File No. S7-04-07 RIN 3235-AJ78

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations
 

D. Rule 17g-3 Annual Financial Reports

Section 15E(k) of the Exchange Act requires an NRSRO to furnish to the Commission, on a confidential basis³⁰⁰ and at intervals determined by the Commission, such financial statements and information concerning its financial condition as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors.³⁰¹ The statute also provides that the Commission may, by rule, require that the financial statements be certified by an independent public accountant.³⁰² Rule 17g-3 requires an NRSRO to furnish the Commission on an annual basis certain financial reports. The furnishing of these reports will serve two important functions in the NRSRO regulatory program.

First, Section 15E(d) of the Exchange Act provides that the Commission shall, by order, censure, place limitations on the activities, functions or operations of, suspend for a period not exceeding 12 months, or revoke the registration of an NRSRO if, among other things, the NRSRO fails to maintain adequate financial and managerial resources to consistently produce credit ratings with integrity.³⁰³ The financial reports will assist the Commission in monitoring the NRSROs financial resources and the resources it commits to management to evaluate whether the Commission must take action under Section 15E(d) of the Exchange Act.³⁰⁴

Second, Section 15E(b)(1) of the Exchange Act requires an NRSRO to promptly amend its application for registration, as prescribed in that section, if any information or document provided in the application becomes materially inaccurate.³⁰⁵ Form NRSRO requires the following financial information: a list of large customers in terms of net revenues; audited financial statements; information about revenues; and information about credit analyst compensation. This information is required to be as of, or for, the NRSROs previous fiscal year. Accordingly, the information only will become materially inaccurate and, therefore, be required to be updated on an annual basis. In addition, the information will be submitted with Form NRSRO on a confidential basis to the extent permitted by law³⁰⁶ and will not have to be made publicly available pursuant to Section 15E(a)(3) of the Exchange Act³⁰⁷ and Rule 17g-1(i) thereunder. Therefore, because the information only will be disclosed to the Commission, it is more appropriate to require that it be updated through the Commissions authority under Section 15E(k) of the Exchange Act and Rule 17g-3 thereunder than through annual furnishings of Form NRSRO.³⁰⁸

After consideration of the comments, Rule 17g-3 has been modified in several ways. In particular, the rule has been restructured to prescribe that the audit requirement only applies to the financial statements. The proposed schedules to the financial statements are now separate financial reports that are not required to be audited. For the reasons discussed above and below, the Commission believes Rule 17g-3, as modified, is necessary or appropriate in the public interest or for the protection of investors.³⁰⁹

1. Paragraph (a) to Rule 17g-3

As adopted, paragraph (a) of Rule 17g-3 requires an NRSRO to annually furnish the Commission four, or in some cases five, financial reports. The reports must be furnished not more than 90 days after the end of the NRSROs fiscal year and the information in the reports must be as of the most recently ended fiscal year. The reports will consist substantially of the same information that would have been in the financial statements and schedules required under Rule 17g-3, as proposed. The Commission received numerous comments requesting that the proposed schedules to the audited financial statements not be subject to the audit requirement.³¹⁰ The comments stated generally that obtaining an audit of the information in the proposed schedules would be difficult and unduly expensive. After consideration of these comments, the Commission has modified Rule 17g-3 to eliminate the requirement that the information that would have been provided in the schedules be audited. This will lessen the burden of preparing the information for submission to the Commission. Moreover, Rule 17g-3 no longer requires that this information be submitted in schedules to the NRSROs financial statements. Instead, the information must be furnished in separate financial reports. This is intended to clarify that the independent auditor that certifies the NRSROs financial statements is not required to include the other unaudited financial reports in the opinion covering the financial statements.

As noted above, Rule 17g-3 requires that the financial reports be furnished within 90 days after the end of the NRSROs fiscal year. One commenter requested that the period be lengthened to 120 days for non-resident NRSROs.³¹¹ The Commission notes that paragraph (c) of Rule 17g-3 provides a mechanism for an NRSRO to seek an extension of the time to furnish the financial reports. An NRSRO that cannot provide its financial reports within 90 days will be able to request an extension under this provision. Therefore, the Commission does not believe it is necessary to create a different standard for non-resident NRSROs, particularly since Rule 17g-3 has been modified to make the preparation of the financial reports less burdensome.

a. Paragraph (a)(1): Audited Financial Statements

The first report, required under paragraph (a)(1) of Rule 17g-3, must contain audited financial statements of the NRSRO. Rule 17g-3, as proposed, also required the submission of audited financial statements and, as noted above, certain schedules to the financial statements. The schedules are now separate financial reports that are not required to be audited. Two commenters stated that an NRSRO that is a separately identifiable department or division of a public company should be permitted to furnish audited financial statements of its parent.³¹² As noted above with respect to Exhibit 11, the Commission believes that, in this case, the financial statements of the parent provide information from which it can assess the financial resources of the NRSRO. The Commission believes, however, that certain financial information about the NRSRO must be furnished as well. For these reasons, the rule has been modified to permit an NRSRO to furnish audited consolidated financial statements of its parent; however, the NRSRO also will have to furnish unaudited consolidating financial statements under paragraph (a)(2) of Rule 17g-3 discussed below.

The audited financial statements must include a balance sheet, an income statement and statement of cash flows, and a statement of changes in ownership equity. They must be prepared in accordance with generally accepted accounting principles in the jurisdiction where the NRSRO or its parent is incorporated, organized, or has its principal office. Finally, the audited financial statements must be certified by an accountant who is qualified and independent in accordance with 17 CFR 240.210.201(a), (b), and (c)(1), (2), (3), (4), (5) and (8). In addition, the accountant must give an opinion on the financial statements in accordance with 17 CFR 210.2-02(a), (b), (c) and (d). The first financial report is how an NRSRO will update the information initially provided in Exhibit 11 of Form NRSRO.

The requirement to have the financial statements audited will provide the Commission with an independent verification that the information in them is presented fairly, in all material respects. The Commission received numerous comments on these audit requirements. Several commenters stated that non-resident NRSROs should be permitted to provide financial statements prepared in accordance with generally accepted accounting principles of the jurisdiction where the NRSRO is incorporated or has its principal place of business.³¹³ The commenters stated that preparing them according U.S. generally accepted accounting principles could be very expensive.³¹⁴ Similarly, several commenters stated that complying with certain provisions of Regulation S-X (17 CFR 210.1-01 - 12-29) would be unduly burdensome for non-resident NRSROs and non-reporting companies.³¹⁵

The Commission notes that the financial statements will be prepared to assist the Commission in carrying out its oversight responsibilities with respect to monitoring the financial resources of NRSROs and not as a disclosure item for public consumption. The Commission staff will have the opportunity to discuss the financial statements with a non-resident NRSRO to gain an understanding of any material divergences from U.S. generally accepted accounting principles. Accordingly, the Commission believes that it is appropriate to permit the financial statements to be prepared in accordance with generally accepted accounting principles in the jurisdiction where the NRSRO or its parent is incorporated, organized, or has its principal office. This will lessen the burden for non-resident NRSROs and still provide the Commission with the financial information necessary to carry out its oversight responsibilities.

For these reasons, the Commission also agrees that applying many provisions of Regulation S-X would be unnecessary and, therefore, has eliminated most of this requirement from the rule. The Commission does believe that certain provisions of Regulation S-X relating to the qualifications and independence of the auditor and the auditors attestation and the scope of the auditors opinion are appropriate for all NRSROs, including non-residents and non-public companies. Consequently, Rule 17g2, as adopted, eliminates the proposed requirement to comply with all the provisions of Regulation S-X. Instead, the rule requires the auditor to be qualified and independent in accordance with 17 CFR 240.210.2-01(a), (b), and (c)(1), (2), (3), (4), (5) and (8).³¹⁶These provisions are designed to ensure that auditors are independent of their audit clients.³¹⁷ In addition, the accountant must give an opinion on the financial statements in accordance with 17 CFR 210.2-02(a), (b), (c) and (d). The retained provisions of Regulation S-X are appropriate for any audit as they relate to general standards of competence, independence, and audit work and are not specifically designed for public companies. Accordingly, the audited financial statements in Rule 17g-3 must be prepared in accordance with them.

As noted with respect to Exhibit 11, two commenters also requested that the proposed rule be modified to permit an NRSRO to furnish a tax return prepared by an accountant in lieu of audited financial statements.³¹⁸ One of the commenters suggested that this lesser requirement only apply to smaller entities (less than $5 to $10 million in asset size) and could be augmented with a requirement to include with the tax return a balance sheet and income statement signed by an accountant.³¹⁹

As discussed with respect to Exhibit 11, the Commission does not believe a tax return will provide sufficient information. Further, the Commission notes that the financial responsibility rules for broker-dealers require audited financial statements for small broker-dealers with a minimum capital requirement of $5,000.³²⁰ The accountants performing an audit of a small NRSRO will tailor the audit and audit report to the size and complexity of the entitys business. This will keep costs for smaller NRSROs lower. This is especially true in light of the changes discussed above with respect to eliminating requirements with respect to Regulation S-X and the proposed requirement that the information proposed for the schedules be audited. Moreover, in response to the second commenter, it is unclear to the Commission in what capacity an accountant would sign financial statements short of performing an audit of them. For the purposes of Rule 17g3, the Commission believes that the only appropriate review of the financial statements is an audit by an independent accountant. The audit, as noted above, is designed to provide a reasonable level of assurance that the financial statements are free of material misstatement.

The Commission believes that the annual audit will be integral to its ability to effectively monitor the financial resources of an NRSRO as required under Section 15E(d) of the Exchange Act, since it provides an independent verification of an NRSROs financial condition. For these reasons, Rule 17g-3, as adopted, requires audited financial statements on an annual basis.³²¹

Finally, one commenter suggested that the requirement that the audited financial statements be certified by the accountant is inconsistent with accounting practice because financial statements are either audited or certified.³²² The Commission notes that the authority to require that an auditor certify the audited financial statements is set forth in Section 15E(k) of the Exchange Act.³²³ Moreover, this provision is consistent with other Commission financial reporting requirements.³²⁴Consequently, the final rule retains the provision.

b. Paragraph (a)(2): Consolidating Financial Statements

As adopted, paragraph (a)(2) of Rule 17g-3 requires an NRSRO furnishing audited consolidated financial statements of its parent to furnish a second report containing unaudited consolidating financial statements of its parent that include the NRSRO. This will provide the Commission with information about the financial condition of the NRSRO as distinct from the financial condition of its parent. One commenter requested that this information not be subject to the audit requirement if the audited consolidated statements include operating segment reporting in accordance with Regulation S-X.³²⁵ As noted above, this financial report is not required to be audited.

c. Paragraph (a)(3): Revenue Information

The third report, required under paragraph (a)(3) of Rule 17g-3, must contain the following unaudited information about the NRSROs revenues: (1) revenue from determining and maintaining credit ratings; (2) revenue from subscribers; (3) revenue from granting licenses or rights to publish credit ratings; and (4) revenue from all other services and products offered by the NRSRO. This financial report will be how an NRSRO updates the information initially provided in Exhibit 12 to Form NRSRO. This information would have been required in the first schedule to the financial statements required under Rule 17g-3, as proposed.

This information will augment the audited financial statements by providing detail as to the revenues generated specifically from credit rating services. The revenue information will assist the Commission in monitoring whether an NRSRO maintains adequate financial resources to consistently produce credit ratings with integrity.³²⁶ As discussed with respect to Exhibit 12, one commenter requested the elimination of a requirement in the proposed rule to separately report revenues from determining private credit ratings (i.e., credit ratings that are not made readily accessible to the public).³²⁷

The commenter stated that it would be difficult to separate private ratings revenue from public ratings revenue. The Commission agrees and the requirement to separately itemize private ratings revenue has been eliminated. This revenue must be included in the revenue item for determining or maintaining credit ratings.

The Commission is adopting this provision with the modifications discussed above.

d. Paragraph (a)(4): Credit Analyst Compensation

The fourth report, required under paragraph (a)(4) of Rule 17g-3, must contain the total aggregate and median annual compensation of the NRSROs credit analysts. The information in this report is not required to be audited. This financial report will be how an NRSRO updates the information initially provided in Exhibit 13 to Form NRSRO. This information would have been required in the second schedule to the financial statements required under Rule 17g-3, as proposed.

The information on analyst compensation will augment the audited financial statements by providing detail as to expenses necessary to retain the credit rating agencys credit analysts. This information collectively will assist the Commission in monitoring whether an NRSRO maintains adequate financial resources to consistently produce credit ratings with integrity.³²⁸ As discussed with respect to Exhibit 13, one commenter requested that the Commission clarify how an NRSRO should treat deferred compensation.³²⁹ The Commission believes an NRSRO should have the flexibility to include or exclude deferred compensation in making the calculation. If deferred compensation is excluded, the rule requires the NRSRO to make a note of that fact in the financial report. The Commission also believes that an NRSRO must be consistent in its approach of either including or excluding deferred compensation.

The Commission is adopting this provision with the modifications discussed above.

e. Paragraph (a)(5): List of Large Customers

The fifth report, required under paragraph (a)(5) of Rule 17g-3, must contain a list of the NRSROs 20 largest issuer and subscriber customers in terms of net revenue earned from the customers and, include in the list, any obligor or underwriter customers that are as large as or larger than the 20^th largest issuer or subscriber customer. The information in this report is not required to be audited. This financial report will be the mechanism that an NRSRO uses to update the information initially provided in Exhibit 10 to Form NRSRO. This information would have been required in the third schedule to the financial statements required under Rule 17g-3, as proposed.

The largest customers will be determined applying the same definitions of net revenues and credit rating services used for Exhibit 10, including the changes to those definitions discussed above with respect to Exhibit 10. In addition, just as with Exhibit 10, obligor and underwriter customers must be added to the list to the extent they are as large as, or larger than, the 20^th largest issuer or subscriber customer.

The list will assist the Commission in identifying conflicts arising from any influence a person may have on the NRSRO given the amount of revenue the person provides the credit rating agency.

2. Paragraph (b) of Rule 17g-3

paragraph (b) of Rule 17g-3 requires that the NRSRO attach to each financial report provided under paragraph (a) a statement by a duly authorized person of the NRSRO that the information in the report presents fairly, in all material respects and as applicable, the financial condition, results of operations, income, cash flows, revenues, and analyst compensation of the NRSRO. This information will provide a level of assurance that the information in the financial reports has been reviewed by the NRSRO. Further, the requirement parallels Commission Rule 17a-5(e)(2), which requires a duly authorized officer of a broker-dealer (or, in the case of a general partnership, the general partner) to attach an oath or affirmation stating the financial statements and schedules required under that rule are true and correct.³³⁰ This requirement was proposed in paragraph (c) of Rule 17g-3.

One commenter suggested that the Commission eliminate this requirement because it was unnecessary given the NRSROs legal exposure for furnishing an inaccurate report.³³¹ The commenter stated that the requirement could dissuade a credit rating agency from registering with the Commission. The Commission believes it is important that a person within the NRSRO be responsible for reviewing the information in the financial reports and stating that they are a fair representation of its financial condition, results of operations, income, cash flows, revenues, and analyst compensation. This provision is designed to enhance the accuracy of these reports insomuch as the individual within the NRSRO will perform some level of due diligence before executing the statements. Moreover, since only the information in the first financial report will be audited, the Commission believes a person within the NRSRO must be responsible for the information in all the reports. For these reasons, the Commission is retaining the requirement in the final rule.

3. Paragraph (c) of Rule 17g-3

paragraph (c) of Rule 17g-3 provides that the Commission may grant an extension of time or exemption from any requirements in the rule either unconditionally or on specified terms and conditions on the written request of an NRSRO, if the Commission finds that such extension or exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. This provision was proposed in paragraph (d) of Rule 17g-3. The Commission did not receive any comments on this provision and is adopting it substantially as proposed.

E. Rule 17g-4 Procedures to Prevent the Misuse of Material, Nonpublic Information

Rule 17g-4 will require an NRSRO to establish procedures to address three areas where material, nonpublic information could be inappropriately disclosed or used. Section 15E(g)(1) of the Exchange Act³³² requires an NRSRO to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information in violation of the Exchange Act.³³³ Section 15E(g)(2) of the Exchange Act provides that the Commission shall adopt rules requiring an NRSRO to establish specific policies and procedures reasonably designed to prevent the misuse of material, nonpublic information.³³⁴

1. Paragraph (a)(1) of Rule 17g-4

Paragraph (a)(1) of Rule 17g-4 requires procedures reasonably designed to prevent the inappropriate dissemination within and outside the NRSRO of material nonpublic information obtained for the purpose of developing a credit rating. Some credit rating agencies, as part of their analysis, contact senior management of the obligors and issuers subject to their credit ratings. In the course of these contacts, an issuer or obligor may provide the credit rating agency with nonpublic information including contemplated business transactions or estimated financial projections.³³⁵Credit rating agencies have commented that this confidential information greatly assists them in issuing credible and reliable ratings.³³⁶ In fact, the Commissions Regulation FD, which governs the disclosure of material, nonpublic information by issuers, contains an exception that permits issuers to intentionally disclose such information to a credit rating agency without making a simultaneous public disclosure of the information.³³⁷The selective disclosure to the credit rating agency, however, must be solely for the purpose of developing a publicly available credit rating.³³⁸

One concern that has been raised in the past is that subscribers to a credit rating agencys more detailed credit reports also may be granted direct access to the credit analysts.³³⁹ If the credit analyst is in possession of material, nonpublic information, there is a risk the information may be inappropriately disclosed to the subscriber during the course of communications with the credit analyst.³⁴⁰

The rule does not prescribe specific procedures that must be established. Therefore, NRSROs will have flexibility to develop procedures tailored to their organizational structures and business models. An NRSRO may have procedures requiring credit analysts to receive training in the laws governing the misuse of material, nonpublic information; defining the persons within the NRSRO with whom the credit analyst can share the information; prohibiting the credit analyst from disclosing the information to any other persons; and requiring the credit analyst to take steps to safeguard documents containing the information. An NRSRO that does not use management contacts as part of its methodology for determining credit ratings may prohibit credit analysts from contacting rated issuers or obligors.

The Commission received one comment on this provision.³⁴¹ The commenter stated that an NRSRO should be permitted to disclose material, nonpublic information in aggregate form (e.g., through usage in models) in a manner that does not identify individual issuers.³⁴² The Commission notes, however, that the rule, by itself, does not expressly prohibit any types of disclosures. As discussed above, Section 15E(g)(1) of the Exchange Act³⁴³ requires an NRSRO to establish, maintain, and enforce written policies and procedures to prevent the misuse of material, nonpublic information in violation of the Exchange Act and the rules thereunder.³⁴⁴ Rule 17g-4 requires an NRSRO to address the inappropriate disclosure of material, nonpublic information when establishing these procedures required by statute.

For these reasons, the Commission is adopting paragraph (a)(1) of Rule 17g-4 substantially as proposed.

2. Paragraph (a)(2) of Rule 17g-4

Paragraph (a)(2) of Rule 17g-4 requires procedures reasonably designed to prevent a person within the NRSRO from purchasing, selling, or otherwise benefiting from any transaction in securities or money market instruments when the person is aware of material, nonpublic information obtained for the purpose of developing a credit rating. This provision requires an NRSRO to address the risk that individuals in possession of material, nonpublic information about an issuer or obligor may trade securities or money market instruments on the information.³⁴⁵

As with paragraph (a), the provision does not prescribe specific procedures that must be established. An NRSRO may have policies prohibiting persons within the NRSRO from purchasing or selling a security or money market instrument that is subject to a pending credit rating action; requiring persons within the NRSRO to obtain pre-approval before purchasing or selling a security or money market instrument; or requiring persons within the NRSRO to be notified of securities or money market instruments that are on a do not trade list.

The Commission made three modifications to the provision, as proposed, to address comments. The Commission believes the commenters identified areas where the provision could cause some practical difficulties in designing procedures. The changes are designed to remove these impediments.

First, the Commission deleted a reference in the provision to members of the household of an NRSRO employee. This change was made in response to a comment that it would be difficult to design procedures addressing the trading activities of household members since a household may include persons that the employee has no influence over, such as roommates.³⁴⁶ The commenter further noted that procedures designed to prevent an employee from otherwise benefiting from the use of material non-public information would cover an employees immediate family members.³⁴⁷

Second, the Commission replaced a reference in the provision to an employee possess[ing] or having access to material, non-public information. The provision, as adopted, refers to an employee being aware of material, nonpublic information. This change was made in response to a comment that having access to material, nonpublic information could be interpreted very broadly, which would make designing procedures to address the issue difficult.³⁴⁸ The commenter also noted that Commission Rule 10b51, which concerns trading on the basis of material, nonpublic information in insider trading cases, refers to being aware of material, nonpublic information.³⁴⁹

The third modification narrowed the scope of the provision to persons within the NRSRO. As proposed, the provision would have required procedures designed to prevent persons associated with the NRSRO from trading on material, nonpublic information. A commenter stated that this made the provision overly broad since the definition of persons associated with an NRSRO in Section 3(a)(63) of the Exchange Act includes employees of affiliates engaged in activities wholly unrelated to credit rating services.³⁵⁰ Similar to Item 8 of Form NRSRO (statutory disclosures) and, as discussed next, Rule 17g-5, the Commission is narrowing the scope of this provision to persons within the NRSRO. Paragraph (b) of Rule 17g-4 defines a person within the NRSRO to mean the NRSRO, its credit rating affiliates identified on Form NRSRO, and any partner, officer, director, branch manager, and employee of the NRSRO or its credit rating affiliates (or any person occupying a similar status or performing similar functions).

Finally, a commenter stated that the provision should not apply to indirect trading in securities such as through transactions in mutual funds.³⁵¹ The Commission notes that the rule by itself does not expressly prohibit any types of transactions. As discussed above, Section 15E(g)(1) of the Exchange Act³⁵² requires an NRSRO to establish, maintain, and enforce written policies and procedures to prevent the misuse of material, nonpublic information in violation of the Exchange Act and the rules thereunder.³⁵³Rule 17g-4 requires an NRSRO to address the inappropriate use of material, nonpublic information when establishing these procedures required by statute.

For these reasons, paragraph (a)(2) of Rule 17g-4 is being adopted with the modifications described above.

3. Paragraph (a)(3) of Rule 17g-4

Paragraph (a)(3) of Rule 17g-4 requires procedures reasonably designed to prevent the inappropriate dissemination within and outside the NRSRO of a credit rating action before issuing the credit rating on the Internet or through another readily accessible means. This provision recognizes that a credit rating action of an NRSRO may be material, nonpublic information. Consequently, an NRSRO must have policies designed to ensure that its pending credit rating actions are not selectively disclosed before the credit rating is issued on the Internet or through another readily accessible means.

As with paragraphs (a)(1) and (a)(2), paragraph (a)(3) does not prescribe specific procedures. However, as applicable to the business model of the NRSRO, these policies may include procedures designed to ensure that a credit rating action is issued in a way that makes it readily accessible to the market place, such as posting the credit rating or an announcement of the credit rating action on the NRSROs Web site or through a news or information service used by market participants or by making it available to all subscribers simultaneously. The policies also may include procedures prohibiting credit analysts from selectively disclosing the pending action to persons outside the NRSRO and to persons inside the NRSRO who do not need to know of the pending action.

At the same time, some credit rating agencies, as part of their methodologies for determining credit ratings, will discuss a proposed credit rating action with the management of the issuer or obligor being rated to solicit their views or provide an opportunity to appeal the decision. NRSROs engaging in this practice must have procedures reasonably designed to ensure that the discussions with the issuer or obligor do not lead to the selective disclosure of the information to persons other than those persons within the issuer or obligor who are authorized to receive the information.

For these reasons, the Commission is adopting paragraph (a)(3) of Rule 17g-4 substantially as proposed.

4. Paragraph (b) of Rule 17g-4

As discussed above with respect to paragraph (a)(2) of Rule 17g-4, paragraph (b) of Rule 17g-4 contains the definition of a person within the NRSRO. The definition narrows the scope of the paragraph (a)(2) to persons involved in credit rating activities.

F. Proposed Rule 17g-5 Management of Conflicts of Interest

Section 15E(h)(1) of the Exchange Act requires an NRSRO to establish, maintain, and enforce policies and procedures reasonably designed, taking into consideration the nature of its business, to address and manage conflicts of interest.³⁵⁴Section 15E(h)(2) of the Exchange Act requires the Commission to adopt rules to prohibit or require the management and disclosure of conflicts of interest relating to the issuance of credit ratings.³⁵⁵ The statute also identifies certain types of conflicts relating to the issuance of credit ratings that the Commission may include in its rules.³⁵⁶ It also contains a catchall provision for any other potential conflict of interest the Commission deems is necessary or appropriate in the public interest or for the protection of investors to include in its rules.³⁵⁷ Rule 17g-5 implements these statutory provisions by prohibiting the conflicts identified in the statute and certain additional conflicts either outright or if the NRSRO has not disclosed them and established policies and procedures to manage them.

1. Paragraph (a) of Rule 17g-5

Paragraph (a) of Rule 17g-5 prohibits a person within an NRSRO from having a conflict of interest relating to the issuance of a credit rating that is identified in paragraph

(b) of the rule unless the NRSRO has disclosed the type of conflict of interest in compliance with Rule 17g-1 (i.e., in Exhibit 6 to Form NRSRO) and has implemented policies and procedures to address and manage the type of conflict of interest in accordance with Section 15E(h)(1) of the Exchange Act.³⁵⁸ Paragraph (d) of Rule 17g-5 defines a person within an NRSRO. The Commission believes that these prohibitions are appropriate in the public interest and for the protection of investors because they are designed to ensure that users of credit ratings are made aware of the potential conflicts of interest that arise from an NRSROs business activities and that an NRSRO establishes policies and procedures for managing the specific conflicts it identifies.

This provision, as proposed, would have made it unlawful for an NRSRO to have a conflict in these circumstances. As adopted, paragraph (a) prohibits an NRSRO from having the conflict. The Commission adopted this change to make the rule text more consistent with the Section 15E(h)(2) of the Exchange Act, which provides the Commission with authority to prohibit, or require the management and disclosure of conflicts of interest.³⁵⁹

For these reasons, the Commission is adopting paragraph (a) of Rule 17g-5 substantially as proposed with the modification described above.

2. Paragraph (b) of Rule 17g-5

The types of conflicts identified in paragraph (b) of Rule 17g-5 are the same conflicts listed in the instructions to Exhibit 6 of Form NRSRO.³⁶⁰ These are the types of conflicts that commonly arise from the business of providing credit rating services. Prohibiting these types of conflicts outright may adversely impact the ability of an NRSRO to operate as a credit rating agency. Nonetheless, the conflicts must be managed through policies and procedures and disclosed so that users of the credit ratings can assess whether the conflict impacts the NRSROs judgment.

Paragraph (b), as adopted, has been restructured from the proposed version of the rule. For example, certain conflicts are now identified in separate paragraphs as opposed to a single paragraph.³⁶¹ The Commissions intent is to provide greater clarity to the descriptions of the types of conflicts and, as noted above, to have them track the conflicts described in Exhibit 6 to Form NRSRO. As discussed below, the conflicts identified in paragraph (b) of Rule 17g-5 are substantially the same conflicts identified in the paragraph as proposed; though they have been refined to address comments. The one exception is the conflict identified in paragraph (b)(5) of Rule 17g-5, which as discussed below the Commission added in response to a comment identifying it as a potential conflict.

a. Paragraph (b)(1) Rule 17g-5

The conflict identified in paragraph (b)(1) of Rule 17g-5 involves being paid by an issuer or underwriter to determine credit ratings with respect to securities or money market instruments they issue or underwrite. The Commission believes the inclusion of this conflict in the rule is necessary or appropriate in the public interest or for the protection of investors. The concern is that an NRSRO may be influenced to issue a more favorable credit rating than warranted in order to obtain or retain the business of the issuer or underwriter. The Commission did not receive any comments on prohibiting this type of conflict unless it is disclosed and managed as required pursuant to Section 15E of the Exchange Act³⁶² and Rule 17g-1 and is adopting the requirement substantially as proposed.

b. Paragraph (b)(2) of Rule 17g-5

The conflict identified in paragraph (b)(2) of Rule 17g-5 involves being paid by an obligor to determine a credit rating of the obligor as an entity. This conflict is identified in Section 15E(h)(2)(A) of the Exchange Act.³⁶³ This business practice raises the same concerns as being paid by an issuer or underwriter to determine a credit rating on a security or money market instrument. The Commission did not receive any comments on prohibiting this type of conflict unless it is disclosed and managed as required pursuant to Section 15E of the Exchange Act³⁶⁴ and Rule 17g-1 and is adopting the requirement substantially as proposed.

c. Paragraph (b)(3) of Rule 17g-5

The conflict identified in paragraph (b)(3) of Rule 17g-5 involves being paid by issuers, underwriters, or obligors for ancillary services when they also have paid for a credit rating. This conflict as it relates to obligors is identified in Section 15E(h)(2)(B) of the Exchange Act.³⁶⁵ The Commission believes the inclusion of this conflict in the rule as it relates to issuers and underwriters is necessary or appropriate in the public interest or for the protection of investors. The concern with respect to all of these types of entities is that the NRSRO may issue a more favorable than warranted credit rating in order to obtain business from them for the ancillary services.³⁶⁶ The Commission did not receive any comments on the requirement that this type of conflict be prohibited unless it is disclosed and managed as required pursuant to Section 15E of the Exchange Act³⁶⁷and Rule 17g-1 and is adopting the requirement substantially as proposed.

d. Paragraph (b)(4) of Rule 17g-5

The conflict identified in paragraph (b)(4) of Rule 17g-5 involves being paid by subscribers for access to credit ratings and for other credit ratings services where such subscribers may use the credit ratings to comply with, and obtain benefits or relief under, statutes and regulations using the term nationally recognized statistical rating organization. The Commission believes the inclusion of this conflict in the rule is necessary or appropriate in the public interest or for the protection of investors. The concern is that a subscriber potentially could be subject to one or more of these statutes and regulations and, consequently, benefit depending on how the NRSRO rates the subscriber, or securities held or issued by the subscriber. A broker-dealer subscriber holding debt securities is able to apply lower haircuts when computing its net capital under Exchange Act Rule 15c3-1 if the securities are rated investment grade by two NRSROs.³⁶⁸ Broker-dealers frequently subscribe to receive credit analysis or other services from credit rating agencies.

As noted with respect to Exhibit 6 to Form NRSRO, several commenters raised a concern with the identification of this conflict because, as proposed, it could have been construed to require an NRSRO to affirmatively ascertain whether, and how, its subscribers were using its credit ratings.³⁶⁹ For this reason, the Commission has modified the description in Exhibit 6 and Rule 17g-5 to make it generally applicable to any subscriber, since any subscriber potentially could be a user of credit ratings for regulatory purposes. Consequently, an NRSRO that has subscribers will be required to make the disclosure in Exhibit 6 and have a policy and procedure to address the conflict.

The Commission notes, however, that Rule 17g-5 does not prescribe any specific policies and procedures to address conflicts of interest. The Commission does not expect that an NRSRO will be required to affirmatively ascertain whether, and how, its subscribers were using its credit ratings to manage this conflict. General policies and procedures designed to keep persons within the NRSRO who participate in the determination of credit ratings free of the undue influence of all persons who pay the NRSRO for credit rating services (e.g., issuers, underwriters, obligors, and subscribers) will be a way of addressing this conflict.

For these reasons, the Commission is adopting the requirement with the modifications discussed above.

e. Paragraph (b)(5) of Rule 17g-5

The conflict identified in paragraph (b)(5) of Rule 17g-5 involves being paid by subscribers that also may own investments or have entered into transactions that could be favorably or adversely impacted by a credit rating issued by the nationally recognized statistical rating organization. As discussed with respect to Exhibit 6, this conflict was added in response to a commenter who pointed out that subscribers who manage investment portfolios also may have interests in a particular credit rating.³⁷⁰ The Commission believes the inclusion of this conflict in the rule is necessary or appropriate in the public interest or for the protection of investors. The Commission believes the commenter identified a conflict that should be disclosed and managed because certain large investors that may derive benefits from the issuance of a particular credit rating could provide a credit rating agency with substantial revenues for credit rating services. As with potential regulatory users, the Commission does not expect that an NRSRO will be required to affirmatively ascertain how the investment portfolios of its subscribers would be impacted by a pending credit rating. General policies and procedures designed to keep persons within the NRSRO who participate in the determination of credit ratings free of the undue influence of clients will be a way of addressing this conflict.

For these reasons, the Commission is adding this conflict to the conflicts identified in paragraph (b) of Rule 17g-5.

f. Paragraph (b)(6) of Rule 17g-5

The conflict identified in paragraph (b)(6) of Rule 17g-5 involves allowing persons within the NRSRO to own directly securities or money market instruments of, or having any other direct ownership interests in, issuers or obligors subject to a credit rating determined by the NRSRO.³⁷¹ This conflict as it relates to obligors is identified in

Section 15E(h)(2)(C) of the Exchange Act.³⁷² The Commission believes the inclusion of this conflict in the rule as it relates to issuers is necessary or appropriate in the public interest or for the protection of investors. The concern is that allowing persons within the NRSRO, even if they are not directly involved in determining the credit rating, to own securities of an issuer or obligor subject to a credit rating could lead to situations where they seek to influence a credit analyst to issue a credit rating favorable to their trading position.³⁷³ For example, a manager or supervisor may be in a position to exert undue influence on a credit analyst.

The Commission, however, does not believe this conflict should be prohibited for employees that have no involvement in determining or approving the credit rating. They should be able to own securities or money market instruments of an issuer or obligor subject to a credit rating issued by the NRSRO, provided the practice is disclosed and managed.³⁷⁴ A prohibition against owning any rated securities may be a particular hardship for the employees of an NRSRO that issues credit ratings with respect to most public companies.

The Commission has modified the description of the conflict so it now involves allowing persons within the NRSRO to have these ownership interests. This is intended to clarify that the conflict does not arise only when these persons actually have such an ownership interest. This distinction is intended to simplify the rule. Specifically, as proposed, the rule could have been construed as requiring an NRSRO to affirmatively determine if, and when, an employee purchased a rated security. The rule, as adopted, only requires the NRSRO to disclose that it allows persons within the NRSRO to have these direct ownership interests in rated securities.

Finally, two commenters noted that indirect ownership of rated securities such as through mutual funds and blind trusts should not be within the scope of the provision.³⁷⁵ The Commission believes that indirect ownership of rated securities by employees does not present the same concerns as direct ownership, since an indirect ownership interest implies the investor does not have control over the decision to purchase or sell a specific security. Therefore, the provision specifically references direct ownership. The Commission also believes that an NRSRO must have flexibility to define through its policies and procedures when an ownership interest would not be direct for the purposes of this provision.

For these reasons, the Commission is adopting the requirement with the modifications described above.

g. Paragraph (b)(7) of Rule 17g-5

The conflict identified in paragraph (b)(7) of Rule 17g-5 involves allowing persons within the NRSRO to have a business relationship that is more than an ordinary course business relationship with an issuer or obligor subject to a credit rating determined by the NRSRO. This conflict as it relates to obligors is identified in Section 15E(h)(2)(C) of the Exchange Act.³⁷⁶ The Commission believes the inclusion of this conflict in the rule as it relates to issuers is necessary or appropriate in the public interest or for the protection of investors. The concern is that persons within the NRSRO having these types of business relationships may be influenced to determine a favorable credit rating for the entity based on the business relationship or exert improper influence on credit analysts to determine a favorable credit rating. The Commission believes an NRSRO should be required to disclose that it allows these types of relationships and be required to have policies and procedures to manage them. Otherwise, the conflicts should be prohibited.

The Commission notes that in the case of a credit analyst it may be difficult to remain impartial with respect to an issuer or obligor where the credit analyst has a non-ordinary course business relationship with the entity. For example, in the case where the issuer or obligor extends a loan to the credit analyst that has an interest rate far below market rates. However, the Commission believes that NRSROs should have flexibility in designing policies and procedures to address these types of conflicts, in part, because of the difficulty of defining when a business relationship creates too much potential for a loss of impartiality on behalf of the credit analyst or person within the NRSRO. Consequently, the Commission is not prohibiting these conflicts outright.

The Commission is modifying the provision to clarify that it does not apply to ordinary course business relationships such as arms length mortgage loans and bank and credit card accounts. Commenters stated that these types of business relationships do not raise conflict of interest concerns.³⁷⁷ The Commission agrees that, for example, a credit analyst likely would not be influenced to issue a favorable credit rating simply because the analyst has a bank account at the rated entity. Examples of a non-ordinary course business relationship would be an employee entering into a joint business venture with a rated obligor or, as noted above, obtaining a loan from an obligor with an interest rate far below market rates.

For these reasons, the Commission is adopting the requirement with the modifications discussed above.

h. Paragraph (b)(8) of Rule 17g-5

The conflict identified in paragraph (b)(8) of Rule 17g-5 involves having a person associated with the NRSRO that is a broker or dealer engaged in the business of underwriting securities or money market instruments. This type of conflict is identified in Section 15E(h)(2)(D) of the Exchange Act.³⁷⁸ The Commission believes the inclusion of this conflict in the rule is necessary or appropriate in the public interest or for the protection of investors. As the Commission discussed with respect to Exhibit 6 of Form NRSRO, an affiliation with a broker or dealer that is in the business of underwriting securities would raise concerns that the NRSRO might be influenced by the affiliation to issue favorable credit ratings for these securities.

This requirement was in paragraph (b)(5) of Rule 17g-5, as proposed. However, the conflict identified was broader in that it referred to having anyaffiliation withan underwriter of securities or money market instruments rated by the [NRSRO].

As discussed with respect to Exhibit 6, the Commission has narrowed the description of the conflict to address concerns that the requirement, as proposed, could have created a difficult compliance standard by requiring an NRSRO to monitor whether any person associated with the NRSRO is an underwriter as that term is defined in Section 2(a)(11) of the Securities Act of 1933.³⁷⁹

For these reasons, the Commission is adopting the requirement with the modifications discussed above.

i. Paragraph (b)(9) of Rule 17g-5

The conflict referred to in paragraph (b)(9) of Rule 17g-5 is any other type of conflict that the NRSRO identifies on Form NRSRO in compliance with Section 15E(a)(1)(B)(vi) of the Exchange Act³⁸⁰ and Rule 17g-1. The Commission believes the inclusion of this provision is necessary or appropriate in the public interest or for the protection of investors. This catchall provision will capture conflicts not specifically listed in the instructions for Exhibit 6 and Rule 17g-5 that the NRSRO has identified on Exhibit 6 to Form NRSRO as arising from its business activities.³⁸¹ The Commission did not receive any comments on the proposal that this type of conflict be prohibited unless it is disclosed and managed as required pursuant to Section 15E of the Exchange Act³⁸² and Rule 17g-1 and is adopting the requirement substantially as proposed.

3. Paragraph (c) of Rule 17g-5

Section 15E(h)(2) of the Exchange Act requires the Commission to adopt rules to prohibit or require the management and disclosure of conflicts of interest relating to the issuance of credit ratings.³⁸³ Paragraph (c) of proposed Rule 17g-5 specifically prohibits outright four types of conflicts of interest. The Commission believes prohibiting these conflicts is necessary or appropriate in the public interest or for the protection of investors. These are conflicts that are not a necessary consequence of how credit rating agencies operate. They would be difficult to manage given the risk that they could cause undue influence. Therefore, the Commission is prohibiting them; rather than requiring they be disclosed and managed. Nonetheless, the Commission intends to monitor how the prohibitions operate in practice and, if it appears a prohibition is interfering inappropriately, the Commission will re-evaluate whether it should be subject to disclosure and management (rather than prohibited).³⁸⁴

a. Paragraph (c)(1) of Rule 17g-5

As adopted, paragraph (c)(1) prohibits an NRSRO from having a conflict relating to the issuance of a credit rating where the person soliciting the credit rating was the source of 10% or more of the total net revenue of the NRSRO during the most recently ended fiscal year.³⁸⁵ Such a person will be in a position to exercise substantial influence on the NRSRO.³⁸⁶ Consequently, it will be difficult for the NRSRO to remain impartial, given the impact on the NRSROs income if the person withdrew its business. Given the Commissions understanding that fees from a single entity generally compose a very small percentage of the revenues of entities currently identified as NRSROs, the Commission believes that a 10% threshold is a reasonable threshold for registered NRSROs.³⁸⁷

Several commenters stated that this conflict should not be prohibited but rather subject to procedures to manage it.³⁸⁸ One commenter, while not requesting that the proposal be changed, noted that in an atypical circumstance such as issuing credit ratings for structured products sponsored by a large client an NRSRO may be required to request a waiver of the prohibition.³⁸⁹ Another commenter also mentioned structured product sponsors as clients that potentially could approach the 10% revenue threshold and, therefore, that exemptive relief may be appropriate in such circumstances.³⁹⁰ The Commission continues to believe that 10% of net revenues is a very high threshold. Moreover, the definition of net revenues has been narrowed to exclude revenues earned by affiliates that are not persons within the NRSRO. Therefore, the threshold will be higher than that proposed for NRSROs with affiliates engaged in activities unrelated to credit ratings. Consequently, the Commission does not believe the conflict should be subject to a requirement that it be managed (rather than prohibited).

Nonetheless, as noted above, the Commission intends to monitor how the prohibition operates in practice, particularly with respect to structured products. The intent behind all the prohibitions in paragraph (c) is not to prohibit a business practice that is a normal part of an NRSROs activities. Rather, the intent is to prohibit conflicts that are not a necessary consequence of providing credit rating services. If the prohibition in paragraph (c)(1) interferes with how NRSROs as a matter of course deal with structured product sponsors, the Commission will evaluate whether the rule should be modified to accommodate this business practice or whether as suggested by the commenter an exemption would be appropriate.

For these reasons, the Commission is adopting the prohibition substantially as proposed.

b. Paragraph (c)(2) of Rule 17g-5

As adopted, paragraph (c)(2) prohibits an NRSRO from having a conflict relating to the issuance of a credit rating with respect to a person (excluding a sovereign nation or an agency of a sovereign nation) where the nationally recognized statistical rating organization, a credit analyst who participated in determining the credit rating, or a person responsible for approving the credit rating, directly owns securities of, or has any other direct ownership interest in, the rated person. This conflict as it relates to obligors is identified in Section 15E(h)(2)(C) of the Exchange Act.³⁹¹ The Commission believes prohibiting these conflicts, including with respect to issuers, is necessary or appropriate in the public interest or for the protection of investors. An NRSRO and persons within the NRSRO that participate in the credit rating should not have a direct financial interest in the issuer or obligor subject to the credit rating. It will be difficult for these persons to remain impartial and issue an objective credit rating in this circumstance.³⁹²

As with the provision in paragraph (b)(6) of Rule 17g-5, the Commission has narrowed the scope of this provision to direct ownership interests. These persons will be permitted to have indirect ownership interests, for example, through mutual funds or blind trusts. The prohibition also excludes from its scope ownership of securities issued by a sovereign government or an agency of a sovereign government. The Commission added this exclusion in response to a comment that sovereign government and agency securities may be held as cash equivalents.³⁹³ Further, the Commission believes for many of these securities it would be difficult to influence their market price through the issuance of a credit rating. Therefore, a prohibition on a credit analyst owning securities of sovereign the analyst rates is not necessary. The Commission notes that this ownership interest is subject to the requirements of paragraphs (a) and (b)(6) of Rule 17g-5. Consequently, it will be required to be addressed in the procedures for managing the conflicts that arise from direct ownership of rated securities.

For the reasons, the Commission is adopting the prohibition with the modifications discussed above.

c. Paragraph (c)(3) of Rule 17g-5

Paragraph (c)(3) prohibits an NRSRO from having a conflict relating to the issuance of a credit rating where the rated entity is a person associated with the NRSRO (i.e., a company directly or indirectly controlling, controlled by, or under common control with, the NRSRO).³⁹⁴ This conflict as it relates to obligors is identified in Section 15E(h)(2)(C) of the Exchange Act.³⁹⁵ The Commission believes prohibiting this conflict, including with respect to issuers, is necessary or appropriate in the public interest or for the protection of investors. The Commission believes that it is appropriate to prohibit such conflicts because of the degree of difficulty the Commission foresees in maintaining an appropriate level of impartiality, when issuing a credit rating with respect to an affiliated entity.

Two commenters stated that this conflict can be managed and should not be prohibited.³⁹⁶ The Commission believes that for a credit analyst to determine a credit rating for the company where the analyst works or an affiliate of that company would place the analyst in an untenable position. Moreover, the Commission does not believe there will be a need for such a credit rating as long as other NRSROs are available to determine credit ratings for these companies. The Commission will entertain requests for exemptive relief from this prohibition where appropriate, such as if circumstances develop to a point where an NRSRO or its affiliate requires a public credit rating and cannot obtain one from another NRSRO. For these reasons, the Commission is adopting this prohibition substantially as proposed.

d. Paragraph (c)(4) of Rule 17g-5

Paragraph (c)(4) prohibits an NRSRO from having a conflict relating to the issuance of a credit rating where the credit analyst who participated in determining the credit rating, or a person responsible for approving the credit rating, also is an officer or director of the person that is the subject of the credit rating.³⁹⁷ This conflict as it relates to obligors is identified in Section 15E(h)(2)(C) of the Exchange Act.³⁹⁸ The Commission believes prohibiting this conflict, including with respect to issuers, is necessary or appropriate in the public interest or for the protection of investors. The Commission believes that an NRSRO or person associated with the NRSRO having such a position will have difficulty remaining objective in these circumstances.

The Commission did not receive any comments on this specific prohibition and is adopting it substantially as proposed.

G. Rule 17g-6 Prohibited Unfair, Coercive, or Abusive Practices

Section 15E(i)(1) of the Exchange Act³⁹⁹ provides that the Commission shall adopt rules prohibiting any act or practice by an NRSRO that the Commission determines is unfair, abusive, or coercive, including certain acts and practices set forth in paragraphs (i)(1)(A)-(C) of Section 15E of the Exchange Act.⁴⁰⁰ In explaining this statutory provision, the Senate Report stated that the Commission, as a threshold consideration, must determine that the practices subject to prohibition under this section are unfair, coercive or abusive before adopting rules prohibiting such practices.

In the proposing release, the Commission made a preliminary determination that the acts and practices described in paragraphs (i)(1)(A)-(C) of Section 15E of the Exchange Act⁴⁰¹ would be unfair, coercive, or abusive. Consequently, the Commission proposed that they be prohibited through provisions in paragraphs (a)(1) through (a)(4) of Rule 17g-6, with one conditional exception. The Commission also made a preliminary determination in the proposing release that using an unsolicited credit rating to pressure an issuer or obligor into paying for the rating or another service would be unfair, coercive, or abusive. Consequently, the Commission proposed to use its authority under Section 15E(i)(1) of the Exchange Act⁴⁰² to prohibit such act and practice through the provisions in paragraph (a)(5) of Rule 17g-6.⁴⁰³

1. Paragraph (a)(1) of Rule 17g-6

Section 15E(i)(1)(A) of the Exchange Act provides that the Commission shall prohibit the following practice if the Commission determines it is unfair, coercive, or abusive:

Conditioning or threatening to condition the issuance of a credit rating on the purchase by the obligor or an affiliate thereof of other services or products, including pre-credit rating assessment products of the nationally recognized statistical rating organization or any person associated with such nationally recognized statistical rating organization[.]⁴⁰⁴

In the proposing release, the Commission preliminarily determined that this practice would be unfair, coercive, or abusive. Consequently, the Commission proposed to prohibit it in paragraph (a)(1) of Rule 17g-6. Specifically, this paragraph, as proposed, would have prohibited an NRSRO from conditioning or threatening to condition the issuance of a credit rating on the purchase of other products or services, including pre-credit rating assessment products.⁴⁰⁵

Credit ratings play an important role in the financial markets. Market participants use them in making financial decisions on whether to buy or sell debt securities and extend credit to rated entities. Moreover, credit ratings of NRSROs are used in federal and state laws and regulations to establish limits or confer exemptions or privileges. Consequently, an entity may benefit from having an NRSRO credit rating because the credit rating makes its securities more marketable; or the credit rating qualifies the entity for an exemption or privilege or makes holding the entitys debt securities or transacting with the entity more attractive to other regulated entities. An NRSRO could abuse this incentive by using it to coerce an issuer or obligor to purchase services from the NRSRO or its affiliates.

The Commission did not receive any comments objecting to its preliminary determination that this practice would be unfair, coercive, or abusive. The Commission has determined this practice would be unfair, coercive, or abusive and, consequently, is adopting paragraph (a)(1) of Rule 17g-6 substantially as proposed in order to prohibit it.

One commenter did state that there are certain circumstances where it would not be unfair, coercive, or abusive to condition the determination of a credit rating on a security on further analysis of the issuer.⁴⁰⁶ Specifically, the commenter stated that to determine a credit rating for a subordinated debt security, a credit rating agency may be required to analyze the overall capital structure of the issuer and determine credit ratings for the issuer as an entity and for its senior debt.⁴⁰⁷ The commenter requested that the rule text in paragraph (a)(1) of proposed Rule 17g-6 be amended to clarify that this specific practice is not prohibited.⁴⁰⁸

The Commission believes that the rule text as proposed and as adopted would not prohibit this specific practice. The prohibition applies to conditioning a credit rating on the purchase of other services of the credit rating agency. In the situation described above, the requirement to analyze the capital structure of the issuer and the creditworthiness of its senior debt is part of the process of determining the credit rating on the subordinated debt. Therefore, the Commission views this as all part of one service and not three different services. For these reasons, the Commission is adopting the prohibition substantially as proposed.

2. Paragraphs (a)(2) and (a)(3) of Rule 17g-6

Section 15E(i)(1)(C) of the Exchange Act provides that the Commission shall prohibit the following practices if the Commissions determines they are unfair, coercive, or abusive:

Modifying or threatening to modify a credit rating or otherwise departing from systematic procedures and methodologies in determining credit ratings, based on whether the obligor, or an affiliate of the obligor, purchases or will purchase the credit rating or any other service or product of the nationally recognized statistical rating organization or any person associated with such organization.⁴⁰⁹

In the proposing release, the Commission preliminarily determined that these practices would be unfair, coercive, or abusive. Consequently, the Commission proposed to prohibit them through paragraphs (a)(2) and (a)(3) of proposed Rule 17g-6. The Commission did not receive any comments objecting to its preliminary determination that these practices are unfair, coercive, or abusive. The Commission has determined they are unfair, coercive, or abusive for the reasons discussed below and, consequently, is adopting paragraphs (a)(2) and (a)(3) of Rule 17g-6 substantially as proposed in order to prohibit them.

As adopted, paragraph (a)(2) prohibits an NRSRO from issuing, or offering or threatening to issue, a credit rating that is not determined in accordance with the NRSROs established procedures for determining credit ratings based on whether the rated person purchases or will purchase the credit rating or another product or service.⁴¹⁰Under this provision, an NRSRO is prohibited from issuing or threatening to issue a credit rating that is lower than would result from using its methodology for determining credit ratings based on whether the issuer or obligor pays for the credit rating or any other service or product of the NRSRO and its affiliates. The NRSRO also will be prohibited from issuing or promising to issue a higher credit rating in these circumstances.⁴¹¹

The practice prohibited in this paragraph is distinguishable from the practice prohibited in Paragraph (a)(1) of Rule 17g-6. Paragraph (a)(1) addresses the situation where an NRSRO conditions the issuance of a credit rating on the purchase of another service or product. Paragraph (a)(2) addresses the situation where an NRSRO conditions the opinion reached in the credit rating on the purchase of the credit rating or another service or product.⁴¹² Thus, unlike paragraph (a)(1), an NRSRO will violate paragraph (a)(2) if it conditions the issuance of the credit rating on the obligor or issuer paying for the credit rating. This is because the NRSRO will not be agreeing to determine a credit rating that reflected the NRSROs assessment of the creditworthiness of the issuer or obligor as determined by its methodologies. Rather, the NRSRO will be agreeing to skew the credit rating higher based on the issuer or obligor agreeing to pay for it.

Paragraph (a)(3) Rule 17g-6 prohibits an NRSRO from modifying, or offering or threatening to modify, a credit rating in a manner contrary to its procedures for modifying a credit rating based on whether the rated person, or an affiliate of the rated person, purchases or will purchase the credit rating or any other service or product of the NRSRO and its affiliates. The prohibition in paragraph (a)(2) of Rule 17g-6 applies to threats or promises with respect to the issuance of a credit rating. Paragraph (a)(3) extends this prohibition to threats or promises with respect to changing an existing credit rating.⁴¹³

The Commission believes these practices are unfair, coercive, or abusive because an entitys cost of credit and, in some cases, ability to obtain credit, generally depends on its credit rating. Entities with lower credit ratings must pay higher interest rates to borrow funds or issue debt. In some cases, a low credit rating could block an entitys access to credit. Thus, it is in a borrowers economic interest to have a high credit rating. This creates the potential for an NRSRO to have inappropriate leverage over an issuer or obligor.

An NRSRO could use this leverage to obtain business by threatening to issue or modify a credit rating in a manner that results in a lower credit rating than would have resulted from using its established methodologies. The NRSRO also could issue a lower credit rating or lower an existing rating to punish an issuer or obligor for not purchasing the credit rating or another service or product of the NRSRO and its affiliates. Conversely, the NRSRO could promise to issue or modify a credit rating in a manner that results in a higher credit rating than would have resulted from using its established methodologies as a reward for purchasing the credit rating or other services or products. Paragraphs (a)(2) and (3) of Rule 17g-6 are designed to provide a check on the potential inappropriate influence an NRSRO may have over issuers and obligors by prohibiting an NRSRO from using this leverage to coerce an issuer or obligor into purchasing a credit rating or other services and products of the NRSRO and its affiliates.

The Commission further notes that these practices could result in credit ratings that mislead the marketplace and undermine the regulatory use of NRSRO credit ratings. An NRSRO that follows through on a threat to issue a low credit rating or promise to issue a high credit rating will be issuing a credit rating that does not accurately reflect the credit rating agencys true assessment of the creditworthiness of the issuer or obligor. The credibility and reliability of an NRSRO and its credit ratings depends on the NRSRO developing and implementing sound methodologies for determining credit ratings and following those methodologies. The fact that an issuer or obligor agrees or refuses to purchase a credit rating or other service or product from the NRSRO and its affiliates should have no bearing on the NRSROs credit assessment of the issuer or obligor.⁴¹⁴For these reasons, the Commission is adopting the prohibition substantially as proposed.

3. paragraph (a)(4) of Rule 17g-6

Section 15E(i)(1)(B) of the Exchange Act provides that the Commission by rule shall prohibit any act or practice the Commission determines to be unfair, coercive, or abusive relating to:

Lowering or threatening to lower a credit rating on, or refusing to rate, securities or money market instruments issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction, unless a portion of the assets within such pool or part of such transaction, as applicable, also is rated by the nationally recognized statistical rating organization[.]⁴¹⁵In explaining this statutory provision, the Senate Report stated that there may be instances when a rating agency may refuse to rate securities or money market instruments for reasons that are not intended to be anti-competitive. The Senate Report further stated that the Commission . . . should prohibit only those ratings refusals that occur as part of unfair, coercive or abusive conduct.

a. Structured Product Credit Rating Practices

Two of the current NRSROs Fitch and DBRS believe two other NRSROs S&P and Moodys engage in anti-competitive practices in the area of determining credit ratings for structured products and, consequently, these practices should be found by the Commission to be unfair, coercive, or abusive.⁴¹⁶ These practices relate to instances where the credit rating agency has not rated particular securities that have been rated by another credit rating agency and that underlie a structured product. S&P and Moodys believe their practices are necessary to determine a credible credit rating.⁴¹⁷

The practices take several forms. The credit rating agency may, as a condition of issuing a credit rating for a structured product, require that it effectively issue a public credit rating for a fee for most, if not all, the assets underlying the structured product.⁴¹⁸The second form involves the credit rating agency insisting that it provide a private credit rating or credit assessment for a fee with respect to the unrated assets.⁴¹⁹ The third form involves the credit rating agency taking into consideration the internal credit analysis of another person (e.g., the underwriter, sponsor, or manager of the structured product) with respect to the unrated assets to determine a credit rating or private credit rating, or perform a credit assessment of the unrated assets.⁴²⁰ The fourth form involves the credit rating agency taking into consideration but not necessarily adopting the credit ratings of another credit rating agency to determine a credit rating or private credit rating, or perform a credit assessment of the unrated assets.⁴²¹ Under this last form, the credit rating agency may employ a standardized methodology to discount (notch down) the credit ratings of the other credit rating agency based on the type of security and category of credit rating.⁴²²

b. Proposed Rule 17g-6(a)(4)

In the proposing release, the Commission preliminarily determined that it would be unfair, coercive, or abusive for an NRSRO to issue or threaten to issue a lower credit rating, lower or threaten to lower an existing credit rating, refuse to issue a credit rating, or to withdraw a credit rating with respect to a structured product unless a portion of the assets underlying the structured product also are rated by the NRSRO. Consequently, the Commission proposed to prohibit these practices in paragraph (a)(4) of proposed Rule 17g-6.

The Commission also proposed an exception to the prohibition that would permit an NRSRO to refuse to issue the credit rating or withdraw the credit rating if the NRSRO has rated less than 85% of the market value of the assets underlying the structured product. This was designed to address the concern that an NRSRO when assessing the creditworthiness of the structured product would be forced to issue a credit rating either when a substantial portion of the underlying assets were not rated or when the underlying assets have been rated by another credit rating agency. If the underlying assets were unrated, the NRSRO may not have sufficient information for issuing a credit rating on the structured product. In the case where the underlying assets were rated by another credit rating agency, the other credit rating agency may have used different methodologies to assess the creditworthiness of the asset and may have determined a credit rating that is different than the credit rating the NRSRO would issue, if it had rated the asset.

c. Comments on Proposed Rule 17g-6(a)(4)

i. Support for a Prohibition

The Commission received far more comments on this provision of the proposed rules than on any other provision. Many commenters expressed strong support for the prohibition; though many of the supporters stated that the 85% exception was too high and should be lowered to at least 66%.⁴²³ These commenters generally believe the proposed rule would serve to increase competition within the credit ratings market, thus benefiting investors in structured products.⁴²⁴

For example, DBRS stated that notching has a ripple effect on competition wider than just the structured products and affects competition in the corporate bond rating market and that the practices employed by S&P and Moodys could have a profound and harmful effect on efforts to increase competition among NRSROs.⁴²⁵ Fitch stated that adoption of the proposed rule is critical to achieving the Rating Agency Acts objective of greater accountability, transparency, and competition in the credit ratings market.⁴²⁶Fitch noted that structured products increasingly are designed to hold other structured products.⁴²⁷ Fitch stated that the practices employed by S&P and Moodys have increased their market share in rating structured products,

As the structured finance market has grown exponentially in terms of both dollar value and number of market participants, it has become increasingly circular. Most notably, [structured product] issuers regularly acquire securities of other [structured product] issuers. The circularity of the market, in which large, intertwined investors are each subject to notching guidelines mandated by Moodys and S&P, has allowed Moodys and S&P to extend their partner monopoly in the traditional bond market to the increasingly prominent structured finance market. Therein lies the power of the unfair, coercive, and abusive practice of notching.⁴²⁸

Academic commenters also stated that Moodys and S&Ps practices are unfair, coercive, and abusive within the meaning of the Rating Agency Act.⁴²⁹ They stated that the securities market would benefit from increased competition in the credit rating market, and that these practices have served to hinder Fitchs ability to compete.⁴³⁰ One commenter also argued that these practices may lead to misleading credit ratings if another credit rating agencys ratings are categorically reduced without analytic support.⁴³¹

As noted above, many of the commenters that supported the prohibition stated that the 85% threshold should be lowered to 66% or less.⁴³² They based this assertion on Fitchs showing that S&P, Moodys, and Fitch each shared approximately 66% of the structured product market before S&P and Moodys began their practices in 2001.⁴³³They further stated that as a direct result of notching, S&P and Moodys have significantly increased their market share; while Fitch has lost market share.⁴³⁴

The commenters that support prohibiting the practices of S&P and Moodys believe that the remedy is to require an NRSRO to rely on the credit ratings of another NRSRO without employing any mapping methodology that would lower the credit rating.⁴³⁵ For example, Fitch argues that historical default, transition rate, and rating comparability studies indicate that the credit ratings of S&P, Moodys, and Fitch for structured products are comparable.⁴³⁶ Therefore, Fitch asserts that NRSROs should rely on the credit ratings of other NRSROs at face value.⁴³⁷ Fitch suggested that the proposed rule be modified to provide that if an NRSRO has rated 66% of the par value of an asset pool, and all assets in the pool are publicly rated by two or more NRSROs, for those assets the NRSRO has not itself rated, the NRSRO be required to use one of the two or more public ratings assigned to the underlying asset.⁴³⁸

ii. Opposition to a Prohibition

S&P, Moodys, and several other commenters (including academic commenters) strongly opposed the prohibition in paragraph (a)(4) of proposed Rule 17g-6.⁴³⁹ They cited a number of reasons, most notably that it would require one NRSRO to rely on the credit ratings of another NRSRO.⁴⁴⁰ Several commenters asserted that the proposed rule would have an anticompetitive effect.⁴⁴¹ They argued that requiring an NRSRO to adopt the credit ratings of competitors in its credit ratings analysis would reduce competition because the ability of an NRSRO to reach an independent determination of creditworthiness based on different methodologies or criteria would be impeded.⁴⁴²

These commenters state that value is brought to the market by allowing NRSROs to deliver different analytical perspectives on issuers and securities.⁴⁴³ Another commenter wrote that the proposed rule would require an NRSRO to put its own reputation at risk on behalf of the commercial interests of a competitor.⁴⁴⁴ Further, Moodys argued that differences among credit rating opinions on the same security tend to be larger than those observed when comparing only published credit ratings on jointly-rated securities, and that differences between credit rating opinions are more common and are often greater when Moodys rates securities in a category other than Aaa.⁴⁴⁵ A rule that prohibited notching would, in the view of many commenters, prohibit an agency from forming its own opinion about the risks of collateral in a structured product.⁴⁴⁶

Additionally, S&P and Moodys believe the proposed rule would unduly interfere with their methodologies for determining credit ratings, could lead to inaccurate credit ratings and credit ratings that violate securities laws, and unnecessarily raise constitutional issues.⁴⁴⁷ They argue that users of credit ratings believe ratings reflect the agencys bona fide opinion of the creditworthiness of a particular issuer, security, or transaction.⁴⁴⁸ S&P wrote that when an agency is asked to rate structured products it must understand the credit quality of all of the underlying assets.⁴⁴⁹ If an NRSRO was required to use the credit rating of another NRSRO, it would in effect lose the right to understand the credit quality of the underlying assets, and lose control over the credit rating opinions it publishes.⁴⁵⁰ Such a result, it argues, would be contrary to the legislative intent that credit ratings be independent and free from interference by third parties, including governments, issuers, investors, and competitors.⁴⁵¹ Moodys similarly argues that such a credit rating would not reflect an evaluation of the credit risk of all the assets in the pool, and therefore, negatively impact the credibility and reliability of its credit ratings and increase the risks to investors who rely on its credit ratings.⁴⁵²

S&P and Moodys argue that prohibiting their practices, in effect, would require them to rely on another NRSROs credit rating even when they believed that credit rating to be unsupportable.⁴⁵³ Further, if they were required to rely on a credit rating from another NRSRO, they argue they would be placed in a position of having to publish credit ratings that they do not believe are accurate or engage in a prohibited practice.⁴⁵⁴They state that this would create the untenable choice of taking an action that is inconsistent with general securities law principles or violating Rule 17g-6.⁴⁵⁵

S&P and Moodys state that their practices are analytically justified methods of forming an independent credit rating opinion.⁴⁵⁶ S&P asserts that it is appropriate to reserve the right to discount the credit ratings of other credit rating agencies when incorporating these credit ratings into its own analysis to account for differences in analytical and surveillance practices among credit rating agencies, preserve its ability to perform its own surveillance of the underlying assets, and account for the possibility that the assets could be down-rated by another credit rating agency without notice.⁴⁵⁷

S&P and Moodys also have disputed the assertion that there are no differences between their credit ratings and Fitchs credit ratings.⁴⁵⁸ S&P argues that historical correlations that may have existed are not a justification for adopting a rule that would require recognition of future credit ratings issued by credit rating agencies that may register as NRSROs.⁴⁵⁹ Moreover, S&P and Moodys say that their practice of mapping to other credit ratings was developed to accommodate structured product sponsors who did not want to wait or pay for credit analysis on the assets underlying a structured product that the agency had not previously rated.⁴⁶⁰ They asserted that this practice provides a quicker means to close a structured product issuance because the existing credit rating serves as a starting point in analyzing a portion of the pool of underlying assets.⁴⁶¹ Therefore, in their view, prohibiting their practices would harm users of credit ratings.⁴⁶²

S&P and Moodys also commented on how paragraph (a)(4) of proposed Rule 17g-6 should be revised. For example, Moodys commented that the 85% threshold in the proposed rule was not appropriate.⁴⁶³ It argued that credit ratings for tranches of structured products are sensitive to the accuracy of credit ratings for even small portions of the underlying asset pool. Further, S&P and Moodys argued that the 85% threshold would create an incentive for collateral managers to include the riskiest securities in the 15% unrated portion of the structured product.⁴⁶⁴ Other commenters also argued the proposed rule would undermine the markets ability to offset potential harm from credit rating shopping.⁴⁶⁵

Moodys and S&P recommended that the Commission strike paragraph (a)(4) of Proposed Rule 17g-6 in its entirety. Alternatively, Moodys commented that if paragraph (a)(4) is retained, the rule should be revised to clearly prohibit only conduct that is motivated by an unfair, coercive or abusive intent.⁴⁶⁶ Moodys suggested that the rule be amended to provide, among other things, that the prohibitions of paragraph (a)(4) shall not apply if any such action is taken in accordance with the NRSROs analytical procedures and methodologies and that the rule should not compel credit rating agencies to use or to rely upon the credit rating opinions of other persons as their own.

S&P commented that one alternative to prohibiting these practices would be a record retention regime whereby NRSROs would be required to retain records related to their decisions to treat another NRSROs credit ratings, including the NRSROs reasons for the treatment.⁴⁶⁷ S&P stated that requiring the firm to explain its reasons would guard against unfair, coercive, or abusive practices.⁴⁶⁸

In lieu of striking paragraph (a)(4) or adopting only recordkeeping requirements, S&P commented that paragraph (a)(4) should be revised to provide that in situations where it has not rated 100% of the underlying assets, an NRSRO should have three options: (i) accepting the credit ratings of others at face value; (ii) refusing to rate the transaction at all; or (iii) reviewing all the underlying assets and receiving compensation for the additional work involved.⁴⁶⁹

d. Final Rule 17g-6(a)(4)
At this time, the Commission cannot determine that the acts and practices described above are unfair, coercive, or abusive in and of themselves. The Commission needs more information about these practices to gain a better understanding of how they were developed and are being employed. The Commission is concerned, however, that these practices have adversely affected competition among credit rating agencies and that they may occur for anticompetitive purposes. Consequently, the Commission is adopting a final rule that is intended to increase accountability and transparency in the structured product credit ratings market.

First, the Commission has determined that the practices identified in Section 15E(i)(1)(B) of the Exchange Act⁴⁷⁰ are unfair, coercive, or abusive to the extent they are practiced with anticompetitive intent. Consequently, paragraph (a)(4) of Rule 17g-6 prohibits an NRSRO from issuing or threatening to issue a lower credit rating, lowering or threatening to lower an existing credit rating, refusing to issue a credit rating, or withdrawing or threatening to withdraw a credit rating, with respect to securities or money market instruments issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction, unless all or a portion of the assets within such pool or part of such transaction also are rated by the nationally recognized statistical rating organization where such practice is engaged in by the nationally recognized statistical rating organization for an anticompetitive purpose.

The Commission recognizes that proving anticompetitive intent will be difficult, particularly where an NRSRO has analysis to support the contention that its methodology is not arbitrary and is designed to make the credit rating of a structured product more accurate. Nonetheless, the Commission believes this prohibition will be an important deterrent against anticompetitive practices when combined with the enhanced recordkeeping requirements in Rule 17g-2 discussed below.

e. Enhanced Recordkeeping Requirements

As noted above, two commenters suggested that an alternative to banning the practices of S&P and Moodys would be a record retention regime whereby NRSROs would be required to retain records related to their decisions on how to treat, and methodology for treating, another NRSROs credit ratings into the credit rating of a structured product.⁴⁷¹ S&P stated that requiring an NRSRO to explain its reasons for the treatment would guard against unfair, coercive, or abusive practices.⁴⁷²

The Commission believes that recordkeeping requirements aimed at these practices are necessary or appropriate in the public interest or for the protection of investors. Consequently, the Commission is adopting three recordkeeping requirements in this area. These requirements will assist the Commission in better understanding how these practices are developed and employed. This information may provide a basis for the Commission to determine whether it should find a specific practice to be unfair, coercive, or abusive. The Commission also believes that increased scrutiny on the practices coupled with the potential for liability under Rule 17g-6 will deter an NRSRO from acting with anticompetitive intent.

i. Paragraph (a)(7) of Rule 17g-2 

As adopted, paragraph (a)(7) of Rule 17g-2 requires an NRSRO to make a record that lists each security and its corresponding credit rating issued by an asset pool or as part of any asset-backed or mortgage-backed securities transaction where the NRSRO in determining the credit rating for the security treats assets within such pool or as a part of such transaction that are not subject to a credit rating of the NRSRO by any or a combination of the practices described above and identified in paragraphs (a)(7)(i) through (iv) of Rule 17g-2.

As discussed above, there are four practices by which a credit rating agency may treat unrated assets underlying a structured product when determining a credit rating for the structured product.⁴⁷³ Moreover, the credit rating agency may condition the issuance of a credit rating for the structured product on its employing one or more of these practices. First, the credit rating agency may require that it effectively issue a public credit rating for most, if not all, the assets underlying the structured product.⁴⁷⁴ This practice is described in paragraph (a)(7)(i) of Rule 17g-2. Second, the credit rating agency may require that it provide a private credit rating or credit assessment for a fee with respect to the unrated assets.⁴⁷⁵ This practice is described in paragraph (a)(7)(ii) of Rule 17g-2.

Third, the credit rating agency may take into consideration the internal credit analysis of another person (e.g., the underwriter, sponsor, or manager of the structured product) with respect to the unrated assets to determine a credit rating or private credit rating, or perform a credit assessment of the unrated assets.⁴⁷⁶ This practice is employed after the credit rating agency has done a review of how the person performs its credit analysis, including a review of the specific procedures and methodologies employed by the person. This practice is described in paragraph (a)(7)(iii) of Rule 17g-2.

Fourth, the credit rating agency may take into consideration but not necessarily adopt the credit ratings of another credit rating agency for the unrated assets to determine a credit rating or private credit rating, or perform a credit assessment of the unrated assets.⁴⁷⁷ Under this last practice, the credit rating agency may employ a standardized methodology to discount (notch down) the credit ratings of the other credit rating agency based on the type of security and category of credit rating.⁴⁷⁸ This practice is described in paragraph (a)(7)(iv) of Rule 17g-2.

The intent of the recordkeeping provision in paragraph (a)(7) of Rule 17g-2  is to alert Commission examiners to those structured product credit ratings issued by an NRSRO that have been determined using one or more of these practices, which commenters have argued are unfair, coercive, or abusive. This will assist the examiners in requesting the records relating to these credit ratings in order to monitor these practices and get a better understanding of how they are employed. The Commission believes this provision is necessary or appropriate in the public interest or for the protection of investors because it will assist the Commission in reviewing whether these practices are being engaged in with anticompetitive intent in violation of Rule 17g6(a)(4).

For these reasons, the Commission is adopting the provision in Rule 17g-2.

ii. Paragraph (b)(8) of Rule 17g-2

As adopted, paragraph (b)(8) of Rule 17g-2 requires an NRSRO to retain internal documents that contain information, analysis, or statistics that were used to develop a procedure or methodology to treat the credit ratings of another NRSRO for the purpose of determining a credit rating of a security or money market instrument issued by an asset pool or part of any asset-backed or mortgage-backed securities transaction.

As discussed above, the commenters who opposed the prohibition in Rule 17g6(a)(4), as proposed, stated that there were legitimate reasons for using, but lowering, another credit rating agencys credit ratings or insisting on performing an independent assessment of the assets rated by another credit rating agency.⁴⁷⁹ As noted above, the Commission has insufficient information at this time to determine that such practices are a pretext for anticompetitive behavior or that such practices are appropriate. The records that an NRSRO must retain under this provision will assist the Commission in understanding whether the NRSROs that engage in these practices have analytical, statistical, or other bases to support their methodologies. The existence (or absence) and nature of such information will assist the Commission in analyzing whether the practices are employed with the intent to improve the quality and accuracy of credit ratings or as pretexts for anticompetitive behavior.

For example, the Commission understands issuers may ask for pre-credit rating assessments for a security from three or more credit rating agencies and, based on the assessments or other considerations, hire one or more, but not all, of the credit rating agencies to issue the credit rating.⁴⁸⁰ A credit rating agency that was not hired to issue a credit rating for the security may use its pre-credit rating assessment as part of an analysis of how it would rate this type of security as compared to the other credit rating agencies. This analysis may be used to develop a procedure or methodology to treat the credit ratings of the other credit rating agencies for securities underlying a structured product in developing a credit rating for the structured product.⁴⁸¹ The treatment may include a schedule in which the credit ratings of the other credit rating agencies are notched down to the extent they are included in the structured product. Under paragraph (b)(8) of Rule 17g-2, an NRSRO that uses pre-credit rating assessments to develop such a schedule will need to retain any records documenting its pre-credit rating assessments and the process by which the pre-credit rating assessments were used to arrive at the number of notches the securities will be discounted.

The Commission believes this provision is necessary or appropriate in the public interest or for the protection of investors because it will assist the Commission in reviewing whether these practices are being engaged in with anticompetitive intent in violation of Rule 17g-6(a)(4).

iii. Paragraph (b)(9) of Rule 17g-2

As adopted, paragraph (b)(9) of Rule 17g-2 requires an NRSRO to retain for each security identified in the record required under paragraph (a)(7) of Rule 17g-2, any document that contains a description of how assets within such pool or as a part of such transaction not rated by the NRSRO but rated by another NRSRO were treated for the purpose of determining the credit rating of the security.

These records will permit Commission examiners to review on a case-by-case basis the method by which an NRSRO incorporates the credit ratings of another NRSRO into the credit rating of a structured product. For example, examiners will be able to compare the methodologies for incorporating highly rated assets with those for lower rated assets. One commenter that strongly supports prohibiting these practices states that credit rating agencies engaging in these practices notch down assets they have rated in the highest credit rating categories even though studies suggest that its credit ratings perform comparably.⁴⁸²

The Commission believes this provision is necessary or appropriate in the public interest or for the protection of investors because it will assist the Commission in reviewing whether these practices are being engaged in with anticompetitive intent in violation of Rule 17g-6(a)(4).

5. Unsolicited credit ratings

In the proposing release, the Commission preliminarily determined that it would be unfair, coercive, or abusive to issue an unsolicited credit rating and communicate with the issuer or obligor to induce or attempt to induce them to pay for the credit rating or another product or service of the NRSRO or its affiliates. Consequently, paragraph (a)(5) of proposed Rule 17g-6 would have prohibited this practice.

Commenters raised a number of concerns with respect to how this prohibition would operate in practice.⁴⁸³ For the most part, they worried it was overbroad and, consequently, would prohibit legitimate business activities that are not coercive.⁴⁸⁴ As discussed with respect to Exhibit 2, issuers and obligors, for example, may consent to the issuance, and participate in the determination, of a credit rating even if they did not specifically request that the credit rating be issued. The Commission wants to gain a better understanding through its examination function of how credit rating agencies define unsolicited credit ratings and the practices they employ with respect to these ratings. The Commission believes it must gain this understanding before prohibiting any practices in this area.

For these reasons, the prohibition has been eliminated from Rule 17g-6.

V. PAPERWORK REDUCTION ACT

Certain provisions of the rules contain a collection of information within the meaning of the Paperwork Reduction Act of 1995 (PRA).⁴⁸⁵ The Commission published a notice requesting comment on the collection of information requirements in the proposing release and submitted the proposed rules to the Office of Management and Budget (OMB) for review in accordance with the PRA. The Commission will publish notice in the Federal Register when it receives clearance from OMB. The Commission did not receive any comments on the burden estimates in the proposing release.

An agency may not conduct or sponsor, and a person is not required to comply with, a collection of information unless it displays a currently valid control number. The titles for the collections of information are:

(1) Rule 17g-1, Application for registration as a nationally recognized statistical rating organization; Form NRSRO and the Instructions for Form NRSRO;

(2) Rule 17g-2, Records to be made and retained by national recognized statistical rating organizations;

(3) Rule 17g-3, Annual financial reports to be furnished by nationally recognized statistical rating organizations; and

(4) Rule 17g-4, Prevention of Misuse of Material Nonpublic Information.