[Federal Register Volume 59, Number 172 (Wednesday, September 7, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-21923]


[[Page Unknown]]

[Federal Register: September 7, 1994]


SECURITIES AND EXCHANGE COMMISSION

[(Release Nos. 33-7085; 34-34616; IC-20508; International Series 
Release No. 706); File No. S7-23-94]

 

Nationally Recognized Statistical Rating Organizations

AGENCY: Securities and Exchange Commission.

ACTION: Concept release.

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SUMMARY: The Securities and Exchange Commission (``Commission'') 
solicits recommendations on the Commission's role in using the ratings 
of nationally recognized statistical rating organizations (``NRSROs''). 
Because of the expanded use of credit ratings in the Commission's 
rules, the Commission believes that it is appropriate to examine the 
process employed by the Commission to designate rating agencies as 
NRSROs and the nature of the Commission's oversight role with respect 
to NRSROs.

DATES: Comments should be received on or before December 6, 1994.

ADDRESSES: Persons wishing to submit written comments should file three 
copies thereof with Jonathan G. Katz, Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, DC 20549. All 
written comments should refer to File No. S7-23-94. All comments 
received will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, 
DC 20549.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, 202/942-0132, 
Roger G. Coffin, 202/942-0136 or Elizabeth K. King, 202/942-0140.

SUPPLEMENTARY INFORMATION:

I. Introduction and Background

    In recent years, the credit ratings issued by agencies that are 
recognized as nationally recognized statistical rating agencies 
(``NRSROs'') have attained an increased level of importance within the 
context of the Commission's rules and regulations. The Commission looks 
to the credit ratings issued by NRSROs in a variety of contexts, and 
for different purposes, to distinguish among various grades of debt and 
other rated securities.
    The increasing utilization of credit ratings as a component in 
Commission rules, in turn, has prompted a number of domestic and 
foreign rating agencies to seek NRSRO status. Currently, the 
Commission's rules do not define the term ``NRSRO,'' nor is there a 
formal mechanism for monitoring the activities of agencies that have 
been recognized as NRSROs. Accordingly, the Commission believes that it 
is appropriate to issue a concept release soliciting comment on the 
appropriate role of ratings in the federal securities laws, and the 
need to establish formal procedures for designating and monitoring the 
activities of NRSROs.

A. The Development of the Term ``NRSRO''

    In 1975, the Commission adopted the uniform net capital Rule, Rule 
15c3-1 under the Securities Exchange Act of 1934 (``Exchange Act''), 
which in part also incorporated the use of ratings issued by NRSROs in 
connection with certain provisions of the net capital rule.1 Rule 
15c3-1 requires broker-dealers, when computing net capital, to deduct 
from net worth certain percentages of the market value (``haircuts'') 
of their proprietary securities positions. Haircuts serve as a 
safeguard against the risks associated with fluctuations in the price 
of each broker-dealer's proprietary securities. Broker-dealers' 
proprietary positions in commercial paper, nonconvertible debt 
securities and nonconvertible preferred stock are accorded preferential 
treatment under the net capital rule, in the form of reduced haircuts, 
if the instruments are rated investment grade by at least two 
NRSROs.2 The Commission did not attempt to define the term in the 
context of the net capital rule and, in using the term subsequently in 
other regulatory contexts, the Commission generally has stated that the 
term should have the same meaning as it does for purposes of the net 
capital rule.3
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    \1\17 CFR 240.15c3-1. See Adoption of Amendments to Rule 15c3-1 
and Adoption of Alternative Net Capital Requirement for Certain 
Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975), 
40 FR 29795 (July 16, 1975).
    \2\See 17 CFR 15c3-1(c)(2)(vi)(E) (haircuts applicable to 
commercial paper that has been rated in one of the three highest 
categories by at least two NRSROs); 17 CFR 15c3-1(c)(2)(vi)(F) 
(haircuts applicable to nonconvertible debt securities that are 
rated in one of the four highest rating categories by at least two 
NRSROs); 17 CFR 15c3-1(c)(2)(vi)(H) (haircuts applicable to 
cumulative, nonconvertible preferred stock rated in one of the four 
highest rating categories by at least two NRSROs).
    \3\See, e.g., Rule 2a-7 under the Investment Company Act of 
1940, 17 CFR 270.2a-7 (the term ``NRSRO'' is defined to mean any 
NRSRO ``as that term is used in Rule 15c3-1. . . .'').
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B. Expanded Use of the Term ``NRSRO'' and Utilization of the 
Ratings Assigned to Securities by NRSROs

    Over time, the NRSRO concept has been incorporated into other areas 
of the federal securities laws and Congress itself employed the term 
``NRSRO'' in the definition of ``mortgage related security.'' Pursuant 
to Section 3(a)(41) of the Exchange Act, which was added by the 
Secondary Mortgage Market Enhancement Act of 1984,4 a mortgage 
related security must, among other things, be rated in one of the two 
highest rating categories by at least one NRSRO.5 Although 
Congress did not define what it meant by an NRSRO, its reliance on the 
term used in Commission rules is significant because it reflects a 
congressional recognition that the ``term has acquired currency as a 
term of art.''6
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    \4\Pub. L. No. 98-440, Sec. 101, 98 Stat. 1689, 1689 (1984). See 
15 U.S.C. 78c(a)(41).
    \5\In 1989, Congress added the term NRSRO to Section 1831e of 
the Federal Deposit Insurance Act, which prescribes the permissible 
activities of savings associations in defining the term ``investment 
grade.'' 12 U.S.C. Sec. 1831e(d)(4)(A). Under Section 
1831e(d)(4)(A), any corporate debt security is not of ``investment 
grade'' unless the security is rated in one of the four highest 
categories by at least one NRSRO.
    \6\H.R. Rep. No. 994, 98th Cong., 2d Sess. 46 (1984) (appending 
Statement of Charles C. Cox, Commissioner, Securities and Exchange 
Commission, to the Subcommittee on Telecommunications, Consumer 
Protection, and Finance of the House Committee on Energy and 
Commerce, March 14, 1984).
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    In addition, several regulations issued pursuant to the Securities 
Act of 1933 (``Securities Act''),7 the Exchange Act,8 and the 
Investment Company Act of 1940 (``Investment Company Act'')9 have 
incorporated the term ``NRSRO'' as it is used in the net capital rule. 
For example, the Commission employs NRSRO ratings as a basis for 
distinguishing between certain types of securities that may be issued 
using simplified registration procedures under the Securities 
Act.10 NRSRO ratings also are employed in connection with 
investment restrictions applicable to money market funds. Rule 2a-7 
under the Investment Company Act requires a money market fund to limit 
its investments to securities that are ``Eligible Securities,''11 
which, among other things, are securities rated in one of the two 
highest rating categories for short-term debt by the requisite number 
of NRSROs.
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    \7\See, e.g., Regulation S-K (17 CFR 229.10); Rule 436 (17 CFR 
230.436); Form S-3 (17 CFR 239.13); Forms F-2 and F-3 (17 CFR 
239.32, 239.33).
    \8\See, e.g., Rule 10b-6 (17 CFR 240.10b-6). See also Form 17-H 
(17 CFR 249.328T).
    \9\See, e.g., Rule 2a-7 (17 CFR 270.2a-7); Rule 10f-3 (17 CFR 
270.10f-3); Rule 3a-7 (17 CFR 270.3a-7). Cf. Investment Company Act 
Release No. 19716, 58 FR 49425 (Sept. 23, 1993) (amending Rule 12d3-
1 by, among other things, dropping the requirement that investment 
companies limit their purchases of debt securities issued by 
securities-related businesses to those that are investment grade).
    \1\0See Adoption of Integrated Disclosure System, Securities Act 
Release No. 6383 (Mar. 16, 1982). Adoption of Simplification of 
Registration Procedures for Primary Securities Offerings, Securities 
Act Release No. 6964 (Oct. 22, 1992).
    \1\1See 17 CFR 270.2a-7.
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    Rule 3a-7 under the Investment Company Act, which exempts certain 
structured financing from registering under and complying with the 
Investment Company Act, also utilizes the ratings of NRSROs.12 
Under paragraph (2)(a) of Rule 3a-7, an issuer of fixed income 
securities that are rated in one of the four highest categories by at 
least one NRSRO is deemed not to be an investment company under the 
Investment Company Act. In adopting the rule, the Commission recognized 
that rating agencies had been ``successful in analyzing the structural 
integrity of financing * * * [and] appear to have been a major factor 
in investor acceptance of structured financing.''13
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    \1\2Exclusion from the Definition of Investment Company for 
Structured Financing, Investment Company Act Release No. 19105 
(November 19, 1992), 52 SEC Dkt. 4014.
    \1\3Id. at 4028.
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    In proposing Rule 3a-7, the Commission requested specific comment 
on whether a rating requirement was necessary and, if not, on what 
alternative bases the Commission should exclude structured financing 
from the Investment Company Act. The Commission also requested comment 
on whether rating agencies should be subject to additional regulatory 
requirements. Those commentators who specifically addressed the issue 
registered strong support for use of NRSRO ratings in the structured 
financing context. The North American Securities Administrators 
Association, Inc. and the Investment Company Institute (``ICI'') 
opposed reliance on NRSRO ratings in this context. Of the commentators 
addressing additional regulatory requirements for rating agencies 
generally, a large majority opposed Commission regulation of rating 
agencies, whereas several others argued that questions of regulatory 
oversight should be addressed separately from the merits of the 
proposed rule. The ICI was the only commentator supporting additional 
government oversight.
    Finally, Rule 10b-6 under the Exchange Act, which prohibits persons 
participating in a distribution of securities from artificially 
conditioning the market for the securities in order to facilitate the 
distribution, employs an NRSRO concept as well. Generally, Rule 10b-6 
exempts certain transactions in nonconvertible debt and nonconvertible 
preferred securities from its coverage if the securities, among other 
things, are rated investment grade by at least one NRSRO.14
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    \1\4See 17 CFR 240.10b-6(a)(4)(xiii). In addition, the Board of 
Governors of the Federal Reserve System uses the term ``NRSRO'' in 
Regulation T. See 12 CFR Part 220.
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    The utilization of NRSRO ratings, therefore, is an important 
component of the Commission's regulatory program. Initially, the 
Commission solicits comment as to whether it should continue to employ 
in its rules the term ``NRSRO'' and the ratings assigned to various 
debt and other rated securities by NRSROs. The Commission also invites 
commentators to consider alternative means by which the Commission 
could distinguish among various grades of debt and other rated 
securities.
    In addition, with the advent of limited scope ratings of the type 
applied, for example, to ``cash flow securities,''\15\ and with the 
proliferation of structured securities subject to substantial non-
credit payment risks, it is appropriate to review the regulatory use of 
ratings and to specify, if necessary, what types of ratings fall within 
each of the regulatory provisions that refer to specific ratings. We 
also request comment regarding whether a limited scope rating by NRSROs 
should qualify for the exemption from liability under section 11 of the 
Securities Act.\16\
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    \1\5A cash flow security represents an interest in a pool of 
several classes of previously issued unrelated mortgage backed 
securities, which typically are highly sensitive to principal 
prepayment speed and have volatile yields. The Commission has been 
informed that certain NRSROs have developed rating techniques to 
measure the likelihood that holders of a particular class of 
securities will receive a specified dollar amount by the maturity 
date, without regard to whether such payment amount constitutes 
interest or principal repayment. Assessing the likelihood of receipt 
of this cash flow combines both a credit rating and non-credit 
payment evaluation of prepayments on the underlying pooled 
securities, and thus represents a significant departure from 
traditional credit rating techniques. The Commission is issuing a 
release that proposes amendments with respect to the use of 
securities ratings in disclosure documents. See Securities Act 
Release No. 33-7086 (Aug. 31, 1994).
    \1\615 U.S.C. Sec. 77k. See also 17 CFR Sec. 230.436(g).
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    Rating agencies and other organizations have developed ratings of 
open-end and other types of investment companies. These ratings serve a 
number of purposes. Three rating agencies, Fitch Investors Service, 
Inc. (``Fitch''), Standard & Poor's Corporation (``Standard & 
Poor's''), and Moody's Investors Service, Inc. (``Moody's''), issue 
ratings that assess the safety of principal invested in a money market 
mutual fund. These rating agencies also have begun to rate different 
characteristics of bond funds.\17\ For example, Fitch, Standard & 
Poor's, and Moody's each issue bond fund ratings designed to identify 
the degree of credit risk in a bond fund's underlying investments. 
Fitch and Standard & Poor's also issue bond fund ``stability'' or 
``market risk'' ratings that purport to quantify the potential 
volatility of the market value of bond fund shares, based on an 
analysis of interest rate risk, spread risk, currency risk, and the 
fund's use of derivatives.\18\ Other organizations issue mutual fund 
risk ratings that are designed to quantify different types of 
investment risk. These ratings may provide investors with information 
that may be useful in assessing the risks of investing in a mutual 
fund; however, they also may create expectations of investment 
performance that may not be achieved, notwithstanding disclaimers that 
they are not projections of future results.
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    \1\7The mutual fund ratings, generally, are accompanied by a 
suffix (e.g., an ``m'' to indicate a money market fund rating or an 
``f'' to indicate a bond fund rating) to differentiate them from 
traditional bond and preferred stock ratings.
    \1\8See Bond Fund Rating Guidelines, Fitch Research, June 14, 
1993; Bond Fund Risk Rating Criteria, Standard & Poor's Credit Week 
(Jan. 17, 1994).
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    Comment is requested regarding whether the Commission should 
encourage or require these types of ratings to be disclosed in fund 
prospectuses, sales literature, and advertisements. Commenters are 
asked to address the type of disclosure that should accompany these 
types of ratings to assure that their significance and limitations are 
appreciated by investors, and any other appropriate conditions for 
their use in fund prospectuses and advertisements (such as conditions 
to assure that an issuer will only use a rating that is current and 
that changes in a fund rating are promptly disclosed to investors). 
Comment is requested as to whether these ratings may lead an investor 
to select a fund based solely on a fund's ratings rather than other 
information that bears on the appropriateness of the fund for the 
investor's investment objectives and goals. Finally, comment is 
requested on whether Rule 436(g) under the Securities Act should be 
amended so that a fund could include these types of ratings in its 
registration statements without having to provide a written consent 
conveying expert liability to the organization preparing the 
ratings.\19\ Further questions regarding NRSROs are set forth below.
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    \1\9Mutual fund ratings relate to the fund's equity securities. 
Currently, because Rule 436(g) under the Securities Act does not 
cover equity securities, a fund would be required to file an NRSRO's 
consent if the rating assigned by the NRSRO to the fund's common 
stock is disclosed in the fund's prospectus. Because NRSROs, 
generally, will not provide the required consent, funds have been 
unable to use NRSRO ratings in their prospectuses. In 1986, the 
Commission proposed to extend Rule 436(g) to ratings of money market 
fund securities. See Investment Company Act Release No. 14984 (Mar. 
14, 1986), 51 FR 9838 (Mar. 21, 1986). These proposed amendments 
were not adopted.
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II. Designating and Monitoring NRSROs

A. Designation of NRSROs

    Six rating organizations currently are ``designated'' as NRSROs for 
purposes of the net capital rule:\20\ (1) Standard & Poor's; (2) 
Moody's; (3) Fitch; (4) Duff & Phelps, Inc. (``Duff & Phelps'');\21\ 
(5) Thomson BankWatch, Inc. (``BankWatch'');\22\ and (6) IBCA Limited 
and its subsidiary, IBCA Inc. (collectively known as ``IBCA'').\23\ 
Standard & Poor's, Moody's and Fitch were the only rating agencies 
initially designated as NRSROs by the Division of Market Regulation 
(``Division''). The Division indirectly designated these three rating 
agencies as NRSROs by granting no-action relief to broker-dealers who 
sought assurances concerning their status as NRSROs for purposes of the 
net capital rule. Subsequently, based on requests directly from rating 
agencies, the Division provided no-action assurances to three 
additional rating agencies, Duff & Phelps, BankWatch and IBCA, that 
they would be considered NRSROs for purposes of the net capital rule.
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    \2\0McCarthy, Crisanti & Maffei, Inc. (``McCarthy''), a seventh 
rating agency designated as an NRSRO on September 13, 1983 by the 
Division of Market Regulation, has discontinued its ratings 
business. Duff & Phelps purchased the credit research and ratings 
business of McCarthy on February 7, 1991. See Letter from Michael A. 
Macchiaroli, Assistant Director, Division of Market Regulation, to 
Paul J. McCarthy, President of McCarthy (Sept. 13, 1983); Letter 
from J. Christopher Jackson, Vice President and Associate General 
Counsel, Van Kampen Merritt, to Michael A. Macchiaroli, Assistant 
Director, Division of Market Regulation (Mar. 13, 1991).
    \2\1See Letter from Nelson S. Kibler, Assistant Director, 
Division of Market Regulation, to John T. Anderson, Attorney, Lord, 
Bissell & Brook, on behalf of Duff & Phelps (Feb. 24, 1982).
    \2\2See Letter from Michael A. Macchiaroli, Assistant Director, 
Division of Market Regulation, to Gregory A. Root, President, 
BankWatch (Aug. 6, 1991). BankWatch is recognized as an NRSRO only 
for the purposes of rating debt issued by banks, bank holding 
companies, non-bank banks, thrifts, broker-dealers and broker-
dealers' parent companies. Id.
    \2\3See Letter from Michael A. Macchiaroli, Assistant Director, 
Division of Market Regulation, to Mr. Robin Monro-Davies, President, 
IBCA Limited (Nov. 27, 1990); Letter from Michael A. Macchiaroli, 
Assistant Director, Division of Market Regulation, to David L. 
Lloyd, Jr., Attorney, Dewey, Ballantine, Bushby, Palmer & Wood, on 
behalf of IBCA (Oct. 11, 1990). At present, IBCA is designated as an 
NRSRO only for the purposes of rating debt issued by banks, bank 
holding companies, United Kingdom building societies, broker-
dealers, broker-dealer parent companies and bank-supported debt. Id.
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    In reaching a decision regarding whether to provide no-action 
assurances to rating agencies regarding NRSRO designation, the Division 
staff undertakes an informal examination of the agency's operations, 
its position in the marketplace, as well as considering other factors. 
If the Division staff determines that no-action assurances are 
appropriate, the staff prepares a letter stating that it will not 
recommend enforcement action to the Commission if the rating agency is 
considered to be an NRSRO for purposes of applying the relevant 
subdivisions of the net capital rule.
    In determining whether a rating agency possesses the 
characteristics of an NRSRO, the staff considers a number of criteria. 
The Division believes that the single most important criterion is that 
the rating agency is in fact nationally recognized by the predominant 
users of ratings in the United States as an issuer of credible and 
reliable ratings. Consistent with this standard of national recognition 
is a minimum level of operational capability and reliability of 
ratings. Therefore, the staff also assesses, among other factors: (a) 
the agency's organizational structure; (b) the agency's financial 
resources (to determine, among other things, whether it is able to 
operate independently of economic pressures); (c) the size and quality 
of the agency's staff (to determine if the entity is capable of 
thoroughly and competently evaluating an issuer's credit); (d) the 
agency's independence from the companies it rates and its reputation 
for integrity in the marketplace; (e) the agency's rating procedures 
(to determine whether it has systematic procedures designed to ensure 
credible and accurate ratings); and (f) the agency's establishment and 
compliance with internal procedures to prevent misuses of non-public 
information.24
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    \2\4See No-Action Letter from Nelson S. Kibler, Assistant 
Director, Division of Market Regulation to John T. Anderson, Esq., 
Lord, Bissell & Brook (Mar. 24, 1982).
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    In the letter providing no-action assurances to a rating agency, 
the Division advises the rating agency that the decision to confer 
NRSRO status has been based on representations made by or on behalf of 
the rating agency during the no-action process. The Division then 
directs the rating agency to bring to its attention any material change 
in the facts that served as the basis for granting the no-action 
letter. In this manner, the Division retains the ability to withdraw a 
no-action letter designating the particular rating agency as an NRSRO 
if the facts so warrant. Although it has the authority to revoke a no-
action letter previously granted to a rating agency, the Commission 
would like to explore more effective vehicles for soliciting 
information from NRSROs. Material changes in an NRSRO's organizational 
structure or modifications of its rating practices, for example, could 
affect the NRSRO's standing in the credit market. Although the 
Commission notes that all of the existing rating agencies that have 
received no-action assurances are registered as investment advisers 
under the Investment Advisers Act of 1940, the Commission receives only 
limited, informational filings from NRSROs.
    The Division staff currently is reviewing no-action requests from 
other rating agencies regarding NRSRO designation. Although no final 
determination has been made, the staff has not been able to provide no-
action assurances to any of these agencies. Nonetheless, the staff 
intends to continue to evaluate these agencies pending the comment 
period for this release.

B. Questions for Comment

    1. Comment is invited on whether the Commission should continue to 
employ an NRSRO concept to distinguish various types of debt and other 
securities for purposes of its rules.
    2. The Commission solicits comment on whether it should propose to 
adopt, in the net capital rule or another rule, a definition of the 
term ``NRSRO,'' for purposes of all of its rules. Commentators are 
invited to provide suggestions as to how the term NRSRO could be 
defined and as to what, if any, objective criteria should be considered 
in determining whether a rating agency is an NRSRO for purposes of the 
Commission's rules.
    3. The Commission requests comment as to whether the current no-
action letter process with respect to NRSROs is satisfactory, or if 
not, whether the Commission should establish alternate procedures for 
designating NRSROs. Commentators are requested to address whether the 
current practice needs to be formalized, and if so, how this should be 
accomplished.
    4. The Commission also solicits comment on the practice of NRSROs 
charging issuers for ratings and, more specifically, whether it is 
appropriate for an NRSRO to charge an issuer based on the size of the 
transactions being rated.
    5. Comment regarding the use of limited scope ratings that may not 
denote an assessment solely of the credit risk of an instrument also is 
requested.
    6. Comment is invited on whether the Commission should take further 
steps regarding NRSROs in order to increase its regulatory oversight 
role, including seeking additional legislative authority, if necessary. 
Commentators are requested to consider whether NRSROs should be 
required to register with the Commission, or whether other types of 
regulatory oversight are appropriate and necessary to satisfy the 
purposes of the federal securities laws.

    By the Commission.

    Dated: August 31, 1994.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-21923 Filed 9-6-94; 8:45 am]
BILLING CODE 8010-01-P