It should have come as no surprise that, within the 2,300 pages of the most sweeping financial regulatory legislation since the Great Depression, there were a few unheralded provisions with significant consequences. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was passed by the U.S. Congress and signed into law by President Obama on July 21, 2010. The legislation introduced broad reforms to many areas of the financial markets, but one provision that garnered little attention prior to the bill becoming law paralyzed the asset-backed securities (“ABS”) market in the aftermath of the law’s enactment. The repeal of a rule exempting credit rating agencies from “expert” designation meant rating agencies could be held liable for material misstatements or omissions with respect to the ratings they attach to securities. Given this potential new exposure, rating agencies refused to allow issuers to include their ratings in registration statements or prospectuses, as required for new public ABS offerings. As such, issuers were briefly unable to bring new bonds to market. The Securities and Exchange Commission (“SEC”) immediately provided temporary relief to the market by granting a six-month reprieve from enforcement of the relevant rule. On November 23, 2010, the SEC extended that reprieve indefinitely, subject of course to further congressional action.
The Dodd-Frank Act Turns Credit Ratings Into Expert Advice
In four lines on the last page of a lengthy section entitled “Improvements to the Regulation of Credit Rating Agencies,” Section 939G of the Dodd-Frank Act transforms the role of rating agencies in ABS offerings by repealing Rule 436(g) under the Securities Act of 1933 (“Securities Act”). The Rule provided that a credit rating from a Nationally Recognized Statistical Rating Organization (“NRSRO”) assigned to a public offering registered under the Securities Act was not considered an expert-certified part of the registration statement, as defined by Sections 7 and 11 of the Securities Act.
The rating agencies’ exception from expert designation was aligned with the historically prevailing view that ratings issued by NRSROs were opinions and entitled to First Amendment protection. That view has been challenged in the last few years, and recent court decisions suggest a First Amendment defense of rating opinions may be fracturing. On September 2, 2009, Judge Scheindlin issued a decision in Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc., denying rating agencies’ motions to dismiss certain claims brought by securities investors, and rejecting the argument that rating opinions were entitled to immunity under the First Amendment.1 She distinguished generalized First Amendment protection for ratings disseminated to the public at large from situations where ratings are provided only to a select group of investors, explaining that, in those narrower circumstances, the ratings do not warrant First Amendment protection. Judge Scheindlin also rejected the argument that the ratings were nonactionable opinions. Finding that plaintiffs had sufficiently pled the rating agencies did not “genuinely or reasonably believe that the ratings they assigned to the Rated Notes were accurate and had a basis in fact,” she held the ratings could be actionable misrepresentations.2
A recent California decision is arguably more expansive. Judge Kramer ruled against rating agencies on another preliminary motion in California Public Employees’ Retirement Systems v. Moody’s Corp. et al.3 The court cited the Abu Dhabi opinion, and explained: “The right to free speech allows us to give our opinions on things of public concern. The issuance of these SIV ratings is not, however, an issue of public concern. Rather, it is an economic activity designed for a limited target for the purpose of making money. That is not something that should be afforded First Amendment protection and the Defendants are not akin to members of the financial press.”4
This body of law is still developing and the ultimate resolution of these speech questions remains uncertain, but meanwhile the Dodd-Frank Act deems the assignment of ratings in public offering documents to be expert advice, not just expressions of opinions ostensibly protected by the First Amendment. But for the SEC’s no-action letters, disclosure of a rating in a registration statement would now require inclusion of consent by the rating agency to be named as an expert, since Section 11 liability otherwise could attach to the rating agency.
Rating Agencies Initially Seek to Avoid Section 11 Expert Liability, Freezing ABS Market
Against this backdrop, Fitch Ratings, Standard & Poor’s Ratings Services, Moody’s Investor Service, and DBRS Inc. all indicated they would not allow their organizations to be named as experts in ABS registration documents filed with the SEC. Typifying the NRSROs’ response, Fitch issued a comprehensive statement explaining its view that ratings are forward-looking and “embody assumptions and predictions about future events that by their nature cannot be verified as facts,” thereby justifying the historical treatment of credit rating agencies as not experts under the Securities Act.5 Despite this position, NRSROs announced intentions to avoid exposure to expert liability under Section 11 following the Dodd-Frank Act: Fitch and other NRSROs indicated they would continue to publish credit ratings and research, but would not consent to include ratings in prospectuses and registration statements until they fully understand the attendant liability issues.
Given the NRSROs’ reaction, the ABS new issue market froze, because Items 1103(a)(9) and 1120 of Regulation AB require ratings to be incorporated in a public registration statement or prospectus for ABS offerings. Issuers must disclose the rating and identity of the rating agency if an issuance or sale of any class of offered asset-backed securities is conditioned on the assignment of a rating by one or more NRSROs.6 Without the consent of the ratings agencies, such disclosures were impossible, and new registered offerings of ABS could not proceed.
Ford Deal Prompts the SEC to Suspend Enforcement, Reviving ABS Market
A plan by Ford Motor Company’s financing arm, Ford Motor Credit Company LLC, to issue $1.082 billion in new debt backed by a pool of auto loans was the first offering to falter in the wake of the Dodd-Frank Act. The day after the legislation was signed, the Ford deal stalled because the company was unable to use credit ratings in its offering documents.
That day, July 22, 2010, Ford wrote to the SEC’s Division of Corporation Finance asking the Division not to recommend enforcement action if Ford did not include ratings in a prospectus relating to an offering completed during a “specified, temporary period of time.”7 The SEC responded immediately, issuing a no-action letter indicating that, given the rating agencies’ refusal to be named experts, the Division of Corporation Finance would not recommend enforcement action if an issuer omits the ratings disclosure required by Items 1103(a)(9) and 1120 of Regulation AB during a six-month grace period.8 The SEC’s no-action position was set to expire with respect to any registered offerings of asset-backed securities with initial bona fide offers on or after January 24, 2011,9 but was recently extended indefinitely.10
In addition to granting Ford Motor Credit Company’s request for an enforcement delay, the SEC staff also published five Compliance & Disclosure Interpretations (“C&DIs”) for corporate debt issuers addressing related issues. Essentially, they allow the status quo issuance process to continue.11
The SEC’s no-action position with regard to the repeal of Rule 436(g) offers relief to the multibillion-dollar market for asset-backed securities, but the SEC has indicated that further changes may be on the horizon.12 The new no-action letter explains that the SEC’s position was driven in part by a need to “allow adequate time to complete the regulatory actions required by the Dodd-Frank Act.”13 The SEC’s approach will permit registered asset-backed securities offerings “to continue without interruption” while the SEC continues its ongoing evaluation of “whether and, if so, how [the Dodd-Frank Act’s] final regulatory actions should affect the Commission’s disclosure requirements regarding credit ratings for asset-backed securities offerings.”14 A final resolution for the ABS market is still to come.
For more information on this alert, please contact any of the lawyers listed below:
Steven G. Brody, Partner, Financial Institutions Litigation
John Arnholz, Partner, Structured Transactions
Reed D. Auerbach, Partner, Structured Transactions
Edward Gainor, Partner, Structured Transactions
David M. Balabanian, Co-chair, Financial Institutions Litigation
Jeffrey Q. Smith, Co-chair, Financial Institutions Litigation
1 651 F. Supp. 2d 155 (S.D.N.Y. 2009).
2 Id. at 176.
3 Superior Court of California, San Francisco County, No. 09-490241 (May 24, 2010).
4 Id. at 8.
5 Press Release, Fitch Ratings, Fitch Comments on U.S. Financial Reform Act’s Implication for Credit Rating Agencies, July 23, 2010.
6 Item 1120 also requires a description of any arrangements to have such ratings monitored while the asset-backed securities are outstanding.
7 Letter from S. Thomas, Ford Motor Credit Company LLC, to K. Hsu, Securities and Exchange Commission, Division of Corporation Finance (July 22, 2010).
8 Ford Motor Credit Company LLC, SEC No-Action Letter (July 22, 2010).
10 Ford Motor Credit Company LLC, SEC No-Action Letter (November 23, 2010).
11 Securities Act Rules, SEC Compliance & Disclosure Interpretations: New Question 233.04, New Question 233.05, New Question 233.06, New Question 233.07, New Question 233.8 (July 27, 2010).
12 Ford Motor Credit Company LLC, SEC No-Action Letter (November 23, 2010).