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Franken Amendment on Random Assignment of Credit Ratings May Yet Be Implemented

By Jim Hamilton

The legislation that passed the Senate on May 20, 2010 contained a provision, Sec. 939D, authored by Senator Al Franken that conducted a frontal attack on the conflict of interest problem by adding new Exchange Act Sec. 15E(w) to create an SRO overseen by the SEC that would assign credit rating agencies to provide initial ratings for asset-backed securities and structured financial products on a rotating basis. There was no comparable provision in the legislation the House passed on December 11, 2009. The House-Senate conference committee that produced the Dodd-Frank Act reached a compromise that directs the SEC to conduct a study on the feasibility of assigning a rating agency to issue ratings on structured products and, if no better method is found, implement the Sec. 15E(w) as authored by Senator Franken. (Sec. 939F of the Dodd-Frank Act).

The SEC study must determine the extent to which the creation of such a system would be viewed as the creation of moral hazard by the Federal Government, and examine any constitutional or other issues concerning the establishment of such a system. The study must also look at the range of metrics that could be used to determine the accuracy of credit ratings; and alternative means for compensating nation rating organizations that would create incentives for accurate credit ratings. The study must assess potential mechanisms for determining fees for the raters and appropriate methods for paying the fees. (Sec. 939F(b) of the Dodd-Frank Act).

Within two years of enactment, the SEC must report to Congress on the findings of the study. (Sec. 939F(c) of the Dodd-Frank Act). After submission of the report, the SEC must establish a system for the assignment of nationally recognized statistical rating organizations to determine the initial credit ratings of structured finance products in a manner that prevents the issuer, sponsor, or underwriter of the product from selecting the rating agency that will determine the initial credit ratings and monitor such credit ratings. In issuing rules, the Commission must give thorough consideration to the Franken-authored Exchange Act. Sec. 15W(e) and must implement the system set forth in Sec. 15W(e) unless the Commission decides that an alternative system would better serve the public interest and protect investors. (Sec. 939F(d) of the Dodd-Frank Act).

The Franken Amendment further attacks the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings on a rotating basis. The SEC will create a credit rating agency board, a self-regulatory organization, tasked with developing a system in which the board assigns a rating agency to provide a product?s initial rating. Requiring an initial credit rating by an agency not of the issuer?s choosing will put a check on the accuracy of ratings, in the Senator?s view. The amendment does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The amendment leaves flexibility to the Board to determine the assignment process. Thus, the new board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn?t get to choose its rating agency. Cong. Record, May 10, 2010, S3465.

Full post as published by Jim Hamilton's World of Securities Regulation on June 28, 2010 (boomark / email).