By Jenna Greene, The National Law Journal

A divided U.S. Securities and Exchange Commission last week adopted new rules for credit-rating agencies, stepping up review and disclosure requirements and adding safeguards to prevent sales and marketing considerations from influencing the ratings.

The new rules “create an extensive framework of robust reforms,” said SEC Chairwoman Mary Jo White at a meeting at the agency’s headquarters in Washington. “Together, this package of reforms will improve the overall quality of [credit ratings] and protect against the re-emergence of practices that contributed to the recent financial crisis.”

Rating agencies such as Standard & Poor’s, Moody’s and Fitch Group were blamed during the financial crisis for giving high ratings to toxic residential mortgage-backed securities. The Justice Department is suing Standard & Poor’s in U.S. district court in Santa Ana, Calif., for $5 billion, accusing the company of inflating its ratings to win more fees from customers and failing to downgrade bad securities quickly enough.

“Many believe the ratings agencies were not just facilitators of the crisis, but its linchpin,” said Commissioner Luis Aguilar, who hailed the SEC’s final rule as a “marked improvement” over the initial proposal issued in 2011, which was criticized by consumer advocates as too lax. He voted in favor of the rule, as did fellow Democrat Kara Stein, who called the rule “long overdue.”

Commissioner Daniel Gallagher, however, criticized the “last-minute imposition of ill-conceived and hastily drafted rule provisions” that he said will create a “terrible, dangerous precedent that I am sure we will soon come to regret.”

Gallagher, a Republican, said the rule should have been reproposed and voted against it. Commissioner Michael Piwowar also voted no, arguing the SEC overstepped, making “discretionary changes … that go well beyond the prescriptions of the Dodd-Frank Act.”

The new rule requires credit-rating agencies to “establish, maintain, enforce and document an effective internal control structure” for determining ratings. That includes regular review and allowing market participants to comment on whether the rating methodology should be updated.

The new rules also bar any credit-­rating agency employee — including senior managers — who “participates in sales or marketing of a product or ­service” to determine or monitor credit ratings, or to be involved in developing the methodology used to set the ­ratings (though very small credit raters can apply for an exemption).

Gallagher called the provision, which he said also includes people “influenced” by sales and marketing considerations, “a novel approach of establishing what amounts to a thought crime. … This new prohibition is solely based on state of mind — there is no requirement that any action be taken,” he said. “I can’t imagine any court in the land not striking down this vague and unverifiable ‘influence’ clause.”

However, Dennis Kelleher, president of Better Markets, called the provision a “significant” improvement over the 2011 draft rule. “The proposed rule was narrowly focused simply on preventing sales personnel from participating in the ratings process, thus ignoring the many ways that sales and revenue incentives can corrupt the ratings that a firm issues,” he said in a written statement. Still, he said the SEC “has more critical work to do to eliminate the core conflicts of interest that persist in the ratings industry.”

The new rule also requires the ratings agencies to conduct a “look-back” review to determine whether the “prospect of future employment by an issuer or underwriter influenced a credit analyst in determining a credit rating.” If so, they have 15 days to determine whether to affirm or revise the rating, and to include a public explanation.

In addition, the raters must publicly disclose information about their initial credit ratings and subsequent changes to the credit ratings so investors and others who rely on the ratings can evaluate the accuracy and compare the performance of credit ratings from agency to agency.

Daniel Noonan, managing director of Fitch Ratings, praised the new rule. “The markets must have clear and consistent rules for credit-rating agencies, and the SEC’s regulatory framework will help ensure investors have confidence in the rating process,” he said in an email.

Contact Jenna Greene at [email protected].

IMAGE: Standard & Poors NYLJ/Monika Kozak

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