[Senate Report 109-326]
[From the U.S. Government Publishing Office]
Calendar No. 590
109th Congress Report
SENATE
2d Session 109-326
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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.
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\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.
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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.
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\2\ Rating agencies that use solely quantitative methods generally
do not meet with issuers.
\3\ 17 CFR 243.100-243.103.
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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.
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\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).
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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.
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\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).
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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\
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\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.
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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.
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\9\ Nationally Recognized Statistical Rating Organizations, Release
No. 34-34616 (August 31, 1994), 59 FR 46314 (September 7, 1994).
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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.
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\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.
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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.
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\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.
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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.
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\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
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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.
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\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).
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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.
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\17\ Definition of Nationally Recognized Statistical Rating
Organization, Release No. 34-51572 (April 19, 2005), 70 FR 21306 (April
25, 2005).
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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\
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\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.
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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\
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\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.
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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\
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\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.
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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.
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\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.
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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.