[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
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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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