Consider this another step away from the rating agencies’ ability to claim “free speech”.
On Monday, in response to certain aspects of the D0dd-Frank Act, Fitch said it would not allow debt issuers to include its ratings in prospectuses or debt registration statements.
Here’s why, according to the rating agency:
The Dodd-Frank Act repeals Rule 436(g) under the Securities Act of 1933 (the Securities Act), which relates to U.S. public offerings registered under the Securities Act. Before repeal, Rule 436(g) provided that credit ratings assigned by a Nationally Registered Statistical Rating Organization (NRSRO) are not considered a part of registration statement prepared or certified by an ‘expert’, as described within the meaning of sections 7 and 11 of the Securities Act, and the NRSRO consent would not be required to include credit ratings in Securities Act registration statements and any related prospectuses.
Historically, credit rating agencies have never been treated as experts under the Securities Act, appropriately so since ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. While Fitch continues to believe that it is not an expert under the plain meaning of sections 7 and 11 of the Securities Act, it is Fitch’s understanding that, absent clarification by the U.S. Securities and Exchange Commission (SEC), immediately after the Dodd-Frank Bill is signed into law an issuer will need to obtain Fitch’s written consent to include a Fitch credit rating in a Securities Act registration statement and any related prospectuses. If Fitch provides its consent for ratings to be included into Securities Act registration statements or prospectuses, Fitch will be potentially exposed to ‘expert’ liability under section 11 of the Securities Act, liability to which Fitch is not currently exposed. Fitch is not willing to take on such liability without a complete understanding of the ramifications of that liability to Fitch’s business and the means by which Fitch may be able to effectively mitigate the risks associated therewith.
Section 7 of the Securities Act concerns the information required in a registration statement, while section 11 deals with ‘civil liabilities on account of false registration statement’.
The latter is presumably what prompted Fitch’s move. Consider these bits of section 11 (emphasis ours):
In case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may, either at law or in equity, in any court of competent jurisdiction, sue–
- every person who signed the registration statement;
- - every person who was a director of (or person performing similar functions) or partner in the issuer at the time of the filing of the part of the registration statement with respect to which his liability is asserted;
- - every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner;
- - every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement, with respect to the statement in such registration statement, report, or valuation, which purports to have been prepared or certified by him;
Dodd-Frank introduces an additional complication with regard to RegFD, which deals with insider trading and selective disclosure.
According to Fitch:
the Dodd-Frank Act directs the SEC to remove the exemption for credit rating agencies from the SEC’s Fair Disclosure Rule (Regulation FD) within 90 days of the enactment of the Dodd-Frank Act. The exemption for credit rating agencies from Regulation FD permits issuers to provide the credit rating agencies with material non-public information without requiring public disclosure of such information. To the greatest extent possible, Fitch will work with the issuer community to put in place appropriate mechanisms so that Fitch can continue to receive confidential information as part of the rating process.
Legal types around the world, on your marks…
(H/T @_alea)
[UPDATE at 16H ET with Moody's]
Looks like Moody’s beat Fitch to this one. According to a ‘special comment’ issued by the former on Thursday July 15, Moody’s will also be declining to consent to the inclusion of its ratings in prospectuses and registration statements “without further study”.
Moody’s also cited Section 933 of the Reform Act, which includes the following language:
“… it shall be sufficient, for purposes of pleading any required state of mind in relation to such action,
that the complaint state with particularity facts giving rise to a strong inference that the credit rating
agencies knowingly or recklessly failed –
(i) to conduct a reasonable investigation of the rated security with respect to the factual elements
relied upon by its own methodology for evaluating credit risk; or
(ii) to obtain reasonable verification of such factual elements (which verification may be based on a
sampling technique that does not amount to an audit) from other sources that the credit rating
agency considered to be competent and that were independent of the issuer and underwriter.”
The rating agency said it is “exploring various ways of addressing the revised pleading standard”.
Calls to S&P for comment on the matter had not, at pixel time, been returned.
[UPDATED at 16:46 ET with S&P comment]
Standard & Poor’s issued the following to clients and investors on Friday July 16 (emphasis in the original):
Repeal Of Exception To Regulation Fair Disclosure
The NRSRO exemption from the SEC’s Reg FD has permitted issuers to share material non-public information with NRSROs without triggering broader disclosure requirements. The proposed legislation eliminates this exemption. We will engage with issuers about appropriate mechanisms so that Standard & Poor’s can continue to receive confidential information as part of the ratings process.Repeal Of Rule 436(g)
Issuers in the US at times have included the rating for a security in the related public offering registration statement. Under the SEC’s Rule 436(g), issuers have been able to include those ratings without obtaining consent from the NRSRO issuing the rating. The proposed legislation would repeal 436(g), potentially exposing NRSROs to “expert” liability if they provide consent for ratings to be included in registration statements. We will explore mechanisms outside of the registration statement to allow ratings to continue to be disseminated to the debt markets. The proposed legislation reinforces our commitment to transparency, and as always, ratings on new issues and pre-sale reports are available to all market participants at www.standardandpoors.com/newissues andwww.standardandpoors.com/presalereports.Pleading Standards
The proposed legislation changes the pleading standards for credit rating agencies. This could potentially lead to more suits as the change may permit claims of federal securities fraud to be brought against a credit rating agency that allegedly “knowingly or recklessly failed to conduct . . . a reasonable investigation . . . or to obtain reasonable verification” of the data it relies on to determine credit ratings.This pleading standard will undoubtedly be tested at some time in the future, and we will be ready to meet this new challenge. As we said, Standard & Poor’s continues to make changes in its business to improve our ratings process and control procedures.
Elimination Of Statutory References To Credit Ratings
The proposed legislation removes statutory references to credit ratings in several areas of federal law in the US. It also calls for federal agencies to review their use of credit ratings in rules and regulations. As many of you know, Standard & Poor’s broadly supports this concept. We believe that investors will continue to view credit ratings as valuable for the analytical insight and transparency they provide even if they are not referred to in the various rules, statutes, and regulations where they appear today. We will continue to increase our outreach efforts to demonstrate the benefit of ratings as a fundamental credit risk benchmark to investors.CRA Selection
Finally, the proposed legislation calls for an SEC review and report on a proposal to establish a Credit Rating Agency Board within the SEC that would choose which NRSROs are deemed to be “qualified” to issue initial ratings of structured debt and then assign an issuer’s security to such an NRSRO for an initial rating. The SEC report on the proposal is due within two years, and the proposal may become effective at that time unless the SEC determines that an alternative would better serve the public interest and protection of investors.
Related links:
Rating agencies lose free-speech claim – Reuters
Senate Approves New Curbs On Rating Agencies, Though One Provision Overlooked – HuffPo
Suddenly, the Rating Agencies Don’t Look Untouchable – NY Times
Rule 436(g): What’s Missing from Rating Agency Reform – Rortybomb