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



 
                      H.R. 2990--THE CREDIT RATING
                       AGENCY DUOPOLY RELIEF ACT

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                           NOVEMBER 29, 2005

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-66











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                 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:
    November 29, 2005............................................     1
Appendix:
    November 29, 2005............................................    29

                               WITNESSES
                       Tuesday, November 29, 2005

Egan, Sean, Managing Director, Egan-Jones Ratings Co.............    15
Macey, Jonathan R., Sam Harris Professor of Corporate Law, 
  Corporate Finance, and Securities Law, Yale Law School.........    13
Reynolds, Glenn L., Chief Executive Officer, CreditSights, Inc...     6
Roberts, Richard Y., Partner, Thelen Reid & Priest LLP, on behalf 
  of Rapid Ratings Pty Ltd.......................................    11
Stevens, Paul Schott, President, Investment Company Institute....     9

                                APPENDIX

Prepared statements:
    Egan, Sean...................................................    30
    Macey, Jonathan R............................................    37
    Reynolds, Glenn L............................................    42
    Roberts, Richard Y...........................................    51
    Stevens, Paul Schott.........................................    68

              Additional Material Submitted for the Record

Financial Executives International:
    Letter to Securities and Exchange Commission, June 9, 2005...    82
    Letter to Hon. Richard H. Baker, November 29, 2005...........    89













                      H.R. 2990--THE CREDIT RATING
                       AGENCY DUOPOLY RELIEF ACT

                              ----------                              


                       Tuesday, November 29, 2005

             U.S. House of Representatives,
                    Committee on Financial Services
                                           Washington, D.C.
    The committee met, pursuant to call, at 10:05 a.m., James 
A. Byrne Courthouse, Ceremonial Courtroom, Philadelphia, 
Pennsylvania, Hon. Michael G. Oxley (chairman of the committee) 
presiding.
    Members present: Representatives Oxley, Baker, and 
Fitzpatrick.
    ChairmanOxley. The committee will come to order.
    Good morning. We are here today in the beautiful City of 
Philadelphia, the City of Brotherly Love, to focus on H.R. 
2990, the Credit Rating Agency Duopoly Relief Act, introduced 
by Bucks County's own Congressman, Mike Fitzpatrick. I would 
like to take a few minutes to assess the committee's oversight 
of the rating agency industry. In response to the largest 
corporate scandals in U.S. history, Congress passed the 
Sarbanes-Oxley Act, strengthening the role of gatekeepers, such 
as auditors and boards of directors, audit committees, and 
equity analysts.
    Another gatekeeper, the credit rating agency, became a 
focus of Congressional interest because the dominant rating 
agencies had rated WorldCom and Enron investment grade just 
prior to their bankruptcy filings. Wanting to understand an 
industry with such a significant impact on the markets, 
Congress directed the SEC to study the credit rating industry. 
Since the release of the SEC's report in January of 2003, the 
Capital Markets Subcommittee, under the leadership of Chairman 
Baker and Ranking Member Kanjorski, has held a series of 
hearings to explore the areas highlighted in the SEC's report 
about the industry, the barriers to entry, the conflicts of 
interest, and the lack of transparency regarding rating 
methodologies.
    The SEC, a number of rating agencies, public company trade 
associations, and academics have all testified before the 
subcommittee about the industry. Congressman Fitzpatrick's 
legislation, the Credit Rating Agency Duopoly Relief Act, 
reflects many of the reform ideas suggested by these witnesses. 
Witnesses repeated three problems in the credit rating agency 
industry: the lack of competition, the lack of transparency, 
and the lack of accountability.
    Congressman Fitzpatrick's legislation works to correct all 
those problems. First, H.R. 2990 fosters competition by simply 
requiring all eligible rating agencies to register with the 
SEC. The registration of credit rating agencies would resemble 
the registration of broker-dealers and investment advisors 
under the Federal securities laws. Registration would replace 
the opaque recognition process the SEC staff now uses to select 
rating agencies. The designation of only a select number of 
agencies has led to troubling concentration in the industry, 
with two firms controlling a vast majority of market share. 
This is far from an efficient market with robust competition.
    The bill takes a further step at encouraging competition by 
prohibiting anticompetitive practices, such as notching, tying, 
and unsolicited rating. Smaller rating agencies and public 
companies have repeatedly alleged that the larger firms engage 
in such practices. To improve transparency, H.R. 2990 requires 
the disclosure of procedures and methodologies used in 
determining ratings, performance statistics, and conflicts of 
interest. These requirements would go far in shedding light on 
the operation of these powerful players in the financial 
markets. In addition, the legislation permits the SEC to adopt 
further reporting and recordkeeping requirements in the 
interest of investor protection. And finally, H.R. 2990 enables 
the Commission to oversee the rating agencies through 
inspection, examinations, and enforcement actions.
    We do hope to pursue this reform in the new year. We are 
holding this second hearing on the bill to ascertain from our 
distinguished panel of witnesses their views on and suggested 
enhancements to Congressman Fitzpatrick's legislation. I look 
forward to hearing their testimony. I now yield to the 
gentleman from Louisiana, Mr. Baker, the chairman of the 
subcommittee.
    Mr. Baker. Thank you, Mr. Chairman. I want to express my 
appreciation to you for conducting this field hearing and make 
the observation that when we return to Washington, we really 
ought to examine the structure of our own committee room. I 
feel a bit smarter sitting this high up. It certainly is 
helpful to be up here, I think.
    I also want to express appreciation to Mr. Fitzpatrick for 
the introduction of H.R. 2990. This is a really big issue. As 
you appropriately pointed out, the rating agencies are 
essentially the gatekeepers to the capital markets for access 
by businesses of all sizes to engage in corporate growth and 
job creation, product development, and all of the things that 
we see in free enterprise as appropriate and good for our 
national economy.
    A system such as this should be subject to extraordinary 
scrutiny and held to the highest standards of marketplace 
accountability. At the current time, I don't believe that can 
actually be claimed. We have a system which has worked, but 
markets have changed dramatically. The provision of credit 
flows differently than any time before in our country's 
history. Technology continues to press the change, and as a 
consequence, it is time for us to look at the gatekeeper's role 
in asserting whether or not there could be modifications made 
that would benefit all players. It is my view that 2990 brings 
about an important discussion that we should have engaged in 
some time ago, but certainly have an obligation to carefully 
consider the provisions of the bill, as Mr. Fitzpatrick has 
proposed them.
    The current and existing leaders in the provision of 
ratings would no doubt, after implementation of 2990, remain 
the predominant providers of ratings in the system, were the 
system changes brought about as proposed under the Fitzpatrick 
plan. But certainly, it would give at least regional 
specialists the opportunity to stay in the oil patch, to do 
skilled work, and be helpful in bringing about a higher degree 
of accountability by the major players, not only as to the way 
in which the work is engaged, but the product quality itself. 
It shouldn't need to be said again, but probably needs to be 
said again, that very few sectors of the market performance met 
our expectations during the Enron-WorldCom days. And to look at 
the performance of these enterprises in that light, there 
certainly is hope for improvement in future performance as we 
make needed changes to the regulatory system.
    It is my hope, Mr. Chairman, that the committee will return 
to Washington sooner rather than later to formally consider the 
provisions of 2990, move forward on the bill as best we can, 
and certainly in the course of the hearing today, as witnesses 
give us their perspectives on how the bill may be enhanced, 
improved, or otherwise modified, to certainly welcome those 
comments. It is important that if we are going to have a 
market-based ratings system that we communicate with the 
professional leadership of the market in helping structure how 
that plan should best be implemented.
    To that end, I am appreciative for your time in being here 
in the great City of Philadelphia this morning, Mr. Chairman. 
Thank you.
    ChairmanOxley. I thank you and now recognize the gentleman 
from Pennsylvania, who is the author of the legislation, Mr. 
Fitzpatrick.
    Mr.Fitzpatrick. Thank you, Mr. Chairman.
    First, let me welcome Chairman Oxley and Chairman Baker to 
the City of Philadelphia, sometimes referred to as the Cradle 
of Liberty, where 230 years ago, not too far from here, some 
patriots decided to challenge the status quo and make a better 
life for themselves and for their children. We are certainly 
very proud of our history in this area, and I am very proud 
indeed to represent this part of Pennsylvania in the United 
States Congress. And I also appreciate, Mr. Chairman, you 
calling this important field hearing today on improving the 
credit rating industry and allowing me the opportunity to speak 
on behalf of legislation that I introduced, the Credit Rating 
Agency Duopoly Relief Act, H.R. 2990.
    Credit ratings agencies have been issuing credit ratings on 
the likelihood of an issuer's default on debt payment since the 
early 20th century. Today, credit rating agencies rate not only 
companies, countries, and bonds, but also assets and 
securities, collateralized debt obligations, commercial paper, 
private placements, certificates of deposit, preferred stocks, 
medium term notes, and shelf registrations. Despite being often 
underestimated and overlooked, their power is indeed immense. 
Credit rating agencies have a great impact on the bottom line 
of companies, municipalities, and school districts. The better 
the credit rating, the lower the interest rate that the 
borrower must pay.
    This expansive influence finally came into question on 
account of the recent corporate scandals and the fact that two 
of the largest nationally recognized statistical rating 
organizations, NRSROs, Standard & Poor's and Moody's, rated 
Enron and WorldCom at investment grade just prior to their 
bankruptcy filings. Essentially, they told the market that 
Enron and WorldCom were safe investments, even though their 
problems were very apparent to the marketplace. As a result, 
reforming the rating agency industry has been the subject of 
much debate in the House Financial Services Committee.
    Before being elected to Congress last year, for 10 years, I 
served as a county commissioner in the county just north of 
here, Bucks County, and many of my constituents held stock in 
Enron and WorldCom, and they were greatly impacted by their 
bankruptcies, just as countless others were across the Nation. 
S&P and Moody's' monitoring and reviewing of Enron and 
WorldCom, in my view, fell far below the careful efforts one 
would have expected from organizations whose ratings hold so 
much importance.
    Today there are over 130 credit rating agencies in the 
market. However, only five are designated as an NRSRO by the 
U.S. Securities and Exchange Commission. The SEC coined the 
term NRSRO without defining it in its 1975 rule on net capital 
requirements when an obligated broker-dealer is to hold more 
capital for those bonds rated junk by an NRSRO. Since then, 
other regulators and the private investment community have 
taken up the term also, though, without defining it. Over the 
past decade, the SEC has issued various releases, reports, and 
proposals relating to the NRSRO designation process and credit 
agency reform generally. In 1994, the SEC issued a concept 
release stating that the most important factor is that the 
rating agency be nationally recognized, that is, considered by 
the financial markets to be an issuer of credible and reliable 
ratings. In 1997, the SEC issued a proposed rule to codify the 
requirements for designation outlined in the 1994 release, but 
the SEC failed to implement the proposal. A possible reason is 
that the Department of Justice objected to the proposal's 
requirement that NRSROs be nationally recognized, that that 
would have been anticompetitive, prohibiting the entry of new 
market participants.
    The SEC's national recognition system is the root of the 
problem. The NRSRO process is practically an insurmountable 
artificial barrier to entry. Credit ratings matter only if they 
are issued by an NRSRO; thus, since debt issuers typically seek 
ratings from NRSROs to comply with a regulation or a contract, 
a rating agency's lack of designation significantly hinders its 
ability to garner the national recognition required to obtain 
status. This difficulty in obtaining the NRSRO label, due to 
the nationally recognized requirement and the lack of clarity 
in the designation process, has created a chicken and the egg 
situation for non-NRSRO credit rating agencies trying to enter 
the credit rating agency, further fostering a duopoly in the 
credit rating industry.
    The credit ratings industry is dominated by S&P and 
Moody's. Together, they have over 80 percent of the market 
share. Under the leadership of Chairman Oxley and Subcommittee 
Chairman Baker, the House Financial Services Committee has 
received testimony that the lack of competition in the rating 
industry has lowered the quality of ratings. They have inflated 
prices. They have stifled innovation and allowed conflicts of 
interest and anticompetitive practices to go unchecked.
    I introduced the Credit Rating Agency Duopoly Relief Act to 
inject greater competition, transparency, and accountability in 
the credit rating agency industry through market-based reform. 
It enhances investor protection by replacing the SEC's opaque 
designation scheme with a more thorough, transparent 
registration process that protects investors. Instead of 
allowing public companies and investors to decide whose ratings 
to use, the SEC decides for them under the current regulatory 
regime. Ironically, the same regulatory agency that freely 
allows individual investors, regardless of their 
sophistication, to choose a mutual fund, steps in and refuses 
rating consumers the same freedom of choice. Stranger still is 
the fact that most of the consumers of ratings data are 
institutional investors, sophisticated actors in the investment 
community.
    Given the current regime, it comes as no surprise that more 
often than not, the SEC decides to force consumers to use the 
two largest agencies in the market, S&P and Moody's. My 
legislation would eliminate the SEC staff's anticompetitive 
NRSRO process. H.R. 2990 would ensure a level playing field for 
all rating agencies. All eligible credit rating agencies would 
be registered with the SEC under the Securities Exchange Act of 
1934. Any credit rating agency meeting the definition of a 
statistical rating organization must register with the SEC. To 
become eligible for and comply with registration as a 
nationally registered statistical rating organization, 
companies must be engaged in the business of issuing credit 
ratings for at least 3 consecutive years prior to filing an 
application for registration. In addition, this new definition 
does not discriminate against certain business models, as the 
SEC currently does in its current definition process, but 
instead accepts firms with a purely quantitative model and 
investor fee-based model.
    As an additional protection for investors, the Act would 
also prohibit anticompetitive industry practices and mandates 
reporting and recordkeeping requirements for registered firms, 
similar to those for mutual funds, investment advisors, and 
brokers. A nationally registered statistical rating 
organization will be required to disclose in its registration 
application not only its long and short term record at rating 
securities and public companies through performance statistics, 
but also the methodologies it uses in deriving its ratings and 
the conflicts its business model raises and the manner in which 
it manages those conflicts. The Credit Rating Agency Duopoly 
Relief Act directs the SEC to develop other reporting 
requirements as it deems appropriate in the interests of 
investor protection. Moreover, registered rating agencies will 
be held accountable under the securities laws. The SEC will be 
able to inspect, examine, and bring enforcement actions against 
rating agencies under the 1934 Act. My legislation incorporates 
most of the SEC staff's proposed outline of the regulatory 
framework.
    A minority of commentators have claimed that any 
registration in this industry amounts to a violation of First 
Amendment privileges. H.R. 2990 does not infringe upon those 
privileges. The legislation neither bans nor restricts First 
Amendment rights in any manner whatsoever. The Government has 
an undeniable interest in registering rating agencies, given 
the credit rating industry's substantial effects and impact on 
the market.
    My legislation regulates the credit ratings industry 
through disclosure, which is the least restrictive means of 
regulation. It is important to note that currently, all five 
SEC approved agencies already registered voluntarily under the 
Investment Advisors Act of 1940. By encouraging competition in 
the industry, prices and anticompetitive practices will be 
reduced, credit ratings quality will improve, and firms will be 
required to innovate. H.R. 2990 presents a commonsense, market-
based approach to reform, the basic problems of the credit 
ratings industry, while protecting our robust marketplace.
    Chairman Oxley and Subcommittee Chairman Baker, thank you 
for your continued leadership in the credit rating industry, 
and I yield back the balance of my time.
    ChairmanOxley. I thank the gentleman and want to also 
congratulate him for his excellent work on this important 
subject. The committee, as all of us have indicated, since the 
fall of Enron, WorldCom, has really concentrated on what I 
guess we would consider the gatekeepers over time, and this is 
one of the areas that we felt really needed some attention, in 
terms of more transparency, more competitiveness, and the like, 
and the committee will proceed, when we return in January, with 
a markup on your legislation.
    Let us now turn to our distinguished panel of witnesses. We 
thank all of you for coming here today to Philadelphia to 
participate: Mr. Glenn Reynolds, chief executive officer of 
CreditSights, Inc; Mr. Paul Schott Stevens, president of the 
Investment Company Institute; Mr. Richard Y. Roberts, partner 
of Thelen Reid & Priest LLP, on behalf of Rapid Ratings Pty 
Ltd.; Mr. Jonathan R. Macey, Sam Harris Professor of Corporate 
Law, Corporate Finance, and Securities Law, with the Yale Law 
School; and Mr. Sean Egan, managing director of Egan-Jones 
Ratings Company.
    Mr. Reynolds, we will begin with you.

     STATEMENT OF GLENN REYNOLDS, CHIEF EXECUTIVE OFFICER, 
                       CREDITSIGHTS, INC.

    Mr.Reynolds. Thank you. It is my pleasure to be here this 
morning.
    My name is Glenn Reynolds. I am the CEO of CreditSights. We 
are an independent research firm offering a range of research 
and data products and with a heavy focus on credit research. 
Our primary business is not credit ratings, however, but we do 
compete with some of the rating agencies in some areas. We 
probably chose a different business model than credit ratings, 
since entering the ratings business was essentially impossible 
under the current regulatory framework. Based on our current 
business model, we are a registered investment advisor 
regulated by the SEC in the U.S. and by the FSA in the UK.
    We have had the opportunity to testify before on the rating 
agency topic in front of the Senate in March 2002, and the SEC 
in November 2002, and it has been interesting to watch the 
process evolve. A lot of man hours have been directed at this 
issue. A lot of hearings have been conducted, a lot of 
testimony filed. The level of due diligence has been 
impressive. It is clear that many parties have a strong 
interest in seeing some progress made and have a lot at stake 
in the issue. It is equally clear that some parties have a big 
stake in seeing no action.
    With 4 years since the Enron fiasco and various other 
market implosions now behind us, it is also clear that there 
has been dramatic change in the securities, banking, and 
accounting industries as we all moved ahead and learned from 
past experiences. It is safe to say that this has not been with 
the credit agencies. The banking and brokerage industry had 
paid out billions of dollars, totally overhauled their 
approaches to research, addressed conflicts of interest, and 
altered compensation strategies to deal with some of the well-
documented issues. The accounting profession has also seen 
sweeping changes in the industry. Business lines have been 
reorganized. Entire firms have disappeared. The ruling 
accounting bodies have made sweeping changes in disclosure and 
accounting requirements. In the broader market, corporate 
management teams are now under more stringent guidelines to 
take responsibility for their financial statements and internal 
controls.
    Remarkably, the one major segment of the capital markets 
that remains on structural cruise control through all of this 
change is the credit rating agencies, or more narrowly, the 
NRSROs. The NRSROs have somehow been able to slow the pace of 
change, frustrate the timely lowering of artificial barriers to 
entry, and continue to expand into non-ratings business lines 
at breakneck pace from their protected enclave as an NRSRO. 
They remain largely insulated from competition by an outdated 
and anachronistic regulatory framework that the overwhelming 
majority of reasonable people, disinterested or otherwise, see 
as overdue for an overhaul to allow more competition. The 
agencies have mounted the usual defenses, but some facts of 
life have to be clear. The rating agencies are, in fact, a 
major force in the capital markets, and they toe the line 
between being an information provider and a de facto part of 
the underwriting process. The regulations have woven the rating 
agencies in the fabric of the securities markets, and the 
agencies have taken every opportunity to tighten the stitching. 
They hold sway over many capital market segments, and most of 
the major trade groups and individual companies are not going 
to mess with them publicly.
    Every next move influences mark-to-market adjustments, 
reserve requirements, asset allocation decisions, forced sale 
of assets, and access to the capital markets generally. They 
are unique in that position and being essentially devoid of 
meaningful regulation. They have a sweet regulatory deal, and 
that brings us to H.R. 2990. H.R. 2990 will immediately address 
the issue of barriers to entry and start the process of 
injecting some competition into the ratings sector. As the 
debate continues, it may also shine some light on the array of 
non-ratings businesses that the rating agencies are entering, 
all the while as they are structurally protected in their main 
credit rating business. As it stands today, an unlevel playing 
field has undermined economic efficiency, kept prices 
artificially high, limited innovation, tapped the brakes on 
quality, and limited diversity of opinion in the marketplace. 
Competition does not cure all ills, but historically, has sure 
proven to be a good start. H.R. 2990 gives it that fresh start. 
There is no doubt that, if passed, we will see more 
competition.
    We can state clearly from our own experience at 
CreditSights that both strategic operators in the financial 
media space and sources of private equity capital see 
investment opportunities in the credit ratings, financial 
information, and financial data space. H.R. 2990 will open up 
the opportunities, and change will come fast. H.R. 2990 is pro-
competition, and it is also rational. It will lower the 
artificial barriers to entry and allow market entrants to 
tackle the natural commercial barriers to entry which are 
demanding enough. The longer the artificial barriers remain up, 
the higher the natural barriers will be stacked by Moody's and 
S&P. The ratings industry is, if anything, not a natural 
duopoly or even a natural oligopoly. In fact, it should be 
naturally competitive, just like the brokerage industry, the 
banking industry, the asset management industry, and the media 
industry. Those industries only get more competitive. The 
ratings industry is in stark contrast. With Moody's and McGraw-
Hill posting remarkable financial performances, exception 
profit margins, especially in their financial businesses at 
McGraw-Hill, and generally dwarfing the stock returns of the 
overall market in the broader peer group of financial 
companies, it is worth asking why we have not seen major market 
entrants. Economics 101 tells us something is wrong. That is 
where the artificial barrier part comes in. It is intuitive and 
obvious that market competition is being held back 
artificially. Scrapping the NRSRO designation entirely is 
preferable to the status quo, but some regulation still is 
prudent, and the disasters of 2001 and 2002 are there to remind 
us of that. We realize that the NRSROs are mounting a furious 
defense against even light-handed regulation after years of 
being essentially protected by regulation and generating 
massive financial benefits from the regulation that kept out 
competitors.
    We would refer you to our formal testimony on some of those 
issues, but a few things are clear. The rating agencies win by 
delay. H.R. 2990 speeds up the process and does so with a 
measured series of steps. It could use some definitional 
tweaking, but has all the right parts to get a little 
resolution to the dilemma. The market holds more opportunities 
today than ever in the credit markets for rapid growth, and 
competition will flourish. Moody's and S&P would like to keep 
the status quo to capture a bigger slice of that growth. Large 
firms and small firms are waiting in the wings. The interests 
of the duopoly will be for more delay or to water down the 
bill. They will propose to make it voluntary or promise a 
fight. They never offered to make entry voluntary over all 
these years as they frustrated competition. The policy decision 
here either calls for a major force in the capital markets to 
be free of all regulation or not. Moody's and S&P will try to 
make this about the First Amendment. The agencies, on the one 
hand, would have you believe their views are like a good or bad 
movie review in Variety. We cannot even believe they can 
seriously and truly believe this is about journalism.
    Philadelphia is a great place for these hearings, to drive 
home the points that this is not about the Constitution. Then 
again, Philly is the right place, since this is all about the 
Benjamins. It is about profit, and it is about who gets it. It 
is about choice and not having it. In some ways, it is that 
simple.
    Thank you to the committee for the opportunity to weigh in 
on these issues.
    [The prepared statement of Glenn L. Reynolds can be found 
on page 42 in the appendix.]
    ChairmanOxley. Thank you, Mr. Reynolds. Mr. Stevens.

STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT, INVESTMENT COMPANY 
                           INSTITUTE

    Mr.Stevens. Mr. Chairman, thank you, and I am delighted to 
be able to join the committee here in Philadelphia this 
morning.
    As you know, I head the national association of U.S. 
Investments Companies, and our members include both open-end 
companies, or mutual funds, closed-end funds, exchange-traded 
funds, and sponsors of unit investment trusts, and the credit 
rating agencies are important to each and every one of these 
classes of our members. Our mutual fund members have assets of 
$8.5 trillion, representing more than 95 percent of all U.S. 
mutual fund assets. They serve about 87 million shareholders 
and more than 51 million households.
    The Institute commends the Financial Services Committee for 
holding this hearing on H.R. 2990, the Credit Rating Agency 
Duopoly Relief Act of 2005, which is intended to improve the 
quality of credit ratings by fostering competition, 
transparency, and accountability in the credit rating industry, 
and to address concerns regarding the current NRSRO designation 
process. This is my second opportunity as president of the ICI 
to testify before the committee which you have so ably led, 
Chairman Oxley. Under your leadership, and that of Ranking 
Member Frank, and Capital Markets Subcommittee Chairman Baker, 
and Ranking Member Kanjorski, the committee has been active in 
critically important issues affecting all aspects of our 
capital markets. This legislation is one more example, and I 
would like to recognize Congressman Fitzpatrick for his 
leadership in advancing this important bill.
    Credit rating agencies play a significant role in the U.S. 
securities markets generally, and other of the witnesses will 
talk about that. I would like to address their importance vis-
a-vis mutual funds in particular. Mutual funds employ credit 
ratings in a variety of ways: to help make investment 
decisions, to define investment strategies, to communicate with 
their shareholders about credit risk, and to inform the process 
for valuing securities.
    The most significant influence of credit ratings on the 
fund industry is on the $2 trillion invested in money market 
mutual funds. Money market funds are a truly remarkable chapter 
in the history of U.S. mutual funds. Initially, they were used 
as savings vehicles. Today, retail and institutional investors 
alike rely on them as a broader cash management tool because of 
the high degree of liquidity, stability, of principal value and 
current yield that they offer. ICI estimates that between 1980 
and 2004, roughly $100 trillion, a staggering number, flowed 
into, and the same amount out of money market funds.
    Now if the money market fund industry is a success story 
for Institute members, money funds are also, most certainly, an 
SEC success story as well. Since 1983, money market funds have 
been governed very effectively by Rule 2a-7 under the 
Investment Company Act of 1940. Rule 2a-7 limits the types of 
securities in which money market funds can investment in order 
to help them achieve the objective of maintaining a stable net 
asset value of one dollar per share. Credit ratings form an 
integral part of these limitations. For example, money market 
funds may only invest in securities either rated by an NRSRO in 
its two highest short-term rating categories or if the 
securities are unrated, they must be determined by the fund's 
board of directors to be of a quality comparable to such rated 
securities.
    Now it is important to note that no Government entity, such 
as the FDIC, insures money market funds. Nevertheless, despite 
an estimated $200 trillion flowing into and out of these funds 
over the past 25 years, through some of the most volatile 
markets in our history, only once has such a fund failed to 
repay the full principal amount of its shareholders' 
investments. In that case, many years ago, a small 
institutional money fund broke the buck due to extensive 
derivatives holdings.
    It is critically important that this record of success 
achieved under Rule 2a-7 continues for the benefit of money 
fund investors. This, in turn, depends upon the ratings issued 
by NRSROs providing credible indications of the risk 
characteristics of those instruments in which money market 
funds invest.
    To promote the integrity and quality of the credit ratings 
process and, in turn, serve the interests of investors who use 
credit ratings, we believe that there are several steps that 
should be taken. First, the NRSRO designation process should be 
reformed to facilitate the recognition of more rating agencies 
and, thereby, introduce much needed competition in the credit 
rating industry.
    The mutual fund industry is one in which intense 
competition has brought unparalleled benefits to investors. I 
firmly believe that robust competition for the credit ratings 
industry can do the same and is the best way to promote the 
continued integrity and reliability of credit ratings. 
Unfortunately, the current designation process does not promote 
but, in fact, creates an affirmative barrier to competition. In 
particular, the current SEC process for designating credit 
rating agencies through the issuance of no action letters has 
not worked effectively. In place of this no action process, the 
Institute recommends mandatory expedited registration with the 
SEC. We are, therefore, pleased that H.R. 2990 properly moves 
the basis for NRSRO designation from a national recognition 
standard to an SEC registration requirement.
    Second, there should be appropriate regulatory oversight by 
the SEC to ensure the credibility and reliability of credit 
ratings. We believe this can be achieved through a combination 
of one, periodic filings with the SEC and, two, appropriate 
inspection by the SEC coupled with adequate enforcement powers. 
Specifically, H.R. 2990 would require that certain important 
information be provided to the SEC upon registration. We 
believe that NRSROs should be required to report to the SEC on 
an annual basis that no material changes have occurred in these 
areas. Similarly, NRSROs should be required to report any 
material changes that do occur on a timely basis, and this 
information should be made available promptly to investors who 
rely on NRSRO ratings. Such disclosures should be accompanied 
by an appropriate SEC inspection process tailored to the nature 
of their specific business activities.
    Third, investors should have regular and timely access to 
information about NRSROs to provide them a continuous 
opportunity to evaluate the ratings that they produce. In 
discussions with our members, they have emphasized the 
importance to them, as investors, of access to information 
about an NRSRO's policies, procedures, and other practices 
relating to credit rating decisions. In particular, it would be 
helpful for NRSROs to disclose to investors their policies and 
procedures, addressing conflicts of interest, as well as the 
conflicts themselves, and periodically to disclose information 
sufficient for investors to evaluate whether they have the 
necessary staffing, resources, structure, internal procedures, 
and issuer contacts to serve effectively as NRSROs.
    Finally, we believe NRSROs should have some accountability 
for their ratings in order to provide them with incentive to 
analyze information critically and to challenge an issuer's 
representations. Specifically, we believe that any reforms to 
the credit ratings process should, at a minimum, make NRSROs 
accountable for ratings issued in contravention of their own 
disclosed procedures and standards. Even if the First Amendment 
applies to credit ratings, it does not, in our view, prevent 
Congress from requiring rating agencies to make truthful 
disclosures to the SEC and to the investing public.
    Now the SEC has been aware of issues relating to credit 
rating agencies for over a decade now. During that time, it has 
issued two concept releases, two rule proposals, and submitted 
a comprehensive report to Congress addressing credit rating 
agencies and NRSRO practices. In the process, the Commission 
has received scores of comment letters, including several from 
the Institute, urging action in this area. No action has been 
forthcoming. In light of this history, we believe action by 
Congress is now necessary. The Institute strongly, therefore, 
supports the goals of H.R. 2990: increased competition, 
appropriate SEC oversight, greater transparency, and heightened 
accountability. These are the right objectives for reform of 
the credit rating industry from the perspective of mutual 
funds, other investment companies, and other investors, and, 
indeed, the securities market as a whole.
    I very much appreciate the opportunity to share the 
Institute's views with you today. We have a number of technical 
comments about the bill that we will be providing separately, 
and we do look forward to working with the committee on these 
and other issues in the months ahead.
    Thank you, Mr. Chairman.
    [The prepared statement of Paul Schott Stevens can be found 
on page 68 in the appendix.]
    ChairmanOxley. Thank you, Mr. Stevens. Mr. Roberts.

STATEMENT OF RICHARD Y. ROBERTS, PARTNER, THELEN REID & PRIEST 
            LLP, ON BEHALF OF RAPID RATINGS PTY LTD.

    Mr.Roberts. Mr. Chairman, I appreciate the opportunity to 
appear today on behalf of Rapid Ratings. I am Rick Roberts. I 
am an attorney in Washington, D.C., with the firm of Thelen 
Reid & Priest. The views that I express today are to be 
considered my own and do not necessarily represent those of my 
law firm or the clients of my law firm. Matter of fact, if the 
views are not well received, I will disclaim them as my own 
after the hearing.
    From 1990 to 1995, I was privileged to serve as an SEC 
Commissioner. During my SEC life, in a couple of speeches in 
1992, I highlighted what I viewed as the potential problems 
imbedded in the NRSRO designation criteria utilized by the SEC. 
First and foremost among them is that that acronym really 
stinks, and it needs to be a lot shorter. It is very hard to 
pronounce. Unfortunately, not much has changed since 1992. I 
believe that H.R. 2990 will introduce much needed competition 
and additional integrity to the rating process for debt 
securities and will reduce systemic risk in the marketplace. In 
my view, H.R. 2990 will serve as a catalyst for reforms that 
will greatly enhance the quality of information provided to 
investors.
    It may be helpful if I talk for a few minutes about Rapid 
Ratings. Rapid Ratings is an organization founded in 1997 and 
is an independent global corporate credit rating agency 
headquartered in Australia, with other offices in New Zealand, 
Singapore, the UK, Canada, and the U.S. Rapid Ratings is 
currently licensed by the Australian Securities and Investment 
Commission as a credit rating agency to provide financial 
advice to wholesale and retail markets. Rapid Ratings 
anticipates that it will file an application seeking to obtain 
NRSRO designation with the SEC in the near future.
    Using proprietary software, Rapid Ratings rates 
approximately 15,000 listed companies globally, including 7,000 
in the U.S. Rapid Ratings follows the original rating agency 
model of being paid by buy-side subscribers, rather than by 
issuers of securities. Unlike current NRSROs, Rapid Ratings 
credit ratings assess the financial health of an institution 
based on industry-specific quantitative models, and the ratings 
are derived solely from publicly disclosed financial 
statements.
    The current NRSRO criteria were designed for rating 
agencies with an issuer-paid business model, despite their 
origins of being paid largely by subscribers. Since NRSRO 
status was introduced in 1975 for net capital rule purposes, 
the largest rating agencies have been increasingly and now 
predominantly paid by issuers of debt to rate those parties, 
and I refer to this as a Type 1 business model. This was, 
perhaps, one of the unintended consequences of the creation of 
NRSRO status. Type 1 rating agencies employ highly skilled and 
highly paid people that go onsite to acquire nonpublic 
information to rate companies. New generation rating agencies, 
such as Rapid Ratings and many others, have an entirely 
different business model, which I will refer to as the Type 2 
model.
    New generation rating agencies are paid by investors or 
other buy-side third parties, such as banks, insurance 
companies, mutual funds, pensions funds, large creditors, et 
cetera, to rate second parties, such as listed and/or unlisted 
companies and their securities, and use only publicly available 
information. Type 2 rating agencies also typically use software 
rather than analysts. Thus, in the Type 2 model, there may be 
no contact between the rating agency and the companies it rates 
and, thus, little potential for conflict of interest. In 
assessing eligibility for NRSRO status, it would be unfair to 
require a Type 2 company to conform to criteria that pertain 
only to Type 1 companies that have such conflicts.
    Now Rapid Ratings believes H.R. 2990 would achieve many of 
the goals that are necessary to promote greater efficiency in 
the debt markets. It would remove most of the current 
restrictions, instituting a registration process for rating 
agencies that have been in business for more than 3 years, and 
substituting "registered" for "recognized" in the NRSRO 
acronym. It also would permit quantitative firms to be 
registered and would allow subscription fees to be charged for 
ratings by not requiring wide dissemination of ratings at no 
cost. Thus, the legislation will ensure that the pre-1975 
practice of having the ratings largely paid for by investors 
and other buy-side subscribers is revived by new generation 
rating agencies with new technology and a strong record for 
providing early warnings to the market. This bill, if enacted, 
goes a long way toward removing the barriers to entry created 
by the current regulatory standards while assuring the 
integrity of the rating process by providing credible market-
based standards.
    And in conclusion, I believe, as I always have, that 
regulation is no substitute for competition in the marketplace. 
Consumer choice is often the best policeman. In my opinion, the 
real potential for enhancing ratings competition arises with 
the entry of innovative rating agencies that offer alternate 
business models. If a level playing field is created to permit 
Type 2 rating agencies with innovative business models that are 
paid by investors to compete effectively with Type 1 rating 
agencies that are paid by issuers, there will be, in my 
judgment, significant benefits to the marketplace, and these 
benefits include earlier warnings to the market of potential 
problems, enhanced protection and choice for investors, greater 
accuracy in ratings, broader coverage of securities and 
issuers, lower costs to issuers and investors, greater 
independence and objectivity, and less risk of systemic shocks. 
In my view, the reduced barriers to entry afforded by H.R. 2990 
will provide substantial benefits to the market and will 
improve the efficiency of the capital allocation process.
    Again, I appreciate the opportunity to participate in the 
hearing, and I will be happy to attempt to respond to any 
questions that you may have at the appropriate time.
    [The prepared statement of Richard Y. Roberts can be found 
on page 51 in the appendix.]
    ChairmanOxley. Thank you, Mr. Roberts, for your testimony. 
We now have Professor Macey.

    STATEMENT OF JONATHAN R. MACEY, SAM HARRIS PROFESSOR OF 
CORPORATE LAW, CORPORATE FINANCE, AND SECURITIES LAW, YALE LAW 
                             SCHOOL

    Mr.Macey. Thank you. It is a pleasure to be here, and 
Chairman Oxley and Subcommittee Chair Baker and Congressman 
Fitzpatrick, I am delighted to be here.
    The previous four speakers did a great job and said a lot 
of the--made a lot of the points I was going to make, so I will 
try to focus on some new and different aspects. But let me 
begin by saying that I think the statute proposed, H.R. 2990, 
provides a very valuable legislative framework that will 
promote more vigorous competition in the rating agency business 
and provide not only better ratings, but also provide strong 
protections for individual investors. I would add to that that 
I think the statute is very simple, elegant, well tailored to 
the problem, so I think that it is something that I strongly 
support.
    There is this strange puzzle in the--those of us who study 
credit rating agencies often observe, which is, as was pointed 
out earlier, we see an industry that makes tremendous amounts 
of profits, but at the same time, seems to do a really bad job, 
as we see with respect to the performance of rating agencies in 
contexts like Mercury Finance, Orange County, Pacific Gas & 
Electric, Enron, WorldCom, and more recently, the lagging 
ratings for companies like General Motors and Ford. And I think 
that there was nothing unintentioned, or there is nothing 
intentioned, rather, or evil in the way this developed. I think 
it was basically inadvertent that the NRSRO designation evolved 
in such a way that it created an artificial demand for ratings 
and people in the financial marketplaces, as was the case with 
the example earlier of Rule 2a-7 of the Investment Company Act 
of 1940. It created a demand for ratings regardless of the 
content or quality of those ratings. We have very little 
competition in that area.
    So I fully support this statute. I want to just say in a 
couple of additional points. One is while I certainly agree 
that there have been drastic improvements in--since the sort of 
Enron era, I don't think it is the case that the credit rating 
agencies are the only sort of noncompetitive node in the 
capital markets, that the GAO has, I think, amply demonstrated 
the lack of competition among the remaining four accounting 
firms for auditing large U.S. companies, stock exchange 
specialist firms, bulge bracket underwriting firms. Self-
regulatory organizations in the financial markets are also like 
the current NRSRO situations where in a perfect world we would 
spend time thinking about how to make those areas of the 
capital markets more competitive. The nice thing about the 
credit rating agency problem, if you will, is that we have 
before us a very, I think, discrete functional solution, and it 
is a terrific, terrific place to start. I would just urge this 
committee to continue down this very good path towards making 
capital markets more competitive.
    A couple of other points. One is on the First Amendment 
issue. Let me just say that generally speaking, I think this is 
a complete red herring. If this statute violates the First 
Amendment, then I think the Securities Act of 1933 registration 
requirements for initial public offerings also violates the 
First Amendment, so we could stop IPOs. I don't think either 
one of them does. I think that is simply a red herring put 
forth by people who want to, for obvious economic reasons, to 
maintain the current status quo.
    One kind of footnote to that is, one aspect of this statute 
would prohibit the newly created registered rating 
organizations from issuing unsolicited or free ratings. I think 
that, given the other changes in the bill, I am not sure that 
is necessary. I do agree that unsolicited ratings are a very 
big problem. There is this issue of whether rating agencies 
engage in shakedowns of companies and municipalities in the 
market for credit. Do agencies demand payment by companies and 
municipalities for ratings? If that is the case, I certainly 
think that there should be regulatory action taken against the 
rating agencies. I also think that rating agencies should be 
required to disclose when the ratings they issue are 
unsolicited, and they should also be required to disclose when 
they are offering services on a fee basis to the entity being 
rated, but were declined, and I think that the agencies 
similarly should be required to disclose whether information on 
which their ratings are based is as complete in the case of an 
unsolicited rating as information that they ordinarily possess 
when generating a solicited fee paid rating. But I am not sure 
I would go as far as the legislation goes and require--and ban 
unsolicited ratings.
    Last is, I certainly support specific features of the 
legislation that would require disclosure of conflicts of 
interest and the procedures and methodologies used in 
determining ratings, as well as the procedures used to prevent 
the misuse of nonpublic information. I would be--certainly, 
though, you would want to--we would want to be careful in 
implementation that, to the extent that companies have 
developed proprietary trade secrets, which would be of use to 
rivals, with respect to the ways that financial data is 
analyzed, and for the generation of a rating, we would want to 
protect that property right.
    But with that said, I think--excuse me, 2990 is an 
important and valuable statute, which I will hope will pass, 
and will improve the quality of the information provided by 
credit rating agencies and establish credit rating agencies as 
an important component in the U.S. system of corporate 
governance and investor protection.
    Thank you.
    [The prepared statement of Jonathan R. Macey can be found 
on page 37 in the appendix.]
    ChairmanOxley. Thank you very much, Professor. And our 
final witness is Mr. Sean Egan. Mr. Egan.

 STATEMENT OF SEAN EGAN, MANAGING DIRECTOR, EGAN-JONES RATING 
                              CO.

    Mr.Egan. Thank you. I am Sean Egan. I am managing director 
of Egan-Jones Ratings.
    We support the proposed legislation for reforming the 
rating industry, since it significantly increases competition.
    The primary purpose of rating firms is to facilitate the 
allocation of capital by assessing the relative riskiness of 
various issuers. The job can be compared to the trucking 
industry, in the sense that capital, rather than goods, are 
moved throughout the financial system. Unfortunately, the 
regulatory process for the trucking industry makes a great deal 
more sense than does the regulatory process for the rating 
industry. In the trucking industry, there are various tests 
drivers need to take to ensure that they are able to operate 
vehicles in a safe manner. The tests are straightforward, and 
passing them is similar to passing a driving test. In the 
rating industry, there has never been a formal process for 
obtaining a license, and at the current rate, there never will 
be. Regulators have been studying the area since the early 
1990s and have yet to establish a set of requirements for 
applicants. Yes, two firms in the past couple of years have 
been recognized, but for the most part, the firms provide 
little competition to the major firms in the industry, S&P and 
Moody's. DBRS rates mainly Canadian issuers, and AM Best 
focuses on insurance firms.
    In the trucking industry, if a shipper is unhappy with the 
rates or service of one particular shipper, there are a variety 
of other shippers available. In contrast, in the rating 
industry, there is relatively little competition. S&P and 
Moody's garner approximately 85 percent of the revenues for 
U.S. corporate debt, and a rating from two firms is normally 
needed for a public issue. The costs for the lack of 
competition is borne by issuers, investors, employees, 
retirees, and non-recognized rating firms.
    To address some of the concerns that have been raised about 
H.R. 2990, facilitating the emergence of a plethora of 
unqualified rating firms, we recommend the following additions 
to Section 3(a) of the Act--of the bill.
    Independence. No NRSRO shall be affiliated with a broker-
dealer, bank, financial institution, issuer, investor, or user 
of credit ratings. Experience. The rating firm shall have 
issued ratings for the past 7 years and shall have generated at 
least $1 million in revenues from such activities in the U.S. 
for a period of 7 years or more. Quality. To reflect the impact 
of events such as acquisitions, major share repurchases, and 
buyouts, all ratings issued will be reviewed using qualitative 
methods. Additionally, the NRSRO shall be available to issuers' 
personnel and capable of reflecting issuer comments in ratings. 
Note, credit ratings based on security prices and spreads can 
be easily manipulated and provide profit opportunity to 
unscrupulous investors.
    Regarding objections to H.R. 2990, below are rebuttals. 
H.R. 2990 does not disrupt the markets. Increased competition 
should improve market conditions. H.R. 2990 does not violate 
First Amendment. Additional competition should not affect First 
Amendment protections. H.R. 2990 does not promote rogue firms. 
Additional competition should encourage the issuance of timely, 
accurate ratings.
    Moving forward on this issue is critical. We are all aware 
of the problems caused by the faulty ratings of WorldCom, 
Enron, and other failed issuers. However, less obvious are the 
problems caused by underrating firms, such as Nextel. As can be 
seen in the attachment, we rated Nextel at BBB-, as of November 
2003, when S&P rated the company at BB-, and Moody's at only 
B2. The difference in cost between a BBB- rating and a B2 
rating is approximately 300 basis points, or 3 percent. Nextel 
had $10 billion of debt at the end of 2003. The additional cost 
is $300 million per year of these faulty ratings, $300 million 
is the amount greater than the earnings of most public firms. 
By the way, both S&P and Moody's raised their rating to 
investment grade in August of 2005.
    Thank you for your time and interest. Attached is 
additional information on Egan-Jones.
    [The prepared statement of Sean Egan can be found on page 
30 in the appendix.]
    ChairmanOxley. Thank you, Mr. Egan, and thank all of you 
gentlemen for excellent presentations.
    Let me begin with a few questions. One of the critiques 
that we have heard over the last few months regarding 
Congressman Fitzpatrick's legislation is there will be--this 
legislation would lead to rating shopping, with the rogue firms 
jumping up and lowballing and the like, creating perhaps an 
artificially competitive marketplace. Are those criticisms 
justified, and let us just begin with Mr. Reynolds and go to my 
left to right.
    Mr.Reynolds. Well, it is, excuse me, it is certainly not 
without past history. That was something that was done in the 
money market business in the '80s, where, with all due respect 
to some of the roll ups, the idea was if you couldn't get 
Moody's and S&P over from an A to a P to a 1 rating, you'd go 
shop at Fitch and Duff to get the Def One F1, so, you know, 
that is a pretty benign form of it. I think the way the reform 
is more likely to play out is you are going to have more 
companies entering the space using investor-based models, not 
issuer-based. Because right now, there is a stranglehold on the 
issuers, and, frankly, the issuers will have a very hard time 
going to smaller organizations that are just on the way up. So 
it is not going to be the issuer that drives the reform. It is 
bringing high information content, high quality ratings to 
investors, and they are certainly not looking for anything 
other than good input to manage their risks. So I think that is 
a real risk, but I would say that is the one in 10 piece of the 
equation. The nine in 10 is how do you build a revenue model, 
how do you build a firm of scale, and in order to do that, you 
are going to have to go to the investors, not the issuers.
    ChairmanOxley. Mr. Stevens.
    Mr.Stevens. For various purposes, mutual funds, as 
investors already have to do independent credit analysis. They 
can't simply rely on ratings. What we would like to see the 
legislation do, Mr. Chairman, is to provide much more 
information about the ratings agencies and their processes so 
that we can assess the quality of the ratings that they are 
producing. There is no incentive that I can see for a mutual 
fund investor to rely upon or to shop for bad, poorly produced 
ratings. Quite the contrary. But as institutional investors, if 
they have access to the information, they can make judgments 
about the quality of the ratings agency and what they are 
producing, and I think then, they will go to the strongest and 
best ratings to utilize in making their investment decisions.
    ChairmanOxley. Mr. Roberts.
    Mr.Roberts. Well, I don't believe that there is that much 
risk with respect to the issue of ratings shopping. First of 
all, as Mr. Reynolds indicated, any organization has to worry 
about its reputational risk, and the marketplace should be able 
to discern pretty easily, through readily available performance 
benchmarks, if someone is systematically an easy grader. There 
are ample, verifiable statistical measures, such as default 
statistics and rating comparisons on issuers rated jointly by 
multiple agencies, which should reveal any such easy grader 
pretty quickly. In my judgment, this concern is probably 
already addressed in the marketplace, where market pricing 
mechanisms such as bond spreads routinely second guess the 
credit rating and would highlight firms that are consistently 
assigning higher ratings than would be warranted by an issuer's 
financial condition. So I would consider the risk fairly 
slight, certainly as compared to the benefits of competition.
    ChairmanOxley. Professor Macey.
    Mr.Macey. I agree with what Mr. Roberts just said. I would 
add to that that given the prominence of institutional 
investors in today's investing world, my inclination is that 
new entrants into the credit rating game are going to be 
extremely concerned about screwing up and giving a high rating 
to somebody that, like to a company, that later implodes and 
getting branded with the sort of moniker of being too easy. So 
I think the market will take care of itself, with the 
institutional investor community being able to sort out the new 
entrants that are providing valuable information and ignoring 
those that are engaged in the sort of race to the bottom that 
was just suggested. So I am not--I think it is--that we will 
see much better quality ratings, and we will see pressure that 
we don't observe now on firms to compete along the vector of 
quality.
    ChairmanOxley. Professor, if I could--let me digress just a 
minute because in your testimony-- I have got to do this before 
I think of it; otherwise it is gone. That is just the way my 
mind works. I was in law school a long time ago, so I am trying 
to come back to this. But anyway, your testimony was regarding 
the accounting firms and the lack of competition now that we 
are down to the final four. I wonder if you could help us 
through that. How do we create an atmosphere in which we create 
more competition and get back to what used to be the Big Eight, 
or at least some semblance of that? How do we recreate that, or 
can we, and what are the prospects?
    Mr.Macey. Well, just to be clear, it is easy, in my view 
anyway, to explain why we have no competition or very little 
competition in accounting, and I want to make it clear also 
that according to the General Accounting Office, the level, the 
lack of competition is much worse than is suggested by the fact 
that there are only four accounting firms. Because if you look 
at the level of specialization in the accounting industry, so 
you have these accounting firms that are focusing on aerospace, 
or focusing on biotech, that, in fact, companies in those 
industries may really, as a practical matter, after the demise 
of Arthur Andersen, only have a couple of firms to choose from. 
So it is really bad.
    Now the reason that we have this problem is very similar in 
many ways historically to the reasons we have this credit 
rating problem, which is it is, if you will forgive me for 
saying so, a little largely attributable to what has turned out 
to be misguided regulation by the SEC, the NRSRO designation, 
in this case. With the case of accounting firms, the problem is 
in order for an accounting firm to qualify to regulate a 
company, it has to be the earning, the income that the 
accounting firm makes from the audit business has to be a small 
percentage of the audit firm's overall revenue, which means 
that you have to be a giant accounting firm, like Arthur 
Andersen, to qualify to audit a firm like Enron because, 
otherwise, your billings to Enron will be too big of a 
percentage of your overall earnings.
    My own view, based on empirical work in the accounting 
industry, which I would be thrilled to discuss with you, 
suggests that the way that we ought to get rid of that 
regulation, and we ought to allow little bitty accounting 
firms, smaller accounting firms, the non-Big Four, and I will 
add, you know, the drop-off after the Big Four is pretty steep, 
to get into the business of auditing big companies, bearing in 
mind that I think this percentage test for independence is 
meaningless. As we saw with Arthur Andersen, what really 
mattered from the standpoint of the independence of the 
auditing firm wasn't Arthur Andersen as a company; it was the 
audit engagement team that was actually doing the work, and 
there, you had this guy David Duncan, and he didn't do anything 
else but Enron, and he lived at Enron, and he basically took, 
acted in many ways like an Enron employee.
    A statute you undoubtedly are aware of, the Sarbanes-Oxley 
Act, deals with that to some extent, with the auditor rotation 
provisions, and I would suggest as an add-on to that that we 
relax these independence restrictions so that we could open up 
competition in the accounting business for the largest U.S. 
companies, beyond just the final four accounting firms that 
remain.
    ChairmanOxley. Thank you. Mr. Egan.
    Mr.Egan. I have to differ with the other panelists. We 
think it is a huge problem, and let me explain why. 
Approximately 90 percent of the revenues in the rating industry 
are generated by the issuers. People respond to the money, and 
there is no reason why you wouldn't have rogue firms emerging 
that are giving very generous ratings. It would be difficult to 
prevent that.
    An extreme example would be, under the current Act, an 
underwriter can form a rating firm. It could be under the 
underwriter's name, Merrill Lynch Ratings, or it could be an 
affiliate of Merrill Lynch, and could say, "Come to us. Don't 
worry about the ratings; we will take that. Yes, we will go to 
S&P and Moody's because they have been there forever. We will 
take care of the ratings. And by the way, there will be a fee 
for that." There is little that can prevent that under the 
current Act.
    If you look at the business, there is about $6 billion in 
revenues. Over $5 billion of it is generated from issuer 
compensation. So I think the fear of the emergence of rogue 
firms is very real, and it makes sense to set up some 
protections against that. In my testimony, I used the analogy 
of trucking firms or drivers. The credit rating market is 
fundamentally different than the investment advisory field. You 
don't want drunk drivers on the road. You don't want 
inexperienced drivers on the road. It is too important. Why is 
it important? Because a lot of parts of the regulatory system 
rely on these ratings. I think you want to have some initial 
checks. If firms don't abide by it, like S&P and Moody's should 
have been put on some kind of probation as a result of the 
Enron, WorldCom ratings, and that didn't exist. There should be 
some kind of checking system, but before they even get on the 
road to issue these ratings, there should be some tests.
    ChairmanOxley. Thank you. Mr. Reynolds, you indicated in 
your testimony that the bill needed definitional tweaking. What 
were you suggesting?
    Mr.Reynolds. In particular, just the area between ratings 
and investment advisory work. It gets greyer by the day, and it 
is--for example, I mean, we are investment advisor. The fact 
that we would probably say buy, hold, or sell on some 
securities is an aspect that would make us want to do that, so 
we did that. With the rating agencies, they have always been 
very clear that they stop short of that, and there is quite a 
bit of a blurring here, not only how they operate today, but 
also really how it is construed in the marketplace. It is the 
form versus substance debate. They have launched a product 
recently, for example, Moody's has, called market implied 
research strategies. They frame their ratings against where 
securities are trading, or where derivatives are pricing risk, 
and it is presented with, as a contrast. If they don't say buy, 
hold, or sell, but it is just about the same thing, it will 
take you right to the doorstep, and everyone sees it who uses 
that product for what it is, and there are other products like 
that as well. You know, you are the third base coach in 
baseball signaling the guy on first to steal second. You don't 
have to scream steal, you know; you just tip your hat. The 
rating agencies are doing the exact same thing. They are in the 
advisory business in substance, if not explicitly in form.
    So one of the aspects of the bill that was a little murky 
for me around investment advisor versus NRSRO, and there are 
quite a bit of overlaps that people should be sensitive to, and 
it is just a little more drilled now in clarification of how 
companies typically operate. Everyone talks about default risk 
as the main issue. The great bulk of assets and risks that is 
managed out there, it is not about default risk. It is in terms 
of perception of default risk, but mostly, it is about short 
term, rapid changes in the risk that affect portfolio 
performance and the result and losses being realized. As this, 
you know, I know I am overdoing the sports metaphor, but the 
great bulk of the activity in the credit markets takes place 
between the 20 yard lines, not in the end zone. The end zone 
would be a default. Default risks are historically very low, 
but credit volatility historically can be very high, and that 
is where investors are harmed, because of short term, sudden 
changes that drive losses. And that is where that investment 
advisory and NRSRO designation starts to overlap, and that 
probably should be worked on a bit.
    ChairmanOxley. Thank you. The gentleman from Louisiana.
    Mr.Baker. Thank you, Mr. Chairman.
    I want to return to Mr. Egan and the response to the 
chairman relative to the potential for creation of rogue firms. 
It would seem from your comment that there should be some 
requirement that a firm must meet beyond registration in order 
to engage in the practice, which might be just a slightly 
different standard than what we have today, as opposed to a 
registration and a free market driven system, which would 
enable a participant to enter without necessarily establishing 
credentials. Am I understanding your objections correctly, or 
is there a slightly different view?
    Mr.Egan. Yes, there should be some credentials before 
someone enters. As it is currently written, anybody, my son, 10 
years old, he can be issuing ratings and become a rating firm 
and--
    Mr.Baker. But do you think an issuer is going to pay your 
son a fee? I mean--
    Mr.Egan. No, he's not going to receive a fee, but that is 
an extreme example, but it could be something like Merrill 
Lynch, who wants to get as much market share as they possibly 
can underwriting, set up their own or another rating firm, you 
know, that is affiliate and facilitate the underwriting 
process.
    Mr.Baker. Well, I take your point, worthy of further 
examination, but it seems to take me back to the dark days of 
the investment banker analyst issues and how one prescribes a 
system that allows the two to simultaneously coexist, but 
provide disclosures to the ultimate users of information, or 
judges of risk, about how a particular decision is being made 
so that if there is a particular unusual relationship between 
Merrill Lynch Ratings and a Merrill Lynch issuer activity, that 
those disclosures would help, in some measure, address it. My 
concern is that if we go to a hard and fast standard of entry, 
we are replicating in just a little bit broader methodology 
that we have today. Today, we are calling it artwork. We don't 
know what one is, but when we see it hanging on the wall, we 
see you are a rating agency. We might want to describe the 
frame. We might want to describe the colors. We might want to 
have the artist's name checked off, but we are really just 
going to have a little bit broader mechanism than we have 
today. If we really go to some sort of undescribed set of 
standards that one must meet. Perhaps, your suggestion of some 
criteria of time in the market--
    Mr.Egan. I think that makes sense. I think money talks. I 
think a certain revenue base makes a lot of sense. I think that 
the fundamental problem that we have right now is that you have 
two firms that are really, and have exerted a lot of influence 
in this process. There are other firms that do qualify, that do 
issue credible ratings, and have not been able to get the NRSRO 
designation, for a variety of reasons. Unfortunately, the 
current regulators aren't willing to state what the problems 
are, why their applications haven't been approved or 
disapproved, or what even the status of the application is. 
Bringing it back to the driver analogy, you need to have some 
fundamental tests because it is too dangerous to the market to 
go from the current market structure right now to wide open 
whereby anybody is allowed to shoot any game they want to. You 
need some levels of credibility, and I think being in the 
market for a couple market cycles makes perfect sense, and 
having a minimal level of revenues from the activity makes a 
huge amount of sense. It also makes sense to exclude certain 
affiliated firms. It makes no sense for a bank to be allowed to 
generate their rating firm because it opens the system to 
abuse. It makes no sense for an underwriter to be allowed to 
set up a rating firm. So--
    Mr.Baker. I don't disagree. I am merely trying to bore down 
a little bit.
    Mr.Egan. Right.
    Mr.Baker. Get a better understanding as to your driver 
example and not letting your 10-year-old son drive. It would be 
just as advisable not to have an 80-year-old grandmother who no 
longer can see.
    Mr.Egan. Absolutely.
    Mr.Baker. Even though she has been driving for 50 years.
    Mr.Egan. Right.
    Mr.Baker. The consequences could be the same. But Mr. 
Stevens, you made a note in your testimony, the NRSROs should 
have some accountability for their ratings in order to provide 
them with an incentive to analyze information critically, and 
then I am not--I am just pointing out that you raised a very 
important issue. Then Mr. Roberts, in your testimony, you talk 
about output criteria should be the measurement that we use, 
for example, ability to anticipate corporate demise ahead of 
the necessary deterioration of share price. Then, you go on 
talking about the qualities of the Type 2 agencies that mark-
to-market using software models often paid for by the buy side, 
which have track records of issuing early warnings and 
objectivity, and then I wind up back at the professor, who 
states that you oppose the disclosure of the requirements of 
telling someone how you go about issuing your ratings. It seems 
across the three of you, we go for a need to have disclosure 
and accountability so that the market can look at a rating 
agency's set of performance standards, then we go to Mr. 
Roberts' output measurement criteria to say this is how we are 
going to look at you and, therefore, hold you accountable. What 
is wrong with some sort of generic disclosure? I understand 
proprietary business formula not being necessarily put on the 
street, but if I am going to be the end user of the rating to 
make a risk judgment, shouldn't I have some appropriate 
disclosure of how they go about doing it? Professor.
    Mr.Macey. Yeah, let me just say I agree with that, the 
generic disclosure, as long as there is not any proprietary 
information. With respect to the sort of--the problem of this 
rogue, or rating agencies popping up like mushrooms in the wake 
of the statute, I want to--it seems that--it is important to 
realize that if this statute were enacted, we would be in a 
much different world, in the sense that we would be--we would 
no longer be in the current situation where companies are only 
permitted to invest in a wide variety of circumstances under 
both Federal law and various State laws, particularly insurance 
laws, in companies that lack this NRSRO ratings, so that the 
vector along which these organizations would compete would be a 
vector of quality, and to be frank, I appreciate Mr. Egan's 
frankness in sort of engaging the discussion. I don't really, 
with all due respect, sort of buy the car analogy because if 
there is some underage driver, or unqualified driver, he poses 
a risk to other people on the road, so you have this sort of 
externality problem that makes sense to regulate. If I am--if I 
exhibit sufficiently bad judgment that I make an investment 
decision on the basis of a rating from a rating agency with a 
poor track record or that is one of these rogue ones that we 
are concerned about existing, I internalize that problem. It is 
not as though I am in the car running someone else over. This 
is, in the world that we are going to see in the wake of the 
statute, if it passes, and I hope it will, then the people who 
make bad judgments with respect to utilizing bad rating agency 
information are going to internalize those costs in a free 
market in exactly the same way they are going to internalize 
the cost of getting bad investment advice from a broker or 
something of that nature, and I think that the markets will do 
a very good job in sorting out the good ones from the bad ones.
    Mr.Baker. Mr. Chairman, I have just got one more follow up. 
Mr. Stevens, you mentioned the--holding the rating system 
accountable in some form or fashion. Do you share the view that 
has been described by Mr. Roberts, outcome analysis as an 
appropriate measure of enforcing accountability, or how would 
you view a system that would be appropriate to create that 
accountability?
    Mr.Stevens. Well, outcome analysis is important information 
to have in the market so that the people who are looking to use 
a particular rating agency or particular rating, have some 
sense of what the track record has been. When I referred to 
accountability in my testimony, it was really accountability of 
the nature that contemplated that if a ratings agency says here 
is my process, this is what I do, then they are to be held to 
do that. If, for example, they say we don't really simply rely 
upon publicly available information. We go and do research on 
the premises. We talk to the officials of the company. We kick 
the tires in other ways as well. And if they then produce a 
rating where they haven't done that, that they really were 
relying on a smaller universe of information, it seems to me 
they ought to be liable and accountable for having 
misrepresented their process.
    This notion of proprietary methods, I think, is a little 
overstated, with all respect. We deal with this issue in 
disclosures all the time. Corporations that are seeking to 
raise money in the marketplace will talk about business 
systems, business activities, business methods. There is a line 
that you can draw between what is truly proprietary and what is 
informative, detailed disclosure--I wouldn't call it generic; 
that suggests boilerplate. It can go into greater detail that 
that. So I think that is a line that we can draw.
    If I might, Mr. Chairman, just add one other thing to this 
question about the drunk driver, the point I am making is, from 
the perspective of an investor, if you can administer the 
breathalyzer, right, and you can determine whether the driver 
is drunk, you can make a decision about whether to pile into 
the vehicle or not, and that is the value of disclosure in the 
marketplace. I see no reason why, well, there have to be 
changes in the way in the SEC has written 2a-7; I see no reason 
why a mutual fund firm that offers a money fund and has its 
franchise and its reputation on the line is going to be 
attracted to a schlocky ratings agency. There is going to be a 
tremendous attraction for the ones with the best track record, 
the best methods, and the greatest reliability and integrity in 
the market because the reputation and the dollars, essentially, 
the wealth of the firm, is going to be on the line in that 
process.
    Mr.Baker. I take your point, and I only one I had entering 
into the new methodology and how we start it up is probably so 
critical because if we have missteps in the early days, it 
really makes recovery in the out years much more difficult. To 
put a personal experience in the discussion, yesterday, when we 
were flying in, we thought we had made it, and everything was 
fine, and we were going to get on the boarding door, and the 
pilot comes on and says he pulled up about 5 feet too far, and 
they are going to have to bring a tug out and push us 
backwards. If I had known my pilot was going to miss my 
boarding door by 5 feet, I probably would have elected another 
flight. You don't want to find that out at your arrival gate. 
You really want to know, did he run over the dog when he came 
to pick me up, or do you keep it on the highway. I think that 
is really the issue right now. I want to get to this outcome 
based analysis. That means you have a record. That means I can 
look at what you've been doing. The problem is from where we 
are now to how do we get there, and I am not yet fully 
conversant with the remedy that gets us past that, but I 
certainly want to go where each of the witnesses have indicated 
they would like to see us go.
    I yield back, Mr. Chair.
    ChairmanOxley. The gentleman from Pennsylvania.
    Mr.Fitzpatrick. Thank you, Mr. Chairman.
    Mr. Reynolds, I appreciate your references to the history 
of the city and Constitution, and in your written testimony, 
you are referring to some of the players out there that 
wouldn't be interested in the success of H.R. 2990, 
specifically those who want a little less free speech, and what 
you say is as it stands now, Moody's and S&P seem to be saying 
Congress shall make no law respecting an establishment of 
competition to the NRSROs.
    With respect to the NRSROs, can you describe how they may 
be using their protected status to get involved in other 
business lines, including some of those lines that your firm, 
CreditSights, is involved in?
    Mr.Reynolds. They are probably coming as close to the line 
of being an investment advisory business as they have ever 
been, and partly, that is a response to building revenue. I 
have heard a lot today about different rules and regulations, 
but at the end of the day, it is about building revenue, 
whether you are at Moody's or you are at a startup, whether you 
are taking it from--we have been in business 5 years; we went 
from eight to a hundred people, and it is painstaking work, 
reinvestment, but you have to have a viable product, and 
someone writes you a check for it. If they write you a check 
for it, it is real, and if they are a sophisticated investor, 
you are getting warm. And the same thing for Moody's, when they 
want to continue to grow their top line, to drive their stock, 
and it certainly has done quite well, they have to find new 
ways to get out of the ratings areas, so they bought KMD; they 
have been buying content assets up. They recently bought a 
group of economists. They will continue to buy assets in 
because at the end of the day, they are a research firm, a 
ratings agency, but they are also in the content business, and 
they have to grow and leverage that fixed cost base. So they 
are pushing into a lot of different ancillary businesses, which 
are meaningful businesses, and how do you reach the equity, the 
stock analysts for example, with credit information?
    As we saw in the last 5 years, turns in the credit market 
can drive the equity performance of different names, so they 
are trying to figure out ways to go after all different types 
of investors using their basic infrastructure and making select 
investments, so they are in the investment advisory business in 
substance. They know it. The market knows it, but they need to 
run a story line because they have to plan their legal 
defenses. They are doing everything but stopping short of 
saying sell, and they are doing that by trying to be also more 
relevant to the market. One of the criticisms, say, 10 years 
ago, was well, you are just a rater, there is low information 
value, and some of your earlier panelists in past hearings have 
testified on the low information content of ratings. So the way 
you crack the line up is you get into the information intensive 
business, something that a powerful institutional investor, or 
a bank, or a brokerage house will write you a check for. That 
is how you build a business. It is the economic reality of 
growth for all of these companies, and I think that Moody's and 
S&P clearly are getting that. KMD was obviously a big landmark 
transaction, getting into default risk analytics. They keep 
that separately housed. But they are into the consulting 
business, for example. They are into economic forecasting. They 
are into all the same things the Street has been into for 
years, except it is not as NASD framework. So that is just a 
fact; I mean, people know it. It is like an ill-kept secret 
from X rating agency, and they will say, they will chuckle 
about the First Amendment discussion because they know that it 
is really not the main issue. They just want to stay free clear 
of any encumbrances and go back to the business line strategy. 
There is a reason why a lot of people want to get in this 
business. Moody's has 55 percent profit margins. That is just 
mind-boggling of pretax margins. The accounting firms don't 
have that, so there is a reason people don't want to get in the 
accounting business, but do want to get in this business. And 
also, at the end of the day, they are not staying up late at 
night worrying about CreditSights, Rapid Ratings, or Egan-
Jones. In a way, we are all boutiques in the context of what 
they do. They are worried about Thompson, Bloomberg, Fax, 
Bertelsmann, Morningstar; these are the guys who will be 
stepping in, so the more barriers you put for their entry and 
their acquisitive activities, the more it is that Moody's and 
S&P will be the same old duopoly 5 years from now. So be 
cognizant of the fact that it takes a lot of capital, a lot of 
resources, a lot of mergers, and a lot of activity the next 5 
years to even mount a viable competitor against a group of 
people who have dominated the industry with what are 
increasingly higher natural barriers to entry. So I am a firm 
believer in letting the market work, and if Fidelity or Imgo or 
these top debt shops will pay you for your service, I think you 
have passed a test that the SEC is less qualified to opine on 
than people who live and breathe that business day in, day out, 
and have responsibility for a lot of retail assets. So I would 
say competition is better and quality is better. Constraints 
impact both in the wrong way.
    Mr.Fitzpatrick. Do any of the other panelists want to 
comment on that? Professor Macey, I think you were--you have 
spoken about the First Amendment issues, as one of the NRSROs, 
I think it was S&P, it seems to be the loudest about the impact 
of this potential legislation on their First Amendment rights. 
You went right to the ledge of saying why you think they may be 
raising that issue. Do you want to expand on that at all?
    Mr.Macey. Well, as I said, with the exception of the 
provision that would prohibit unsolicited ratings, there is 
nothing in this that has the remotest impact on free speech. I 
think that, you know, if I were a paid consultant for S&P or 
Moody's, you know, I might play the First Amendment card 
because it gets people's attention. It slows the process down. 
And it seems to have been--it seems to be the case that the 
process slowed down quite a lot. Mr. Reynolds and I were--
testified together before that Senate committee--I guess it was 
a couple of years, 2 or 3 years ago now--and we are still 
working toward some resolution of this issue. So, I mean, as I, 
you know, I don't think that there is a--I don't think there is 
a respectable argument. I think a lot of the things we have 
talked about today, Mr. Egan's point is perfectly respectable 
that, you know, this is a concern about, I don't happen to 
agree with it myself, but it is certainly a respectable 
argument to say you know, we are worried about quality of the 
new entrants and the issues about disclosure that Mr. Stevens 
is raising quite--I may come out a slightly different place, 
but quite respectable. The First Amendment issue is, in the 
context of the development of the securities laws in the United 
States and the high premium that we put on disclosure and 
investment, investor protection, this is really--this doesn't 
even ruffle the waters in the pond with respect to First 
Amendment concerns. I think it is purely a tactic to impede the 
progress of legislation that would improve the competition in 
this industry.
    Mr.Fitzpatrick. To that issue of, I guess, Mr. Egan's 
concerns about his 10-year-old son issuing rating, getting 
recognized. I mean, the statute, the bill as written does 
require 3 years background and does require disclosure of short 
term and long term performance statistics, so if you are in the 
business for 3 years, and there are benchmarks, and you are 
reaching those benchmarks, as Chairman Baker says, you know, if 
somebody is willing to pay your 10-year-old son, wouldn't it be 
discriminatory, if your son was only 10 years old and they--
    Mr.Baker. We have this freedom of speech, I think, is what 
you are talking about.
    Mr.Fitzpatrick. If you are doing a great job, I mean, you 
wouldn't want to prohibit your 10-year-old son genius from 
being involved in this business.
    Mr.Egan. Maybe he can get it right. However, I think that 
this NRSRO designation is too important. It is used in too many 
different areas of financial markets, and I think more than 3 
years is needed. I think you need some kind of market test, and 
a revenue based test isn't a reasonable way. I think you have 
to exclude some firms that have an inherent conflict, such as 
underwriters becoming rating firms, or having underwriting 
affiliates, or major investors, or banks, or insurance 
companies. I think that there are some--to go from where we are 
right now to a more competitive market, you have to be careful 
in the way you take those steps. It would be foolish to open it 
up to anybody who applies after a 3-year waiting period. It 
makes--that doesn't--it would hurt the market too much. It is 
too great a risk. Yes, it might work, but you know, it is--we 
are not talking about a small economy here. It is very 
important to get it right. Another thing is that somebody 
brought up the breathalyzer test. I don't know if the guy who I 
am facing on the road has taken that test when I am driving and 
he is driving at 80 miles; I don't have that information. So I 
want somebody to test him before he gets in the vehicle, and 
there are certain safeguards if he messes up that he loses his 
license. I think that that is what you need. Also, some people 
say don't worry, the market is going to sort it out. Well, the 
reality is that that is fantasy. It is fantasy because S&P and 
Moody's rated Enron at investment grade approximately 30 days 
before it went bankrupt. They had similar faults with WorldCom. 
So the market doesn't necessarily respond to good information. 
In fact, S&P and Moody's operating income has doubled. It has 
doubled over the past 3 years. You hear about it all the time 
in the economist book, but it doesn't work; full disclosure 
just simply doesn't work or else S&P and Moody's revenue and 
operating income would not have doubled during the process of 
these major debacles. So you need some safeguards on the front 
end of this, and you also need safeguards as you go along.
    Mr.Fitzpatrick. It looks like Professor Macey--do you want 
to respond to that?
    Mr.Macey. Well, I guess I will pay a visit from fantasy 
land over here, in terms of having faith in the markets. First, 
with respect to the point about Enron. Certainly, Mr. Egan is 
right. This was not a poster day for the credit rating 
agencies. It seems to me the question that we need to ask 
ourselves is not the question, you know, will there be errors, 
and will credit ratings agencies screw up under the new 
regulatory regime, the new statutory regime that we are talking 
about today. The question is will the quality of information in 
the marketplace be better, not will it be perfect. And 
certainly, I think one thing Mr. Egan and I would agree about 
is that the quality of the information that is out there now 
is, generated by the credit rating agencies, is not good. It is 
not good for two reasons. Number one, it tends not to be very 
accurate and, number two, the adjustments that are made to 
credit ratings come very slow, and they are--that every 
financial economist or empirical scholar who has looked at this 
for the last 30 years has understood that credit ratings 
systematically lag stock market prices and that anybody, for 
free, can look at stock market prices and get a much better 
view of what is going on at Enron, what is going on at 
WorldCom, what is going on in any of the companies that have 
been so much in the press over the last 3 or 4 years. If we 
open the system up to competition, certainly, there will be 
errors. Certainly, some of the new firms that emerge in this 
business will make mistakes, but on balance, consumers in this 
market will have a lot more to choose from. They don't have to 
rely on one rating. They can look at several, and the market 
will sort out the poor performers and, again, the people who 
are--make the misjudgment, the miscalculation, to rely on the 
bad ratings that emerge in a new competitive environment will 
bear the costs associated with that, which is exactly what 
ought to happen in a free market economy.
    Mr.Stevens. Mr. Fitzpatrick, may I add something in 
response to the questions that you had posed, just very 
briefly? The question of 3 years or 7 years is one of these 
classic conundrums I suspect that the committee, the Congress 
faces all the time. I think of it as the prunes issue. Are 3 
too few; are 7 too many to get, you know, regularity restored? 
The fact is seven years strikes me as fine if you are part of a 
firm that has been doing this for the past 7 years, but it 
might be that you have a wonderful new market participant ready 
to enter, and if they are told well, no, you have to do this, 
theoretically, for 7 years before you can get into the 
business, that has a significant anticompetitive impact. So 
while, you know, this is sort of in the eye of the beholder, I 
think, some proving ground or time period, where you are 
involved, and can demonstrate to potential users that you are 
serious about this business, that you have been doing it with 
the kind of rigor and quality, is fine. Three years strikes me 
as a good choice in that regard. Seven years strikes me as not 
really trying to serve opening up this market to the kind of 
competition which I think has been your purpose and the purpose 
of other supporters of your legislation.
    ChairmanOxley. The gentleman yields back. On behalf of the 
members, I want to thank all of you for excellent 
participation. The record that we have continued to build for 
this legislation I think is extraordinary. We have had a 
diverse group of witnesses over a number of months, and this 
may or may not be the last hearing, but it certainly was one of 
the most productive, and I thank you, and I also want to thank 
the Federal District Court for providing this wonderful place 
for a hearing. This is as close as I am going to get to being a 
Federal judge.
    Mr.Fitzpatrick. I hope it is as close as I get to a Federal 
judge.
    ChairmanOxley. That is right. I would like to sentence a 
couple people right now, but I don't have it in me. Again, 
thank you all, and the committee is adjourned.
    [Whereupon, at 11:40 a.m., the committee was adjourned.]
                            A P P E N D I X



                           November 29, 2005



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