SEC Proposals Address Credit Rating Agencies, Technology And Small Business

Copyright 2008 Gale Group, Inc.All Rights ReservedBusiness and Management Practices <span id="x_hitDiv1">Bank Accounting & Finance <br> <br> <span id="x_hitDiv2">October 2008 <br> <br> Pg. 44 Vol. 21 No. 6 ISSN: 0894-3958 <br> <br> 6066746 <br> <br> 2723 words <br> <br> <br> SEC proposals address credit rating agencies, technology and small business: rule changes aim to reduce undue reliance on credit ratings.<br> <br> <p></p> SEC Update <br> <br> <p></p> During the second quarter, the Securities and Exchange Commission (SEC) proposed several rule changes to address certain issues arising from the role of credit rating agencies, especially as a result of the SEC staff's examinations conducted under the Credit Rating Agency Reform Act of 2007 (CRARA) and their focus on the subprime mortgage market. The SEC also updated its rules to reflect improvements in the use of technology to provide information on companies' Web sites. In addition, the SEC proposed rule changes and adopted a rule to assist small businesses in obtaining financing and complying with the Sarbanes-Oxley Act of 2002 ("SOX"). <p></p> Credit Rating Agencies' Practices and Disclosure to Investors <p></p> The SEC released the findings from its staff's examinations of three major credit rating agencies under the authority granted to it by CRARA. The SEC noted that the examinations uncovered significant weaknesses in ratings practices and the need for remedial action by the firms to provide meaningful ratings and the necessary levels of disclosure to investors. <p></p> The SEC's staff conducted the examinations to evaluate whether credit rating agencies were adhering to their published methodologies for determining ratings and managing conflicts of interest. The SEC staff noted that with the recent subprime market turmoil, it has been particularly interested in the rating agencies' policies and practices in rating mortgage-backed securities and the impartiality of those ratings. <p></p> The SEC staff found that rating agencies struggled with the increase in the number and complexity of subprime residential mortgage-backed securities (RMBS) and collateralized debt obligation (CDO) deals. The SEC staff stated that the examinations uncovered that none of the credit rating agencies examined had specific written comprehensive procedures for rating RMBS and CDOs. Furthermore, significant aspects of the rating process were not always disclosed or even documented by the firms, and conflicts of interest were not always managed appropriately. According to the SEC staff, the examinations found the following: <p></p> * There was a substantial increase in the number and in the complexity of RMBS and CDO deals since 2002, and some of the credit rating agencies appear to have struggled with the growth. <p></p> * Significant aspects of the ratings process were not always disclosed. <p></p> * Policies and procedures for rating RMBS and CDOs can be better documented. <p></p> * The credit rating agencies are implementing new practices with respect to the information provided to them. <p></p> * The credit rating agencies did not always document significant steps in the ratings process (including the rationale for deviations from their models and for rating committee actions and decisions), and the credit rating agencies did not always document significant participants in the ratings process. <p></p> * The surveillance processes used by the credit rating agencies appear to have been less robust than the processes used for initial ratings. <p></p> * Issues were identified in the management of conflicts of interest, and improvements can be made. <p></p> * The credit rating agencies' internal audit processes varied significantly. <p></p> The SEC noted that it proposed a comprehensive series of credit rating agency reforms to bring increased transparency to the ratings process and curb practices that contributed to recent turmoil in the credit markets. The SEC proposed rule changes to regulate the conflicts of interests, disclosures, internal policies and business practices of credit rating agencies. The SEC noted that CRARA allows it to promulgate rules regarding public disclosure, record-keeping and financial reporting and substantive requirements designed to ensure that credit rating agencies conduct their activities with integrity and impartiality. The additional proposed rules supplement initial rules implemented by the SEC under the CRARA in June 2007. <p></p> The SEC proposed rule changes to address conflicts of interest in the credit ratings industry and to require new disclosures designed to increase the transparency and accountability of credit rating agencies. Specifically, the SEC proposed to amend its Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment Company Act of 1940 ("Investment Company Act") and to amend Rule 206(3)-3T under the <span id="x_hitDiv3">Investment <span id="x_hitDiv3">Advisers Act of 1940 ("<span id="x_hitDiv4">Investment <span id="x_hitDiv4">Advisers Act") to address concerns that the reference to credit rating agency ratings in SEC rules may have contributed to an undue reliance on credit rating agency ratings by market participants. The SEC's proposed rule changes would accomplish the following: <p></p> * Prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available. <p></p> * Prohibit credit rating agencies from structuring the same products that they rate. <p></p> * Require credit rating agencies to make all of their ratings and subsequent rating actions publicly available. The SEC noted that this data would be required to be provided in a way that will facilitate comparisons of each credit rating agency's performance. The SEC noted that by making this data available, it would provide a powerful check against providing ratings that are persistently overly optimistic and further strengthen competition in the ratings industry. <p></p> * Attack the practice of buying favorable ratings by prohibiting anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it. <p></p> * Prohibit gifts from those who receive ratings to those who rate them in any amount over $25. <p></p> * Require credit rating agencies to publish performance statistics for one, three and 10 years within each rating category, in a way that facilitates comparison with their competitors in the industry. <p></p> * Require disclosure by the rating agencies of the way they rely on the due diligence of others to verify the assets underlying a structured product. <p></p> * Require disclosure of how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings. <p></p> * Require credit rating agencies to make an annual report of the number of ratings actions they took in each ratings class and require the maintenance of an Extensible Business Reporting Language (XBRL) database of all rating actions on the credit rating agency's Web site. The SEC noted that would permit easy analysis of both initial ratings and ratings change data. <p></p> * Require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The SEC noted that such disclosure would permit broad market scrutiny, as well as competitive analysis by other credit rating agencies that are not paid by the issuer to rate the product. <p></p> * Require documentation of the rationale for any significant out-of-model adjustments. <p></p> The proposed rule change would require credit rating agencies to differentiate the ratings they issue on structured products from those they issue on bonds, either through the use of different symbols, such as attaching an identifier to the rating, or by issuing a report disclosing the differences between ratings of structured products and other securities. Specifically, the proposed rule change would amend Regulation S-K and the rules and forms under the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act"). In Regulation S-K, the proposal would amend Items 10, 1100,1112 and 1114. Under the Securities Act, the proposal would amend Rules 134,138,139,168,415,436, Form S-3, Form S-4, Form F-l, Form F-3, Form F-4 and Form F-9. The SEC also proposed to amend Schedule 14A under the Exchange Act. <p></p> The proposed rule changes would also clarify for investors the limits and purposes of credit ratings and ensure that the role assigned to ratings in SEC rules is consistent with the objectives of having investors make an independent judgment of credit risks. The SEC noted that the proposed rule changes are designed to ensure that the role the SEC has assigned to ratings in its rules is consistent with the objective of having investors make an independent judgment of risks and of making it clear to investors the limits and purposes of credit ratings for structured products. Specifically, the proposed amendments are designed to address concerns that the reference to a credit rating agency's ratings in the SEC rules and forms may have contributed to an undue reliance on credit rating agencies' ratings by market participants. <p></p> The SEC noted that the proposed rule changes also address recent recommendations issued by the President's Working Group on Financial Markets (PWG), the Financial Stability Forum (FSF) and the Technical Committee of the International Organization of Securities Commissions (IOSCO). Consistent with those recommendations, the SEC stated, it considered whether the inclusion of requirements related to ratings in its rules and forms had, in effect, placed an "official seal of approval" on ratings that could adversely affect the quality of due diligence and investment analysis. The SEC stated the proposed rule changes could reduce undue reliance on credit ratings and result in improvements in the analysis that underlies investment decisions. <p></p> Use of Corporate Web Sites for Disclosures to Investors <p></p> The SEC issued an interpretative release to public companies about how to comply with the securities laws while developing their Web sites to serve as an effective means for disseminating important information to investors. The interpretative release provides information for companies considering providing investors with interactive content on their Web sites as well as summary information and links to third-party information. The interpretative release addresses a recommendation made by the SEC's Advisory Committee on Improvements to Financial Reporting that suggested the SEC should provide clarity on issues and questions that arise in connection with SEC rules against selective disclosure of material nonpublic information. The interpretative release clarifies the following: <p></p> * How information posted on a company Web site can be considered "public" and helps companies comply with public disclosure requirements under Regulation FD. <p></p> * The liability framework for certain types of electronic disclosure, including (1) how companies can provide access to historical or archived data without it being considered reissued or republished every time it is accessed; (2) how companies can link to third-party information or Web sites without having to "adopt" that content for liability purposes; and (3) the appropriate use of summary information in the context of the securities laws' antifraud provisions. <p></p> * The antifraud provisions apply to statements made by the company (or by a person acting on behalf of the company) in blogs and electronic shareholder forums, and companies cannot require investors to waive protections under the federal securities laws as a condition to enter or participate in a blog or electronic shareholder forum. <p></p> * The information posted on company Web sites would not generally be subject to rules under SOX relating to a company's "disclosure controls and procedures." <p></p> * The information need not satisfy a printer-friendly standard (unless other rules explicitly require it) that could restrict creative Web enhancements that incorporate interactive and dynamic design features. <p></p> Extension for Small Businesses from Auditor Attestation Requirement <p></p> The SEC approved a one-year extension of the compliance date for smaller public companies to meet the Section 404(b) auditor attestation requirement of SOX. The SEC noted that with the extension, smaller companies will now be required to provide the attestation reports in their annual reports for fiscal years ending on or after December 15, 2009. <p></p> The SEC also stated that it received Office of Management and Budget (OMB) approval to proceed with data collection for a study of the costs and benefits of Section 404 implementation, focusing on the consequences for smaller companies and the effects of the Section 404 auditor attestation requirements. The results of the study are expected to become available during the extension period. Section 404 has two provisions: <p></p> * Section 404(a) requires company management to assess the effectiveness of the company's internal controls over financial reporting. <p></p> * Section 404(b) requires an auditor attestation on management's assessment. <p></p> The SEC noted that larger companies, comprising more than 95 percent of the market capitalization of U.S equity securities markets, have been subject to both provisions since 2004. The SEC noted that the extension of the Section 404(b) compliance date for smaller companies is the latest in a series of SEC efforts to help reduce unnecessary compliance costs for smaller companies while preserving important investor protections. The SEC noted that in 2007, it issued new guidance for management's Section 404 assessment to help companies focus their reviews on the internal control issues that matter most to investors. Companies of all sizes, including smaller companies, filed their first 404(a) reports this year with the benefit of the new guidance. Furthermore, the SEC and the Public Company Accounting Oversight Board (PCAOB) replaced the standard for the 404(b) auditor attestation, which is intended to make the process more efficient. In 2008, larger companies filed their first Section 404(b) reports under new PCAOB Audit Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements. <p></p> Opportunities for Small Business Financing <p></p> The SEC adopted a rule amendment under the Investment Company Act to increase the availability of capital to certain smaller companies that may not have ready access to the public capital markets or other forms of conventional financing. The SEC noted that in 1980, business development companies (BDCs) were established as a type of publicly traded investment company to help make capital more readily available to small, developing and financially troubled businesses. To accomplish that purpose, the Investment Company Act generally prohibits a BDC from making any investment unless, at the time of the investment, at least 70 percent of its total assets are invested in securities of certain specific types of companies, including "eligible portfolio companies." <p></p> The Investment Company Act defines eligible portfolio company to include a domestic operating company that, among other things, does not have any class of securities that are marginable under rules issued by the Board of Governors of the Federal Reserve System (FRB). The SEC stated that in 1998, for reasons unrelated to small business capital formation, the FRB amended its margin rules to include all publicly traded equity securities and most debt securities. Those 1998 amendments had the unintended consequence of substantially reducing the number of companies that met the definition of eligible portfolio company. <p></p> The SEC noted that in 2006, it adopted rules under the Investment Company Act to address the effect of the FRB's 1998 amendments on the definition of eligible portfolio company. The SEC adopted Rule 2a-46 to include in the definition of eligible portfolio company all private companies and public companies whose securities are not listed on a national securities exchange and also adopted Rule 55a-1 to conditionally permit a BDC to include in its 70 percent basket any follow-on investments in a company that met the new definition of eligible portfolio company at the time of the BDC's initial investment in it. The SEC amended Rule 2a-46 to expand the definition of eligible portfolio company to include any domestic operating company with securities listed on a national securities exchange, if the company has a market capitalization of less than $250 million. <p></p> Adrian P. Fitzsimons is a Professor in the Department of Accounting and Taxation at St. John's University, Queens, New York. Contact him at <a href="mailto:[email protected]">[email protected]</a> <p></p> Benjamin R. Silliman is Assistant Professor at St. John's University, Queens, New York. Contact hint at <a href="mailto:[email protected]">[email protected]</a> <br> <br> November 25, 2008 <br> <br> <div> <div class="x_nshr"> <center></center> <center><a href="http://www.lexis-nexis.com/lncc/about/copyrt.html" target="_new" class="x_pagelinks">Copyright © 2008 LexisNexis, a division of Reed Elsevier Inc. 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