Disclosure of Security Ratings; Proposed Rule and Nationally Recognized Statistical Rating Organizations; Notice

Federal RegisterSep 7, 1994

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 228, 229, 230 and 249

[Release Nos. 33-7086; 34-34617; IC-20509; File No. S7-24-94]

RIN 3235-AG20

Disclosure of Security Ratings

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules.

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SUMMARY: The Securities and Exchange Commission (``Commission'') today

is publishing for comment proposals to require disclosure with respect

to security ratings in prospectuses under the Securities Act of 1933

and material changes in security ratings on Form 8-K under the

Securities Exchange Act of 1934. The proposals specify the disclosure

necessary with respect to ratings, whether disclosed voluntarily or

pursuant to the new requirements. Today's proposals are intended to

improve the quality and timeliness of security ratings disclosures

provided to investors and the financial markets in prospectuses and

periodic reports, and to reduce the potential for market

misunderstanding and confusion over the scope and meaning of security

ratings.

DATES: Comments should be received on or before December 6, 1994.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,

NW., Washington, DC 20549. Comment letters should refer to File No. S7-

24-94. All comments received will be available for public inspection

and copying at the Commission's Public Reference Room, 450 Fifth

Street, NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: Brian P. Miller, or Michael H.

Mitchell, at (202) 942-2900, Division of Corporation Finance,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549. For issues relating to investment companies, contact Kenneth

J. Berman, at (202) 942-0721, Division of Investment Management,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is publishing for comment

proposed Item 202(g) of Regulation S-K\1\ and proposed Item 202(d) of

Regulation S-B\2\ under the Securities Act of 1933 (``Securities

Act'')\3\ and the Securities Exchange Act of 1934 (``Exchange

Act'')\4\ to require disclosure of solicited security ratings assigned

by nationally recognized statistical rating organizations (``NRSROs'')

to registered securities or any rating, whether or not assigned by an

NRSRO, that is used by a participant in the offering, and to mandate

the disclosure necessary in connection with any discussion of ratings,

voluntary or required, in prospectuses. The Commission also is

publishing for comment new Item 9 of Form 8-K\5\ under the Exchange Act

to require disclosure of material rating changes. The Commission is

proposing to rescind its policy on voluntary security ratings

disclosure set forth in Section 10 of Regulations S-K and S-B,\6\ and

is proposing technical amendments to Rules 134(a)(14),\7\ 430A,\8\ and

436(g)\9\ under the Securities Act.

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\1\17 CFR 229.202(g).

\2\17 CFR 228.202(d).

\3\15 USC 77a-77aa.

\4\15 USC 78a-78jj.

\5\17 CFR 249.308.

\6\17 CFR 229.10(c) and 228.10(c).

\7\17 CFR 230.134(a)(14).

\8\17 CFR 230.430A.

\9\17 CFR 230.436(g).

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I. Background

A. Disclosure of Security Ratings--Current Policy

In 1981, the Commission, recognizing the importance of security

ratings to investors and to the marketplace, reversed its historic

policy of precluding disclosure of security ratings in registration

statements, prospectuses, and other offering documents.\10\ The

Commission adopted a policy that permits, but that does not require,

issuers to disclose in Commission filings security ratings assigned by

rating organizations to classes of debt securities, convertible debt

securities, and preferred stock.

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\10\Securities Act Release No. 6336 (Aug. 6, 1981). While

adopting the policy in 1981, the Commission set forth its views on

ratings disclosure in Regulation S-K, Item 10(c), 17 CFR 229.10(c),

in connection with adoption of its integrated disclosure system in

1982. Securities Act Release No. 6383 (Mar. 16, 1982).

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The policy distinguishes between security ratings assigned by

NRSROs and those assigned by other rating organizations.\11\ The most

significant distinction is the provision allowing the inclusion of a

security rating by an NRSRO in a registration statement without having

to provide a written consent from the NRSRO to be named as an expert

for purposes of Section 11 of the Securities Act.\12\ Any non-NRSRO

rating organization must furnish a consent and take on expert liability

under the Securities Act if its rating is included in the registration

statement and prospectus.\13\ In addition, under the policy, issuers

may disclose a rating in tombstone advertisements on a limited basis,

provided that the rating is assigned by an NRSRO.\14\ As part of the

same initiative, the Commission incorporated eligibility criteria based

on ratings by NRSROs into its short form registration forms under the

Securities Act.\15\ In doing so, the Commission noted that investment

grade securities typically were purchased on the basis of interest

rates and ratings.\16\

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\11\For purposes of the policy, the term ``NRSRO'' has the same

meaning as used in the Commission's net capital rule, Rule 15c3-1.

17 CFR 240.15c3-1. In so doing, the Commission noted that the

purposes underlying the voluntary ratings disclosure policy differ

from those underlying the net capital rule, but did not believe that

a different meaning of NRSRO was necessary. The process by which

rating organizations are recognized as NRSROs is discussed in the

companion ratings concept release issued by the Commission today

which solicits comment on the Commission's role in using the ratings

of NRSROs (Exchange Act Rel. 34616 (Aug. 31, 1994)).

\12\15 USC 77k. See also 17 CFR 230.436(g).

\13\See Robert A. Stanger & Co., SEC No-Action Letter (Nov. 7,

1986); See also Securities Act Release No. 6383, in which the

Commission adopted the integrated disclosure system; 17 CFR 436(g).

\14\See Rule 134(a)(14)(ii) under the Securities Act. 17 CFR

230.134(a)(14)(ii).

\15\See Securities Act Release No. 6383; Forms S-3 (17 CFR

239.13) and F-3 (17 CFR 239.33).

\16\See Securities Act Release No. 6383.

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Underlying the Commission's change in policy and the disclosure

guidance it provided in its policy statement was an understanding of

rating practices and disclosures as they had developed through the

1970s. In announcing the policy, the Commission noted the significance

and usefulness of security ratings, as shown by the use of ratings ``by

investors, by market professionals in establishing the appropriate

price and yield for a particular security and by regulatory bodies,

including the Commission.''\17\

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\17\Securities Act Release No. 6336. Even before the Commission

adopted its 1981 ratings disclosure policy, the Commission relied on

or permitted disclosure of ratings in other contexts. The first

regulatory use of ratings was in the Commission's net capital rule,

which allows broker/dealers reduced deductions from net capital for

certain holdings rated in certain investment grade categories. 17

CFR 240.15c3-1. In addition, the Commission used ratings in certain

of its rules under the Investment Company Act of 1940 (``Investment

Company Act'') and permitted disclosure of certain ratings in

investment companies' registration statements. See, e.g., Rule 10f-3

under the Investment Company Act. 17 CFR 270.10f-3. The policy

release also noted the extent to which state legal investment laws

for banks, savings and loans, and insurance companies incorporated

security ratings.

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The security ratings encompassed by the Commission's policy were

understood generally to be credit ratings. In the release announcing

the policy, the Commission noted that the typical security rating at

the time was ``an alphabetical designation which attempts to quantify

the likelihood that an issuer will be able to comply with the terms of

a particular obligation,''\18\ and cited one rating organization's

designation as a ``current assessment of the creditworthiness of an

obligor with respect to a specific debt obligation.''\19\ The release

went on to state that a debt rating was ``an evaluation of the

likelihood that an issuer will be able to make timely interest payments

and will be able to repay principal,'' and a preferred stock rating was

an ``assess[ment] of the relative security of dividend payments.''\20\

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\18\Securities Act Release No. 6336.

\19\Id.

\20\Id.

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In adopting a policy of voluntary ratings disclosure, the

Commission noted that the state of affairs at the time did not show a

``pressing need'' for mandatory disclosure.\21\ Underlying the

Commission's action was an understanding that the market viewed debt

securities and preferred stock with the same rating designation and

comparable payment terms as fungible.

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\21\Id.

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The importance of security ratings continues today. Ratings

influence a company's cost of capital. Investment bankers and issuers

often solicit the rating organizations' views when developing new

financial instruments or structuring financing transactions. Investors

typically use ratings for various reasons such as establishing internal

investment guidelines and considering alternative investments. Because

of changes in the securities market the Commission has determined to

reconsider its policy of voluntary ratings disclosure.

B. Growth of Customized, Structured, and Derivative Securities

Since adoption of the Commission's policy on security ratings,

there has been a dramatic proliferation in the types of securities

offered in the marketplace, with the development of a vast market for

mortgage and asset backed securities and other highly structured or

derivative financial instruments. The rights and obligations evidenced

by these financial instruments typically differ significantly from the

traditional fixed obligations, evidenced by corporate debt and

preferred stock, to pay sums certain in the form of interest and

principal or dividends at set intervals. Moreover, in addition to the

change in the types of securities being rated, the scope and meaning of

ratings themselves have become more variable. Disclosure concerning

ratings, however, has remained largely static.

1. Evolution of Financial Instruments

Unlike the traditional debt and preferred stock instruments upon

which the 1981 policy was based, today many securities with the same

rating are not viewed by the market as generic and fungible. An

investor's investment return and the issuer's payment obligations

evidenced by these instruments often are contingent on, and highly

sensitive to, changes in the values of underlying assets, indices,

interest rates and cash flows. Risks relating to fluctuations in

interest rates and other economic and market factors may be as

important to an instrument's investment return as the issuer's

creditworthiness. Because of these non-credit payment risks, there is

substantially greater uncertainty relating to yield and total return

than for traditional debt obligations of comparable credit rating.

Moreover, the terms of these financial instruments are highly complex

and frequently are individually tailored to specific investor demands.

In short, today's instruments run along a spectrum from a fixed

obligation to pay sums certain to a highly contingent residual interest

in variable future cash flows.

For example, structured notes offer an infinite variety of payment

obligations and present substantial cash flow, market, and liquidity

risks in addition to credit risk.\22\ To illustrate, a structured note

may promise a specified interest payment monthly for two years, but

principal payable at maturity may be determined by reference to the

number of days an interest index exceeds a benchmark rate, subject to a

cap. If the index never exceeds the benchmark rate during the

measurement period, by the instrument's terms, the investor receives

the minimum principal amount (which often is less than face or stated

value). Such note could be assigned a ``triple-a'' rating under a

credit analysis if issued by a highly-capitalized, financially sound

company. The credit rating would address the likelihood that the issuer

will be able to pay any principal due, not the likelihood that the

investor will receive any principal payment.

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\22\``Structured notes are debt securities whose cash flow

characteristics (coupon, redemption amount, or stated maturity)

depend upon one or more indices or that have imbedded forwards or

options. Such imbedded forwards and options in the structure of the

notes allow underwriters to create an unlimited number of risk/

reward profiles and to customize risk characteristics to fit an

investor's desired risk exposure.'' Comptroller of the Currency,

Administrator of National Banks, OCC Advisory Letter 94-2, Purchases

of Structured Notes 1 (July 21, 1994).

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Likewise, from the relatively simple mortgage-backed obligations

(single-class securities representing equal, undivided interests in a

pool of mortgages) that were developed in the 1970s, mortgage-backed

and asset-backed pooled securities have evolved through financial

engineering into highly customized instruments with unlimited potential

variations. While credit risk remains important to investors in

mortgage-backed securities, additional investment considerations are

introduced by uncertain principal prepayment speeds associated with the

underlying interest rate sensitive assets.

Simple mortgage-backed securities may include multiple senior-

subordinated class structures, with the subordinated classes bearing a

disproportionate share of the credit risk, but all classes sharing

prepayment risk equally. With more complex, customized collateralized

mortgage obligations (``CMOs''), the cash flows (i.e., the stream of

payments on the underlying mortgage loans) are ``carved up'' into a

multi-class bond structure so that the prepayment risk is

disproportionately allocated to certain classes. Each class receives

interest and/or principal payments based on the priorities in the

payment structure. For example, a ``planned amortization class''

(``PAC'') is designed to produce more stable cash flows by redirecting

prepayments on the underlying pooled assets to other classes called

``companion classes,'' which act as ``shock absorbers'' for the PAC

with respect to prepayments. Both the PAC and the companion classes

could be senior securities, and rank ``pari passu'' with respect to

credit defaults on the underlying loans and both could be rated

``triple a,'' notwithstanding the disproportionate share of prepayment

risk borne by the companion classes, a risk not addressed by a

traditional credit rating.

``Residual'' securities, typically representing a beneficial

interest in whatever cash flows remain in the pool of financial assets

after obligations to pay all other outstanding classes have been

satisfied, have been rated. In a number of cases, because of the highly

speculative nature of these cash flows, the residual has incorporated a

fixed promise to pay a nominal amount, e.g., $10,000 principal in the

early months of the security's existence, to the residual holder. The

amount of the fixed nominal obligation may have no relationship to the

amount paid for the residual, nor to the anticipated residual cash

flow. The credit rating for the residual represents only an evaluation

of the likelihood that the holder will receive the promised nominal

amount. Thus, a residual could be rated ``triple-a'' even if there are

other securities in the offering that are not.

2. Non-Credit Payment Evaluations

In response to developments of derivative and structured securities

that have significant non-credit risks, rating organizations are

developing analytical models to evaluate the non-credit risks of these

instruments. For example, one rating organization has developed a

``volatility'' rating (``V-Rating''), scaled V1-V5, intended to provide

an indication of the volatility (or, conversely, predictability) of a

security in total return, price, and cash flow over a range or various

interest rate scenarios.23 The volatility of ``current coupon

agency certificates''24 is used as a benchmark. Classes assigned

ratings of V1, V2, and V3 demonstrate volatility less than or equal to

current coupon agency certificates over the range of interest rate

scenarios. Classes assigned ratings of V4 and V5 demonstrate greater

volatility over the range of interest rate scenarios than do current

coupon agency certificates.25

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\2\3V-Ratings analyze the potential impact of interest rate

movements on individual tranches but do not rate the probability of

specific interest rate scenarios. Fitch Investors Service, CMO

Volatility Ratings (Special Report) (Feb. 6, 1992).

\2\4This term refers to current rates on new Federal National

Mortgage Association (``FNMA''), Federal Home Loan Mortgage

Corporation (``FHLMC''), and Government National Mortgage

Association (``GNMA'') mortgage participation certificates. Id.

\2\5Id.

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Another rating organization has adopted the practice of attaching a

symbol--the letter ``r''--to its traditional credit rating for certain

derivative securities to alert investors that the instruments may

experience high volatility or dramatic fluctuations in their expected

returns because of market risk.26 The principal function of the

``r'' symbol is to serve as an investor alert. It does not provide a

measure or quantification of the non-credit payment risk (although the

rating organization continues in its efforts to develop market-risk

measures which might quantify non-credit payment risk).27 The

rating organization notes, however, that ``[t]he absence of an ``r''

symbol should not be taken as an indication that an obligation will

exhibit no volatility or variability in total return.''28

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\2\6``r'' Added To Volatile Derivative/Hybrid Ratings,

Creditweek (Standard & Poor's Corp.), July 11, 1994.

\2\7Id.

\2\8Id.

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A new rating permutation has evolved in response to the creation of

cash flow securities, also known as ``kitchen-sink'' bonds.29 A

cash flow security represents an interest in a pool of several classes

of previously issued unrelated mortgage backed securities, which

typically are highly sensitive to principal prepayment speed and have

volatile yields. Because each underlying security may have been issued

at different times, be backed by different pools of mortgage loans,

have different allocations of principal and interest among the various

classes, and perform differently in various interest rate and

prepayment rate environments, the performance of the cash flow security

will reflect a combination of the performance characteristics of the

various underlying securities. In registered cash flow bond offerings

seen to date, where the aggregate stated principal amounts of the

underlying pooled securities was less than the stated principal balance

of the cash flow securities, the cash flow securities would not qualify

for a ``triple a'' credit rating with respect to principal repayment.

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\2\9Laura Jereski, Kitchen-Sink Bonds May Offer Everything But

Stability, Wall St. J., Nov. 18, 1993, at C1, C17.

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Two rating organizations separately have developed and applied a

methodology to analyze the likelihood of receipt of a specified amount

of cash flow (combined interest and principal payments on the

underlying assets) from the pooled securities, without regard to

whether such payment amount constitutes interest or principal

repayment.30 Assessing the likelihood of receipt of this cash flow

combines both a credit rating and non-credit payment evaluation of

prepayments on the underlying pooled securities. Applying prepayment

analysis to determine the likelihood of receipt of aggregate cash flows

represents a significant development in rating techniques.

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\3\0See, e.g., Duff & Phelps Credit Rating Co., Rating

Prepayment-Sensitive Cash Flow Securities (Special Report) (Aug.

1993).

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The cash flow ratings do not address the likelihood of receipt of

the original principal amount of the cash flow security or the receipt

of any specified amount of interest; the rating assesses the likelihood

of receiving a specified dollar amount of cash over the life of the

security. Because the cash flow rating does not address the marketed or

expected promises, a cash flow rating may be viewed as a limited scope

rating in that it does not rate the likelihood of payment in accordance

with the instrument's actual or expected terms.

Initially, cash flow ratings were assigned the same rating

designations as assigned for traditional credit ratings. One rating

organization has appended, and the other has expressed a willingness to

append, a suffix to rating designations for cash flow securities.

3. Security Ratings Disclosure Practices

Notwithstanding these developments, little has changed with respect

to most ratings disclosures and regulatory policies using such ratings.

Today, a traditional corporate debt instrument with fixed principal and

interest obligations, a structured note whose principal or interest is

tied, for example to an index of securities, an ``interest-only'' strip

(``IO''), a collateralized mortgage obligation (``CMO'') security, a

residual interest in a CMO offering, and a cash flow (or ``kitchen-

sink'') bond all can be designated ``triple-a,'' notwithstanding that

investment returns on most of these instruments are largely dependent

on factors in addition to the issuer's creditworthiness and that the

scope of the rating differs among the securities. Moreover, despite the

differences among these securities, issuers, financial intermediaries,

and investors have availed themselves of the regulatory accommodations

provided for securities rated investment grade by NRSROs.31

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\3\1In a companion concept release issued today, the Commission

is soliciting comment on the Commission's regulatory use of the

ratings assigned by NRSROs. The release solicits a wide range of

comments both as to the specific regulatory uses of NRSRO ratings,

as well as the Commission's process for designating and monitoring

NRSROs. See Exchange Act Release No. 34616.

The proposals contained in this release are aimed at improving

the quality and timeliness of disclosure of ratings in Commission

filings under the current regulatory approach to ratings and rating

organizations.

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II. Proposals

A. General

The growth of customized asset-backed, derivative, and structured

securities that have significant non-credit payment risks, as well as

the development of ``limited scope'' ratings,32 have caused the

Commission to reconsider its voluntary ratings disclosure policy. When

these complex, customized securities first developed, they were

purchased by a relatively small number of large, highly sophisticated

institutional investors. Recent evidence suggests that these securities

are increasingly being offered and sold to a larger investor base,

either directly or through mutual funds and pension plans.33

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\3\2For purposes of this release, a ``limited scope'' rating

means a rating that assesses less than the promised (or expected, if

different from the promised) return on the security.

\3\3See supra note 26.

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Current rating designations and the variation in meaning and scope

of the ratings represented, together with the widely disparate payment

obligations of the securities rated, have a substantial potential to

confuse, and in some cases mislead, investors. This problem is

exacerbated in secondary market transactions where no disclosure

document may be delivered and ratings are described simply by shorthand

reference to the rating letter designation. Even where there is a

delivered disclosure document, it is often difficult to understand

clearly the scope of the rating. Likewise, many market participants

have assumed that the same regulatory treatment should apply to

similarly rated securities, notwithstanding significant differences in

the nature of the payment obligations, the significant non-credit

payment risk exposure for many of today's securities, and the limited

scope of some security ratings. Given the extensive use of, and

reliance on, ratings, and the wide disparity in the meaning and

significance of the rating, the Commission today is proposing a

mandatory ratings disclosure scheme.

B. Mandated Disclosures

Today's proposals would replace the current voluntary ratings

disclosure policy with a system requiring disclosure in a final

prospectus of a rating given by an NRSRO whenever a rating with respect

to the securities being offered is obtained by or on behalf of an

issuer. Material changes in ratings would be required to be reported on

Form 8-K under the Exchange Act. The new disclosure requirements are

intended to enhance security rating disclosures so that investors

clearly understand what terms of a security are being rated and the

limitations, if any, on the rating, and are advised on a current basis

of material rating changes. In particular, the proposed disclosure

would highlight whether the assigned rating covers timely payment of

all obligations or whether it is limited in its scope, and whether

there are significant non-credit payment risks not addressed by the

rating.

1. Mandated Prospectus Disclosure

Under the proposal, when a security rating is obtained by or on

behalf of an issuer from an NRSRO (a ``solicited rating''), the issuer

would be required to disclose in the final prospectus34 the rating

assigned and a discussion of the scope of the rating.35 The issuer

would be required to keep the prospectus disclosure of ratings current

so long as the offering continued.36 The mandated disclosure also

would apply when any rating (whether or not assigned by an NRSRO) is

used in connection with the offer or sale of a security by any

participant in the offering.37 Commenters are requested to address

the proposed treatment of ratings used by any participant in the

offering, particularly in view of the need to provide a consent of the

rating organization if it is not an NRSRO.

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\3\4As used in this release, final prospectus refers to a

prospectus complying with Section 10(a) under the Securities Act. 15

USC 77j.

\3\5When a final rating is not assigned until after

effectiveness of a registration statement, a preliminary prospectus

should disclose the preliminary rating (if any) assigned by the

rating organization in accordance with the disclosure requirements

described below. If a disclosed rating is materially changed or if a

materially different rating becomes available before effectiveness,

the issuer should file a pre-effective amendment and should consider

recirculating the preliminary prospectus. The issuer would update

the final prospectus to reflect the final rating assigned and all

related disclosure. Under the proposals, the final rating is

considered ``pricing information'' that may be included in a final

prospectus under Rule 430A of Regulation C. 17 CFR 230.430A.

In connection with delayed shelf offerings, the final rating

would be disclosed in a prospectus supplement. If a consent is

required, it would be filed as part of a post-effective amendment

or, for companies eligible to use a short-form registration

statement, a Form 8-K.

\3\6Changes in the rating information during the offering period

would be disclosed in a prospectus supplement filed with the

Commission pursuant to Rule 424(b). 17 CFR 230.424.

\3\7Participant refers to the issuer, any selling

securityholder, any underwriter and any member of the selling group.

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As proposed, the rule would require disclosure of ``obtained''

NRSRO ratings, whether or not the issuer (or a participant in the

offering) chooses to use the rating in the selling effort. Commenters

should address whether this requirement could lead to attempts to

thwart the mandated disclosure merely by non-substantive or procedural

modification to the practice of assigning ratings so that, for example,

an issuer would not view a security rating as ``obtained by or on

behalf of the issuer'' unless agreed to by the issuer. Of course, such

attempts would raise substantial antifraud issues. If this outcome is

possible, should the disclosure obligation be keyed off another event

such as when an NRSRO provides the issuer with a ``preliminary''

indication of what the rating would be? Should the rule mandate

disclosure only when the NRSRO rating is used in the offering? Would

this result in use and therefore disclosure of favorable ratings, and

non-use and non-disclosure of unfavorable ratings? Where no NRSRO

rating is provided in the prospectus, should the rule require

disclosure that the securities have not been rated by an NRSRO, a

discussion of whether there were any contacts with an NRSRO about

rating the securities, and a summary description of the contacts which

would include any actions taken by the NRSRO, and any views expressed

by the NRSRO? Commenters also should address the extent to which

practices to avoid disclosure of unfavorable ratings are likely to

occur.

For purposes of the proposed rules, a ``security rating'' is

defined as a credit assessment of an issuer's ability to make payments

of principal, interest, dividends (as applicable), or other payments on

the instrument being rated.38 The proposed rules also would

require disclosure of any designation assigned in connection with a

rating organization's evaluation of the security's non-credit payment

risks. For example, the evaluations covered by such designation would

include an organization's analysis of prepayment speeds, effects of

interest rates or other market based factors, event risk provisions, or

volatility assessments done in connection with or in addition to a

solicited rating.39 Comment is requested whether all these

evaluations should be required to be disclosed and whether any or all

these evaluations should be required to be disclosed even if issued in

the absence of a solicited security rating.40

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\3\8It should be noted that the definition of security rating

only applies in the context of determining whether a disclosure

obligation exists. This release should not be taken to imply that

all security ratings would qualify as ``ratings'' for all regulatory

purposes under the Commission's other rules.

\3\9See supra section I.B.2., ``Noncredit Payment Evaluations.''

\4\0Neither ``security rating'' nor ``evaluation'' is intended

to include rankings of interests in direct participation programs.

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The proposed rules do not mandate, but would continue to permit,

disclosure of ratings by rating organizations that are not designated

NRSROs. However, the mandated disclosure proposals would extend to

ratings assigned by non-NRSROs that are used voluntarily in the

prospectus. Comment is requested, however, as to whether disclosure

should be required when a non-NRSRO rating is used to market the

securities. Historically, the consent requirement has, for the most

part, foreclosed disclosure of such ratings. Disclosure of such ratings

in the prospectus would continue to require the rating organization to

consent to be named in the registration statement as an expert, and

thereby assume potential Section 11 liability under the Securities

Act.41

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\4\115 USC 77k.

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The Commission solicits comment on the continued appropriateness of

its policy of exempting NRSROs from providing consents, while other

rating organizations are required to provide consents for their ratings

to be disclosed in prospectuses and registration statements. Would the

proposed disclosure requirements cause issuers to forgo ratings or seek

ratings from non-NRSROs? Should the Commission expand the consent

exemption to all ratings organizations? Would this result in ratings

being issued by unqualified parties and the potential for investors to

be misled? If the exemption were extended to all rating organizations,

should the proposed rule mandate disclosure with respect to all ratings

obtained by or on behalf of a registrant, whether or not issued by an

NRSRO?

On the other hand, should the exemption be rescinded for NRSROs? If

the exemption were rescinded, and rating disclosure were mandated, what

would be the effect on the practice of rating securities? Would issuers

forgo obtaining ratings? Should the exemption be rescinded even if the

Commission were to determine to continue its voluntary disclosure

policy? Would this cause issuers to eliminate ratings disclosure in

prospectuses and registration statements? If so, would ratings

disclosure be eliminated entirely for registered public offerings or

disseminated outside the prospectus and registration statement?

As proposed, the rules would not require disclosure of unsolicited

ratings--ratings issued by a rating organization on securities on its

own initiative, not at the request of the company and not used by any

participant in the offering. Where the company does not have any

involvement with the rating, and does not use or permit the use of a

rating in an offering, it would appear unwarranted for it to have to

assume disclosure responsibility and liability for such ratings. On the

other hand, the ability to disclose a favorable solicited rating and

not disclose a lower unsolicited rating arguably could encourage rating

shopping and could allow companies to avoid disclosure that there are

disagreements about the creditworthiness of a particular security.

Should issuers be required to disclose unsolicited ratings by NRSROs if

materially different from that disclosed? If so, to what extent should

issuers be responsible for ascertaining whether an unsolicited rating

has been issued? If such unsolicited ratings are required to be

disclosed, should the mandated disclosure be limited to the rating

assigned and name of the issuing rating organization? Would mandated

disclosure of unsolicited ratings in effect compel issuers to obtain

ratings from all NRSROs to protect against having to disclose

unsolicited ratings that may be based on incomplete information?

The Commission also solicits comment on the need to require

disclosure in the prospectus on the method of compensating the rating

organization. Likewise, comment is requested as to whether the extent

of the rating organization involvement in the structuring of the

security should be disclosed.

Closed-end investment companies (``closed-end funds'') often issue

senior securities that are rated by one or more NRSROs. As with non-

investment companies, closed-end funds are not required to disclose

these ratings in their prospectuses. Form N-2,42 the form used by

closed-end investment companies to register under the Investment

Company Act of 194043 and to register their securities under the

Securities Act, sets forth the disclosure requirements for ratings when

the rating is included in a closed-end fund prospectus.44 Comment

is requested whether the mandatory disclosure approach being proposed

today also should be applied to closed-end funds and other investment

companies.

---------------------------------------------------------------------------

\4\217 CFR 274.11a-1.

\4\315 USC 90a et seq.

\4\4In addition, Guide 6 to Form N-2 sets forth certain risk-

related disclosures that should be made when a closed-end fund's

senior securities are issued with an NRSRO rating. 17 CFR 274.11a-1.

---------------------------------------------------------------------------

2. Disclosure Required with Respect to Security Ratings

Regulations S-K and S-B are proposed to be amended to specify the

disclosure required whenever a security rating is disclosed, either

voluntarily or pursuant to Commission rule. The ratings disclosure

should tie directly to the description of securities so that potential

investors may compare the actual payment obligations, expected

payments, and risks with the promises and risks assessed by the

assigning rating organization. The proposed rules require description

of: (1) What elements of the securities the rating addresses; (2) all

material limitations or qualifications on the rating; (3) any related

designation (or other published evaluation) of non-credit payment risks

assigned by the rating organization with respect to the security; and

(4) any material differences between the terms of the security as

assumed in rating the security, and the minimum obligations of the

security as specified in the governing instruments or, if significantly

different, the terms as marketed to investors. For example, the rating

description should explain if the security was rated using a yield

assumption which differs from the expected yield being marketed to

investors. Also, by way of example, a statement that the rating

``covers payment obligations in accordance with the terms of the

security'' usually would not be informative where the security permits

the issuer to defer interest payments for a specified time period. In

this instance, the ratings discussion should explain whether the rating

assumes that the interest deferral provision is or is not exercised.

The issuer would disclose the required information for each

solicited rating. If the rating designation includes a reference to a

designation or published evaluation of non-credit payment risk (e.g.,

sensitivity to movements in interest rates), the additional analysis

should be described. Where related evaluations are done, any use of the

rating designation should include the designation for the related non-

credit payment evaluation so investors relying on the designation are

not left unaware of the related evaluation. For example, where a cash

flow security is evaluated both for likelihood of cash receipt and

susceptibility to interest rate volatility, the designation always

should be presented in combination.

Not infrequently, the problem in clearly understanding the scope

and meaning of the rating of structured instruments is exacerbated by

the complexity and lack of clarity in the description of the securities

being offered.45 In some cases, even the title of the securities

could lead to investor misunderstanding of the nature of the

securities. The description of the securities should make clear the

extent to which payment obligations are fixed or contingent, clearly

explaining the nature of the contingencies.

---------------------------------------------------------------------------

\4\5See Item 202 of Regulation S-K. 17 CFR 229.202.

---------------------------------------------------------------------------

In many cases, securities are offered on the basis of expected

returns that can vary from the issuer's contractual commitments. For

example, the terms of some asset-backed securities obligate the issuer

only to pay available funds passed through from the underlying assets,

but investors may expect a minimum stated return and, in fact, the

security may be marketed as providing a stated return. In such cases,

care needs to be used in both primary and secondary transaction

disclosures to ensure that investors understand the limited obligation

of the issuer.

Comment is requested on the adequacy of the proposed disclosure

requirements and whether the proposed requirements would assure that

investors will be able to understand the limitations associated with a

rating and will be able to compare ratings. Commenters suggesting

alternative items should be specific in their suggestions. Commenters

also should suggest approaches to ensure that the description of

securities is clear and complete, and to ensure that security titles

convey the risks involved in an investment.

Comment also is requested as to whether issuers should be required

to disclose activities that could be viewed as ``rating shopping''--

that is approaching a number of rating organizations to determine which

organization will provide the highest rating on security terms most

favorable to the issuer. To what extent does this practice occur and

warrant such disclosure? Should the rules require issuers to disclose

contacts with any NRSRO with respect to rating the securities being

registered? If such disclosure is favored, should it only be required

if the issuer discloses a rating in its prospectus? Alternatively,

should such contacts be reported even if no rating is disclosed or

required to be disclosed in the prospectus? If disclosure of

preliminary contacts with NRSROs is required, what effect will such

disclosures have on rating practices?

Mutual funds often represent that they invest only in securities

that have a specified rating, such as investment grade, or disclose the

percentage of their portfolios comprised of securities with specified

ratings. As discussed above, a rating may not convey a security's level

of market risk, and, in the absence of appropriate disclosure,

investors may not perceive the limitations of a rating or the

investment characteristics it addresses. Comment is requested whether

current mutual fund disclosure practices and requirements adequately

address the limitations and scope of ratings and how mutual fund

disclosure documents could be improved to improve investor

understanding of the limitations of ratings.

3. Rating Designations

As discussed above, rating organizations frequently have used the

same rating designations to represent their evaluation of a wide range

of instruments with disparate types of payment obligations and, in many

cases, subject to substantial market, cash flow, and liquidity risks.

In some cases, the same designation has been used to represent limited

scope ratings such as those involving cash flow securities and

residuals. Recently, some NRSROs, when rating various interest rate

sensitive instruments, have begun to use modifying designations to

indicate the existence of non-credit payment risk but not a judgment of

the extent of this risk.

Given the market's widespread use of ratings, and the common use of

simple letter designations as shorthand communications of the rating,

there is a substantial potential for investor misunderstanding. This

problem can be particularly acute in the secondary markets.

Comment is requested as to the potential for investors to be

confused or misled about the nature of the security or the meaning of a

rating as the result of current rating designation practices. Should

the disclosure of ratings require the use of designations that clearly

distinguish traditional credit ratings from cash flow, residual or

other limited scope ratings? Should ratings of securities subject to

substantial non-credit related payment risks continue to be designated

the same as securities that do not carry such risks? To the extent that

commentators believe that there is a significant likelihood that

investors may be misled through rating designations, should the

Commission rely on rating organizations' self regulation to address the

problem, or should the Commission take regulatory action to assure that

a rating organization's designation system avoids issuing the same

rating designation to securities having substantially different credit

or other non-credit payment risks?

4. Security Rating Changes

The Commission is proposing to require issuers to report material

changes in security ratings of their securities on Form 8-K. Not only

is such information of importance to a company's security holders, but,

as noted in the Commission's recent release on municipal disclosures,

timely disclosure of such rating action is important to the efficiency

and transparency of the debt markets.46

---------------------------------------------------------------------------

\4\6See Securities Act Release No. 7049.

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Under the proposal, issuers would be required to file a Form 8-K

report within 15 calendar days of having been advised by the rating

organization of a material change in any NRSRO rating obtained for its

securities, including commercial paper, or any other rating of its

securities that has been previously disclosed in a prospectus or

registration statement for such securities registered under the

Securities Act. As proposed, the disclosure of the changed rating would

be accompanied by the same disclosure specified in Item 202(g) of

Regulation S-K.47

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\4\7Only information with respect to the ratings subject to

change would be required.

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Comment is requested as to whether the Commission's proposal to

mandate disclosure of material ratings upgrades is appropriate. Under

the proposal, it is contemplated that reporting of all adverse rating

changes would be required. The Commission requests comment as to

whether there are rating downgrades that commenters believe should be

viewed as immaterial. In particular, are there classes of securities as

to which information on downgrades would not be material to a company's

shareholders or debtholders?

Comment also is requested as to the appropriateness of the 15 day

calendar period for reporting the rating change. Should the period be

shorter, e.g. 5 business days, or longer, e.g. 20 days? Should the

period run from the date of the rating change, rather than the date of

notice of the change to the issuer? Should rating changes be reportable

on a quarterly basis on Form 10-Q and Form 10-K (for the fourth

quarter) rather than Form 8-K?

Commenters also should address the extent of the proposed

disclosure matters. Should the proposed disclosure be streamlined to

require only reporting: the NRSRO or other rating organization taking

the action; the title of the securities affected; and both the prior

and the new ratings? Comment also is requested as to whether the

proposed disclosure requirement should be triggered when there is a

change in a rating disclosed in any filing with the Commission (e.g.,

annual report on Form 10-K).

III. Request for Comment

Any interested persons wishing to submit written comments on the

proposals, as well as any other matters that might have an impact on

the proposals set forth in the release are requested to do so. The

Commission requests comments on the impact of the proposals on issuers,

potential investors, security holders, broker-dealers, rating

organizations, and others. Comments also are requested on whether the

proposed rule would have an adverse effect on competition that is

neither necessary nor appropriate in furthering the purposes of the

Securities Act and the Exchange Act. The Commission will consider

comments in complying with its responsibilities under Section 19(a) of

the Securities Act48 and Section 23(a) of the Exchange Act.49

---------------------------------------------------------------------------

\4\815 USC 77s(a).

\4\915 USC 78w(a).

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IV. Cost-Benefit Analysis

Assist the Commission in its evaluation of the costs and benefits

that may result from the proposals, commenters are requested to provide

views and data relating to any costs and benefits associated with these

proposals. The proposals are expected to increase to some extent the

net costs to issuers associated with registering securities for sale

and complying with reporting requirements; these costs could be

significant if the exemption for NRSROs from the consent requirements

under the Securities Act were rescinded and the disclosure of ratings

were mandatory. The costs to investors associated with these proposals

are minimal. The proposals are expected to provide additional benefits

to investors by enlarging the mix of information available to investors

regarding security ratings and by alleviating the potential for market

misunderstanding. Currently, many issuers seek security ratings for

their securities in order to make them marketable. Because the

proposals would require disclosure of security ratings and do not

address whether issuers should obtain security ratings, the proposals

are not expected to affect the issuance of rated securities, assuming

the exemption for NRSROs from the consent requirements under the

Securities Act is retained.

V. Summary of Initial Regulatory Flexibility Analysis

An Initial Regulatory Flexibility Analysis has been prepared in

accordance with 5 U.S.C. 603 for the proposed amendments. The analysis

notes that the proposals are expected to increase regulatory costs for

small entities which offer securities registered under the Securities

Act.

As discussed more fully in the analysis, the proposed changes may

affect persons that are small entities, as defined by the Commission's

rules. While it may be unlikely that small entities will publicly sell

rated securities (because of the costs of obtaining a rating and

because of the exemptions from registration available), any such small

entity would be required to prepare additional disclosure regarding

certain ratings assigned to the small entity's securities. While this

would increase the compliance burdens of small entities, the analysis

notes that no other significant alternative would achieve the

Commission's objective of reducing the potential for market confusion

about the scope and meaning of security ratings.

Commenters are urged to comment on any aspect of the analysis. All

comments will be available publicly. Any comments will be considered in

preparing the Final Regulatory Flexibility Analysis if the proposals

are adopted. For a copy of the analysis, contact Brian P. Miller,

Division of Corporation Finance, Securities and Exchange Commission,

450 Fifth Street, NW., Washington, DC 20549.

VI. Statutory Basis for Rule

All amendments are being proposed pursuant to Securities Act

Sections 5,50 6,51 7,52 10,53 11,54 17,55

and 19(a),56 as amended, and Exchange Act Sections 1357 and

23(a),58 as amended.

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\5\015 USC 77e.

\5\115 USC 77f.

\5\215 USC 77g.

\5\315 USC 77j.

\5\415 USC 77k.

\5\515 USC 77g.

\5\615 USC 77s(a).

\5\715 USC 78m.

\5\815 USC 78w(a).

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List of Subjects in 17 CFR Parts 228, 229, 230 and 249

Reporting and recordkeeping requirements, Securities.

Text of Proposed Amendments

In accordance with the foregoing, Title 17, Chapter II, of the Code

of Federal Regulations is proposed to be amended as follows:

PART 228--INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS

1. The authority citation for part 228 continues to read as

follows:

Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s,

77aa(25), 77aa(26), 77ll, 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn,

77sss, 78l, 78m, 78n, 78o, 78w, 80a-8, 80a-29, 80a-30, 80a-37, 80b-

11, unless otherwise noted.

2. By removing paragraph (e) of Sec. 228.10.

3. By amending Sec. 228.202 to add paragraph (d) and Instructions

to Item 202 to read as follows:

Sec. 228.202 (Item 202) Description of Securities.

* * * * *

(d) Security Ratings.

(1)(i) If a registrant has obtained a security rating from a

nationally recognized statistical rating organization (``NRSRO'') with

respect to a class of securities being registered under the Securities

Act or any rating (whether or not assigned by an NRSRO) is used in the

offer or sale of the securities by any participant in an offering, the

registrant shall include in the forepart of the prospectus the

information required by this paragraph (d) for each such rating

obtained or used.

(ii) If a registrant voluntarily discloses any security rating

assigned by a rating organization other than an NRSRO in a prospectus

or registration statement under the Securities Act, the registrant

shall include in the prospectus the information required by this

paragraph (d).

(iii) If a registrant is required to disclose a change in a

security rating pursuant to Item 9 of Form 8-K (17 CFR 249.308), the

registrant shall disclose the information required by this paragraph

(d) to the extent not disclosed previously, or to the extent different.

(2) Whenever a registrant discloses a security rating pursuant to

this paragraph (d), the registrant shall disclose the following for

each security rating disclosed:

(i) The identity of the rating organization assigning the rating;

(ii) The rating assigned;

(iii) The relative rank of the rating within the assigning rating

organization's overall classification system;

(iv) A description of what the rating addresses;

(v) All material scope limitations of the rating;

(vi) Any material differences between the terms of the security as

assumed in rating the security, and the terms of the security as

specified in the governing instruments;

(vii) Any material differences in the terms of the security as

assumed in rating the security, and the terms of the security as

marketed to investors;

(viii) A statement informing investors that a security rating is

not a recommendation to buy, sell, or hold securities, that it may be

subject to revision or withdrawal at any time by the assigning rating

organization, and that each rating should be evaluated independently of

any other rating; and

(ix) Any published designation reflecting the results of any other

evaluation done by the rating organization in connection with the

rating, along with an explanation of the designation's meaning and the

relative rank of the designation.

Instructions to Item 202

1. For purposes of paragraph (d), the term nationally recognized

statistical rating organization shall have the same meaning as used in

Sec. 240.15c3-1(c)(2)(vi)(F) of this chapter.

2. A registrant shall disclose any material limitations to the

security rating on the outside front cover page of the prospectus.

3. If a registrant includes information about security ratings in a

prospectus pursuant to paragraph (d), the registrant shall update the

description of each rating as set forth in this instruction 3:

A. If a change in a rating already included in the prospectus is

available subsequent to the filing of the registration statement, but

prior to its effectiveness, the registrant shall include such rating

change in the final prospectus. If the rating change is material, or if

the registrant is required to disclose a materially different rating

from any disclosed rating which becomes available during this period,

the registrant shall amend the registration statement to include the

rating change or the additional rating and should consider

recirculating the preliminary prospectus.

B. If an additional rating that the registrant is required to

disclose, or if a material change in a rating already included, becomes

available during any period in which offers or sales are being made,

the registrant shall disclose such additional rating or rating change

by means of a post-effective amendment, or sticker to the prospectus

pursuant to Sec. 230.424(b) of this chapter. However, a post-effective

amendment or sticker is not required in the case of a registration

statement on Form S-3 (Sec. 239.13 of this chapter) if the registrant

timely discloses the additional rating or the rating change in a

document incorporated by reference into the registration statement

subsequent to its effectiveness and prior to termination of the

offering.

4. If a registrant discloses a security rating not assigned by an

NRSRO, the registrant also should include the written consent of the

non-NRSRO rating organization. With respect to the written consent of

any NRSRO, see Sec. 230.436(g) of this chapter. When the registrant has

filed a registration statement on Form F-9 (Sec. 239.39 of this

chapter), see Sec. 230.436(g) of this chapter with respect to the

written consent of any rating organization specified in the Instruction

to paragraph (A)(2) of General Instruction I of Form F-9.

PART 229--STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES

ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND

CONSERVATION ACT OF 1975--REGULATION S-K

4. The authority citation for part 229 continues to read in part as

follows:

Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s,

77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn,

77sss, 78c, 78i, 78l, 78m, 78n, 78o, 78w, 78ll, 79e, 79n, 79t, 80a-

8, 80a-29, 80a-30, 80a-37, 80b-11, unless otherwise noted.

* * * * *

Sec. 229.10 [Amended]

5. By removing paragraph (c) of Sec. 229.10.

6. By amending Sec. 229.202 to add paragraph (g) and Instructions 6

through 9 to Item 202 to read as follows:

Sec. 229.202 (Item 202) Description of registrant's securities.

* * * * *

(g) Security Ratings.

(1)(i) If a registrant has obtained a security rating from a

nationally recognized statistical rating organization (``NRSRO'') with

respect to a class of securities being registered under the Securities

Act or any rating (whether or not assigned by an NRSRO) is used in the

offer or sale of the securities by any participant in an offering, the

registrant shall include in the forepart of the prospectus the

information required by this paragraph (g) for each such rating

obtained or used.

(ii) If a registrant voluntarily discloses any security rating

assigned by a rating organization other than an NRSRO in a prospectus

or registration statement under the Securities Act, the registrant

shall include in the prospectus the information required by this

paragraph (g).

(iii) If a registrant is required to disclose a change in a

security rating pursuant to Item 9 of Form 8-K (17 CFR 249.308), the

registrant shall disclose the information required by this paragraph

(g) to the extent not disclosed previously, or to the extent different.

(2) Whenever a registrant discloses a security rating pursuant to

this paragraph (g), the registrant shall disclose the following for

each security rating disclosed:

(i) The identity of the rating organization assigning the rating;

(ii) The rating assigned;

(iii) The relative rank of the rating within the assigning rating

organization's overall classification system;

(iv) A description of what the rating addresses;

(v) All material scope limitations of the rating;

(vi) Any material differences between the terms of the security as

assumed in rating the security, and the terms of the security as

specified in the governing instruments;

(vii) Any material differences in the terms of the security as

assumed in rating the security, and the terms of the security as

marketed to investors;

(viii) A statement informing investors that a security rating is

not a recommendation to buy, sell, or hold securities, that it may be

subject to revision or withdrawal at any time by the assigning rating

organization, and that each rating should be evaluated independently of

any other rating; and

(ix) Any published designation reflecting the results of any other

evaluation done by the rating organization in connection with the

rating, along with an explanation of the designation's meaning and the

relative rank of the designation.

Instructions to Item 202.

* * * * *

6. For purposes of paragraph (g), the term nationally recognized

statistical rating organization shall have the same meaning as used in

Sec. 240.15c3-1(c)(2)(vi)(F).

7. A registrant shall disclose any material limitations to the

security rating on the outside front cover page of the prospectus.

8. If a registrant includes information about security ratings in a

prospectus pursuant to paragraph (g), the registrant shall update the

description of each rating as set forth in this instruction 8: