans reviewed. Instead, third-party due diligence providers may be paid a standard service fee for each loan reviewed.

89

88

See id.

at 2.

89

See id.

at 3.

c. Industry Practices

The Commission staff conducts annual examinations of each NRSRO and publishes a report summarizing the essential findings of the examinations, as required by section 15E(p)(3) of the Exchange Act.

90

The staff's 2013 report noted improvements, relative to prior examinations, among the NRSROs in five general areas that are related to the amendments and new rules being adopted today: Enhanced documentation, disclosure, and board of director oversight of criteria and methodologies; investment in software or computer systems for electronic recordkeeping and monitoring employee securities trading; increased prominence of the role of the designated compliance officer within NRSROs; implementation or enhancement of internal controls over the rating process (for example, use of audits and other testing to verify compliance with federal securities laws, and employee training on compliance matters); and adherence to internal policies and procedures.

91

The report also discussed certain weaknesses or concerns in a number of review areas: Adherence to policies, procedures, and methodologies;

92

management of conflicts of interest;

93

implementation of ethics policies;

94

internal supervisory controls;

95

governance;

96

the activities of the designated compliance officer;

97

the processing of complaints;

98

and the policies governing post-employment activities of former staff of the NRSRO.

99

These essential findings were related to several areas of NRSRO operations and were not limited to activities relating to rating asset-backed securities.

90

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

See

Public Law 111-203, 932(a)(8). 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). Annual inspection reports for 2011, 2012, and 2013 are available at

http://www.sec.gov/divisions/marketreg/ratingagency.htm.

91

See

Commission staff,

2013 Summary Report of Commission Staff's Examinations of Each Nationally Recognized Statistical Rating Organization

(Dec. 2013) (“2013 Annual Staff Inspection Report”), pp. 7-9.

92

See

2013 Annual Staff Inspection Report, pp. 9-11.

93

Id.

at 11-13.

94

Id.

at 13-14.

95

Id.

at 14-19.

96

Id.

at 19-20.

97

Id.

at 20-21.

98

Id.

at 21-22.

99

Id.

at 22-23.

3. Broad Economic Considerations

In this section, the Commission describes the primary economic impacts that may derive from the amendments and new rules being adopted today, relative to the baseline discussed above. A detailed analysis of the particular economic effects—including the costs and benefits and the impact on efficiency, competition, and capital formation—that may result from the amendments and rules is presented in the focused economic analyses in section II of this release.

100

100

See

sections II.A.4., II.B.4., II.C.3., II.D.2., II.E.4., II.F.3., II.G.6., II.H.4., II.I.3., II.J.3., II.K.2., II.L.2., and II.M.5. of this release.

Section 3(f) of the Exchange Act requires the Commission, when engaging in rulemaking that requires the Commission to consider or determine whether an action is necessary or appropriate in the public interest, to also consider whether the action will promote efficiency, competition, and capital formation.

101

Further, section 23(a)(2) of the Exchange Act requires the Commission, when adopting rules under the Exchange Act, to consider the impact that any new rule would have on competition and to not adopt any rule that would impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.

102

The Commission's analysis of the economic effects, including the likely costs and benefits and the likely impact on efficiency, competition, and capital formation of the amendments and new rules, include those attributable to the rulemaking that the Commission is mandated to undertake in accordance with the Dodd-Frank Act and those attributable to the exercise of the Commission's discretionary authority.

101

See

15 U.S.C. 78c(f).

102

See

15 U.S.C. 78w(a)(2);

see also

Current Guidance on Economic Analysis in SEC Rulemakings (available at:

http://insider.sec.gov/divisions_offices/hqo/dera/rsfi-guidance-econ_analysis-rulemaking.pdf

)

In the proposing release, the Commission solicited comments on all aspects of the costs and benefits associated with the proposed rules. In addition to comments on the economic effects of specific provisions, which will be discussed in section II of this release, the Commission received comments on the overall economic effects of the proposed amendments and new rules. Generally, commenters expressed concerns that the potential cumulative burden and costs associated with the proposed amendments and new rules could be so onerous that they would have negative effects on competition by imposing an excessive burden on smaller NRSROs and raising barriers to entry for credit rating agencies that seek to register as NRSROs.

103

In particular, one commenter suggested that “fostering competition among rating agencies was a primary goal of both the Rating Agency Act of 2006 and the Dodd-Frank Act” but that “the proposed rules will be so costly to implement that additional credit rating agencies are unlikely to register as NRSROs and the existing pool of registrants may contract.”

104

103

See A.M. Best Letter; DBRS Letter; EJR Letter; Kroll Letter; Morningstar Letter; S&P Letter; TradeMetrics Letter.

104

See DBRS Letter.

This commenter also stated that a “contradiction lies in the fact that, while directing the Commission to impose costly and onerous new obligations on rating agencies who choose to register as NRSROs, the Dodd-Frank Act also directs the Commission to remove all references to credit ratings from the federal securities regulations.”

See DBRS Letter. See also

Public Law 111-203, 939A.

As discussed in section II of this release, the Commission has considered these comments and has modified the amendments and new rules being adopted today from the proposals in a number of ways that are designed to reduce the cumulative burden and costs associated with complying with the new requirements. Nonetheless, the Commission recognizes—as reflected in the economic analysis—that the amendments and rules establish a substantial package of new requirements applicable to NRSROs and that complying with these requirements will entail significant costs to NRSROs.

105

The amendments and rules also impose burdens on issuers and underwriters of asset-backed securities and providers of third-party due diligence services with respect to asset-backed securities. As discussed throughout the economic analysis, the Commission believes that

the new requirements should result in substantial benefits and should not impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.

105

Some NRSROs may be subject to rules in foreign jurisdictions under which certain of their policies and procedures or other practices are affected by requirements of these foreign jurisdictions that may be similar to some of the requirements imposed by the amendments and new rules. While the requirements of foreign jurisdictions are not analyzed here in detail, they may impact the incremental costs and benefits of the amendments and new rules.

In particular, the amendments and new rules being adopted today are designed to implement Title IX, Subtitle C of the Dodd-Frank Act, which, in turn, was designed to address the causes of certain market failures (that is, the principal-agent problem,

106

including conflicts of interest, and asymmetric information) that may impair the integrity and transparency of NRSRO credit ratings and the procedures and methodologies NRSROs use to determine credit ratings. Some of the amendments and new rules are primarily designed to enhance the integrity of how NRSROs determine credit ratings by improving internal governance of NRSROs, managing potential principal-agent problems and conflicts of interest in the credit rating process, and promoting adherence to the procedures and methodologies for determining credit ratings and compliance with laws and regulations.

107

For example, provisions in the amendments and new rules require an NRSRO, among other things, to: (1) Assess and report on the effectiveness of internal controls; (2) address conflicts of interest relating to sales and marketing activities and employment of former analysts; (3) have policies and procedures relating to their procedures and methodologies for determining credit ratings; (4) have standards of training, experience and competence for their credit analysts; and (5) have policies and procedures to promote the consistent use of credit rating symbols.

108

106

A principal-agent problem occurs when one person (the “agent”) is able to act in the person's own best interest rather than in the interest of another person (the “principal”). The problem arises when the parties have different interests and the agent has more information than the principal so that the principal cannot ensure that the agent is always acting in the principal's best interests, especially where activities that are useful to the principal are costly to the agent and where monitoring of the agent's activities is costly to the principal. For example, a principal-agent problem may arise if an NRSRO produces credit ratings that, as a result of conflicts of interest, are not informative to the users of credit ratings.

107

These requirements are discussed below in sections II.A., II.B., II.C., II.D., II.F., II.I., II.J., and II.K. of this release.

108

These requirements are discussed below in sections II.A., II.B., II.C., II.F., II.I., and II.J. of this release.

Other provisions in the amendments and new rules being adopted today are designed mainly to enhance the transparency of NRSRO credit ratings by increasing disclosure and reducing information asymmetries that may adversely affect users of credit ratings. This should facilitate external scrutiny of NRSRO activities. More specifically, provisions in the amendments and new rules require an NRSRO, among other things, to disclose: (1) Standardized performance statistics; (2) increased information about credit rating histories; (3) information about material changes and significant errors in the procedures and methodologies used to determine credit ratings; and (4) information about a specific rating action.

109

The main objective of these requirements is to improve the information provided to users of credit ratings, including investors. The enhanced disclosure may reduce information asymmetries between the NRSRO and the users of its credit ratings, enabling the users to make more informed investment and credit related decisions and allowing them to compare the performance of credit ratings by different NRSROs. Additionally, there are requirements in the amendments and new rules that are designed to reduce information asymmetries among issuers and underwriters of asset-backed securities, NRSROs rating asset-backed securities, and the users of credit ratings for asset-backed securities.

110

These requirements may benefit NRSROs and users of credit ratings, including investors in these securities.

109

These requirements are discussed below in sections II.E., II.F., II.G., and II.L. of this release.

110

These requirements are discussed below in sections II.E., II.G., and II.H of this release.

a. Amendments and Rules Enhancing NRSRO Governance and Integrity of Credit Ratings

The requirements in the amendments and new rules being adopted today that are primarily designed to enhance an NRSRO's internal governance should have economic benefits, relative to the existing baseline, in terms of promoting the integrity of how NRSROs determine and monitor credit ratings. In particular, there are new requirements applicable to NRSROs that assign responsibilities to an NRSRO's management and board of directors, which should promote accountability and facilitate internal oversight over the processes governing the determination of credit ratings and the implementation of the procedures and methodologies an NRSRO uses to determine credit ratings. For example, an NRSRO is required to file an annual report containing an assessment by management of the effectiveness during the fiscal year of the internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings.

111

Similarly, an NRSRO is required to establish, maintain, enforce, and document policies and procedures reasonably designed to ensure that the procedures and methodologies, including qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are approved by its board of directors or a body performing a function similar to that of a board of directors.

112

The board's oversight may prevent situations in which an NRSRO seeks to implement a procedure or methodology to determine credit ratings that is designed to inappropriately issue favorable credit ratings for existing and prospective clients in order to retain or gain market share.

113

111

This requirement is discussed below in section II.A.3. of this release.

112

This requirement is discussed below in section II.F.1. of this release.

113

See

Griffin and Tang,

Did Subjectivity Play a Role in CDO Credit Ratings?

There are new requirements applicable to NRSROs pursuant to which they must avoid certain conflicts of interest and have policies and procedures to take certain actions to address credit ratings that are influenced by a conflict of interest.

114

These requirements may facilitate the alignment of incentives at both the NRSRO and individual NRSRO employee level to ultimately promote the production of unbiased credit ratings. At the NRSRO level, for example, sales and marketing considerations may influence the NRSRO's production of credit ratings. Consequently, there is a new requirement that prohibits an NRSRO from issuing or maintaining a credit rating where a person within the NRSRO who participates in determining or monitoring the credit rating, or developing or approving procedures or methodologies used for determining the credit rating, including qualitative and quantitative models, also: (1) Participates in sales or marketing of a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (2) is influenced by sales or marketing considerations.

115

This absolute prohibition should result in internal policies, procedures, and organizational solutions that isolate the analytical function from sales and marketing considerations within the NRSRO. To the extent that the absolute prohibition prevents credit analysts that participate in the determination of

credit ratings from being influenced by sales and marketing considerations, this should curb potential conflicts of interest related to “rating catering” practices that have been suggested by anecdotal evidence

116

and academic literature.

117

Isolating the production of credit ratings and the development of procedures and methodologies for determining credit ratings from sales and marketing considerations should promote the integrity and quality of credit ratings to the benefit of their users.

114

These requirements are discussed below in sections II.B. and II.C. of this release.

115

This requirement is discussed below in section II.B.1. of this release.

116

See

Coffee Testimony I, pp. 2-3.

117

See

John M. Griffin, Jordan Nickerson, Dragon Yongjun Tang,

Rating Shopping or Catering? An Examination of the Response to Competitive Pressure for CDO Credit Ratings,

Rev. Fin. St. 2270-2310 (2013). The authors draw a distinction between rating shopping and rating catering. “Rating shopping” refers to a situation in which issuers solicit ratings from multiple credit rating agencies and then hire the credit rating agencies that will issue the most favorable credit ratings (Skreta and Veldkamp, 2009). Even though rating agencies adhere to their rating procedures and methodologies and issue unbiased ratings, credit rating inflation is a natural consequence of the rating shopping process and is not driven by the rating agencies. “Rating catering” refers to a situation in which issuers solicit credit ratings from multiple credit rating agencies and the credit rating agencies may not strictly adhere to their procedures and methodologies for determining credit ratings in order to issue more favorable credit ratings. The authors argue that under pressure from investment banks, the credit rating agency with a more stringent procedure or methodology for determining credit ratings stretches the procedure or methodology to match more lenient competitors (Bolton, Freixas, and Shapiro, 2012).

At the individual level, an analyst's incentives may be distorted by the prospect of future employment at an issuer or underwriter, which could influence the analyst in determining a credit rating for that issuer or underwriter. Consequently, there is a new requirement that an NRSRO must have policies and procedures that address instances in which this conflict of interest influenced a credit rating that are reasonably designed to ensure that the NRSRO promptly determines whether the current credit rating 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 and to promptly publish a revised credit rating, an affirmation of the credit rating, or potentially place the credit rating on watch or review and in each case include certain disclosures about the existence of the conflict.

118

This provision is designed to require the NRSRO to promptly address a conflicted credit rating, and it will likely limit the potential risk that users of credit ratings may make investment decisions using biased or inaccurate information. The disclosures also should provide information to investors and other users of credit ratings that they can use to scrutinize an NRSRO, thereby promoting accountability to the market for failing to appropriately manage this conflict of interest.

118

This requirement is discussed below in section II.C.1. of this release.

In terms of accountability, the Commission is finalizing a rule amendment pursuant to which an NRSRO could have its registration suspended or revoked for violating a rule governing conflicts of interest.

119

In addition, the Commission is amending Form NRSRO to provide notice to an NRSRO or a credit rating agency applying for registration as an NRSRO that an NRSRO is subject to applicable fines, penalties, and other sanctions under the Exchange Act.

120

This may serve as a reminder to the NRSRO or applicant of the potential consequences of failing to comply with federal laws and regulations. Taken together, these accountability measures may have incremental effects on the integrity of an NRSRO's activities and credit ratings by promoting compliance with the Commission's rules.

119

This requirement is discussed below in section II.B.3. of this release.

120

This requirement is discussed below in section II.D.1. of this release.

There are new requirements applicable to NRSROs pursuant to which they must establish, maintain, enforce, and document policies and procedures that are reasonably designed to ensure that: (1) The procedures and methodologies, including qualitative and quantitative data and models, the NRSRO uses to determine credit ratings are developed and modified in accordance with the policies and procedures of the NRSRO; and (2) material changes to the procedures and methodologies, including changes to qualitative and quantitative data and models, that the NRSRO uses to determine credit ratings are applied consistently to all current and future credit ratings to which the changed procedures or methodologies apply and, to the extent that the changes are to surveillance or monitoring procedures and methodologies, applied to current credit ratings to which the changed procedures or methodologies apply within a reasonable period of time, taking into consideration the number of credit ratings impacted, the complexity of the procedures and methodologies used to determine the credit ratings, and the type of obligor, security, or money market instrument being rated.

121

To the extent that these policies and procedures are effectively implemented and enforced, their application may enhance the integrity of how NRSROs determine credit ratings.

121

This requirement is discussed below in section II.F.1. of this release.

There are new requirements applicable to NRSROs pursuant to which they must establish, maintain, enforce, and document standards of training, experience, and competence for the individuals they employ to participate in the determination of credit ratings that are reasonably designed to achieve the objective that the NRSRO produces accurate credit ratings in the classes of credit ratings for which the NRSRO is registered. At a minimum, these standards must include: (1) A requirement for periodic testing of the individuals employed by the NRSRO to participate in the determination of credit ratings on their knowledge of the procedures and methodologies used by the NRSRO to determine credit ratings in the classes and subclasses of credit ratings for which the individual participates in determining credit ratings; and (2) a requirement that at least one individual with an appropriate level of experience in performing credit analysis, but not less than three years, participates in the determination of a credit rating.

122

These requirements may increase the level of competence and experience of the credit analysts employed by the NRSRO to participate in the production of credit ratings with possible positive effects on the integrity and quality of credit ratings.

123

122

See

section II.I.1. of this release (providing a more detailed discussion of the requirements of this paragraph).

123

See

Cesare Fracassi, Stefan Petry, and Geoffrey Tate,

Are Credit Ratings Subjective? The Role of Credit Analysts in Determining Ratings

(2014),

available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2230915

. The authors find that the identity of the credit analysts covering a firm significantly affects the firm's credit rating, comparing credit ratings for the same firm at the same time across credit rating agencies. Analyst effects account for 30% of the variation within credit ratings. In addition, the quality of credit ratings varies with observable analyst characteristics.

There are new requirements applicable to NRSROs pursuant to which they must have reasonably designed policies and procedures relating to: (1) Assessing the probability that an issuer of a security or money market instrument will default, fail to make timely payments, or otherwise not make payments in accordance with the terms of the security or money market instrument; (2) clearly defining each symbol, number, or score in the rating scale used by the NRSRO and including the definitions in Exhibit 1 to Form NRSRO; and (3) applying any symbol,

number, or score in the rating scale used by the NRSRO in a manner that is consistent for all types of obligors, securities, and money market instruments for which the symbol, number, or score is used.

124

Compliance with these policies and procedures may increase the likelihood that NRSROs apply rating symbols, numbers, or scores consistently across classes of credit ratings to the benefit of the users of credit ratings and obligors and issuers that are subject to credit ratings.

124

These requirements are discussed below in section II.J. of this release.

Finally, there are new requirements applicable to NRSROs pursuant to which they must retain records of certain internal controls, policies, procedures and standards they are required to document.

125

These record retention requirements should facilitate Commission oversight of NRSROs to the benefit of users of credit ratings. Similarly, the Exchange Act requires an annual report of the NRSRO's designated compliance officer to be filed on a confidential basis with the Commission.

126

The new requirement should facilitate Commission oversight as well.

125

These requirements are discussed below in sections II.A.2., II.C.2., II.F.2., II.I.2., and II.J.2. of this release.

126

This requirement is discussed below in section II.K. of this release.

There will be costs associated with the amendments and new rules being adopted today related to governance of NRSROs.

127

These costs will be primarily incurred by NRSROs.

128

Initial and ongoing direct costs, including compliance costs, may vary among the NRSROs depending on the size and complexity of their business activities (for example, number of credit ratings outstanding, number of analysts, or number of classes of credit ratings). Among other costs, NRSROs also may incur training costs in order to make their personnel aware of the changes in internal controls, policies, and procedures required by the amendments and new rules. These costs are difficult to quantify because they depend significantly on how the required changes differ from the internal policies and procedures currently in place within each NRSRO. In addition, they depend on factors such as the NRSRO's size and business complexity. For example, an NRSRO may need to train its credit analysts and sales and marketing staff in the updated policies and procedures related to the sales and marketing conflict requirements. Among other factors, this cost will likely vary significantly with the degree of the existing separation between the functions of analytical staff and sales and marketing personnel.

129

127

A detailed analysis of the economic costs, including compliance costs that can potentially result from each amendment and/or rule is presented in the focused economic analyses in section II of this release.

See

sections II.A.4., II.B.4., II.C.3., II.D.2., II.E.4., II.F.3., II.G.6., II.H.4., II.I.3., II.J.3., II.K.2., II.L.2., and II.M.5. of this release.

128

NRSROs may be able to pass some of the incremental costs to their clients.

129

This requirement is discussed below in section II.B.4. of this release.

Keeping all other factors constant, the costs associated with establishing, maintaining, enforcing, and documenting internal policies and procedures may be higher for structured finance products because the inherent conflict of interest that credit rating agencies face in rating these products is more acute than it is with respect to rating other types of securities.

130

In addition, keeping all other factors constant, NRSROs operating under a business model that combines the issuer-pay and subscriber-pay models may face greater direct costs, given that the two models may entail different internal policies and procedures to prevent different sources of potential conflicts of interest. A component of these costs may also be fixed, which may have a disproportionate impact on smaller NRSROs that may find it more difficult to bear the costs. If NRSROs are not able to readily pass the overall additional costs to clients, there may be adverse effects, particularly on smaller NRSROs.

130

See Amendments to Rules for Nationally Recognized Statistical Rating Organizations,

74 FR at 63844. (“In the case of structured finance products, the Commission believes this `issuer/underwriter-pay' conflict is particularly acute because certain arrangers of structured finance products repeatedly bring ratings business to the NRSROs. As sources of frequent, repeated deal-based revenue, some arrangers have the potential to exert greater undue influence on an NRSRO than, for example, a corporate issuer that may bring far less ratings business to the NRSRO.”) (footnotes omitted).

As a result of the amendments and new rules being adopted today, the number of credit rating agencies registered with the Commission as NRSROs may decline if current registrants believe that the cost of being registered and being subject to these new requirements outweighs the benefit of registration. The barriers to entry for credit rating agencies to register as NRSROs may rise, discouraging credit rating agencies from registering as NRSROs. Further, historically, successful new entrants have established themselves by first specializing in a particular industry, creating a track record in a particular rating class, and building the necessary reputational capital to achieve marketplace acceptance of their credit ratings.

131

Compliance costs may reduce the incentive for an NRSRO to expand its rating business into new classes of credit ratings, with adverse effects on competition in certain market segments. Also, if compliance costs significantly erode profit margins for NRSROs, the barriers to exit from being registered as an NRSRO in certain or all classes of credit ratings may lower. The risk for deregistration may likely be higher for smaller NRSROs. As mentioned earlier, these costs also should depend on the complexity of operations within the NRSRO. Further, given that the conflict of interest in rating structured finance products is more acute, the competitive effects could be greater within the markets for rating these products. These potential consequences could reduce competition among NRSROs.

131

See

Commission,

Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets

(Jan. 2003), p. 24.

An amendment being adopted today provides a mechanism for a small NRSRO to seek an exemption from the sales and marketing prohibition.

132

The exemption based on size may decrease the burden on small NRSROs. However, this amendment could create adverse effects on competition as exempted NRSROs may be able to draw business through rating catering. In particular, exempted NRSROs may be able to more readily produce conflicted and inflated ratings

133

or generate a greater stream of revenue from selling rating and ancillary services than non-exempted NRSROs. Reputation, which is an important disciplinary mechanism in this industry, may mitigate this risk to a certain extent.

134

132

This provision is discussed below in section II.B.3. of this release.

133

See

Griffin, Nickerson, and Tang,

Rating Shopping or Catering? An Examination of the Response to Competitive Pressure for CDO Credit Ratings

.

134

See

Jerome Mathis, James McAndrews, and Jean-Charles Rochet,

Rating the Raters: Are Reputation Concerns Powerful Enough to Discipline Rating Agencies?,

J. of Monetary Economics 657-674 (July 2009).

A number of credit rating agencies located in the United States have not registered as NRSROs.

135

As U.S. regulatory agencies continue to remove references to NRSRO credit ratings from the regulations they administer, market

participants subject to these regulations may choose to use unregistered credit rating agencies thereby diminishing the incentive to register as an NRSRO.

136

On the other hand, users of credit ratings may choose to use NRSROs over unregistered credit rating agencies because of the NRSRO registration and oversight program, which is being enhanced by the amendments and new rules being adopted today.

135

See, e.g.,

James H. Gellert, Chairman and CEO, Rapid Ratings International, Inc.,

Testimony Concerning: Oversight of the Credit Rating Agencies Post Dodd-Frank

(July 27, 2011) (testimony before the U.S. House of Representatives, Committee on Financial Services, Subcommittee on Oversight and Investigations),

available at http://www.rapidratings.com/images/custom/gellert_testimony_to_house_cfs_oversight_and_investigations_july_27_2011_final_w_bio.pdf

.

136

See

Public Law 111-203, 939A.

To the extent that these amendments and new rules improve the quality of credit-related information, they may have effects related to allocative efficiency and capital formation. As a result of these amendments and new rules, users of credit ratings could make more efficient investment decisions based on higher-quality information. Market efficiency also may improve if credit ratings become more informative and the additional information is reflected in asset prices. To the extent that the amendments and rules will be effective in enhancing the integrity and quality of NRSRO credit ratings, users of these credit ratings may benefit from an enhanced confidence in the quality of the creditworthiness assessments reflected in the credit ratings, which may have positive effects on the willingness of investors to participate in the securities markets and thereby enhance capital formation, as capital efficiently flows to more productive uses. The benefits in terms of efficiency and capital formation arising from the rules enhancing governance and the integrity of credit ratings are likely to be greater for asset-backed securities, where the inherent conflict of interest in the issuer-pay model is more acute, and, as a result of the amendments and new rules, investors may become less reluctant to invest in asset-backed securities.

b. Amendments and Rules Enhancing Disclosure and Transparency of Credit Ratings

The requirements in the amendments and new rules being adopted today that are primarily designed to enhance disclosure should have economic benefits, relative to the baseline that existed before the amendments and rules were adopted, in terms of promoting the transparency of credit ratings and NRSRO activities and, therefore, NRSRO accountability. This should benefit users of credit ratings, including investors. The amendments and rules also should enhance disclosure requirements with respect to asset-backed securities for the benefit of users of credit ratings, including investors in these securities.

The amendments significantly enhance the existing requirements for NRSROs to produce and disclose performance statistics to make the disclosures more comparable across NRSROs and easier for users of credit ratings and others to understand.

137

Similarly, the existing requirements for NRSROs to disclose rating histories are being enhanced to make the histories more complete in terms of the scope of credit ratings that must be included in the histories and more robust in terms of the information that must be disclosed with each rating action.

138

To the extent that the new disclosures facilitate the evaluation of the performance of an NRSRO's credit ratings and the comparison of rating performance across all NRSROs—including direct comparisons of the rating history of the same obligor or instrument across two or more NRSROs—the rules may benefit users of credit ratings, including investors. In particular, the enhanced disclosure may allow them to better assess the reliability of credit ratings from different NRSROs and, in the case of issuer-paid credit ratings or subscriber-paid credit ratings, make more informed decisions regarding whether to hire, or subscribe to the credit ratings of, a particular NRSRO.

137

These amendments are discussed below in section II.E.1. of this release.

138

These amendments are discussed below in section II.E.3. of this release.

There are new requirements applicable to NRSROs pursuant to which they must publish on their Internet Web sites: (1) Material changes to the procedures and methodologies, including to qualitative models or quantitative inputs, the NRSRO uses to determine credit ratings, the reason for the changes, and the likelihood the changes will result in changes to any current credit ratings; and (2) notice of the existence of a significant error identified in a procedure or methodology, including a qualitative or quantitative model, the NRSRO uses to determine credit ratings that may result in a change to current credit ratings.

139

These requirements may benefit users of NRSRO credit ratings in terms of their ability to evaluate the procedures and methodologies used by an NRSRO to determine credit ratings. In this way, they also may promote the NRSROs' accountability to the market and the issuance of quality credit ratings.

139

These amendments are discussed below in section II.F.1. of this release.

There are new requirements applicable to NRSROs pursuant to which they must publish two items when taking a rating action: (1) A form containing certain quantitative and qualitative information about the credit rating that is the result or subject of the rating action; and (2) any certification of a third-party due diligence provider relating to the credit rating.

140

The required disclosures may be used by investors and other users of credit ratings to better understand credit ratings issued by NRSROs. Specifically, the forms and certifications will provide incremental information about how a credit rating was produced (for example, disclosure about assumptions, limitations, information relied on, version of the procedure or methodology used, potential conflicts of interest) and the information content of the credit rating. The information disclosed in the form, including information about the limitations of the credit rating and information regarding due diligence, may discourage undue reliance on credit ratings by investors and other users of credit ratings in making investment and other credit-based decisions.

140

These amendments are discussed below in section II.G. of this release.

There is a new requirement applicable to issuers and underwriters of asset-backed securities pursuant to which they must disclose the findings and conclusions of any third-party due diligence report they obtain.

141

The rule applies to both registered and unregistered offerings of asset-backed securities. Additionally, there is a new requirement applicable to providers of third-party due diligence services with respect to asset-backed securities pursuant to which they must provide a written certification to any NRSRO that is producing a credit rating with respect to the asset-backed security.

142

The certification must disclose information about the due diligence performed, including a summary of the findings and conclusions of the third party, and identification of any relevant NRSRO due diligence criteria that the third party intended to meet in performing the due diligence.

141

These amendments are discussed below in section II.H.1. of this release.

142

These amendments are discussed below in sections II.H.2. and II.H.3. of this release.

As discussed above, the amendments and new rules are intended to reduce asymmetric information in the asset-backed security market. NRSROs producing credit ratings for asset-backed securities may benefit from receiving the information in the certification. The certification also will be signed by an individual who is duly authorized by the third-party due diligence provider to

make such a certification, promoting confidence in the accuracy of the information disclosed. Importantly, issuers and underwriters can no longer select what part of this information to provide to NRSROs, reducing the possibility of less favorable information being withheld from NRSROs and reducing the risk that the credit ratings will be based on imperfect or incomplete information (to the extent the NRSROs use information about due diligence in producing their credit ratings). Further, making this information available to all NRSROs (rather than just the NRSROs hired to rate the asset-backed security) could promote the issuance of more credit ratings for a given asset-backed security, including credit ratings that provide a more diverse range of views on the creditworthiness of the security. Users of credit ratings, including investors and other participants in the asset-backed securities markets, may benefit both directly and indirectly from the disclosures made by issuers, underwriters, and providers of third-party due diligence services. To the extent that findings and conclusions of all third-party due diligence reports were not previously disclosed to these persons, the amendments and new rules should enhance information available to the public.

Finally, there are new requirements pursuant to which NRSROs must use the Commission's Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system to electronically submit Form NRSRO and required exhibits to the form to the Commission.

143

Having all information available in an electronic format in EDGAR will provide a centralized location and should make the information and the history of that information more easily accessible, comparable, and searchable to users of credit ratings, including investors.

143

See

section II.L. of this release (providing a more detailed discussion of the amendments).

There will be costs associated with the amendments and new rules being adopted today that are related to enhanced disclosure and transparency.

144

These costs will be primarily incurred by NRSROs,

145

issuers and underwriters of asset-backed securities, and third-party due diligence providers. Initial and ongoing direct costs, including compliance costs, may vary among the affected parties depending on their size and the complexity of their business activities (for example, number of credit ratings outstanding, number of analysts, number of classes of credit ratings, number of years issuing credit ratings, and number of historical credit ratings). Keeping all other factors constant, NRSROs operating according to a subscriber-pay model may face greater losses in revenue from the sale of access to historical ratings data, as more of this data becomes publicly available, since they are likely to be more dependent on this source of revenue than NRSROs operating according to the issuer-pay model. A component of these costs may also be fixed, affecting more significantly smaller NRSROs that may find it more difficult to bear the costs. If NRSROs are not able to readily pass the overall additional costs to clients, there may be adverse effects, especially on smaller NRSROs.

144

A detailed analysis of the economic costs, including compliance costs that can potentially result from each rule is presented in the focused economic analyses in section II of this release.

See

sections II.A.4., II.B.4., II.C.3., II.D.2., II.E.4., II.F.3., II.G.6., II.H.4., II.I.3., II.J.3., II.K.2., II.L.2., and II.M.5. of this release.

145

NRSROs may be able to pass some of the incremental costs to their clients.

Similar to the amendments and new rules relating to governance, the amendments and new rules relating to disclosure and transparency could reduce the number of credit rating agencies registered with the Commission as NRSROs to the extent that current registrants believe the cost of being registered and subject to these new requirements outweighs the benefit of registration. In addition, the barriers to entry for credit rating agencies to register as NRSROs may rise, especially for smaller credit rating agencies. NRSROs may have a reduced incentive to register for a new class of credit ratings with adverse effects on competition in certain market segments. Barriers to exit from registration as an NRSRO may lower due to the possible erosion of profit margins, though an NRSRO's decision to deregister from certain or all classes of credit ratings may depend on whether users of credit ratings will favor NRSROs because of the NRSRO registration and oversight program, which is being enhanced by the amendments and new rules being adopted today. The risk for deregistration will likely be higher for smaller NRSROs, given the fixed component of some compliance costs and the greater difficulty to pass the increase in costs to their clients.

Also, the amendments and new rules may impact competition among third-party due diligence providers. Although the Commission knows little about the characteristics of the market for the services they provide, the certification requirement may increase the liability risk for these providers, particularly for those who do not already bear expert liability under Rule 193.

146

If third-party due diligence providers are not able to charge more for performing the asset review to account for the heightened risk of liability, some providers may exit the market or some entities that otherwise would have entered the market may decide against doing so.

146

See

17 CFR 230.193; 17 CFR 229.1111. Under Rule 193 and Item 1111 of Regulation AB, an issuer of a registered asset-backed security is required to perform a review of the assets underlying the asset-backed security and disclose the nature of the review. In meeting this requirement, an issuer may engage a third party to perform the required review of the underlying assets. If the third party's findings and conclusions are to be attributed to it, the third-party must consent to being named in the issuer's registration statement as an “expert,” thus subjecting the third party to so-called “expert liability” under the Securities Act. If third-party diligence providers are not subject to legal liability as experts, the issuer itself remains legally accountable for the accuracy of the disclosures it makes to investors.

The amendments and new rules also may have positive effects on competition, efficiency and capital formation. The enhanced standardization of the information content may facilitate comparing performance statistics and rating histories across NRSROs. Clients of NRSROs (for example, issuers, subscribers, and others) may use the performance statistics to inform their hiring or subscribing decisions, increasingly promoting competition among NRSROs on the basis of the quality of their credit ratings and the procedures and methodologies used to determine credit ratings. To the extent that the adopted rules facilitate the external monitoring and comparative analysis of NRSROs, they may allow users of credit ratings to develop more refined views of NRSRO performance and thereby indirectly increase accountability and encourage integrity in the production of credit ratings. This, in turn, may facilitate the ability of NRSROs to establish and maintain reputations for issuing quality credit ratings to remain competitive. More comparable performance data may also help relatively smaller and newer NRSROs, including subscriber-paid NRSROs, to attract attention to their rating performance, enhancing their ability to develop a reputation for producing quality credit ratings. This may allow them to better compete with more established competitors. Also, the ability of non-hired NRSROs to obtain the information disclosed in the third-party due diligence certification may provide them with an advantage in producing informative unsolicited credit ratings, relative to unregistered

credit rating agencies that cannot obtain this information.

The new disclosure requirements in the form and certifications that accompany a rating action may reduce information asymmetries about how a credit rating was determined by providing additional information about the rating process, such as assumptions, limitations, version of the procedures or methodologies used, and, in the case of an asset-backed security, a description of the findings and conclusions of a third-party due diligence provider, if such services were employed. To the extent that the required disclosure does not diminish the content and timeliness of the information conveyed with the rating actions, the enhanced information may increase the ability of users of credit ratings to accurately interpret the information, potentially resulting in more efficient investment decisions and higher overall market efficiency to the benefit of those investors that use credit ratings. This, in turn, may increase investors' participation in the securities markets with positive effects on capital formation. Because of the higher degree of information asymmetry in the asset-backed security market, the benefits in efficiency and capital formation resulting from the enhanced disclosure and transparency of credit ratings are likely to be greater for these securities, with the result that investors may become more willing to participate in this market.

II. Final Rules and Rule Amendments

As discussed in detail below, the Commission is adopting new rules and amendments to existing rules to implement Title IX, Subtitle C of the Dodd-Frank Act and to enhance the NRSRO registration and oversight program administered by the Commission. In designing rules to implement Title IX, Subtitle C of the Dodd-Frank Act, the Commission has taken into account section 15E(c)(2) of the Exchange Act.

147

This section provides, in pertinent part, that neither the Commission nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedures and methodologies by which any NRSRO determines credit ratings.

148

One way the Commission has sought to reconcile the rulemaking mandated by the Exchange Act, as amended by the Dodd-Frank Act, with the limitation in section 15E(c)(2) is to model rule text closely on statutory text.

147

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

148

See

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

A. Internal Control Structure

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

149

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 (“internal control structure”), taking into consideration such factors as the Commission may prescribe, by rule.

150

While section 15E(c)(3)(A) provides that the Commission “may” prescribe factors an NRSRO would need to take into consideration when establishing, maintaining, enforcing, and documenting the internal control structure, the requirement that an NRSRO “establish, maintain, enforce, and document an effective internal control structure” is self-executing.

151

Consequently, an NRSRO must adhere to this provision irrespective of whether the Commission prescribes factors pursuant to section 15E(c)(3)(A).

149

See

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

150

See

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

151

See id.

Section 15E(c)(3)(B) of the Exchange Act provides that the Commission “shall prescribe” rules requiring each NRSRO to submit an annual internal controls report to the Commission, which shall contain: (1) A description of the responsibility of the management of the NRSRO 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, of the NRSRO.

152

152

See

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

In the proposing release, the Commission: (1) Deferred prescribing factors the NRSRO must take into consideration in establishing, maintaining, enforcing, and documenting an effective internal control structure; (2) proposed amending the NRSRO recordkeeping rule (Rule 17g-2) to require that the documentation of the internal control structure be subject to the rule's record retention requirements; and (3) proposed amending the NRSRO annual reporting rule (Rule 17g-3) to require an NRSRO to file an unaudited annual internal controls report with the Commission.

153

153

See Nationally Recognized Statistical Rating Organizations,

76 FR at 33421-33425.

1. Prescribing Factors

In the proposing release, the Commission stated that it was deferring prescribing factors an NRSRO must take into consideration when establishing, maintaining, enforcing, and documenting an effective internal control structure to provide the Commission with an opportunity—through the NRSRO examination process and the submission of annual reports by the NRSROs on the effectiveness of their internal control structures—to review how NRSROs have complied with the self-executing requirement in section 15E(c)(3)(A) of the Exchange Act to establish, maintain, enforce, and document an effective internal control structure.

154

However, the Commission sought comment on whether it would be appropriate as part of this rulemaking to prescribe factors and on potential factors the Commission could prescribe.

155

In particular, the Commission identified factors relating to: (1) The establishment of an internal control structure; (2) the maintenance of an internal control structure; and (3) the enforcement of an internal control structure.

156

154

Id.

at 33421-33423.

155

Id.

156

Id.

at 33422-33423.

In terms of establishing an internal control structure, the Commission requested comment on the following factors:

• 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 (for example, 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;

157

157

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).

• 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;

• Controls reasonably designed to ensure that in-use methodologies for determining credit ratings are periodically reviewed (for example, 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;

• 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;

• 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;

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

• 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;

• 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;

• Controls reasonably designed to ensure that measures (for example, 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;

• 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 (for example, having the work reviewed through a rating committee process);

• 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; and

• 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.

158

158

See Nationally Recognized Statistical Rating Organizations,

76 FR at 33422.

In terms of maintaining an internal control structure, the Commission requested comment on the following factors:

• 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;

• 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; and

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

159

159

Id.

In terms of enforcing an internal control structure, the Commission requested comment on the following factors:

• 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; and

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

160

160

Id.

at 33422-33423.

In terms of documenting the internal control structure, the Commission asked for comment on whether there should be a factor relating to the level of written detail about the internal control structure that should be documented.

161

161

Id.

A number of commenters addressed whether the Commission should prescribe factors as part of this rulemaking and, if so, the type of factors the Commission should prescribe.

162

NRSROs urged the Commission to defer rulemaking and stated that the Commission should not prescribe factors.

163

For example, one NRSRO stated that the Commission should defer rulemaking until it has the opportunity to determine through the examination process and its review of the NRSROs' annual reports the “best practices utilized” by NRSROs to comply with the self-executing requirement in section 15E(c)(3)(A) and that the Commission's “examination feedback regarding best practices related to internal controls will be an important element for the adequate design and monitoring of internal controls.”

164

Another NRSRO stated that it “strongly agrees” with the Commission's proposal to defer rulemaking but that, if the Commission proceeds with rulemaking, it should “exercise caution” because attempting to create a “one-size fits all” rule in “such a short timeframe could result in the creation of an anti-competitive environment and the attendant unintended consequences.”

165

A third NRSRO stated that “NRSROs should have the flexibility to implement whatever control structure suits their size and particular business operations.”

166

162

See AFSCME Letter;

A.M. Best Letter; Better Markets Letter;

CFA/AFR Letter; CFA II Letter;

COPERA Letter; DBRS Letter;

Kroll Letter; Levin Letter;

Morningstar Letter; S&P Letter;

TradeMetrics Letter.

163

See A.M. Best Letter;

DBRS Letter; Kroll Letter;

Morningstar Letter; S&P Letter.

164

See Morningstar Letter.

165

See A.M. Best Letter

(“prescribing specific factors implies that all NRSROs are the same, which they are not. NRSROs vary in size, ownership, business plans, and management. `Specific factors' would undoubtedly be designed to apply to the largest NRSROs—this scenario would create a disproportionate impact on smaller NRSROs, whose internal control structure would be best served by designing and implementing policies and procedures that apply the law to the specific characteristics of the NRSRO.”).

166

See DBRS Letter.

In contrast, several other commenters stated that the Commission should not defer rulemaking.

167

For example, one commenter stated that the Commission “already has significant information about the weak internal controls at the NRSROs and has already identified a number of factors critical to an effective internal control system” and that “[p]ostponing the issuance of any standards will result in the NRSROs developing different internal control

structures, making oversight and the implementation of minimum standards more difficult, time consuming, and expensive down the line.”

168

Another commenter stated that the proposed approach “will be ineffective in reforming credit rating agency practices and will leave the Commission with little if any ability to hold ratings agencies accountable if they adopt weak and ineffective controls.”

169

These commenters and others recommended that the Commission prescribe factors,

170

and one of the commenters recommended that the Commission re-propose the rule to prescribe factors.

171

167

See AFR II Letter;

AFSCME Letter; Better Markets Letter;

CFA/AFR Letter; COPERA Letter;

Levin Letter.

168

See Levin Letter.

169

See CFA/AFR Letter.

See also CFA II Letter.

170

See AFGI Letter;

AFSCME Letter; Better Markets Letter;

CFA/AFR Letter; COPERA Letter;

Harrington Letter; Levin Letter;

TradeMetrics Letter.

171

See CFA II Letter

One commenter discussed factors that the commenter believed should be included in “a set of mandatory minimum standards for an effective internal control system for credit ratings.”

172

Another commenter stated that “the criteria on which the Commission seeks comment are precisely the sort of controls that ought to be in place if the system is operating effectively.”

173

A third commenter agreed that the rule should “incorporate all of these factors [as described in the proposing release].”

174

Two commenters pointed to the internal control framework developed by the Committee of Sponsoring Organizations of the Treadway Commission in 1992 as a model.

175

Two commenters stated that the rule should require that the documentation of the internal control structure include specific elements, such as how the board of directors conducted its oversight of the internal control structure.

176

172

See Levin Letter.

173

See CFA/AFR Letter.

174

See Better Markets Letter.

175

See CFA/AFR Letter;

AFSCME Letter.

176

See AFSCME Letter

(stating that the NRSRO should be required to document: the control environment; risk assessment; control activities; and information and communication within the NRSRO);

CFA/AFR Letter

(stating that the NRSRO should be required to document: The design of the system of internal controls; the evidence obtained and conclusions reache

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