[Congressional Record Volume 152, Number 125 (Friday, September 29, 2006)]
[Extensions of Remarks]
[Pages E1957-E1958]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




                CREDIT RATING AGENCY REFORM ACT OF 2006

                                 ______
                                 

                               speech of

                      HON. MICHAEL G. FITZPATRICK

                            of pennsylvania

                    in the house of representatives

                     Wednesday, September 27, 2006

  Mr. FITZPATRICK of Pennsylvania. Mr. Speaker, I would like to extend 
and revise my remarks made on September 27th regarding S. 3850, the 
Credit Rating Agency Reform Act of 2006. I submit the attached 
statement by Brian Carroll in Vol. 232 Number 186 of the Legal 
Intelligencer.

             [From the Legal Intelligencer, Sept. 26, 2005]

         Enron Scandals Spur Proposed Credit Rating Legislation

                           (By Brian Carroll)

       The regulatory legacy of Enron, WorldCom and other major 
     accounting frauds remains a work in process. Credit rating 
     agencies, such as Moody's Investor Services Inc., Fitch Inc. 
     and the Standard and Poor's Division of the McGraw-Hill 
     Companies Inc. (S&P), issued favorable credit ratings of 
     WorldCom bonds just three months before it declared 
     bankruptcy and, more disturbing, Moody's and S&P favorably 
     opined on Enron bonds four days before its bankruptcy. The 
     unexpected collapse of these issuers cost investors billions 
     of dollars. This raised the question: Why did credit rating 
     agencies issue favorable bond ratings that did not appear to 
     accurately reflect the likelihood of these bankruptcies?
       While the Sarbanes-Oxley Act of 2002 fundamentally recast 
     the statutory responsibilities of chief executive and 
     financial officers, audit committees and auditors, it took a 
     different tack when it came to credit rating agencies: 
     Section 702(b) mandated that the Securities and Exchange 
     Commission study the role of credit rating agencies in 
     securities markets. While acknowledging this study, Bucks 
     County Congressman Michael G. Fitzpatrick, R-8th District, 
     has introduced the Credit Rating Agency Duopoly Relief Act of 
     2005, aimed at increasing competition among credit rating 
     agencies while extending SEC oversight authority. This 
     article reviews the role of credit rating agencies and 
     compares the SEC's approach to credit rating agency 
     regulation with Fitzpatrick's proposed legislation.


                           CREDIT RATING FIAT

       Some credit rating agencies have enjoyed an enviable 
     position. Demand for certain agency services is statutorily 
     guaranteed--no less than dozens of federal, state and foreign 
     government statutes, including securities, banking, higher 
     education finance, and housing and community development 
     statutes, mandate creditworthiness ratings by credit rating 
     agencies that qualify as a `nationally recognized statistical 
     rating organization' (NRSRO). Innumerable private contracts, 
     such as loan and merger agreements, and more than 20 SEC 
     rules require use of NRSRO services.
       NRSRO credit ratings have significant consequences. For 
     example, Rule 2a-7 under the Investment Company Act of 1940 
     sets a minimum credit rating benchmark for certain money 
     market fund investments. An issuer's failure to meet that 
     benchmark renders the security ineligible for money market 
     investment. Many regulations set mandatory threshold credit 
     rating benchmarks. From an issuer perspective, there is 
     generally an inverse relationship between the credit rating 
     an issuer's debt instrument receives and, the rate of 
     interest the issuer will pay on the borrowing. Finally, 
     institutional and individual investors rely on credit ratings 
     in making investment decisions.
       The SEC, through its staff, controls the supply of NRSROs 
     by staff determinations of whether to issue what is called a 
     `No Action' letter, to provide assurance to a credit rating 
     agency that its ratings can be considered those of an NRSRO 
     without the SEC initiating an enforcement action. The SEC 
     staff began issuing No Action letters in 1975, as part of the 
     agency's efforts to clarify the application of its broker-
     dealer Net Capital Rule. At present, only three NRSROs have 
     staff No Action letters: Moody's, S&P and Fitch Inc., with 
     the first two capturing nearly 80 percent of the market.
       Under this process, a credit rating agency requests the SEC 
     staff conduct an informal inquiry to determine whether the 
     agency is qualified. If satisfied, the SEC staff issues a No 
     Action letter to a credit rating agency, effectively 
     designating it an NRSRO. Once the letter is issued, an NRSRO 
     registers as an adviser pursuant to the Investment Advisers 
     Act of 1940 (Advisers Act).
       According to the SEC's Report on the Role and Function of 
     Credit Rating Agencies in the Operation of the Securities 
     Markets, as required under Section 702(b) of Sarbanes-Oxley, 
     some NRSROs consider their registration as an adviser to be 
     voluntary. Similarly, other NRSROs assert that Advisers 
     Act requirements to retain and produce to the SEC certain 
     books and records are inapplicable because they operate as 
     journalist under the protection of the First Amendment.
       Some support for this position is found in Lowe v. SEC, 
     where the U.S. Supreme Court in 1985 ruled that a publisher 
     of investment materials fell within the Advisers Act 
     exclusion for publishers. In 1999's Jefferson County School 
     District No. R-1 v. Moody's Investor's Services Inc, the 10th 
     U.S. Circuit Court of Appeals held that Moody's was not 
     liable for allegedly materially false bond ratings, based in 
     part on finding that Moody's was functioning as a journalist 
     and therefore entitled to First Amendment protections. 
     Further supporting the NRSROs' argument, in 2004's Compuware 
     Corp. v. Moody's Investors Services Inc., the Eastern 
     District of Michigan held that Moody's qualified for 
     protection from discovery requests under New York's Shield 
     Law. Although the case law in this area is less than settled, 
     there is support for this position.
       In addition to potential constitutional protections, the 
     SEC has granted NRSROs relief from potential civil and SEC 
     enforcement liability. For example, Rule 436(g)(1) under the 
     Securities Act of 1933 provides that an NRSRO's credit rating 
     appearing in registration statement is not considered part of 
     the statement for purposes of, among others, Section 11 of 
     the Securities Act, a strict liability provision applicable 
     to experts who participate in preparing a security's 
     registration statement. Violations of this section are 
     commonly alleged in shareholder class action suits. In 
     another vein, SEC Regulation Fair Disclosure excludes credit 
     rating agencies from prohibitions on receiving non-public 
     information from issuers. Although this section covers all 
     credit rating agencies, it most commonly would benefit 
     agencies retained by issuers, i.e. NRSROs.
       The SEC has wrestled with the issue of how to define an 
     NRSRO. As early as 1994, the SEC issued a concept release 
     requesting comments on a wide range of NRSRO issues, 
     including how they should be defined. In 1997, the SEC issued 
     a proposed rule that would have defined NRSRO, which was not 
     adopted. In January 2003, the SEC submitted its Section 
     702(b) report to Congress. In April 2003, the SEC issued 
     another concept release calling for comments on, among other 
     things, how to define an NRSRO. In 2005, the SEC issued 
     another proposed rule reviewing the SEC approach to the 
     issue. It is currently pending.
       The current proposed rule would define an NRSRO as a credit 
     rating agency that issues publicly available credit ratings 
     (meaning at no cost) and is generally accepted by financial 
     markets as credible and reliable. Some comments on the 
     proposed rule question whether requiring only free public 
     credit ratings would discourage investors, as opposed to the 
     issuer of the security, from paying for credit rating 
     services. More importantly, the SEC recognizes that some view 
     the `generally accepted' requirement as creating a `chicken 
     and egg' barrier to entry where an agency has to first obtain 
     NRSRO-like status before meeting the SEC's definition of an 
     NRSRO.
       Given the applicable case law, limitations of the Advisers 
     Act and the No Action letter process, the SEC has 
     questionable authority to conduct any follow-up oversight of 
     NRSROs, such as requiring them to maintain certain books and 
     records, conducting examinations or, when appropriate, 
     instituting enforcement actions. On this issue, former SEC 
     director, division of market regulation, and current 
     Commissioner Annette L. Nazareth testified before Congress 
     that without taking a formal position, `[the] Commission 
     believes that to conduct a rigorous program of NRSRO 
     oversight, more explicit regulatory authority from Congress 
     is necessary.'


                      PROPOSED FEDERAL LEGISLATION

       On June 28, Fitzpatrick addressed the House of 
     Representatives in support of his bill by arguing that two 
     NRSROs currently dominate the ratings market, with SEC 
     approval, which creates `an uncompetitive marketplace, 
     stifles competition from other rating agencies, lowers the 
     quality of ratings and allows conflicts of interest to go 
     unchecked.' Consistent with this rationale, his Credit Rating 
     Agency Duopoly Relief Act of 2005, H.R. 2990, is designed to 
     achieve two primary objectives: decrease regulatory barriers 
     to credit rating agencies qualifying as an SEC approved 
     statistical rating organization, a new designation to replace 
     NRSRO; and increase SEC statutory authority to oversee 
     approved credit rating agencies.
       Under H.R. 2990, a credit rating agency must meet only two 
     requirements to be considered a statistical rating 
     organization and eligible to register with the SEC. First, 
     under the new definition of statistical rating

[[Page E1958]]

     organization, an agency must have been in the business of 
     primarily issuing publicly available ratings at least for the 
     most recent three consecutive years. Here, `publicly 
     available' is defined as certain ratings disseminated via the 
     Internet for free or a fee. This provision permits both 
     issuer and investor financed ratings to qualify.
       Second, H.R. 2990 requires that an agency employ either a 
     quantitative or qualitative model in determining its publicly 
     available ratings. This provision permits agencies that rely 
     on purely analytic measures for determining a credit rating, 
     as opposed to interviews with the issuer's senior management. 
     Notably, there is no `generally accepted by the financial 
     markets' component to this definition, eliminating the 
     `chicken and egg' barrier.
       Fitzpatrick's bill would amend Section 15 of the Exchange 
     Act by creating a public registration procedure for becoming 
     a statistical rating organization. As part of the procedure, 
     an eligible agency must disclose how it handles potential 
     conflicts of interest and misuse of non-public information, 
     as well its methodologies for determining credit ratings. If 
     denied, the agency could appeal the SEC's decision to the 
     circuit courts.
       Under H.R. 2990, a registered statistical rating 
     organization must also maintain policies and procedures aimed 
     at preventing conflicts of interest, anticompetitive 
     practices and misuse of nonpublic information. Recent events 
     underscore the importance of these continuing requirements. 
     For example, the report describes one anti-competitive 
     practice known as notching--refusing to rate or lowering the 
     rating of some securities unless the issuer permits the 
     agency to rate other securities. Also, the report notes 
     concerns over agency pressure on issuers to purchase other 
     agency services, presumably to stay in its good graces. 
     Finally, in SEC v. Marano, et al, the SEC alleged that 
     employees of S&P's Financial Rating Services violated Section 
     10(b) of the Exchange Act and Rule 10b-5 by engaging in 
     insider trading on material nonpublic information obtained 
     through employment at S&P.
       Perhaps most important, Fitzpatrick's bill would provide 
     the SEC with statutory authority under the Exchange Act to 
     require statistical rating organizations to maintain certain 
     books and records, conduct examinations and, when 
     appropriate, institute enforcement actions against the SRO 
     itself. This type of SEC oversight already applies to 
     brokers, dealers, municipal securities dealers, transfer 
     agents and clearing agents under existing provisions of the 
     Exchange Act. Consistent with this requirement to register 
     under the Exchange Act, H.R. 2990 prohibits a statistical 
     rating organization from registering as investment adviser 
     and reliance on existing No Action letters concerning NRSROs.


                               CONCLUSION

       In light of the history of this issue, H.R. 2990 would, if 
     enacted, go a long way toward strengthening the SEC's 
     authority to oversee this key area of our securities 
     regulation scheme while reducing the SEC's role in deciding 
     who is qualified to perform credit ratings. With this 
     legislation, the SEC would be in a better position to 
     challenge industry assertions of constitutional protection. 
     Some of these legal questions may be resolved sooner, for a 
     recent newspaper article reports that New York Attorney 
     General Eliot Spitzer has subpoenaed credit rating documents 
     from Moody's as part of an investigation into insurance 
     industry practices.
       Brian Carroll is a CPA and Special Counsel to the U.S. 
     Securities and Exchange Commission in the Philadelphia 
     District Office. The U.S. Securities and Exchange Commission 
     disclaims responsibility for any private publication or 
     statement of any Commission employee or Commissioner. This 
     article expresses the author's view and does not necessarily 
     reflect those of the Commission, the Commissioners or other 
     members of the staff.

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