August 24 2010
The Dodd-Frank Wall Street Reform and Consumer Protection Act(1) has repealed Rule 436(g) promulgated under the Securities Act of 1933, as amended, thereby eliminating the exemption from the expert consent and liability provisions under the Securities Act for any credit ratings issued by a "nationally recognized statistical rating organization". As a result, bond issuers that wish to include – or, in the case of issuers of publicly registered asset-backed securities (ABS), that are required to include – ratings information in registration statements or prospectuses (either expressly or by incorporating disclosure in the issuer's annual report on Form 10-K or quarterly Report on Form 10-Q) will be required to obtain the consent of those rating agencies. Thus far, the four largest rating agencies have publicly stated that they will not provide such consent.(2) The Dodd-Frank Act also eliminates the provision of Regulation FD which protected communications between issuers and rating agencies from the disclosure requirements of Regulation FD.(3) These changes will affect registered offerings of debt securities, as well as how issuers interact with rating agencies going forward.
Former Rule 436(g) promulgated under the Securities Act provided that a credit rating assigned to a class of debt securities, convertible debt securities or preferred stock by an nationally recognised statistical rating organisation would not be considered "part of a registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the [Securities] Act".(4) Section 7 provides that when certain experts are named as having prepared or certified "any part" of the registration statement, the registrant must file the written consent of such person with the registration statement. Section 11 imposes civil liability on specified classes of person in the event that any part of the registration statement contains an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading.(5) The effect of former Rule 436(g) was to exclude from both Section 7 and the liability provisions of Section 11 any ratings information provided by nationally recognised statistical rating organisations included in the registration statement.(6) From a practical standpoint, this meant that issuers could include – and often did include – ratings information in their prospectuses and public reports without obtaining (and filing) the rating agencies' consents.
Before the enactment of Rule 436(g) in 1982, on a number of occasions the Securities Exchange Commission (SEC) considered how to deal with rating agencies and ratings information, from both a liability and a disclosure perspective.(7) The SEC has always permitted ratings disclosure, but has never required it (except in the case of issuers of publicly registered ABS).(8) The discussion of the appropriateness of imposing Section 11 liability on nationally recognised statistical rating organisations was tabled until 1994, when the SEC again issued a concept release discussing, among other things, whether Rule 436(g) was appropriate.(9) The most recent discussion of the possibility of repealing Rule 436(g) was described in the SEC 2009 Concept Release.
Section 939(g) of the Dodd-Frank Act rescinded Rule 436(g). This section of the act is self-implementing and is now fully effective. There are several ramifications to this repeal that are important for industry participants and practitioners.
The practical result of the repeal of Rule 436(g) is that non-ABS issuers that elect to include credit ratings issued by a rating agency (whether or not a nationally recognised statistical rating organisation) in its registration statement or prospectus must first obtain and file the consent of the rating agencies whose ratings are included. The four largest rating agencies have already indicated that they will not provide consent (for now, at least).(10) As a result, issuers and underwriters are now precluded from engaging in the historic market practice of including ratings in registration statements or prospectuses. The inclusion of ratings information in pricing term sheets or free writing prospectuses is still permitted by the SEC.(11) It has also been common practice for investment grade issuers to include ratings information in their annual reports on Form 10-K or quarterly reports on Form 10-Q. Without guidance from the SEC, the repeal of Rule 436(g) may have been interpreted to require an issuer that included ratings information in its periodic reports to remove the otherwise incorporated ratings information in order to avoid having to obtain a rating agency's consent.
In response to these and other uncertainties related to the effect of the Dodd-Frank Act's repeal of Section 436(g), the SEC staff issued new compliance and disclosure interpretations on July 22 2010 relating to the need to obtain rating agency consent for issuers of corporate debt securities.
For registration statements declared effective on or before July 22 2010 that include more than "issuer disclosure-related ratings information",(12) the SEC would not require consent of the rating agencies until the next post-effective amendment to or supplement of such registration statement(13) (eg, the issuer's next Form 10-K filing) provided that no subsequently filed periodic report that is incorporated by reference into a registration statement includes more than "issuer disclosure-related ratings information". As such, no amendments to already filed periodic reports are necessary.
For registration statements declared effective after July 22 2010 that include more than "issuer disclosure-related ratings information", consent will be required.
The repeal of Rule 436(g) had immediate consequences for ABS issuers.(14) This resulted from the intersection between the repeal of Rule 436(g) and existing disclosure requirements for public issuances of ABS set forth in Regulation AB.(15) Regulation AB currently requires an issuer of publicly registered ABS to disclose in its registration statement the minimum credit rating that must be assigned to such ABS, as well as the identity of each rating agency providing such rating to the extent that the issuance or sale of any such class of ABS being offered is conditioned on the assignment of such minimum credit rating.(16) Given the repeal of Rule 436(g) and the statement by a majority of the rating agencies that they would not be providing consent to the inclusion of ratings information in registration statements, ABS issuers found themselves in the unfortunate situation where, directly as a result of the repeal of Rule 436(g), they were unable to bring publicly registered ABS deals to market.(17) The SEC acted swiftly through the issuance of a no-action letter which allowed issuers of publicly registered ABS to omit credit ratings from registration statements filed under Regulation AB.(18) The SEC noted that this relief, which extends until January 24 2011, is to "facilitate a transition for asset backed issuers" following the repeal of Rule 436(g). In a recent statement, the American Securitisation Forum noted its current understanding that Congress intends to work on a "correction bill" to address the issues raised by the repeal of Rule 436(g) for ABS issuers subject to Regulation AB.(19)
Regulation FD governs the selective disclosure of material non-public information by issuers with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended, or that are required to file reports under Section 15(d) of that act.(20) Regulation FD requires that unless an exemption applies, an issuer must publicly disclose any such information selectively disclosed to any person described in the rule. Rule 100(b)(2)(iii) currently provides an exemption for information delivered to an entity whose "primary business is the issuance of credit ratings, provided that the information is disclosed solely for the purpose of developing a credit rating and the entity's ratings are publicly available". Section 939B of the Dodd-Frank Act requires the SEC, within 90 days of the enactment of the act, to revise Regulation FD to delete Rule 100(b)(2)(iii). It is unlikely that the deletion of this exemption will have any practical impact on an issuer's ability to share information with rating agencies during the process of obtaining a credit rating for two reasons.
First, a rating agency is not the type of "person" to which disclosure is prohibited under Regulation FD. Rule 100 of Regulation FD provides that disclosure to the following persons is covered by the rule:
"any person outside the issuer: (i) who is a broker or a dealer, or a person associated with a broker or a dealer, as those terms are defined in Section 3(a) of the Securities Exchange Act of 1934; (ii) who is (A) an investment adviser, as that term is defined in Section 202(a)(11) of the Investment Advisers Act of 1940; (B) an insti-tutional investment manager... (C) a person associated with either of the foregoing;... (iii) who is an investment company...; or (iv) who is a holder of the issuer's securities, under circumstances under which it is reasonably foreseeable that the person will purchase or sell the issuer's securities on the basis of the information."
Historically, it was thought that a rating agency was an 'investment adviser' and, as such, disclosure to a rating agency would be covered by the ambit of the rule. This is no longer the case,(21) and therefore a rating agency will not fall within the type of person to which disclosure is prohibited.
Second, if the rating agencies agree (in a confidentiality agreement or a confidentiality section of the engagement letter) to maintain the disclosed information in confidence, the communication would likely fall within the ambit of Rule 100(b)(2)(ii).(22) It is expected that the rating agencies will work with issuers to create some form of confidentiality arrangement going forward.(23)
(1) The Dodd-Frank Act was enacted on July 21 2010. Section 939(g) of the act provides that "Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force and effect".
(2) Letter from Devin Sharma, president of Standard & Poor's, July 16 2010; Moody's Investors Service Special Comment, "Moody's to Begin Implementing Changes Relating to US Regulatory Reform Act", July 15 2010; "Fitch Releases Market Letter with Perspectives on Implementing Dodd-Frank Act", July 23 2010; "DBRS Comments on US Financial Reform Legislation", July 20 2010.
"Notwithstanding the provisions of paragraph (a) and (b) of this section, the security rating assigned to a class of debt securities, a class of convertible debt securities or a class of preferred stock by a nationally recognized statistical rating organization, . . . , shall not be considered part of a registration statement prepared or certified by a person within the meaning of Sections 7 and 11 of the Act."
(5) Liability under Section 11 extends to the issuer, officers and directors who sign the registration statement, underwriters and persons who prepare or certify any part of the registration statement or who are named as having prepared or certified a report or valuation for use in connection with the registration statement. If a rating agency is deemed to be an expert under Section 7, it would fall within the liability scheme for experts set forth in Section 11.
(6) One troubling effect of this rule was to create a dichotomy between a nationally recognised statistical rating organisation and a credit rating agency that was not a nationally recognised statistical rating organisation. See the Concept Release on Possible Rescission of Rule 436(g) Under the Securities Act of 1933, Release 33-9071 (October 7 2009), in which the SEC noted that:
"[b]y virtue of Rule 436(g), an NRSRO is not subject to liability under Section 11 even if its rating is disclosed in a registration statement... By contrast, if a credit rating assigned by a credit rating agency that is not an NRSRO is disclosed in a registration statement, the credit rating agency would be subject to potential liability under Section 11. The registrant is required to file the credit rating agency's consent with its registration statement, and the experts' defense may be available."
(7) In the 2009 concept release, in which the SEC sought comment as to whether Rule 436(g) should be repealed, the SEC discussed previous concept releases issued in both 1977 and 1981 which sought comment on, among other things, whether a nationally recognised statistical rating organisation is the type of person from which consent should be required under Section 7 of the Securities Act, which would in turn subject the nationally recognised statistical rating organisation to liability under Section 11 of the Securities Act. See Disclosure of Security Ratings, Release 33-5882 (November 9 1977) and Disclosure of Ratings in Registration Statements, Release 33-6336 (August 6 1981). Comments received from industry participants and the legal community in response to these concept releases posited various reasons why imposing Section 11 liability on a nationally recognised statistical rating organisation was not appropriate, including, among other reasons, that it would "interfere with the substance and timing of the registration process,... result in changes to the way credit ratings were issued, and... result in increased costs and uncertainty over the scope of liability".
In addition, similar to what is occurring today, at the time, the nationally recognised statistical rating organisations indicated that they would not consent to the inclusion of ratings information in registration statements. When Rule 436(g) was adopted in 1982, the SEC claimed that exempting nationally recognised statistical rating organisations from liability under the Securities Act was appropriate given the difficulty in obtaining consents from the rating agencies and the protection that investors received from the fact that nationally recognised statistical rating organisations were still subject to the anti-fraud provisions of the Securities Act. See Adoption of Integrated Disclosure System, Release 33-6383 (March 3 1982). The basis for that belief was that at the time, rating agencies generally were required to register as investment advisers and, as such, were subject to the anti-fraud rules under Section 10(b) of the federal securities laws. Following the passage of the Credit Rating Reform Act of 2006, nationally recognised statistical rating organisations are now excluded from having to register as an investment adviser. See Credit Rating Reform Act in 2006, Pub L 1032-291, 120 stat 1327 (September 29 2006).
(8) See Items 1103(a)(9) and 1120 of Regulation AB, which require that an issuer must indicate whether "the issuance or sale of any class of offered securities is conditioned on the assignment of a rating" and if so to "identify each rating agency and the minimum rating that must be assigned".
(9) See Disclosure of Security Ratings, Release 33-7086 (August 31 1994). Many commentators again expressed their opinion that imposing Section 11 liability on nationally recognised statistical rating organisations was not appropriate. For example, Moody's Investors Service argued in a comment letter that:
"ratings published by [nationally recognised statistical rating organisations] are expressions of opinion about risk, not state-ments, and even if the security defaults in an individual case, it would not necessarily be an indication that the opinion was wrong."
(11) A 'prospectus' is defined for the purposes of the Securities Act in Rule 405 as a "prospectus meeting the requirements of Section 10(a) of the [Securities] Act". This would include typical 424(b) prospectuses and prospectus supplements filed in connection with specific offerings. See Compliance and Disclosure Interpretation, Question 233.06. A 'free writing prospectus' is defined in Section 405 of the Securities Act as a "written communication... [that] is made by means other than a prospectus satisfying the requirements of Section 10(a) of the [Securities] Act". Additionally, the SEC has stated that a free writing prospectus is not considered "part of the registration statement" and instead relates to a registered offering that is the subject of a registration statement. See Securities Act Reform, Release 33-8591 (July 19 2005). Therefore, a free writing prospectus is neither a prospectus nor part of a registration statement within the meaning of Section 7 or 11 of the Securities Act. This analysis would also permit the issuer to avoid having to file the consent of the rating agencies and still comply with the requirements of the particular form the issuer is using to register its securities. If the free writing prospectus is not part of the registration statement by definition, the inclusion of ratings information in such a communication would not implicate the form requirements contained in the Securities Act.
(12) 'Issuer disclosure-related ratings information' includes information relating only to "changes to a credit rating, the liquidity of the registrant, the cost of funds for a registrant or the terms of agreements that refer to credit ratings", such as discussion of ratings-based coupon adjustments. See Compliance and Disclosure Interpretation, Question 233.04.
(13) See Rule 401(a) promulgated under the Securities Act which provides that "the form and contents of a registration statement... shall conform to the applicable rules and forms as in effect on the initial filing date of such registration statement". The SEC determined that an issuer will not be required to modify existing registration statements because at the time the registration statement went 'effective', the issuer was complying with the requirements of the applicable form (ie, did not include the rating agency's consent).
(14) Less than 48 hours after the Dodd-Frank Act was signed into law, reports surfaced that Ford Motor Credit (and at least one other asset-backed issuer) had scuttled plans to launch contemplated offerings of ABS. "Bond Sale? Don't Quote Us, Request Credit Firms", Wall Street Journal, July 21 2010.
(17) Leading industry advocate groups, including the American Securitisation Forum and the Securities Industry and Financial Markets Association, immediately issued statements expressing their concern over a regulation that had the impact of stalling (rather than bolstering) the ABS market. Letter of American Securitisation Forum to the SEC titled "Need for Immediate SEC Action with respect to Repeal of Rule 436(g)", dated July 22 2010; Securities Industry and Financial Markets Association press release titled "SIFMA Deeply Concerned About Public ABS Markets", dated July 21 2010.
(23) One issue to consider is the interplay between Regulation FD and amended Rule 17g-5 promulgated under the Exchange Act. Amended Rule 17g-5 generally provides that if a nationally recognised statistical rating organisation is paid by an issuer, sponsor or underwriter (each, an 'arranger') to assign a credit rating to ABS, the nationally recognised statistical rating organisation must obtain representations from such arranger to (i) maintain a password-protected website on which all information that was provided to the nationally recognised statistical rating organisation for purposes of determining and undertaking surveillance on the credit rating on such ABS is posted, and (ii) provide access to such website to other nationally recognised statistical rating organisations not engaged to provide ratings on such ABS. To the extent that an ABS issuer is required under amended Rule 17g-5 to post information the dissemination of which would be subject to Regulation FD, such ABS issuer will need to consider whether the mechanisms put into place to maintain the confidentiality of information posted to such websites are sufficient to satisfy the requirements of Regulation FD.
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