SEC to Reduce Reliance on Ratings

The Securities and Exchange Commission appears to be following Congress' lead when it comes to the rating agencies. The summer's massive financial regulation bill sought to remove the rating agencies' influence from federal regulation whenever possible. As a result, the SEC wants to eliminate their role in the registration process for certain types of securities. The move is not incredibly surprising, but it is significant.

Here's the gist of the SEC's proposed rule:

The SEC's proposed rule amendments would remove the NRSRO investment grade ratings condition included in SEC forms S-3 and F-3 for offerings of non-convertible securities, such as debt securities. And instead of ratings, the new short-form test for shelf-offering eligibility of companies would be tied to the amount of debt and other non-convertible securities they have sold in the past three years

In general, this is a good idea. In fact, even at least one rating agency supports it. Standard & Poor's is on board, according to the New York Times. Why wouldn't they want regulators to require their blessing? For two reasons. First, the market will still want an agencies' blessing. The three big rating agencies are pretty well-established, so they don't really need regulators' help to secure market share. Second, the further the agencies can distance their ratings from deal documentation, the easier it will be to rely on their free speech argument to avoid liability for incorrect ratings.

This second principle was at the heart of the problem that became clear back in July. At that time, the financial regulation bill went into effect and ordered that agencies would be held liable for their ratings included in deal documentation. The raters balked, refusing to rate securities if they would be held liable. As the market began to seize, SEC responded by indefinitely suspending this requirement. This new rule would reinforce the SEC's move to remove the agencies' mention from deal documents.

There is one strange aspect of the new rule, however. Currently, at least one rating is needed to file the securities offering. So the SEC seeks to find a different way to ensure that a deal is legitimate for registration. It does that by intending to only allow firms to register the types of securities mentioned above without ratings if they have issued at least $1 billion of such securities during the past three years.

The problem here should be kind of obvious: how do smaller competitors enter the landscape? If a new firm wants to begin issuing securities, it will be legally prohibited. Moreover, even if there are some existing smaller firms that issued less than $1 billion in securities over the specified period, they would also be kept out of the market. This concern has already been stated by some Republican commissioners, according to the New York Times. We'll have to wait to see if a better alternative is proposed before the rule is made final.