SEC to Offer New Rules for Raters

WASHINGTON - Securities and Exchange Commission chairman Mary Schapiro said yesterday that the SEC will propose new rules for rating agencies, stemming from a broad but "intense review" of how to restore confidence in the financial system.

Schapiro said the SEC must consider additional rules because "the status quo just isn't good enough," even though the commission last year completed a 10-month examination of the three major rating agencies and then proposed a series of rules deigned to limit conflicts of interest and boost competition among them.

"As much as we have done, there is still more to do," she said in opening remarks at a six-hour roundtable on the rating agencies the SEC oversees, which are known as Nationally Recognized Statistical Rating Organizations, or NRSROs.

"Rating agency performance in the area of mortgage-backed securities backed by residential subprime loans, and the collateralized debt obligations linked to such securities, has shaken investor confidence to its core," she added.

Speaking rhetorically, Schapiro asked if the SEC should consider rules to "better align" the raters' interests with the investors who principally rely on them. "Stated another way, does one form of rating agency business model represent a better way of managing conflicts of interest than another? Is there a way to realign incentives so that rating agencies view investors as the ultimate customer?" she said.

She also asked if the SEC should "borrow a page from the research analyst conflicts of interest settlement of several years ago and require a mechanism that provides for the issuance of multiple ratings for every security, including one generated independently?" Her remarks referenced the $1.4 billion settlement the SEC reached with 10 securities firms in 2003 over charges that many of their research analysts hyped up stocks to generate investment banking business.

Damon Silvers, associate general counsel for the AFL-CIO who testified on a panel on the barriers to entering the rating agency industry, said that idea was "something definitely worth exploring."

Meanwhile, Schapiro asked if some securities products are so inherently complicated or risky that ratings are, "at best, meaningless, or even worse, misleading."

"In other words, is everything really ratable?" she asked an initial panel comprised of NRSRO officials.

Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pa., said there is "no question" that a number of structured finance products shouldn't have been rated or even issued, and compared NRSROs to "meat inspectors" to highlight their failures to accurately rate mortgage-backed structured products that helped fuel the financial crisis.

"If there's garbage coming down the pike, the rating agencies should identify which of these things are tainted meat because the public can't understand it," he said. "Intellectually, there's no reason why CDOs or CDOs of CDOs should be out there."

SEC commissioner Kathleen Casey asked what time frame is appropriate to determine if the commission is achieving its goals to promote accuracy and accountability in ratings issued by NRSROs.

James Gellert of Rapid Ratings International, answered by asking how many NRSRO applications are before the commission.

"A year from now there were none, and I imagine there aren't a lot now," he said, noting that of the 10 NRSROs, just three have been approved by the commission and seven were "grandfathered" under the law giving the SEC more oversight. To reduce barriers to becoming a NRSRO, Gellert stressed that the commission ought to remove a requirement that a rating agency first be in business for three years, among other things.

In prepared testimony, Investment Company Institute president Paul Schott Stevens, who participated in a panel on users' perspectives, urged the SEC to increase the disclosure of ratings on municipal securities. But Stevens said that legislation would be needed to "truly improve disclosure in the municipal securities market" and to "improve the content and timing of required disclosures," specifically by repealing the 1975 Tower Amendment that restricts the SEC or the Municipal Securities Rulemaking Board from directly indirectly regulating issuer disclosures prior to when bonds are sold.

"As we have stated numerous times, because of these restrictions, the disclosure regime for municipal securities is woefully inadequate, and the regulatory framework is insufficient for investors in today's complex marketplace," he said. "The disclosure is limited, non-standardized, and often stale, and the disparities from the corporate issuer disclosure regime are numerous."

Of the numerous ideas floated to alter the way the rating agencies rate securities, one that may have a welcome impact in the municipal market - at least for many issuers that have pushed for their debt to be rated on the same scale as corporate securities and based on the probably of default alone - came from Frank Partnoy, a professor of law and finance at the University of San Diego Law School.

Partnoy suggested that one way to achieve both a "public good" and to help retail investors would be to transition from the existing use of "shorthand" letters to a simple statement on the probability of default and the likelihood of recovery after a default.

The SEC roundtable comes as Sen. Jack Reed, D-R.I., who sits on the Senate Banking Committee, has drafted legislation that would, among other things, make it easier for investors to sue the rating agencies for inaccurate ratings, according to market participants who have seen a draft bill. Currently, investors who sue rating agencies for inaccurate ratings must prove "scienter," essentially intentional wrongdoing, which is difficult to prove.

Though the legislation appears to mark the palpable frustration with the rating agencies on Capitol Hill, congressional sources said that lawmakers hope to give the SEC time to draft additional rules for NRSROs, and note that the SEC was given authority to regulate only two years ago.

Though the ratings of municipal securities were not the topic of any of the roundtable discussions, the MSRB issued a statement applauding the SEC for reviewing rating agency regulation and urged it to consider increasing accessibility to all credit ratings for municipal bonds.

The board also reiterated guidance from a 2008 notice that stated that if an underwriter suspects the bond insurer wrapping a muni transaction may be downgraded or that the issuer's underlying rating might be material or key information for investors, then the dealer is obligated under the MSRB's Rule G-17 on fair dealing to disclose that rating to investors.

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