[Federal Register: June 25, 2008 (Volume 73, Number 123)]
[Proposed Rules]
[Page 36211-36252]
[DOCID:fr25jn08-46]

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Part III

Securities and Exchange Commission

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17 CFR Parts 240 and 249b

Proposed Rules for Nationally Recognized Statistical Rating
Organizations; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 249b

[Release No. 34-57967; File No. S7-13-08]
RIN 3235-AK14

Proposed Rules for Nationally Recognized Statistical Rating
Organizations

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Proposed rule.

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SUMMARY: In the first of three related actions the Commission is
proposing rule amendments that would impose additional requirements on
nationally recognized statistical rating organizations (``NRSROs'') in
order to address concerns about the integrity of their credit rating
procedures and methodologies in the light of the role they played in
determining credit ratings for securities collateralized by or linked
to subprime residential mortgages. Second, the Commission also makes a
proposal related to structured finance products rating symbology. And
third, in the near future, the Commission intends to propose rule
amendments that would be intended to reduce undue reliance in the
Commission's rules on NRSRO ratings.

DATES: Comments should be received on or before July 25, 2008.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-13-08 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-13-08. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at<PHONE_NUMBER>; Thomas K. McGowan, Assistant Director, at
(202) 551-5521; Randall W. Roy, Branch Chief, at<PHONE_NUMBER>; Joseph
I. Levinson, Attorney, at<PHONE_NUMBER>; Carrie A. O'Brien, Attorney,
at<PHONE_NUMBER>; Sheila D. Swartz, Special Counsel, at (202) 551-
5545; Rose Russo Wells, Special Counsel, at<PHONE_NUMBER>; Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-6628 or, with respect to questions involving
the proposed amendments as they implicate the Securities Act of 1933,
Kathy Hsu, Special Counsel, at<PHONE_NUMBER> or Eduardo Aleman,
Special Counsel, at<PHONE_NUMBER>; Division of Corporation Finance,
Securities and Exchange Commission, 100 F Street, NE, Washington, DC
20549-3628.

SUPPLEMENTARY INFORMATION:

I. Background

A. Introduction

    Beginning in the early 2000s, originators started to increasingly
make residential mortgage loans based on lower underwriting standards
(``subprime loans'').\1\ For the first few years there did not appear
to be any negative repercussions from this lending practice. However,
beginning in mid-2006, home values leveled off and soon began to
decline, which, in turn, led to a corresponding increase in
delinquencies and, ultimately, defaults in subprime loans.\2\ This
marked increase in subprime loan delinquencies and, ultimately, in
defaults has had substantial adverse effects on the markets for, and
market values and liquidity of, residential mortgage-backed securities
(``RMBS'') backed by subprime loans and on collateralized debt
obligations (``CDOs'') linked to such loans (collectively ``subprime
RMBS and CDOs'').\3\
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    \1\ There is no standard definition of a subprime loan. However,
such a loan can broadly be described as a mortgage loan that does
not conform to the underwriting standards required for sale to the
government sponsored enterprises (non-conforming loans) and are made
to borrowers who: (1) Have weakened credit histories such as payment
delinquencies, charge-offs, judgments, and bankruptcies; (2) have
reduced repayment capacity as measured by credit scores (e.g.,
FICO), debt-to-income ratios, loan-to-value rations, or other
criteria; (3) have not provided documentation to verify all or some
of the information, particularly financial information, in their
loan applications; or (4) have any combination of these factors.
Non-conforming loans made to less risky borrowers fall into two
other classifications: jumbo and Alt-A.
    \2\ See e.g., Testimony of John C. Dugan, Comptroller of the
Currency, before the U.S. Senate Committee on Banking, Housing, and
Urban Affairs (March 4, 2008) (``Dugan March 4, 2008 Senate
Testimony''), pp. 8-12; Statement of Sheila C. Bair, Chairman,
Federal Deposit Insurance Corporation, before U.S. Senate Committee
on Banking, Housing, and Urban Affairs (March 4, 2008) (``Bair March
4, 2008 Senate Statement''), pp. 5-6.
    \3\ See e.g., Dugan March 4, 2008 Senate Testimony, pp. 12-14;
Bair March 4, 2008 Senate Statement, pp. 6-7.
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    Moreover, the impacts from the troubles experienced by subprime
loans extended beyond subprime RMBS and CDOs to the broader credit
markets and the economy as a whole.\4\ As a result, the parties that
participated in various parts of the process of making subprime loans,
packaging them into subprime RMBS and CDOs, and selling these debt
instruments, including mortgage brokers, loan originators, securities
sponsors and underwriters, and NRSROs have come under intense scrutiny.
Today, the Commission is proposing a series of new requirements that
are designed to address concerns that have been raised about NRSROs in
light of the role they played in this process. Additionally, two weeks
from today, the Commission will complete its proposal of this series of
rule changes. These changes would be intended to reduce undue reliance
in the Commission's rules on NRSRO ratings, thereby promoting increased
investor due diligence.
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    \4\ See e.g., Statement of Ben S. Bernanke, Chairman, Board of
Governors of the Federal Reserve System, before the U.S. Senate
Committee on Banking, Housing, and Urban Affairs (February 28, 2008)
(``Bernanke February 28, 2008 Senate Statement''), pp. 1-3; Dugan
March 4, 2008 Senate Testimony, pp. 12-15.
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B. The Credit Rating Agency Reform Act of 2006

    The purpose of the Credit Rating Agency Reform Act of 2006 (the
``Rating Agency Act''), enacted on September 29, 2006, is to ``improve
ratings quality for the protection of investors and in the public
interest by fostering accountability, transparency, and competition in
the credit rating industry.'' \5\ The operative provisions of the
Rating Agency Act became applicable upon the Commission's

adoption in June 2007 of a series of rules implementing a registration
and oversight program for credit rating agencies that register as
NRSROs.\6\
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    \5\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs to Accompany S. 3850, Credit Rating Agency Reform Act
of 2006, S. Report No. 109-326, 109th Cong., 2d Sess. (Sept. 6,
2006) (``Senate Report''), p. 1.
    \6\ See Oversight of Credit Rating Agencies Registered as
Nationally Recognized Statistical Rating Organizations, Securities
Exchange Act of 1934 (``Exchange Act'') Release No. 55857 (June 5,
2007), 72 FR 33564 (June 18, 2007) (``Adopting Release''). The rules
adopted by the Commission prescribe: how a credit rating agency must
apply to the Commission for registration as an NRSRO (Rule 17g-1 (17
CFR 240.17g-1)); the form of the application and the information
that must be provided in the application (Form NRSRO and the
Instructions to Form NRSRO (17 CFR 240.249b.300)); the records an
NRSRO must make and maintain (Rule 17g-2 (17 CFR 240.17g-2)); the
reports an NRSRO must furnish to the Commission annually (Rule 17g-3
(17 CFR 240.17g-3)); the areas that must be addressed in an NRSRO's
procedures to prevent the misuse of material nonpublic information
(Rule 17g-4 (17 CFR 240.17g-4)); the types of conflicts of interest
an NRSRO must disclose and manage or is prohibited from having (Rule
17g-5 (17 CFR 240.17g-5)); and certain unfair, coercive, or abusive
practices an NRSRO is prohibited from engaging in (Rule 17g-6 (17
CFR 240.17g-6)).
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    To date, a total of nine credit rating agencies have been granted
registration with the Commission as NRSROs pursuant to the Rating
Agency Act and the rules thereunder.\7\ These registrants include the
credit rating agencies most active in rating subprime RMBS and CDOs:
Fitch Ratings, Inc. (``Fitch''), Moody's Investors Service
(``Moody's''), and Standard and Poor's Rating Services (``S&P'').\8\ In
the fall of 2007, the Commission, exercising the new authority
conferred by the Rating Agency Act, began a staff examination of the
NRSROs' activities in rating subprime RMBS and CDOs in order to review
whether they adhered to their stated and documented procedures and
methodologies for rating these debt instruments and the extent, if any,
to which their ratings may have been impaired by conflicts of
interest.\9\
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    \7\ See Commission Orders granting registration of A.M. Best
Company, Inc. (34-56507, September 24, 2007), DBRS Ltd. (34-56508,
September 24, 2007), Fitch, Inc. (34-56509, September 24, 2007),
Japan Credit Rating Agency, Ltd, (34-56510, September 24, 2007),
Moody's Investor Services, Inc. (34-56511, September 24, 2007),
Rating and Investment Information, Inc. (34-56512, September 24,
2007), Standard & Poor's Rating Services (34-56513, September 24,
2007), Egan-Jones Rating Company (34-57031, December 21, 2007) and
LACE Financial Corp. (34-57300, February 11, 2008).
    \8\ According to their most recent Annual Certifications on Form
NRSRO, S&P rates 197,700 issuers of asset-backed securities, the
category that includes RMBS, Moody's rates 110,000 such issuers, and
Fitch rates 75,278 such issuers. No other registered NRSRO reports
rating more than 1,000 issuers of asset-backed securities. See
Standard & Poor's 2007 Annual Certification on Form NRSRO, available
at http://www.standardandpoors.com; Moody's Investor Services 2007
Annual Certification on Form NRSRO, available at http://
www.moodys.com; Fitch, Inc. 2007 Annual Certification on Form NRSRO,
available at http://www.fitchratings.com.
    \9\ See Testimony of Christopher Cox, Chairman, Commission,
before the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (April 22, 2008) (``Cox April 22, 2008 Senate Testimony''),
pp. 2-3.
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    In addition to the examination, the Commission has worked closely
with other regulators and supervisors of the financial markets in
analyzing the credit market turmoil and in developing recommendations
and principles for market participants, including NRSROs.\10\ For
example, the President's Working Group on Financial Markets issued a
Policy Statement on Financial Market Developments in March 2008.\11\
Further, as a member of the International Organization of Securities
Commissions (``IOSCO''), the Commission played a substantial role in
drafting The Role of Credit Rating Agencies in Structured Finance
Markets, which was issued for consultation by IOSCO in March 2008.\12\
Also, the Commission, as part of its participation in the Financial
Stability Forum, worked with its counterparts in the U.S. and abroad on
The Report of the Financial Stability Forum on Enhancing Market and
Institutional Resilience released in April 2008, which discussed credit
rating agencies.\13\
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    \10\ See Id, p. 4.
    \11\ A copy of the policy statement is available at: http://
www.ustreas.gov.
    \12\ A copy of the report is available at: http://www.iosco.org.
    \13\ A copy of the report is available at: http://
www.fsforum.org.
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    These and other efforts have assisted the Commission in identifying
a number of areas in which its current NRSRO rules could be augmented
to address concerns about the role NRSROs played in the credit market
turmoil.\14\ As a result, the Commission is proposing amendments to its
existing NRSRO rules and a new rule with the goal of improving the
quality of credit ratings determined by NRSROs generally and, in
particular, for structured finance products such as RMBS and CDOs.\15\
These proposals and the proposals to be considered in two weeks are
designed to:
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    \14\ See Cox April 22, 2008 Senate Testimony, pp. 6-8.
    \15\ The term ``structured finance product'' as used throughout
this release refers broadly to any security or money market
instrument issued by an asset pool or as part of any asset-backed or
mortgage-backed securities transaction. This broad category of
financial instrument includes, but is not limited to, asset-backed
securities (``ABS'') such as RMBS and to other types of structured
debt instruments such as CDOs, including synthetic and hybrid CDOs.
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     Enhance the disclosure and comparability of credit ratings
performance statistics;
     Increase the disclosure of information about structured
finance products;
     Require more information about the procedures and
methodologies used to determine credit ratings for structured finance
products;
     Strengthen internal control processes through reporting
requirements; and
     Address conflicts of interest arising from the process of
rating structured finance products; and
     Reduce undue reliance in the Commission's rules on NRSRO
ratings, thereby promoting increased investor due diligence.
    The Commission believes these proposals would further the purpose
of the Rating Agency Act to improve the quality of NRSRO credit ratings
by fostering accountability, transparency, and competition in the
credit rating industry.\16\
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    \16\ See Senate Report, p. 2.
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C. The Role of Credit Ratings in the Credit Market Turmoil

    The growth in the origination of subprime loans began in the early
2000s.\17\ For example, Moody's reports that subprime loans amounted to
$421 billion of the $3.038 trillion in mortgages originated in 2002
(14%) and $640 billion of the $2.886 trillion in mortgages originated
in 2006 (22%).\18\ This growth was facilitated by steadily rising home
values and a low interest rate environment.\19\ In addition, increases
in the breadth of the credit risk transfer markets as a result of new
investors willing to purchase credit based structured finance products
provided an opportunity for lenders to originate subprime loans and
then move them off their balance sheets by packaging and selling them
through the securitization process to investors as subprime RMBS and
CDOs.\20\ The investors in subprime RMBS and CDOs included domestic and
foreign mutual funds, pension funds, hedge funds, banks, insurance
companies, special investment vehicles, and state government operated
funds.
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    \17\ See e.g., Statement of Sheila C. Bair, Chairman, Federal
Deposit Insurance Corporation, before U.S. Senate Committee on
Banking, Housing, and Urban Affairs (January 31, 2008) (``Bair
January 31, 2008 Senate Statement''), p. 4.
    \18\ According to Moody's, subprime mortgage loans represented
$421 billion of $3.038 trillion total mortgage origination in 2002
and $640 billion of $2.886 trillion total mortgage origination in
2006. See A Short Guide to Subprime, Moody's, March 25, 2008, p. 1.
    \19\ See e.g., Dugan March 4, 2008 Senate Testimony, pp. 8-11.
    \20\ Id.
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    This ``originate to distribute'' business model created demand for
residential

mortgage loans, including subprime loans. For example, according to
Moody's, of the approximately $2.5 trillion worth of mortgage loans
originated in 2006, $1.9 trillion were securitized into RMBS and
approximately 25%, or $520 billion worth, of these loans were
categorized as subprime.\21\ The demands of the loan securitization
markets encouraged lenders to lower underwriting standards to maintain
a steady volume of loans and to use less traditional products such as
adjustable rate, negative amortization, and closed-end second lien
mortgages.\22\
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    \21\ Subprime Residential Mortgage Securitizations: Frequently
Asked Questions, Moody's, April 19, 2007, p. 1.
    \22\ See e.g., Bernanke February 28, 2008 Senate Testimony, p.
1; Dugan March 4, 2008 Senate Testimony, pp. 8-10.
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1. The Creation of Subprime RMBS and CDOs
    The creation of an RMBS begins by packaging a pool of mortgage
loans, usually numbering in the thousands, and transferring them to a
bankruptcy remote trust. The trust purchases the loan pool and becomes
entitled to the interest and principal payments made by the borrowers.
The trust finances the purchase of the loan pool through the issuance
of RMBS. The monthly interest and principal payments from the loan pool
are used to make monthly interest and principal payments to the
investors in the RMBS.
    The trust typically issues different classes of RMBS (known as
``tranches'') offering a sliding scale of coupon rates based on the
level of credit protection afforded to the security. Credit protection
is designed to shield the tranche securities from loss of interest and
principal arising from defaults of the loans backing the RMBS. The
degree of credit protection afforded a tranche security is known as its
``credit enhancement'' and is provided through several means. The
primary source of credit enhancement is subordination, which creates a
hierarchy of loss absorption among the tranche securities. For example,
if a trust issued securities in 10 different tranches of securities,
the first (or senior) tranche would have nine subordinate tranches, the
next highest tranche would have eight subordinate tranches and so on
down the capital structure. Losses of interest and principal
experienced by the trust from delinquencies and defaults among loans in
the pool are allocated first to the lowest tranche until its principal
amount is exhausted and then to the next lowest tranche and so on up
the capital structure. Consequently, the senior tranche would not incur
any loss until the principal amounts from all the lower tranches have
been exhausted through the absorption of losses from the underlying
loans.
    A second form of credit enhancement is over-collateralization,
which is the amount that the principal balance of the mortgage pool
underlying the trust exceeds the principal balance of the tranche
securities issued by the trust. This excess principal creates an
additional ``equity'' tranche below the lowest tranche security to
absorb losses. In the example above, the equity tranche would sit below
the 10th tranche security and protect it from the first losses
experienced as a result of defaulting loans.
    A third form of credit enhancement is excess spread, which consists
of the amount by which the interest derived from the underlying loans
in the aggregate exceeds interest payments due to investors in the
tranche securities in the aggregate plus the administrative expenses of
the trust such as fees due the loan servicer as well as premiums due on
derivatives contracts and bond insurance. In other words, the excess
spread is the amount that the monthly interest income from the pool of
loans exceeds the weighted average interest due to the RMBS
bondholders. This excess spread can be used to build up loss reserves
or pay off delinquent interest payments due to a tranche security.
    A fourth form of credit enhancement sometimes employed is bond
insurance. When used, bond insurance is typically purchased only for
the senior RMBS tranche.
    The creation of a typical CDO is similar to that of an RMBS. A
bankruptcy remote trust is created to hold the CDO's assets and issue
its securities. The underlying assets, however, are generally debt
securities rather than mortgage loans. The CDO trust uses the interest
and principal payments from the approximately 200 underlying debt
securities to make interest and principal payments to investors in the
securities issued by the trust. The trust is structured to provide
differing levels of credit enhancement to the securities it issues.
Similar to RMBS, credit enhancement is provided through subordination,
over-collateralization, excess spread, and bond insurance. In addition
to the underlying assets, one significant difference between a CDO and
an RMBS is that the CDO may be actively managed such that its
underlying assets change over time, whereas the mortgage loan pool
underlying an RMBS remains static for the most part.
    In recent years, CDOs have been some of the largest purchasers of
subprime RMBS and the drivers of demand for those securities. For
example, according to Fitch, the average percentage of subprime RMBS in
the collateral pools of CDOs it rated grew from 43.3% in 2003 to 71.3%
in 2006.\23\ Generally, the CDOs holding subprime RMBS issued fell into
one of two categories: High grade and mezzanine. High grade CDOs are
generally defined as those that hold RMBS tranches with AAA, AA, or A
credit ratings, whereas mezzanine CDOs are those that hold RMBS
tranches rated predominantly BBB. Securities issued by mezzanine CDOs
pay higher yields than those issued by high grade CDOs since the BBB-
rated RMBS underlying the mezzanine CDOs pay higher yields than the AAA
to A rated RMBS underlying high grade CDOs. In addition to CDOs holding
subprime RMBS, a market for CDOs holding other CDOs that held subprime
RMBS developed in recent years. These debt instruments are known as
``CDOs-squared.''
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    \23\ Rating Stability of Fitch-Rated Global Cash Mezzanine
Structured Finance CDOs with Exposure to U.S. Subprime RMBS, Fitch,
April 2, 2007, p. 1.
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    As the market for mortgage related CDOs grew, CDO issuers began to
use credit default swaps to replicate the performance of subprime RMBS
and CDOs. In this case, rather than purchasing subprime RMBS or CDOs,
the CDO entered into credit default swaps referencing subprime RMBS or
CDOs, or indexes on RMBS. These CDOs, in some cases, are composed
entirely of credit default swaps (``synthetic CDOs'') or a combination
of credit default swaps and cash RMBS (``hybrid CDOs''). The use of
credit default swaps allowed the CDO securities to be issued more
quickly, since the issuer did not have to wait to accumulate actual
RMBS for the underlying collateral pool.
2. Determining Credit Ratings for Subprime RMBS and CDOs
    A key step in the process of creating and ultimately selling a
subprime RMBS and CDO is the issuance of a credit rating for each of
the tranches issued by the trust (with the exception of the most junior
``equity'' tranche). The credit rating for each rated tranche indicated
the credit rating agency's view as to the creditworthiness of the debt
instrument in terms of the likelihood that the issuer would default on
its obligations to make interest and principal payments on the debt
instrument.\24\ To varying degrees,

many investors rely on credit ratings in making the decision to
purchase subprime RMBS or CDOs, particularly with respect to the senior
AAA rated tranches. Some investors use the credit ratings to assess the
risk of the debt instruments. In part, this may be due to the large
number of debt instruments in the market and their complexity. Other
investors use credit ratings to satisfy client investment mandates
regarding the types of securities they can invest in or to satisfy
regulatory requirements based on certain levels of credit ratings, or a
combination of these conditions. Moreover, investors typically only
have looked to ratings issued by Fitch, Moody's, and S&P, which causes
the arrangers \25\ of the subprime RMBS and CDOs to use these three
NRSROs to obtain credit ratings for the tranche securities they brought
to market.
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    \24\ See, e.g., Inside the Ratings: What Credit Ratings Mean,
Fitch, August 2007 (``Inside the Ratings''), p. 2; Testimony of
Michael Kanef, Group Managing Director, Moody's Investors Service,
Before the United States Senate Committee on Banking, Housing, and
Urban Affairs (September 26, 2007) (``Kanef September 26, 2007
Senate Testimony''), p. 2; Principles-Based Rating Methodology For
Global Structured Finance Securities, S&P, May 29, 2007, p. 3. Since
credit ratings are issued for tranches of RMBS and CDOs
individually, rather than for the issuers of those tranches, the
NRSRO credit ratings are estimates of the probability of default of
each RMBS or CDO tranche as an independent instrument.
    \25\ As bankruptcy remote stand-alone legal entities, RMBS and
CDO trusts had no employees. Consequently, they relied on third-
parties to create and manage them. The term ``arranger'' is used
herein to refer to the party that oversees the creation of the RMBS
and CDO, which would include the process of obtaining credit ratings
for the various tranches. Frequently, the arranger also served as
the underwriter of the securities.
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    The procedures followed by these three NRSROs in developing ratings
for subprime RMBS are generally similar. The arranger of the RMBS
initiates the rating process by sending the credit rating agency a
range of data on each of the subprime loans to be held by the trust
(e.g., principal amount, geographic location of the property, credit
history and FICO score of the borrower, ratio of the loan amount to the
value of the property, and type of loan: First lien, second lien,
primary residence, secondary residence), the proposed capital structure
of the trust, and the proposed levels of credit enhancement to be
provided to each RMBS tranche issued by the trust. Upon receipt of the
information, the NRSRO assigns a lead analyst who is responsible for
analyzing the loan pool, proposed capital structure, and proposed
credit enhancement levels and, ultimately, for formulating a ratings
recommendation for a rating committee composed of analysts and/or
senior-level personnel not involved in the analytic process.
    The next step in the ratings process is the development of
predictions, based on a quantitative expected loss model and other
qualitative factors, as to how many of the loans in the collateral pool
would default under stresses of varying severity. This analysis also
includes assumptions as to how much principal would be recovered after
a defaulted loan is foreclosed. Each NRSRO generally uses between 40
and 60 specific credit characteristics to analyze each loan in the
collateral pool of an RMBS in order to assess the potential future
performance of the loan under various possible scenarios. These
characteristics include the loan information described above as well as
the amount of equity that the borrowers have in their homes, the amount
of documentation provided by borrowers to verify their assets and/or
income levels, and whether the borrowers intend to rent or occupy the
homes.\26\
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    \26\ See, e.g., Kanef September 26, 2007, Senate Testimony, p.
7.
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    The purpose of this loss analysis is to determine how much credit
enhancement a given tranche security would need for a particular
category of credit rating. The severest stress test (i.e., the one that
would result in the greatest number of defaults among the underlying
loans) is run to determine the amount of credit enhancement required
for an RMBS tranche issued by the trust to receive an AAA rating. For
example, this test might result in an output that predicted that under
the ``worst case'' scenario, 40 percent of the loans in the underlying
pool would default and that after default the trust would recover only
50 percent of the principal amount of each loan in foreclosure.
Consequently, to get an AAA rating, an RMBS tranche security issued by
the trust would need credit enhancement sufficient to cover at least 20
percent of the principal amount of all the RMBS tranches issued by the
trust. In other words, absent other forms of credit enhancement such as
excess spread, at least 20 percent of the principal amount of the RMBS
tranches issued by the trust, including the equity tranche, would have
to be subordinate to the senior tranche and, therefore, obligated to
absorb the losses resulting from 40% of the underlying loans
defaulting.\27\ The next severest stress test is run to determine the
amount of credit enhancement required of the AA tranche and so on down
the capital structure. The lowest rated tranche (typically BB or B) is
analyzed under a more benign market scenario. Consequently, its
required level of credit enhancement--typically provided primarily or
exclusively by a subordinate equity tranche--is based on the number of
loans expected to default in the normal course given the lowest
possible level of macroeconomic stress.
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    \27\ To the extent that the RMBS included other forms of credit
enhancement besides the subordination and over-collateralization
provided in this example, e.g., excess spread, this 20 percent
subordination figure would be reduced accordingly.
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    Following the determination of the level of credit enhancement
required for each credit rating category, the next step in the ratings
process is to check the proposed capital structure of the RMBS against
these requirements. For example, if the proposed structure would create
a senior RMBS tranche that had 18 percent of the capital structure
subordinate to it (the other RMBS tranches, including, as applicable,
an equity tranche), the analyst reviewing the transaction might
conclude that based on the output of the loss model the senior tranche
should be rated AA since it would need 20 percent subordination to
receive an AAA credit rating. Additionally, the analyst could take
other factors into consideration such as the quality of the loan
servicer or the actual performance of similar pools of loans underlying
other RMBS trusts to determine that in this case 18 percent
subordination would be sufficient to support an AAA rating (to the
extent these factors were not covered by the model).
    Typically, if the analyst concludes that the capital structure of
the RMBS did not support the desired ratings--in the example above, if
it determined that 18 percent credit enhancement is insufficient for
the desired AAA rating--this preliminary conclusion would be conveyed
to the arranger. The arranger could accept that determination and have
the trust issue the securities with the proposed capital structure and
the lower rating or adjust the structure to provide the requisite
credit enhancement for the senior tranche to get the desired AAA rating
(e.g., shift 2 percent of the principal amount of the senior tranche to
a lower tranche or add or remove certain mortgages from the proposed
asset pool). Generally, arrangers aim for the largest possible senior
tranche, i.e., to provide the least amount of credit enhancement
possible, since the senior tranche--as the highest rated tranche--pays
the lowest coupon rate of the RMBS' tranches and, therefore, costs the
arranger the least to fund.
    The next step in the process is a cash flow analysis on the
interest and principal expected to be received by the trust from the
pool of subprime loans to determine whether it will be sufficient to
pay the interest and principal due on each RMBS tranche issued by the
trust. The NRSROs use quantitative cash flow

models that analyze the amount of principal and interest payments
expected to be generated from the loan pool each month over the terms
of the RMBS tranche securities under various stress scenarios. The
outputs of this model are compared against the priority of payments
(the ``waterfall'') to the RMBS tranches specified in the trust legal
documents. The waterfall documentation could specify over-
collateralization and excess spread triggers that, if breached, would
reallocate principal and interest payments from lower tranches to
higher tranches until the minimum levels of over-collateralization and
excess spread were reestablished. Ultimately, the monthly principal and
interest payments derived from the loan pool need to be enough to
satisfy the monthly payments of principal and interest due by the trust
to the investors in the RMBS tranches as well as to cover the
administrative expenses of the trust.
    In addition to expected loss and cash flow analysis, the analysts
review the legal documentation of the trust to evaluate whether it is
bankruptcy remote, i.e., isolated from the effects of any potential
bankruptcy or insolvency of the arranger. They also review operational
and administrative risk associated with the trust, using the results of
periodic examinations of the principal parties involved in the issuance
of the security, including the mortgage originators, the issuer of the
security, the servicer of the mortgages in the loan pool, and the
trustee.\28\ In assessing the servicer, for example, an NRSRO might
review its past performance with respect to loan collection, billing,
recordkeeping, and the treatment of delinquent loans.
---------------------------------------------------------------------------

    \28\ Principal parties are not rated de novo in each RMBS
transaction; rather, each NRSRO has its own procedures and schedules
for reviewing those parties on a periodic basis in order to
incorporate its assessment of those entities into the rating
process.
---------------------------------------------------------------------------

    Following these steps, the analyst develops a rating recommendation
for each RMBS tranche, which then is presented to a rating committee
composed of analysts and/or senior-level personnel not involved in the
analytic process. The rating committee votes on the ratings for each
tranche and usually approaches the arranger privately to notify it of
the ratings decisions. In most cases, an arranger can appeal a rating
decision, although the appeal is not always granted (and, if granted,
may not necessarily result in any change in the rating decision). Final
ratings decisions are published and subsequently monitored through
surveillance processes. The NRSRO typically is paid only if the credit
rating is issued, though sometimes it receives a breakup fee for the
analytic work undertaken even if the credit rating is not issued.
    The process for assigning ratings to subprime CDOs also involves a
review of the creditworthiness of each tranche of the CDO. As with
RMBS, the process centers on an examination of the pool of assets held
by the trust and analysis of how they would perform individually and in
correlation during various stress scenarios. However, this analysis is
based primarily on the credit rating of each RMBS or CDO in the
underlying pool or referenced through a credit default swap entered
into by the CDO. In other words, the credit rating is the primary
characteristic of the underlying debt instruments that the NRSROs take
into consideration when performing their loss analysis. Hence, this
review of the debt instruments in the collateral pool and the potential
correlations among those securities does not ``look through'' those
securities to their underlying asset pools. The analysis, consequently,
generally only goes one level down to the credit ratings of the
underlying instruments or reference securities.
    CDOs collateralized by RMBS or by other CDOs often are actively
managed. Consequently, there can be frequent changes to the composition
of the cash assets (RMBS or CDOs), synthetic assets (credit default
swaps), or combinations of cash and synthetic assets in the underlying
pool. As a result, NRSRO ratings for managed CDOs are based not on the
closing date composition of the pool but instead on covenanted limits
for each potential type of asset that could be put in the pool.
Typically, following a post-closing period in which no adjustments can
be made to a CDO's collateral pool, the CDO's manager has a
predetermined period of several years in which to adjust that asset
pool through various sales and purchases pursuant to covenants set
forth in the CDO's indenture. These covenants set limitations and
requirements for the collateral pools of CDOs, often by establishing
minimum and maximum concentrations for certain types of securities or
certain ratings.
    NRSROs use a CDO's indenture guidelines to run ``worst-case''
scenarios based on the various permutations of collateral permitted
under the indenture. For example, an indenture might specify that a
CDO's collateral pool must include between 10 and 20 percent AAA-rated
subprime RMBS, with the remaining 80 to 90 percent composed of
investment-grade, but not AAA, subprime RMBS. In preparing a rating for
that CDO, an NRSRO will run its models based on all possible collateral
pools permissible under the indenture guidelines, placing the most
weight on the results from the weakest potential pools (i.e., the
minimum permissible amount, 10 percent, of AAA-rated securities and the
lowest-rated investment grade securities for the remaining 90 percent).
As with RMBS ratings, the model results are then compared against the
capital structure of the proposed CDO to confirm that the level of
subordination, over-collateralization and excess spread available to
each tranche provides the necessary amount of credit enhancement to
sustain a particular rating.
3. The Downgrades in Credit Ratings of Subprime RMBS and CDOs
    As noted above, the development of the credit risk transfer markets
gave rise to an ``originate to distribute'' model whereby mortgage
loans are originated with the intent to securitize them. Under this
model, arrangers earn fees from originating, structuring, and
underwriting RMBS and servicing the loans underlying the RMBS, as well
as frequently a third set of fees from structuring, underwriting, and
managing CDOs composed of RMBS. Moreover, the yields offered by
subprime RMBS and CDO tranches (as compared to other types of similarly
rated debt instruments) led to increased investor demand for these debt
instruments. The originate to distribute model creates incentives for
originating high volumes of mortgage loans while simultaneously
reducing the incentives to maintain high underwriting standards for
making such loans. The continued growth of the housing market through
2006, which led to increased competition among lenders, also
contributed to looser subprime loan underwriting standards.\29\
---------------------------------------------------------------------------

    \29\ See e.g., Dugan March 4, 2008 Senate Testimony, p. 10;
Bernanke February 28, 2008 Senate Testimony, p. 1.
---------------------------------------------------------------------------

    By mid-2006, however, the steady rise in home prices that had
fueled this growth in subprime lending came to an end as prices began
to decline.\30\ Moreover, widespread areas of the country began to
experience declines whereas, in the past, poor housing markets
generally had been confined to distinct geographic areas.\31\ The
downturn in the housing market has been accompanied by a marked
increase

in delinquencies and defaults of subprime loans.\32\
---------------------------------------------------------------------------

    \30\ See e.g., Id; Bair March 4, 2008 Senate Statement, pp. 5-8;
Bair January 31, 2008 Senate Statement, p. 3.
    \31\ See e.g., Bair January 31, 2008 Senate Statement, p. 3.
    \32\ Id.
---------------------------------------------------------------------------

    The increases in delinquency and default rates have been
concentrated in loans made in 2006 and 2007, which indicates that
borrowers have been falling behind within months of the loans being
made.\33\ For example, by the fourth quarter of 2006, the percentage of
subprime loans underlying RMBS rated by Moody's that were in default
within six months of the loans being made stood at 3.54 percent, nearly
four times the average six month default rate of 0.90 percent between
the first quarter of 2002 and the second quarter of 2005. Similarly,
default rates for subprime loans within 12 months of the loans being
made rose to 7.39 percent as compared to 2.00 percent for the period
from the first quarter of 2002 through the second quarter of 2005.\34\
Figures released by S&P show similar deterioration in the performance
of recent subprime loans.\35\ According to S&P, the serious delinquency
rate \36\ for subprime loans underlying RMBS rated by S&P within twelve
months of the initial rating was 4.97 percent of the current aggregate
pool balance for subprime RMBS issued in 2005, 10.55 percent for
subprime RMBS issued in 2006, and 15.19 percent for subprime RMBS
issued in 2007.\37\
---------------------------------------------------------------------------

    \33\ See e.g., Bair March 24, 2008 Senate Statement, p. 6
(``Serious delinquency rates on subprime mortgages securitized in
2006 are significantly higher than those for any of the previous
three years.'').
    \34\ Early Defaults Rise in Mortgage Securitizations: Updated
Data Show Continued Deterioration, Moody's, September 19, 2007, pp.
3-4.
    \35\ U.S. Subprime RMBS Performance Update: January 2008
Distribution Date, S&P, February 25, 2008, p. 1.
    \36\ Defined as 90-plus day delinquencies, foreclosures, and
real estate owned. Id.
    \37\ Id.
---------------------------------------------------------------------------

    Along with the deterioration in the performance of subprime loans,
there has been an increase in the losses incurred after the loans are
foreclosed. According to S&P, the actual realized losses on loans
underlying 2007 subprime RMBS after 12 months of seasoning were 65
percent higher than the losses recorded for RMBS issued in 2006 at the
same level of seasoning.\38\
---------------------------------------------------------------------------

    \38\ Id.
---------------------------------------------------------------------------

    The rising delinquencies and defaults in subprime loans backing the
RMBS rated by the NRSROs has exceeded the projections on which they
based their initial ratings. Furthermore, the defaults and foreclosures
on subprime loans have resulted in realizable losses to the lower RMBS
tranches backed by the loans and, correspondingly, to the lower CDO
tranches backed by those RMBS. As discussed above, the reduction in the
amount of monthly principal and interest payments coming from the
underlying pool of subprime loans or, in the case of a CDO, RMBS
tranches or other CDO tranches is allocated to the tranches in
ascending order. In addition to directly impairing the affected
tranche, the losses--by reducing the principal amount of these
tranches--decreased the level of subordination protecting the more
senior tranches. In other words, losses suffered by the junior tranches
of an RMBS or CDO directly reduced the level of credit enhancement--the
primary factor considered by NRSROs in rating tranched securities--
protecting the senior tranches of the instrument. These factors have
caused the NRSROs to reevaluate, and in many cases downgrade, their
ratings for these instruments.
     As of February 2008, Moody's had downgraded at least one
tranche of 94.2 percent of the subprime RMBS deals it rated in 2006
(including 100 percent of 2006 RMBS deals backed by subprime second-
lien mortgage loans) and 76.9 percent of all subprime RMBS deals it
rated in 2007. Overall, 53.7 percent and 39.2 percent of 2006 and 2007
tranches, respectively, had been downgraded by that time. RMBS tranches
backed by first lien loans issued in 2006 were downgraded an average of
6.0 notches from their original ratings, while RMBS tranches backed by
second-lien loans issued that year were downgraded 9.7 notches on
average. The respective figures for 2007 first- and second-lien backed
tranches were 5.6 and 7.8 notches.\39\
---------------------------------------------------------------------------

    \39\ U.S. Subprime RMBS 2005-2007 Vintage Rating Actions Update:
January 2008, Moody's, February 1, 2008, pp. 2-4.
---------------------------------------------------------------------------

     As of March 2008, S&P had downgraded 44.3 percent of the
subprime RMBS tranches it had rated between the first quarter of 2005
and the third quarter of 2007, including 87.2 percent of second-lien
backed securities. Downgrades to subprime RMBS issued in 2005 averaged
four to six notches, while the average for those issued in 2006 and
2007 was 6.0 to 11 notches.\40\
---------------------------------------------------------------------------

    \40\ Transition Study: Structured Finance Rating Transition And
Default Update as of March 21, 2008, S&P, March 28, 2008, pp. 2-3.
---------------------------------------------------------------------------

     As of December 7, 2007, Fitch had issued downgrades to
1,229 of the 3,666 tranches of subprime RMBS issued in 2006 and the
first quarter of 2007, representing a par value of $23.8 billion out of
a total of $193 billion.\41\ Subsequently, on February 1, 2008, Fitch
placed all subprime first-lien RMBS issued in 2006 and the first half
of 2007, representing a total outstanding balance of approximately $139
billion, on Rating Watch Negative.\42\
---------------------------------------------------------------------------

    \41\ U.S. RMBS Update, Fitch, February 20, 2008 p. 5.
    \42\ Update on U.S. Subprime and Alt-A: Performance And Rating
Reviews, Fitch, March 20, 2008, p. 13.
---------------------------------------------------------------------------

    The extensive use of subprime RMBS in the collateral pools of CDOs
has led to similar levels of downgrade rates for those securities as
well. Moreover, the use of subprime RMBS as reference securities for
synthetic CDOs magnified the effect of RMBS downgrades on CDO ratings.
Surveillance of CDO credit ratings has been complicated by the fact
that the methodologies used by the NRSROs to rate them relied heavily
on the credit rating of the underlying RMBS or CDOs. Consequently, to
adjust the CDO rating, the NRSROs first have needed to complete their
reviews of the ratings for the underlying RMBS or adjust their
methodologies to sufficiently account for the anticipated poor
performance of the RMBS.\43\ Ultimately, the NRSROs have downgraded a
substantial number of CDO ratings.
---------------------------------------------------------------------------

    \43\ For example, in November 2007, Fitch announced that in
rating CDOs with asset pools which included subprime RMBS, it would
adjust all subprime RMBS securities on Rating Watch Negative
downwards by three categories--or notches--(six in the case of 2007
subprime RMBS rated BBB+ or lower) before factoring them into a re-
assessment of the CDO's rating. See Global Criteria for the Review
of Structured Finance CDOs With Exposure to U.S. Subprime RMBS,
Fitch, November 15, 2007, p. 4.
---------------------------------------------------------------------------

     Over the course of 2007, Moody's issued 1,655 discrete
downgrade actions (including multiple rating actions on the same
tranche), which constituted roughly ten times the number of downgrade
actions in 2006 and twice as many as in 2002, previously the most
volatile year for CDOs. Further, the magnitude of the downgrades
(number of notches) was striking. The average downgrade was roughly
seven notches as compared to a previous average of three to four
notches prior to 2007. In the words of a March 2008 report by Moody's,
``[T]he scope and degree of CDO downgrades in 2007 was unprecedented.''
\44\
---------------------------------------------------------------------------

    \44\ 2008 U.S. CDO Outlook and 2007 Review, Moody's, March 3,
2008, p. 6.
---------------------------------------------------------------------------

     As of April 1, 2008, S&P had downgraded 3,068 tranches
from 705 CDO transactions, totaling $321.9 billion in issuance, and
placed 443 ratings from 119 transactions, with a value of $33.8
billion, on CreditWatch negative, ``as a result of stress in the

U.S. residential mortgage market and credit deterioration of U.S.
RMBS.'' \45\
---------------------------------------------------------------------------

    \45\ 86 Ratings Lowered On 20 U.S. CDOs Of ABS Deals; $9.107
Billion In Issuance Affected, S&P, April 1, 2008, p. 1.
---------------------------------------------------------------------------

     By mid-December, 2007, Fitch had issued downgrades to 158
of the 431 CDOs it had rated with exposure to RMBS.\46\ Among the 30
CDOs with exposure to the subprime RMBS which ``suffered the greatest
extent and magnitude of negative rating migration,'' all but $82.7
million of the $20.7 billion in balance was downgraded.\47\
---------------------------------------------------------------------------

    \46\ Summary of Global Structured Finance CDO Rating Actions,
Fitch, December 14, 2007, p. 1.
    \47\ Id., p. 6.
---------------------------------------------------------------------------

    The scope and magnitude of these downgrades has caused a loss of
confidence among investors in the reliability of RMBS and CDO credit
ratings issued by the NRSROs.\48\ This lack of confidence in the
accuracy of NRSRO ratings has been a factor in the broader dislocation
in the credit markets.\49\ For example, the complexity of assessing the
risk of structured finance products and the lack of commonly accepted
methods for measuring the risk has caused investors to leave the
market, including the market for AAA instruments, particularly
investors that had relied primarily on NRSRO credit ratings in
assessing whether to purchase these instruments.\50\ This has had a
significant impact on the liquidity of the market for these
instruments.\51\
---------------------------------------------------------------------------

    \48\ See, e.g., Dugan March 4, 2008 Senate Testimony, p. 13.
    \49\ Id., Bair March 4, 2008 Senate Statement, p. 7.
    \50\ Id., Bernanke February 28, 2008 Senate Testimony, p. 3.
    \51\ See, e.g., Dugan March 4, 2008 Senate Testimony, p. 13;
Bair January 31, 2008 Senate Testimony, pp. 3-4.
---------------------------------------------------------------------------

    In the wake of these events, the NRSROs that rated subprime RMBS
and CDOs have come under intense criticism and scrutiny. It has been
suggested that changes may be needed to address the conflicts of
interest inherent in the process of rating RMBS and CDOs.\52\ The
NRSROs that have been the primary ratings providers for subprime RMBS
and related CDOs each operate under an ``issuer-pays'' model in which
they are paid by the arranger to rate a proposed RMBS or CDO. The
arranger has an economic interest in obtaining the highest credit
rating possible for each security issued by the trust and the NRSRO has
an economic interest in having the arranger select it to rate the next
RMBS or CDO brought by the arranger to market. Observers have
questioned whether, given the incentives created by this arrangement,
the NRSROs are able to issue unbiased ratings, particularly as the
volume of deals brought by certain arrangers increased in the mid-
2000s.\53\ The above concerns are compounded by the arrangers' ability
to ``ratings shop.'' Ratings shopping is the process by which an
arranger will bring its proposed RMBS and CDO transaction to multiple
NRSROs and choose, on a deal-wide or tranche-by-tranche basis, which
two (or in some cases one) to use based on the preliminary ratings of
the NRSROs.
---------------------------------------------------------------------------

    \52\ See, e.g., Opening Statement of Senator Richard C. Shelby
for the Hearing of the U.S. Senate Committee on Banking, Housing,
and Urban Affairs (September 26, 2007), pp. 1-2.
    \53\ See, e.g., Testimony of Professor John C. Coffee, Jr.,
Adolf A. Berle Professor of Law, Columbia University Law School,
before the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (September 26, 2007), pp. 4-5.
---------------------------------------------------------------------------

    In addition, the interaction between the NRSRO and the arranger
during the RMBS and CDO rating process has raised concerns that the
NRSROs are rating products they designed (i.e., evaluating their own
work).\54\ A corporate issuer is more constrained in how it can adjust
in response to an NRSRO to improve its creditworthiness in order to
obtain a higher rating. In the context of structured finance products,
the arranger has much more flexibility to make adjustments to obtain a
desired credit rating by, for example, changing the composition of the
assets in the pool held by the trust or the subordination levels of the
tranche securities issued by the trust. In fact, an arranger frequently
will inform the NRSRO of the rating it wishes to obtain for each
tranche and will choose an asset pool, trust structure, and credit
enhancement levels based on its understanding of the NRSRO's
quantitative and qualitative models. The credit analyst will use the
expected loss and cash flow models to, in effect, check whether the
proposed assets, trust structure and credit enhancement levels are
sufficient to support the credit ratings desired by the arranger.
---------------------------------------------------------------------------

    \54\ See, e.g., Opening Statement of Senator Jack Reed for the
Hearing of the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (September 26, 2007), pp. 1-2.
---------------------------------------------------------------------------

    The NRSRO rules adopted by the Commission in June of 2007 preceded
the full emergence of the credit market turmoil. The Commission, in
light of its experience since the final rules became effective, is
proposing amendments to those rules and a new rule with the goal of
further enhancing the utility of NRSRO disclosure to investors,
strengthening the integrity of the ratings process, and more
effectively addressing the potential for conflicts of interest inherent
in the ratings process for structured finance products.

II. Proposed Amendments

A. Amendments to Rule 17g-5

    The Commission adopted Rule 17g-5, in part, pursuant to authority
``to prohibit, or require the management and disclosure of, any
conflicts of interest relating to the issuance of credit ratings by an
[NRSRO].'' \55\ The rule identifies a series of conflicts arising from
the business of determining credit ratings. Under the rule, some of
these conflicts must be disclosed and managed, while other specified
conflicts are prohibited outright.
---------------------------------------------------------------------------

    \55\ See Section 15E(h)(2) of the Exchange Act (15 U.S.C. 78o-
7(h)(2)).
---------------------------------------------------------------------------

    Paragraph (a) of Rule 17g-5 prohibits an NRSRO from having a
conflict identified in paragraph (b) of the rule unless the NRSRO
discloses the type of conflict on Form NRSRO and establishes,
maintains, and enforces procedures to manage it.\56\ Paragraph (b)
identifies eight types of conflicts, which include being paid by
issuers or underwriters to determine credit ratings with respect to
securities or money market instruments they issue or underwrite \57\ or
being paid by persons for subscriptions to receive or access credit
ratings where such persons also may own investments or have entered
into transactions that could be favorably or adversely impacted by a
credit rating.\58\
---------------------------------------------------------------------------

    \56\ 17 CFR 240.17g-5(a).
    \57\ 17 CFR 240.17g-5(b)(1).
    \58\ 17 CFR 240.17g-5(b)(5).
---------------------------------------------------------------------------

    Paragraph (c) of Rule 17g-5 prohibits outright four types of
conflicts of interest. Consequently, an NRSRO would violate the rule if
it has the type of conflict described in paragraph (c) even if it
disclosed the conflict and established procedures to manage it. In the
Adopting Release, the Commission explained that these conflicts were
prohibited because they would be difficult to manage given their
potential to cause undue influence.\59\
---------------------------------------------------------------------------

    \59\ Adopting Release, 72 FR at 33598.
---------------------------------------------------------------------------

    The Commission is proposing to amend Rule 17g-5 to require the
disclosure and establishment of procedures to manage an additional
conflict and to prohibit certain other conflicts outright, as described
below.

1. Addressing the Particular Conflict Arising From Rating Structured
Finance Products by Enhancing the Disclosure of Information Used in the
Rating Process
a. The Proposed Amendment
    The Commission is proposing to amend Rule 17g-5 \60\ to add to the
list of conflicts that must be disclosed and managed the additional
conflict of repeatedly being paid by certain arrangers to rate
structured finance products. This conflict is a subset of the broader
conflict already identified in paragraph (b)(1) of Rule 17g-5; namely,
``being paid by issuers and underwriters to determine credit ratings
with respect to securities or money market instruments they issue or
underwrite.'' \61\ In the case of structured finance products, the
Commission preliminarily believes this ``issuer/underwriter-pay''
conflict is particularly acute because certain arrangers of structured
finance products repeatedly bring ratings business to the NRSROs.\62\
As sources of constant deal based revenue, some arrangers have the
potential to exert greater undue influence on an NRSRO than, for
example, a corporate issuer that may bring far less ratings business to
the NRSRO.\63\ Consequently, the Commission is proposing amendments to
Rule 17g-5 that would require additional measures to address this
particular type of ``issuer/underwriter-pay'' conflict.
---------------------------------------------------------------------------

    \60\ 17 CFR 240.17g-5.
    \61\ 17 CFR 240.17g-5(b)(1). As the Commission noted when
adopting Rule 17g-5, the concern with conflict identified in
paragraph (b)(1) ``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.'' Adopting
Release, 72 FR at 33595.
    \62\ See e.g., Testimony of Professor John C. Coffee, Jr., Adolf
A. Berle Professor of Law, Columbia University Law School, before
the U.S. Senate Committee on Banking, Housing, and Urban Affairs
(April 22, 2008) (``Coffee April 22, 2008 Senate Testimony''), pp.
4-6.
    \63\ Id.
---------------------------------------------------------------------------

    Specifically, the proposed amendment would re-designate paragraph
(b)(9) of Rule 17g-5 as paragraph (b)(10) and in new paragraph (b)(9)
identify the following conflict: issuing or maintaining a credit rating
for a security or money market instrument issued by an asset pool or as
part of any asset-backed or mortgage-backed securities transaction that
was paid for by the issuer, sponsor, or underwriter of the security or
money market instrument. To address this conflict, proposed new
paragraph (a)(3) would require that as a condition to the NRSRO rating
a structured finance product the information provided to the NRSRO and
used by the NRSRO in determining the credit rating would need to be
disclosed through a means designed to provide reasonably broad
dissemination of the information.\64\ The intent behind this disclosure
is to create the opportunity for other NRSROs to use the information to
rate the instrument as well. Any resulting ``unsolicited ratings''
could be used by market participants to evaluate the ratings issued by
the NRSRO hired to rate the product and, in turn, potentially expose an
NRSRO whose ratings were influenced by the desire to gain favor with
the arranger in order to obtain more business.\65\
---------------------------------------------------------------------------

    \64\ This proposed requirement would be in addition to the
current requirements of paragraph (a) that an NRSRO disclose the
type of conflict of interest in Exhibit 6 to Form NRSRO; and
establish, maintain and enforce written policies and procedures to
address and manage the conflict of interest. 17 CFR 240 17g-5(a)(1)
and (2).
    \65\ As used herein, an ``unsolicited rating'' is one that is
determined without the consent and/or payment of the obligor being
rated or issuer, underwriter, or arranger of the securities being
rated.
---------------------------------------------------------------------------

    The proposed amendment would require the disclosure of information
provided to an NRSRO by the ``issuer, underwriter, sponsor, depositor,
or trustee.'' The Commission preliminarily believes that, taken
together, these are the parties that provide all relevant information
to the NRSRO to be used in the initial rating and rating monitoring
processes. The Commission is not proposing to specify the party--NRSRO,
arranger, issuer, depositor, or trustee--that would need to disclose
the information. It may be that the issuer through the arranger and
trustee would be in the best positions to disclose the information. In
this case, in contracting with these parties to provide a rating for a
structured finance product, the NRSRO could require a representation
from them that the necessary information would be disclosed as required
by the proposed rule. The Commission notes, however, that the proposed
rule does not provide a safe harbor for an NRSRO arising from such a
representation. Consequently, an NRSRO would violate the proposed rule
if it issued a credit rating for a structured finance product where the
information is not disclosed notwithstanding any representations from
the arranger.
    The goal of this proposed amendment is to promote the effective
management of this conflict of interest, increase the transparency of
the process for rating structured finance products, and foster
competition by making it feasible for more market participants, in
particular NRSROs that are not contracted by the arranger to issue a
rating but still wish to do so, to perform credit analysis on the
instrument and to monitor the instrument's creditworthiness. As noted
above, by providing the opportunity for more NRSROs to determine credit
ratings for structured finance products, this proposal is designed to
increase the number of ratings extant for a given instrument and, in
particular, promote the issuance of ratings by NRSROs that are not
hired by the arranger. The goal would be to expose an NRSRO that was
unduly influenced by the ``arranger-pay'' conflict into issuing higher
than warranted ratings.\66\ An ancillary benefit would be that the
proposal could make it easier for users of credit ratings to identify
potentially inaccurate credit ratings and incompetent NRSROs. The
proposal also is designed to make it more difficult for arrangers to
exert influence on the NRSROs that they hire to determine ratings for
structured finance products. Specifically, by opening up the rating
process to greater scrutiny, the proposal is designed to make it easier
for the hired NRSRO to resist pressure from the arranger by increasing
the likelihood that any steps taken to inappropriately favor the
arranger could be exposed to the market. Further, as noted above, an
ancillary benefit of the proposal is that it could operate as a check
on inaccuracy and incompetence.
---------------------------------------------------------------------------

    \66\ The Commission notes that ``unsolicited'' ratings could be
used to obtain business with arrangers by creating a track record of
favorable ratings. The Commission believes the potential to expose
such conduct would be equal to that of exposing an NRSRO influenced
by the ``arranger-pay'' conflict insomuch as the paid for ratings
(usually at least two) would be consistently lower than the
``unsolicited'' ratings.
---------------------------------------------------------------------------

    To further these goals, the proposal would require the disclosure
of the following information:
     All information provided to the nationally recognized
statistical rating organization by the issuer, underwriter, sponsor,
depositor, or trustee that is used in determining the initial credit
rating for the security or money market instrument, including
information about the characteristics of the assets underlying or
referenced by the security or money market instrument, and the legal
structure of the security or money market instrument; \67\
---------------------------------------------------------------------------

    \67\ See proposed paragraph (a)(3)(i)(A) and (B) of Rule 17g-5.
---------------------------------------------------------------------------

     All information provided to the nationally recognized
statistical rating organization by the issuer, underwriter, sponsor,
depositor, or trustee that is used by the nationally recognized
statistical rating organization in undertaking credit rating
surveillance on the security or money market

instrument, including information about the characteristics and
performance of the assets underlying or referenced by the security or
money market instrument.\68\
---------------------------------------------------------------------------

    \68\ See proposed paragraph (a)(3)(ii) of Rule 17g-5.
---------------------------------------------------------------------------

    For the purposes of the proposed amendment, the Commission would
consider only information that is taken into account in generating the
credit rating or in performing surveillance to be ``used'' by the NRSRO
in those contexts. This would exclude information about collateral
pools (i.e., ``loan tapes'') provided by the arranger containing a mix
of assets that is different than the composition of the final
collateral pool upon which the credit rating is based. The proposed
rule also would exclude from disclosure most, if not all,
communications between the NRSRO and the issuer, underwriter, sponsor,
depositor, or trustee to the extent the communications do not contain
information necessary for the NRSRO to determine an initial credit
rating or perform surveillance on an existing credit rating.
    The Commission recognizes that the NRSRO would define the
information that it uses for purposes of generating credit ratings and,
likely, would obtain representations from the arranger that the
information is being disclosed as required under the rule. There is a
potential that an NRSRO that uses relatively little information to
generate credit ratings would be favored by arrangers to minimize the
amount of information subject to the disclosure requirement. The
Commission preliminarily believes that there is some degree of
standardization as to the information used by NRSROs to rate structured
finance products (e.g., loan level information, payment priorities
among the issued tranched securities, and legal structure of the
issuer). An NRSRO that requires less than the standard level of
information would need to convince users of credit ratings, most
notably investors, that its ratings process was credible. Otherwise,
arrangers ultimately would not use the NRSRO since it would be more
difficult to sell the structured finance products if they carried
ratings that were not accepted by the marketplace. Nonetheless, the
Commission, if this proposal is adopted, intends to monitor whether it
results in a significant reduction in the information provided to
NRSROs.
    The timing and scope of the disclosures of the first set
information described above--information used in determining the
initial credit rating--would depend on the nature of the offering:
public, private, or offshore. \69\ In an offering registered under the
Securities Act of 1933 (15 U.S.C. 77a et seq.), the information would
need to be disclosed on the date the underwriter and the issuer or
depositor set the offering price of the securities being rated (the
``pricing date''). \70\ In offerings that are not registered under the
Securities Act of 1933 (15 U.S.C. 77a et seq.), the information would
need to be disclosed to investors in the offering and entities meeting
the definition of ``credit rating agency'' in Section 3(a)(61) of the
Exchange Act (which would include credit rating agencies registered,
and not registered, as NRSROs) \71\ and on the pricing date and
disclosed publicly on the first business day after the transaction
closes.
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    \69\ See Sections II.A.1.b.i--iii below for a broader discussion
of the scope of the disclosures that would be required under the
proposed amendments.
    \70\ See proposed paragraph (a)(3)(i)(A) of Rule 17g-5.
    \71\ 15 U.S.C. 78c(a)(61).
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    The Commission is proposing the pricing date as the time of the
first disclosures because it preliminarily believes that this is the
earliest date upon which the asset pool and legal structure of the
trust are settled on. Thus, the information that would be disclosed
would reflect the actual characteristics of the securities to be issued
and not, for example, preliminary assets pools with different
compositions of loans. At the same time, the disclosure of the
information before the securities are sold is designed to provide the
opportunity for other credit rating agencies to use the information to
develop ``unsolicited ratings'' for the tranche securities before they
are purchased by investors. To the extent unsolicited ratings are
issued, they would provide investors with a greater range of credit
assessments and, in particular, assessments from credit rating agencies
that are not subject to the ``arranger-pay'' conflict.
    The Commission anticipates that the information that would need to
be disclosed (i.e., the information used by the hired NRSRO to
determine the initial rating) generally would include the
characteristics of the assets in the pool underlying the structured
finance product and the legal documentation setting forth the capital
structure of the trust, payment priorities with respect to the tranche
securities issued by the trust (the waterfall), and all applicable
covenants regarding the activities of the trust. For example, for an
initial rating for an RMBS, this information generally would include
the ``loan tape'' (frequently a spreadsheet) that identifies each loan
in the pool and its characteristics such as type of loan, principal
amount, loan-to-value ratio, borrower's FICO score, and geographic
location of the property. In addition, the disclosed information also
would include a description of the structure of the trust, the credit
enhancement levels for the tranche securities to be issued by the
trust, and the waterfall cash flow priorities. With respect to the loan
pool information, the Commission does not intend that the proposed
disclosure would include any personal identifying information on
individual borrowers or properties (such as names, phone numbers,
addresses or tax identification numbers).
    After the disclosure of the information used by the NRSRO to
perform the initial rating, the proposed amendment would require the
disclosure of information about the underlying assets that is provided
to, and used by, the NRSRO to perform any ratings surveillance.\72\ The
Commission anticipates that generally this information would consist of
reports from the trustee describing how the assets in the pool
underlying the structured finance product are performing. For an RMBS
credit rating, this information likely would include the ``trustee
report'' customarily generated to reflect the performance of the loans
constituting the collateral pool. For example, an RMBS trustee may
generate reports describing the percentage of loans that are 30, 60,
and 90 days in arrears, the percentage that have defaulted, the
recovery of principal from defaulted loans, and information regarding
any modifications to the loans in the asset pool. The disclosure of
this information would allow NRSROs that were not hired to rate the
deal, including ones that determined unsolicited initial ratings, to
monitor on a continuing basis the creditworthiness of the tranche
securities issued by the trust. The proposed amendment provides that
this information would need to be disclosed at the time it is provided
to the NRSRO. This is designed to put other NRSROs and other interested
parties on an equal footing with the NRSRO hired by the arranger
insomuch as they would all obtain the information at the same time.
Consequently, they all could begin any surveillance processes
simultaneously.
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    \72\ Proposed paragraph (a)(3)(ii) of Rule 17g-5.
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    The goal of this aspect of the proposal again would be to expose an
NRSRO that was allowing business considerations to impact its judgment.

For example, in order to maintain favor with a particular arranger, an
NRSRO may be reluctant to downgrade a credit rating for a structured
finance product to its appropriate category even where a downgrade is
implied by its surveillance procedures and methodologies. Increasing
the number of credit ratings extant for the instrument, including
ratings not paid for by the arranger, would make it more difficult to
conceal the fact that a particular NRSRO was being unduly influenced by
an arranger as to its surveillance process.
    As discussed below, the manner and breadth of the disclosures,
including how widely the information could be disseminated, would
depend on the nature of the offering for the rated structured finance
product: public, private, or offshore. The proposed amendment's
requirement that the information be ``disclosed through a means
designed to provide reasonably broad dissemination'' would be
interpreted by the Commission to mean in the manner described in
sections II.A.1.b.i--iii below that discuss the proposed amendment in
the context of public, private, and offshore offerings.
    The Commission is proposing these amendments to Rule 17g-5, in
part, pursuant to the authority in Section 15E(h)(2) of the Exchange
Act.\73\ The provisions in this section of the statute provide the
Commission with authority to prohibit, or require the management and
disclosure of, any potential conflict of interest relating to the
issuance of credit ratings by an NRSRO.\74\ The Commission
preliminarily believes the proposed amendments are necessary and
appropriate in the public interest and for the protection of investors
because they are designed to address conflicts of interest and improve
the quality of credit ratings for structured finance products by: (1)
Increasing the transparency of the ratings process and thereby making
it more apparent when an NRSRO may be allowing business considerations
to impair its objectivity and (2) enhancing competition by creating the
opportunity for NRSROs that are not hired to rate structured products
to nonetheless determine credit ratings and establish track records for
rating these products.
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    \73\ 15 U.S.C. 78o-7(h)(2).
    \74\ Id.
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    The Commission preliminarily believes that it is appropriate to
require an NRSRO to address and manage the conflict of interest raised
by the NRSRO's recurring relationships with structured finance product
arrangers by making the rating process more transparent in terms of the
information used to determine the ratings. This would create an
opportunity for other NRSROs (including subscriber based NRSROs),
unregistered credit rating agencies, and other interested parties to
assess the creditworthiness of these products and issue their own
credit ratings or credit assessments.\75\ Market participants and
observers would be able to compare the ratings of the NRSROs hired by
the arrangers against the ratings of NRSROs and others not hired by the
arrangers. As discussed above, the Commission preliminarily believes
that this would enhance the integrity of the ratings process by making
it easier for users of credit ratings to compare NRSROs and evaluate
whether an NRSRO's objectivity had been compromised by the undue
influence of an arranger. It also could make it easier for the NRSROs
hired to determine credit ratings for structured finance products to
resist pressure from arrangers insomuch as the parties would be aware
that the potential for exposing a compromised NRSRO had been increased
through the proposed amendment's disclosure requirements.
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    \75\ As discussed below, for private offerings and offshore
offerings, this information would not be disclosed publicly before
the offering closes but instead would be provided via a password-
protected Internet Web site to credit rating agencies and accredited
investors. After the offering closes, the information would be
required to be disclosed publicly and, therefore, made available to
market observers such as academics.
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    The Commission generally requests comment on all aspects of this
proposed amendment. In addition, the Commission requests comment on the
following questions related to the proposal.
     Would the information proposed to be required to be
disclosed sufficient to permit the determination of an unsolicited
credit rating? Conversely, would the proposed amendment require the
disclosure of more information than would be necessary to permit the
determination of an unsolicited credit rating? Commenters believing
more information should be disclosed should specifically describe the
additional information and the practicality of requiring its
disclosure, while commenters believing that less information should be
disclosed should specifically describe what information would be
unnecessary and explain why it would be unnecessary to disclose.
     The proposed amendment would require the disclosure of
information provided to an NRSRO by the ``issuer, underwriter, sponsor,
depositor, or trustee'' based on the Commission's preliminary belief
that these would be the parties relevant to an NRSRO's performance of
the ratings process, i.e., that taken together, these are the parties
that would provide all relevant information to the NRSRO. Are there
other entities that should be included in this category?
     Should the Commission provide a ``safe harbor'' so that an
NRSRO that obtained a representation from one or more parties to a
transaction to disclose the required information would not be held in
violation of the rule if the party did not fulfill its disclosure
obligations under the representation?
     Should the Commission also require the disclosure of
information about the steps, if any, that were taken by the NRSRO,
issuer, underwriter, sponsor, depositor, or trustee to verify
information about the assets underlying or referenced by the security
or money market instrument, or, if no such steps were taken, a
disclosure of that fact?
     Would the disclosure of the initial information on the
pricing date provide enough time for other NRSROs to determine
unsolicited ratings before the securities were sold to investors? If
not, would it be appropriate to require that this information be
disclosed prior to the pricing date? Alternatively, would it be more
appropriate to require NRSROs hired by the arranger to wait a period of
calendar or business days (e.g., 2, 4, 10 days) after the asset pool is
settled upon by the arranger before issuing the initial credit rating
in order to provide other NRSROs with sufficient time to determine an
unsolicited rating?
     Should the Commission also require the disclosure of the
results of any steps taken by the NRSRO, issuer, underwriter, sponsor,
depositor, or trustee to verify information about the assets underlying
or referenced by a structured finance product? Alternatively, should
the Commission require a general disclosure of whether any steps were
taken to verify the information and, if so, a description of those
steps?
     Do NRSROs obtain information about the underlying assets
of structured products--particularly in the surveillance process--from
third-parties such as vendors rather than from issuers, underwriters,
sponsors, or trustees? If so, would it be necessary to require the
disclosure of this information as proposed or can the goals of the
proposed amendments in promoting unsolicited ratings be achieved under
current practices insomuch as the information necessary for
surveillance can be obtained from third-party vendors, albeit for a
fee?

     Does the information provided to NRSROs by issuers,
underwriters, sponsors, depositors, or trustees about assets underlying
structured products (e.g., mortgage loans, home equity loans, consumer
loans, credit card receivables) commonly include personal identifying
information about individuals such as names, social security numbers,
addresses, and telephone numbers? If so, are there practical ways to
ensure that this information is not disclosed?
     Does any of the information provided to NRSROs by issuers,
underwriters, sponsors, depositors, or trustees about assets underlying
structured products contain proprietary information? Commenters that
believe this is the case should specifically identify any such
information.
b. Proposed Guidance for Compliance With Provisions of the Securities
Act of 1933
    As noted above, the proposed amendments to Rule 17g-5 that would
require the disclosure of information about the underlying assets of a
structured finance product implicate the Securities Act.\76\ As
explained below, the means by which information would be disclosed for
the purposes of the proposed amendments to Rule 17g-5 would be governed
by the nature of the offering. The Securities Act restricts the types
of offering communications that issuers or other parties subject to the
Securities Act's provisions (such as underwriters) may use during a
registered public offering and, for private offerings, restricts the
methods by which communications may be made so as to avoid general
solicitation or general advertising of the private offering to
potential purchasers. Communications that may be considered offers \77\
are subject to these restrictions.\78\ Likewise, with respect to
unregistered offshore offerings that are intended to comply with the
safe harbor provisions of Regulation S, communications that are deemed
to be offers in the United States or directed selling efforts in the
United States are prohibited. Information about securities that are the
subject of an offering that has been provided to NRSROs and is required
to be disclosed pursuant to the proposed rules would be considered
offers or directed selling efforts and therefore subject to these
restrictions relating to offering communications.\79\
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    \76\ 15 U.S.C. 77a et seq.
    \77\ Securities Act Section 2(a)(3) (15 U.S.C. 77b(a)(3))
defines an ``offer'' as any attempt to offer to dispose of, or
solicitation of any offer to buy, a security or interest in a
security for value. The term ``offer'' has been interpreted broadly
and goes beyond the common law concept of an offer. See Diskin v.
Lomasney & Co., 452 F. 2d 871 (2d Cir. 1971); SEC v. Cavanaugh, 1 F.
Supp. 2d 337 (S.D.N.Y. 1998). The Commission has explained that
``the publication of information and publicity efforts, made in
advance of a proposed financing which have the effect of
conditioning the public mind or arousing public interest in the
issuer in its securities constitutes an offer * * *.'' Guidelines
for the Release of Information by Issuers Whose Securities are in
Registration, Securities Act Release No. 5180 (August 16, 1971), 36
FR 16506.
    \78\ Before the registration statement is filed, all offers, in
whatever form, are prohibited. See Securities Act Section 5(c) (15
U.S.C. 77e(c)). Between the filing of the registration statement and
its effectiveness, offers made in writing (including by e-mail or
Internet), by radio, or by television are limited to a ``statutory
prospectus'' that conforms to the information requirements of
Securities Act Section 10. See Securities Act Section 5(b)(1) (15
U.S.C. 77e(b)(1)) and Securities Act Section 10 (15 U.S.C. 77j).
After the registration statement is declared effective, offering
participants may make written offers only through a statutory
prospectus, except that they may use additional offering materials
if a final prospectus that meets the requirements of Securities Act
Section 10(a) is sent or given prior to or with those materials. See
Securities Act Section 2(a)(10) (15 U.S.C. 77b(a)(10)) and Section
5(b)(1).
    \79\ This may be the case even if the information relates to
pools backing prior issuances. In an offering of securities backed
by the same class of assets, the information provided for
surveillance and required to be disclosed pursuant to proposed Rule
17g-5(a)(3)(iii) may be static pool data as described in Item 1105
of Regulation AB (17 CFR 229.1105).
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    In the following three sections, the Commission provides guidance
on how the information that would be required to be disclosed under
proposed new paragraph (a)(3) of Rule 17g-5 (``Paragraph (a)(3)
Information'') would need to be disclosed under the proposed amendment
and consistent with the Securities Act. As discussed below, the manner
and breadth of the disclosures under the proposed amendment would
depend on whether the structured finance product was issued under a
public, private, or offshore offering.
i. Public Offerings
    With respect to registered offerings at the time the Paragraph
(a)(3) Information would be required to be disclosed (the pricing
date), the information would be written communications and the issuer,
underwriter, or other offering participant also would have to comply
with the Securities Act with regard to the disclosure of such written
communications.\80\ In addition, such written communications would be
subject to the civil liability and antifraud provisions of the
Securities Act.\81\
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    \80\ See Securities Offering Reform, Securities Act Release 33-
8591 (July 19, 2005), 70 FR 44722 (August 3, 2005) (the ``Securities
Offering Reform Release'') for a discussion of the definition of
written communications and rules relating to permitted
communications in registered offerings. See also Asset-Backed
Securities, Securities Act Release No. 8518 (December 22, 2004) 70
FR 1506 (January 7, 2005) (the ``Asset-Backed Securities Release'')
for rules applicable to offerings of asset-backed securities.
    \81\ Under the Securities Act, purchasers of an issuer's
securities in a registered offering have private rights of action
for materially deficient disclosure in registration statements under
Section 11 and in prospectuses and oral communications under Section
12(a)(2). Under Securities Act Section 12(a)(2) and Securities Act
Rule 159, the liability determination as to an oral communication,
prospectus, or statement, as the case may be, does not take into
account information conveyed to a purchaser only after the time of
sale (including the contract of sale), including information
contained in a final prospectus, prospectus supplement, or Exchange
Act filing that is filed or delivered subsequent to the time of sale
(including the contract of sale) where the information is not
otherwise conveyed at or prior to that time. The time of sale under
the Securities Act includes the time of the contract of sale--the
time at which an investor has taken the action the investor must
take to become committed to purchase the securities and therefore
entered into a contract of sale.
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    As discussed in the Commission's Securities Offering Reform Release
adopting several reforms to the securities offering process,\82\
issuers of structured finance products have potentially two sets of
rules under the Securities Act on which they may rely in using written
offering materials. If the offering is registered on Securities Act
Form S-3,\83\ then the written materials may constitute ABS
informational and computational materials, as defined in Item 1101 of
Regulation AB,\84\ and

should be filed on Exchange Act Form 8-K \85\ in accordance with Rules
167 and 426 of the Securities Act.\86\ The written materials may
constitute a free writing prospectus, as defined in Rule 405 of the
Securities Act.\87\ In that case, the information that is disclosed
must be filed in accordance with Rules 164 and 433 of the Securities
Act.\88\ Given that the Paragraph (a)(3) Information could constitute
offering materials, the Commission believes it is important to explain
how the rules under the Securities Act may be relied upon when
Paragraph (a)(3) Information is made publicly available.\89\
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    \82\ See Section III.D.3.b.iii(C)(3)(a)(iii) of the Securities
Offering Reform Release, 70 FR 44722, 44751.
    \83\ 17 CFR 239.13. An ABS issuer is eligible to use Form S-3 if
the conditions of General Instruction V are met.
    \84\ 17 CFR 229.1101. Item 1101 of Regulation AB provides the
following definition:
    (a) ABS informational and computational material means a written
communication consisting solely of one or some combination of the
following:
    (1) Factual information regarding the asset-backed securities
being offered and the structure and basic parameters of the
securities, such as the number of classes, seniority, payment
priorities, terms of payment, the tax, Employment Retirement Income
Security Act of 1974, as amended, (29 U.S.C. 1001 et seq.)
(``ERISA'') or other legal conclusions of counsel, and descriptive
information relating to each class ( e.g., principal amount, coupon,
minimum denomination, anticipated price, yield, weighted average
life, credit enhancements, anticipated ratings, and other similar
information relating to the proposed structure of the offering);
    (2) Factual information regarding the pool assets underlying the
asset-backed securities, including origination, acquisition and pool
selection criteria, information regarding any prefunding or
revolving period applicable to the offering, information regarding
significant obligors, data regarding the contractual and related
characteristics of the underlying pool assets ( e.g., weighted
average coupon, weighted average maturity, delinquency and loss
information and geographic distribution) and other factual
information concerning the parameters of the asset pool appropriate
to the nature of the underlying assets, such as the type of assets
comprising the pool and the programs under which the loans were
originated;
    (3) Identification of key parties to the transaction, such as
servicers, trustees, depositors, sponsors, originators and providers
of credit enhancement or other support, including a brief
description of each such party's roles, responsibilities, background
and experience;
    (4) Static pool data, as referenced in Item 1105 of this
Regulation AB, such as for the sponsor's and/or servicer's
portfolio, prior transactions or the asset pool itself;
    (5) Statistical information displaying for a particular class of
asset-backed securities the yield, average life, expected maturity,
interest rate sensitivity, cash flow characteristics, total rate of
return, option adjusted spread or other financial or statistical
information relating to the class or classes under specified
prepayment, interest rate, loss or other hypothetical scenarios.
Examples of such information under the definition include:
    (i) Statistical results of interest rate sensitivity analyses
regarding the impact on yield or other financial characteristics of
a class of securities from changes in interest rates at one or more
assumed prepayment speeds;
    (ii) Statistical information showing the cash flows that would
be associated with a particular class of asset-backed securities at
a specified prepayment speed; and
    (iii) Statistical information reflecting the financial impact of
losses based on a variety of loss or default experience, prepayment,
interest rate and related assumptions.
    (6) The names of underwriters participating in the offering of
the securities, and their additional roles, if any, within the
underwriting syndicate;
    (7) The anticipated schedule for the offering (including the
approximate date upon which the proposed sale to the public will
begin) and a description of marketing events (including the dates,
times, locations, and procedures for attending or otherwise
accessing them); and
    (8) A description of the procedures by which the underwriters
will conduct the offering and the procedures for transactions in
connection with the offering with an underwriter or participating
dealer (including procedures regarding account-opening and
submitting indications of interest and conditional offers to buy).
The Commission confirmed in the Asset-Backed Securities Release that
loan level information could be included in ABS information and
computational materials.
    \85\ 17 CFR 249.308.
    \86\ 17 CFR 230.167 and 17 CFR 230.426.
    \87\ 17 CFR 230.405. The contents of free writing prospectuses
are not limited to ABS informational and computational materials.
    \88\ 17 CFR 230.164 and 17 CFR 230.433. Rule 433 also provides
that a free writing prospectus or portion thereof required to be
filed under Rule 433 containing only ABS informational and
computational materials may be filed under Rule 433 but within the
time frame required for satisfaction of the conditions of Rule 426,
and that such filing will satisfy the conditions of Rule 433.
    \89\ Depending on whether the materials constitute a free
writing prospectus or ABS informational and computational materials,
the liability provisions governing the disclosure may differ. Free
writing prospectuses are subject to liability under Section 12(a)(2)
and Section 17(a) of the Securities Act. 15 U.S.C. 77l(a)(2) and 15
U.S.C. 77q(a). A free writing prospectus will not be part of a
registration statement subject to liability under Securities Act
Section 11 unless the issuer elects to file it as part of the
registration statement. See also Asset-Backed Securities Release at
footnote 335. On the other hand, ABS informational and computational
materials also are subject to Section 12(a)(2) and Section 17(a)
liability, but they must be filed on Form 8-K and therefore, by
virtue of incorporation by reference into a registration statement,
are subject to Section 11 liability.
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    Most elements of the Paragraph (a)(3) Information would need to be
filed in accordance with the rules governing free writing prospectuses
or ABS informational and computational materials pursuant to Rules 433
and 426.\90\ Currently, the timing or filing requirements under these
rules is tied to when the information is provided to specific
investors. However, unlike other free writing prospectuses and ABS
informational and computational materials that may be provided to
specific investors, in a public offering, the Paragraph (a)(3)
Information would be required to be disclosed publicly. Therefore, the
Commission believes that it is appropriate to clarify when the
materials should be filed with the Commission.
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    \90\ 17 CFR 230.433 and 17 CFR 230.426.
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    Under Rule 426, ABS informational and computational materials are
required to be filed by the later of the due date for filing the final
prospectus under Rule 424(b) or two days after the date of first use.
Under Rule 433, a free writing prospectus must be filed with the
Commission no later than the date of first use. However, in order to
conform certain asset-backed free writing prospectuses with the filing
requirements for ABS informational and computational materials in Rule
426, Rule 433(d)(6) provides that a free writing prospectus containing
only ABS information and computational materials may be filed in the
time provided by Rule 426(b). Thus, under both rules the information
must be filed by the later of the due date for filing the final
prospectus under Rule 424(b) or two days after the date of first use.
    In addition, Rule 433 requires filing by issuers of free writing
prospectuses prepared by or on behalf of, or used or referred to by,
issuers or, depositors, sponsors, servicers, or affiliated depositors,
whether or not the issuer, but not by underwriters or dealers, unless
they contain issuer information or are distributed in a manner
reasonably designed to lead to its broad dissemination. The Paragraph
(a)(3) Information that would be required to be disclosed would not be
considered underwriter or dealer information, even if prepared by the
underwriter or dealer, given the broad dissemination and thus would
need to be filed.
    Rules 164 and 167 provide the exemption from Section 5(b)(1) of the
Securities Act for the use of free writing prospectuses and ABS
informational and computational materials, respectively. For the most
part, Rule 164 should be available for the use of the Paragraph (a)(3)
Information, even where the issuer is an ineligible issuer,\91\ given
that the rule provides that ineligible issuers that are asset-backed
issuers may use a free writing prospectus as long as the free writing
prospectus contains only specified information.\92\ Much of the
Paragraph

(a)(3) Information should contain information that can be included in a
free writing prospectus used by an asset-backed issuer pursuant to Rule
164. To the extent that Rule 167 is not available because the offering
is registered on Form S-1 rather than Form S-3, and Rule 164 is not
available, the information should be filed in an amendment to the
registration statement.
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    \91\ An ``ineligible issuer,'' as the term is defined in Rule
405 of the Securities Act, includes, in the case of asset-backed
issuers, the depositor or any issuing entities previously
established, directly or indirectly by the depositor, who are not
current in their Exchange Act reports and other materials required
to be filed during the prior 12 months (or such shorter period that
the issuer was required to file such reports and materials), other
than reports on Form 8-K required solely pursuant to an item
specified in General Instruction I.A.4 of Form S-3.
    \92\ In asset-backed offerings by ineligible issuers, free
writing prospectuses used by ineligible issuers are limited to the
following information:
    (1) Factual information regarding the asset-backed securities
being offered and the structure and basic parameters of the
securities, such as the number of classes, seniority, payment
priorities, terms of payment, the tax, ERISA or other legal
conclusions of counsel, and descriptive information relating to each
class (e.g., principal amount, coupon, minimum denomination,
anticipated price, yield, weighted average life, credit
enhancements, anticipated ratings, and other similar information
relating to the proposed structure of the offering);
    (2) factual information regarding the pool assets underlying the
asset-backed securities, including origination, acquisition and pool
selection criteria, information regarding any prefunding or
revolving period applicable to the offering, information regarding
significant obligors, data regarding the contractual and related
characteristics of the underlying pool assets (e.g., weighted
average coupon, weighted average maturity, delinquency and loss
information and geographic distribution) and other factual
information concerning the parameters of the asset pool appropriate
to the nature of the underlying assets, such as the type of assets
comprising the pool and the programs under which the loans were
originated;
    (3) identification of key parties to the transaction, such as
servicers, trustees, depositors, sponsors, originators and providers
of credit enhancement or other support, including a brief
description of each such party's roles, responsibilities, background
and experience;
    (4) static pool data;
    (5) the names of underwriters participating in the offering of
the securities, and their additional roles, if any, within the
underwriting syndicate;
    (6) the anticipated schedule for the offering (including the
approximate date upon which the proposed sale to the public will
begin) and a description of marketing events (including the dates,
times, locations, and procedures for attending or otherwise
accessing them); and
    (7) a description of the procedures by which the underwriters
will conduct the offering and the procedures for transactions in
connection with the offering with an underwriter or participating
dealer (including procedures regarding account opening and
submitting indications of interest and conditional offers to buy).
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    In addition, the Commission understands that currently at least
some of the information that would constitute Paragraph (a)(3)
Information, if not included in a free writing prospectus, is often
included as a schedule to pooling and servicing agreements. Those
agreements, along with their schedules and exhibits, should be filed by
the time of the offering of securities. Therefore they should be filed
at the time of the takedown as exhibits to a Form 8-K incorporating
them by reference into the Form S-3 registration statement.\93\
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    \93\ See Form S-3 (17 CFR 239.13), Form 8-K (17 CFR 249.308) and
Item 601(b)(4) of Regulation S-K (17 CFR 229.601).
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    The Commission generally requests comment on all aspects of this
proposed guidance. In addition, the Commission requests comment on the
following questions related to the proposal.
     Do we need to give more guidance on the relationship
between the proposed disclosure requirements regarding information
about the underlying assets provided to, and used by, the NRSRO to
perform ratings surveillance and the requirements of Regulation FD?
\94\ If commenters believe that the proposed requirements are not
consistent with Regulation FD, they should provide a detailed
explanation as to why not.
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    \94\ 17 CFR 243.100 to 103.
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     The proposed disclosure requirements regarding information
about the underlying assets provided to, and used by, the NRSRO to
perform ratings surveillance may be the same as the information
required to be disclosed on Form 10-D for so long as the issuer has an
Exchange Act reporting obligation. Given that the Form 10-D reporting
obligation is typically suspended for most asset-backed issuers after
the first year of reporting, does the proposed disclosure requirement
raise any issues regarding Exchange Act reporting?
     ABS informational and computation materials, as defined in
Item 1101 of Regulation AB, can include, among other things, factual
information regarding the pool assets underlying the asset-backed
securities, including origination, acquisition and pool selection
criteria, information regarding any prefunding or revolving period
applicable to the offering, information regarding significant obligors,
data regarding the contractual and related characteristics of the
underlying pool assets (e.g., weighted average coupon, weighted average
maturity, delinquency and loss information and geographic distribution)
and other factual information concerning the parameters of the asset
pool appropriate to the nature of the underlying assets, such as the
type of assets comprising the pool and the programs under which the
loans were originated.\95\ As noted above, the Commission believes that
at least some of the proposed Paragraph (a)(3) Information could fall
within this category and therefore constitute ABS informational and
computational materials. Since there may be a wide variety of
information that is provided to an NRSRO, it is not clear that all
information provided would fit within the definition of ABS
informational and computation materials, or in the various categories
of free writing prospectus. Should the Commission provide additional
interpretation regarding what types of material that could be provided
and would be required to be disclosed to fit within this category? Is
there information that is likely to be provided and disclosed that does
not appear to fit within these definitions? Should the Commission
instead revise the definitions to specifically include the information
required to be disclosed?
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    \95\ See Asset-Backed Securities Release.
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     Is there any need for the Commission to revise Securities
Act Rules 426 or 433 to clarify when the materials need to be filed?
     Are there any additional requirements in Regulation AB or
under the Securities Act that are implicated by the proposed
amendments? Is there any information that would typically need to be
disclosed under this proposed amendment that is not already generally
disclosed in filings with the Commission?
     Should the Commission amend Regulation AB to require that
the Paragraph (a)(3) Information be disclosed?
ii. Private Offerings
    The proposed amendments also would implicate the Securities Act
restrictions affecting private offerings. Offerings of securities made
in reliance on an exemption from registration contained in Securities
Act Section 4(2),\96\ the rules promulgated thereunder or pursuant to
Regulation D,\97\ are offerings that are not made to the public. As a
result, general solicitation or advertising is prohibited in these
offerings under Securities Act Section 4(2) and the applicable
Securities Act rules.\98\ As a result of the application of the general
solicitation and advertising restrictions, public disclosure of
offering or security information pursuant to the proposed rules could
cause the private offering exemptions to be unavailable to securities
offerings to which the proposed rules apply.
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    \96\ 15 U.S.C. 77d(2).
    \97\ 17 CFR 230.501 through 230.508.
    \98\ See Securities Act Section 4(2) (15 U.S.C. 77d(2)) and
Securities Act Rules 504, 505 and 506 of Regulation D (17 CFR
230.504, 230.505 and 230.506). An exception to the prohibition
against general solicitation applies to some limited offerings under
Rule 504(b)(1) (17 CFR 230.504(b)(1)) when an issuer has satisfied
state securities laws of specified types. See Revision of Rule 504
of Regulation D, the ``Seed Capital'' Exemption, Securities Act
Release No. 7644 (February 25, 1999), 64 FR 11090. The restriction
on general solicitation or advertising applies to all methods by
which the communication can be made, including electronic, paper,
mail, radio, television, or in newspapers or magazines.
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    As discussed above, the Commission believes it is likely that much
of the information that would need to be disclosed under the proposed
amendment would contain extensive loan level data, and thus anticipates
that a common medium for disclosure of this information would be an
Internet Web site. The Commission has indicated that the placement of
private offering materials on an Internet Web site, without sufficient
procedures to limit access only to accredited investors, is
inconsistent with the prohibition against general solicitation or
advertising in Securities Act Rule 502(c).\99\ However, as discussed
above, the Commission also believes that to address the conflict of
interest inherent in the structured finance product arranger-pay
business model it would be beneficial to make this information
available to investors and entities meeting the definition of ``credit
rating agency'' in Section 3(a)(61) of the Exchange Act (which would
include NRSROs) \100\ on the date the placement agent and the issuer or
depositor set the offering price of the securities being

rated, and to the general public on the first business day after the
offering closes.
    The Commission believes, therefore, that in a private offering,
Paragraph (a)(3) Information would need to be provided to investors,
NRSROs, and credit rating agencies by posting the information on a
password-protected Internet Web site.\101\ On the first business day
after the offering closes, however, the Paragraph (a)(3) Information
would need to be disclosed publicly. The Commission believes that
removing the password protection from the Internet Web site where the
Paragraph (a)(3) Information is posted after the offering closes is
consistent with the Securities Act restrictions on private offerings
while satisfying the requirements of proposed Rule 17g-5(a)(3).
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    \99\ See Use of Electronic Media, Securities Act Release No.
7856 (April 28, 2000), 65 FR 25843 (the ``Electronic Media
Release''). The Commission noted in the Electronic Media Release
that the federal securities laws apply equally to information
contained on an issuer's Web site as they do to other communications
made by or attributed to the issuer.
    \100\ 15 U.S.C. 78c(a)(61).
    \101\ A password-protected Web site would meet the requirements
of an amended Rule 17g-5 in the context of private offerings.
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    As discussed above, the Commission believes it would be appropriate
to allow early access to credit rating agencies other than those hired
to issue a rating to provide them with an opportunity to perform
independent assessments of the validity of ratings and identify flaws,
opportunities for improvement, or compromised procedures in the hired
NRSRO's approach. While permitting access to this information to credit
rating agencies in addition to accredited investors extends beyond the
Commission's previous interpretations on what constitutes a general
solicitation or advertising, the Commission believes it balances those
issues with the benefits of having other credit rating agencies able to
assess the quality of, or provide additional, ratings.\102\ This
approach is designed to promote competition among NRSROs by providing
credit rating agencies that were not paid by the issuer to rate the
issuer's products with information they need to issue unsolicited
ratings and allowing other market participants to also have access to
the information to allow them to evaluate the ratings. In a private
offering, disclosure of this information is undertaken in two steps in
order to avoid issues of general solicitation. The Commission is
providing the above guidance only in the context of the proposed
amendments. Moreover, the guidance expressed in this release is
applicable only if the proposed amendments are adopted.
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    \102\ The Commission noted in Interpretative Release on
Regulation D, Securities Act Release No. 6455 (March 3, 1983), 17
CFR 231, that Rule 502(c) relates to the nature of the offering, not
the nature of the offerees.
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    The Commission generally requests comment on all aspects of this
proposed guidance. In addition, the Commission requests comment on the
following questions related to the proposal.
     Are there other parties besides credit rating agencies and
investors that should be eligible to access Paragraph (a)(3)
Information in the context of a private offering without raising issues
of general solicitation?
     Should any of the foregoing guidance regarding the use of
Paragraph (a)(3) Information be codified?
     Is expanding the categories of parties who can access the
information that would be contained in the proposed Paragraph (a)(3)
Information consistent with the purposes of the Securities Act?
     Is there any Paragraph (a)(3) Information that should
remain accessible only to credit rating agencies and investors, rather
than, as proposed, disclosed to the public on the business day after
the offering has closed?
     Should the requirement to publicly disclose the Paragraph
(a)(3) Information on the first business day after the offering has
closed also permit the NRSRO, depositor, etc. to omit deal-specific
information relating to the transaction such that only ``generic''
information is provided to the public?
     Does disclosure of information provided for purposes of
credit rating surveillance raise issues of general solicitation in the
context of subsequent offerings of the same asset class? If so, does
this vary by asset class?
iii. Offshore Offerings
    Similar to private offerings, the proposed amendments would
implicate restrictions under Regulation S. Under the General Statement
of Regulation S,\103\ the provisions of Section 5 of the Securities Act
apply to offers and sales of securities that occur in the United States
and do not apply to those that occur outside the United States.
Regulation S contains various safe harbor procedures that issuers,
offering participants and others can follow for unregistered offerings
outside the United States. These procedures include restrictions
against offers being made to persons in the United States\104\ and
restrictions against directed selling efforts in the United States by
the issuer, distributor, any of their respective affiliates, or persons
acting on their behalf.\105\
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    \103\ Rule 901 of Regulation S, 17 CFR 230.901.
    \104\ Rule 903(a)(1).
    \105\ Rule 903(a)(2).
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    As noted above, the Commission believes that it is likely that much
of the information that would be required to be disclosed would contain
extensive loan level data and thus anticipates that a common medium for
disclosure of this information would be an Internet Web site. The
Commission has provided guidance with respect to the use of Internet
Web sites for securities offerings outside the United States.\106\ This
guidance sets out a general approach that when adequate measures are
implemented to prevent U.S. persons from participating in an offshore
offer, the Commission would not view the offer as occurring in the
United States for registration purposes. The Commission believes that
this guidance can be equally applied to the proposed disclosure of the
proposed Paragraph (a)(3) Information.
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    \106\ See Statement of the Commission Regarding Use of Internet
Web Sites to Offer Securities, Solicit Securities Transactions or
Advertise Investment Services Offshore, Securities Act Release No.
7516 (March 23, 1998).
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    Under this guidance, what constitutes adequate measures would
depend on all of the facts and circumstances of a particular
transaction. As the Commission noted previously:

    ``We generally would not consider an offshore Internet offer
made by a non-U.S. offeror as targeted at the United States,
however, if: (1) the Web site contains a prominent disclaimer making
it clear that the offer is directed only to countries other than the
United States; * * * and (2) the Web site offeror implements
procedures that are reasonably designed to guard against sales to
U.S. persons in the offshore offering.'' \107\
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    \107\ Id.>

These procedures are not exclusive.
    The Commission's prior guidance distinguishes among foreign issuers
and U.S. issuers each conducting offshore offerings under Regulation S
and U.S. offerings conducted on an exempt basis. The Commission
believes it is appropriate to continue this treatment with respect to
the proposed disclosure of the Paragraph (a)(3) Information. Under this
guidance, a foreign issuer making an offshore offering with no
concurrent U.S. private offering is not required to password-protect
Internet-based offering communications so long as adequate measures are
put in place. Thus, credit rating agencies and other market
participants should be able to have ready access to any Paragraph
(a)(3) Information that is posted by a foreign issuer. A foreign issuer
making an offshore offering concurrently with private offerings in the
United States could implement additional other procedures to prevent
its offshore Internet communications from being

used to solicit participants for its U.S.-based exempt offering, and
U.S. issuers conducting an offshore offering should implement
procedures similar to those for private placements, such as password-
type procedures, under which only non-U.S. persons can obtain access to
the materials. Consistent with the procedures for private offerings,
there could be pricing date disclosure to credit rating agencies that
are not purchasers in the offering through a password-protected
Internet Web site. As a result, when a foreign issuer is conducting a
U.S. private offering under Section 4(2), and when a U.S. issuer is
conducting an offshore offering under Regulation S or a private
offering under Section 4(2), it would follow the procedures outlined in
Section II.A.1.b.ii above with respect to private offerings, including
procedures calling for public disclosure of Paragraph (a)(3)
Information on the business day after the closing date.
    The Commission generally requests comment on all aspects of this
proposed guidance. In addition, the Commission requests comment on the
following questions related to the proposal.
     Are there other parties besides credit rating agencies
that should be eligible to access Paragraph (a)(3) Information in the
context of an offshore offering without raising issues of directed
selling efforts or offers of securities in the Unites States?
     Should any of the foregoing guidance regarding the use of
Paragraph (a)(3) Information be codified?
     Is expanding the categories of parties who can access the
information that would be contained in the proposed Paragraph (a)(3)
Information consistent with the purposes of the Securities Act?
     Is there any Paragraph (a)(3) Information that should
remain accessible only to credit rating agencies and investors, rather
than, as proposed, be disclosed to the public on the business day after
the offering has closed?
     Should the requirement to publicly disclose the Paragraph
(a)(3) Information on the first business day after the offering has
closed also permit the NRSRO, depositor, etc. to omit deal-specific
information relating to the transaction such that only ``generic''
information is provided to the public?
2. Rule 17g-5 Prohibition on Conflict of Interest Related to Rating an
Obligor or Debt Security Where Obligor or Issuer Received Ratings
Recommendations From the NRSRO or Person Associated With the NRSRO
    The Commission is proposing to amend Rule 17g-5(c) to add a new
paragraph (5) that would prohibit an NRSRO from issuing a credit rating
with respect to an obligor or security where the NRSRO or a person
associated with the NRSRO, as defined in Section 3(a)(63) of the
Exchange Act,\108\ made recommendations to the obligor or the issuer,
underwriter, or sponsor of the security (that is, the parties
responsible for structuring the security) about the corporate or legal
structure, assets, liabilities, or activities of the obligor or issuer
of the security. This proposal would prohibit the NRSRO and, in
particular, its credit analysts from making recommendations to
obligors, issuers, underwriters, and sponsors such as arrangers of
structured finance products about how to obtain a desired credit rating
during the rating process. It also would prohibit an NRSRO from issuing
a credit rating where a person associated with the NRSRO, such as an
affiliate, made such recommendations.
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    \108\ 15 U.S.C. 78c(a)(63).
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    The Commission is proposing this amendment to Rule 17g-5, in part,
pursuant to the authority in Section 15E(h)(2) of the Exchange
Act.\109\ The provisions of this section of the statute provide the
Commission with authority to prohibit, or require the management and
disclosure of, any potential conflict of interest relating to the
issuance of credit ratings by an NRSRO.\110\ The Commission
preliminarily believes the proposed amendment is necessary and
appropriate in the public interest and for the protection of investors
because it would address a potential practice that could impair the
objectivity, and, correspondingly, the quality, of a credit rating. It
has been suggested that during the process of rating structured finance
products the NRSROs have recommended to arrangers how to structure a
trust or complete an asset pool to receive a desired credit rating and
then rated the securities issued by the trust--in effect, rating their
own work.\111\ This proposal would prohibit this conduct based on the
Commission's preliminary belief that it creates a conflict that cannot
be effectively managed insomuch as it would be very difficult for an
NRSRO to remain objective when assessing the creditworthiness of an
obligor or debt security where the NRSRO or person associated with the
NRSRO made recommendations about steps the obligor or issuer of the
security could take to obtain a desired credit rating.
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    \109\ 15 U.S.C. 78o-7(h)(2).
    \110\ Id.
    \111\ See e.g., Coffee April 22, 2008 Senate Testimony, pp. 2-3.
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    The proposal is not intended to prohibit all interaction between
the NRSRO and the obligor, issuer, underwriter, or sponsor during the