The Credit Agency Reform Act: What Leasing Companies Need to Know

Credit rating agencies occupy a centrally important role in the capital markets. Requirements for ratings issued by these agencies are widely used in securities, banking, and other regulations, as well as in privately established investment guidelines and contracts. But notwithstanding their considerable power, rating agencies have largely policed themselves, although not without drawing criticism. Credit rating agencies were among those blamed by lawmakers for not better protecting investors from the failures at Enron Corp., WorldCom Inc., and from other large bankruptcies. Rating agencies maintained high ratings for Enron securities, even as Enron's stock plummeted, until 4 days before its bankruptcy filing on Dec. 2, 2001. Corporate trade groups have long complained about what they consider abusive practices of rating agencies, including the practice of sending an issuer unsolicited ratings with a bill. The result has been a rising tide of financial professionals dissatisfied with the unregulated nature of the credit rating agency industry and the 'duopoly' power wielded by the two predominant agencies: Moody's and Standard & Poor's.

History of Legislation

The SEC has relied in several important regulatory areas on ratings supplied by credit rating agencies. The term 'rating agencies' is synonymous with 'Nationally Recognized Statistical Rating Organizations' or 'NRSROs' ' a term originated by the SEC in 1975 when it needed, in calculating capital charges against broker-dealers under the 'net capital rules,' to distinguish between investment and non-investment grade securities.

Over time, the NRSRO concept became a convenient tool and its use spread into other SEC rules, as well as federal and state legislation, rules issued by financial and other regulators, foreign regulatory schemes, and private financial contracts. It is now incorporated in more than 15 SEC rules. For example, when Congress defined the term 'mortgage rated security' in the context of the Exchange Act, it required that such securities be rated in one of the two highest rating categories by at least one NRSRO. State savings and loans are generally prohibited by federal law from investing in corporate debt securities unless those securities or their issuers are rated 'investment grade' by at least one NRSRO. Money market funds regulated under the Investment Company Act of 1940 can only invest in certain high-quality, short-term instruments, and that measurement test is determined by ratings assigned by NRSROs.

However, the SEC never defined what constitutes an NRSRO, and addressed who qualified as one strictly on an informal basis through no-action letters issued starting in 1975. There are presently five credit rating agencies, out of an estimated 130, certified by the SEC as NRSROs: A.M. Best, Dominion Bond Rating Service, Fitch Ratings, Moody's Investors Service, and Standard & Poor's. According to testimony before the Senate Banking Committee, S&P and Moody's undeniably hold the dominant position by controlling more than 80% of the market as measured by revenue. Moreover, S&P and Moody's are estimated to rate more than 99% of the debt obligations and preferred stock issues publicly traded in the United States.

Beginning in 1994, recognizing the substantial marketplace role that rating agencies had come to play in the financial markets, the SEC issued the first of several concept releases soliciting comment on its use of NRSRO ratings. These concept releases sought reaction from the investment community as to whether credit ratings should continue to be used for regulatory purposes and, if so, whose credit ratings should be used, the level of oversight to apply to such credit ratings, and whether to establish a definition for NRSRO. Most commenters supported the continued use of the NRSRO concept and recommended that the SEC adopt a formalized process for identifying and regulating NRSROs.

Continuing with its broad-based study of credit rating agencies, in 2002, the SEC issued an order directing investigation into the role of credit rating agencies in the U.S. securities markets and conducted several public hearings to address the issue. In addition to the SEC initiative, Congress, in SOX, required that the SEC conduct a study of credit rating agencies and submit a report to the president and Congress, which report was submitted in early 2003.

The results of the SEC report were significant. According to Senate committee notes, SEC examiners found: 1) potential conflicts of interest resulting from the issuer-paid business model of the NRSROs; 2) that NRSRO marketing of supplementary, fee-based services, including corporate consulting, exacerbated the inherent conflict in the NRSRO business model; 3) the potential for the NRSROs, given their substantial power in the marketplace, to improperly pressure issuers to pay for ratings and purchase ancillary services; and 4) evidence relating to whether NRSROs were adequately protecting confidential information. In addition, SEC examiners found evidence that the NRSROs were possibly in violation of '17(b) of the Securities Act of 1933, with respect to disclosure of fees from issuers.

Finally, in April 2005, the SEC issued a proposed rule release intended to define the term 'NRSRO' under the Exchange Act. An NRSRO would be 'an entity that (1) issues publicly available credit ratings that are current assessments of the creditworthiness of obligors with respect to specific securities or money market instruments; (2) is generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings; and (3) uses systematic procedures designed to ensure credible and reliable ratings, manage potential conflicts of interest, and prevent the misuse of nonpublic information, and has sufficient financial resources to ensure compliance with those procedures.' But although the deadline for the comments expired in June 2005 and there was significant public interest in the SEC's efforts to establish a regulatory framework, the rule was never finalized.

Congress meanwhile started its own initiative. Both the House and Senate began holding committee hearings on proposed legislation. Witnesses at these hearings asserted that the NRSRO system was 'dysfunctional' in that it was conflicted and monopolistic. They expressed concern about the existing SEC staff approval system (testimony confirmed there is no formal application process and some applicants have waited a decade without a final decision by the SEC staff). Commenters complained that the rating industry had high barriers to entry, emphasizing that the most important requirement for acquiring the coveted status presented an obvious Catch-22: To get the designation you must be nationally recognized, but you cannot become nationally recognized without first having the designation.

While regulators, lawmakers, and market participants clearly recognized the need for oversight of credit rating agencies, the slow pace of forward progress left many believing reform was potentially years away. But in the latter part of this year, with mid-term elections looming, Con-gress suddenly shifted into high gear, and in only slightly more than 3 weeks from its initial introduction on the Senate floor, the Act passed both Houses of Congress and was signed into law.

Summary of the Act

The Act contains official Congress-ional findings that credit rating agencies are of 'national importance' in that, among other things, their 'ratings, publications, writings, analyses and reports' occur in 'such volume as substantially to affect interstate commerce, the securities markets, the national banking system, and the national economy' and that the 'oversight of such credit rating agencies serves the compelling interest of investor protection.' The Act seeks to further the goals of 'accountability, transparency and competition' in the credit rating industry by introducing a clear and objective definition of an NRSRO, giving the SEC exclusive NRSRO registration and qualification authority and the power to oversee registered NRSROs, directing the SEC to issue rules regarding NRSRO conflicts of interest and the misuse of nonpublic information, and requiring NRSROs to disclose requirements that enhance transparency of the industry, including whether or not it has a code of ethics.

The Act defines an NRSRO as a credit rating agency that, among other requirements, 'has been in business as a credit rating agency for at least three consecutive years immediately preceding the date of its application for registration ' ' Proponents of this definition of NRSRO argue that a 3-year benchmark is an objective and transparent way for the SEC to decide whether to grant the NRSRO status to a rating agency. A credit rating agency that wishes to be treated as an NRSRO (including the five existing NRSROs qualified under the SEC's previous no-action letters) must submit an application for registration that contains information such as its credit ratings performance measurement statistics over short-term, mid-term and long-term periods, the procedures and methodologies that the applicant uses in determining credit ratings, its policies and procedures to prevent misuse of nonpublic information, and the amount of revenue received from its 20 largest issuers and subscribers during the prior fiscal year.

The Act also requires each applicant (other than the current five NRSROs) to submit written certifications from not fewer than 10 qualified institutional buyers (informally known as 'QIBs') which state that the QIBs have used the credit ratings of the applicant for at least 3 years preceding the date of certification.

The Act sets a strict timeline for approval of NRSRO status. Applicants will only have to wait for 90 days for the SEC initial decision and 120 days for the final decision, instead of years. Once the agency is registered as a NRSRO, the SEC will continue to monitor its activities and may require additional disclosure.

Significantly, the SEC is given legislative authority to issue rules requiring NRSROs to implement policies and procedures to prevent misuse of nonpublic information, and to manage and disclose conflicts of interest relating to the issuance of credit ratings, and prohibiting any act or practice that the SEC determines to be unfair, coercive, or abusive. Each NRSRO must designate an individual responsible for implementing the policies and procedures required pursuant to the Act and ensuring compliance with the securities laws. Any NRSRO that violates the SEC rules is subject to censure; limitations on its activities, functions, or operations; or suspension or revocation of its registration. The SEC must promulgate these rules within 270 days of enactment of the Act.

Proponents of the Act argue that lowering barriers to industry entry will encourage competition and, therefore, transparency and innovation. Moreover, higher numbers of competitors will lead to more efficient markets and reduce the potential for such anticompetitive conduct as coercion, tying, notching, and
other devices designed to preserve market share.

Opponents of the Act argue that a simple increase in the quantity of rating agencies would be a disservice to investors. S&P and Fitch claim that 3 years is not a sufficient time for an agency to learn how to accurately rate issuers and issues. Moreover, in their view, the time that a credit rating agency has been in business does not equate to the quality of the ratings it produces. S&P further argues that numerous studies have found that any potential conflicts of interests either have not materialized or have been efficiently managed and, therefore, there is no need for governmental involvement. S&P has also taken the position that rating agencies are analogous to trade or investment journals, and that ratings are opinions or expressions of free speech and need to be constitutionally protected as such, without fear of pressure from government interference.

Notwithstanding these reservations, all of the major rating agencies have voiced their fundamental support of the new legislation.

Conclusion

It is too early to say whether the Act will enhance competition or confuse investors with too many NRSRO ratings, whether the SEC's regulation of the agencies will create a more reliable and transparent environment, or whether disclosure required from the NRSROs will be more costly and burdensome than beneficial. Moreover, the Act may not be sufficient to break the Catch-22 problem expressed by witnesses at Congres-sional hearings. Issuers will still want the gold standard imprimatur of Moody's and S&P, and who will fault investors who refuse to purchase securities rated poorly or not at all by those agencies. Finally, many of the currently unregistered rating agencies are specialists that may not need SEC registration.

Clearly, Congress has taken a legislative step with broad-based support in the financial community, giving the SEC its long sought-after regulatory powers in this arena. Whether this is a step that will 'serve the compelling interest of investor protection' will only become apparent over time.

Barbara M. Goodstein is a partner in the New York office of LeBoeuf, Lamb, Greene & MacRae, L.L.P. She specializes in equipment finance, securitization, and restructurings. She may be reached at 212-424-8664 or [email protected]. Margarita Glinets is an associate in the Corporate Group in the firm's New York office and may be reached at [email protected].

Any equipment leasing or finance company desiring to access the debt capital markets must quickly become adept at dealing with a unique feature of that world: the credit rating and its gatekeeper, the credit rating agency. Entering this realm can be a jolt for finance officers used to the relationship-friendly, competitive environment of commercial banks. Dominated by two monoliths, Standard & Poor's and Moody's, the rating agency process is steeped in the clinical analytics of credit modeling. Rating agencies are viewed by many as academic in perspective and, to some, remote and obscure in their approach.

Some of this may soon begin to change. On Sept. 29, 2006, President Bush signed into law the Credit Rating Agency Reform Act of 2006 (Public Law No. 109-291, at http://thomas.loc.gov/). This Act is the first legislation to regulate credit rating agencies and states its purpose as 'to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating agency industry.'

The Act results from long and extensive debate regarding: 1) the role of the credit rating agencies in the securities markets, and 2) the degree of governmental involvement needed to protect investors who rely on such credit ratings. Many see the Act, which grants the SEC the power to oversee and regulate credit rating agencies, as the final reform in the spirit of the Sarbanes-Oxley Act of 2002 ('SOX'). (It is not surprising that Representative Michael G. Oxley introduced the original House version of the legislation.)

Credit rating agencies occupy a centrally important role in the capital markets. Requirements for ratings issued by these agencies are widely used in securities, banking, and other regulations, as well as in privately established investment guidelines and contracts. But notwithstanding their considerable power, rating agencies have largely policed themselves, although not without drawing criticism. Credit rating agencies were among those blamed by lawmakers for not better protecting investors from the failures at Enron Corp., WorldCom Inc., and from other large bankruptcies. Rating agencies maintained high ratings for Enron securities, even as Enron's stock plummeted, until 4 days before its bankruptcy filing on Dec. 2, 2001. Corporate trade groups have long complained about what they consider abusive practices of rating agencies, including the practice of sending an issuer unsolicited ratings with a bill. The result has been a rising tide of financial professionals dissatisfied with the unregulated nature of the credit rating agency industry and the 'duopoly' power wielded by the two predominant agencies: Moody's and Standard & Poor's.

History of Legislation

The SEC has relied in several important regulatory areas on ratings supplied by credit rating agencies. The term 'rating agencies' is synonymous with 'Nationally Recognized Statistical Rating Organizations' or 'NRSROs' ' a term originated by the SEC in 1975 when it needed, in calculating capital charges against broker-dealers under the 'net capital rules,' to distinguish between investment and non-investment grade securities.

Over time, the NRSRO concept became a convenient tool and its use spread into other SEC rules, as well as federal and state legislation, rules issued by financial and other regulators, foreign regulatory schemes, and private financial contracts. It is now incorporated in more than 15 SEC rules. For example, when Congress defined the term 'mortgage rated security' in the context of the Exchange Act, it required that such securities be rated in one of the two highest rating categories by at least one NRSRO. State savings and loans are generally prohibited by federal law from investing in corporate debt securities unless those securities or their issuers are rated 'investment grade' by at least one NRSRO. Money market funds regulated under the Investment Company Act of 1940 can only invest in certain high-quality, short-term instruments, and that measurement test is determined by ratings assigned by NRSROs.

However, the SEC never defined what constitutes an NRSRO, and addressed who qualified as one strictly on an informal basis through no-action letters issued starting in 1975. There are presently five credit rating agencies, out of an estimated 130, certified by the SEC as NRSROs: A.M. Best, Dominion Bond Rating Service, Fitch Ratings, Moody's Investors Service, and Standard & Poor's. According to testimony before the Senate Banking Committee, S&P and Moody's undeniably hold the dominant position by controlling more than 80% of the market as measured by revenue. Moreover, S&P and Moody's are estimated to rate more than 99% of the debt obligations and preferred stock issues publicly traded in the United States.

Beginning in 1994, recognizing the substantial marketplace role that rating agencies had come to play in the financial markets, the SEC issued the first of several concept releases soliciting comment on its use of NRSRO ratings. These concept releases sought reaction from the investment community as to whether credit ratings should continue to be used for regulatory purposes and, if so, whose credit ratings should be used, the level of oversight to apply to such credit ratings, and whether to establish a definition for NRSRO. Most commenters supported the continued use of the NRSRO concept and recommended that the SEC adopt a formalized process for identifying and regulating NRSROs.

Continuing with its broad-based study of credit rating agencies, in 2002, the SEC issued an order directing investigation into the role of credit rating agencies in the U.S. securities markets and conducted several public hearings to address the issue. In addition to the SEC initiative, Congress, in SOX, required that the SEC conduct a study of credit rating agencies and submit a report to the president and Congress, which report was submitted in early 2003.

The results of the SEC report were significant. According to Senate committee notes, SEC examiners found: 1) potential conflicts of interest resulting from the issuer-paid business model of the NRSROs; 2) that NRSRO marketing of supplementary, fee-based services, including corporate consulting, exacerbated the inherent conflict in the NRSRO business model; 3) the potential for the NRSROs, given their substantial power in the marketplace, to improperly pressure issuers to pay for ratings and purchase ancillary services; and 4) evidence relating to whether NRSROs were adequately protecting confidential information. In addition, SEC examiners found evidence that the NRSROs were possibly in violation of '17(b) of the Securities Act of 1933, with respect to disclosure of fees from issuers.

Finally, in April 2005, the SEC issued a proposed rule release intended to define the term 'NRSRO' under the Exchange Act. An NRSRO would be 'an entity that (1) issues publicly available credit ratings that are current assessments of the creditworthiness of obligors with respect to specific securities or money market instruments; (2) is generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings; and (3) uses systematic procedures designed to ensure credible and reliable ratings, manage potential conflicts of interest, and prevent the misuse of nonpublic information, and has sufficient financial resources to ensure compliance with those procedures.' But although the deadline for the comments expired in June 2005 and there was significant public interest in the SEC's efforts to establish a regulatory framework, the rule was never finalized.

Congress meanwhile started its own initiative. Both the House and Senate began holding committee hearings on proposed legislation. Witnesses at these hearings asserted that the NRSRO system was 'dysfunctional' in that it was conflicted and monopolistic. They expressed concern about the existing SEC staff approval system (testimony confirmed there is no formal application process and some applicants have waited a decade without a final decision by the SEC staff). Commenters complained that the rating industry had high barriers to entry, emphasizing that the most important requirement for acquiring the coveted status presented an obvious Catch-22: To get the designation you must be nationally recognized, but you cannot become nationally recognized without first having the designation.

While regulators, lawmakers, and market participants clearly recognized the need for oversight of credit rating agencies, the slow pace of forward progress left many believing reform was potentially years away. But in the latter part of this year, with mid-term elections looming, Con-gress suddenly shifted into high gear, and in only slightly more than 3 weeks from its initial introduction on the Senate floor, the Act passed both Houses of Congress and was signed into law.

Summary of the Act

The Act contains official Congress-ional findings that credit rating agencies are of 'national importance' in that, among other things, their 'ratings, publications, writings, analyses and reports' occur in 'such volume as substantially to affect interstate commerce, the securities markets, the national banking system, and the national economy' and that the 'oversight of such credit rating agencies serves the compelling interest of investor protection.' The Act seeks to further the goals of 'accountability, transparency and competition' in the credit rating industry by introducing a clear and objective definition of an NRSRO, giving the SEC exclusive NRSRO registration and qualification authority and the power to oversee registered NRSROs, directing the SEC to issue rules regarding NRSRO conflicts of interest and the misuse of nonpublic information, and requiring NRSROs to disclose requirements that enhance transparency of the industry, including whether or not it has a code of ethics.

The Act defines an NRSRO as a credit rating agency that, among other requirements, 'has been in business as a credit rating agency for at least three consecutive years immediately preceding the date of its application for registration ' ' Proponents of this definition of NRSRO argue that a 3-year benchmark is an objective and transparent way for the SEC to decide whether to grant the NRSRO status to a rating agency. A credit rating agency that wishes to be treated as an NRSRO (including the five existing NRSROs qualified under the SEC's previous no-action letters) must submit an application for registration that contains information such as its credit ratings performance measurement statistics over short-term, mid-term and long-term periods, the procedures and methodologies that the applicant uses in determining credit ratings, its policies and procedures to prevent misuse of nonpublic information, and the amount of revenue received from its 20 largest issuers and subscribers during the prior fiscal year.

The Act also requires each applicant (other than the current five NRSROs) to submit written certifications from not fewer than 10 qualified institutional buyers (informally known as 'QIBs') which state that the QIBs have used the credit ratings of the applicant for at least 3 years preceding the date of certification.

The Act sets a strict timeline for approval of NRSRO status. Applicants will only have to wait for 90 days for the SEC initial decision and 120 days for the final decision, instead of years. Once the agency is registered as a NRSRO, the SEC will continue to monitor its activities and may require additional disclosure.

Significantly, the SEC is given legislative authority to issue rules requiring NRSROs to implement policies and procedures to prevent misuse of nonpublic information, and to manage and disclose conflicts of interest relating to the issuance of credit ratings, and prohibiting any act or practice that the SEC determines to be unfair, coercive, or abusive. Each NRSRO must designate an individual responsible for implementing the policies and procedures required pursuant to the Act and ensuring compliance with the securities laws. Any NRSRO that violates the SEC rules is subject to censure; limitations on its activities, functions, or operations; or suspension or revocation of its registration. The SEC must promulgate these rules within 270 days of enactment of the Act.

Proponents of the Act argue that lowering barriers to industry entry will encourage competition and, therefore, transparency and innovation. Moreover, higher numbers of competitors will lead to more efficient markets and reduce the potential for such anticompetitive conduct as coercion, tying, notching, and
other devices designed to preserve market share.

Opponents of the Act argue that a simple increase in the quantity of rating agencies would be a disservice to investors. S&P and Fitch claim that 3 years is not a sufficient time for an agency to learn how to accurately rate issuers and issues. Moreover, in their view, the time that a credit rating agency has been in business does not equate to the quality of the ratings it produces. S&P further argues that numerous studies have found that any potential conflicts of interests either have not materialized or have been efficiently managed and, therefore, there is no need for governmental involvement. S&P has also taken the position that rating agencies are analogous to trade or investment journals, and that ratings are opinions or expressions of free speech and need to be constitutionally protected as such, without fear of pressure from government interference.

Notwithstanding these reservations, all of the major rating agencies have voiced their fundamental support of the new legislation.

Conclusion

It is too early to say whether the Act will enhance competition or confuse investors with too many NRSRO ratings, whether the SEC's regulation of the agencies will create a more reliable and transparent environment, or whether disclosure required from the NRSROs will be more costly and burdensome than beneficial. Moreover, the Act may not be sufficient to break the Catch-22 problem expressed by witnesses at Congres-sional hearings. Issuers will still want the gold standard imprimatur of Moody's and S&P, and who will fault investors who refuse to purchase securities rated poorly or not at all by those agencies. Finally, many of the currently unregistered rating agencies are specialists that may not need SEC registration.

Clearly, Congress has taken a legislative step with broad-based support in the financial community, giving the SEC its long sought-after regulatory powers in this arena. Whether this is a step that will 'serve the compelling interest of investor protection' will only become apparent over time.

Barbara M. Goodstein is a partner in the New York office of LeBoeuf, Lamb, Greene & MacRae, L.L.P. She specializes in equipment finance, securitization, and restructurings. She may be reached at 212-424-8664 or [email protected]. Margarita Glinets is an associate in the Corporate Group in the firm's New York office and may be reached at [email protected].