[Senate Report 109-326]
[From the U.S. Government Publishing Office]



                                                       Calendar No. 590
109th Congress                                                   Report
                                 SENATE
 2d Session                                                     109-326

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



 
                CREDIT RATING AGENCY REFORM ACT OF 2006

                                _______
                                

               September 6, 2006.--Ordered to be printed

Mr. Shelby, from the Committee on Banking, Housing, and Urban Affairs, 
                        submitted the following

                              R E P O R T

                         [To accompany S. 3850]

    The Committee on Banking, Housing, and Urban Affairs 
reported S. 3850, a bill to improve ratings quality for the 
protection of investors and in the public interest by fostering 
accountability, transparency, and competition in the credit 
rating industry. The Committee reports favorably an original 
bill, and recommends that the bill do pass.

                              INTRODUCTION

    In the wake of highly publicized failures by the large 
credit rating agencies to warn investors in a timely manner 
about the impending bankruptcies of Enron, WorldCom, and 
others, the Congress, in section 702(b) of the Sarbanes-Oxley 
Act of 2002, directed the Securities and Exchange Commission 
(``SEC'' or ``Commission'') to examine the role and performance 
of rating agencies, barriers to entry into the rating industry, 
and conflicts of interest plaguing rating agencies. The SEC 
published its Report on the Role and Function of Credit Rating 
Agencies in the Operation of the Securities Markets \1\ in 
January 2003. In its review, the SEC documented its 
unsuccessful efforts since 1994 to define ``nationally 
recognized statistical rating organizations'' (``NRSROs'') and 
establish a regulatory program to oversee such NRSROs.
---------------------------------------------------------------------------
    \1\ Report on the Role and Function of Credit Rating Agencies in 
the Operation of the Securities Markets, As Required by Section 702(b) 
of the Sarbanes-Oxley Act of 2002, U.S. Securities and Exchange 
Commission, January 2003.
---------------------------------------------------------------------------
    Over the years, the SEC has been criticized at times for 
not awarding more NRSRO designations and thereby perpetuating 
an anticompetitive industry, and for failing to supervise and 
inspect NRSROs to ensure compliance with the federal securities 
laws and NRSRO requirements. NRSROs have been criticized by a 
broad array of interested parties with respect to conflicts of 
interest, ratings that significantly lag the markets, and 
anticompetitive and abusive business practices.

                       PURPOSE OF THE LEGISLATION

    The purpose of the ``Credit Rating Agency Reform Act'' 
(``the Act'') is to improve ratings quality for the protection 
of investors and in the public interest by fostering 
accountability, transparency, and competition in the credit 
rating industry.

                                HEARINGS

    On February 8, 2005, the Committee held a hearing titled 
``Examining the Role of Credit Rating Agencies in the Capital 
Markets.'' The following witnesses testified at the hearing: 
Ms. Kathleen A. Corbet, President, Standard & Poor's (``S&P''); 
Mr. Sean J. Egan, Managing Director, Egan-Jones Ratings 
Company; Mr. Micah S. Green, President, The Bond Market 
Association; Mr. Yasuhiro Harada, Executive Vice President, 
Rating and Investment Information, Inc.; Mr. Stephen W. Joynt, 
President and Chief Executive Officer, Fitch Ratings 
(``Fitch''); Mr. James A. Kaitz, President and Chief Executive 
Officer, Association for Financial Professionals; and Mr. 
Raymond W. McDaniel, Jr., President, Moody's Investors Service, 
Inc. (``Moody's'').
    On March 7, 2006, the Committee held a hearing titled 
``Assessing the Current Oversight and Operations of Credit 
Rating Agencies.'' The following witnesses testified at the 
hearing: Mr. Paul Schott Stevens, President, Investment Company 
Institute; Mr. Glenn Reynolds, Chief Executive Officer, 
CreditSights, Inc.; Ms. Vickie Tillman, Executive Vice 
President for Credit Market Services, S&P Mr. Frank Partnoy, 
Professor of Law, University of San Diego School of Law; Ms. 
Colleen Cunningham, President and Chief Executive Officer, 
Financial Executives International; Mr. Damon Silvers, 
Associate General Counsel, AFL-CIO; Mr. Jeffrey Diermeier, 
President and Chief Executive Officer, CFA Institute; and Mr. 
Alex Pollock, Resident Fellow, American Enterprise Institute.

                  BACKGROUND AND NEED FOR LEGISLATION

    A credit rating is a rating agency's assessment with 
respect to the ability and willingness of an issuer to make 
timely payments on a debt instrument, such as a bond, over the 
life of that instrument. Investors use ratings to help price 
the credit risk of fixed-income securities. In order to 
determine an appropriate rating, credit analysts use publicly 
available information, market and economic data, and often 
engage in discussions with senior management of the debt 
issuer.\2\ The rating agencies also have access to, and 
receive, non-public information because of their exemption from 
Regulation Fair Disclosure,\3\ an SEC rule that prohibits 
companies from disseminating material information to a select 
audience.
---------------------------------------------------------------------------
    \2\ Rating agencies that use solely quantitative methods generally 
do not meet with issuers.
    \3\ 17 CFR 243.100-243.103.
---------------------------------------------------------------------------
    At the largest rating organizations, the process for 
developing an initial rating on an issuer is generally as 
follows: analysts (i) review financial statements and draft a 
preliminary rating; (ii) visit management of the issuer; (iii) 
prepare a brief report explaining the rationale forthe rating; 
and (iv) make a presentation to the rating committee, which then 
determines a final rating. The rating and report is sent to the issuer 
to ensure that it is factually accurate and does not disclose any 
confidential information. The rating, paid for by the debt issuer, is 
disseminated to the public at no cost. The report accompanying the 
rating is available to paid subscribers. Ratings are monitored on an 
ongoing basis.
    The agencies rate both long-term and short-term debt. S&P, 
Fitch, and others designate investment grade, or lower risk, 
long-term debt with ratings of AAA, AA, A and BBB, and 
speculative grade, or higher risk, with BB, B, CCC, CC, C and 
D. The rating classification system employed by Moody's uses 
Aaa, Aa, A and Baa for investment grade and Ba, B, Caa, Ca and 
C for speculative grade. The historic default rate for AAA-
rated securities is well under one percent in any given ten-
year period. For B-rated securities, the ten-year probability 
of default is approximately 45 percent.
    The modern ratings business was founded nearly a century 
ago when Mr. John Moody first published ratings on railroad 
bonds. Although S&P and Moody's remain the dominant companies, 
the industry has undergone dramatic changes in the past few 
decades. Around 1970, the leading credit raters moved away from 
a pure subscription model to a hybrid one where issuers pay for 
ratings and subscribers receive in-depth reports explaining the 
basis for each rating. In the past few decades, credit ratings 
have assumed increased importance due to regulatory decisions, 
the development of complex financial products such as asset-
backed securities and credit derivatives, the globalization of 
financial markets, and other factors. The industry is much 
larger today simply because the bond markets have experienced 
such dramatic growth. For example, S&P has more than 700,000 
ratings outstanding and issues 500-1,000 rating actions each 
day. In recent years, the increase in structured finance 
transactions has been responsible for explosive revenue growth 
at the rating agencies.

I. Overview of regulatory landscape

    The largest NRSROs, S&P and Moody's, wield enormous power 
in the global capital markets system. Their ratings affect the 
cost of capital and the structure of transactions for debt 
issuers, and determine which securities may be purchased by 
money market mutual funds, banks, credit unions, insurers, 
state pension funds, local governments, and local school 
boards. Regulatory actions have tended to insulate industry 
leaders from competition.\4\ Yet, once accorded this privileged 
status, they are virtually unregulated.
---------------------------------------------------------------------------
    \4\ See, e.g., Mr. Alex J. Pollock, ``End the Government-Sponsored 
Cartel in Credit Ratings,'' American Enterprise Institute for Public 
Policy Research, January 2005, at 1. Mr. Pollock explains that the 
NRSRO designation is an ``extremely valuable franchise'' that ``allows 
entry into a cartel with only three U.S. members, which represent about 
95 percent of sector revenues'' (at 1).
---------------------------------------------------------------------------
    Following corporate scandals at Enron, WorldCom, and 
elsewhere, Congress and the securities regulators adopted new 
rules governing the conduct of public companies, corporate 
boards and officers, accountants, stock research analysts, 
investment bankers, and attorneys. Rating agencies are not 
subject to similar regulation in spite of widespread criticism 
for failing to warn investors about several of the largest 
bankruptcies in U.S. history, conflicts of interest, 
anticompetitive and abusive business practices, and an absence 
of transparency, regulatory oversight, and meaningful 
competition.

II. NRSRO system

    The SEC originally adopted the term ``NRSRO'' in 1975 
solely for determining capital charges on different grades of 
debt securities under the Net Capital Rule.\5\ The Net Capital 
Rule requires broker-dealers, when computing net capital, to 
deduct from their net worth certain percentages of the market 
value of their proprietary securities positions. These 
``haircuts'' provide a margin of safety against losses that 
might be incurred by broker-dealers in those positions. The 
Commission determined that it was appropriate to apply a lower 
haircut to securities held by a broker-dealer that were rated 
investment grade by a nationally recognized rating agency 
because those securities typically were lower-risk investments. 
The requirement that the rating agency be ``nationally 
recognized'' was designed to ensure that its ratings were 
credible and reasonably relied upon by the marketplace.
---------------------------------------------------------------------------
    \5\ 17 CFR 240.15c3-1. Adoption of Uniform Net Capital Rule and an 
Alternative Net Capital Requirement for Certain Brokers and Dealers, 
Release No. 34-11497 (June 26, 1975), 40 FR 29795 (July 16, 1975).
---------------------------------------------------------------------------
    Since 1975, increased marketplace and regulatory reliance 
on credit ratings has made use of the NRSRO concept more 
prevalent. Some regulations issued by the Commission 
incorporate the concept by cross-reference to the Net Capital 
Rule. For example, under Rule 2a-7 of the Investment Company 
Act of 1940, money market funds are limited to investing in 
securities rated by an NRSRO in the two highest ratings 
categories for short-term debt. Also, Congress has incorporated 
this concept into legislation such as the Federal Deposit 
Insurance Act.
    Over the past few decades, financial regulators have 
increasingly used credit ratings to help monitor the risk of 
investments held by regulated entities and to provide an 
appropriate disclosure framework for securities of differing 
risks. In fact, ratings by NRSROs today are widely used as 
benchmarks in federal and state legislation, rules issued by 
financial and other regulators, foreign regulatory schemes, and 
private financial contracts. Most of these laws and regulations 
define eligible portfolio investments for institutional 
investors as those rated in one of the highest investment grade 
categories by at least one NRSRO. Today, it has become standard 
industry practice for most issuers to purchase ratings from two 
or more rating agencies.
    The firms designated as ``nationally recognized statistical 
rating organizations'' are recognized as such by Commission 
staff through the no-action letter process. Currently, there 
are only five NRSROs: S&P, Moody's, Fitch, Dominion Bond Rating 
Service Limited and A.M. Best Company. It is an extremely 
concentrated industry. The largest rating agencies--S&P and 
Moody's--have approximately 80 percent of industry market share 
as measured by revenues. S&P and Moody's rate more than 99 
percent of the debt obligations and preferred stock issues 
publicly traded in the United States. Hearing witnesses 
testifying before the Committeeexpressed concern about this 
level of concentration and called S&P and Moody's a ``partner 
monopoly'' \6\ and an ``oligopoly.'' \7\ They have also been called a 
``government-sponsored cartel.'' \8\
---------------------------------------------------------------------------
    \6\ Testimony of Mr. Sean Egan, Managing Director, Egan-Jones 
Ratings Company, before the Committee on Banking, Housing, and Urban 
Affairs, U.S. Senate, February 8, 2005, at 1-2. Mr. Egan asserted that 
it was a mistake to refer to S&P and Moody's as an oligopoly. He said 
the two ratings firms were more accurately characterized by the 
Department of Justice as a ``partner monopoly'' because S&P and Moody's 
``do not compete against each other for the two ratings which are 
normally required. This is important. They do not compete against each 
other . . . what I mean by that is that if S&P is brought into a 
transaction, Moody's is soon to follow, so they both get paid for 
issuing.'' See also the testimony of Mr. Glenn Reynolds, Chief 
Executive Officer, CreditSights, Inc., before the Committee on Banking, 
Housing, and Urban Affairs, U.S. Senate, March 7, 2006, at 4 (also 
referring to S&P and Moody's as a ``partner monopoly'').
    \7\ Partnoy, op. cit., at 4. Mr. Partnoy also said ``the NRSRO 
regime poses a serious threat to the financial system'' (at 4).
    \8\ Pollock, op. cit. Mr. Pollock, in a subsequent opinion piece, 
suggests that ``shared monopoly'' may be the most accurate description. 
See ``Cartel to Competition,'' American Enterprise Institute for Public 
Policy Research, July 18, 2006.
---------------------------------------------------------------------------

III. SEC efforts to oversee the rating industry

    For more than a decade, the SEC has attempted to devise a 
regulatory scheme for rating agencies. These efforts were 
prompted by concerns that the SEC had never defined the term 
and that there was inadequate oversight of NRSROs. To address 
these issues, the Commission issued a Concept Release in 1994 
\9\ soliciting public comment on the appropriate role of 
ratings in the federal securities laws and whether formal 
procedures were needed for recognizing and monitoring the 
activities of NRSROs.
---------------------------------------------------------------------------
    \9\ Nationally Recognized Statistical Rating Organizations, Release 
No. 34-34616 (August 31, 1994), 59 FR 46314 (September 7, 1994).
---------------------------------------------------------------------------
    The 1994 Concept Release led to a rule proposal in 
1997,\10\ which would have amended the Net Capital Rule by 
defining ``NRSRO'' and establishing a formal application 
process for NRSRO recognition. Under the proposal, Commission 
staff would consider five factors in deciding whether to grant 
the NRSRO designation. Whether an entity was ``nationally 
recognized'' would be accorded the most significance.\11\ The 
Department of Justice filed a comment letter stating that the 
recognition requirement ``is likely to create a nearly 
insurmountable barrier to new entry into the market for NRSRO 
services.'' \12\ The proposed rule was never adopted.
---------------------------------------------------------------------------
    \10\ Capital Requirements for Brokers or Dealers Under the 
Securities Exchange Act of 1934, Release No. 34-39457 (December 17, 
1997), 62 FR 68018 (December 30, 1997).
    \11\ Interestingly, under the proposal NRSROs were required to 
register under the Investment Advisers Act of 1940 (``Advisers Act'') 
and access to corporate executives was one of the five factors weighed 
by Commission staff.
    \12\ ``Comments of the U.S. Department of Justice before the 
Securities and Exchange Commission,'' March 1998.
---------------------------------------------------------------------------
    In 2002, the Commission issued an Order \13\ directing 
investigation, pursuant to Section 21(a) of the Securities 
Exchange Act and the examination authority of the Advisers Act, 
into the role of credit rating agencies in the U.S. securities 
markets. These SEC examinations of the then-three NRSROs (S&P, 
Moody's, and Fitch), ostensibly triggered by the NRSRO failures 
relating to Enron, revealed numerous problems.\14\ SEC 
examiners found (i) potential conflicts of interest resulting 
from the issuer-paid business model of the NRSROs; (ii) that 
NRSRO marketing of supplementary, fee-based services, including 
corporate consulting, exacerbated the inherent conflict in the 
NRSRO business model; (iii) the potential for the NRSROs, given 
their substantial power in the marketplace, to improperly 
pressure issuers to pay for ratings and purchase ancillary 
services; and (iv) evidence relating to whether NRSROs were 
adequately protecting confidential information. The 
examinations suffered from an overall lack of cooperation 
offered by the NRSROs with respect to document production. In 
addition, SEC examiners found evidence that the NRSROs were 
possibly in violation of Section 17(b) of the Securities Act of 
1933, with respect to disclosure of fees from issuers.
---------------------------------------------------------------------------
    \13\ Order In the Matter of the Role of Rating Agencies in the U.S. 
Securities Markets Directing Investigation Pursuant to Section 21(a) of 
the Securities Exchange Act of 1934, and Designating Officers for Such 
Designation (March 19, 2002).
    \14\ From all indications, these were the only comprehensive 
Commission inspections of the NRSROs since the designations were first 
awarded in 1975.
---------------------------------------------------------------------------
    Later in 2002, the SEC held two days of public hearings 
\15\ on the role and function of rating agencies. In 2003, the 
Commission issued the report on the operation of rating 
agencies that was mandated by the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
    \15\ The Current Role and Function of Credit Rating Agencies in the 
Operation of the Securities Markets, Hearings Before the U.S. 
Securities and Exchange Commission (November 15 and 21, 2002). Full 
hearing transcripts are available on the SEC's Web site at http://
www.sec.gov/spotlight/ratingagency.htm
---------------------------------------------------------------------------
    Later in 2003, the Commission issued another Concept 
Release \16\ soliciting public comment with respect to whether 
credit ratings should continue to be used for regulatory 
purposes under the federal securities laws, and, if so, the 
process of determining whose credit ratings should be used, and 
the level of oversight to apply to such credit rating agencies.
---------------------------------------------------------------------------
    \16\ Concept Release: Rating Agencies and the Use of Credit Ratings 
under the Federal Securities Laws, Release No. 33-8236 (June 4, 2003), 
68 FR 35258 (June 12, 2003).
---------------------------------------------------------------------------
    In 2005, the Commission proposed another rule \17\ defining 
``NRSRO,'' which unlike the 1997 proposal, would not establish 
a formal application process or require Advisers Act 
registration. The 2005 proposal, which has not been acted upon, 
would define ``NRSRO'' as an entity (i) that issues publicly 
available credit ratings that are current assessments of the 
creditworthiness of obligors with respect to specific 
securities or money market instruments; (ii) is generally 
accepted in the financial markets as an issuer of credible and 
reliable ratings, including ratings for a particular industry 
or geographic segment, by the predominant users of securities 
ratings; and (iii) uses systematic procedures designed to 
ensure credible and reliable ratings, manage potential 
conflicts of interest, prevent the misuse of public 
information, and has sufficient financial resources to ensure 
compliance with these procedures.
---------------------------------------------------------------------------
    \17\ Definition of Nationally Recognized Statistical Rating 
Organization, Release No. 34-51572 (April 19, 2005), 70 FR 21306 (April 
25, 2005).
---------------------------------------------------------------------------

IV. Critiques of NRSRO system: Inadequate transparency, competition, 
        and accountability

    Witnesses appearing before the Committee described the 
current system for approving rating agencies as vague, 
arbitrary, and anticompetitive.\18\ The term ``NRSRO'' remains 
undefined by the Commission after three decades. There is no 
formal application process. Some applicants have waited a 
decade without a final decision by the staff. SEC commissioners 
are not formally involved in the decision whether to recognize 
new NRSROs. The most important requirement for acquiring the 
coveted status presents an obvious ``Catch 22'': to get the 
designation you must be nationally recognized, but you cannot 
become nationally recognized without first having the 
designation. Mr. Yasuhiro Harada, Executive Vice President of 
Rating and Investment Information, Inc., expressed the almost 
universal view that the national recognition requirement was a 
``circular test.'' \19\ Several witnesses testifying before the 
Committee noted that the standard has served as a substantial 
barrier to entry for new entrants and that greater competition 
would benefit investors by generating more innovation and 
higher quality ratings at lower costs.\20\
---------------------------------------------------------------------------
    \18\ See, e.g., the testimony of Mr. Alex Pollock, Resident Fellow, 
American Enterprise Institute, before the Committee on Banking, 
Housing, and Urban Affairs, U.S. Senate, March 7, 2006, at 1.
    \19\ Testimony of Mr. Yasuhiro Harada, Executive Vice President, 
Rating and Investment Information, Inc., before the Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate, February 8, 2005, at 
2. Mr. Harada explained that his ratings firm, the most recognized firm 
in Japan and the broad Asian markets, had unsuccessfully sought NRSRO 
status for a decade. He said it ``has been an exercise in delay and 
disappointment'' (at 2).
    \20\ See, e.g., the testimony of Mr. Paul Schott Stevens, 
President, Investment Company Institute, before the Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate, March 7, 2006, at 5-
7.
---------------------------------------------------------------------------
    Witnesses also testified that the absence of any meaningful 
SEC oversight of rating agencies has led to accountability 
problems and to questions relating to NRSRO compliance with 
federal securities laws and the criteria listed in the no-
action letter. Mr. Frank Partnoy, Professor of Law, University 
of San Diego School of Law, asserted that the voluntary 
policing regimes are ``self-serving and toothless'' and that 
``NRSROs will not police their conduct without a credible 
enforcement mechanism.'' \21\ For these reasons, the witnesses 
urged the Committee to replace the NRSRO system with a 
registration system. \22\ Ms. Colleen S. Cunningham, President 
and Chief Executive Officer of Financial Executives 
International, testified that ``the most effective way to 
increase competition in the credit rating market would be to 
eliminate the broken `no action' process and replace it with 
transparent registration requirements . . . By establishing 
stringent yet clear criteria for registration, Congress would . 
. . generate more competition . . . more choice for issuers; 
lower costs . . . and higher quality service.'' \23\
---------------------------------------------------------------------------
    \21\ For a groundbreaking and highly influential analysis of credit 
rating agencies, see Mr. Partnoy's law review article, ``The Siskel and 
Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating 
Agencies,'' Washington University Law Quarterly, Fall 1999.
    \22\ See, e.g., Stevens, op. cit., at 7.
    \23\ Testimony of Ms. Colleen Cunningham, President and Chief 
Executive Officer, Financial Executives International, before the 
Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 7, 
2006, at 4.
---------------------------------------------------------------------------

V. Reforms included in the credit rating agency reform act

    The Credit Rating Agency Reform Act establishes fundamental 
reform and improvement of the designation process. Most 
importantly, the Act replaces the artificial barriers to entry 
created by the current SEC staff approval system with a 
transparent and voluntary registration system that favors no 
particular business model, thus encouraging purely statistical 
models to compete with the qualitative models of the dominant 
rating agencies and investor subscription-based models to 
compete with fee-based models. The Committee believes that 
eliminating the artificial barrier to entry will enhance 
competition and provide investors with more choices, higher 
quality ratings, and lower costs.
    Credit rating agencies that choose to register as NRSROs 
must disclose important information such as ratings 
performance, conflicts of interest, and the procedures used in 
determining ratings. Rating performance statistics will be 
updated annually. This information will facilitate informed 
decisions by giving investors the opportunity to compare the 
ratings quality of different firms.
    Witnesses testifying at the Committee's rating agency 
hearings asserted that the bankruptcies at Enron, WorldCom, and 
other corporations demonstrated that NRSROs are not providing 
investors with timely and accurate ratings.\24\ All of the 
then-three NRSROs rated Enron at investment grade until only 
four days before default. WorldCom was rated investment grade 
debt only 42 days prior to its bankruptcy filing. Mr. Sean 
Egan, Managing Director of Egan-Jones Ratings Company, citing 
these and other missed calls,\25\ testified that the rating 
industry is a ``dysfunctional . . . partner monopoly'' that is 
in ``crisis.'' \26\
---------------------------------------------------------------------------
    \24\ In testimony before the Committee, the NRSROs explained their 
performance by saying that Enron and WorldCom also misled them.
    \25\ Egan, op. cit., at 1-2. Mr. Egan also referenced the 
California utilities, Global Crossing, AT&T Canada, and Parmalat as 
prominent examples where the NRSROs failed to protect investors.
    \26\ Egan, op. cit., at 1-2.
---------------------------------------------------------------------------
    Several witnesses described the business model for the 
dominant rating agencies as inherently conflicted.\27\ Debt 
issuers pay the rating agencies for their rating. In addition, 
rating agencies increasingly market ancillary, fee-based 
consulting services, thus exacerbating the basic conflict.\28\ 
The Act addresses these concerns by requiring registration form 
disclosure of any conflict of interest relating to the 
applicant's issuance of credit ratings, and by requiring the 
Commission to adopt rules prohibiting conflicts of interest or 
requiring the management and disclosure of such conflicts.
---------------------------------------------------------------------------
    \27\ Rating agencies acknowledge the inherent conflict of issuers 
paying for ratings. But they argue that it is effectively managed 
inasmuch as analysts do not benefit financially from any of their 
rating decisions. Analysts are not permitted to own any of the 
securities they follow. Also, because the fees from each issuer amount 
to less than one percent of overall revenues, the rating agencies argue 
that no issuer is likely to impair independence.
    \28\ See, e.g., testimony of Mr. James A. Kaitz, President and 
Chief Executive Officer, Association for Financial Professionals, 
before the Committee on Banking, Housing, and Urban Affairs, U.S. 
Senate, February 8, 2005, at 6. See also Partnoy, op. cit., at 4.
---------------------------------------------------------------------------
    Prior to the Committee mark-up of the Act, a broad 
coalition of interested parties that typically offer different 
ideological perspectives expressed support for the bipartisan 
product:
    The Investment Company Institute said the Act ``brings much 
needed sunlight to credit ratings'' and ``will benefit a wide 
range of market participants.''
    The AFL-CIO expressed its ``strong support'' for the 
legislation and said it would ``protect the investing public 
against conflicts of interest within the credit rating agencies 
. . . [and] encourages in a responsible manner greater 
competition.''
    The Association for Financial Professionals said the bill 
will ``foster competition, stimulate innovation, hold credit 
rating agencies accountable, and improve the quality of 
information available to investors, and, as a result, restore 
confidence in the credit ratings market.''
    The Bond Market Association said the bill would create a 
``more competitive credit rating industry [that] will 
contribute to more robust and efficient capital markets that 
will ultimately benefit investors and the overall economy.''
    Consumer Federation of America wrote that it will ``help 
ensure that only high quality ratings will be used for 
economically important regulatory purposes'' and praised the 
bill's requirements for ``certifications by Qualified 
Institutional Buyers . . . and [for] giving the . . . SEC . . . 
authority to deny NRSRO status to rating agencies that lack the 
financial and managerial resources to produce ratings of 
integrity.''
    Financial Executives International said the bill 
``positively addresses three issues of great importance to our 
members: competition, accountability, and conflicts of 
interest,'' and ``urge[d] Congress to enact this important 
legislation this year.''
    Fitch said it ``represents a significant step forward to 
prudently enhance competition in the rating agency industry.''
    Fidelity Investments said the bill ``will improve ratings 
quality by fostering transparency and accountability.''
    Ratings and Investment Information, Inc. commended the bill 
for ``establishing a much more transparent application process 
and, most importantly, prescribing a specific timeline within 
which the agency must act.''

                        COMMITTEE CONSIDERATION

    On August 2, 2006, the Committee considered a managers' 
amendment offered by Chairman Shelby and Senator Sarbanes that 
revised the base text of the Committee Print. The managers' 
amendment made essentially two changes. First, it ensured that 
the SEC would not regulate the rating methodologies used to 
determine ratings. Second, it clarified that rating agencies 
registering under the bill would not in any way waive or 
otherwise diminish any right, privilege, or defense that such 
rating agencies may otherwise have under State or Federal law. 
The amendment also made some technical changes to the Committee 
Print. On a unanimous vote, the Committee reported the bill, as 
amended, to the Senate for consideration.

                 SECTION-BY-SECTION ANALYSIS OF THE ACT

    Section 1. The Short Title is ``Credit Rating Agency Reform 
Act of 2006.''
    Section 2. Findings are based on the SEC study issued 
pursuant to Section 702 of the Sarbanes-Oxley Act, Senate 
Banking Committee and House Financial Services Committee 
hearings in the 108th and 109th Congresses, comments on the SEC 
Concept Releases and Proposed Rules, and ``facts otherwise 
disclosed and ascertained.'' Specifically, Congress finds that: 
(1) Credit ratings, reports, and related documents are 
distributed and contracts negotiated by use of the mails and 
means of interstate commerce; (2) ratings related to the 
purchase and sale of securities traded on exchanges and in 
interstate commerce; (3) the transactions ``substantially . . . 
affect interstate commerce and securities markets, the national 
banking system, and the national economy''; (4) oversight of 
such credit rating agencies serves the compelling interest of 
investor protection; (5) the two largest rating agencies serve 
the vast majority of the market, and additional competition is 
in the public interest; and (6) the Commission has indicated it 
needs statutory authority to oversee the credit rating 
industry.
    Section 3. Definitions are added to Section 3(a) of the 
Exchange Act for CREDIT RATING, CREDIT RATING AGENCY, 
NATIONALLY RECOGNIZED STATISTICAL RATING ORGANIZATION, PERSON 
ASSOCIATED WITH A NATIONALLY RECOGNIZED STATISTICAL RATING 
ORGANIZATION, and QUALIFIED INSTITUTIONAL BUYER (``QIB'' or 
``QIBs'').
    Section 4. Registration creates a new Section 15E of the 
Exchange Act with subsections as follows:
    (a) A credit rating agency that wants to become an NRSRO 
must furnish an application that contains the following 
required information: (i) rating statistics over short-, mid-, 
and long-term periods; (ii) procedures and methodologies that 
the rating agency uses to determine ratings; (iii) policies or 
procedures to prevent misuse of material nonpublic information; 
(iv) organizational structure; (v) whether the rating agency 
has a code of ethics and, if not, the reasons; (vi) conflicts 
of interest related to the issuance of ratings; (vii) the types 
of ratings it intends to issue (financial institutions; broker-
dealers; insurance companies; corporate issuers; issuers of 
asset-backed securities; and issuers of government securities); 
(viii) on a confidential basis, a list of the 20 largest 
issuers and subscribers that use the rating services; (ix) on a 
confidential basis, certifications from at least 10 QIBs that 
they have used the ratings for at least the three most recent 
years, including two certifications for each type of rating it 
will issue--no QIB will be liable in any private right of 
action for what it states in a certification; and (x) other 
data the SEC requires.
    Within 90 days of receiving the application, the SEC shall 
grant registration or institute proceedings to determine 
whether registration should be denied, which will be concluded 
within 120 days unless extended for good cause. The Commission 
will grant registration unless it finds that ``the applicant 
does not have adequate financial and managerial resources to 
consistently produce credit ratings with integrity and to 
materially comply with the procedures andmethodologies'' 
disclosed and with certain of its other representations. Upon granting 
the registration the completed application will be made public.
    With respect to the certifications from QIBs stating that 
they have ``used'' the agencies'' ratings, the Committee 
intends ``used'' to mean that the QIB seriously considered the 
ratings in some of their investment decisions. Thus, a QIB 
whose analysts regularly read and consider an agency's ratings 
in the course of making investment decisions would have 
``used'' them under the meaning of the bill. A QIB whose 
employees subscribe to or regularly receive the ratings but do 
not read them or, if they read them, rarely or never consider 
them in making their investment decisions would not be deemed 
to have ``used'' the ratings.
    (b) An NRSRO must update its application ``promptly'' if 
the application becomes ``materially inaccurate'' except with 
respect to its ratings performance statistics and the QIB 
certifications. An NRSRO must annually certify that the 
application documents (other than the QIB certifications) 
remain accurate and list any material changes that occurred.
    (c) The SEC has the authority to prevent NRSROs from 
issuing ``credit ratings in material contravention of those 
procedures'' which such NRSROs included in their applications 
and reports. The SEC's rules ``shall be narrowly tailored to 
meet the requirements of this title . . . and shall not purport 
to regulate the substance of credit ratings or the procedures 
and methodologies'' by which such NRSROs determine their 
ratings.
    (d) The SEC can by order censure, limit, suspend, or revoke 
registration of the NRSRO, after notice and comment, for the 
protection of investors and in the public interest if the NRSRO 
commits any of a variety of specified types of misconduct, if 
the NRSRO ``fails to file the [annual] certification 
required,'' or ``fails to maintain adequate financial and 
managerial resources to consistently produce credit ratings 
with integrity.''
    (e) An NRSRO can terminate registration voluntarily, 
subject to the terms and conditions of the SEC.
    (f) An NRSRO may not represent that it ``has been 
designated, sponsored, recommended, or approved, or that the 
abilities or qualifications thereof'' have been ``passed upon'' 
by the United States or any U.S. agency or employee. A rating 
agency that is not registered may not state that it is an 
NRSRO.
    (g) The Commission must promulgate rules to require NRSROs 
to establish, maintain, and enforce written policies and 
procedures to prevent the misuse of material nonpublic 
information that it obtains.
    (h) The Commission must promulgate rules to require NRSROs 
to prohibit, or require the management and disclosure of, any 
conflicts of interest that arise from their business. These 
rules must address: (A) compensation of the NRSRO for ratings 
and other services; (B) the provision of consulting services to 
companies the NRSRO rates; (C) conflicts in business 
relationships with the NRSRO and an entity it rates; (D) 
affiliations between an NRSRO and a securities underwriter; and 
(E) other potential conflicts that the SEC deems appropriate in 
the public interest or for the protection of investors.
    (i) The Commission must promulgate rules to require NRSROs 
to address any acts or practices that the Commission determines 
to be ``unfair, coercive, or abusive,'' including those related 
to: (A) conditioning or threatening to condition an issuer's 
credit rating on the purchase of other services or products; 
(B) lowering or threatening to lower a credit rating, or 
refusing to rate securities or money market instruments issued 
by an asset pool, unless a portion of the assets in the pool 
also is rated by the NRSRO; and (C) modifying or threatening to 
modify a credit rating based on whether the issuer or an 
affiliate will purchase other services from the NRSRO.
    The Committee intends that the Commission, as a threshold 
consideration, must determine that the practices subject to 
prohibition under this section are unfair, coercive, or abusive 
before adopting rules prohibiting such practices.
    With respect to the activities described in subparagraph 
(B), the Committee recognizes that there are instances when a 
rating agency may refuse to rate securities or money market 
instruments for reasons that are not intended to be 
anticompetitive. Indeed, in this section, the Committee intends 
that the Commission, after resolving the threshold 
consideration described above, should prohibit only those 
rating refusals that occur as part of unfair, coercive, or 
abusive conduct.
    (j) Each NRSRO must designate an individual responsible for 
compliance with the securities laws.
    (k) Each NRSRO shall on a confidential basis furnish the 
Commission with financial statements as the Commission 
determines by rule to be necessary or appropriate.
    (l) Upon enactment of the Act, a credit rating agency can 
only be registered as an NRSRO by applying under the new law. 
Existing NRSROs will no longer be able to rely on the no-action 
letters the Commission staff has issued. The Commission will 
notify other Federal agencies that use the NRSRO designation in 
their rules and regulations about its actions to implement the 
new law.
    (m) (1) Registration does ``not constitute a waiver of, or 
otherwise diminish, any right, privilege, or defense that a 
nationally recognized statistical rating organization may 
otherwise have under any provision of State or Federal law, 
including any rule, regulation, or order thereunder.'' (2) The 
law does not create a private right of action regarding any 
report furnished by an NRSRO under this law.
    (n) The Commission shall issue rules implementing the new 
law, and review and amend (as appropriate) existing rules, 
within 270 days after the date of enactment.
    (o) This section shall become effective on the earlier of 
the date on which regulations are issued in final form or 270 
days after enactment of this section.
    (p) Conforming amendments [to various statutory 
provisions].
    Section 5. Any report that an NRSRO is required by 
Commission rules to make is deemed to be ``furnished'' and not 
filed. The SEC is authorized to adopt reporting and 
recordkeeping requirements for NRSROs.
    Section 6. The Commission annually shall report to the 
Senate Banking Committee and House Financial Services Committee 
about the applicants for registration, actions taken on these 
applications, and views of the Commission on the state of 
competition, transparency, and conflicts of interest among 
NRSROs.
    Section 7. The Government Accountability Office shall study 
and report to the Senate Banking Committee and the House 
Financial Services Committee within 3-4 years after enactment 
on the impact of the new law on the quality of ratings; the 
financial markets; competition among NRSROs; the incidence of 
inappropriate conflicts and sales practices; and the process 
for registration. Also, the GAO would report on the problems, 
if any, faced by business organizations resulting from the 
Act's implementation and recommended solutions to such 
problems.

                        CHANGES IN EXISTING LAW

    On August 2, 2006, the Committee unanimously approved a 
motion by the Chairman to waive the Cordon rule. Thus, in the 
opinion of the Committee, it is necessary to dispense with the 
requirement of section 12 of rule XXVI of the Standing Rules of 
the Senate in order to expedite the business of the Senate.

                      REGULATORY IMPACT STATEMENT

    In accordance with paragraph 11(b), rule XXVI, of the 
Standing Rules of the Senate, the Committee makes the following 
statement concerning the regulatory impact of the bill.
    The Act seeks to improve ratings quality for the protection 
of investors and in the public interest by fostering 
accountability, transparency, and competition in the credit 
rating industry. It would result in no significant costs to 
either the Federal Government or state, local, and tribal 
governments. The Act's provisions requiring certain public 
disclosures and establishing rules relating to conflicts of 
interest and other matters would impose mandates on the private 
sector resulting in de minimis costs.

                          COST OF LEGISLATION

    Section 11(b) of rule XXVI of the Standing Rules of the 
Senate, and Section 403 of the Congressional Budget Impoundment 
and Control Act, require that each Committee Report on a bill 
contain a statement estimating the cost of the proposed 
legislation. The Congressional Budget Office has provided the 
following cost estimate and estimate of costs of private-sector 
mandates.

                                     U.S. Congress,
                               Congressional Budget Office,
                                 Washington, DC, September 1, 2006.
Hon. Richard C. Shelby,
Chairman, Committee on Banking, Housing and Urban Affairs,
U.S. Senate, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for the Credit Rating 
Agency Reform Act of 2006.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contacts are Susan 
Willie (for federal costs), and Paige Piper/Bach (for the 
impact on the private sector).
            Sincerely,
                                           Robert T. Murphy
                           (For Donald B. Marron, Acting Director).
    Enclosure.

Credit Rating Agency Reform Act of 2006

    The legislation would require the Securities and Exchange 
Commission (SEC) to establish a registration process for credit 
rating agcncies (organizations that determine the credit 
worthiness of securities or money market instruments) that seek 
to be designated by the SEC as a nationally recognized 
statistical rating organization (NRSRO). Under current law, 
thcre is no formal registration process; SEC staff currently 
identifies five credit rating agcncies as NRSROs.
    Under the bill, SEC would impose disclosure and filing 
requirements on credit rating agencies seeking registration. 
The SEC would prohibit certain activities of registered credit 
rating agencies, including issuing or modifying ratings on the 
condition that the customer purchase other services from the 
credit rating agency. Registered credit rating agencies would 
be subject to new rules developed by the SEC designed to 
protect private information held by the agencies and prevent 
conflicts of interest. Based on information from the Commission 
and assuming the availability of appropriated funds, CBO 
estimates that implementing the registration and enforcement 
requirements of the bill would cost $3 million over the 2007-
2011 period. Enacting the bill would not affect direct spending 
or revenues.
    The bill contains no intergovernmental mandates as defined 
in the Unfunded Mandates Reform Act (UMRA) and would impose no 
costs on state, local, or tribal governments.
    The bill would impose a new private-sector mandate as 
defined in UMRA on credit rating agencies that are currently 
identified as NRSROs. Under current law, credit rating agencies 
are identified as NRSROs upon receiving a ``no-action'' letter 
from the Securities and Exchange Commission. The bill would 
defme the term ``nationally recognized statistical rating 
organization'' and void any ``no-action'' letters previously 
received from the SEC. Thus, the bill would require credit 
rating agencies that currently are identified as NRSROs to 
register with the SEC and follow certain requirements if they 
want the NRSRO designation as defined under the bill. According 
to government sources, only five credit rating agencies are 
currently identified as NRSROs. Based on information from 
government sources, CBO estimates that the incremental cost for 
those agencies to register and follow any prescribed rules 
would be small and fall below the annual threshold for private-
sector mandates established by UMRA ($128 million in 2006, 
adjusted annually for inflation).
    On June 29, 2006, CBO transmitted a cost estimate for H.R. 
2990, the Credit Rating Agency Duopoly Relief Act of 2006, as 
ordered reported by the House Committee on Financial Services, 
on June 14, 2006. Both this bill and H.R. 2990 would require 
the SEC to establish a registration process for credit rating 
agencies; accordingly, CBO's cost estimates are the same.
    The staff contacts for this cost estimate are Susan Willie 
(for federal costs), and Paige Piper/Bach (for the impact on 
the private-sector). This estimate was approved by Paul R. 
Cullinan, Unit Chief for the Human Resources Cost Estimate 
Unit, Budget Analysis Division.

                                  
