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SEC Proposes to Alter References to Credit Rating Agencies in Its Rules and Forms

The The SEC voted yesterday to issue for public comment three releases in which it proposes to change the use of credit ratings by nationally recognized statistical
rating organizations ("NRSROs") in the agency's rules and forms. The amendments are intended to address concerns that references to NRSRO ratings in the
rules and forms might have contributed to an undue reliance on NRSRO ratings by market participants. The proposals constitute the third piece of the SEC's
efforts to reform the regulation of credit rating agencies. The Commission approved the first two sets of proposals on June 11.

At yesterday's meeting, the SEC also voted to issue for comment a proposed definition of "annuity contract" and "optional annuity contract" under the 1933 Act that would clarify the status under the federal securities laws of equity-indexed annuities. The Commission approved the release of proposed changes to 1934 Act rule 15a-6 to expand the conditions under which a foreign broker-dealer could operate without triggering 1934 Act registration and reporting requirements. Finally, the SEC approved a rule amendment and the issuance of interpretive guidance to streamline the self-regulatory organization rule filing process.

In developing the credit ratings proposals, the staff of the Divisions of Trading and Markets, Corporation Finance and Investment Management reviewed all of rules and forms within their areas of expertise. In total, the three Divisions examined 44 rules and forms, and proposed changes to 38 of them. They recommended eliminating references to credit ratings in 11 rules and forms, substituting a standard based on a more clearly stated regulatory purpose or other concept in 27 rules and forms, and leaving the reference unchanged in 6 rules and forms.

Commissioner Paul Atkins supported the proposals, but said that they are likely to meet with some resistance from the public. "For three decades we have embedded credit ratings in the rule book, and they have become a crutch for market participants," he said. He agreed with Chairman Christopher Cox's view that credit ratings should not discourage investors from making an independent judgment of the risks associated with a particular security.

Division of Trading and Markets Director Erik Sirri said that he believes the proposed amendments accomplish the goal of reducing any over-reliance on NRSRO ratings by market participants. His Division presented a number of amendments, but he focused his remarks on the haircut provisions of 1934 Act rule 15c3-1. The proposed amendments would replace the current NRSRO ratings-based criterion in the securities haircut provisions with new subjective standards.

Sirri said that the new standards should continue to enable broker-dealers to make net capital computations that reflect the market risk inherent in the positioning of the securities. The Division believes that broker-dealers have the financial sophistication necessary to make the determination of whether a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk, he said.

He emphasized that one means of complying with the proposed amendments would be for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the rule. If the amendments are adopted, he said, the staff expects to take the view in the adopting release that securities rated in one of the three highest categories by at least two NRSROs would satisfy the requirements of the proposed new standard for commercial paper. Securities rated in one of the four highest rating categories by at least two NRSROs would satisfy the requirements of the proposed new standards for nonconvertible debt securities and cumulative, nonconvertible preferred stock, he added.

John White, the director of the Division of Corporation Finance, said that one key piece of his staff's proposals is changes to the Form S-3 eligibility requirements. Under existing provisions, an offering of investment grade asset-backed securities can be registered on Form S-3. The proposed amendments would replace the investment grade eligibility criteria with an alternate provision that would require that initial sales be made in minimum denomination of $250,000 and initial and subsequent sales be made to qualified institutional buyers.

In addition, the amendments would replace the Forms S-3 and F-3 eligibility criteria for a primary offering of non-convertible securities offered for cash with an alternate provision based on the debt issuer component of the definition of a "well-known seasoned issuer." Under the proposal, a primary offering of non-convertible securities for cash would be eligible for short form registration if the issuer has issued for cash more than $1 billion in non-convertible securities, other than common equity, through registered primary offerings within the prior three years.

The proposals concerning annuity contracts, the treatment of certain foreign broker-dealers and the SRO rule filing process will be discussed in greater detail in Friday's edition of SEC Today.