[Federal Register Volume 68, Number 113 (Thursday, June 12, 2003)]
[Notices]
[Pages 35258-35264]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-14867]



[[Page 35257]]

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Part II





Securities and Exchange Commission





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Rating Agencies and the Use of Credit Ratings Under the Federal 
Securities Laws; Notice

  Federal Register / Vol. 68, No. 113 / Thursday, June 12, 2003 / 
Notices  

[[Page 35258]]


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SECURITIES AND EXCHANGE COMMISSION

[Release Nos. 33-8236; 34-47972; IC-26066; File No. S7-12-03]
RIN 3235-AH28


Rating Agencies and the Use of Credit Ratings Under the Federal 
Securities Laws

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Concept release; request for comments.

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SUMMARY: As part of the Commission's review of the role of credit 
rating agencies in the operation of the securities markets, the 
Commission is seeking comment on various issues relating to credit 
rating agencies, including 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.

DATES: Comments should be received on or before July 28, 2003.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by hard copy or e-mail, but not by 
both methods. Comments sent by hard copy should be submitted in 
triplicate to Jonathan G. Katz, Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Comments 
also may be submitted electronically at the following electronic mail 
address: [email protected]. All comment letters should refer to 
File No. S7-12-03. This file number should be included in the subject 
line if electronic mail is used. Comment letters will be available for 
public inspection and copying in the Commission's Public Reference 
Room, 450 Fifth Street, NW., Washington, DC 20549. Electronically 
submitted comment letters will be posted on the Commission's Internet 
Web site (http://www.sec.gov).\1\
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    \1\ We do not edit personal identifying information, such as 
names or electronic mail addresses, from electronic submissions. You 
should submit only information that you wish to make publicly 
available.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at (202) 942-0132; Thomas K. McGowan, Assistant Director, at 
(202) 942-4886; Mark M. Attar, Special Counsel, at (202) 942-0766; or 
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Mandy B. Sturmfelz, Attorney, at (202) 942-0085.

SUPPLEMENTARY INFORMATION:

I. Introduction \2\
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    \2\ For a detailed discussion on credit rating agencies and the 
Commission's use of credit ratings under the Federal securities 
laws, see the 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 (hereinafter, the ``Report''). 
The Report is available on the Commission's Web site at http://www.sec.gov/news/studies/credratingreport0103.pdf.
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    Since 1975, the Commission has relied on credit ratings from 
market-recognized credible rating agencies for distinguishing among 
grades of creditworthiness in various regulations under the Federal 
securities laws. These credit rating agencies, known as ``nationally 
recognized statistical rating organizations,'' or ``NRSROs,'' are 
recognized as such by Commission staff through the no-action letter 
process. There currently are four NRSROs \3\--Moody's Investors 
Service, Inc.; Fitch, Inc.; Standard & Poor's, a division of the 
McGraw-Hill Companies, Inc.; and Dominion Bond Rating Service Limited 
(``DBRS'').\4\ Although the Commission originated the use of the term 
``NRSRO'' for a narrow purpose in its own regulations, 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. The Commission's 
initial regulatory use of the term ``NRSRO'' was solely to provide a 
method for determining capital charges on different grades of debt 
securities under the Commission's net capital rule for broker-dealers, 
rule 15c3-1 under the Exchange Act (the ``Net Capital rule''). Over 
time, as the reliance on credit rating agency ratings increased, so too 
did the use of the NRSRO concept.
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    \3\ Since 1975, four additional rating agencies have been 
recognized as NRSROs. However, each of these firms has since merged 
with or been acquired by other NRSROs. These four additional rating 
agencies were Duff and Phelps, Inc., McCarthy, Crisanti & Maffei, 
Inc., IBCA Limited and its subsidiary, IBCA, Inc., and Thomson 
BankWatch, Inc.
    \4\ On February 24, 2003, the Commission's Division of Market 
Regulation (the ``Division'') responded to a request by DBRS that 
the Division will not recommend enforcement action against broker-
dealers that consider ratings by DBRS as NRSRO ratings when 
computing net capital pursuant to rule 15c3-1 under the Securities 
Exchange Act of 1934 (``Exchange Act''). See letter from Annette L. 
Nazareth, Director, Division, Commission, to Mari-Anne Pisarri, 
Pickard and Djinis LLP (February 24, 2003). This letter is available 
on the Commission's Internet Web site at http://www.sec.gov/divisions/marketreg/mr-noaction/dominionbond022403-out.pdf.
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    In recent years, the Commission and Congress have reviewed a number 
of issues regarding credit rating agencies and, in particular, the 
subject of regulatory oversight of them. In 1994, the Commission 
solicited public comment on the appropriate role of credit ratings in 
rules under the Federal securities laws, and the need to establish 
formal procedures for recognizing and monitoring the activities of 
NRSROs.\5\ Comments received by the Commission led to a rule proposal 
in 1997 which, among other things, would have defined the term 
``NRSRO'' in the Net Capital rule.\6\ However, the Commission has not 
acted upon that rule proposal. More recently, the initiation of broad-
based Commission and Congressional reviews of credit rating agencies 
following the collapse of Enron has resulted in the need for a fresh 
look at the issue.
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    \5\ See Nationally Recognized Statistical Rating Organizations, 
Release No. 34-34616 (August 31, 1994), 59 FR 46314 (September 7, 
1994).
    \6\ See 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).
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    On January 24, 2003, the Commission submitted to Congress its 
Report on the role and function of credit rating agencies in the 
operation of the securities markets in response to the Congressional 
directive contained in section 702 of the Sarbanes-Oxley Act of 2002 
(the ``Sarbanes-Oxley Act'').\7\ The Report was designed to address 
each of the topics identified for Commission study in section 702, 
including the role of credit rating agencies and their importance to 
the securities markets, impediments faced by credit rating agencies in 
performing that role, measures to improve information flow to the 
market from credit rating agencies, barriers to entry into the credit 
rating business, and conflicts of interest faced by credit rating 
agencies.\8\ The Report also addresses certain issues regarding credit 
rating agencies, such as allegations of anticompetitive or unfair 
practices, the level of due diligence performed by credit rating 
agencies when taking rating actions, and the extent and manner of 
Commission oversight of credit rating agencies, that go beyond those 
specifically identified in the Sarbanes-Oxley Act.
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    \7\ See the Report, supra note 2.
    \8\ Sarbanes-Oxley Act of 2002, Pub. L. 107-204, Sec.  702(b), 
116 Stat. 745 (2002).
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    As the Commission enters the next phase of its review, a 
fundamental threshold matter is the appropriate degree of regulatory 
oversight that should be applied to credit rating agencies. At one end 
of the spectrum, the Commission could cease using the NRSRO 
designation, exit the business of rating agency oversight, and devise 
alternative means to fulfill its regulatory objectives. At the other, 
the Commission

[[Page 35259]]

could implement, perhaps with additional legislative authority, a much 
more pervasive regulatory scheme for credit rating agencies that 
addresses the full range of issues raised in the Report.
    Discussed below are broad issues that have been raised during the 
Commission's ongoing review of credit rating agencies. Following the 
discussion of each issue is a possible approach the Commission could 
develop to address that issue, as well as a series of questions, the 
answers to which would assist the Commission in its review. The 
Commission wishes to encourage comments from market participants, other 
regulators, and the public at large.

II. Discussion

A. Alternatives to the NRSRO Designation

    Some commenters \9\ believe that the NRSRO designation acts as a 
barrier to entry into the credit rating business. Others have raised 
concerns about the extent of the Commission's legal authority to 
regulate or impose requirements on NRSROs. Commenters argue that the 
Commission does not have explicit regulatory authority over NRSROs, and 
that it would be inappropriate for the Commission to impose a more 
comprehensive regulatory framework on rating agencies absent 
legislation. Others have argued that NRSRO rating activities are 
journalistic and are consequently afforded a high level of protection 
under the First Amendment. According to these commenters, suggestions 
that the Commission inspect or otherwise impose regulatory burdens on 
NRSROs would implicate the NRSROs' First Amendment rights. They further 
believe that new legislation providing the Commission with additional 
authority over NRSROs would face the same First Amendment challenges.
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    \9\ The term ``commenters'' includes those who formally 
submitted comments in response to the Commission's 1994 concept 
release and 1997 rule proposal, as well as those contributing to the 
Commission's recent review of credit rating agencies, including 
participants at the Commission's November 2002 hearings.
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    In light of these concerns, some commenters have recommended that 
the Commission consider ceasing its use of the NRSRO designation. 
Before doing so, however, the Commission would need to identify 
alternatives capable of achieving the regulatory objectives currently 
served by use of the NRSRO designation in certain Commission rules.\10\ 
(Other regulatory or legislative bodies would need to determine 
appropriate substitutes for that designation in any non-Commission 
rules or legislation.) To further that discussion, the Commission staff 
has identified possible alternatives to the NRSRO designation for 
significant Commission rules that utilize that concept. For example:
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    \10\ The NRSRO concept is currently utilized in the following 
Commission rules: 17 CFR 228.10(e), 229.10(c), 230.134(a)(14), 
230.436(g), 239.13, 239.32, 239.33, 240.3a1-1(b)(3), 240.10b-
10(a)(8), 240.15c3-1(c)(2)(vi)(E), (F), and (H), 240.15c3-
1a(b)(1)(i)(C), 240.15c3-1f(d), 242.101(c)(2), 242.102(d), 
242.300(k)(3) and (l)(3), 270.2a-7(a)(10), 270.3a-7(a)(2), 270.5b-
3(c), and 270.10f-3(a)(3).
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    [sbull] Rule 15c3-1 under the Exchange Act. The Commission could 
allow broker-dealers to use internally-developed credit ratings for 
purposes of determining the capital charges on different grades of debt 
securities under the Net Capital rule. Strict firewalls could be 
required between the broker-dealer employees who develop internal 
credit ratings and those responsible for revenue production. In 
addition, a broker-dealer could be required to obtain regulatory 
approval of its credit rating procedures and rating categories before 
it could use internal credit ratings for calculating capital charges. 
The Commission also could allow broker-dealers to calculate capital 
charges using model-based statistical scoring systems and/or market-
based alternatives, such as credit spreads. Finally, the Commission 
could require the securities industry self-regulatory organizations 
(``SROs'') to set appropriate standards for broker-dealers to use in 
determining rating categories for net capital purposes.
    [sbull] Rule 2a-7 under the Investment Company Act of 1940. Rule 
2a-7 limits money market funds to investing in ``high quality'' 
securities. The rule contains minimum quality standards based on an 
objective test--ratings issued by NRSROs--and on a subjective test--the 
credit analysis performed by the adviser to the money market fund. The 
Commission could eliminate the objective test from rule 2a-7, and rely 
solely on the subjective test.
    [sbull] Form S-3 under the Securities Act of 1933. The Commission 
could allow a registrant to use Form S-3 for offerings of certain 
nonconvertible securities and asset-backed securities where specified 
investor sophistication or large size denomination criteria are met. 
With regard to asset-backed securities, the Commission also could 
permit Form S-3 to be used where specified asset and structure 
experience criteria are met.
    The Commission seeks commenters' views in evaluating the 
advisability and feasibility of eliminating the NRSRO designation from 
Commission rules, the possible alternatives identified above, and/or 
any other possible alternatives to the NRSRO designation. In 
particular, the Commission seeks commenters' views in response to the 
following questions:
    Question 1: Should the Commission eliminate the NRSRO designation 
from Commission rules?
    Question 2: If so, what alternatives could be adopted to meet the 
regulatory objectives of the Commission rules that currently 
incorporate the NRSRO designation? What are their respective strengths 
and weaknesses?
    Question 3: Specifically, what are the advantages and disadvantages 
of allowing broker-dealers to use internally-developed credit ratings 
to determine capital charges under the Net Capital rule? Is it 
appropriate to require strict firewalls between the broker-dealer 
employees who develop internal credit ratings and those responsible for 
revenue production? Should a broker-dealer be required to obtain 
regulatory approval of its credit rating procedures and rating 
categories before it could use internal credit ratings for calculating 
capital charges? If so, what factors should the Commission review in 
determining whether to grant such approval? If the Commission 
substitutes internal credit ratings for the NRSRO designation in the 
Net Capital rule, what would be the impact on broker-dealers, including 
small broker-dealers, and what costs would be associated with this 
change? If there would be an inordinate financial impact on small 
broker-dealers, are there market-based solutions that could reduce the 
compliance costs for them? For example, should the Commission permit 
large broker-dealers to sell their internal credit ratings to small 
broker-dealers for these purposes? If so, would this help to provide a 
more competitive marketplace for credit ratings? To what extent should 
the Commission exercise additional regulatory oversight of this 
activity (e.g., to control potential conflicts of interest)?
    Question 4: What are the advantages and disadvantages of allowing 
broker-dealers to use credit spreads to determine capital charges under 
the Net Capital rule and/or other Commission rules? How could capital 
charges be determined using credit spreads? For example, could the 
Commission base capital charges on the yield differential between 
particular debt securities and U.S. Treasury securities of comparable 
maturity, such that a larger differential results in a larger haircut? 
How could credit spreads be determined for newly-issued, thinly-traded, 
or privately-issued securities? Or for variable rate and other short-
term synthetic securities

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held by money market funds? Are there readily available public sources 
of information sufficient to calculate credit spreads on domestic and 
foreign debt securities? Are there other model-based statistical 
scoring systems and/or market-based alternatives that would be viable 
alternatives to NRSRO ratings?
    Question 5: What are the advantages and disadvantages of requiring 
the SROs to set appropriate standards for broker-dealers to use in 
determining rating categories for net capital purposes? What form might 
these standards take?
    Question 6: What are the advantages and disadvantages of 
eliminating the ``objective test'' from rule 2a-7, and relying solely 
on the ``subjective test''--the credit analysis performed by the 
adviser to the money market fund--for the purposes of determining asset 
quality?
    Question 7: What are the advantages and disadvantages of relying 
upon specified investor sophistication, large size denomination, or 
asset and structure experience criteria for purposes of determining 
Form S-3 eligibility? Should the Commission explore these possibilities 
in more depth? If so, what specific criteria should be considered?
    Question 8: Are there alternatives other than those discussed above 
that might be better substitutes for the NRSRO designation in 
particular Commission rules?
    Question 9: If the Commission discontinued using the NRSRO 
designation, should an entity other than the Commission recognize 
NRSROs for uses other than Commission rules? If another entity, which 
entity? How would the transition from the Commission to that entity 
take place?
    Question 10: If, on the other hand, the Commission should continue 
to use the NRSRO designation in some Commission rules, could that 
designation be eliminated from other rules? If so, which rules?

B. Recognition Criteria

    Since the Commission adopted the NRSRO designation, Commission 
staff has developed a number of criteria for assessing the credit 
rating agencies whose ratings can be used for regulatory purposes. 
Before recognizing a credit rating agency as an NRSRO, the Commission 
staff first determines that the rating agency satisfies certain 
established criteria. The single most important criterion is that the 
rating agency is widely accepted in the U.S. as an issuer of credible 
and reliable ratings by the predominant users of securities ratings. 
The staff also reviews the operational capability and reliability of 
the rating agency, including: (1) The organizational structure of the 
rating agency; (2) the rating agency's financial resources (to 
determine, among other things, whether it is able to operate 
independently of economic pressures or control from the companies it 
rates); (3) the size and experience and training of the rating agency's 
staff (to determine if the entity is capable of thoroughly and 
competently evaluating an issuer's credit); (4) the rating agency's 
independence from the companies it rates; (5) the rating agency's 
rating procedures (to determine whether it has systematic procedures 
designed to produce credible and reliable ratings); and (6) whether the 
rating agency has internal procedures to prevent the misuse of non-
public information and to minimize possible conflicts of interest, and 
whether those procedures are followed. These criteria are intended to 
reflect the view of the marketplace as to the credibility of the credit 
rating agency, and were developed, in part, after evaluating public 
comments received by the Commission on the NRSRO designation.
    While some commenters believe that the current NRSRO recognition 
criteria are appropriate given the objectives of the NRSRO designation, 
others have commented that the criteria impose barriers to entry into 
the business of acting as a credit rating agency. Commenters have also 
indicated that the current NRSRO recognition process is not 
sufficiently transparent.
    In addition, in light of recent corporate failures, some have 
criticized the performance of the credit rating agencies. Concerns also 
have been raised regarding the training and qualifications of credit 
rating agency analysts.
    If the Commission retains the NRSRO designation, the Commission 
could seek to improve the transparency of the NRSRO recognition process 
by developing the following approach:
    [sbull] The Commission could specify in more detail the types of 
information applicants need to provide to demonstrate, and that could 
be reviewed in evaluating, satisfaction of the various NRSRO criteria. 
For example, in reviewing the general acceptance of a rating agency as 
an issuer of credible and reliable ratings, the Commission could 
clarify that the review would consider evidence such as: (1) 
Attestations from authorized officers of users of securities ratings 
representing a substantial percentage of the relevant market that the 
applicant's ratings are credible and actually relied on by the user; 
(2) interviews with representatives of such users regarding the same; 
and (3) statistical data demonstrating market reliance on the 
applicant's ratings (e.g., market movements in response to the 
applicant's rating changes).
    [sbull] A rating agency that confines its activity to a limited 
sector of the debt market could be recognized as an NRSRO. The 
appropriateness of recognizing as an NRSRO a rating agency that 
confines its activity to a limited, or largely non-U.S., geographic 
area also could be considered.
    [sbull] Recognition of NRSROs could occur through Commission action 
(rather than through staff no-action letters).
    [sbull] Applications for NRSRO recognition could be publicized by 
the Commission, and public comment sought on the credibility and 
reliability of the applicant's ratings.
    [sbull] The Commission could develop supplemental criteria that 
would be used to evaluate ratings quality applicable to both rating 
agencies performing traditional fundamental credit analysis and those 
primarily reliant on statistical models.
    [sbull] A rating agency could be required to follow generally 
accepted industry standards of diligence, to be developed in 
consultation with a broad-based committee of market participants, in 
performing its ratings analysis.
    [sbull] The Commission could establish a time period (e.g., 90 days 
from receipt of all required information) to serve as a goal for action 
on NRSRO applications.
    To assist the Commission in determining whether to modify the 
criteria currently used to recognize NRSROs (assuming the Commission 
continues to utilize the NRSRO concept), we seek commenters' views in 
response to the following questions:
Existing Substantive Criteria
    Question 11: Are the criteria currently used by Commission staff to 
determine whether a credit rating agency qualifies as an NRSRO 
appropriate? If not, what are the appropriate criteria? How should a 
determination be made as to whether a credit rating agency has met each 
criterion?
    Question 12: Is it appropriate to condition NRSRO recognition on a 
rating agency being widely accepted as an issuer of credible and 
reliable ratings by the predominant users of securities ratings in the 
United States (e.g., underwriters, dealers, banks, insurance companies, 
mutual funds, issuers)? Would this general acceptance be verifiable 
through the examples set forth above (e.g., requiring verification 
through attestations from, and interviews with, authorized officers of

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users of securities ratings, as well as using statistical data to 
demonstrate market reliance on an applicant's ratings)? As a more 
objective way of evidencing market reliance and credibility, should 
NRSRO recognition be conditioned on a credit rating agency documenting 
that it has been retained to rate securities issued by a broad group of 
well-capitalized firms?
    Question 13: Should the Commission condition NRSRO recognition on a 
rating agency developing and implementing procedures reasonably 
designed to ensure credible, reliable, and current ratings? At a 
minimum, should each NRSRO have rating procedures designed to ensure 
that a similar analysis is conducted for similarly situated issuers and 
that current information is used in the rating agency's analysis? What 
minimum standards should the Commission use to determine whether the 
agency's ratings are current? Should each NRSRO use uniform rating 
symbols, as a means of reducing the risk of marketplace confusion? When 
reviewing a rating agency's procedures for obtaining information on 
which to base a rating action, should the Commission establish minimum 
due diligence requirements for rating agencies? How could these minimum 
requirements be developed? By the Commission? By the industry, with 
Commission oversight?
    Question 14: Should the extent of contacts with the management of 
issuers (including access to senior level management of issuers) be a 
criterion used to determine NRSRO status? Should the Commission limit 
the credit ratings that can be used for regulatory purposes to credit 
ratings that include access to senior management of an issuer? If so, 
why?
    Question 15: To the extent a credit rating agency uses computerized 
statistical models, what factors should be used to review the models? 
Could a credit rating agency that solely uses a computerized 
statistical model and no other qualitative inputs qualify as an NRSRO?
    Question 16: Should the size and quality of the credit rating 
agency's staff be considered when determining NRSRO status? Should the 
Commission condition NRSRO recognition on a rating agency adopting 
minimum standards for the training and qualifications of its credit 
analysts? If so, what entity should be responsible for oversight of 
qualifications and training? How could the Commission verify whether a 
member of a rating agency's staff is or was previously subject to 
disciplinary action by a financial (or other) regulatory authority?
    Question 17: Should the Commission condition NRSRO recognition on 
an entity's meeting standards for a minimum number of rating analysts 
or a maximum average number of issues covered per analyst? For example, 
should the Commission question whether a single analyst can credibly 
and reliably issue and keep current credit ratings on securities issued 
by hundreds of different issuers? Or would this level of scrutiny 
involve the Commission too deeply in the business practices of rating 
agencies?
    Question 18: Is a credit rating agency's organizational structure 
an appropriate factor to consider when evaluating a request for NRSRO 
status? Should the agency that seeks recognition consent to limiting 
its business to issuing credit ratings or could it conduct other 
activities, such as rating advisory services?
    Question 19: Should the Commission consider a credit rating 
agency's financial resources as a factor in determining NRSRO status? 
If so, how? Should NRSRO recognition be conditioned on a rating agency 
meeting minimum capital or revenue requirements?
Other Factors To Be Considered
    Question 20: Should a rating agency that confines its activity to a 
limited sector of the debt market be considered for NRSRO recognition? 
Should a rating agency that confines its activity to a limited (or 
largely non-U.S.) geographic area also be considered?
    Question 21: Should the Commission consider a provisional NRSRO 
status for rating agencies that comply with NRSRO recognition criteria 
but lack national recognition?
    Question 22: Should the Commission develop supplemental criteria to 
evaluate ratings quality that would be applicable to both rating 
agencies performing traditional fundamental credit analysis and those 
primarily reliant on statistical models?
    Question 23: Should the Commission consider other criteria in 
making the NRSRO determination, such as the existence of effective 
procedures reasonably designed to prevent conflicts of interest and 
alleged anticompetitive, abusive, and unfair practices, and improve 
information flow surrounding the ratings process?\11\
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    \11\ See sections D, E, and F infra for additional discussion of 
these issues.
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    Question 24: Should the Commission expect NRSROs to follow 
generally accepted industry standards of diligence? If so, should the 
Commission encourage the establishment of a committee of market 
participants to develop those standards? Or should they be devised 
through other means?
Recognition Process
    Question 25: Should recognition of NRSROs occur through Commission 
action (rather than through staff no-action letters)? Should the 
Commission establish an appeal process if the staff remains responsible 
for the recognition of NRSROs?
    Question 26: Should the Commission publicize applications for NRSRO 
recognition, and seek public comment on the credibility and reliability 
of the applicant's ratings?
    Question 27: Should the Commission establish a time period to serve 
as a goal for action on applications for NRSRO recognition? If so, 
would an appropriate time period be 90 days after all required 
information has been received, or a shorter or longer period?

C. Examination and Oversight of NRSROs

    Each of the current NRSROs is registered as an investment adviser 
under the Investment Advisers Act of 1940 (``Advisers Act''). The 
Commission's 1997 NRSRO rule proposal would have required this 
registration. Commenters disagree on whether NRSROs should or could be 
subject to this amount of regulatory oversight, or even greater 
regulatory oversight. Some indicate that greater regulation is 
essential given the importance of their credit ratings to investors, 
and the influence such ratings can have on the securities markets. 
Others question the authority and the feasibility of the Commission to 
impose greater oversight. Some also question whether additional 
regulatory oversight--particularly the burdens associated with the 
possibility of a regulatory assessment of the quality of ratings 
analysis--is justified in light of the performance of credit rating 
agencies over the past decades.
    Assuming the Commission can and should increase its ongoing 
oversight of NRSROs, the Commission could develop the following 
approach:
    [sbull] The Commission could condition NRSRO recognition on a 
rating agency's agreeing to file annual certifications with the 
Commission that it continues to comply with all of the NRSRO criteria.
    [sbull] The Commission also could solicit public comment annually 
on the performance of each NRSRO, including whether the NRSRO's ratings 
continue to be viewed as credible and reliable.
    [sbull] The Commission could condition NRSRO recognition on a 
rating agency's

[[Page 35262]]

agreeing to maintain specified records relating to its ratings 
business, including those relating to ratings decisions.
    [sbull] The Commission could condition NRSRO recognition on a 
rating agency's agreeing to submit to regular Commission inspections 
and examinations to determine compliance with the appropriate 
regulatory regime for NRSROs.
    [sbull] The Commission could condition NRSRO recognition on a 
rating agency's agreeing to provide Commission staff with access to all 
personnel and books and records.
    [sbull] The Commission could condition NRSRO recognition on a 
rating agency's agreeing to cooperate with the Commission in relevant 
investigations, including providing access to records and personnel.
    To seek commenters' views on whether credit rating agencies should 
be subject to ongoing oversight, the Commission requests responses to 
the following questions:
    Question 28: Should NRSRO recognition be conditioned on an NRSRO's 
meeting the original qualification criteria on a continuing basis? If 
so, should a failure to meet the original qualification criteria lead 
to revocation of NRSRO recognition? Should some other standard of 
revocation apply?
    Question 29: What would be the appropriate frequency and intensity 
of any ongoing Commission review of an NRSRO's continuing compliance 
with the original qualification criteria?
    Question 30: Should NRSRO recognition be conditioned on a rating 
agency's filing annual certifications with the Commission that it 
continues to comply with all of the NRSRO criteria?
    Question 31: Should the Commission solicit public comment on the 
performance of each NRSRO, including whether the NRSRO's ratings 
continue to be viewed as credible and reliable? If so, how frequently 
should public comment be solicited (e.g., annually)?
    Question 32: Should NRSROs be subject to greater regulatory 
oversight? If so, what form should this additional oversight take? If 
necessary, should the Commission seek additional jurisdictional 
authority from Congress?
    Question 33: Should NRSRO recognition be conditioned on a rating 
agency's registering as an investment adviser under the Advisers Act? 
If so, how should the various sections of the Advisers Act apply to 
NRSROs? Could the Advisers Act rules be amended to make them more 
relevant to the businesses of NRSROs? Alternatively, would it be more 
appropriate for the Commission to adopt a separate registration and 
regulatory regime for NRSROs?
    Question 34: Should NRSRO recognition be conditioned on 
recordkeeping requirements specifically tailored to the ratings 
business? Should NRSRO recognition be conditioned on a rating agency's 
maintaining records relating to the ratings business, including those 
relating to rating decisions?
    Question 35: Are there minimum standards or best practices to which 
NRSROs should adhere? If so, how should these be established? By the 
Commission? By the industry, with Commission oversight? Should they be 
incorporated into the conditions for NRSRO recognition? Would it, or 
would it not, be a productive use of Commission resources to develop 
the expertise to review, e.g., issues related to the quality and 
diligence of the ratings analysis?
    Question 36: If a currently recognized NRSRO gave up its NRSRO 
recognition because of concerns regarding the regulatory and liability 
environment, what effect, if any, would that action have on the market?

D. Conflicts of Interest

    Conflicts of interest may arise in several areas within a credit 
rating agency. As registered investment advisers, the current NRSROs 
have a legal obligation to avoid conflicts of interest or disclose them 
fully to subscribers. Reliance by credit rating agencies on issuer fees 
could lead to a conflict of interest and the potential for rating 
inflation. While many commenters believe that NRSROs have effectively 
managed this conflict, they stress the importance of NRSROs 
implementing stringent firewalls, independent compensation, and other 
related procedures. The NRSROs have represented that they have 
implemented a number of policies and procedures designed to assure the 
independence and objectivity of the ratings process, such as requiring 
ratings decisions to be made by a ratings committee, imposing 
investment restrictions, and adhering to fixed fee schedules. In 
addition, they assert that rating analyst compensation is merit-based 
(e.g., based on the demonstrated reliability of their ratings), and is 
not dependent on the level of fees paid by issuers the analyst rates. 
Further, the NRSROs take the position that their reputation for issuing 
objective and credible ratings is of paramount importance and that they 
would not jeopardize their reputation by attempting to appease an 
issuer.
    Some also believe that conflicts of interest can arise when credit 
rating agencies offer consulting or other advisory services to the 
entities they rate. The NRSROs generally represent that they have 
established extensive guidelines to manage conflicts in this area, 
including firewalls to separate their ratings services from other 
ancillary businesses. They also indicate that advisory services 
presently represent a very small portion of their total revenues. 
Commenters have also expressed concern that conflicts in this area 
could become much greater if these ancillary services were to become a 
substantial portion of an NRSRO's business, and suggestions were made 
that their percentage contribution to the total revenues of an NRSRO be 
capped. Others were concerned that issuers could be unduly pressured to 
purchase advisory services, particularly in cases where they were 
solicited by a rating analyst at an NRSRO.
    Finally, some have expressed concern that subscribers, as a 
practical matter, have preferential access to rating analysts and, as a 
result, inappropriately may learn of potential rating actions or other 
nonpublic information.
    To manage these potential conflicts of interest, the Commission 
could develop the following approach:
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
developing and implementing procedures to address issuer influence 
(e.g., prohibiting ratings employees from participating in the 
solicitation of new business or fee negotiations, and basing their 
compensation on factors other than business maintenance or 
development).
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
developing and implementing procedures to address subscriber influence 
(e.g., restricting private contacts between ratings employees and 
subscribers, to help prevent intentional or inadvertent disclosure of 
confidential issuer information and information regarding forthcoming 
rating changes).
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
developing and implementing procedures to address issues regarding 
ancillary fee-based services (e.g., establishing strict firewalls 
between ratings employees and ancillary business development, and 
prohibiting compensation of ratings employees from being impacted by 
revenues from these services).
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
having adequate financial resources (e.g., net assets of at least 
$100,000, or annual gross revenues of at least $1,000,000) to

[[Page 35263]]

reduce dependence on individual issuers or subscribers.
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
deriving less than a certain percentage of its revenues (e.g., 3%) from 
a single source to help assure that the NRSRO operates independently of 
economic pressures from individual customers.
    To address the concerns raised with regard to conflicts of 
interest, the Commission requests commenters' views in response to the 
following questions:
    Question 37: Should the Commission condition NRSRO recognition on 
an NRSRO's agreeing to document its procedures that address potential 
conflicts of interest in its business including, but not limited to, 
potential issuer and subscriber influence? If so, what other potential 
conflicts should these procedures address?
    Question 38: To what extent could concerns regarding potential 
conflicts of interest be addressed through the disclosure of existing 
and potential conflicts of interest when an NRSRO publishes ratings?
    Question 39: Should NRSRO recognition be conditioned on an NRSRO 
prohibiting employees involved in the ratings process (e.g., rating 
analysts and rating committee members) from participating in the 
solicitation of new business and from fee negotiations? Would 
conditioning NRSRO recognition on a rating agency's establishing strict 
firewalls between employees in these areas and credit analysts address 
potential conflicts? Should the Commission also address the credit 
analyst compensation structure to minimize potential conflicts of 
interest?
    Question 40: Should NRSRO recognition be conditioned on an 
agreement by a rating agency not to offer consulting or other advisory 
services to entities it rates? Could concerns regarding conflicts of 
interest be addressed by limiting or restricting consulting or advisory 
services offered by rating agencies?
    Question 41: Should NRSRO recognition be conditioned on a 
prohibition on credit rating analysts employed by NRSROs from 
discussing rating actions with subscribers? If not prohibited, should 
the Commission adopt limits on contacts between analysts and 
subscribers? Or are existing remedies--antifraud, contractual, or 
otherwise--sufficient to deter inappropriate disclosures to 
subscribers?
    Question 42: Should NRSRO recognition be conditioned on a rating 
agency having adequate financial resources (e.g., net assets of at 
least $100,000, or annual gross revenues of at least $1,000,000) to 
reduce dependence on individual issuers or subscribers?
    Question 43: Should NRSRO recognition be conditioned on a rating 
agency not deriving more than a certain percentage of its revenues 
(e.g., 3%) from a single source to help assure that the NRSRO operates 
independently of economic pressures from individual customers?
    Question 44: Are there other ways to address potential conflicts of 
interest in the credit rating business or to minimize their 
consequences?

E. Alleged Anticompetitive, Abusive, and Unfair Practices

    Some have alleged that certain of the larger credit rating agencies 
abused their dominant market position by engaging in certain aggressive 
competitive practices. Fitch complained that S&P and Moody's were 
attempting to squeeze it out of certain structured finance markets by 
engaging in the practice of ``notching''--lowering their ratings on, or 
refusing to rate, securities issued by certain asset pools (e.g., 
collateralized debt obligations), unless a substantial portion of the 
assets within those pools were also rated by them.
    With respect to unsolicited ratings, some commenters have 
questioned the appropriateness of a rating agency's attempting to 
induce an issuer to pay for a rating the issuer did not request (e.g., 
sending a bill for an unsolicited rating, or sending a fee schedule and 
``encouraging'' payment).
    To address these issues, the Commission could develop the following 
approach:
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
implementing adequate procedures to prevent anticompetitive and other 
unfair practices, including prohibitions on: (1) Requiring a ratings 
client to purchase an ancillary service as a precondition for 
performance of the ratings service and, perhaps, other anticompetitive 
practices (even those that would not violate the antitrust laws); and 
(2) engaging in specified ``strong-arm'' tactics with respect to 
unsolicited ratings.
    The Commission invites commenters' views concerning the existence 
of these practices and requests commenters' views on the following 
questions:
    Question 45: Should the Commission identify specific anti-
competitive practices that NRSROs would agree to prohibit as a 
condition to NRSRO recognition? If so, what are those practices?
    Question 46: Would it be sufficient to condition NRSRO recognition 
on the adoption of procedures intended to prevent anticompetitive, 
abusive, and unfair practices from occurring?
    Question 47: Should NRSRO recognition specifically be conditioned 
on an NRSRO's agreeing to forbear from requiring issuers to purchase 
ancillary services as a precondition for performance of the ratings 
service?
    Question 48: Should NRSRO recognition specifically be conditioned 
on an NRSRO's not engaging in specified practices with respect to 
unsolicited ratings (e.g., sending a bill for an unsolicited rating, 
sending a fee schedule and ``encouraging'' payment, indicating a rating 
might be improved with the cooperation of the issuer)?

F. Information Flow

    Several commenters have stressed the importance of transparency in 
the ratings process. Among other things, they assert that fluctuations 
in security prices in response to rating actions could often be less 
pronounced if credit rating agencies disclosed more information about 
the assumptions underlying their ratings (e.g., specific events that 
might prompt a rating change), as well as the information and documents 
reviewed by them in reaching a ratings decision (e.g., whether the 
issuer participated in the rating process).
    To address issues that have been raised with regard to information 
flow from credit rating agencies, the Commission could develop the 
following approach:
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
implementing procedures to assure appropriate disclosure of key 
information about its ratings and rating processes, including: (1) 
Widespread public dissemination of its ratings; (2) identifying an 
unsolicited rating as such; (3) annual disclosure of specified ratings 
performance information; and (4) public disclosure of the key bases of, 
and assumptions underlying, the ratings decision (pursuant to generally 
accepted industry standards to be developed by a broad-based committee 
of market participants).
    [sbull] NRSRO recognition could be conditioned on a rating agency's 
implementing procedures to assure appropriate public notification when 
it ceases rating/following an issuer.
    To explore ways to improve the quality of information available to 
users of credit ratings, the Commission requests commenters' views on 
the following questions:
    Question 49: Should the Commission address concerns about 
information flow from rating agencies? If so, should

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the Commission condition NRSRO recognition on a rating agency's 
agreeing to establish procedures to assure certain disclosures relating 
to its ratings business, such as those described above? Are there other 
disclosures that could be appropriate?
    Question 50: Specifically, should NRSRO recognition be conditioned 
on a rating agency disclosing the key bases of, and assumptions 
underlying its rating decisions? If so, should these disclosures be 
made pursuant to standards developed by the industry, or otherwise?
    Question 51: Would it be advisable for the Commission to condition 
NRSRO recognition on a rating agency's agreeing to disclose performance 
information periodically? If so, what type of performance information 
would be most useful? How often should it be disclosed?
    Question 52: Should NRSRO recognition be conditioned on a rating 
agency's disclosing whether or not an issuer participated in the rating 
process? Or, could issuers be required to make such disclosures?
    Question 53: Concerns have been raised that certain credit rating 
agencies make their credit ratings available only to paid subscribers, 
and that it would be inappropriate to require users of credit ratings 
to subscribe for a fee to an NRSRO's services to obtain credit ratings 
for regulatory purposes. What steps, if any, should the Commission take 
to address these concerns? For example, should NRSRO recognition be 
conditioned on a rating agency's agreeing to public dissemination of 
its ratings on a widespread basis at no cost, as is currently the case?
    Question 54: Should NRSRO recognition be conditioned on a rating 
agency's implementing procedures to assure public notification when it 
ceases rating/following an issuer. If so, what form of public 
notification would be appropriate?

G. Other

    During the Commission's review of credit rating agencies, certain 
issues were raised that do not directly relate to the topics discussed 
above, but on which the Commission is interested in receiving comment. 
First, the Commission is interested in exploring whether there are 
types of information that, if disclosed by an issuer, or disclosed in a 
more meaningful way, would be useful to rating agencies in making their 
credit assessments. In addition, concerns were raised that a ``ratings 
cliff'' exists in the commercial paper market, such that a slight 
downgrade of an issuer's commercial paper rating can dramatically 
restrict its access to the U.S. money markets.
    In this regard, the Commission solicits commenters' answers to the 
following questions:
    Question 55: What steps, if any, can the Commission take to improve 
the extent and quality of disclosure by issuers to rating agencies or 
to the public generally, and in particular, regarding: (a) Ratings 
triggers in financial covenants tied to downgrades; (b) conditional 
elements of material financial contracts; (c) short-term credit 
facilities; (d) special purpose entities; and (e) material future 
liabilities.
    Question 56: Is it appropriate for the Commission to take steps to 
minimize the ratings ``cliff'' that has been represented to be 
particularly pronounced in the commercial paper market? If so, what 
steps should the Commission take?

III. Solicitation of Additional Comments

    In addition to the areas for comment identified above, we are 
interested in any other issues that commenters may wish to address 
relating to credit rating agencies. Please be as specific as possible 
in your discussion and analysis of any additional issues.

    By the Commission.

    Dated: June 4, 2003.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-14867 Filed 6-11-03; 8:45 am]
BILLING CODE 8010-01-P