[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]




 
                   REFORMING CREDIT RATING AGENCIES:
                      THE SEC'S NEED FOR STATUTORY
                              AUTHORITY

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             APRIL 12, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-14


                    U.S. GOVERNMENT PRINTING OFFICE
23-047                      WASHINGTON : 2005
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092250 Mail: Stop SSOP, Washington, DC 20402ï¿½090001

                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana          PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio                  MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North          HAROLD E. FORD, Jr., Tennessee
    Carolina                         RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
VITO FOSSELLA, New York              STEVE ISRAEL, New York
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio              JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
TOM FEENEY, Florida                  STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina   AL GREEN, Texas
KATHERINE HARRIS, Florida            EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona                  MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico            GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas               
TOM PRICE, Georgia                   BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK, 
    Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina

                 Robert U. Foster, III, Staff Director
  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

JIM RYUN, Kansas, Vice Chair         PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              DENNIS MOORE, Kansas
FRANK D. LUCAS, Oklahoma             MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
EDWARD R. ROYCE, California          RUBEN HINOJOSA, Texas
SUE W. KELLY, New York               JOSEPH CROWLEY, New York
ROBERT W. NEY, Ohio                  STEVE ISRAEL, New York
VITO FOSSELLA, New York,             WM. LACY CLAY, Missouri
JUDY BIGGERT, Illinois               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
J. GRESHAM BARRETT, South Carolina   BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
TOM FEENEY, Florida                  NYDIA M. VELAZQUEZ, New York
JIM GERLACH, Pennsylvania            MELVIN L. WATT, North Carolina
KATHERINE HARRIS, Florida            ARTUR DAVIS, Alabama
JEB HENSARLING, Texas                MELISSA L. BEAN, Illinois
RICK RENZI, Arizona                  DEBBIE WASSERMAN SCHULTZ, Florida
GEOFF DAVIS, Kentucky                BARNEY FRANK, Massachusetts
MICHAEL G. FITZPATRICK, 
    Pennsylvania
MICHAEL G. OXLEY, Ohio


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    April 12, 2005...............................................     1
Appendix:
    April 12, 2005...............................................    23

                                WITNESS
                        Tuesday, April 12, 2005

Nazareth, Annette, Director of Market Regulation, United States 
  Securities and Exchange Commission.............................     4

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    24
    Fitzpatrick, Hon. Michael G..................................    26
    Gillmor, Hon. Paul E.........................................    27
    Kanjorski, Hon. Paul E.......................................    28
    Nazareth, Annette............................................    30

              Additional Material Submitted for the Record

Kanjorski, Hon. Paul E.:
    Written letter to Hon. William H. Donaldson, Chairman, U.S. 
      Securities and Exchange Commission, April 12, 2005.........    39


                   REFORMING CREDIT RATING AGENCIES:
                      THE SEC'S NEED FOR STATUTORY
                               AUTHORITY

                              ----------                              


                        Tuesday, April 12, 2005

             U.S. House of Representatives,
        Subcommittee on Capital Markets, Insurance,
              and Government Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 2:05 p.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ryun, Kelly, Brown-Waite, 
Hensarling, Kanjorski, and Wasserman Schultz.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order.
    Today, the committee meets for the purpose of receipt of 
testimony from Annette Nazareth, who is the director of the 
Divsion of Market Regulation of the U.S. Securities and 
Exchange Commission.
    The committee has had for some number of years interest in 
and perhaps concern for the manner by which rating agencies are 
regulated and overseen in their function, consistent with the 
requirements of the Investment Company Act, which when a public 
operating company chooses to issue debt and enter the public 
markets, must receive at least two ratings from independent 
rating agencies for that debt to be properly issued. That, of 
course, sets in motion a number of concerns as to the 
independence and insightfulness of the agencies which are 
charged with the responsibility to conduct these ratings.
    A brief summary of our history and how we arrive at our 
hearing today, it was in 1994 that the SEC first established 
the nationally recognized credit rating agency definition and 
left unclear exactly what it was required of an entity to 
become an NRSRO. Subsequent to the 1994 establishment of that 
principle, in 1997 the agency issued a subsequent release which 
was not adopted because of opinions issued in writing by the 
Department of Justice indicating that the standards attempting 
to be established would prohibit, in all likelihood, entry into 
the market or make it substantially difficult so that there 
would not be an ability of competitors to enter into the rating 
agency business.
    In 2003, the SEC issued another release posing 54 questions 
for public comment. A number of issues were raised as a result 
of those responses and yet no action of a substantive form was 
taken at that time. A rule is now pending issued by the SEC 
which is making the attempt, as I view it, to redefine what 
constructs the elements of an NRSRO. There are three specific 
items listed, but unfortunately I have come to the conclusion 
that those elements are not sufficiently different or unique 
from the understandings originally posed by the term ``NRSRO.''
    Subsequently to the 2003 questions issued to stakeholders 
and the number of issues raised in that release and public 
comment period, I consider the current rule to be inadequate in 
scope and in content. In order to make the point of our 
concerns, there is publicly disclosed information by one rating 
agency on its financials and in the year 2004 enjoyed an 
unbelievable 690 percent return on equity. I know of no other 
public operating company that is even close. While more 
remarkably, the other principal agency engaged in the market 
does not even disclose its financials at all.
    Further, there has been neither establishment of nor 
disclosure of the methodologies by which a rating agency enters 
into a corporation and comes to its ratings determinations. 
That remains unclear. The ability to rate a public operating 
company without being requested by that company, and of course 
subsequently sending the company an invoice, presents some 
clear ethical question, at least in my mind, that needs to be 
addressed.
    In summary, I feel that the rating agencies are somewhat of 
mystical anointed monopoly, not unlike our good friends Fannie 
and Freddie, but with even less accountability. I hope today in 
the course of our questions and answers with Ms. Nazareth to be 
able to come to a better understanding of what action, if any, 
the Congress should take in assisting the SEC to come to final 
resolution on all these matters of public importance.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    We meet for the third time in the last 2 years to explore 
the issue of regulating credit rating agencies. As I have 
regularly noted during the past examinations, entities like 
Moody's, Standard and Poor's, and Fitch have long published 
their views on the credit worthiness of issuers of debt 
securities. The significance of these opinions has also greatly 
expanded in recent years as a result of increases in the number 
of issues and issuers, the globalization of our financial 
markets, and the introduction of complex financial products.
    Although rating agencies received some scrutiny after the 
recent surge of corporate scandals, we have not yet mandated 
any substantive changes in their practices. One witness at one 
of our past hearings nevertheless noted that the agencies 
``played a significant role'' in Enron's failure. A Senate 
investigative report also determined that the monitoring and 
review of Enron's finances ``fell far below the careful efforts 
one would have expected from organizations whose ratings hold 
so much importance.''
    Outside Enron's auditors, the rating agencies probably had 
the greatest access to non-public information about the firm's 
complicated financial arrangements. Even with this data, the 
agencies exhibited a disappointing reliability in the accuracy 
of their coverage. In fact, the three existing nationally 
recognized statistical rating organizations at the time of 
Enron's failure, rated the company at investment-grade until 4 
days before its bankruptcy filing.
    The failure of the nationally recognized agencies to lower 
their credit ratings in a timely manner in this case and other 
instances such as the WorldCom bankruptcy, New York City's debt 
crisis, Washington Public Power Supply System's default, and 
Orange County's collapse has resulted in great financial losses 
for many Americans who little understood the true credit risks 
of their investments.
    This issue is therefore one on which we should focus our 
attention in the 109th Congress. During our past hearings, it 
has also become increasingly clear to me that while our capital 
markets and the rating industry have evolved considerably in 
recent years, the Commission's rules in this area have changed 
little, even though it has studied these issues for more than a 
decade. Additionally, The Washington Post late last year in a 
series of investigative reports on credit ratings concluded 
that although the agencies with national recognition are the 
gatekeepers of capitalism, they have no commensurate oversight 
or accountability.
    The regulation of rating agencies, I believe, is ripe for 
examination and action. I know that the Securities and Exchange 
Commission agrees. Today's witness, Annette Nazareth, the 
Commission's Director of Market Regulation, has previously 
observed that while rating agencies have generally performed 
their work well for nearly a century, they have also missed 
some colossal failures in recent years. She has further 
described our debt markets as the dark corner of the securities 
industry. The time has come to shine some light into this dimly 
lit field.
    Accordingly, I was pleased that the Commission recently and 
finally put forward for public comment a proposed rule to 
define what constitutes a nationally recognized statistical 
rating organization and the process for making such a 
designation. While this proposal is a good step, more still 
needs to be done in the area of rating agency oversight. The 
agencies, as I am aware, are also working with the Commission 
to establish a voluntary framework to improve transparency.
    While some hope that this agreement will be effective, many 
have lingering doubts. After all, Chairman Donaldson has 
already indicated that he does not have the confidence that 
these discussions will result in substantive reforms because 
the existing agencies with national recognition have taken the 
position that they will not allow the Commission to conduct 
inspections or take enforcement actions.
    As you know, Mr. Chairman, top officials at the Commission 
have also regularly suggested that additional legislative 
authority may be needed in the area of rating agencies. 
Consequently, I have come to conclude that it is time for us to 
ask the Commission what specific authorities it believes it 
needs to effectively oversee rating agencies. I will therefore 
be sending a letter to the Commission after today's hearing to 
request this technical assistance. The Congress will ultimately 
decide whether to consider a bill related to these issues, but 
obtaining the insights of the experts at the Commission will 
help us in crafting an appropriately balanced piece of 
legislation that addresses First Amendment concerns.
    Learning of the Commission's views now on the needed 
statutory authority will also help us to expedite future action 
if the voluntary framework negotiations break down or result in 
a flawed product.
    In closing, Mr. Chairman, we must act to ensure the 
continued integrity of the rating agencies and the credit 
rating process. I also look forward to hearing from our witness 
today and to moving forward prudently and promptly on these 
important matters.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 28 in the appendix.]
    Chairman Baker. I thank the gentleman.
    I am advised that no other member desires to make an 
opening statement at this time, but all members' statements, if 
submitted, will be made part of the official record.
    At this time, I would like to recognize Ms. Annette 
Nazareth, Director, Division of Market Regulation.
    Your official statement will be made part of the record. 
Please proceed at your leisure, and welcome.

  STATEMENT OF ANNETTE NAZARETH, DIRECTOR, DIVISION OF MARKET 
  REGULATION, UNITED STATES SECURITIES AND EXCHANGE COMMISSION

    Ms. Nazareth. Thank you, Chairman Baker, Ranking Member 
Kanjorski and members of the subcommittee. Thank you for the 
opportunity to testify before you today on behalf of the 
Securities and Exchange Commission.
    Today, I plan to provide you with an overview of the SEC's 
recent work concerning credit rating agencies. I will begin 
with a brief history of the SEC's involvement in this area and 
then I will discuss recent SEC initiatives regarding credit 
rating agencies.
    Since 1975, the SEC has relied on credit ratings by market-
recognized rating agencies for distinguishing among grades of 
credit worthiness in various rules under the federal securities 
laws. These nationally recognized statistical rating 
organizations, or NRSROs, have received no-action letters from 
the SEC staff. To date, nine firms have received such no-action 
letters. However, during the 1990s, several NRSROs consolidated 
so that there are currently five such NRSROs: A.M. Best 
Company, Dominion Bond Rating Service, Limited, Fitch, Inc., 
Moody's Investor Service, Inc., and Standard and Poor's 
Division of McGraw Hill Companies, Inc.
    The term ``NRSRO'' was originally adopted by the Commission 
solely for determining capital charges on different grades of 
debt securities under the Commission's net capital rule for 
broker-dealers. Over time, however, the NRSRO concept has been 
incorporated into a number of additional SEC rules and 
regulations, including rules issued under the Securities Act of 
1933, the Securities Exchange Act of 1934, and the Investment 
Company Act of 1940.
    Congress also has used the NRSRO concept in legislation, as 
have other regulatory bodies including banking regulators both 
at home and abroad. During the past few years, the Commission 
has pursued several approaches on its own and at the direction 
of Congress to conduct a thorough and meaningful study of 
credit rating agencies and the use of credit ratings under the 
federal securities laws. For example, approximately 2 years 
ago, the SEC responded to a congressional directive under the 
Sarbanes-Oxley Act of 2002 by issuing a report on the role of 
credit rating agencies in the securities markets.
    To assist in preparing the report, the SEC held 2 full days 
of public hearings. Hearing participants included 
representatives from credit rating agencies, broker-dealers, 
buy-side firms, issuers and the academic community. The 
Sarbanes-Oxley report identified a number of substantive issues 
that the Commission planned to explore in more depth, including 
improved information flow in the credit rating process, 
potential conflicts of interest, alleged anti-competitive or 
unfair practices, potential regulatory barriers to entry in the 
credit rating business, and ongoing regulatory oversight of 
credit rating agencies.
    On June 4, 2003, the SEC issued a concept release seeking 
public comment on the issues raised in the Sarbanes-Oxley 
report. Generally, the SEC sought comment on whether credit 
ratings should continue to be used for regulatory purposes 
under the federal securities laws and if so, the process of 
determining whose credit ratings should be used. The Commission 
also sought comment on the appropriate level of oversight that 
should be applied to credit rating agencies.
    Forty-six commenters responded to the concept release. Most 
of the 46 commenters supported retention of the NRSRO concept. 
Many represented that eliminating the concept would be 
disruptive to the capital markets and would be costly and 
complicated to replace. Only four commenters supported 
elimination of the concept and there was very little discussion 
of regulatory alternatives.
    Generally, commenters supported improving the clarity of 
the process for identifying NRSROs to the extent credit ratings 
continued to be relied upon by the Commission in its rules and 
regulations. Specifically, commenters generally supported the 
Commission's suggestions to specify in more detail what credit 
rating agencies need to provide to obtain an NRSRO no-action 
letter. With respect to ongoing oversight, a number of 
commenters recommended that the Commission enhance the staff's 
ability to verify whether an NRSRO continues to meet the 
minimum standards that led to its designation.
    However, a number of commenters, including each of the 
current NRSROs, also raised concerns about the extent of the 
Commission's authority to impose requirements on NRSROs. These 
commenters argued that the SEC does not have explicit 
regulatory authority over NRSROs and that NRSRO rating 
activities are journalistic and are afforded a high level of 
protection under the First Amendment.
    More recently, the Commission on March 3, 2005 voted to 
issue a rule proposal that would define the term ``NRSRO'' for 
purposes of commission rules. The proposal builds on earlier 
commission work relating to the credit rating agencies. The 
goal of the proposal is to provide greater clarity and 
transparency to the process of determining whether a credit 
rating agency's ratings should be relied on as NRSRO ratings 
for purposes of commission rules.
    The proposed definition and the interpretations thereof are 
intended to provide credit rating agencies with a better 
understanding of whether they qualify as an NRSRO. The proposed 
definition of the term ``NRSRO'' is composed of three 
components which the Commission believes to be the most 
important criteria in determining whether an entity's ratings 
should be relied upon for purpose of commission rules and 
regulations.
    Specifically, the Commission is proposing to define the 
term as an entity that issues publicly available credit ratings 
that are current assessments of the credit worthiness of 
obligors with respect to specific securities or money market 
instruments; that is generally accepted in the financial 
markets as an issuer of credible and reliable ratings, 
including ratings for a particular industry or geographic 
segment by the predominant users of securities ratings; and 
finally, uses systematic procedures designed to ensure credible 
and reliable ratings, manage potential conflicts of interest, 
and prevent the misuse of non-public information and has 
sufficient financial resources to ensure compliance with these 
procedures. These three components are described in more detail 
in my written testimony.
    The rule proposal also states the belief that while 
adopting a definition of NRSRO would help address commenter 
concerns regarding transparency, credit rating agencies might 
desire to continue to seek no-action letters in order to 
clarify the ability of third parties to rely on their ratings 
for regulatory purposes. As such and in light of the 
longstanding reliance by broker-dealers, issuers, investors and 
others on the existing staff no-action process, the Commission 
states in the proposal that if it were to adopt a definition of 
NRSRO, it plans to continue to make commission staff available 
to provide no-action letters as appropriate to those entities 
that choose to seek it. No-action letters would be granted for 
a specific period of time, after which the relief would need to 
be reconsidered.
    As I mentioned previously, a number of commenters to the 
2003 concept release recommended that the Commission enhance 
the staff's ability to verify whether an NRSRO continues to 
meet the minimum standards that led to its designation. Due to 
apparent limits on the Commission's authority in this area, the 
Commission staff has worked with the current NRSROs during the 
past 6 months to craft a framework for voluntary oversight by 
the Commission. At this time, our dialogue with the industry 
has not resulted in an agreed upon voluntary oversight 
framework.
    Nonetheless, I believe a strong and effective industry-led 
regime could prove to be a constructive and reasonable approach 
to address a number of concerns involving the credit rating 
industry that have been raised in recent years by Congress, the 
Commission and others such as the International Organization of 
Securities Commissions.
    That said, the Commission believes that to conduct a 
rigorous program of NRSRO oversight, more explicit regulatory 
authority from Congress is necessary. The Commission has not 
taken a formal position on whether additional legislation 
should be forthcoming, but it does believe that congressional 
hearings on this issue are useful to ensure that this important 
question is properly vetted. A well thought-out regulatory 
regime could provide significant benefits in such cases as 
recordkeeping and addressing conflicts of interest in the 
industry.
    As Chairman Donaldson said last month before the Senate 
Committee on Banking, Housing and Urban Affairs, the Commission 
welcomes congressional attention and of course would stand 
ready to work with Congress on crafting appropriate legislation 
if Congress determines such legislation is necessary.
    Thank you for inviting me to testify. I welcome any 
questions.
    [The prepared statement of Annette Nazareth can be found on 
page 30 in the appendix.]
    Chairman Baker. Thank you very much, Ms. Nazareth.
    I really want to start with your conclusions reached. In 
Sarbanes-Oxley, there were a specific litany of, I will list 
them as concerns or subjects to explore, which you made 
reference to in your remarks. It would seem that the current 
definition discussion by the SEC relative to what constitutes 
an NRSRO really focuses on one of those points raised in the 
Sarbanes-Oxley recitation, which is the potential regulatory 
barrier to entry into the market.
    However, the other four principal points, conflicts of 
interest, anticompetitive or unfair practices, regulatory 
oversight, would seem to fall in the area that you made 
reference to in your concluding remarks that may be outside the 
scope of current authority of the agency requiring going 
forward some legislative action. Is that a fair conclusion to 
reach from your comments?
    Ms. Nazareth. Yes. Basically, we have the authority to use 
the term in our rules and to define what the term meant. But as 
you pointed out in your statement, this is a very important 
area and one where people have become very reliant on this 
term. As a result, we believe that it is important to not only 
determine that a credit rating agency has met the terms of the 
definition at the outset when the no-action letter is issued, 
but also that it continue on an ongoing basis to meet that 
definition.
    In order to do that effectively, one would at the very 
minimum need a voluntary framework to be able to oversee the 
process and to ensure that those conditions continue to be met 
or have a more rigorous oversight program through legislative 
authority which would give us the ability to require 
recordkeeping and examinations and other things that are more 
akin to what a full regulatory program would entail.
    Chairman Baker. Assume for the moment that we enter into a 
voluntary agreement. I have some familiarity with voluntary 
agreements with other enterprises. If they then choose not to 
comply, the penalties are some adverse market reaction or 
litigation over the terms of the contract, which would seem to 
me to put the regulator in a very deficient posture.
    What I am proposing is that if we can identify the areas 
beyond the definition of NRSRO, that currently are not within 
your enforcement authority, I would be very interested in a 
statutory framework enabling the regulator to take on at least 
as a minimum scope those five points identified in Sarbanes-
Oxley because that did pass the scrutiny of the committee, 
voted on by the Congress. There should not be debate that those 
five points are good public policy to implement. You would not, 
I take it, see that as an inappropriate thing for the committee 
to pursue.
    Ms. Nazareth. No, not at all.
    Chairman Baker. As to the proposed definition that is now 
pending, it basically requires that the entity making 
application for admission issue publicly available ratings, is 
generally accepted in the market as an issuer of reliable 
ratings, and uses systematic procedures. I am not sure I 
understand how those three elements constitute something 
different from what has been historic practice.
    Even though we talk about ``nationally recognized'' as 
being the art term, when the Commission reviews applicants' 
requests for approval, it is that you have to be in the 
business of credit ratings. You have to be viewed as a credible 
person or entity giving good information out. Obviously, you 
have to have some process to arrive at a rating.
    So I am having a little trouble understanding how this 
three-pronged approach is significantly structurally different 
from the current NRSRO requirement. Can you enlighten me on 
what you think is the distinction?
    Ms. Nazareth. It is not dramatically different. You are 
correct. I think after all of this analysis and the hearings 
and the comments that we analyzed, it was clear that while 
there are some concerns about competitive impact, the strong 
majority of opinion was that this is a process that the 
marketplace has come to rely upon and that there would be great 
market disruption to abandon this process entirely.
    That having been said, I think that we were looking to 
improve the current situation. So what we did was, this is the 
first time we have actually defined the term, which adds 
greater transparency, makes it easier for new entrants to 
understand what they will have to evidence in order to obtain a 
no-action letter. We also did try to be somewhat broader in the 
scope of the entities that we would recognize under the 
definition.
    So for example, for the first time we made it very clear 
that you could be nationally recognized even if your expertise 
was in a limited sector, either geographically or by topic, 
that you did not have to be nationally recognized as in 
everybody was using you for all purposes. So we have tried to 
find other ways to address some of the competitive concerns. So 
in that respect, it is a little bit different, but again we 
were hoping that the transparency of the definition would also 
make it somewhat easier to apply and might encourage others to 
apply.
    Chairman Baker. My time is out, but I am going to ask one 
more, and given the fact that we have other members, try to 
keep it within reasonable time constraints. The definition says 
that the entity making application must have a systemic process 
by which its ratings are achieved.
    Ms. Nazareth. Yes.
    Chairman Baker. Does Standard and Poor's have some systemic 
process they publicly disclose as to how they go about their 
rating process?
    Ms. Nazareth. I believe that each of the NRSROs does have 
internal processes that they follow in order to issue credit 
ratings.
    Chairman Baker. But they are not necessarily the same? They 
are not necessarily disclosed to the person who is being 
reviewed? In other words, if I am the business guy and I want a 
rating, I would like to know what is it you are going to need 
to know so I can prepare when you knock on the door. What is 
worse is when you show up unannounced and do it to me anyway, 
but that is another point.
    Ms. Nazareth. Yes, which is another problem. I do think 
that they do endeavor to apply consistent policies and 
procedures across whatever sectors they are covering. I believe 
that they make it clear to the entities that they are rating 
what it is that the entities will need to evidence to them. A 
number of their procedures, including their conflicts 
procedures and the like, actually they do publish and are on 
their Web sites. We think it is very important that there not 
only be rigorous procedures, but that they be uniformly 
followed. Obviously, it would be problematic if they had 
certain high standards for rating some entities and then did 
not apply those standards to others. It is a critical issue.
    Chairman Baker. Just a quick follow-on, then. If I were to 
request of you help secure for the committee S&P, Moody's, 
Fitch, the other two entities, their systematic review of just 
financial service entities. Let's just make it just banks. That 
we should expect each of those systematic reviews to be 
somewhat comparable and similar?
    Ms. Nazareth. That is their role, that they should be 
comparable.
    Chairman Baker. Do you have knowledge that they are? Or 
that is what you believe as to their professional 
responsibility?
    Ms. Nazareth. I believe that they have procedures that 
establish that they should uniformly apply with respect to 
their reviews. Whether or not they actually do that is another 
question. I would hope that they do that, but given that we do 
not have examination authority or the ability to audit that, I 
cannot represent that that is what is happens.
    Chairman Baker. I appreciate that problem. Thank you very 
much.
    Mr. Kanjorski?
    Mr. Kanjorski. Ms. Nazareth, we talked about the 
discussions that are ongoing. I suspect that is between the SEC 
and the rating agencies?
    Ms. Nazareth. Yes.
    Mr. Kanjorski. How long have they been ongoing?
    Ms. Nazareth. Well, it has been off and on. There were 
holidays in between and other events, but I think we started 
talking around November.
    Mr. Kanjorski. Could you give us just your initial reaction 
of how successful those discussions have been to date? I notice 
the one suggestion that they are not able to be regulated 
because of the protection of the First Amendment. Are the major 
five rating agencies asserting that on a regular basis, 
seemingly without fear?
    Ms. Nazareth. It is a complicated process. I have to say 
that in the past when we have negotiated voluntary initiatives 
with entities, they tended to be entities that we had regulated 
for other purposes and therefore were used to SEC oversight. 
The question was whether or not in a new area of their business 
they would agree to some sort of voluntary regime.
    This is a little more difficult. I believe that the rating 
agencies are dealing with us in good faith, but it is more 
difficult given that they are not really as used to SEC 
oversight. There are some legitimate questions on First 
Amendment issues and concerns about regulators imposing 
themselves into the editorial process that they are very 
sensitive to. So I think it has made the discussions somewhat 
more complicated, to say the least.
    Mr. Kanjorski. Are you more optimistic than Chairman 
Donaldson seemed to be in his testimony before the Senate?
    Ms. Nazareth. I don't know if I would say more optimistic. 
I certainly agree with the tenor of his testimony. I am 
certainly willing to continue our discussions, but I think 
Congress should continue its review at the same time and we 
will see where we come out.
    Mr. Kanjorski. You heard in my opening statement the fact 
that I am addressing a letter today to the Commission to give 
us an outline of the additional authorities you think you may 
need in order to carry on an officially sanctioned involuntary 
regulation of these entities. From what I gather from the 
chairman's comments, he tends to agree that we now need that. 
Can that be forthcoming in a reasonably short period of time?
    Ms. Nazareth. Yes, we could definitely do that.
    Mr. Kanjorski. I have a feeling that we have had some 
consideration of this issue for a number of years now. Can you 
give me a qualitative evaluation of success in that ongoing 
process? Or is this just dragging along at the slowest rate to 
accomplish no regulatory authority?
    Ms. Nazareth. I think certainly we have had some progress 
in the sense that the Commission now has proposed a rule that 
is intended to add greater transparency to the process of 
granting no-action relief regarding NRSROs. That is progress. I 
think it is progress that Congress is partnering with us to 
look at this issue and to determine whether now is the time to 
have additional authority or whether to rely on private sectors 
means. But I do think that this is the next opportunity to make 
some progress in this area.
    Mr. Kanjorski. My druthers would be that we do not have to 
regulate, as I am sure Mr. Donaldson and you would join us in 
that. But do you think that they doubt that we have the 
backbone here in the Congress to take such action?
    Ms. Nazareth. Who would doubt the backbone?
    Mr. Kanjorski. These rating agencies.
    Ms. Nazareth. I do not think anyone doubts your intentions.
    Mr. Kanjorski. Is there any stronger message that we can 
send to them? Would it be introduction of authorizing 
legislation to give regulatory authority to the Commission? 
Would that help in the discussions?
    Ms. Nazareth. I think they are well aware of Congress's 
efforts. I think to be frank, I think there is a bit of a 
dilemma that they have as well, because if they start investing 
the time in a voluntary initiative and congressional authority 
is forthcoming, it may be that they have to switch gears and do 
things somewhat differently. So they have a little bit of a 
dilemma themselves in terms of whether they should at this 
point invest the resources in that effort, or should they wait 
for Congress to give us authority and then just wait for a 
rulemaking.
    Mr. Kanjorski. Does that underlie the observation on your 
part that they perhaps are not doing their best in investing 
time and effort in these ongoing discussions?
    Ms. Nazareth. I think it is a factor. I would not say they 
are not doing their best. They are five very different 
organizations with different structures that also have to try 
to come to some common conclusion on what to do. But I 
certainly think the combination of Congress's review of this 
issue as well as a number of initiatives in Europe has made it 
difficult for them to assess what exactly is going to be the 
landscape in which they are operating, and should they take the 
lead or should they wait to see what happens.
    Mr. Kanjorski. Well, if I can again urge you to get that 
outline of the authorities necessary to pursue this as fast as 
possible to see whether or not they can invest some of their 
time in responding to the actual legislation.
    Thank you.
    Chairman Baker. I thank the gentleman.
    Mr. Hensarling?
    Mr. Hensarling. Thank you, Mr. Chairman.
    Ms. Nazareth, I think you indicated in your testimony we 
have five recognized NRSROs. I am curious, does the SEC have 
information on just how many market participants there are out 
there, how many credit rating agencies there are who have not 
achieved the NRSRO status?
    Ms. Nazareth. The information that we have is that there 
are probably at this point over 100 credit rating agencies. The 
number of participants has actually expanded quite a bit. I 
think the FSA recently discussed the number of participants and 
it was quite interesting to us. A great number of them have not 
expressed any interest in applying for this. In other words, 
their business models do not dictate that they have to be in 
this NRSRO business in order to be successful.
    Mr. Hensarling. Would you say that the number has been 
increasing in recent years?
    Ms. Nazareth. I believe it has been increasing, yes.
    Mr. Hensarling. Can you discuss aspects of market evolution 
or technology that might account for this fact, I guess really 
over the last couple of decades, since the SEC first designated 
the NRSRO regulation, back in 1975? Can you talk about trends 
that might have led to the fact that there are indeed more 
rating agencies now and what has led to that?
    Ms. Nazareth. I gather that there is obviously a tremendous 
appetite for investment in debt securities and the number of 
products and the complexity of debt products have really been 
explosive in the last several decades. There is an appetite and 
a market for good in-depth analysis in order to understand 
these products. So a number of market participants are willing 
to pay for these analyses to help them better understand their 
particular issues.
    Mr. Hensarling. It sounds like there has been an increase 
perhaps in the number of these rating agencies who are dealing 
in niche markets. I believe on page six of your testimony you 
talk about that even though a credit rating agency might only 
rank debts, say, in a limited sector of the market or in a 
geographic area, they might be able to achieve the NRSRO 
status. But it does not sound like in reality or in 
practicality that is actually happening, since we still have 
only five. Is this correct?
    Ms. Nazareth. This is the first time we have articulated 
this goal of recognizing entities that are in these limited 
sectors, although we have historically done so. Again, I think 
it depends on whether these market participants choose to 
apply. We have had several instances in the past where we would 
have been more than happy to entertain the requests, but there 
was no interest on the part of those credit rating agencies to 
apply.
    Mr. Hensarling. Last year before this subcommittee, there 
was a gentleman from the American Enterprise Institute, Alex 
Pollock, who called the current NRSRO designation a catch-22 
because, and I am sure you have heard the argument, if you are 
a non-NRSRO you have to become widely accepted to become an 
NRSRO. But if you are not an NRSRO, say that three times 
quickly, you cannot become widely accepted. So how do you 
address his argument that we will continue to have a catch-22 
under these new guidelines? If so, how will we ever go beyond 
our five recognized agencies?
    Ms. Nazareth. Again, I think there are, as we have said 
earlier, there are over 100 of these entities, many of which 
are very highly regarded in their niche markets. Should they 
choose to apply, we would be very pleased to consider their 
applications. We have in the past recognized NRSROs within 5 
years of their beginning to rate debt securities.
    So it is something that we are very obviously concerned 
about and interested in. We believe that it is important for 
purposes of SEC regulations that the term apply to firms that 
really are providing a rating that is based on a process with 
high integrity and that is widely recognized in the 
marketplace.
    That having been said, we do not want this regulation in 
any way to impede competition or the ability for new entrants 
to enter. So hopefully this new definition with its emphasis on 
the niche players as well will assist in that area.
    Mr. Hensarling. I see I am out of time.
    Thank you.
    Chairman Baker. Ms. Wasserman Schultz?
    Ms. Wasserman Schultz. Mr. Chairman, I do not have any 
questions. Thank you.
    Chairman Baker. I thank the gentlelady.
    Ms. Kelly?
    Mrs. Kelly. Thank you, Mr. Chairman, for holding this 
hearing.
    Quite frankly, I appreciate your appearing here, Ms. 
Nazareth. You state in your testimony that Congress has given 
no authority to the SEC to regulate nationally recognized 
credit rating agencies.
    In my estimation, the ability of the SEC to identify and 
define the NRSROs contains the ability to define NRSROs to 
exclude from the definition any institution that fails to meet 
the standards the SEC expects. Do you agree with that? Could 
you please explain it?
    Ms. Nazareth. Yes, we certainly have the ability to define 
the term and to interpret which entities meet that definition. 
What we do not have express authority to do is to have an 
ongoing oversight regime to ensure that those who meet the 
definition continue to do so and that some of the really 
fundamental principles on which we determine to grant the no-
action letter continue to exist.
    Mrs. Kelly. Which means that you are seeking authority from 
Congress to rate the raters. Is that correct?
    Ms. Nazareth. No. We are not seeking authority. We have no 
official position on seeking authority. What is being discussed 
is granting the Commission authority to have an oversight 
regime for those entities who fit the definition and who have 
applied for recognition.
    Mrs. Kelly. The courts ruled that speech about credit 
worthiness is protected by the First Amendment. Wouldn't the 
explicit regulation of the NRSROs violate their First Amendment 
right to speak freely on the financial markets?
    Ms. Nazareth. There are issues on journalistic privilege 
and First Amendment issues that do factor into this analysis, 
which is why we feel that it is very important for Congress to 
be involved in this determination. If Congress determines that 
more regulatory oversight is necessary in this area, for 
Congress to expressly grant that authority because we feel that 
to take an aggressive position in this area, particularly where 
there are First Amendment issues involved, would not be 
appropriate.
    Mrs. Kelly. I am not quite sure how the SEC authority, how 
broad that is. Is it limited to how the publicly traded 
companies use the information that they get, whether it is paid 
or unsolicited from credit agencies? Can you define just a 
little bit more about how broad that is?
    Ms. Nazareth. Yes, the term was originally used for a very 
limited purpose, which was to describe those entities who rated 
debt securities, whose investment-grade ratings could be relied 
upon by broker-dealers for purposes of some capital benefits 
under the net capital rule. So it basically said if a broker-
dealer had in its portfolio bonds that were rated investment 
grade, those bonds would have a lower haircut or a lower 
capital charge to the firm's capital than would bonds that did 
not have such a rating.
    So it was really a way for the Commission to determine that 
to give this regulatory or capital relief, but doing so in a 
way that it felt was responsible in that the ratings that were 
being relied upon were generally accepted as reliable and 
credible ratings. It was used for that purpose.
    What happened was the term over time became a useful proxy 
for creditworthy ratings, and was used in other SEC regulations 
and then was used in a number of regulations, both by the 
states and abroad. We feel that given the reliance that is put 
on this definition that it would be certainly more appropriate 
to have some sort of ongoing review of whether the entities 
that enjoy this designation continue to meet up to the terms of 
the definition.
    Mrs. Kelly. Credit rating agencies have been accused of 
maintaining high ratings on some issuers and arbitrarily 
lowering others. I am amazed at some of the stories that I have 
read where schools have been bent over backwards by some of 
these agencies, municipalities, businesses. I think the public 
really does not know that schools, municipalities and 
businesses have to pay the credit rating agencies in order to 
get those credit ratings.
    It seems to me that instead of trying to regulate the 
NRSROs, the market might be best served to encourage as many 
people to go into the credit reporting field as possible in 
order to provide a lot of viewpoints, and then let market 
forces make whatever corrections they are going to make in that 
field. I would be interested in what your response is to that.
    Ms. Nazareth. I think, as I said before, there are a number 
of people in this field. There are over 100 credit rating 
agencies. Again, this term was used by the Commission for much 
more narrow purposes and has taken on a life of its own. There 
is nothing in the use of the term or there is nothing that 
would in any way require investors to rely solely on the 
ratings of these raters. There are a number of other services 
that they could use.
    Mrs. Kelly. I am sorry. I really did not understand that. 
You said there are a lot of people in the field, but there are 
only five NRSROs.
    Ms. Nazareth. Right.
    Mrs. Kelly. There are hurdles, if I understand the 
Chairman's and Mr. Kanjorski's and Mr. Hensarling's comments, 
hurdles that these other agencies really have to jump, and 
there have been precious few. It seems to me congressional 
pressure has pushed the SEC to at least admit two more agencies 
because there were originally only three.
    I do not see how these others in the field are going to get 
into the business if we have high hurdles and more regulation.
    I am out of time. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentlelady.
    Ms. Brown-Waite?
    Ms. Brown-Waite. Thank you very much, Mr. Chairman.
    I came in probably towards the end of your testimony, but 
the basic question that I have is that in your new proposal, 
you are apparently limiting it solely to implementation of a 
definition and you do not plan to take any other action with 
regard to NRSROs without specific statutory authority.
    Have you asked for that statutory authority? You may have 
covered this in your testimony.
    Ms. Nazareth. The Commission has not yet taken a position 
on whether it is requesting statutory authority. What the 
Commission has done is make clear that it believes that to do 
more would require statutory authority.
    Ms. Brown-Waite. I think you are repeating what I said. Are 
you requesting statutory authority?
    Ms. Nazareth. No, we are not at this time officially 
requesting statutory authority.
    Ms. Brown-Waite. So if I understand you correctly, then you 
are just going to do the same old-same old and not expand the 
number of them?
    Ms. Nazareth. That has nothing to do with the statutory 
authority question. That goes to the definitional question. We 
would be able to, I believe, designate or recognize additional 
credit rating agencies as NRSROs under this definitional 
rulemaking that we have done. Whether or not we have the 
authority to do more ongoing oversight of those entities once 
they receive the no-action letter, that goes to the issue of 
authority, ongoing oversight, examinations, recordkeeping 
requirements, potential registration requirements.
    But the Commission does have the authority to define the 
term ``NRSRO'' and that is what the proposed rulemaking seeks 
to do. It also seeks to expand potentially the universe of 
firms who would be able to satisfy that definition by making it 
clear that one could be ``nationally recognized'' even though 
that firm is really more recognized for a limited sector of the 
market or a limited geographical area. So there is a 
recognition that while we feel we need to have high standards 
in the definition, we also do not want the definition to 
preclude additional parties from being able to apply and to 
obtain the NRSRO no-action letter.
    Ms. Brown-Waite. After Enron and WorldCom, I think the 
question needs to be asked: Who really has oversight over these 
NRSROs? Do the firms require continuous education? Our whole 
economy was thrown on its heels partially as a result of the 
Enron and WorldCom scandals. So what kind of self-governing, 
maybe is my question, do they engage in?
    Ms. Nazareth. Well, all the credit rating agencies have 
policies and procedures in place that include standards on the 
educational backgrounds of the people they hire and on how 
frequently they review the firms that they rate and the like. 
Those procedures are supposed to obviously be rigorously 
internally enforced.
    Frankly, one of the issues that we will have whether or not 
the Commission gets authority here is that there are some 
things that it will be difficult for regulation to address. 
Regulation is not going to make anybody faster or smarter, but 
we can require that people have rigorous procedures that they 
follow and hopefully that in and of itself will improve the 
process. Certainly having procedures on conflicts of interest 
and disclosure of nonpublic information and the like is 
important to have in any industry. But it certainly will not be 
a guarantee against mistakes in the future in any area.
    Ms. Brown-Waite. I do not think you answered my question, 
and maybe you are not the right person to answer this, but who 
really governs the NRSROs?
    Ms. Nazareth. They are not regulated.
    Ms. Brown-Waite. They are not regulated at all? Totally not 
regulated?
    Ms. Nazareth. As part of the no-action process, they were 
registered as investment advisers, but really their advisory 
work is minimal at best. So for these purposes, their credit 
rating processes are not regulated.
    Ms. Brown-Waite. Thank you.
    Chairman Baker. I am going to start a second round. Since 
we have a limited number of members, it will not take long.
    Just to follow on to Ms. Brown-Waite's observations, there 
is no process clinically established in law or in regulation on 
how you become one of these things. Up to the contemplated rule 
now pending, you had to be nationally recognized. If you were 
not national, you could not be considered.
    Now we have a three-part test which is sort of nationally 
recognized. You do not have to be national in organizational 
scope, with offices from California to New York, but you have 
to be recognized nationally for your work in the field of oil 
futures. You have to have the financial stability to be able to 
operate on a national basis and have a proven record of 
credible, reliable, analytical work.
    Strangely enough, that standard does not now apply to those 
who are NRSROs. We do not know, for example, that all five have 
the similar procedure for gauging the financial credit 
worthiness of all those in the oilfield sector. One could be 
using one methodology; one could be using another. But the 
investment company world requires that that oilfield company 
which is going to issue public debt have at least two ratings 
from two independent entities.
    When you look at the way the structure of the current 
process works, the profit margins are excessively egregious, 
and that is only because we have the voluntary disclosure by 
some of their rates of return. Some do not even disclose their 
financials period. They are the only entities that have an 
exception from Reg FD. They can get access to material fact 
that no other person can get and make disclosure of subsequent 
to some civil or criminal action, and they can make selective 
disclosure of information pursuant to executive interview.
    Then they say if we are going to have the SEC either by 
rule or by statute come in and perform an audit of the books to 
find out if somebody has cooked their books or if somebody is 
running off to Tahiti with shareholder funds, they say wait a 
minute, you are going to abridge our First Amendment rights. 
Huh? If you want to find out as to the analysts who are 
performing the work have been previously accused of fraudulent 
activities in the world of accounting, they hold up the First 
Amendment shield.
    Now, the First Amendment shield only goes to the 
preparation and release of a statement publicly made. By 
removing their designation as an NRSRO, they can still make all 
the statements they want, they just cannot charge very much for 
them. Therein is the problem. We have a monopoly governmentally 
granted without a clear standard of conduct to maintain 
professional accreditation. By the way, there has never been 
any entity designated an NRSRO that has ever been 
decommissioned, and I would like in a minute to ask what is the 
process to decommission someone if you find out that they have 
engaged in blatant fraudulent conduct.
    These enterprises are not outside the law. There is no law. 
This is the Wild West, and if you ride through their ranch and 
you do not pay their fee, you get shot. You are required under 
the Investment Company Act to ride across their ranch. If you 
do not pay their freight, you are in real trouble. Plus, they 
will show up on your ranch unannounced, perform an audit, and 
then give you a B rating when you ought to be an A rating. What 
is your recourse?
    They have the public operating companies of this country by 
the throat. This has got to be at least subject to disclosure 
and awareness by the public as to what is going on here because 
4 days before Enron, the three NRSROs that were designated at 
that time in our country's history all of them listed Enron as 
investment-grade investments.
    Now, you remember what this committee did to the analysts 
and the investment bankers for missing it by a year? What are 
we going to do to these guys for missing it by 4 days? And yet 
we still have a commission that has been reviewing this matter 
for over a decade. This committee has been looking at it for 
almost that long.
    I do not make this to be interpreted as any kind of threat 
at all. I am saying this out of frustration. We need to help 
you. We need to give you the authority to act. We need to make 
sure that these people are responding to the market need in 
professional criteria. And we will have legislation.
    Now, I cannot speak to the content of that bill. I do not 
know your ability, given the lack of commission direction at 
this point to be able to comment, and I do not want to get you 
in that adverse position. But should you and those of your 
office choose to work with us in the formulation of a bill that 
is responsive, I have no confidence in a voluntary agreement. I 
have had bad experiences with those.
    So I think going forward, we are just going to have to give 
the agency the ability to regulate and subsequently to that or 
concurrent with that, figure out a way to get past this NRSRO 
designation business and let people who want to rate, rate. We 
do not do that in the securities and the equities world. We 
have all sorts of analysts giving all kinds of ratings all day 
long. If you want a rating, I am sure you can find the one you 
want because they are all over the map. The point is the market 
works without having a governmental designation of who should 
become a rating agency.
    Back to my question, since I rambled on for my entire time, 
has there ever been an NRSRO once designated ever 
decommissioned? And is there a process for doing so?
    Ms. Nazareth. There has not been one that has been 
decommissioned. Again, I am not sure what I would conclude from 
that because certainly one of the issues is the ability to do a 
rigorous ongoing oversight, which more authority would give us. 
Since there has not been as rigorous ongoing review----
    Chairman Baker. Let me help you. What you are saying is the 
regulator does not have the tools to know whether they are 
doing a good job or a bad job. Therefore, how could you 
decommission them without the facts?
    Ms. Nazareth. But we certainly do have the authority to 
remove the no-action letter. As with any market participant, we 
have enforcement authority to go after any sort of illegal act 
under the securities laws.
    Chairman Baker. So you would tell me that over the course 
of the 1980s and the 1990s, when investment bankers, analysts, 
securities markets, mutual funds, everybody you can name in the 
financial services sector got it wrong and there were people 
held criminally accountable in most cases, that the monopoly of 
the credit rating agencies was above the fray and did 
everything right.
    Ms. Nazareth. It was not subject to the same regulatory 
oversight as those entities.
    Chairman Baker. Thank you very much.
    Mr. Kanjorski?
    Mr. Kanjorski. Mr. Chairman, what I love about you is you 
make me look like a flaming conservative.
    [Laughter.]
    I think we are pretty much in agreement that the committee 
wants to do something that will arm the SEC with the authority 
to accomplish its end. I do not know I am as far as the 
Chairman on these conclusions, but certainly we are both 
thinking along those lines.
    Chairman Baker. I will give you a little time. You will get 
there.
    [Laughter.]
    Mr. Kanjorski. I will come there.
    The one question I did want you, Ms. Nazareth, to address, 
in the 1990s the Commission came very close to issuing rules 
and regulations regarding the control of the credit rating 
agencies, and then they did not act. At that time, therefore 
they must have made the conclusion that they had the legal 
authority to do that. Has anybody revisited why that has 
changed? I know at the time I do not think they could get a 
majority of the Commission to adopt the rule, but somebody must 
have structured the legal authority there in existing law.
    Ms. Nazareth. Even in the 1990s, the proposal from 1997 was 
quite similar to the proposal that the Commission put out for 
comment last month. It was marginally more aggressive on the 
authority side, but not terribly so. I think that in light of 
various challenges to the Commission's authority and in light 
particularly of the First Amendment issues that have been 
raised, we think it would be prudent to wait for authority to 
do anything beyond the definitional term.
    Mr. Kanjorski. The comments that the Chairman made 
regarding almost extortion, have you heard complaints of this 
or factual information that would support that in some 
instances these entities have acted in that regard?
    Ms. Nazareth. I think historically there were complaints 
about unsolicited ratings. My understanding was that several 
years ago the Department of Justice actually looked at it and 
took no action. My understanding is also that since that time, 
the rating agencies became I think more sensitive to the issue. 
I have not heard quite the number of complaints in recent years 
that we did in the past. I think that there has been more of a 
sensitivity to indicating on the rating itself that it was 
unsolicited. But I think unsolicited ratings do still exist, 
but I am not sure at quite the same magnitude that they did in 
the past.
    Mr. Kanjorski. Okay. The only other question that I have 
is, you talked about a remedy as releasing the use letter? Or 
withdrawing the use letter?
    Ms. Nazareth. Withdrawing the letter, yes.
    Mr. Kanjorski. How could you do that if you have no 
criteria on which it is issued?
    Ms. Nazareth. The criteria was always articulated in the 
area, what we had looked at in order to issue the letter. So 
certainly if we became aware of the fact that the basis on 
which the letter was issued no longer applied, we could 
withdraw the letter. The question is how much comes to our 
attention and whether there is an ongoing process to examine 
for that.
    Mr. Kanjorski. There is no question, though, that we should 
get involved in this area.
    Ms. Nazareth. I think Chairman Donaldson was quoted that we 
welcome your involvement.
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Ms. Kelly?
    Mrs. Kelly. Thank you, Mr. Chairman.
    Ms. Nazareth, I received a letter that indicated, it was 
actually from S&P. It indicates that S&P ratings was designated 
as an NRSRO in 1976, although it did not affirmatively seek 
that status. If they could be declared an NRSRO without 
applying and without affirmatively seeking that status, can't 
the SEC just declare a company an NRSRO without asking the 
designee?
    Ms. Nazareth. At that time, the request was made by members 
of the brokerage industry who wanted to be able to rely on S&P 
ratings for purposes of the capital rule. So there was a 
request. It was not made directly by S&P.
    Mrs. Kelly. If other agencies now, credit rating agencies, 
had the same event happen, couldn't the SEC declare a company 
an NRSRO without the designee asking?
    Ms. Nazareth. It is a little difficult because it still 
requires the cooperation of the entity because there are a 
number of things, as the definition of the proposed rule would 
imply, that we would have to look at. There is a lot of 
proprietary information that we would only be able to get if we 
had the cooperation of the entity. But certainly, more recently 
I think the requests have come directly from the credit rating 
agencies themselves, but originally the procedure was that the 
securities industry would ask whether they could rely on the 
ratings of a particular credit rating agency for purposes of 
the rules.
    Mrs. Kelly. What if a consumer asked for a credit agency to 
be rated? What you implied by your answer to me, if I 
understand you correctly, is yes, the SEC could if the person 
who someone has asked to be rated an NRSRO, if they cooperated 
with you, you could go ahead and rate them as an NRSRO if 
someone came forward and said, I would like to see this agency 
put in. Can the consumer do that?
    Ms. Nazareth. We have two different ways. Either the credit 
rating agency that wishes to be considered an NRSRO asks 
directly, or an entity that has to make use of the term for our 
rules has to ask for it. So it is not just a consumer asking 
for it. A consumer I do not believe would have standing here. 
It would either be in this case S&P or someone who has to use 
the term for purposes of the rules.
    Mrs. Kelly. I am just thinking of a group of schools or 
colleges. If they banded together and said, look, we would like 
you to declare this credit rating agency, which is currently 
not an NRSRO, to be an NRSRO, and that credit rating agency 
worked with you, you could in fact declare them to be an NRSRO. 
Is that correct?
    Ms. Nazareth. Yes. Any credit rating agency could apply. As 
long as they cooperate, we could treat it as if they had 
applied themselves.
    Mrs. Kelly. I have another question about the rule that has 
not yet been published. Basically, from what I understand, 
there are a bunch of different prongs. One of them says that an 
NRSRO must be ``generally accepted'' as an issuer of credible 
and reliable ratings. Another one says an NRSRO must use 
systematic procedures to ensure ratings quality, manage 
conflicts, prevent misuse, et cetera, et cetera.
    My question is that both of those terms, ``generally 
accepted,'' ``systematic procedures,'' are very difficult to 
define. Without very precise wording on the definitions, I do 
not see the transparency needed here for people to understand 
what your rule is going to say. Are there going to be very 
specific definitions beyond just these two terms?
    Ms. Nazareth. Those are the definitions that the release, 
which you have not had the opportunity to read, will set forth 
on how one would go about satisfying the various prongs. It 
would give examples of what a credit rating agency could show 
the Commission to evidence that it meets that criteria. It asks 
whether, because it is a proposal, it asks whether other 
indicia should be considered as well. So at this point, 
obviously it is a proposal. It is not the final rule, but it 
does give a lot more meat to the definition and asks for 
comment on additional criteria.
    Mrs. Kelly. I think the most important thing here is that 
we make sure that anything that happens with regard to 
oversight, and it is clear to me, I agree with our chairman and 
Mr. Kanjorski, I think there is a need for us to really examine 
this and get it right. But we definitely need transparency, and 
I am very concerned about reducing regulatory barriers because 
to do that opens up the market which I think can only be good. 
I am a true believer in free markets.
    Thank you very much for testifying today.
    Ms. Nazareth. Thank you.
    Chairman Baker. Thank you, Ms. Kelly.
    Ms. Wasserman Schultz?
    Ms. Wasserman Schultz. Thank you, Mr. Chairman.
    Ms. Nazareth, I just wanted to ask you to clear up some 
confusion because a couple of minutes ago in response to a 
question you said that you would welcome, as a result of 
Chairman Donaldson's indication, our involvement, but you are 
in the process of preparing a voluntary framework.
    So I guess I want to have you clarify the seemingly 
conflicting statements. Do you think a voluntary framework is 
enough and how would it work? Or do you think we should get 
involved as a congress and statutorily require regulation?
    Ms. Nazareth. We have not arrived at a final voluntary 
framework, so it is not possible for us to say whether that 
would be sufficient. I do think that this committee has 
expressed enough concern about the issue that I think it would 
be inappropriate to say that the committee should not on its 
own consider the issue, particularly since it is a very nuanced 
one. It does go beyond simply regulating an entity. It does 
raise First Amendment and other issues that have to be balanced 
in the process. That is why I think it is an appropriate issue 
for Congress to address.
    Ms. Wasserman Schultz. Do you have an opinion on whether or 
not you think a voluntary framework is enough? It is not that 
it is not appropriate for you to comment. You are in the 
process of developing a voluntary framework.
    Ms. Nazareth. I cannot speak for the Commission on the 
issue, and frankly I do not think the Commission has really 
been able to fully vet the issue either. But I guess what I am 
concerned about is that, or at least to be cautious about, is 
that Congress rightfully has high expectations of what they 
expect to happen in this area, and if you are looking, frankly, 
for a regime that is most similar to other regulatory regimes 
we have, it would be very difficult for a voluntary initiative 
to meet all of those criteria.
    For instance, to require people to maintain books and 
records similar to what a broker-dealer would require or to 
permit our examiners to go in and request emails, all the 
things that we do with broker-dealers I think would be unlikely 
to be achieved through a voluntary initiative.
    On the other hand, I am sure there are some real benefits 
that we could achieve through a voluntary initiative. So it 
partly depends on what people's expectations are, whether they 
want to do it in a two-step process to see how a voluntary 
initiative goes, or whether they think now is the time to go 
consider a more full-blown regulatory program.
    Ms. Wasserman Schultz. Okay, thank you.
    I yield back the balance of my time.
    Chairman Baker. I thank the gentlelady.
    I certainly want to express my appreciation to Ms. Nazareth 
for appearing here today. As is evidenced, the various members 
have different perspectives on the issue, but suffice it to say 
there is concern about moving forward. We certainly wish to be 
cooperative with and of assistance to the SEC in its 
deliberations.
    We look forward to working with you in the coming days.
    Ms. Nazareth. Thank you very much.
    Chairman Baker. Our meeting stands adjourned. Thank you.
    [Whereupon, at 3:19 p.m., the subcommittee was adjourned.]


                            A P P E N D I X



                             April 12, 2005


[GRAPHIC] [TIFF OMITTED] T3047.001

[GRAPHIC] [TIFF OMITTED] T3047.002

[GRAPHIC] [TIFF OMITTED] T3047.003

[GRAPHIC] [TIFF OMITTED] T3047.004

[GRAPHIC] [TIFF OMITTED] T3047.005

[GRAPHIC] [TIFF OMITTED] T3047.006

[GRAPHIC] [TIFF OMITTED] T3047.007

[GRAPHIC] [TIFF OMITTED] T3047.008

[GRAPHIC] [TIFF OMITTED] T3047.009

[GRAPHIC] [TIFF OMITTED] T3047.010

[GRAPHIC] [TIFF OMITTED] T3047.011

[GRAPHIC] [TIFF OMITTED] T3047.012

[GRAPHIC] [TIFF OMITTED] T3047.013

[GRAPHIC] [TIFF OMITTED] T3047.014

[GRAPHIC] [TIFF OMITTED] T3047.015

[GRAPHIC] [TIFF OMITTED] T3047.016

[GRAPHIC] [TIFF OMITTED] T3047.017

